UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2005
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-25675
PATRON SYSTEMS, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-3055158
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
500 N. MICHIGAN AVE, SUITE 300
CHICAGO, IL 60611
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(312) 396-4031
(ISSUER'S TELEPHONE NUMBER)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |_| No |X|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [_] No [X]
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 60,427,299 shares of common stock
outstanding as of November 11, 2005.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
------------------------------ ----
ITEM 1. FINANCIAL STATEMENTS...................................................3
Condensed Consolidated Balance Sheet at September 30, 2005 (unaudited).........3
Condensed Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2005 and
2004 (unaudited)......................................................4
Condensed Consolidated Statement of Stockholders' (Deficiency)
Equity for the Nine Months Ended September 30, 2005 (unaudited).......5
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2005 and 2004 (unaudited).............6
Notes to Condensed Consolidated Financial Statements (unaudited)...............7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...................................32
ITEM 3. CONTROLS AND PROCEDURES...............................................44
PART II - OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS.....................................................47
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS...........47
ITEM 6. EXHIBITS..............................................................48
SIGNATURES....................................................................49
FORWARD LOOKING STATEMENTS
The following discussion and explanations should be read in conjunction with the
financial statements and related notes contained elsewhere in this Form 10-QSB.
Certain statements made in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements can be identified by terminology such as "may",
"will", "should", "expects", "intends", "anticipates", "believes", "estimates",
"predicts", or "continue" or the negative of these terms or other comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these forward-looking statements. Although
Patron Systems believes that expectations reflected in the forward-looking
statements are reasonable, it cannot guarantee future results, performance or
achievements. Moreover, neither Patron Systems nor any other person assumes
responsibility for the accuracy and completeness of these forward-looking
statements. Patron Systems is under no duty to update any forward-looking
statements after the date of this report to conform such statements to actual
results.
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
SEPTEMBER 30,
2005
------------
ASSETS
Current Assets:
Cash ...................................................... $ 80,233
Restricted cash ........................................... 517,003
Accounts receivable, net .................................. 174,110
Other current assets ...................................... 186,447
------------
Total current assets ................................... 957,793
Property and equipment, net ................................. 160,012
Deferred financing costs .................................... 3,000
Intangible assets, net ...................................... 2,851,064
Goodwill .................................................... 22,413,300
------------
Total assets ........................................... $ 26,385,169
============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current Liabilities
Accounts payable .......................................... $ 1,505,808
Accrued payroll and related expenses ...................... 1,095,191
Accrued interest .......................................... 999,880
Consulting agreement payable .............................. 100,000
Demand notes payable ...................................... 1,007,556
Bridge notes payable ...................................... 9,443,013
Acquisition notes payable ................................. 4,500,000
Notes payable (to creditors of acquired business,
including $1,655,548 to related parties) ................ 2,588,000
Expense reimbursements due to officers and
stockholders ............................................ 243,340
Notes payable to officers and stockholders ................ 284,212
Other current liabilities ................................. 977,555
Amounts due under settlement with former officer .......... 982,123
Deferred revenue .......................................... 265,018
------------
Total current liabilities .............................. 23,991,696
Note payable - stock repurchase obligation due to
former officer ........................................... 1,738,667
------------
Total liabilities ...................................... 25,730,363
------------
Common stock subject to put right (2,000,000 shares) ........ 1,000,000
------------
Stockholders' Deficiency
Preferred stock, par value $0.01 per share,
75,000,000 shares authorized, none issued
and outstanding ......................................... --
Common stock, par value $0.01 per share,
150,000,000 shares authorized, 50,219,867
shares issued and outstanding as of September
30, 2005 (net of 2,000,000 shares subject to
put right) .............................................. 502,199
Additional paid-in capital ................................ 56,996,739
Common stock to be issued (8,409,080 shares) .............. 3,558,016
Common stock repurchase obligation ........................ (1,300,000)
Deferred compensation ..................................... (250,250)
Accumulated deficit ....................................... (59,851,898)
------------
Total stockholders' deficiency ......................... (345,194)
------------
Total liabilities and stockholders' deficiency ......... $ 26,385,169
============
See notes to condensed consolidated financial statements.
3
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
(Development (Development
Stage) Stage)
Revenue ................................ $ 339,212 $ -- $ 152,941 $ --
------------ ------------ ------------ ------------
Cost of Sales
Cost of products/services ............ 203,934 -- 116,757 --
Amortization of technology ........... 272,792 -- 133,124 --
------------ ------------ ------------ ------------
Total cost of sales ................ 476,726 -- 249,881 --
------------ ------------ ------------ ------------
Gross loss ........................... (137,514) -- (96,940) --
------------ ------------ ------------ ------------
Operating Expenses
Salaries and related expenses ........ 3,314,154 620,233 1,399,189 479,745
Consulting expense ................... 1,239,083 477,817 286,208 318,692
Professional fees .................... 986,405 283,489 279,272 146,701
General and administrative ........... 888,608 414,192 545,540 89,013
Amortization of intangibles .......... 69,691 -- 30,814 --
Stock based penalties under
accomodation agreements ........... 823,747 1,040,400 134,645 445,200
Assessment fee ....................... 370,000 -- -- --
Loss on collateralized financing
arrangement ....................... 366,193 -- -- --
Change in intrinsic value of common
stock put right ................... (300,000) -- (300,000)
Loss/(gain) associated with settlement
agreements ........................ (343,571) 438,667 45,532 --
------------ ------------ ------------ ------------
Total operating expenses .......... 7,414,310 3,274,798 2,421,200 1,479,351
Loss from operations ................... (7,551,824) (3,274,798) (2,518,140) (1,479,351)
Other Income (Expense)
Interest income ...................... 19,250 57,750 -- 19,250
Loss on sale of property and equipment (544) -- (544) --
Interest expense ..................... (12,376,904) (99,263) (10,159,038) (33,087)
------------ ------------ ------------ ------------
Total Other Expense .................... (12,358,198) (41,513) (10,159,582) (13,837)
------------ ------------ ------------ ------------
Loss before income taxes ............... (19,910,022) (3,316,311) (12,677,722) (1,493,188)
Income taxes ......................... -- -- -- --
------------ ------------ ------------ ------------
Net loss ............................... $(19,910,022) (3,316,311) $(12,677,722) (1,493,188)
============ ============ ============ ============
Net Loss Per Share - Basic and Diluted . $ (0.35) $ (0.09) $ (0.21) $ (0.04)
============ ============ ============ ============
Weighted Average Number of Shares
Outstanding
- Basic and diluted ................. 57,284,490 38,610,646 61,499,103 39,010,560
============ ============ ============ ============
See notes to condensed consolidated financial statements.
4
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIENCY (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005
ADDITIONAL SHARES OF VALUE OF COMMON STOCK
SHARES OF PAR VALUE PAID IN COMMON STOCK COMMON STOCK REPURCHASE
COMMON STOCK COMMON STOCK CAPITAL TO BE ISSUED TO BE ISSUED OBLIGATION
------------ ------------ ------------ ------------ ------------ ------------
Balance, January 1, 2005
(development stage) ................ 37,006,212 $ 370,062 $ 28,973,711 5,951,648 $ 4,671,400 $ (1,300,000)
Common stock issued in purchase
business combinations
Complete Security Solutions, Inc. .. -- -- 6,300,000 7,500,000 75,000 --
LucidLine, Inc. .................... -- -- 3,696,000 4,400,000 44,000 --
Entelagent Software Corporation .... -- -- 2,520,000 3,000,000 30,000 --
Amortization of deferred stock-based
compensation ....................... -- -- -- -- -- --
Issuance of warrants and bridge
notes to investors 1/1/05
through 3/31/05 .................... -- -- 1,043,860 -- -- --
Issuance of warrants issued as
purchase consideration ............. -- -- 1,912,500 -- -- --
Issuance of warrants to
transaction advisors ............... -- -- 255,000 -- -- --
Issuance of warrants to placement
agent - Interim Bridge Financing I . -- -- 297,500 -- -- --
Common stock to be issued under
accommodation agreement as a penalty -- -- -- 1,350,000 745,501 --
Common stock issued under
collateralized financing arrangement 890,500 8,905 397,300 -- -- --
Common stock to be issued under
collateralized financing
arrangement as a penalty ........... -- -- -- 130,587 78,247 --
Common stock issued in lieu of cash .. 1,000,000 10,000 939,000 (1,000,000) (949,000) --
Common stock issued in purchase
business combinations .............. 11,323,155 113,232 -- (11,323,155) (113,232) --
Recission of common stock to be
issued under consulting agreement
payable ............................ -- -- -- (100,000) (78,900) --
Issuance of warrants to Bridge
Note II investors .................. -- -- 532,723 -- -- --
Issuance of warrants to placement
agent - Interim Bridge Financing II -- -- 80,867 -- -- --
Issuance of warrants in connection
with bridge loan extension -
extension warrants ................. -- -- 822,500 -- -- --
Issuance of stock options to Chief
Executive Officer .................. -- -- 30,000 -- -- --
Issuance of warrants to Bridge Note
III investors ...................... -- -- 550,778 -- -- --
Adjustment to shares issuable under
compensation arrangement ........... -- -- 945,000 (1,500,000) (945,000) --
Reduction of intrinsic value of
put right .......................... -- -- (300,000) -- -- --
Conversion option in connection with
Interim Bridge Financing I ......... -- -- 3,500,000 -- -- --
Conversion option in connection with
Subordinated Notes ................. -- -- 4,500,000 -- -- --
Net Loss ............................. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 2005 .......... 50,219,867 $ 502,199 $ 56,996,739 8,409,080 $ 3,558,016 $ (1,300,000)
============ ============ ============ ============ ============ ============
DEFERRED ACCUMULATED
COMPENSATION DEFICIT TOTAL
------------ ------------ ------------
Balance, January 1, 2005
(development stage) ................ $ (1,475,333) $(39,941,876) $ (8,702,036)
Common stock issued in purchase
business combinations
Complete Security Solutions, Inc. .. -- -- 6,375,000
LucidLine, Inc. .................... -- -- 3,740,000
Entelagent Software Corporation .... -- -- 2,550,000
Amortization of deferred stock-based
compensation ....................... 1,239,083 -- 1,239,083
Issuance of warrants and bridge
notes to investors 1/1/05
through 3/31/05 .................... -- -- 1,043,860
Issuance of warrants issued as
purchase consideration ............. -- -- 1,912,500
Issuance of warrants to
transaction advisors ............... -- -- 255,000
Issuance of warrants to placement
agent - Interim Bridge Financing I . -- -- 297,500
Common stock to be issued under
accommodation agreement as a penalty -- -- 745,501
Common stock issued under
collateralized financing arrangement -- -- 406,205
Common stock to be issued under
collateralized financing
arrangement as a penalty ........... -- -- 78,247
Common stock issued in lieu of cash .. -- -- --
Common stock issued in purchase
business combinations .............. -- -- --
Recission of common stock to be
issued under consulting agreement
payable ............................ -- -- (78,900)
Issuance of warrants to Bridge
Note II investors .................. -- -- 532,723
Issuance of warrants to placement
agent - Interim Bridge Financing II -- -- 80,867
Issuance of warrants in connection
with bridge loan extension -
extension warrants ................. -- -- 822,500
Issuance of stock options to Chief
Executive Officer .................. (14,000) -- 16,000
Issuance of warrants to Bridge Note
III investors ...................... -- -- 550,778
Adjustment to shares issuable under
compensation arrangement ........... -- -- --
Reduction of intrinsic value of
put right .......................... -- -- (300,000)
Conversion option in connection with
Interim Bridge Financing I ......... -- -- 3,500,000
Conversion option in connection with
Subordinated Notes ................. -- -- 4,500,000
Net Loss ............................. -- (19,910,022) (19,910,022)
------------ ------------ ------------
BALANCE, SEPTEMBER 30, 2005 .......... $ (250,250) $(59,851,898) $ (345,194)
============ ============ ============
See notes to condensed consolidated financial statements.
5
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
SEPTEMBER 30,
----------------------------
2005 2004
------------ ------------
Cash Flows from Operating Activities
Net loss ........................................................ $(19,910,022) $ (3,316,311)
============ ============
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization ................................ 382,872 --
Amortization of deferred compensation ........................ 1,239,083 --
Accretion related to warrants issued for notes payable ....... 1,927,374 --
Amortization of deferred financing costs ..................... 1,825,606 --
Common stock issued in lieu of cash for services ............. -- 477,817
Stock based penalty on accomodation agreement ................ 823,747 1,040,400
Stock options issued to chief executive officer .............. 16,000 --
Penalty warrants issued to bridge note holders ............... 8,000,000 --
Reduction in intrinsic value of put right .................... (300,000) --
Gain on settlement of consulting agreement payable ........... (228,900) --
Loss on collateralized financing arrangement ................. 366,194 --
Gain on legal settlement ..................................... (389,103) --
Loss associated with settlement agreement .................... -- 438,667
Non-cash increase in notes payable to former officer ......... 17,399 --
Non-cash interest income ..................................... (19,250) (57,750)
Changes in assets and liabilities:
Restriced cash escrowed to settle liabilities assumed ...... (517,003) --
Prepaid expenses ......................................... 51,487 (27,359)
Accounts receivable ...................................... (38,465) --
Other current assets ..................................... (93,858) --
Accounts payable ......................................... (284,594) (6,311)
Accrued interest ......................................... 12,202 99,263
Deferred revenue ......................................... 65,267 --
Expense reimbursements due to officers and shareholders .. (30,521) --
Accrued payroll and payroll related expenses ............. (1,043,209) 179,653
Other current liabilities ................................ 399,155 --
Consulting agreements payable ............................ (50,000) 300,000
Loss on sale of property and equipment ................... 544 --
Other accrued expenses ................................... (3,413) --
------------ ------------
Total adjustments ............................................ 12,128,614 2,444,380
------------ ------------
NET CASH USED IN OPERATING ACTIVITIES ............................. (7,781,408) (871,931)
============ ============
CASH FLOWS USED IN INVESTING ACTIVITIES
Advances to prospective acquiree businesses ..................... -- (20,000)
Cash payments in purchase business combinations ................. (857,633) --
Cash acquired in purchase business combinations ................. 416,397 --
Acquisition of intellectual property ............................ (92,547) --
Proceeds from sale of property and equipment .................... 1,500 --
Purchase of fixed assets ........................................ (67,445) --
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES ............................. (599,728) (20,000)
============ ============
CASH FLOWS FROM FINANCING ACTIVITIES
Expenses financed by (repaid to) officers and stockholders ...... (273,223) 151,842
Advances from stockholders ...................................... -- (8,169)
Advances from prospective acquiree business ..................... -- 135,500
Deferred financing costs ........................................ (621,739) --
Repayments of amounts due under settlement with former officer .. (200,000) --
Proceeds from issuance of bridge notes .......................... 7,100,000 --
Proceeds from issuance of common stock .......................... -- 700,000
Proceeds from issuance of notes ................................. 2,543,000 41,134
Deferred financing charges ...................................... (6,000) --
Repayments of advances from shareholders ........................ (126,570) --
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ......................... 8,415,468 1,020,307
============ ============
NET INCREASE IN CASH .............................................. 34,332 128,376
CASH, beginning of period ......................................... 45,901 22,957
============ ============
CASH, end of period ............................................... $ 80,233 $ 151,333
============ ============
Supplemental Disclosures of Cash Flow Information:
Issuance of note under stock repurchase obligation .............. $ 1,300,000 $ --
Obligation to repurchase 2,000,000 shares of common stock subject
to put right ................................................. 1,000,000 --
Cash paid during the period for:
Interest ........................................................ 527,231 301,370
Supplemental non-cash investing and financial activity:
Acquisition of businesses:
Current tangible assets acquired .............................. 300,911 --
Non-current tangible assets acquired .......................... 2,809,689 --
Current liabilities assumed with acquisitions ................. (8,403,374) --
Non-current liabilities assumed with acquisitions ............. (447,790) --
Intangible assets acquired .................................... 3,101,000 --
Goodwill recognized on purchase business combinations ......... 22,413,300 --
Non-cash consideration ...................................... (19,332,500) --
Cash acquired in purchase business combinations ............. 416,397 --
------------ ------------
Cash paid to acquire businesses ............................. 857,633 --
============ ============
See notes to condensed consolidated financial statements.
6
PATRON SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2005
NOTE A - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems, Inc. (the "Company," "Patron," "us," or "we") have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and the instructions to Form 10-QSB.
Accordingly, they do not include all the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. In the opinion of management all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position, results of operations and cash flows for all periods
presented have been made. The results of operations for the nine-month period
ended September 30, 2005 are not necessarily indicative of the operating results
that may be expected for the entire year ending December 31, 2005.
This form 10QSB should be read in conjunction with the Company's 10KSB for the
year ended December 31, 2004.
NOTE B - THE COMPANY
ORGANIZATION AND DESCRIPTION OF BUSINESS
Patron Systems, Inc., ("Systems") is a Delaware corporation formed in April 2002
to provide comprehensive, end-to-end information security solutions to global
corporations and government institutions.
Pursuant to an Amended and Restated Share Exchange Agreement dated October 11,
2002, Combined Professional Services ("CPS"), Systems and the stockholders of
Systems consummated a share exchange ("Share Exchange"). As a result of the
Share Exchange, the former stockholders of Systems became the majority
stockholders of CPS. Accordingly, Systems became the accounting acquirer of CPS
and the exchange was accounted for as a reverse merger and recapitalization of
Systems. CPS subsequently changed its name to Patron Systems, Inc. (the
"Company" or "Patron").
DEVELOPMENT STAGE OPERATIONS
In accordance with Statement of Financial Accounting Standard ("SFAS") No.7, the
Company was considered to be a development stage enterprise through December 31,
2004, as its activities principally consisted of raising capital and screening
potential acquisition candidates in the information and homeland security
segments. As described in Note E, the Company consummated acquisitions of three
businesses that have developed technologies, customer bases and are generating
revenue. Accordingly, the Company is no longer considered to be a development
stage enterprise effective for the nine months ended September 30, 2005.
NOTE C - LIQUIDITY AND FINANCIAL CONDITION
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company incurred a net loss of
$19,910,022 for the nine months ended September 30, 2005, which includes an
aggregate of $13,661,022 net of non-cash charges including the fair value of
common stock of the Company issued as penalties under certain registration
rights agreements, the fair value of common stock warrants issued as penalties
to bridge note and subordinated note holders, the conversion option cost for
bridge note and subordinated note holders, non-cash interest expense and the
amortization of deferred compensation under a stock based compensation
arrangement. The Company used net cash flows in its operating activities of
$7,781,408 during the nine months ended September 30, 2005. The Company's
working capital deficiency at September 30, 2005 amounted to $23,033,903 and the
Company is continuing to experience shortages in working capital. The Company is
also involved in substantial litigation and is being investigated by the
Securities and Exchange Commission with respect to certain of its press releases
and its use of form S-8 to register shares of common stock issued to certain
7
consultants (Note Q). The Company cannot provide any assurance that the outcome
of these matters will not have a material adverse affect on its ability to
sustain the business. These matters raise substantial doubt about the Company's
ability to continue as a going concern. The accompanying financial statements do
not include any adjustments that may result from the outcome of this
uncertainty.
The Company expects to continue incurring losses for the foreseeable future due
to the inherent uncertainty that is related to establishing the commercial
feasibility of technological products and developing a presence in new markets.
The Company's ability to successfully integrate the acquired businesses
described in Note E is critical to the realization of its business plan. The
Company raised $9,643,000 of gross proceeds ($9,015,261 net proceeds after the
payment of certain transaction expenses) in financing transactions during the
nine months ended September 30, 2005. The Company used $7,781,408 of these
proceeds to fund its operations (which includes a $1,388,000 escrow deposit for
the payment of liabilities assumed in business combinations), and a net of
$599,728 in investing activities, which principally includes the cash component
of purchase business combinations that the Company consummated during February
and March of 2005, (net of cash acquired) and the purchase of property and
equipment. In addition, the Company repaid an aggregate of $668,093 of certain
obligations due to certain officers/stockholders, $339,256 of which was a
reduction of the funds held in the restricted cash escrow account established in
connection with the Entelagent Merger (Note E).
On September 23, 2005, the Company offered its creditors and claimants a
proposed agreement to issue common stock for amounts owed to the holders of the
Company's indebtedness (including lenders, past-due trade accounts, and
employees, consultants and other service providers with claims for fees, wages
or expenses) (Note S). The Company is currently unable to determine whether any
of its creditors will accept the Company's proposal. The Company is currently
unable to provide assurance that any of its creditors will accept this proposal
or that the acceptance of such proposal will actually improve the Company's
ability to fund the further development of its business plan or improve its
operations.
Subsequent to September 30, 2005 the Company raised approximately $820,000 in
additional gross funds in three capital financing transactions consummated with
a related party that were used principally to fund operations (Note T).
The Company is currently in the process of attempting to raise additional
capital and has taken certain steps to conserve its liquidity while it continues
to integrate the acquired businesses. Although management believes that the
Company has access to capital resources, the Company has not secured any
commitments for additional financing at this time nor can the Company provide
any assurance that it will be successful in its efforts to raise additional
capital and/or successfully execute its business plan.
NOTE D - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, Entelagent Software Corporation, IDK Enterprises,
Inc. and LucidLine, Inc. All significant inter-company transactions have been
eliminated.
CASH
The Company considers all highly liquid securities purchased with original
maturities of three months or less to be cash.
REVENUE RECOGNITION
The Company derives revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) services, which include internet access, back-up,
retrieval and restoration services and professional consulting services.
8
The Company applies the revenue recognition principles set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and Exchange Commission Staff Accounting Bulletin ("SAB") 104 "Revenue
Recognition" with respect to all of its revenue. Accordingly, the Company
records revenue when (i) persuasive evidence of an arrangement exists, (ii)
delivery has occurred, (iii) the vendor's fee is fixed or determinable, and (iv)
collectability is probable.
The Company generates revenues through sales of software licenses and annual
support subscription agreements, which include access to technical support and
software updates (if and when available). Software license revenues are
generated from licensing the rights to use products directly to end-users and
through third party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of the Company's software sales are supported
by a written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. The Company uses the residual method
prescribed in SOP 98-9 to allocate revenues to delivered elements once it has
established vendor-specific evidence for such undelivered elements.
The Company provides its internet access and back-up, retrieval and restoration
services under contractual arrangements with terms ranging from 1 year to 5
years. These contracts are billed monthly, in advance, based on the
contractually stated rates. At the inception of a contract, the Company may
activate the customer's account for a contractual fee that it amortizes over the
term of the contract in accordance with Emerging Issues Task Force Issue
("EITF") 00-21 "Revenue Arrangements with Multiple Deliverables." The Company's
standard contracts are automatically renewable by the customer unless terminated
on 30 days written notice. Early termination of the contract generally results
in an early termination fee equal to the lesser of six months of service or the
remaining term of the contract.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. The Company
recognizes revenue under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19.
ACCOUNTS RECEIVABLE
The Company adjusts its accounts receivable balances that it deems to be
uncollectible. The allowance for doubtful accounts is the Company's best
estimate of the amount of probable credit losses in the Company's existing
accounts receivable. The Company reviews its allowance for doubtful accounts on
a monthly basis and determines the allowance based on an analysis of its past
due accounts. All past due balances that are over 90 days are reviewed
individually for collectability. Account balances are charged off against the
allowance after all means of collection have been exhausted and the potential
for recovery is considered remote.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets (generally
three to five years). Maintenance and repairs are charged to expense as
incurred; cost of major additions and betterments are capitalized. When property
and equipment is sold or otherwise disposed of, the cost and related accumulated
depreciation are eliminated from the accounts and any resulting gains or losses
are reflected in the statement of operations in the period of disposal.
9
GOODWILL
Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other
Intangible Assets", requires that goodwill be tested for impairment at the
reporting unit level (operating segment or one level below an operating segment)
on an annual basis (September 30th for the Company) and between annual tests in
certain circumstances. Application of the goodwill impairment test requires
judgment, including the identification of reporting units, assigning assets and
liabilities to reporting units, assigning goodwill to reporting units, and
determining the fair value. Significant judgments required to estimate the fair
value of reporting units include estimating future cash flows, determining
appropriate discount rates and other assumptions. Changes in these estimates and
assumptions could materially affect the determination of fair value and/or
goodwill impairment for each reporting unit. We have recorded goodwill in
connection with the Company's acquisitions described in Note E amounting to
$22,413,300. The Company has determined that no impairment charges are necessary
during the nine months ended September 30, 2005.
LONG LIVED ASSETS
The Company periodically reviews the carrying values of its long lived assets in
accordance with SFAS 144 "Long Lived Assets" when events or changes in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their realizable value and records impairment charges when
necessary. The Company has determined that no impairment charges are necessary
during the nine months ended September 30, 2005.
STOCK OPTION PLANS
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," the Company has elected to continue to follow the
intrinsic value method in accounting for its stock-based compensation
arrangements as defined by Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees," and related interpretations
including Financial Accounting Standards Board ("FASB") Interpretation No. 44
"Accounting for Certain Transactions Involving Stock Compensation," an
interpretation of APB No. 25.
The following table summarizes the proforma operating results of the Company,
had compensation expense for stock options granted to employees been determined
in accordance with the fair market value based method prescribed by SFAS No.
123. The Company has presented the following disclosures in accordance with SFAS
No. 148.
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
Net Loss, as reported ................. $(19,910,022) $ (3,316,311) $(12,677,722) $ (1,493,188)
(+) Stock-based compensation cost
reflected in the financial statements -- -- -- --
(-) Stock-based employee compensation
expense under the fair value method. 375,000 613,333 225,000 204,444
------------ ------------ ------------ ------------
Proforma Net Loss ..................... $(20,285,022) $ (3,929,644) $(12,902,722) $ (1,697,632)
============ ============ ============ ============
Net Loss per Share-
Basic and Diluted, as reported ...... $ (0.35) $ (0.09) $ (0.21) $ (0.04)
============ ============ ============ ============
Basic and Diluted, proforma ......... $ (0.35) $ (0.10) $ (0.21) $ (0.04)
============ ============ ============ ============
Weighted Average Number of Shares
Outstanding:
Basic and Diluted ................... 57,284,490 38,610,646 61,499,103 39,010,560
============ ============ ============ ============
10
NON-EMPLOYEE STOCK BASED COMPENSATION
The cost of stock based compensation awards issued to non-employees for services
are recorded at either the fair value of the services rendered or the
instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in EITF 96-18,
"Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services."
COMMON STOCK PURCHASE WARRANTS
The Company accounts for the issuance of common stock purchase warrants issued
with registration rights in accordance with the provisions of EITF 00-19
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock."
Based on the provisions of EITF 00-19, the Company classifies as equity any
contracts that (i) require physical settlement or net-share settlement or (ii)
gives the company a choice of net-cash settlement or settlement in its own
shares (physical settlement or net-share settlement). The Company classifies as
assets or liabilities any contracts that (i) require net-cash settlement
(including a requirement to net cash settle the contract if an event occurs and
if that event is outside the control of the company) (ii) give the counterparty
a choice of net-cash settlement or settlement in shares (physical settlement or
net-share settlement).
INCOME TAXES
The Company accounts for income taxes pursuant to SFAS No. 109, "Accounting for
Income Taxes". Deferred taxes arise from temporary differences, primarily
attributable to the use of the cash method for tax purposes and accrual method
for book purposes and net operating loss carry-forwards. The Company records
valuation allowances for deferred tax assets when circumstances indicate it is
more likely than not that the Company will not realize the benefit of its
deferred tax assets.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
As a result of the consummation of the Share Exchange described in Note B, the
Company included 1,200,000 stock options with an exercise price of $.01 per
share that it issued to certain employees during 2002 in its calculation of
weighted-average number of common shares outstanding for all periods presented.
Net loss per common share excludes the following outstanding options, warrants
and convertible notes as their effect would be anti-dilutive:
SEPTEMBER 30,
-------------------------------
2005 2004
---------- ----------
Options .............................. 11,190,000 3,925,000
Warrants ............................. 9,639,080 15,000
Convertible Notes .................... 30,720,000 120,462
---------- ----------
51,549,080 4,060,462
========== ==========
11
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheet for cash, accounts
receivable, accounts payable accrued expenses, advances from stockholders and
all note obligations classified as current liabilities approximate their fair
values based on the short-term maturity of these instruments. The carrying
amounts of the Company's convertible and subordinated note obligations, stock
repurchase obligation and common stock subject to put right approximate fair
value as such instruments feature contractual interest rates that are consistent
with current market rates of interest or have effective yields that are
consistent with instruments of similar risk, when taken together with any equity
instruments concurrently issued to holders.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board issued FASB
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46").
This interpretation of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," provides guidance for identifying a controlling interest
in a variable interest entity ("VIE") established by means other than voting
interest. FIN 46 also requires consolidation of a VIE by an enterprise that
holds such controlling interest. In December 2003, the FASB completed its
deliberations regarding the proposed modifications to FIN No., 46 and issued
Interpretation Number 46R, "Consolidation of Variable Interest Entities - an
Interpretation of ARB 51" ("FIN No. 46 R"). The decisions reached included a
deferral of the effective date and provisions for additional scope exceptions
for certain types of variable interests. Application of FIN No. 46R is required
in financial statements of public entities that have interests in VIE's or
potential VIE's commonly referred to as special-purpose entities for periods
ending after December 15, 2003. Application by public issuers' entities is
required in all interim and annual financial statements for periods ending after
December 15, 2004. The adoption of this pronouncement did not have material
effect on the Company's financial statements.
In December 2004, the FASB issued SFAS No. 123R "Share Based Payment". This
statement is a revision of SFAS Statement No. 123, "Accounting for Stock-Based
Compensation" and supersedes APB Opinion No. 25, "Accounting for Stock Issued to
Employees", and its related implementation guidance. SFAS 123R addresses all
forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options, restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest and will result in a charge to operations
for stock-based compensation expense. The charge will be reflected in the
Company's Statements of Operations during periods in which such charges are
recorded, but will not affect its Balance Sheets or Statements or Cash Flows.
SFAS 123R is effective for public entities that file as small business
issuers--as of the beginning of the first reporting period of the fiscal year
that begins after December 15, 2005. The Company is currently in the process of
evaluating the effect that the adoption of this pronouncement will have on its
financial statements.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets". SFAS 153 amends APB Opinion No. 29 to eliminate the exception for
non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. A non-monetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS 153 are effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier
application is permitted for non-monetary asset exchanges occurring in fiscal
periods beginning after December 16, 2004. The provisions of this statement are
intended be applied prospectively. The adoption of this pronouncement is not
expected to have a material effect on the Company's financial statements.
12
EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on
Diluted Earnings per Share." The EITF reached a consensus that contingently
convertible instruments, such as contingently convertible debt, contingently
convertible preferred stock, and other such securities should be included in
diluted earnings per share (if dilutive) regardless of whether the market price
trigger has been met. The consensus became effective for reporting periods
ending after December 15, 2004. The adoption of this pronouncement did not have
a material effect on the Company's financial statements.
NOTE E - BUSINESS COMBINATIONS
MERGER WITH COMPLETE SECURITY SOLUTIONS, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with Complete Security Solutions, Inc. ("CSSI") became
effective. The merger was consummated pursuant to a definitive Supplemental
Agreement and the Agreement and Plan of Merger, entered into as of February 24,
2005, each among the Company, CSSI Acquisition Co. I, Inc., a wholly-owned
subsidiary of the Company and CSSI. Pursuant to the terms of the Supplemental
Agreement and Agreement and Plan of Merger with CSSI, CSSI Acquisition Co. I,
Inc. merged with and into CSSI, with CSSI surviving the merger as a wholly-owned
subsidiary of the Company.
CSSI sells computer software that supports real-time secure collection, delivery
and sharing of field-based report information for public safety agencies. The
Company believes that CSSI's electronic forms technology provides law
enforcement and other justice agencies with secure, real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system. The Company acquired CSSI because it believes that
such technologies fit within its strategic plan of building a business that
addresses the urgency of homeland and information security initiatives.
In connection with the CSSI merger, the Company issued 7,500,000 shares of
common stock in exchange for the outstanding shares of the common stock of CSSI,
and subordinated promissory notes in the aggregate principal amount of
$4,500,000 (the "Subordinated Notes") and warrants to purchase 2,250,000 shares
of common stock ("Purchase Warrants") in exchange for the outstanding shares of
the preferred stock of CSSI. The Purchase Warrants have a term of 5 years and an
exercise price of $0.70 per share. The Subordinated Notes and Purchase Warrants
were issued to Apex Investment Fund V, L.P. ("Apex"), The Northwestern Mutual
Life Insurance Company ("Northwestern"), and Advanced Equities Venture Partners
I, L.P ("Advanced Equities").
The Subordinated Notes issued to the holders of the outstanding preferred stock
of CSSI have an initial term of 120 days (due on June 25, 2005), with the
Company's option to extend the term for an additional 60 days to August 24,
2005. The Subordinated Notes are interest free and automatically convert into
the securities offered by the Company at the first closing of a subsequent
financing for the Company, for such number of offered securities as could be
purchased for the principal amount being converted.
The Company did not redeem the Subordinated Notes on August 24, 2005 and, as a
result, the notes became automatically convertible into 3.84 shares of common
stock for each $1 of principal then outstanding in accordance with the original
note agreement. Accordingly, the Company recorded a charge of $4,500,000 based
upon the intrinsic value of this conversion option measured at the original
issuance date of the note in accordance with EITF 00-27 "Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios" ("EITF 00-27"). The Company has agreed to file
with the SEC, a registration statement for the resale of the restricted shares
of the Company's common stock issuable upon exercise of the conversion option
that would be issued in this transaction, on a best efforts basis.
The Company has agreed to register the resale of the 7,500,000 shares of common
stock issued to the holders of the outstanding common stock of CSSI and the
2,250,000 shares of common stock issuable upon the exercise of the warrants
issued to the holders of the outstanding preferred stock of CSSI at such time as
the Company next files a registration statement with the Securities and Exchange
Commission ("SEC") on a best efforts basis.
13
MERGER WITH LUCIDLINE, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with LucidLine, Inc. ("LucidLine") became effective. The
merger was consummated pursuant to a definitive Supplemental Agreement and the
Agreement and Plan of Merger entered into as of February 24, 2005, each among
the Company, LL Acquisition I Corp., a wholly-owned subsidiary of the Company
and LucidLine. Pursuant to the terms of the Supplemental Agreement and Agreement
and Plan of Merger with LucidLine, LL Acquisition I Corp. merged with and into
LucidLine, with LucidLine surviving the merger as a wholly-owned subsidiary of
the Company.
LucidLine provides high-speed Internet access, synchronized remote back-up,
retrieval, and restoration services to small and mid-size businesses. The
Company acquired LucidLine because it believes that LucidLine's information
protection technologies fit within its strategic plan of building a business
that addresses the urgency of homeland and information security initiatives.
In connection with the LucidLine merger, the Company issued 4,400,000 shares of
common stock and $200,000 of cash, in exchange for all of the outstanding shares
of LucidLine's common stock. The Company has agreed to register the resale of
the shares of common stock issued to the holders of the outstanding common stock
of LucidLine at such time as the Company next files a registration statement
with the SEC on a best efforts basis.
MERGER WITH ENTELAGENT SOFTWARE CORP.
On November 24, 2002, the Company, ESC Acquisition, Inc., a California
corporation and wholly-owned subsidiary of Patron ("Entelagent Mergerco"), and
Entelagent Software Corp., a California corporation ("Entelagent"), entered into
an Agreement and Plan of Merger, (the "Entelagent Merger Agreement") whereby
Entelagent Mergerco would be merged with and into Entelagent with Entelagent
surviving as a wholly-owned subsidiary of the Company (the "Entelagent Merger").
The Company, Entelagent Mergerco and Entelagent also concurrently entered into a
Supplemental Agreement (the "Entelagent Supplemental Agreement").
On February 24, 2005, the Company entered into a definitive Amended and Restated
Supplemental Agreement pursuant to which Entelagent Mergerco would merge with
and into Entelagent, with Entelagent surviving the merger as a wholly-owned
subsidiary of the Company. On March 30, 2005, pursuant to the filing of an
Amended and Restated Agreement and Plan of Merger, Patron's merger with
Entelagent became effective. The Amended and Restated Agreement and Plan of
Merger amended and restated the Entelagent Merger Agreement.
Entelagent provides flexible and scalable real-time content-aware email
monitoring and post-event review of e-mail messages and their attachments as
well as infrastructure for knowledge management of archived e-mail messages and
attachments in all media. Entelagent's e-mail content monitoring technology
addresses the need for comprehensive internal security measures to safeguard
company intellectual capital. The Company acquired Entelagent because it
believes that Entelagent's information surveillance and protection technologies
fit within its strategic plan of building a business that addresses the urgency
of homeland and information security initiatives.
In connection with the Entelagent Merger, the Company issued 3,000,000 shares of
the Company's common stock in exchange for all of the outstanding shares of the
capital stock of Entelagent. The Company has agreed to register the resale of
the 3,000,000 shares of common stock issued to the holders of the outstanding
capital stock of Entelagent at such time as the Company next files a
registration statement with the SEC on a best efforts basis. In addition,
pursuant to the terms of the Amended and Restated Supplemental Agreement, the
Company also agreed to (i) issue to certain officers, directors, stockholders
and creditors of Entelagent, in consideration of amounts owed by Entelagent to
such parties, promissory notes in the aggregate principal amount of $2,640,000,
with interest payable thereon at a rate of 8% per annum and maturing one year
after the completion of the merger and (ii) pay $1,388,000 in outstanding
liabilities of Entelagent from the net proceeds of the Interim Bridge Financing
I completed on February 28, 2005. Accordingly, the Company placed $1,388,000 of
the proceeds it received from the Interim Bridge Financing I financing
transaction in an escrow account to be specifically used for the payment of such
liabilities. The non-disbursed funds as of September 30, 2005 are presented as
restricted cash in the accompanying balance sheet.
14
Subsequent to the date of the acquisition, the Company modified its purchase
price allocation to offset approximately $52,000 of previously existing advances
against the note, which reduced the aggregate balance of the note to $2,588,000.
BUSINESS COMBINATION ACCOUNTING
The Company accounted for its acquisitions of CSSI, LucidLine and Entelagent
using the purchase method of accounting prescribed under SFAS 141 "Business
Combinations." Under the purchase method, the acquiring enterprise records any
purchase consideration issued to the sellers of the acquired business at their
fair values. The aggregate of the fair value of the purchase consideration plus
any direct transaction expenses incurred by the acquiring enterprise is
allocated to the assets acquired (including any separately identifiable
intangibles) and liabilities assumed based on their fair values at the date of
acquisition. The excess of cost of the acquired entities over the fair values of
identifiable assets acquired and liabilities assumed was recorded as goodwill.
The results of operations for each of the acquired companies following the dates
of each business combination is included in the Company consolidated results of
operations for the quarter ended September 30, 2005.
The Company evaluated each of the aforementioned transactions to identify the
acquiring entity as required under SFAS 141 for business combinations effected
through an exchange of equity interests. Based on such evaluation the Company
determined that it was the acquiring entity in each transaction (and
cumulatively for all transactions) as (1) the larger portion of the relative
voting rights in the Company after each combination was retained by its
previously existing stockholders, (2) the previously existing stockholders,
through their retention of a majority of voting rights, retained the ability to
elect or appoint a voting majority of the governing body of the combined entity,
and (3) under the terms of the exchange of equity securities, the Company paid a
premium over the market value of the equity securities of the other combining
entities.
The following table provides a breakdown of the purchase price including the
fair value of purchase consideration issued to the sellers of the acquired
business and direct transaction expenses incurred by the Company in connection
with consummating these transactions:
CSSI LUCIDLINE ENTELAGENT TOTAL
----------- ----------- ----------- -----------
Cash ........................ $ -- $ 200,000 $ -- $ 200,000
Common Stock ................ 6,375,000 3,740,000 2,550,000 12,665,000
Subordinated promissory notes 4,500,000 -- -- 4,500,000
Common stock warrants ....... 1,912,500 -- -- 1,912,500
Transaction expenses ........ 398,128 154,611 359,894 912,633
----------- ----------- ----------- -----------
Total Purchase Price ..... $13,185,628 $ 4,094,611 $ 2,909,894 $20,190,133
=========== =========== =========== ===========
The fair value of common stock issued to the sellers as purchase consideration
was determined in accordance with the provisions of EITF 99-12 "Determination of
the Measurement Date for the Market Price of Acquirer Securities Issued in a
Purchase Business Combination." The fair value of subordinated notes issued to
the sellers as purchase consideration is considered to be equal to their
principal amounts due to the short-term maturity of those instruments. The
Company calculated the fair value of common stock purchase warrants issued to
the sellers as purchase consideration using the Black-Scholes option-pricing
model.
Transaction expenses, which include legal fees and transaction advisory services
directly related to the acquisitions amount to $912,633. Such fees include
$657,633 paid in cash and $255,000 for the fair value of 300,000 common stock
purchase warrants issued to Laidlaw & Company UK Ltd. ("Laidlaw") in its
capacity as a transaction advisor.
PRELIMINARY PURCHASE PRICE ALLOCATION
Under business combination accounting, the total preliminary purchase price was
allocated to CSSI's and LucidLine's net tangible and identifiable intangible
assets based on their estimated fair values as of February 25,
15
2005. The total preliminary purchase price allocation for Entelagent's net
tangible and identifiable intangible assets was based on their estimated fair
values as of March 30, 2005. The preliminary allocation of the purchase price
for these three acquisitions is set forth below. The excess of the purchase
price over the net tangible and identifiable intangible assets was recorded as
goodwill.
The Company assumed $476,594 of payroll and sales tax liabilities in its
acquisition of Entelagent that were in arrears at the date the transaction was
consummated (Note M). These liabilities have been estimated at their fair value
in the preliminary purchase price allocation. The settlement of these amounts is
in negotiation and could change, as the outcome of any proposed settlement is
unknown at the date of acquisition.
CSSI LUCIDLINE ENTELAGENT TOTAL
------------ ------------ ------------ ------------
Fair value of tangible assets:
Cash ........................ $ 399,636 $ 9,563 $ 7,198 $ 416,397
Accounts receivable ......... 27,791 22,936 84,918 135,645
Employee receivables ........ 111,773 2,000 27,500 141,273
Other current assets ........ 45,177 326 5,990 51,493
------------ ------------ ------------ ------------
Total current assets ...... 584,377 34,825 125,606 744,808
Property and Equipment ...... 62,000 61,000 12,000 135,000
Other assets ................ -- -- -- --
Advances to prospective
affiliates ............... 2,674,689 -- -- 2,674,689
------------ ------------ ------------ ------------
Total tangible assets ..... 3,321,066 95,825 137,606 3,554,497
Liabilities assumed:
Accounts payable ............ (128,854) (32,473) (345,769) (507,096)
Advances from prospective
affiliate ................ -- (829,032) (2,363,359) (3,192,391)
Accrued expenses and other
current liabilities ...... (391,141) -- (4,340,246) (4,731,387)
------------ ------------ ------------ ------------
Total current liabilities . (519,995) (861,505) (7,049,374) (8,430,874)
Long term liabilities ....... -- (102,460) (345,330) (447,790)
------------ ------------ ------------ ------------
Total liabilities assumed . (519,995) (963,965) (7,394,704) (8,878,664)
------------ ------------ ------------ ------------
Net tangible assets acquired . 2,801,071 (868,140) (7,257,098) (5,324,167)
Value of excess allocated to:
Developed technology ........ 670,000 -- 1,900,000 2,570,000
Customer relationships ...... 180,000 -- -- 180,000
Trademarks and tradenames ... 55,000 -- 106,000 161,000
In-process research and
development .............. 190,000 -- -- 190,000
Goodwill .................... 9,289,557 4,962,751 8,160,992 22,413,300
------------ ------------ ------------ ------------
Purchase Price ............... $ 13,185,628 $ 4,094,611 $ 2,909,894 $ 20,190,133
============ ============ ============ ============
The purchase price allocation is preliminary, based on management's estimates
and a valuation study performed by an independent outside appraisal firm that
has not yet been finalized. The Company considered its intention for future use
of the acquired assets, analyses of the historical financial performance of each
of the acquired businesses and estimates of future performance of each acquired
businesses' products and services. The Company made certain adjustments during
the nine months ended September 30, 2005 to its original purchase price
allocation as a result of having negotiated settlements of certain liabilities
that it assumed in its business combination with Entelagent and reevaluating the
carrying amounts of certain accounts receivable balances recorded in purchase
accounting. These changes resulted in a net decrease of $110,663 to the
Company's previous determination of goodwill. In addition, the Company reduced
both other current assets and current liabilities by $27,500 to offset a
prepayment of a liability that occurred prior to the acquisition. The Company's
final determination of the purchase price allocation could
16
result in additional changes to the amounts reflected in its preliminary
estimate. The Company is in the process of finalizing the information required
to file its Form 8-K with the SEC and will do so as soon as practicable.
The Company, as of September 30, 2005, evaluated the carrying amounts of its
goodwill and other intangible assets it recorded in its business combinations
with Entelagent, LucidLine and CSSI. The Company made its evaluation to
determine whether conditions exist that would indicate that reductions in the
carrying amounts of these assets would be required. The Company concluded, based
upon (a) its hiring of a full-time sales staff and (b) recent marketing
initiatives it has undertaken as part of its plan to integrate the acquired
business, that demand for its products is significant. Accordingly, the Company
believes there are currently no conditions that would indicate that carrying
amounts of its goodwill and amortizable intangible assets is impaired.
The Company has established December 31, as the date to perform its annual
evaluation of goodwill and intangible assets in accordance with SFAS 142 and
SFAS 144, which valuation will be formally conducted by an outside specialist.
The Company intends to continue monitoring the carrying amounts of these assets
to determine whether circumstances change and, if necessary, record impairment
charges if required.
PROFORMA FINANCIAL INFORMATION
The unaudited financial information in the table below summarizes the combined
results of operations of the Company and CSSI, LucidLine and Entelagent, on a
proforma basis, as if the companies had been combined as of the beginning of
each of the periods presented.
The unaudited proforma financial information for the nine months ended September
30, 2005 combines the historical results for Patron for the nine months ended
September 30, 2005 and the historical results for CSSI and LucidLine for the
period from January 1, 2005 to February 24, 2005 and the historical results for
Entelagent for the period from January 1, 2005 to March 30, 2005. The unaudited
proforma financial results for the nine months ended September 30, 2004 combines
the historical results for Patron for this period with the historical results
for CSSI, Entelagent and LucidLine for the nine months ended September 30, 2004.
2005 2004
------------ ------------
Total revenues ............................. $ 498,172 $ 940,208
Net loss ................................... (21,276,483) (6,244,863)
Weighted average shares outstanding
on a proforma basis ..................... 60,703,538 55,610,931
Proforma net loss per share, basic
and diluted ............................. $ (0.35) $ (0.11)
The proforma financial information is presented for informational purposes only
and is not indicative of the results of operations that would have been achieved
if the acquisitions of these three companies had taken place at the beginning of
each of the periods presented.
NOTE F - OTHER CURRENT ASSETS
Other current assets consist of the following:
SEPTEMBER 30,
2005
----------
Employee receivables ................................... $ 18,371
Prepaid expenses ....................................... 140,055
Deposits ............................................... 28,021
----------
Other current assets ................................. $ 186,447
==========
NOTE G - PROPERTY AND EQUIPMENT
SEPTEMBER 30,
2005
----------
Computers .............................................. $ 160,197
Furniture and Fixtures ................................. 39,949
----------
sub-total .......................................... 200,146
less: accumulated depreciation ......................... (40,134)
----------
Property and equipment, net ........................ $ 160,012
==========
Depreciation expense for the nine months ended September 30, 2005 was $40,389.
17
NOTE H - DEFERRED FINANCING COSTS
Deferred financing costs, which amount to $3,000 are presented net of
amortization and include the following:
Interim Bridge Financing
--------------------------------------------------------
Bridge I Bridge II Bridge III Total
----------- ----------- ----------- -----------
Cash fees paid to agent and
investor to originate loans ... $ 316,579 $ 305,160 $ 6,000 $ 627,739
Fair value of warrants issued to:
Placement agent ............... 297,500 80,867 -- 378,367
Investors upon the extension
of due dates ................ 822,500 -- -- 822,500
----------- ----------- ----------- -----------
1,436,579 386,027 6,000 1,828,606
Accumulated amortization ........ (1,436,579) (386,027) (3,000) (1,825,606)
----------- ----------- ----------- -----------
Deferred financing costs, net ... $ -- $ -- $ 3,000 $ 3,000
=========== =========== =========== ===========
The Company incurred $316,579 of cash fees and $297,500 of non-cash fees
representing the fair value of 350,000 common stock purchase warrants issued to
Laidlaw in its capacity as the placement agent in the $3,500,000 Interim Bridge
Financing I completed in February 2005. Fees incurred in connection with the
Interim Bridge 1 financing were fully amortized during the nine months ended
September 30, 2005.
On June 28, 2005, the Company elected to extend the due date of the Interim
Bridge Financing I notes in exchange for 1,750,000 additional common stock
purchase warrants (the "Bridge I Extension Warrants") that were issued to the
investors in this transaction. The aggregate fair value of the warrants, which
amounted to $822,500 was recorded as a deferred financing cost and was fully
amortized over the 60-day extension period, which ended on August 27, 2005.
The Company incurred cash fees of $305,160 and non-cash fees of $80,867
representing the fair value of 152,580 common stock purchase warrants issued to
Laidlaw & Company (UK) Ltd. in its capacity as the placement agent in the
$2,543,000 Interim Bridge Financing II (Note K). These deferred financing costs
were fully amortized during the nine months ended September 30, 2005.
The Company paid $6,000 to Advanced Equities on July 29, 2005 with respect to
transaction services performed in connection with the Interim Bridge Financing
III completed in September 2005. The fees are being amortized over the term of
the note to November 25, 2005.
The fair value of all of the aforementioned warrants was determined using the
Black-Scholes option-pricing model. Aggregate amortization expense with respect
to deferred financing costs amounted to $1,825,606 for the nine months ended
September 30, 2005 and is included as a component of interest expense in the
accompanying statement of operations.
NOTE I - INTANGIBLE ASSETS
The components of intangible assets as of September 30, 2005 are set forth in
the following table:
18
NET BOOK ESTIMATED
FAIR VALUE ACCUMULATED VALUE AT USEFUL
AND ADDITIONS AMORTIZATION 9/30/2005 LIFE
---------- ---------- ---------- ----------
Developed technology ..... $2,662,547 $ 272,792 $2,389,755 5 years
Customer relationships ... 180,000 26,250 153,750 4 years
Trademarks and tradenames 161,000 21,272 139,728 4 years
In-process research and
development ........... 190,000 22,169 167,831 5 years
---------- ---------- ----------
$3,193,547 $ 342,483 $2,851,064
========== ========== ==========
The Company classifies amortization of developed technology as a component of
cost of sales.
AMORTIZATION OF INTANGIBLE ASSETS
The amortization of intangible assets will result in the following additional
expense by year:
INTANGIBLE
AMORTIZATION
------------
October 1, 2005 to
December 31, 2005 $ 193,186
YEARS ENDED DECEMBER 31:
------------------------
2006 655,759
2007 655,759
2008 655,759
2009 584,718
2010 105,883
-----------
$2,851,064
-----------
NOTE J - DEMAND NOTES PAYABLE
Through December 31, 2004, the Company borrowed an aggregate amount of $695,000
from four unrelated parties. These notes are payable on demand and bear interest
at the rate of 10% per annum. Interest expense on these notes amounted to
$53,625 for each of the nine months ended September 30, 2005 and 2004,
respectively.
Demand notes also include a note payable to Lok Technology secured by
Entelagent's accounts receivable. At September 30, 2005, the balance outstanding
on this note is $312,556. The note bears interest at 15% per annum. Interest on
this note amounted to $25,163 for the nine months ended September 30, 2005.
NOTE K - BRIDGE NOTES PAYABLE
INTERIM BRIDGE FINANCING I
On February 28, 2005, the Company completed a $3,500,000 financing (the "Interim
Bridge Financing I") through the issuance of 10% Senior Convertible Promissory
Notes (the "Bridge I Notes") and warrants to purchase up to 1,750,000 shares of
the Company's common stock ("Bridge I Warrants"). The warrants have a term of 5
years and an exercise price of $0.70 per share. The aggregate fair value of the
Bridge I Warrants amounts to $1,487,500. Prior to final maturity, the Bridge I
Notes may be converted into securities that would be issuable at the first
closing of a subsequent financing by the Company, for such number of offered
securities that could be purchased for the principal amount being converted. The
Bridge I Notes had an initial term of 120 days (due on June 28, 2005) with
19
interest at a contractual rate of 10% per annum and featured an option for the
Company to extend the term for an additional 60 days to August 27, 2005.
In accordance with APB 14, the Company allocated $2,456,140 of the proceeds to
the Bridge I Notes and $1,043,860 of proceeds to the Bridge I Warrants. The
difference between the carrying amount of the Bridge I Notes and their
contractual redemption amount was accreted as interest expense to June 28, 2005,
their earliest date of redemption. Accretion of the aforementioned discount
amounted to $1,043,860 for the nine months ended September 30, 2005 and is
included as a component of interest expense in the accompanying statement of
operations.
On June 28, 2005, the Company elected to extend the contractual maturity date of
the Bridge I Notes for an additional 60 days to August 27, 2005, which caused
the contractual interest rate to increase to 12% per annum. In addition, the
Company was required to issue the 1,750,000 additional warrants (the "Bridge I
Extension Warrants") to purchase such number of shares of common stock equal to
1/2 of a share for each $1.00 of principal amount outstanding. The Bridge I
Extension Warrants have a term of 5 years and an exercise price of $0.70 per
share. The Bridge I Warrants are included in Deferred Financing Costs at their
fair value, which amounts to $822,500.
The Company did not redeem the Bridge I Notes on August 27, 2005 and, as a
result, the notes became automatically convertible into 3.84 shares of common
stock for each $1 of principal then outstanding in accordance with the original
note agreement. Accordingly, the Company recorded a charge of $3,500,000 based
upon the intrinsic value of this conversion option measured at the original
issuance date of the note in accordance with EITF 00-27. The Company has agreed
to file with the SEC, a registration statement for the resale of the restricted
shares of the Company's common stock issuable upon exercise of the conversion
option that would be issued in this transaction, on a best efforts basis.
Contractual interest expense on the Bridge I Notes amounted to $204,167 for the
nine months ended September 30, 2005 and is included as a component of interest
expense in the accompanying statement of operations.
The Company sold these securities to thirty-three accredited investors
introduced by Laidlaw, the placement agent in the Interim Bridge Financing I. As
described in Note H, the Company incurred $614,079 of fees in connection with
this transaction including $297,500 for the fair value of warrants to purchase
up to 350,000 shares of the Company's common stock (the "Placement Agent
Warrants") at an exercise price of $0.70 per share.
INTERIM BRIDGE FINANCING II
On June 6, 2005, the Company completed a $2,543,000 financing (the "Interim
Bridge Financing II") through the issuance of (i) 10% Junior Convertible
Promissory Notes (the "Bridge II Notes") and (ii) warrants to purchase up to
1,271,500 shares of common stock (the "Bridge II Warrants"). The warrants have a
term of 5 years and an exercise price of $0.60 per share. The aggregate fair
value of the Bridge II Warrants amounts to $673,895. Prior to maturity, the
Junior Convertible Promissory Notes may be converted into the securities offered
by the Company at the first closing of a subsequent financing for the Company,
for such number of offered securities as could be purchased for the principal
amount being converted.
In accordance with APB 14, the Company allocated $2,010,277 of the proceeds to
the Bridge II Notes and $532,723 of proceeds to the Bridge II Warrants. The
difference between the carrying amount of the Bridge II Notes and their
contractual redemption amount is being accreted as interest expense to October
3, 2005, their earliest date of redemption. Accretion of the aforementioned
discount amounted to $532,723 for the nine months ended September 30, 2005 and
is included as a component of interest expense in the accompanying statement of
operations.
The Bridge II Notes have an initial term of 120 days (due on various dates
beginning October 3, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an additional 60 days to various dates
beginning December 2, 2005. Upon the extension of the maturity date of the
Bridge II Notes, the contractual interest rate would increase to 12% per annum,
and the Company would be required to issue warrants (the "Bridge II Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to one-half of a share for each $1.00 of principal then outstanding. The Bridge
II Extension Warrants issuable upon extension of the maturity date of the Junior
Convertible Promissory notes feature a term of 5 years and an exercise price of
$0.60 per
20
share. In addition, if the Bridge II Notes are not paid in full on or before the
extended maturity date, each note becomes convertible into 3.84 shares of the
Company's common stock for each $1.00 of principal then outstanding. The
intrinsic value of this conversion option measured at the issuance date of the
notes amounts to $2,543,000 and would be recognized as interest expense in
accordance with EITF 00-27. The Company has agreed to file with the SEC, a
registration statement for the resale of the restricted shares of its common
stock issuable upon exercise of the conversion option that would be issuable in
this transaction, on a best efforts basis.
The Company sold these securities to seven accredited investors introduced by
Laidlaw, placement agent in the Interim Bridge Financing II. As described in
Note H, the Company incurred $386,027 of fees in connection with this
transaction including a cash fee of $305,160 and $80,867 for the fair value of
warrants to purchase 152,580 shares of the Company's common stock at an exercise
price of $0.60 per share.
As described in Note T, the Company elected to extend the due dates of these
notes by an additional 60 days to various dates beginning December 2, 2005.
INTERIM BRIDGE FINANCING III
Beginning on July 1, 2005, and continuing through September 30, 2005, the
Company completed a $3,600,000 financing (the "Interim Bridge Financing III")
through the issuance of (i) 10% Junior Convertible Promissory Notes (the "Bridge
III Notes") and (ii) warrants to purchase up to 1,800,000 shares of common stock
(the "Bridge III Warrants"). The warrants have a term of 5 years and an exercise
price of $0.60 per share. The aggregate fair value of the Bridge III Warrants
amounts to $550,778. Prior to maturity, the Junior Convertible Promissory Notes
may be converted into the securities offered by the Company at the first closing
of a subsequent financing for the Company, for such number of offered securities
as could be purchased for the principal amount being converted.
In accordance with APB 14, the Company allocated $3,049,222 of the proceeds to
the Bridge III Notes and $550,778 of proceeds to the Bridge III Warrants. The
difference between the carrying amount of the Bridge III Notes and their
contractual redemption amount is being accreted as interest expense to various
dates from November 1, 2005, their earliest date of redemption. Accretion of the
aforementioned discount amounted to $350,791 for the nine months ended September
30, 2005 and is included as a component of interest expense in the accompanying
statement of operations.
The Bridge III Notes have an initial term of 120 days (due on various dates
beginning October 28, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an additional 60 days to various dates
beginning December 28, 2005. Upon the extension of the maturity date of the
Bridge III Notes, the contractual interest rate would increase to 12% per annum,
and the Company would be required to issue warrants (the "Bridge III Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to one-half of a share for each $1.00 of principal then outstanding. The Bridge
III Extension Warrants issuable upon extension of the maturity date of the
Junior Convertible Promissory Notes feature a term of 5 years and an exercise
price of $0.60 per share. In addition, if the Bridge III Notes are not paid in
full on or before the extended maturity date, each note becomes convertible into
3.84 shares of the Company's common stock for each $1.00 of principal then
outstanding. The intrinsic value of this conversion option measured at the
issuance date of the notes amounts to $3,600,000 and would be recognized as
interest expense in accordance with EITF 00-27. The Company has agreed to file
with the SEC, a registration statement for the resale of the restricted shares
of its common stock issuable upon exercise of the conversion option that would
be issuable in this transaction, on a best efforts basis.
The Company sold these securities to Apex, Northwestern, and Advanced Equities.
Funding for the Bridge III Notes included the conversion of $1,650,000 of
stockholder advances made during the period March 30, 2005 to June 30, 2005 into
Bridge III Notes. In conjunction with Bridge III Notes, Advanced Equities was
paid a fee of $6,000 as described in Note H.
21
NOTE L - RELATED PARTY TRANSACTIONS
EXPENSE REIMBURSEMENTS DUE TO OFFICERS AND STOCKHOLDERS
Certain stockholders and officers of the Company have paid expenses on the
Company's behalf since its inception, of which $243,340 remains outstanding at
September 30, 2005. The amounts payable to such officers and stockholders are
due on demand.
NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS
Notes payable to officers and stockholders, which amount to $284,212, bear
interest at 10% per annum and are due on demand. Interest expense on these notes
amounted to $19,314 for the nine months ended September 30, 2005.
CONSULTING AGREEMENT PAYABLE
On June 8, 2005, the Company negotiated a settlement regarding the consulting
agreement payable with a related party. The terms of the settlement agreement
terminates the prior agreement and reduces the remaining payments due under the
contract to $150,000 including a $50,000 payment that was made upon the
execution of the agreement and two additional $50,000 payments including one to
be made upon the completion of a follow-on-financing by the Company and one not
later than September 30, 2005. The $150,000 reduction in payments was recorded
as a reduction of general and administrative expense during the quarter ended
June 30, 2005. Additionally, the settlement agreement terminates an obligation
for the Company to issue 100,000 shares of unrestricted stock. This stock
issuable under this commitment was recorded in 2004 as "Stock to be issued in
lieu of cash for services" in the amount of $78,900 and the 100,000 shares was
classified as shares to be issued. The termination of the stock issuance
obligation resulted in an additional reduction of $78,900 in general and
administrative expenses during the quarter ended June 30, 2005.
The payment due on September 30, 2005 was not made by the Company. The balance
due under this arrangement is included in the liabilities that the Company has
offered to settle under the proposed creditor and claimant liabilities
restructuring described in Note S.
NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)
The notes issued to creditors of Entelagent described in Note E, include
$1,655,548 payable to related parties for settlement of accrued payroll, notes
payable and expense reimbursements. In addition, the Company offset $52,000 of
previously existing advances made to certain of the parties to reduce the note
to an aggregate carrying amount of $2,588,000. Aggregate interest expense on
this note amounts to $98,962 for the nine months ended September 30, 2005.
RELATED PARTY PAYMENTS
During the nine months ended September 30, 2005, the Company made payments of
$514,867 to related parties from the $1,388,000 restricted cash escrow account
established in connection with the Entelagent Merger (Note E). Such payments
reduced certain outstanding liabilities of Entelagent including advances from
shareholders, accounts payable and payroll liabilities.
During the nine months ended September 30, 2005, the Company made a $200,000
payment to Patrick J. Allin and the Allin Dynastic Trust under the terms of the
settlement agreement reached on June 6, 2005 (Note O).
NOTE M - OTHER CURRENT LIABILITIES
Other current liabilities principally consists of $476,594 of accrued payroll
and sales tax liabilities, the settlement of which is being negotiated, and
estimated penalties that the Company assumed in its acquisition of Entelagent
(Note E). These liabilities are intended to be paid from restricted cash. Also
included in this balance is $469,622 related to two judgments against the
Company (Note Q).
22
NOTE N - DEFERRED REVENUE
Deferred revenue includes (1) $123,287 for the fair value of remaining service
obligations on maintenance and support contracts and (2) $141,730 for contracts
on which the revenue recognition is deferred until contract deliverables have
been completed.
NOTE O - SETTLEMENT WITH PATRICK J. ALLIN, FORMER CHIEF EXECUTIVE OFFICER
On June 6, 2005, the Company entered into a settlement of certain employment and
indemnification related claims brought by Patrick J. Allin, the Company's former
Chief Executive Officer and a former member of the Company's Board of Directors,
against the Company during the year ended December 31, 2004. Pursuant to the
Settlement Agreement and Mutual Release dated June 2, 2005, among the Company,
Mr. Allin and The Allin Dynastic Trust, the Company agreed to pay to Mr. Allin,
in settlement of Mr. Allin's claims, an aggregate payment of One Million One
Hundred Fifty Thousand Dollars ($1,150,000) payable as follows: (i) $200,000
that was paid upon execution of the Settlement Agreement and Mutual Release and
(ii) Nine Hundred Fifty Thousand Dollars ($950,000) payable in cash and/or a
promissory note upon the consummation of a follow-on-financing by the Company.
The parties also agreed to release all claims existing as of the date of the
Settlement Agreement and Mutual Release. The Settlement Agreement and Mutual
Release featured a provision to terminate on August 15, 2005 if the Company did
not consummate a follow-on-financing by such date. As described herein, the
Company and Mr. Allin agreed to extend the termination date for an additional
120 days to December 13, 2005. The Company accrued an aggregate of $927,167 in
amounts repayable to Mr. Allin up through the date of his termination in
February 2004. The difference between the amounts accrued and the cash
settlement, which difference amounts to $216,507, was recorded in general and
administrative expense in the quarter ended March 31, 2004. The remaining
amounts payable to Mr. Allin under this provision of the settlement are
presented net of the $200,000 payment made to him upon the execution of the
agreement and includes $46,845 of interest accrued during the nine months ended
September 30, 2005.
Pursuant to the Settlement Agreement and Mutual Release, the Company also agreed
to purchase from Mr. Allin and The Allin Dynastic Trust an aggregate of four
million (4,000,000) shares of the Company's common stock as follows: (i) two
million (2,000,000) shares (the "Initial Shares") through the issuance of
promissory notes in the aggregate principal amount of One Million Six Hundred
Thousand Dollars ($1,600,000) and (ii) two million (2,000,000) shares (the
"Remainder Shares") through a cash payment from the proceeds of a
follow-on-financing by the Company, at a price per share equal to the lesser of
(a) $.50 per share or (b) 90% of the issue price or conversion price, as the
case may be, of the security issued in a follow-on-financing, provided however
that in the event that 90% of the issue price or conversion price, as the case
may be, of the security issued in the follow-on-financing is less than $.50 per
share, Mr. Allin and/or The Allin Dynastic Trust may, at their option, refuse to
sell any or all of the Remainder Shares to the Company. The Initial Shares are
to be held in escrow pursuant to a mutually agreed upon Escrow Agreement to be
subsequently entered into between the parties. Each of Mr. Allin and The Allin
Dynastic Trust have agreed to lock-up their shares until the shorter of (y) the
six month period subsequent to the consummation of a follow-on-financing and (z)
the date on which the next registration statement filed by the Company becomes
effective.
The promissory notes issued to purchase the Initial Shares bear interest at an
annual rate of 8%, with interest payments due and payable on the last day of
August, November, February and May during the term of the promissory notes, with
a maturity date of June 30, 2006. In addition, if the Company defaults on
certain terms under the promissory notes, and such default remains uncured for
five days, all payments under the promissory notes accelerate and the Company
agrees to confess to a judgment against the Company in a court of the promissory
note holder's choosing in Cook County, Illinois. In the alternative, the holders
of the promissory notes may demand that the shares purchased by the promissory
notes be returned in fulfillment of all obligations remaining under such
promissory notes.
As a result of this agreement to repurchase shares of common stock from Mr.
Allin and The Allin Dynastic Trust, the Company has recorded certain liabilities
and adjustments to stockholders' deficiency retroactively to the quarter ended
March 31, 2004.
23
For the Initial Shares the Company recorded a $1,738,667 note payable to Mr.
Allin with a corresponding increase of $1,600,000 in stockholders' deficiency
and a $138,667 charge to operations for interest payable through June 6, 2006.
For the Remainder Shares, the Company recorded a $1,000,000 put right as
temporary equity with a corresponding $300,000 charge to operations for the
intrinsic value of the put right on June 6, 2005 (fair value of common stock of
$.65 per share less the minimum conversion price of $50. per share) and a
$700,000 net increase in stockholders' deficiency. The aggregate charge of
$438,667 for the interest and the intrinsic value of the conversion option
embedded in the remainder shares is presented as a litigation loss in the
statement of operations for the six months ended June 30, 2004. Common stock
outstanding in the accompanying balance sheet is presented net of the 2 million
Initial Shares that are subject to the repurchase obligation.
As of September 30, 2005, the Company's fair value of its common stock was $0.14
per share, which resulted in a reduction of the charge for the intrinsic value
of the put right granted on June 6, 2005 to $0. Such reduction is presented as a
change in the intrinsic value of put right in the accompanying statement of
operations for the nine months ended September 30, 2005.
On August 15, 2005, the Company and Patrick J. Allin ("Allin") and the Allin
Dynastic Trust ("Allin Trust") entered into an agreement to provide the Company
with up to an additional 120 days to arrange the follow-on-financing described
under the terms of the original settlement. Under the terms of the time
extension, 1) the Company agrees that the 6 month lockup period for the Allin
and Allin Trust shares shall begin August 15, 2005; 2) the Company will pay
Allin a penalty of $500 per day for each day after August 15 that the $950,000
remains unpaid; 3) the Company will also pay the Allin Trust a $100 per day
penalty for each day after August 31 that the interest on the promissory note to
purchase the Allin Trust shares remains unpaid provided that $8,000 of this
interest is paid by September 15, 2005. If the September 15th amount is not
paid, the Company will pay a $250 per day penalty commencing August 31, 2005
with all overdue interest and penalties to be paid out of the
follow-on-financing. If the promissory note interest of $16,000 due on November
30, 2005 is not paid by that date, an additional $250 per day penalty will be
paid; 4) the Company shall pay Allin a $100 per day penalty for each day after
August 31 that the interest on the promissory note to purchase the Allin shares
remains unpaid provided that $8,000 of this interest is paid by September 15,
2005. If the September 15th amount is not paid, the Company will pay a $250 per
day penalty commencing August 31, 2005 with all overdue interest and penalties
to be paid out of the follow-on-financing. If the promissory note interest of
$16,000 due on November 30, 2005 is not paid by that date, an additional $250
per day penalty will be paid; and 5) At the end of the 120 day extension period,
if the Company has not completed its follow-on-financing and made all payments
to Allin and the Allin Trust due and owing under the amended agreement, all
payments under the amended agreement will become immediately due and owing.
Allin and the Allin Trust will have the option of keeping the Initial and
Remainder Shares or demanding payment of the associated notes. The Company will
confess to a judgment in a court of Allin's choosing for the $950,000 and the
promissory notes for purchase of the Allin Trust shares (if payment is demanded
for the notes to purchase shares). Any actions that would preclude the Company
making the payments under this agreement will accelerate all payments due and
the Company will confess to judgment. As of September 30, 2005, the $950,000
promissory note has not be repaid, interest on the promissory note to purchase
the Allin Trust shares has not been paid, nor has the September 15th amount
totaling $8,000 been paid.
Additional interest and penalties under this arrangement amounted to $55,900
during the nine months ended September 30, 2005.
NOTE P - ACCOMMODATION AGREEMENT
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the "Lender"), pursuant to which the Company would
borrow $950,000 under a note to be collateralized by the pledge of 950,000
shares of registered stock from five different stockholders. In connection with
this arrangement, the Company executed a series of Accommodation Agreements with
these stockholders wherein each stockholder pledged their shares in return for
the right to receive on or before November 17, 2003 the return of the pledged
shares, or replacement shares in the event of foreclosure, and one additional
share of common stock for every four shares pledged as compensation. The Company
also agreed to use "best efforts" to register these shares with the US
Securities and Exchange Commission 12 months from the date of issue.
24
In December 2002, the Company received approximately $450,000 of proceeds under
the note and provided the Lender the pledged shares. Since that date, no
additional proceeds were provided by the Lender and repeated attempts were made
by the Company to secure the additional proceeds. The Company has effectively
accounted for the Lender's failure to fund the facility and return the pledged
shares as a foreclosure on the loan collateral. Accordingly, the Company
recorded a $1,047,728 loss during the year ended December 31, 2002.
On March 13, 2003, the Company issued 1,200,000 replacement shares with an
aggregate fair value of $3,708,000 to the stockholders who pledged their shares
under the Accommodation Agreements. Accordingly, the Company recorded an
additional loss of $2,210,272 during the year ended December 31, 2003 for the
difference between the loss the Company recorded upon the Lender's foreclosure
of the collateral and the aggregate fair value of the replacement shares.
In addition, the Accommodation Agreements provided for the Company to pay a
penalty in the event of its failure to cause the replacement shares to be
registered on or before March 31, 2003. As a result, the Company has accrued a
penalty of 450,000 shares per quarter, which penalty amounted to $118,500 in the
three months ended September 30, 2005 and $745,501 in the nine months ended
September 30, 2005.
STOCK PLEDGE ARRANGEMENT
In April 2004, a stockholder of the Company entered into a one-year stock loan
financing arrangement ("Stock Financing Facility") with a third party financial
institution, pursuant to which such stockholder committed to obtain financing
for the Company under a credit facility collateralized by the pledge of 685,000
shares of registered stock (the "Pledged Stock") that was pledged by a second
stockholder (the "Pledging Stockholder"). In connection with this arrangement,
the Company executed an accommodation agreement with the Pledging Stockholder
committing to issue 685,000 shares of restricted stock (the "Replacement Stock")
on April 2, 2005 (the "Termination Date") in the event of a loss of the Pledged
Stock, plus a premium of 205,500 shares (the "Premium Shares") for entering into
the agreement. The Company also agreed to register 300,000 shares of restricted
stock held by the Pledging Stockholder (the "Held Stock") within thirty days of
the agreement and to use its best efforts register with the SEC, both the
Replacement Stock and Premium Stock within 12 months from their date of issue.
The Company received $40,012 of funds but was unable to recover the Pledged
Stock on the Termination Date. In addition, due to a delay in registering all of
the shares under this arrangement, the Company entered into a secondary
agreement with the Pledging Stockholder providing for: (1) the immediate
issuance of the Replacement Shares and Premium Shares; (2) registration of the
Replacement Shares, Premium Shares and Held Shares; (3) the retroactive accrual
of a penalty from May 2, 2004 through the date the registration statement is
filed payable in such number of shares that is equal to 15% of the Held Stock
(prorated for each fraction of a year); and (4) the accrual of an additional
penalty from April 2, 2005 through the date the registration statement is filed
equal to 15% of the Replacement Stock and Premium Stock (prorated for each
fraction of a year).
The Company recorded a charge of $406,205 for the fair value of the Replacement
Stock and Premium Stock (890,500 shares) issued to the Pledging Stockholder
under this arrangement. Such charge, net of $40,012 of advances received, is
presented as a loss on collateralized financing arrangement in the accompanying
statement of operations. The Company also recorded a $78,247 charge during the
nine months ended September 30, 2005 and $17,145 during the three months ended
September 30, 2005 for the fair value of 130,587 shares issuable to the Pledging
Stockholder as penalties for the delays in registering the stock. The charges
associated with the penalties are included in stock based penalties under
accommodation agreements in the accompanying statements of operations.
25
NOTE Q - COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
Sherleigh Associates Inc. Profit Sharing Plan ("Sherleigh") filed a complaint
against the Company, Patrick Allin, former Chief Executive Officer of the
Company, and Robert E. Yaw, the Company's non-executive Chairman, on February 3,
2004, in the United States District Court for the Southern District of New York
(the "Court") alleging common law fraud. The complaint alleged that Sherleigh
was fraudulently induced into purchasing 1,000,000 shares of Company common
stock in reliance upon certain of the Company's press releases and allegedly
false statements by Mr. Allin and Mr. Yaw, concerning the Company's plans to
acquire two target companies, TrustWave Corporation (currently a strategic
partner of the Company) and Entelagent (a current subsidiary of the Company),
and its financing arrangements regarding those acquisitions. Sherleigh seeks
rescission of its purchase agreement and return of its $2,000,000 purchase price
or compensatory damages to be proven at trial. Mr. Allin recently entered into a
settlement agreement with Sherleigh and is requesting that the Court include in
its dismissal order a finding that the settlement is reasonable and a
prohibition against any claims by the Company or Mr. Yaw against Mr. Allin for
contribution or indemnification with respect to Sherleigh's claims. The Company
has opposed Mr. Allin's request. The Court has not yet issued any ruling on Mr.
Allin's request. Discovery has been completed, but no trial date has been set by
the Court. The Company believes the Plaintiff's claims are without merit and
intends to continue to defend against them through trial, if necessary. The
amount of loss, if any, with respect to the claim cannot be predicted or
quantified at this time and, therefore, no amounts have been recorded on the
books of the Company.
In April of 2005, Richard L. Linting, a former President of the Company's
Professional Services Group, filed a complaint against the Company and Robert E.
Yaw, II, the Company's non-executive Chairman, in the Circuit Court of Cook
County, Illinois alleging breach of his purported employment contract and
seeking sums allegedly owed under the employment contract in the amount of
$1,321,809, plus court costs and fees. On August 22, 2005, the Company, Mr.
Linting and Mr. Yaw entered into a Settlement Agreement and Release whereby Mr.
Linting agreed to release all claims against the Company and Mr. Yaw existing as
of that date in consideration for (i) the payment by the Company to Mr. Linting
of $100,000 in cash, (ii) the issuance by the Company of an aggregate of 422,827
shares ("Linting Shares") of the Company's common stock (equivalent to $192,809
divided by $0.456) to be transferred to Mr. Linting in such numbers and at such
times as directed by Mr. Linting subsequent to the registration of the Linting
Shares, (iii) the Company's agreement to register the Linting Shares through the
filing of a registration statement on or before September 30, 2005, and (iv) the
Company's affirmation of the validity of options previously issued to Mr.
Linting and agreement to permit exercises of those options for 100,000 shares in
each calendar month over a period of 3 years. The Company and Mr. Linting also
agreed to the filing of a stipulation to dismiss Mr. Linting's suit with
prejudice and without costs with the court retaining jurisdiction to reinstate
the case and enforce the terms of the Settlement Agreement and Release in the
event the Company defaulted on its obligations under the Settlement Agreement
and Release, and to enter judgment, by motion, against the Company for the
balance due or appropriate relief. The Company did not make the $100,000 payment
required under the Settlement Agreement and Release, erroneously issued the
Linting Shares to Mr. Linting, and did not file a registration statement to
register the Linting Shares on or before September 30, 2005. Subsequent to
September 30, 2005, Mr. Linting obtained a judgment against the Company for
$100,452 in cash and 422,827 shares of the Company's common stock to be issued
to Mr. Linting at his determination upon registration thereof. The Company
continues to negotiate with Mr. Linting regarding the amounts owed to him.
In December of 2004, Marie Graul, the Company's former Chief Financial Officer,
informed the Company of her intention to assert a claim against the Company for
sums allegedly owed under her employment agreement with the Company. On August
31, 2005, the Company and Ms. Graul entered into a Settlement Agreement and
Mutual Release whereby Ms. Graul agreed to release all claims against the
Company arising from any act or omission occurring on or prior to that date in
consideration of (i) the payment by the Company to Ms. Graul of an aggregate of
$176,458 no later than September 30, 2005, $1,458 of which was payable on
execution of the Settlement Agreement and Mutual Release, and (ii) the Company's
affirmation of the validity of options previously issued to Ms. Graul. The
Company also agreed to confess to a judgment against the Company in a court of
Ms. Graul's choosing in the event of the Company's breach of the Settlement
Agreement and Mutual Release. The Company did not make the payments required by
the Settlement Agreement and Mutual Release. Subsequent to September 30, 2005,
Ms. Graul
26
obtained a judgment against the Company for $176,853 in cash. The Company
continues to negotiate with Ms. Graul regarding the amounts owed to her.
In the event the Company is required to pay damages in connection with any one
or more of the claims asserted in these actions, such payment could have a
material adverse effect on the Company's business and operations.
SETTLEMENT WITH COOK ASSOCIATES, INC.
On June 29, 2005, the Company entered into a settlement with Cook Associates,
Inc. ("Cook Associates") to settle all claims and potential claims related to
the lawsuit that had been filed by Cook Associates against the Company in
October 2004. Under the terms of the settlement, Cook Associates agreed to
dismiss its lawsuit and associated claim for $528,081 in damages and the Company
agreed to remove any and all conditions/restrictions that would prevent the
600,000 shares of Company common stock owned by Cook Associates from being
freely traded. The Company had previously recorded $389,103 of payables to Cook
Associates that it reversed following its execution of the settlement. The
reversal was recorded as a gain and is included in loss/(gain) on settlement
agreements in the accompanying statements of operations for the nine months
ended September 30, 2005.
SEC INVESTIGATION
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating Officers to Take Testimony (C-03739-A, February 12, 2004)) (the
"Order") that a private investigation (the "SEC Investigation") be made to
determine whether certain actions of, among others, the Company, certain of its
officers and directors and others violated Section 5(a) and 5(c) of the
Securities Act and/or Section 10 and Rule 10b-5 promulgated under the Exchange
Act. Generally, the Order provides, among other things, that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8, filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the resale of, in the aggregate, 4,375,000 shares of common stock issued to
various consultants of the Company, and (ii) whether in connection with the
purchase or sale of shares of common stock, certain officers and directors of
the Company and others (a) sold common stock in violation of Section 5 of the
Securities Act and/or, (b) made misrepresentations and/or omissions of material
facts and/or employed fraudulent devices in connection with such purchases
and/or sales relating to certain of the Company's press releases regarding,
among other items, proposed mergers and acquisitions that were never
consummated. If the SEC brings an action against the Company, it could result
in, among other items, a civil injunctive order or an administrative
cease-and-desist order being entered against the Company, in addition to the
imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely the Company's ability to
have its common stock become listed on a stock exchange and/or quoted on the
NASD Bulletin Board or NASDAQ, the Company being able to sell its securities
and/or have its securities registered with the SEC and/or in various states
and/or the Company's ability to implement its business plan. To date, the
Company's legal counsel representing the Company in such matters has indicated
that the SEC Investigation is ongoing and the Staff has not indicated whether it
will or will not recommend that the SEC bring an enforcement action against the
Company, its officers, directors and/or others.
ROBERT CROSS, CHIEF EXECUTIVE OFFICER - EMPLOYMENT AGREEMENT
On July 1, 2005, the Company entered into an employment agreement (the
"Employment Agreement") with Robert W. Cross ("Mr. Cross"), the Company's Chief
Executive Officer. The term of the Employment Agreement is one year with
automatic one-year renewal unless Mr. Cross is provided with written notice of
non-renewal 90 days prior to expiration of the current term of the Employment
Agreement. The Employment Agreement provides for a base salary of $200,000 per
year with a non-recoverable draw of $100,000 (grossed up for taxes) during the
first six months of the Agreement. The Employment Agreement also provides for a
performance bonus determined in accordance with quarterly revenue milestones
that are yet to be established by the Board of Directors. Mr. Cross is eligible
to receive a bonus of up to 100% of base salary for each quarter that the
Company achieves the agreed upon revenue milestones. Additionally, the
Employment Agreement provides for the grant of 1,000,000 stock options at an
exercise price of $0.65 per share with the options vesting 25% on July 1, 2005,
25% on September 30, 2005, 25% on December 31, 2005 and 25% on March 31, 2006.
The options expire on June 30, 2012.
27
LEASE AGREEMENT
On August 24, 2005, the Company entered into an office lease agreement for 4,876
square feet of space for its office in Boulder, Colorado. The lease commences on
October 1, 2005 and has a term of fifty-four months including a six-month lease
abatement. The minimum rental payments, beginning April 2006, amount to $4,063
per month. In addition, the Company was required to make a $19,995 security
deposit at the inception of the lease.
The future minimum rental commitments under the terms are as follows:
For the period of October 1, 2005 through
December 31, 2005 $ -
For the year ended December 31,
2006 36,567
2007 48,756
2008 48,756
2009 48,756
2010 12,189
--------
Total $195,024
NOTE R - STOCKHOLDERS' DEFICIENCY
ISSUANCE OF COMMON STOCK AS PURCHASE CONSIDERATION
On February 25, 2005 the Company committed to issue an aggregate of 11,900,000
shares of its common stock with an aggregate fair value of $10,115,000 as
purchase consideration to the sellers of CSSI and LucidLine (Note E). On
February 28, 2005, the Company committed to issue an additional 3,000,000 shares
of its common stock with an aggregate fair value of $2,550,000 as purchase
consideration to the sellers of Entelagent (Note E). The aforementioned
transactions were recorded as common stock to be issued in the statement of
stockholder's (deficiency). The Company issued 11,323,155 of these shares to
certain of the selling stockholders during the nine months ended September 30,
2005 and the remaining shares are presented as common stock to be issued in the
accompanying balance sheet at September 30, 2005.
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On February 25, 2005, the Company issued 2,250,000 common stock purchase
warrants with a term of 5 years and an exercise price of $0.70 per share as a
portion of purchase consideration associated with the acquisition of the
preferred stock of CSSI (Note E). The aggregate fair value of these warrants
amounted to $1,912,500.
On February 28, the Company issued warrants to purchase up to 1,750,000 shares
of its common stock to the Bridge Notes investors described in Note K. The fair
value of the warrants amounted to $1,054,860. Additionally, the Company issued
350,000 common stock purchase warrants with an aggregate fair value of $297,500
to the Placement Agent in the Interim Bridge Financing I transaction.
On February 28, the Company also issued warrants for 300,000 shares at a $0.70
per share exercise price to Laidlaw & Company and/or its designees in connection
with the receipt of acquisition related services for the Entelagent, LucidLine
and CSSI mergers (Note E). The aggregate fair value of these warrants amounted
to $255,000.
On June 6, 2005, the Company issued warrants to purchase up to 1,271,500 shares
of its common stock at $0.60 per share exercise price to the Interim Bridge
Financing II investors described in Note K. The fair value of the warrants
amounted to $532,732.
On June 30, 2005 the Company issued warrants for 152,580 shares at a $0.60 per
share exercise price to Laidlaw in connection with the Interim Bridge Financing
II financing. The aggregate fair value of these warrants amounted to $80,867 and
was accounted for as deferred financing costs.
28
On June 29, 2005, the Company issued warrants to purchase up to 1,750,000 shares
of its common stock at $0.70 per share exercise price, as Bridge Extension
Warrants, to the investors in Interim Bridge Financing I as described in Note K.
The fair value of the warrants, which amounted to $822,500, was accounted for as
a deferred financing cost.
On July 1, 2005, the Company issued warrants for 925,000 shares at a $0.60 per
share exercise price to Apex and Northwestern in connection with the Interim
Bridge Financing III financing. The aggregate fair value of these warrants
amounted to $415,891.
On July 29, 2005, the Company issued warrants for 50,000 shares at a $0.60 per
share exercise price to Advanced Equities in connection with the Interim Bridge
Financing III financing. The fair value of these warrants amounted to $22,481.
On August 19, 2005, the Company issued warrants for 225,000 shares at a $0.60
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The fair value of these warrants amounted to $55,263.
On September 30, 2005 the Company issued warrants for 600,000 shares at a $0.60
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The fair value of these warrants amounted to $57,143.
All of the aforementioned warrants, unless otherwise noted, are reflected as an
increase to additional paid-in capital in the accompanying balance sheet and
statement of stockholders' deficiency at September 30, 2005.
ISSUANCE OF COMMON STOCK AS PENALTY UNDER AN ACCOMMODATION AGREEMENT
The Accommodation Agreements (Note P) provided for a penalty in the event the
Company failed to register the replacement shares on or before March 31, 2003.
The replacement shares were not registered on or before March 31, 2003. As a
result, the Company has accrued a penalty of 450,000 shares per quarter for the
five stockholders, in the aggregate. The Company recorded charges of $745,501
for the nine months ended September 30, 2005. The Company intends to include the
replacement and penalty shares in a registration statement to be filed in 2005,
at which time the penalty will cease to accrue. The penalty shares are presented
as common stock to be issued in the accompanying balance sheet and statements of
stockholders' deficiency at September 30, 2005.
STOCK ISSUED UNDER STOCK PLEDGE ARRANGEMENT
The Company issued an aggregate of 890,500 shares of common stock (Replacement
Shares and Premium Shares) with an aggregate fair value of $406,205 and recorded
a commitment to issue an additional 130,587 shares of stock with a fair value of
$78,247 as penalties for the delays in registering the stock under the original
agreement (Note P).
STOCK ISSUED IN LIEU OF CASH FOR SERVICES
On June 8, 2005, the Company negotiated a settlement regarding the Consulting
Agreement Payable with a related party. As part of this agreement, an obligation
to issue 100,000 shares of unrestricted common stock previously recorded in the
quarter ended September 30, 2004 was terminated. This termination resulted in a
reduction in general and administrative expenses of $78,900 and the reduction of
100,000 shares from the Shares to be Issued classification.
ISSUANCE OF EMPLOYEE STOCK OPTIONS
During the three months ended September 30, 2005, the Company issued stock
options to employees to purchase 5,265,000 shares. These options include a grant
to purchase 1,000,000 shares at $0.65 per share to the Chief Executive Officer
of the Company, Mr. Robert Cross. Mr. Cross' option grant resulted in a $30,000
expense related to the intrinsic value of the options versus the market price on
the date of grant. This amount is being amortized over the vesting period. For
the nine months ended September 30, 2005, the Company recorded $16,000 of
compensation expense related to Mr. Cross' options and recorded $14,000 to
deferred compensation at September
29
30, 2005. The remaining options were granted at the closing sale price on the
date immediately prior to the date of grant, $0.35 per share.
NOTE S - PROPOSED CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING
On September 23, 2005, the Company mailed a package containing a proposed
arrangement to (a) restructure approximately $26,000,000 of obligations that the
Company owes to a majority of its creditors, and (b) settle $2,000,000 of
contingent liabilities under the legal proceedings with Sherleigh as described
in Note O. The proposal was delivered to the holders of the Company's
indebtedness (including certain lenders, all past-due trade creditors, and
employees, consultants and other service providers with claims for fees, wages
or expenses). Under the proposed arrangement, all creditors with acknowledged
balances and all claimants with agreed claims would promptly be issued one share
of Patron common stock for each $0.18 of such balances or claims. The Company
would endeavor to register such shares under applicable securities laws promptly
following the conclusion of this settlement program. There would be no cash
available to pay any of the indebtedness, and there would be no preferential
payments. All creditors and claimants would be treated the same on a pro rata
basis.
The Company is presently in the process of contacting such creditors and
claimants to explain the proposal and to solicit responses. Certain of the
creditors and claimants responded subsequent to September 30, 2005 (Note T). If
the requisite agreements and approvals are obtained, the Company anticipates
issuing the shares following the final determination of the claims and
subsequently filing a registration statement to register such shares under
applicable securities laws.
The Company is currently unable to determine whether any of its creditors will
accept the Company's proposal. The Company is currently unable to provide
assurance that any of its creditors will accept this proposal or that the
acceptance of such proposal will actually improve the Company's ability to fund
the further development if its business plan or improve its operations.
NOTE T - SUBSEQUENT EVENTS
ADVANCES FROM STOCKHOLDERS
On October 17, 2005, the Company received a $360,000 advance from Apex, on
October 25, 2005, the Company received an additional $75,000 advance from Apex
and on October 31, 2005, the Company received an additional $385,000 advance
from Apex. Apex is a current stock and warrant holder of the Company. No
expenses were incurred in connection with these transactions.
These funds will be included in the Interim Bridge III Financing and will
receive identical terms as described in Note K above. Under terms of the Interim
Bridge III Financing, Apex will be issued a total of 217,500 common stock
purchase warrants. These warrants will have a term of 5 years and an exercise
price of $0.60 per share.
EXTENSION OF THE INTERIM BRIDGE II FINANCING
On October 4, 2005, the Company elected to extend the contractual maturity date
of the Interim Bridge II Financing for an additional 60 days to various dates
beginning December 2, 2005. Exercise of the extension provision of the Interim
Bridge II Financing caused the contractual interest rate to increase to 12% per
annum. In addition, the Company was required to issue to the holders of the
notes issued in the Bridge II Financing, the 1,271,500 additional warrants (the
"Bridge II Extension Warrants") to purchase 1,271,500 shares of common stock.
The Bridge II Extension Warrants were equivalent to 1/2 of a share for each
$1.00 of principal amount outstanding. The Bridge II Extension Warrants have a
term of 5 years and an exercise price of $0.60 per share.
EXTENSION OF THE INTERIM BRIDGE III FINANCING - FIRST TWO FUNDINGS
On October 4, 2005, the Company elected to extend the contractual maturity date
of the first two fundings of the Interim Bridge III Financing for an additional
60 days to December 28, 2005. Exercise of the extension provision of
30
the Interim Bridge III Financing causes the contractual interest rate to
increase to 12% per annum. In addition, the Company was required to issue to the
holders of the notes issued in the Bridge III Financing, the 925,000 additional
warrants (the "Bridge III Extension Warrants") to purchase 925,000 shares of
common stock. The Bridge III Extension Warrants were equivalent to 1/2 of a
share for each $1.00 of principal amount outstanding. The Bridge III Extension
Warrants have a term of 5 years and an exercise price of $0.60 per share.
OFFICE LEASE AGREEMENT
On October 5, 2005, the Company entered into an office lease agreement providing
the Company with 1,269 square feet of space for a sales office in Dallas, Texas.
The lease commences on October 24, 2005 and has a term of 12 months. The minimum
rental payments, beginning October 2005, amount to $1,851 per month. In
addition, the Company was required to make a $2,035 security deposit at the
inception of the lease.
STATUS OF PROPOSED CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING
During November 2005, the Company reevaluated its proposal regarding the
restructuring of creditor and claimant liabilities. Due to a reduction in the
price per share of the Company's common stock since the original proposal was
issued to creditors and claimants, the Company repriced the proposal to $0.10
per share and will be issuing new documents to all creditors that have not
already accepted the offer. All claimants that have already accepted the offer
will automatically receive the revised proposal pricing. Of the approximately
$26,000,000 of claims, approximately $15,000,000 is represented by current
Company shareholders.
CONSULTING AGREEMENT
On October 28, 2005, the Board of Directors authorized the establishment of a
consulting agreement with an investor relations consultant. Under terms of the
agreement, the Company will issue, as payment for the consultant's services,
200,000 shares of the common stock of the Company and the Company will grant the
consultant a three-year stock option to purchase up to 200,000 shares of the
common stock of the Company at an exercise price of $0.25 per share.
ISSUANCE OF EMPLOYEE STOCK OPTIONS
On October 28, the Company issued stock options to an employee to purchase
50,000 shares. The options were granted at market price on the date of grant,
$0.09 per share.
STATUS OF LEGAL PROCEEDINGS
On November 2, 2005, Mr. Linting obtained a judgment against the Company for
$100,452 in cash and 422,827 shares of the Company's common stock to be issued
to Mr. Linting at his determination upon registration thereof. The Company
continues to negotiate with Mr. Linting regarding the amounts owed to him.
On October 27, 2005, Ms. Graul obtained a judgment against the Company for
$176,853 in cash. The Company continues to negotiate with Ms. Graul regarding
the amounts owed to her.
31
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SEPTEMBER 30, 2005
The following discussion and analysis should be read in conjunction with the
Annual Report on Form 10-KSB, including the consolidated financial statements,
and the related notes thereto, for the years ended December 31, 2004, 2003 and
2002 of Patron Systems, Inc. and subsidiaries (collectively referred to as
"Patron," the "Company," "we," "us," or "our"). Except for historical
information contained herein, the matters discussed below are forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Such statements involve risks and uncertainties,
including, but not limited to, economic, governmental, political, competitive
and technological factors affecting our operations, markets, products, prices
and other factors discussed elsewhere in this report and other reports filed by
us with the Securities and Exchange Commission ("SEC"). These factors may cause
results to differ materially from the statements made in this report or
otherwise made by or on our behalf.
OVERVIEW
On February 25, 2005, we consummated the acquisitions of Complete Security
Solutions, Inc. ("CSSI") and LucidLine, Inc. ("LucidLine") pursuant to the
filings of Agreements and Plans of Merger with the Secretaries of State of the
States of Delaware and Illinois, respectively. On February 28, 2005, Patron
Systems, Inc. consummated a private placement with accredited investors in the
amount of $3.5 million. On March 30, 2005, we consummated the acquisition of
Entelagent Software Corp. ("Entelagent") pursuant to the filing of an Agreement
and Plan of Merger with the Secretary of State of the State of California. From
March 31, 2005 to September 30, 2005, we borrowed $3,300,000 from a shareholder,
Apex Investment Fund V, LP. During the three months ended September 30, 2005 we
raised approximately $3,600,000 in additional gross funds in five capital
financing transactions, which includes converting $1,650,000 in advances from
stockholders into Bridge Notes. Net proceeds from all of these transaction
amounted to $3,594,000, which were used principally to fund operations and repay
certain liabilities. We discuss these transactions in further detail in this
report.
Our acquisitions have allowed us to develop a platform for trusted security
services and next generation integrated security products, which we intend to
deliver to global corporations and government institutions. We intend to work
with organizations to ensure that global enterprises implement information
security policies, procedures and products that result in "trusted" information
environments.
We currently offer software solutions that fit into overall corporate compliance
and data protection initiatives by automatically finding, archiving and applying
persistent protection to sensitive data - beyond authentication - whenever,
wherever and however sensitive data is shared, accessed and stored. Additionally
we offer software solutions that support real-time secure collection, delivery
and sharing of field-based report information. This software allows law
enforcement and public-safety agencies to have real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system.
We also offer a range of services to corporate and government entities utilizing
fiber optics and data replication technologies to provide secure robust off-site
data backup, recovery, restoration, and retrieval services coupled with
high-speed data communication turnkey solutions. Our secure and scalable
high-speed data communication solutions facilitate seamless instantaneous backup
of mission critical business data and enable immediate access to data and
real-time restoration of critical business functionality in the event of a
crisis or disaster. Additionally, we offer our clients a comprehensive Risk and
Vulnerability Assessment (RAVA) evaluation service. This service provides
security and business impact assessments, which evaluate an organization's
compliance with both Homeland Security and NTSA standards.
32
Furthermore, we intend to address the homeland security requirements that are
being imposed on state, county and municipal governments. The Company believes
that we offer state, county and municipal governments a unique group of product
and service offerings focused on their specific homeland security information
infrastructure issues. This is accomplished by utilizing the full range of our
capabilities for evaluating and assessing information infrastructure risks and
vulnerabilities, combined with our experience in designing, implementing and
managing large, secure information infrastructure systems. Also contributing is
our extensive experience in implementing real-time, secure data collection and
the multi-jurisdictional sharing of law enforcement and public-safety
information combined with our experience in developing and deploying software
solutions which provide secure data and content delivery and management.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the Condensed Consolidated Financial Statements and Notes thereto. Our
application of accounting policies affects these estimates and assumptions.
Actual results could differ from these estimates under different assumptions or
conditions.
REVENUE RECOGNITION
We derive revenues from the following sources: (1) sales of computer software,
which includes new software licenses and software updates and product support
revenues and (2) services, which include internet access, back-up, retrieval and
restoration services and professional consulting services.
We apply the revenue recognition principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff Accounting Bulletin ("SAB") 104 "Revenue Recognition" with
respect to all of our revenue. Accordingly, we record revenue when (i)
persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii)
the vendor's fee is fixed or determinable, and (iv) collectability is probable.
We generate revenues through sales of software licenses and annual support
subscription agreements which include access to technical support and software
updates (if and when available). Software license revenues are generated from
licensing the rights to use our products directly to end-users and through third
party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of our software sales are supported by a
written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. We use the residual method prescribed in
SOP 98-9 to allocate revenues to delivered elements once it has established
vendor-specific evidence for such undelivered elements.
We provide internet access and back-up, retrieval and restoration services under
contractual arrangements with terms ranging from 1 year to 5 years. These
contracts are billed monthly, in advance, based on the contractually stated
rates. At the inception of a contract, we may activate the customer's account
for a contractual fee that it amortizes over the term of the contract in
accordance with Emerging Issues Task Force Issue ("EITF") 00-21 "Revenue
Arrangements with Multiple Deliverables." Our standard contracts are
automatically renewable by the customer unless terminated on 30 days written
notice. Early termination of the contract generally results in an early
termination fee equal to the lesser of six months of service or the remaining
term of the contract.
33
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19.
BUSINESS COMBINATIONS
In accordance with business combination accounting, we allocate the purchase
price of acquired companies to the tangible and intangible assets acquired,
liabilities assumed, as well as in-process research and development based on
their estimated fair values. We have engaged a third-party appraisal firm to
assist management in determining the fair values of certain assets acquired and
liabilities assumed. Such a valuation requires management to make significant
estimates and assumptions, especially with respect to intangible assets.
Management makes estimates of fair value based upon assumptions believed to be
reasonable. These estimates are based on historical experience and information
obtained from the management of the acquired companies. Critical estimates in
valuing certain of the intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements, customer
contracts and acquired developed technologies; expected costs to develop the
in-process research and development into commercially viable products; the
acquired company's brand awareness and market position, as well as assumptions
about the period of time the acquired brand will continue to be used in the
combined company's product portfolio; and discount rates. These estimates are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur which may
affect the accuracy or validity of such assumptions, estimates or actual
results.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with SFAS No. 141,
"Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets." Under SFAS No. 142, goodwill and intangibles that are deemed to have
indefinite lives are no longer amortized but, instead, are to be reviewed at
least annually for impairment. Intangible assets continue to be amortized over
their estimated useful lives.
INCOME TAXES
We account for income taxes pursuant to SFAS No. 109, "Accounting for Income
Taxes". Deferred taxes arise from temporary differences, primarily attributable
to the use of the cash method for tax purposes and accrual method for book
purposes and net operating loss carry-forwards. The Company reserves for
deferred tax assets when more likely than not, the benefit of the asset will not
be realized in the future.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
STOCK OPTION PLANS
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," we have elected to continue to follow the intrinsic
value method in accounting for our stock-based compensation arrangements as
defined by Accounting Principles Board ("APB") Opinion No. 25 "Accounting for
Stock Issued to Employees," and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44 "Accounting for
Certain Transactions Involving Stock Compensation," an interpretation of APB No.
25.
34
NON-EMPLOYEE STOCK BASED COMPENSATION
We record the cost of stock based compensation awards that we have issued to
non-employees for services at either the fair value of the services rendered or
the instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in EITF 96-18,
"Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services."
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2004.
For the three months ended September 30, 2005, our consolidated revenues
amounted to $152,941 compared to $0 for the three months ended September 30,
2004. The increase is the result of business combinations that we consummated
with CSSI and LucidLine in February 2005 and Entelagent in March 2005.
Cost of Sales for the three months ended September 30, 2005 amounted to $249,881
compared to $0 for the three months ended September 30, 2004. Cost of sales
during the three months ended September 30, 2005 includes $133,124 associated
with the amortization of developed technology that we acquired from CSSI and
Entelagent.
Operating expenses amounted to $2,421,200 for the three months ended September
30, 2005 as compared to $1,479,351 for the three months ended September 30,
2004, an increase of $941,849. The increase in operating expenses includes
approximately $919,000 for salaries associated with an increase in the number of
employees from acquired businesses, approximately $133,000 for legal and
professional fees that we incurred principally in connection with bringing the
Company into compliance with its Securities and Exchange Commission reporting
obligations, approximately $31,000 for amortization of acquired intangible
assets, and approximately $456,000 for increased general and administrative
expenses associated with the acquired businesses. These increases were partially
offset by an approximately $32,000 reduction in expense associated with the
amortization of stock-based compensation arrangements, a $300,000 gain on the
reduction in intrinsic value of a stock put right and approximately $311,000
reduction in expense associated with a penalty provision of an Accommodation
Agreement.
Our consolidated loss from operations for the three months ended September 30,
2005 amounted to $2,518,140 compared to a loss of $1,479,351 for the same period
in 2004. Our loss increased as a result of the increases in operating expenses
discussed above.
Interest expense during the three months ended September 30, 2005 amounted to
$10,159,038 as compared to $33,087 for the three months ended September 30,
2004. The increase is directly related to our issuances of notes and the
increased borrowings that we made to finance our acquisitions of CSSI, LucidLine
and Entelagent and fund our working capital needs. Non cash interest relating to
the amortization of deferred financing costs, penalty warrants issued to bridge
note holders and the accretion of debt discounts during the three months ended
September 30, 2005 amounted to approximately $9,853,000 compared to $0 in same
period in 2004. The intrinsic value of the conversion option for bridge note
holders and subordinated note holders, which has been classified as interest
expense amounted to $8,000,000 for the three months ended September 30, 2005
compared to $0 in the same period in 2004. Amortization of deferred finance
charges which have been classified as interest expense was approximately
$1,115,000 in the three months ended September 30, 2005 compared to $0 in the
same period in 2004. Accretion of debt discounts during the three months ended
September 20, 2005 were approximately $750,000 compared to $0 in the same period
in 2004. Interest income, was $0 and $19,250 in the three months ended September
30, 2005 and 2004, respectively. Interest income represents the interest earned
from loans that we made to Entelagent prior to our acquisition of that business
on March 30, 2005.
For the three months ended September 30, 2005, the net loss was $12,677,722 or
$(0.21) per share on 61,499,103 weighted average shares outstanding compared to
a net loss of $1,493,188 or $(0.04) per share on 39,010,560 weighted average
shares outstanding for the three months ended September 30, 2004.
35
NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER
30, 2004.
For the nine months ended September 30, 2005, our consolidated revenues amounted
to $339,212 compared to $0 for the nine months ended September 30, 2004. The
increase is the result of business combinations that we consummated with CSSI
and LucidLine in February 2005 and Entelagent in March 2005.
Cost of Sales for the nine months ended September 30, 2005 amounted to $476,726
compared to $0 for the nine months ended September 30, 2004. Cost of sales
during the nine months ended September 30, 2005 includes $272,792 associated
with the amortization of developed technology that we acquired from CSSI and
Entelagent.
Operating expenses amounted to $7,414,310 for the nine months ended September
30, 2005 as compared to $3,274,798 for the nine months ended September 30, 2004,
an increase in operating expenses of $4,139,512. The increase in operating
expenses includes approximately $2,694,000 for salaries associated with an
increase in the number of employees from acquired businesses, approximately
$761,000 for the amortization of a stock based compensation arrangements,
approximately $703,000 for legal and professional fees that we incurred
principally in connection with bringing the Company into compliance with its
Securities and Exchange Commission reporting obligations, approximately $70,000
for amortization of acquired intangible assets, approximately $474,000 for
increased general and administrative expenses associated with the acquired
businesses, $366,193 loss on collateralized financing arrangement and a $370,000
expense associated with the preparation of a homeland security operational
requirements assessment related to Will County, Illinois. These increases were
partially offset by an approximate $217,000 reduction in expense associated with
the stock based penalties under an accommodation agreement, an approximate
$439,000 reduction in expense associated with losses taken on settlement
agreements, and a gain of approximately $344,000 on settlement of legal claims.
Our consolidated loss from operations for the nine months ended September 30,
2005 amounted to $7,551,824 compared to a loss of $3,274,798 for the same period
in 2004. Our loss increased as a result of the increases in our operating
expenses discussed above.
Interest expense during the nine months ended September 30, 2005 amounted to
$12,376,904 as compared to $99,263 for the nine months ended September 30, 2004.
The increase is directly related to our issuances of notes and the increased
borrowings that we made to finance our acquisitions of CSSI, LucidLine and
Entelagent and to fund our working capital needs. Non-cash interest relating to
the amortization of deferred financing costs, penalty warrants issued to bridge
note and subordinated note holders and the accretion of debt discounts during
the nine months ended September 30, 2005 amounted to approximately $11,740,000
compared to $0 in same period in 2004. Amortization of deferred finance charges
which have been classified as interest expense was approximately $1,826,000 in
the nine months ended September 30, 2005 compared to $0 in the same period in
2004. The intrinsic value of the conversion feature on bridge notes and
subordinated notes, which has been classified as interest expense amounted to
$8,000,000 for the nine months ended September 30, 2005 compared to $0 in the
same period in 2004. Accretion of debt discounts during the nine months ended
September 30, 2005 were approximately $1,927,000 compared to $0 in the same
period in 2004. Interest income, was $19,250 and $57,750 in the nine months
ended September 30, 2005 and 2004, respectively. Interest income represents the
interest earned from loans that we made to Entelagent prior to our acquisition
of that business on March 30, 2005.
For the nine months ended September 30, 2005, the net loss was $19,910,022 or
$(0.35) per share on 57,284,490 weighted average shares outstanding compared to
a net loss of $3,316,311 or $(0.09) per share on 38,610,646 weighted average
shares outstanding for the nine months ended September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss of $19,910,022 for the nine months ended September 30,
2005, which includes $14,598,275 of non-cash charges associated with the fair
value of common stock we issued as penalties under certain registration rights
agreements ($823,747), fair value of common stock warrants issued as a penalty
to bridge note and subordinated note holders ($8,000,000), amortization of
deferred compensation under a stock based compensation arrangement ($1,239,083),
accretion related to warrants issued in conjunction with notes payable
($1,927,374), amortization of deferred financing costs ($1,825,606), loss on a
collateralized financing arrangement ($366,194),
36
non-cash increase in notes payable to a former officer ($17,399), depreciation
and amortization ($382,872) and a charge for the intrinsic value of stock
options ($16,000). The non-cash charges were offset by non-cash gains of
$228,900 associated with the settlement of a related party consulting agreement,
a gain on reduction in intrinsic value of a put right of $300,000, a gain on
legal settlement of $389,103 and $19,250 non-cash interest income. Including the
amounts above, we used net cash flows in our operating activities of $7,781,408
during the nine months ended September 30, 2005. Our working capital deficiency
at September 30, 2005 amounts to $23,033,903 and we are continuing to experience
shortages in working capital. We are also involved in substantial litigation and
are being investigated by the Securities and Exchange Commission with respect to
certain of our press releases and our use of form S-8 to register shares of
common stock that we issued to certain consultants in prior periods. We cannot
provide any assurance that the outcome of these matters will not have a material
adverse affect on our ability to sustain the business. These matters raise
substantial doubt about our ability to continue as a going concern.
We expect to continue incurring losses for the foreseeable future due to the
inherent uncertainty that is related to establishing the commercial feasibility
of technological products and developing a presence in new markets. The
Company's ability to successfully integrate the acquired businesses described in
Note E is critical to the realization of its business plan. The Company raised
$9,643,000 of gross proceeds ($9,015,261 net proceeds after the payment of
certain transaction expenses) in financing transactions during the nine months
ended September 30, 2005. The Company used $7,781,408 of these proceeds to fund
its operations (which includes a $1,388,000 escrow deposit for the payment of
liabilities assumed in business combinations), and a net of $599,728 in
investing activities, which principally includes the cash component of purchase
business combinations that the Company consummated (during February and March of
2005), net of cash acquired in the business combinations and the purchase of
property and equipment. In addition, the Company repaid an aggregate of $668,093
of certain obligations due to certain officer/stockholders, $339,256 of which
was a reduction of the funds held in the restricted cash escrow account
established in connection with the Entelagent Merger (Note E). Subsequent to
September 30, 2005 the Company raised approximately $820,000 in additional gross
funds in three capital financing transactions consummated with a related party
that were used principally to fund operations (Note T).
We are currently in the process of attempting to raise additional capital and
have taken certain steps to conserve our liquidity while we continue to
integrate the acquired businesses. Although we believe that we have access to
capital resources, we have not secured any commitments for additional financing
at this time nor can we provide any assurance that we will be successful in our
efforts to raise additional capital and/or successfully execute our business
plan. In an effort to secure additional financing, the Company has, subsequent
to September 30, 2005, offered its creditors and claimants a proposed agreement
to issue common stock for amounts owed to the holders of the Company's
indebtedness (including lenders, past-due trade accounts, and employees,
consultants and other service providers with claims for fees, wages or expenses)
(see Note S).
OFF-BALANCE SHEET ARRANGEMENTS
At September 30, 2005, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, variable interest or special purpose entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. As such, we are
not exposed to any financing, liquidity, market or credit risk that could arise
if we had engaged in such relationships.
CAUTIONARY STATEMENTS AND RISK FACTORS
The risks noted below and elsewhere in this report and in other documents we
file with the SEC are risks and uncertainties that could cause our actual
results to differ materially from the results contemplated by the
forward-looking statements contained in this report and other public statements
we make.
RISKS RELATED TO OUR COMMON STOCK
THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
37
may become insolvent. As of September 30, 2005, our cash balance was $80,233 and
we had a working capital deficit of $23,033,903. This raises substantial doubt
about our ability to continue as a going concern. Historically, we have funded
our capital requirements with debt and equity financing. Our ability to obtain
additional equity or debt financing depends on a number of factors including our
financial performance and the overall conditions in our industry. If we are not
able to raise additional financing or if such financing is not available on
acceptable terms, we may liquidate assets, seek or be forced into bankruptcy,
and/or continue operations but suffer material harm to our operations and
financial condition. These measures could have a material adverse affect on our
ability to continue as a going concern.
INVESTORS MAY NOT BE ABLE TO ADEQUATELY EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR LIMITED OPERATING HISTORY, LACK OF REVENUES AND LACK OF PRODUCT
OFFERINGS.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. Combined Professional Services was
incorporated in Nevada in 1995 and Patron was incorporated in Delaware in 2002.
We have not had significant business operations since inception. As a result of
our limited history, it may be difficult to plan operating expenses or forecast
our revenues accurately. Our assumptions about customer or network requirements
may be wrong. The revenue and income potential of these products is unproven,
and the markets addressed by these products are volatile. If such products are
not successful, our actual operating results could be below our expectations and
the expectations of investors and market analysts, which would likely cause the
price of our common stock to decline.
We generated no revenue from operations through December 31, 2004 and relied on
financing generated from our capital raising activities to fund the
implementation of our business plan. We have incurred operating and net losses
and negative cash flows from operations since our inception. As of September 30,
2005, we had an accumulated deficit of approximately $60 million. We may
continue to incur operating and net losses, due in part to implementing our
acquisitions strategy, engaging in financing activities and expansion of our
personnel and our business development capabilities. We will continue to seek
financing for the acquisition of other acquisition targets that we may identify
in the future. We continue to believe that we will secure financing in the near
future, but there can be no assurance of our success. If we are unable to obtain
the necessary funding, it will materially adversely affect our ability to
execute our business plan and to continue our operations.
In addition, we may not be able to achieve or maintain profitability, and, even
if we do achieve profitability, the level of any profitability cannot be
predicted and may vary significantly from quarter to quarter.
THERE CAN BE NO GUARANTY THAT A MARKET WILL DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.
We currently have a limited offering of products. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH MAY RESULT IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
38
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate fluctuations, could also cause the market price of our common stock to
decline. Our common stock has experienced, and is likely to continue to
experience, these fluctuations in price, regardless of our performance.
WE ARE CURRENTLY SUBJECT TO AN SEC INVESTIGATION.
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), the staff of
the SEC (the "Staff"), issued an order (In the Matter of Patron Systems, Inc. -
Order Directing a Private Investigation and Designating Officers to Take
Testimony (C-03739-A, February 12, 2004)) (the "Order") that a private
investigation (the "SEC Investigation") be made to determine whether certain of
our actions, among others, certain of its officers and directors and others (as
described below) violated Section 5(a) and 5(c) of the Securities Act and/or
Section 10 and Rule 10b-5 promulgated under the Exchange Act. Generally, the
Order provides, among other things, that the Staff is investigating (i) the
legality of two (2) separate Registration Statements filed by us on Form S-8,
filed on December 20, 2002 and on April 2, 2003, as amended on April 9, 2003
(collectively, the "Registration Statements"), covering the resale of, in the
aggregate, 4,375,000 shares of common stock issued to various of our
consultants, and (ii) whether in connection with the purchase or sale of shares
of common stock, certain of our officers, directors and others (a) sold common
stock in violation of Section 5 of the Securities Act and/or, (b) made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection with such purchases and/or sales relating to certain of
our press releases regarding, among other items, proposed mergers and
acquisitions that were never consummated. If the SEC brings an action against
us, it could result in, among other items, a civil injunctive order or an
administrative cease-and-desist order being entered against us, in addition to
the imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely our ability to have our
common stock listed on a stock exchange and/or quoted on the NASD Bulletin Board
or NASDAQ, our ability to sell our securities and/or have our securities
registered with the SEC and/or in various states and/or our ability to implement
its business plan. To date, our legal counsel representing us in such matters
has indicated that the SEC Investigation is ongoing and the Staff has not
indicated whether it will or will not recommend that the SEC bring an
enforcement action against us, our officers, directors and/or others.
THE CONCENTRATION OF OUR CAPITAL STOCK OWNERSHIP WITH INSIDERS IS LIKELY TO
LIMIT THE ABILITY OF OTHER STOCKHOLDERS TO INFLUENCE CORPORATE MATTERS.
As of September 30, 2005, the executive officers, directors and entities
affiliated with any of them together beneficially own approximately 17% of our
outstanding common stock. As a result, these stockholders may be able to
exercise control over matters requiring approval by our stockholders, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership might also have the effect of delaying or
preventing a change in our control that might be viewed as beneficial by other
stockholders.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of September 30, 2005, there are
60,427,299 shares of common stock outstanding and shares to be issued, of which
all but 49,998,049 shares are held by directors, executive officers and other
affiliates, the sale of which are subject to volume limitations under Rule 144,
various vesting agreements and our quarterly and other "blackout" periods.
Furthermore, shares subject to outstanding options and warrants and shares
reserved for future issuance under our stock option plan will become eligible
for sale in the public market to the extent permitted by the provisions of
various vesting agreements, the lock-up agreements and Rule 144 under the
Securities Act.
39
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
o the demand for our subsidiaries' current product offerings and our
future products;
o the length of sales cycles;
o the timing of recognizing revenues;
o new product introductions by us or our competitors;
o changes in our pricing policies or the pricing policies of our
competitors;
o variations in sales channels, product costs or mix of products sold;
o our ability to develop, introduce and ship in a timely manner new
products and product enhancements that meet customer requirements;
o our ability to obtain sufficient supplies of sole or limited source
components for our products;
o variations in the prices of the components we purchase;
o our ability to attain and maintain production volumes and quality
levels for our products at reasonable prices at our third-party
manufacturers;
o our ability to manage our customer base and credit risk and to collect
our accounts receivable; and
o the financial strength of our value-added resellers and distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses.
OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES. THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.
If at any time a company has net tangible assets of $5,000,000 or less and the
common stock has a market price per share of less than $5.00, transactions in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:
o make a special written suitability determination for the purchaser;
o receive the purchaser's written agreement to a transaction prior to
sale;
o provide the purchaser with risk disclosure documents which identify
certain risks associated with investing in "penny stocks" and which
describe the market for these "penny stocks" as well as a purchaser's
legal remedies; and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the required
risk disclosure document before a transaction in a "penny stock" can be
completed.
If our common stock becomes subject to these rules, broker-dealers may find it
difficult to effectuate customer transactions and trading activity in our
securities may be adversely affected. As a result, the market price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.
RISKS RELATED TO OUR BUSINESS
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.
40
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. The process of integrating could
cause an interruption of, or loss of momentum in, the activities of our business
and the loss of key personnel. The diversion of management's attention and any
delays or difficulties encountered in connection with our integration of
acquired operations could have an adverse effect on our business, results of
operations, financial condition or prospects.
WE CURRENTLY DO NOT HAVE SUFFICIENT REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES
AND IF OPERATING LOSSES CONTINUE, WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL
THROUGH FINANCINGS WHICH WE MAY NOT BE ABLE TO SECURE.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like ours, remains
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Inability to obtain
additional financing may require us to delay, scale back or eliminate certain of
our growth plans which could have a material and adverse effect on our business,
financial condition or results of operations or to cease operations. Even if we
are able to obtain additional financing, such financing could be structured as
equity financing that would dilute the ownership percentage of any investor in
our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for our current products and other products we intend to offer
depends on economic conditions affecting the broader Internet infrastructure,
network security and related markets. Downturns in these markets may cause
enterprises and carriers to delay or cancel security projects, reduce their
overall or security-specific information technology budgets or reduce or cancel
orders for our current products and other products we intend to offer. In this
environment, customers such as distributors, value-added resellers and carriers
may experience financial difficulty, cease operations and fail to budget or
reduce budgets for the purchase of our current products or other products we
intend to offer. This, in turn, may lead to longer sales cycles, delays in
purchase decisions, payment and collection, and may also result in price
pressures, causing us to realize lower revenues, gross margins and operating
margins. In addition, general economic uncertainty caused by potential
hostilities involving the United States, terrorist activities, the decline in
specific markets such as the service provider market in the United States, and
the general decline in capital spending in the information technology sector
make it difficult to predict changes in the purchase and network requirements of
our potential customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on information technology. A decline in capital spending in the markets we
intend to serve may adversely affect our future revenues, gross margins and
operating margins and make it necessary for us to gain significant market share
from our future competitors in order to achieve our financial goals and achieve
profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we currently offer or intend to
offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we have. In addition, some
of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we currently offer and intend to offer. If any of our larger
potential competitors were to commit greater technical, sales, marketing and
other resources to the markets we intend to serve, or reduce prices for their
products over a sustained period of time, our ability to successfully sell the
products we intend to offer, increase revenue or meet our or market analysts
expectations could be adversely affected.
41
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced
security capabilities into our intended product offerings. Some of these
products and enhancements may require us to develop new hardware architectures
that involve complex and time-consuming processes. In developing and introducing
our intended product offerings, we have made, and will continue to make,
assumptions with respect to which features, security standards and performance
criteria will be required by our potential customers. If we implement features,
security standards and performance criteria that are different from those
required by our potential customers, market acceptance of our intended product
offerings may be significantly reduced or delayed, which would harm our ability
to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer deployments and, as a consequence, our revenues may be adversely
affected. In addition, the introduction of products embodying new technologies
could render existing products we intend to offer obsolete, which would have a
direct, adverse effect on our market share and revenues. Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating results to be below our expectations
and the expectations of investors and market analysts, which would likely cause
the price of our common stock to decline.
WE HAVE MATERIAL WEAKNESSES IN OUR FINANCIAL SYSTEMS, INTERNAL CONTROLS AND
OPERATIONS THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS,
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. Our
Chief Executive Officer and Acting Chief Financial Officer evaluated the
effectiveness of our disclosure controls and procedures in accordance with
Exchange Act Rules 13a-15 or 15d-15 and identified material weaknesses in our
internal control relating to, among other things, our limited segregation of
duties, ability to identify and record complex transactions including capital
financing transactions and business combinations and timely file our tax
returns. The identification of these material weaknesses has led our Chief
Executive Officer and Acting Chief Financial Officer to conclude that our
disclosure controls and procedures are currently not adequate to enable us to
record, process, summarize and report information required to be included in our
periodic SEC filings within the required time period.
We have limited management resources to date and are still establishing our
management and financial systems. Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Our future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not
42
interoperate with those within our end customers' networks, installations could
be delayed or orders for our products could be cancelled, which could
significantly reduce our anticipated revenues.
AS A PUBLIC COMPANY, WE MAY INCUR INCREASED COSTS AS A RESULT OF RECENTLY
ENACTED AND PROPOSED CHANGES IN LAWS AND REGULATIONS RELATING TO CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.
Recently enacted and proposed changes in the laws and regulations affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased costs for us as we
evaluate the implications of these laws, regulations and standards and respond
to their requirements. These laws and regulations could make it more difficult
or more costly for us to obtain certain types of insurance, including director
and officer liability insurance, and we may be forced to accept reduced policy
limits and coverage or incur substantially higher costs to obtain the same or
similar coverage. The impact of these events could also make it more difficult
for us to attract and retain qualified persons to serve on our board of
directors, board committees or as executive officers. We cannot estimate the
amount or timing of additional costs we may incur as a result of these laws and
regulations.
WE WILL DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A
RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR
RETAIN EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
Our future success depends upon the continued services of our executive
officers. The loss of the services of any of our key employees, the inability to
attract or retain qualified personnel in the future, or delays in hiring
required personnel, could delay the development and introduction of, and
negatively impact our ability to sell, our intended product offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
o stop or delay selling, incorporating or using products that use the
challenged intellectual property; and/or
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology, which license might not
be available on reasonable terms or at all; or redesign the products
that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
43
THE INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. The inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and
domestic sales. The United States and various foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, especially encryption technology. In addition, from time
to time, governmental agencies have proposed additional regulation of encryption
technology, such as requiring the escrow and governmental recovery of private
encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might decrease demand for our intended product
offerings and services. In addition, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete more effectively than we can in the domestic and
international network security market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES
Members of our management, including our Chief Executive Officer and Acting
Chief Financial Officer, have evaluated the effectiveness of our disclosure
controls and procedures, as defined by paragraph (e) of Exchange Act Rules
13a-15 or 15d-15. Based on that evaluation and the material weakness described
below, our Chief Executive Officer and Acting Chief Financial Officer concluded
that our disclosure controls and procedures were not adequate to enable us to
record, process, summarize and report information required to be included in our
periodic SEC filings within the required time period.
DISCLOSURE CONTROLS AND INTERNAL CONTROLS
Disclosure controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934, as amended, such as this Report, is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Disclosure controls are also designed with the
objective of ensuring that such information is accumulated and communicated to
our management, including our Chief Executive Officer and Senior Vice President,
Finance and Administration, as appropriate, to allow timely decisions regarding
required disclosure. Internal controls are procedures which are designed with
the objective of providing reasonable assurance that our transactions are
properly authorized, recorded and reported and our assets are safeguarded
against unauthorized or improper use, to permit the preparation of our financial
statements in conformity with generally accepted accounting principles.
44
Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not required to deliver management's report on control over our
financial reporting until our fiscal year ended December 31, 2006. Nevertheless,
we identified certain matters that would constitute material weaknesses (as
defined under the Public Company Accounting Oversight Board Auditing Standard
No. 2) in our internal controls over financial reporting.
We have identified deficiencies in our system of internal controls, which are
considered to be material weaknesses. These material weaknesses have led us to
conclude that we currently have an inadequate structure with respect to our
financial reporting systems. Until March of 2005, we had no central corporate
accounting department. Each of our subsidiaries separately maintained its own
books and records and independently controlled its cash disbursements and cash
receipts. The decentralized nature of our accounting system limits the
effectiveness of our internal control procedures and our ability to detect
potential misstatements and incorrect accounting and financial reporting. The
subsidiary accounting departments do not have the sophistication to critically
evaluate and implement new accounting pronouncements, and stock based
transactions for options, warrants and common stock. At times these transactions
were not recorded properly and required additional procedures and review and we
were required to record adjustments proposed by our independent registered
public accounting firm.
Certain of the material weaknesses we identified relate to our limited
segregation of duties. Segregation of duties within our company is limited due
to the fact that we have not had (until recently) any full-time employees since
February 10, 2004 and, until the completion of business combinations during the
quarter ended March 31, 2005, our Company's affairs have been managed by our
non-executive Chairman and Sole Director Robert E, Yaw, II. In addition, our
financial records up until that time were maintained by a former employee who
had been providing these services to us on a consulting basis. This condition
constituted a material weakness in our financial reporting system and a system
of internal controls that has affected our ability to timely close our books on
a quarterly and annual basis.
The second material weakness we identified is in our ability to implement the
requirements of complex accounting pronouncements. We have had difficulty with
ensuring that the accounting for our equity-based transactions is accurate and
complete. Since April 30, 2002 (Inception), we have consummated a series of
complex equity transactions involving the application of highly specialized
accounting principles. The equity based transactions that we have had difficulty
with specifically relate to stock to be issued under consulting agreements, the
penalty shares to be issued in connection with the Accommodation Agreements, and
the common stock to be repurchased in connection with the Allin Settlement
Agreement. We also experienced difficulty with applying the requirements of SFAS
141 "Business Combinations" and related pronouncement as it relates to our
acquisitions of CSSI, LucidLine and Entelagent. Although we believe that certain
of these events are unique and that our equity based transactions in the future
are likely to be substantially reduced, we are evaluating certain corrective
measures to provide us with the structure we need at such times that we may
engage in equity based transactions and consummate additional business
combinations in the future.
The third material weakness we identified is in our ability to implement a tax
reporting structure to file, on a timely basis, Federal and state tax returns.
This material weakness is primarily due to our limited segregation of duties.
Through our acquisitions of CSSI, LucidLine and Entelagent, we have
significantly increased the number of employees working for us and intend to
implement a tax reporting structure to address this deficiency.
We believe these material weaknesses resulted from continued working capital
deficiencies and a failure to generate cash flows from operations. Immediately
following our acquisitions, we appointed a Chief Executive Officer/Acting Chief
Financial Officer who is principally responsible for overseeing our financial
affairs. In addition, we increased our number of employees with our acquisitions
of Entelagent, LucidLine and CSSI and have begun the process of screening
candidates for key positions in our finance department. We believe that the
expansion of our operations and increase in the number of employees will enable
us to take corrective measures once we finish evaluating our existing
capabilities and our available resources to take such corrective measures.
Additionally, we expect to hire a Chief Financial Officer with public company
experience within the next twelve months and relieve our Chief Executive Officer
of his current Acting Chief Financial Officer duties.
We believe that any such risks are partially mitigated by the fact that we had
minimal assets and activities during our most recent reporting periods,
recordkeeping and authorization function were not being performed by the same
individual and the non-executive Chairman reviewed and approved all of our
transactions. However, we
45
acknowledge that additional control procedures are necessary to ensure that our
transactions are properly recorded and that our assets are appropriately
safeguarded.
INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes in our internal control over financial reporting or in
other factors identified in connection with the evaluation required by paragraph
(d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the nine months
ended September 30, 2005 or the four quarters ended December 31, 2004 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
46
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In April of 2005, Richard L. Linting, a former President of the Company's
Professional Services Group, filed a complaint against the Company and Robert E.
Yaw, II, the Company's non-executive Chairman, in the Circuit Court of Cook
County, Illinois alleging breach of his purported employment contract and
seeking sums allegedly owed under the employment contract in the amount of
$1,321,809, plus court costs and fees. On August 22, 2005, the Company, Mr.
Linting and Mr. Yaw entered into a Settlement Agreement and Release whereby Mr.
Linting agreed to release all claims against the Company and Mr. Yaw existing as
of that date in consideration for (i) the payment by the Company to Mr. Linting
of $100,000 in cash, (ii) the issuance by the Company of an aggregate of 422,827
shares ("Linting Shares") of the Company's common stock (equivalent to $192,809
divided by $0.456) to be transferred to Mr. Linting in such numbers and at such
times as directed by Mr. Linting subsequent to the registration of the Linting
Shares, (iii) the Company's agreement to register the Linting Shares through the
filing of a registration statement on or before September 30, 2005, and (iv) the
Company's affirmation of the validity of options previously issued to Mr.
Linting and agreement to permit exercises of those options for 100,000 shares in
each calendar month over a period of 3 years. The Company and Mr. Linting also
agreed to the filing of a stipulation to dismiss Mr. Linting's suit with
prejudice and without costs with the court retaining jurisdiction to reinstate
the case and enforce the terms of the Settlement Agreement and Release in the
event the Company defaulted on its obligations under the Settlement Agreement
and Release, and to enter judgment, by motion, against the Company for the
balance due or appropriate relief. The Company did not make the $100,000 payment
required under the Settlement Agreement and Release, erroneously issued the
Linting Shares to Mr. Linting, and did not file a registration statement to
register the Linting Shares on or before September 30, 2005. Subsequent to
September 30, 2005, Mr. Linting obtained a judgment against the Company for
$100,452 in cash and 422,827 shares of the Company's common stock to be issued
to Mr. Linting at his determination upon registration thereof. The Company
continues to negotiate with Mr. Linting regarding the amounts owed to him.
In December of 2004, Marie Graul, the Company's former Chief Financial Officer,
informed the Company of her intention to assert a claim against the Company for
sums allegedly owed under her employment agreement with the Company. On August
31, 2005, the Company and Ms. Graul entered into a Settlement Agreement and
Mutual Release whereby Ms. Graul agreed to release all claims against the
Company arising from any act or omission occurring on or prior to that date in
consideration of (i) the payment by the Company to Ms. Graul of an aggregate of
$176,458 no later than September 30, 2005, $1,458 of which was payable on
execution of the Settlement Agreement and Mutual Release, and (ii) the Company's
affirmation of the validity of options previously issued to Ms. Graul. The
Company also agreed to confess to a judgment against the Company in a court of
Ms. Graul's choosing in the event of the Company's breach of the Settlement
Agreement and Mutual Release. The Company did not make the payments required by
the Settlement Agreement and Mutual Release. Subsequent to September 30, 2005,
Ms. Graul obtained a judgment against the Company for $176,853 in cash. The
Company continues to negotiate with Ms. Graul regarding the amounts owed to her.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In connection with the Settlement Agreement and Release entered into among the
Company, Robert E. Yaw, II and Richard Linting, the Company erroneously issued
422,827 shares of its common stock to Mr. Linting. The Company is exerting all
efforts to obtain the return of the shares.
47
The following unregistered derivative securities (warrants) have been issued by
us during the period from July 1, 2005 to September 30, 2005:
NAME OF NAME OR CLASS OF
DATE OF GRANT TITLE AND AMOUNT OF SECURITIES PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
DATE OF GRANT GRANTED/EXERCISE PRICE IF APPLICABLE UNDERWRITER SECURITIES RECEIVED
------------- ------------------------------------ ----------- ---------- --------
July 925,000/Common Stock Purchase None 2 Accredited Investors $0.00(1)
2005 Warrants in Interim Bridge
Financing III
July 50,000/Common Stock Purchase Warrants None Advanced Equities $0.00(2)
2005 Venture Partners I,
L.P.
August 225,000/Common Stock Purchase None Apex Investment Fund V, $0.00(3)
2005 Warrants L.P.
August 13,440,000/Common Stock Purchase None 33 Accredited Investors $0.00(4)
2005 Warrants in Interim Bridge
Financing I
August 17,280,000/Common Stock Purchase None 3 Accredited Investors $0.00(5)
2005 Warrants holding Subordinated
Notes
September 600,000/Common Stock Purchase None Apex Investment Fund V, $0.00(6)
2005 Warrants L.P.
1. On July 1, 2005, we issued warrants to purchase up to 925,000 shares of
our common stock to 2 accredited investors who invested in our Interim
Bridge Financing III. The warrants have a term of 5 years and an
exercise price of $0.60 per share.
2. On July 29, 2005, we issued warrants to purchase up to 50,000 shares of
our common stock to Advanced Equities Investment Fund V, L.P. who
invested in our Interim Bridge Financing III. The warrants have a term
of 5 years and an exercise price of $0.60 per share.
3. On August 19, 2005, we issued warrants to purchase up to 225,000 shares
of our common stock to Apex Investment Fund V, L.P. who invested in our
Interim Bridge Financing III. The warrants have a term of 5 years and
an exercise price of $0.60 per share.
4. On August 28, 2005, we issued warrants to purchase up to 13,440,000
shares of our common stock to 33 accredited investors who invested in
our Interim Bridge Financing I. The warrants have a term of 5 years and
may be exercised only by the presentation of the outstanding Interim
Bridge Financing I note in payment of the exercise price.
5. On August 25, 2005, we issued warrants to purchase up to 17,280,000
shares of our common stock to 3 accredited investors who received
Subordinated Notes in conjunction with our acquisition of Complete
Security Solutions, Inc. The warrants have a term of 5 years and may be
exercised only by the presentation of the outstanding Subordinated
Notes in payment of the exercise price.
6. On September 30, 2005, we issued warrants to purchase up to 600,000
shares of our common stock to Apex Investment Fund V, L.P. who invested
in our Interim Bridge Financing III. The warrants have a term of 5
years and an exercise price of $0.60 per share.
The above unregistered securities were issued pursuant to an exemption from the
registration requirements of the Securities Act under Section 4(2) of the
Securities Act.
ITEM 6. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------------
10.1 Lease Agreement dated August 31, 2005, between Patron Systems, Inc. and
Flatiron Boulder Office, Inc.
31.1 Certification of principal executive officer and acting principal
financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350. as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
48
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: November 21, 2005 PATRON SYSTEMS, INC.
--------------------
(Registrant)
/S/ ROBERT CROSS
--------------------------------------------
By: Robert Cross
Its: Chief Executive Officer and
Acting Chief Financial Officer
49