UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB/A
[X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the quarterly period ended March 31, 2003
[ ] Transition Report Under Section 13 or 15(d) of the Exchange Act
For the transition period from to
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Commission file number 0-25675
PATRON SYSTEMS, INC.
(Exact name of small business issuer as specified in its charter)
DELAWARE 74-3055158
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(State or other jurisdiction of incorporation (IRS Employer
or organization) Identification No.)
311 BELLE FORET DRIVE, SUITE 150, LAKE BLUFF, IL 60044
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(Address of principal executive offices)
(847) 295-7338
-----------------------
(Issuer's telephone number)
--------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Check whether the registrant filed all documents and reports required to be
filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of
securities under a plan confirmed by a court. Yes [ ] No [ ]
As of May 20, 2003 there were 68,144,148 shares of the issuer's common stock,
par value $0.01 per share, outstanding.
Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]
PATRON SYSTEMS, INC.
INDEX
Page
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets at March 31, 2003 (Unaudited and Restated) and December 31, 2002 1
(Unaudited and Restated) Consolidated Statements of Operations for the Three-Months Ended
March 31, 2003 and the period from inception (April 30, 2002) to March 31, 2003 2
(Unaudited and Restated) Consolidated Statement of Stockholders' Deficit for the period from
inception (April 30, 2002) to March 31, 2003 3
(Unaudited and Restated) Consolidated Statements of Cash Flows for the Three-Months Ended
March 31, 2003 and the period from inception (April 30, 2002) to March 31, 2003 4
Notes to Unaudited Consolidated Financial Statements 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION 9
ITEM 3. CONTROLS AND PROCEDURES 21
PART II. OTHER INFORMATION
ITEMS 6. EXHIBITS AND REPORTS ON FORM 8-K 21
SIGNATURES 22
CERTIFICATIONS 23
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2003 2002
------------------------------------------------------------------------------------------------------------------
(UNAUDITED AND RESTATED)
ASSETS
CURRENT ASSETS
------------------------------------------------
Cash and cash equivalents $ 11,486 $ 362
Loans to TrustWave Corp. and Entelagent Software Corp. 3,036,729 1,188,654
------------------------------------------------
TOTAL CURRENT ASSETS 3,048,215 1,189,016
DEFERRED COSTS ASSOCIATED WITH PENDING ACQUISITIONS 296,863 212,509
TOTAL ASSETS $ 3,345,078 $ 1,401,525
------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Notes Payable $ 229,900 $ 229,900
Accounts payable 1,408,880 1,200,274
Expense reimbursement due to officers and shareholders 208,516 453,127
Accrued payroll and payroll related expenses 740,833 659,858
Advances from Shareholders 1,243,500 628,500
------------------------------------------------
TOTAL CURRENT LIABILITIES 3,831,629 3,171,659
OBLIGATION UNDER FINANCING ARRANGEMENT -- 1,497,728
STOCKHOLDERS' EQUITY (DEFICIT)
Common stock, par value $.01 per share, 150,000,000
shares authorized, 49,269,247 and 41,137,417 shares
issued and outstanding as of March 31, 2003 and
December 31, 2002, respectively 492,692 41,137
Additional paid in capital 39,715,793 26,254,632
Shares issued and held in escrow (14,592,760 shares) (20,792,986) (13,235,293)
Accumulated Deficit during Developmental Stage (19,902,050) (16,328,338)
------------------------------------------------
Total Stockholders' Equity (Deficit) (486,551) (3,267,862)
------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 3,345,078 $ 1,401,525
------------------------------------------------------------------------------------------------------------------
1
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED AND RESTATED)
PERIOD FROM
INCEPTION
THREE-MONTHS ENDED (APRIL 30, 2002) TO
MARCH 31, 2003 MARCH 31, 2003
------------------ -------------------
REVENUE $ -- $ --
------------------ -------------------
General and Administrative Expenses (1,474,555) (3,913,615)
Charge associated with issuance of stock in reverse merger transaction -- (3,965,726)
Common stock issued for business development consulting services -- (4,168,750)
Stock options granted for services -- (4,676,000)
------------------ -------------------
LOSS FROM OPERATIONS (1,474,555) (16,724,091)
OTHER INCOME (EXPENSE)
Loss on financing arrangement (2,210,272) (3,258,000)
Interest Income (Expense) 111,115 80,041
------------------ -------------------
LOSS BEFORE INCOME TAXES (3,573,712) (19,902,050)
INCOME TAX BENEFIT -- --
------------------ -------------------
NET LOSS $ (3,573,712) $ (19,902,050)
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Net Loss Per Share--Basic and Diluted $ (0.10) $ (0.65)
------------------ -------------------
Weighted Average Number of Shares Outstanding--Basic and Diluted 34,190,495 30,380,203
------------------ -------------------
2
CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT (UNAUDITED AND RESTATED)
For the period from inception (April 30, 2003) to March 31, 2003
------------------------------------------------------------------------------------------------------------------------------------
DEFICIT
PAR VALUE ADDITIONAL SHARES HELD ACCUMULATED
SHARES OF COMMON PAID IN DURING THE
COMMON STOCK STOCK CAPITAL IN ESCROW DEVELOPMENT STAGE TOTAL
--------------------------------------------------------------------------------------
Balance at Inception (April 30, 2002) -- $ -- $ -- -- $ -- $ --
Issuance of founders shares 25,000,000 25,000 225,000 -- -- 250,000
Shares issued to predecessor in exchange
transaction 2,687,200 2,687 -- -- -- 2,687
Issuance of common stock in share exchange
transaction 2,201,688 2,202 3,960,836 -- -- 3,963,038
Common stock issued in lieu of cash for
services 2,425,000 2,425 4,166,325 -- -- 4,168,750
Stock options issued in lieu for cash for
services -- -- 4,676,000 -- -- 4,676,000
Issuance of common stock as collateral to
anticipated financing 8,823,529 8,823 13,226,471 (13,235,293) -- --
Net loss for period ended
December 31, 2002 (16,328,338) (16,328,338)
--------------------------------------------------------------------------------------
Balance, December 31, 2002 41,137,417 41,137 26,254,632 (13,235,293) (16,328,338) (16,328,338)
Issuance of common stock in private
placement transactions 1,162,500 7,125 2,640,027 2,647,152
Common stock issued under Accommodation
Agreement 1,200,000 1,200 3,706,672 3,707,872
Issuance of common stock as collateral to
anticipated financing 5,769,231 5,769 7,551,923 (7,557,693) --
Adjustment to Par Value for Redomestication
to Delaware 437,461 (437,461) --
Net loss for period ended March 31, 2003 (3,573,712) (3,573,712)
--------------------------------------------------------------------------------------
Balance, March 31, 2003 49,269,148 $ 492,692 $ 39,715,793 (20,792,986) $ (19,902,050) $ (486,551)
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3
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED AND RESTATED)
PERIOD FROM INCEPTION
THREE-MONTHS ENDED (APRIL 30, 2002) TO
MARCH 31, 2003 MARCH 31, 2003
------------------------ -----------------------
Cash Flows from Operating Activities
Net loss $ (3,573,712) $ (19,902,050)
------------------------ ------------------------
Adjustments to reconcile net loss to net cash provided in
operating activities:
Non-cash charge associated with share exchange transaction -- 3,965,726
Common stock issued in lieu of cash for services -- 4,168,750
Stock options issued in lieu of cash for services -- 4,676,000
Non-cash loss on financing arrangement 2,210,272 3,258,000
Changes in assets and liabilities:
Accounts payable 208,606 1,693,880
Expense reimbursement due to officers and shareholders (244,741) 208,516
Accrued payroll and payroll related expenses 80,976 754,144
------------------------ ------------------------
Total adjustments 2,255,113 18,725,016
------------------------ ------------------------
Net Cash Used in Operating Activities (1,318,599) (1,177,034)
------------------------ ------------------------
Cash Flows Used in Investing Activities
Loans to TrustWave Corp. and Entelagent Software Corp. (1,848,075) (3,335,040)
Deferred costs associated with pending acquisitions (84,354) (296,863)
------------------------ ------------------------
Net Cash Used in Investing Activities (1,932,429) (3,631,903)
Cash Flows from Financing Activities
Proceeds from issuance of notes payable -- 229,900
Proceeds from issuance of common stock 2,647,152 2,897,023
Advances from shareholders 615,000 1,243,500
Proceeds received under financing arrangement -- 450,000
------------------------ ------------------------
Net Cash Provided by Financing Activities 3,262,152 4,820,423
Net Cash Increase (Decrease) 11,124 11,486
------------------------ ------------------------
Cash and Cash Equivalents, beginning of period 362 --
Cash and Cash Equivalents, end of period $ 11,486 $ 11,486
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4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- GENERAL
In the opinion of management, the accompanying unaudited consolidated financial
statements contain all adjustments (consisting of normal recurring accruals)
necessary to present fairly the financial position of Patron Systems, Inc., and
its subsidiaries at March 31, 2003 and December 31, 2002, and the results of its
operations and its cash flows for the three-month period ended March 31, 2003.
In addition, the accompanying unaudited consolidated financial statements
reflect restatement adjustments to reflect certain cash activity disclosed in
Note F. Such activity was not reflected in the Company's original Form 10-QSB
filing as of and for the quarter ended March 31, 2003. In addition, the Company
has reclassified its obligations related to Advances from Shareholders to a
current liability to reflect the related amounts are due on demand and has
revised the reported weighted average shares outstanding for the three months
ended March 31, 2003 to exclude shares held issued but held in escrow.
The results of operations presented are not necessarily indicative of the
results that may be expected for the fiscal year ending December 31, 2003. The
significant accounting principals and practices followed by Patron Systems, Inc.
are set forth in the Notes to Consolidated Financial Statements in Patron
System's Annual Report on Form 10KSB for the year ended December 31, 2002.
NOTE B -- ORGANIZATION AND BUSINESS
Patron Systems, Inc. (herein referred to as "Systems" or the "Company") is a
successor entity to Combined Professional Services, Inc., a Nevada corporation
originally formed in October 1995 (CPS), which later changed its name in a share
exchange to Patron Holdings, Inc. (Holdings). Holdings (as CPS) was originally
formed to provide corporate financial services to other business entities, but
abandoned that business plan shortly after formation. Holdings, therefore, has
never had business operations or revenue.
On October 11, 2002, Holdings (as CPS), Systems and the stockholders of Systems
consummated a share exchange (Share Exchange) pursuant to an Amended and
Restated Share Exchange Agreement, whereby Holdings (as CPS) issued to each
Systems stockholder, on a one-for-one basis and in exchange for all of the
outstanding shares of Systems capital stock, an aggregate of 25,400,000 shares
of Holdings (as CPS) common stock. Upon the closing of the Share Exchange,
Systems' stockholders held approximately 85 percent of the outstanding capital
stock of Holdings (as CPS), and Systems became a wholly-owned subsidiary of
Holdings (as CPS). The share exchange was accounted for as a reverse merger
whereby Systems, as the surviving company, was treated as the acquirer for
financial statement purposes.
On March 26, 2003, Holdings merged with and into Systems, for the purpose of
changing its state of incorporation from Nevada to Delaware (Redomestication
Merger). Systems became the surviving corporation of the Redomestication Merger,
and its Second Amended and Restated Certificate of Incorporation, Amended and
Restated Bylaws are the governing documents of the surviving corporation.
Systems' Board of Directors is the governing body of the Surviving Corporation.
Patron Systems, Inc., a Delaware corporation, was formed in April 2002 to
provide comprehensive, end-to-end information security solutions to global
corporations and government institutions. Systems' founders intended to raise
capital on a private equity basis, but determined that there was a need for
public currency to achieve their growth path. Systems identified CPS during this
process and determined that CPS was well-suited to provide Systems with its
public currency because of its lack of operational history, affording Systems an
open platform from which to grow, without the necessity of divesting existing
operations or incurring liabilities as a result of existing operations.
The Company has yet to begin revenue-generating operations and, as such, is a
development stage company. Since its inception, the Company has reported a net
loss of approximately $19,900,000, principally associated with expenses related
to the formation of the Company, assembling its management team, and capital
formation and acquisition activities consistent with its business plan. A
significant portion of this net loss can be attributed to non-cash capital stock
transactions, such as the issuance of capital stock or stock options in lieu of
cash for services.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. Critical to the Company's future
success is its ability to close on the acquisitions described in Note D,
together with raising capital sufficient to fund both its obligations arising
from these transactions as well as the Company's ongoing working capital
requirements. Working capital to date has been provided by loans, advances and
private placements received from certain shareholders and officers of the
Company. While no assurances can be given
5
that the Company will be successful in closing its pending acquisitions or
raising sufficient capital, management believes it will be successful in doing
so.
NOTE C -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
Effective with the reincorporation merger on March 26, 2003, Patron Holdings,
Inc., merged into its wholly owned Delaware subsidiary, Patron Systems, Inc. As
such, the accompanying financial statements represent the accounts of Patron
Systems, Inc., and its two subsidiaries, TWC Acquisition Inc. and ESC
Acquisition Inc. The accompanying financial statements are unaudited. However,
management believes they contain all necessary adjustments and disclosures to be
presented in accordance with generally accepted accounting principles.
ACQUISITION COSTS
The Company has incurred certain expenses, principally legal fees, in connection
with the pending acquisitions described in Note D, which have been capitalized
and deferred pending the completion of each acquisition. Upon closing, such
costs will be included in the purchase price of each respective target company
and allocated to the assets received and obligations assumed. In the event a
pending acquisition does not occur, such costs will be expensed at that time.
START UP COSTS
All expenses incurred in connection with formation of the Company and related
start up activities have been expensed as incurred and are included in general
and administrative expenses in the accompanying consolidated financial
statements.
STOCK OPTION PLANS
The Company accounts for employee stock option grants using the intrinsic method
in accordance with Accounting Principles Board (APB) Opinion No. 25 "Accounting
for Stock Issued to Employees" and accordingly associated compensation expense,
if any, is measured as the excess of the underlying stock price over the
exercise price on the date of grant. The Company complies with the disclosure
option of Statement of Financial Accounting Standards (SFAS) No. 123 "Accounting
for Stock Based Compensation", as amended by SFAS No. 148 "Accounting for
Stock-Based Compensation--Transition and Disclosure" which requires pro-forma
disclosure of compensation expense associated with stock options under the fair
value method.
The following sets forth proforma information as if the Company were using the
fair value method under SFAS No. 123 for the three months ended March 31, 2003
and the period from inception to March 31, 2003:
Period from
Inception
Three Months Ended (April 30, 2002) to
March 31, 2003 March 31, 2003
----------------------------------------
Net Loss, as reported $ (3,573,712) $ (19,902,050)
Stock-based employee compensation cost under the fair value
method of SFAS No. 123 39,000 52,000
-------------------------------------
Pro-Forma Net Loss $ (3,612,712) $ (19,952,050)
-------------------------------------
Pro-Forma Net Loss per Share-Basic and Diluted (.11) (.66)
6
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. Common
stock equivalents at March 31, 2003, consist primarily of 4,615,532 vested stock
options.
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.
NOTE D--PENDING ACQUISITIONS SUBJECT TO CLOSING
TRUSTWAVE CORP.
On November 23, 2002, Patron Systems, Inc., TWC Acquisition, Inc., a Maryland
corporation and wholly-owned subsidiary of Patron Systems Inc., (TrustWave
Mergerco), and TrustWave Corp., a Maryland corporation (TrustWave), entered into
an Agreement and Plan of Merger, as subsequently amended, (the TrustWave Merger
Agreement) whereby TrustWave will be merged with and into TrustWave Mergerco a
wholly-owned subsidiary of Patron Systems, Inc. (the TrustWave Merger). Patron
Systems, Inc. TrustWave Mergerco and TrustWave also concurrently entered into a
Supplemental Agreement, as amended (the TrustWave Supplemental Agreement), along
with certain shareholders of TrustWave. Upon the consummation of the TrustWave
Merger, shareholders of TrustWave will receive, in the aggregate: (1)
$22,000,000 in cash, $10,000,000 of which will be paid at the closing of the
TrustWave Merger and $12,000,000 of which will be paid no later than three
months after the closing of the TrustWave Merger; and (2) 15,000,000 shares of
Patron System's common stock, subject to a one-time increase of up to 100
percent in the event that the shares of Patron's common stock fails to trade at
or above $12 per share, on average, over the 21 days prior to and including the
first anniversary of the closing date. In addition, Patron will issue stock
options to current TrustWave option holders. The exact number of options will be
determined at the closing and will be deducted from the closing common stock
consideration.
The TrustWave Merger has been approved by the Boards of Directors of Patron
Systems, TrustWave Mergerco, TrustWave, and TrustWave's shareholders. The
TrustWave Merger is intended to be a tax-free reorganization under the Internal
Revenue Code. In connection with the consummation of the TrustWave Merger,
certain executive officers of TrustWave will execute employment agreements with
Patron. The closing of the acquisition is subject to several closing conditions
including the receipt of adequate financing to complete the acquisition and fund
certain working capital needs of TrustWave.
TrustWave, founded in 1995, provides enterprise information assurance and
security services and solutions to corporate, educational and government
customers. In early 2002, TrustWave began work on a contract with a Fortune 100
financial services company to conduct security compliance audits and ongoing
remote vulnerability testing using TrustWave's proprietary technology and
products.
In connection with this transaction, Patron is required to provide working
capital financing to TrustWave. Advances under such notes bear interest at 10
percent per annum and are repayable on demand. Total outstanding advances under
such notes at March 31, 2003 were $2,240,000 and approximately $50,000 in
accrued interest.
ENTELAGENT SOFTWARE CORP.
On November 24, 2002, Patron Systems, ESC Acquisition, Inc., a California
corporation and wholly-owned subsidiary of Patron Systems Inc. (Entelagent
Mergerco), and Entelagent Software Corp., a California corporation (Entelagent),
entered into an Agreement and Plan of Merger, as amended (the Entelagent Merger
Agreement) whereby
7
Entelagent Mergerco will be merged with and into Entelagent with Entelagent
surviving as a wholly owned subsidiary of Patron Systems Inc. (the Entelagent
Merger). Patron, Entelagent Mergerco and Entelagent also concurrently entered
into a Supplemental Agreement, as amended (the Entelagent Supplemental
Agreement). Upon the consummation of the Entelagent Merger, shareholders of
Entelagent will receive, in the aggregate, 1,800,000 shares of Patron and Patron
will assume certain debts and obligations of Entelagent.
The Entelagent Merger has been approved by the Boards of Directors of Patron,
Entelagent Mergerco and Entelagent. The Entelagent Merger is intended to be a
tax-free reorganization under the Internal Revenue Code. In connection with the
consummation of the Entelagent Merger, certain executive officers of Entelagent
will execute employment agreements with Patron. The closing of the acquisition
is subject to certain closing conditions, including approval of the transaction
by Entelagent shareholders, the consummation of Patron's merger with TrustWave
and obtaining funding for the additional working capital needs of Entelagent.
Working capital advances under such notes bear interest at 10 percent per annum
and are repayable upon demand. Total outstanding advances under such notes at
March 31, 2003, were $780,000 plus accrued interest of approximately $16,500.
Management periodically assesses such loans for collectibility and as of March
31, management believes the amounts loaned to Entelagent are fully collectible.
As such, an allowance has not been established. However, should matters arise
that indicate that the Company may not collect all or a portion the balance of
such loans, a charge to earnings may result.
Subsequent to the closing of this transaction, the Company will be obligated to
grant 440,000 common stock options to certain employees and non-employee
consultants of Entelagent.
Entelagent is an information technology products and services company founded in
1996. Entelagent's products and services are focused on e-mail management
solutions, including monitoring and data mining with a particular focus on
ensuring compliance with laws and regulations in the financial services and
brokerage industries.
NOTE E -- RELATED PARTY TRANSACTIONS
ADVANCES FROM SHAREHOLDERS
Since its inception, the Company has obtained financing from certain
shareholders for working capital needs. At March 31, 2003, the face amount of
notes with these shareholders was approximately $1,243,500 and related accrued
interest of $44,260 has been included in accounts payable. These advances bear
interest at rates ranging from 8 percent to 10 percent per annum and are due on
demand.
REIMBURSEMENTS OF EXPENSES INCURRED BY SHAREHOLDERS, OFFICERS AND DIRECTORS
Certain shareholders, officers and directors of the Company have incurred
operating expenses totaling $827,000 on the Company's behalf. Such expenses have
been recorded in the accompanying consolidated financial statements with a
corresponding obligation to reimburse the shareholders, officers and directors.
Included in such expenses is approximately $60,000 of expenses incurred by a
founder prior to incorporation of the Company for which the Company has agreed
to reimburse the founder. As of March 31, 2003, approximately $597,000 in
reimbursements has been paid to the shareholders, officers and directors.
NOTE F -- NOTES PAYABLE
CONVERTIBLE NOTES PAYABLE
In 2002, the Company borrowed an aggregate amount of $145,000 from four
unrelated third parties. The notes bear interest at 8 percent and are
convertible into shares of the Company's common stock with the conversion price
based on the underlying fair market value at the dates that the notes are
settled.
8
DEMAND NOTES PAYABLE
In 2002, the Company borrowed an aggregate amount of $85,000 from two unrelated
third parties under demand notes payable, which bear interest at 10 percent.
Accommodation Agreements
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the Lender), which called for the Company to borrow
$950,000 under a note to be collateralized by the pledge of 950,000 shares of
the Company's common stock from five different stockholders. In connection with
this arrangement, the Company executed a series of Accommodation Agreements with
the five stockholders wherein each stockholder pledged shares in return for the
right to receive on or before March 31, 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 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.
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 have been provided by the Lender and repeated attempts have
been made by the Company to secure the additional proceeds. The Company plans to
take the necessary legal steps to either enforce the loan or secure the return
of the pledged shares.
In the accompanying financial statements as of March 31, 2003, the Company has
effectively accounted for these events as a foreclosure on the loan collateral
by the Lender. On March 13, 2003, the Company replaced the shares to the five
stockholders who pledged shares under the Accommodation Agreements for a total
of 1,200,000 shares of Patron common stock. The value of the replacement shares
issued totaled $3,708,000. As a result, the Company recorded a loss of
approximately $2,200,000 upon issuance of the replacement shares for difference
between the value of the shares issued and the amount of loss accrued in its
2002 financial statements.
SECURED PROMISSORY NOTE
In December 2002, the Company entered into a collateral loan agreement and
promissory note with Mercatus & Partners, Ltd. in the amount of $3 million. On
January 3, 2002, the Company entered into a second promissory note with Mercatus
& Partners, Ltd. in the amount of $1.5 million. As of April 29, 2003, the
Company has not borrowed any amounts under these arrangements. The $3 million
note was collateralized by 8,823,529 shares of restricted common stock, which
were placed in a custodial account for the benefit of the Lender as security for
the loan. The $1.5 million note was collateralized by 5,769,231 shares of
restricted common stock, which were also placed in a custodial account for the
benefit of the Lender to securitize the loan. Shares associated with the $3
million and the $1.5 million notes have been reflected as shares issued and
outstanding and held in escrow in the accompanying consolidated statement of
stockholders' deficit.
On March 31, 2003, the Company terminated the collateral loan agreements and
promissory notes for failure of Mercatus & Partners, Ltd. to deliver funds. The
Company has requested that all collateral shares be returned to the Company's
transfer agent for cancellation and retirement, which will reduce the number of
issued and outstanding shares of the Company by 14,592,760 shares.
FUNDS RECEIVED FROM COMPANY OFFICER
In March 2003, an officer of the Company (the "officer") borrowed $635,000 from
third parties and used these funds to pay certain legitimate business expenses
of the Company. This was done without the knowledge of the CEO and CFO.
Pending determination by Management and the Board as to whether the funds were
obtained personally by the officer and deposited in a Company account or whether
this officer obtained the funds on behalf of the Company, these transactions and
the related funds, as well as the subsequent disbursement of funds to pay
liabilities of the Company have been reflected in the financial statements as
they occurred 9
inasmuch as the funds were received into and disbursed out of a
Company account. The Company's recognizes its obligation to repay the principal
due either to the officer or to the third parties.
The funds in the amount of $635,000 received by the officer were used to
reimburse certain creditors and officers of the Company for expenses paid on the
Company's behalf, to fund certain expenses of its start up operation in the
United Kingdom, and to advance additional funds to Entelagent Software
Corporation. The remaining cash balance in this account of $310 is reflected in
the accompanying March 31, 2003 financial statements. Because these transactions
were not known by or approved by the CEO or CFO, a breach of the Company's
internal controls occurred. Management, the Board and legal counsel are
evaluating actions necessary to prevent a similar breach in the future.
NOTE G -- PRIVATE PLACEMENTS
In March 2003, the Company completed three separate private placements of
restricted securities with unaffiliated third parties. A total of 1,162,500
shares were purchased in a range of $2.00 to $4.00 per share. Total proceeds
were approximately $2,600,000. These proceeds were used principally as working
capital advances to TrustWave Corp. and Entelagent Software Corp., including
$1,000,000 to TrustWave and $250,000 to Entelagent. The remainder of the
proceeds was used for partial repayment of accrued audit and legal fees, as well
as reimbursement of shareholder and officer expenses incurred on behalf of the
Company.
NOTE H -- CONSULTING AGREEMENTS
Patron, in an attempt to generate merger and acquisition prospects quickly, has
issued shares of Common Stock which it has registered on registration statement
on Form S-8 to compensate consultants. On March 31, 2003, Patron entered into
consulting agreements with each M. Rashid Qajar, who currently holds more than
5% of our outstanding voting stock, and Paul Harary of Security Management
Partners. The term of each agreement is two years. The consulting services to be
provided by Mr. Qajar shall be to advise and consult with Patron regarding
general business matters including, but not limited to, development of an
international business strategy, the evaluation and analysis of management needs
and identifying and introducing Patron to prospective merger, asset, business or
other acquisition candidates. The consulting services to be provided by Mr.
Harary include, but are not limited to, the identification of potential
candidates in the enterprise security service and technology field for
acquisition by Patron. For and as consideration for the services provided
pursuant to the consulting agreements, Patron has agreed to issue to Mr. Qajar
2,050,000 shares of Patron Common Stock and Mr. Harary 200,000 shares of Patron
Common Stock. On April 2, 2003, Patron registered 2,250,000 shares of Patron
Common Stock on Form S-8. Mr. Qajar has agreed to refrain from transferring
1,500,000 of his shares of Patron common stock for a period of twelve months.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
FORWARD-LOOKING STATEMENTS
The following discussion and analysis of the financial condition and results of
operation for Patron Systems, Inc. should be read in conjunction with our
unaudited financial statements and related notes appearing elsewhere in this
report. This discussion contains forward-looking statements and information
relating to Patron Systems, Inc. our industry and planned business operations as
well as other information security businesses that involve risks and
uncertainties. The statements contained in this report that are not historical
statements of fact are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 (Securities Act) and Section 21E of the
Securities Exchange Act of 1934, as amended (Exchange Act). Forward-looking
statements include, among other things, statements regarding our expectations,
beliefs, intentions or strategies regarding the future. All forward-looking
statements included in this report are based on information available to us up
to and including the date of this document, and we expressly disclaim any
obligation to update or alter our forward-looking statements, whether as a
result of new information, future events or otherwise. Our actual results could
differ significantly from those anticipated in these forward-looking statements
as a result of certain factors, including those set forth below, under the
caption "Risk Factors" and elsewhere in this report.
GENERAL INFORMATION AND OVERVIEW
Patron Systems, Inc. is a successor entity to Combined Professional Services,
Inc., a Nevada corporation originally formed in October 1995 ("CPS"), which
later changed its name in a share exchange to Patron Holdings, Inc.
("Holdings"). Holdings (as CPS) was originally formed to provide corporate
financial services to other business entities, but abandoned that business plan
shortly after formation. Holdings, therefore, has never had business operations
or revenue.
Patron was formed as a Delaware corporation in April 2002 to provide
comprehensive, end-to-end information security solutions to global corporations
and government institutions. Patron's founders intended to raise capital on a
private equity basis, but determined that there was a need for a public company
currency to achieve their growth plan. Patron identified CPS during this process
and determined that CPS was well-suited to provide Patron with its public
currency because of its lack of operational history, affording Patron an open
platform from which to grow, without the necessity of divesting existing
operations or incurring liabilities as a result of existing operations.
On October 11, 2002, Holdings (as CPS), Patron and the stockholders of Patron
consummated a share exchange pursuant to an Amended and Restated Share Exchange
Agreement, whereby Holdings (as CPS) issued to each Patron stockholder, on a
one-for-one basis and in exchange for all of the outstanding shares of Patron
capital stock, an aggregate of 25,400,000 shares of Holdings (as CPS) common
stock. Upon the closing of the share exchange, Patron stockholders held
approximately 85 percent of the outstanding capital stock of Holdings (as CPS),
and Patron became a wholly owned subsidiary of Holdings (as CPS). The share
exchange was accounted for as a reverse merger whereby Patron, as the surviving
company, was treated as the acquirer for financial statement purposes.
On March 26, 2003, Holdings merged with and into Patron for the purpose of
changing its state of incorporation from Nevada to Delaware. Patron became the
surviving corporation of this redomestication merger, and its Second Amended and
Restated Certificate of Incorporation, Amended and Restated Bylaws are the
governing documents of the surviving corporation. Systems' Board of Directors is
the governing body of the surviving corporation.
Prior to the date of the redomestication merger, Patron had no material assets
or business operations. Patron's principal activities since its formation in
April 2002 consisted of the development of its business plan, capital raising
and evaluation and negotiation of potential acquisitions.
PLAN OF OPERATION
During the first quarter ended March 31, 2003, the Company incurred a net loss
of $3,573,712. The Company was not in operation in the comparable period of the
prior year. A major element of the net loss in the 2003 period was general
administrative expenses of $1,474,555, comprised of management salaries and
associated expenses incidental to the
11
development of its business and a charge of $500,000 representing an estimated
liability associated with employment arrangements entered into in commencing
operations in the United Kingdom. In addition, the Company incurred a charge of
$2,210,272 representing the difference between the value of replacement shares
issued in connection with a financing arrangement, valued at $3,708,000, and the
amount accrued in the 2002 financial statements associated with this
arrangement. (See "Financing Arrangement" in Notes to Financial Statements).
During the next 12 months, Patron intends to implement its business plan to
offer trusted security services and next generation integrated security products
through acquisitions and internal growth. Patron intends to work with
organizations to ensure that global enterprises implement information security
policies, procedures and products that result in "trusted" information
environments. Patron expects to offer information security and vulnerability
assessments, certification programs, remediation, implementation, training,
monitoring and management services.
In executing its current plans, Patron intends to identify and pursue potential
acquisition targets consistent with its business plan; seek additional financing
to fund ongoing business operations and to support its acquisitions strategies;
develop management and information systems and technology to support operations;
and attract and retain qualified personnel. Patron's ability to pursue this plan
and to carry out its proposed business activities is dependent upon its ability
to implement its acquisitions strategies, and to operate acquired companies
efficiently, and to obtain required financing.
Patron has yet to begin revenue generating operations and as such is a
development stage company. Since its inception, Patron has reported a net loss
of approximately $19,900,000, principally associated with expenses related to
its formation, assembling its management team, and capital formation and
acquisition activities consistent with its business plan.
Patron has 4 corporate employees as of the date of this report. Patron intends
to hire additional employees during the next 12 months as it completes pending
acquisitions and executes its business plan, which will be dependent upon
Patron' ability to raise necessary funding.
PENDING ACQUISITIONS
Patron intends to consummate the merger with TrustWave Corp. as soon as possible
subject to Patron's satisfaction of certain closing conditions under the
Agreement and Plan of Merger dated November 23, 2002 as amended. As of the date
of this report, the closing date for the TrustWave merger has been verbally
extended pending finalization of financing and merger terms. Patron's
wholly-owned subsidiary will merge with and into TrustWave, with TrustWave
surviving as a wholly owned subsidiary of Patron. At the closing of the merger
with TrustWave, shareholders of TrustWave will receive, in the aggregate: (1)
$22,000,000 in cash, $10,000,000 of which will be paid at the closing of the
merger and the balance of which will be paid three months after the closing; and
(2) approximately 15,000,000 shares of Patron's common stock, subject to a
one-time increase of up to 100 percent in the event that the shares of the
Patron's common stock fail to trade at or above $12 per share, on average, over
the 21 days prior to and including the first anniversary of the closing date.
Included in the 15,000,000 shares, Patron will issue approximately 2,900,000
stock options to current TrustWave option holders. In connection with this
transaction, Patron provided working capital financing to TrustWave. Total
outstanding advances at March 31, 2003, were $2,240,000.
On November 24, 2002, Patron, ESC Acquisition, Inc., a California corporation
and wholly-owned subsidiary of Patron, and Entelagent Software Corp., a
California corporation, entered into an Agreement and Plan of Merger whereby ESC
Acquisition will be merged with and into Entelagent with Entelagent surviving as
a wholly owned subsidiary of Patron. Patron, ESC Acquisition and Entelagent also
concurrently entered into a Supplemental Agreement. Upon the consummation of the
Entelagent Merger, shareholders of Entelagent will receive, in the aggregate,
1,800,000 shares of Patron's Common Stock and will assume certain debts and
obligations of Entelagent. The closing of the acquisition is subject to several
closing conditions, including approval of the transaction by Entelagent's
shareholders.
Subsequent to the closing of this transaction, Patron will be obligated to grant
440,000 common stock options to certain employees and non-employee consultants
of Entelagent.
12
In connection with this transaction, Patron agreed to provide working capital
financing to Entelagent. Advances under such notes bear interest at 10 percent
per annum and are repayable upon demand. Total outstanding advances under such
notes at March 31, 2003, were $780,000.
LIQUIDITY AND CAPITAL RESOURCES
Patron has been financed to date by a group of shareholders and private
investors with "seed" capital. Patron's strategy is to seek capital at the
lowest possible rates in order to implement its growth and acquisition strategy
at the lowest cost of capital. Patron will continue to seek favorable financing
as it implements its acquisition strategy in the information security market.
Patron's future capital requirements will depend on a number of factors,
including its success in integrating and operating acquired companies,
technological developments, competition and costs associated with current and
future acquisitions. Patron believes that its existing cash and cash equivalents
and additional funding from its shareholders will be sufficient to fund its
business operations for the next two to three months and expects that it will be
required to raise an additional $20 to $30 million in order to meet its cash
requirements over the next 12 months. This estimate is based on assumptions that
may prove to be wrong and is a forward-looking statement that involves risks and
uncertainties. Actual results could differ from this forecast as a result of a
number of factors, including, but not limited to, timing of acquisition
closings, various revenue contracts, and private placement closings.
Until we generate sufficient levels of cash from operations, which we do not
expect to do in the foreseeable future, we expect to continue to finance future
cash needs through the sale of equity securities and debt financing. This
financing may not be available when needed or, if available, on terms that are
unfavorable to Patron or its stockholders. If additional funds are raised by
issuing equity securities, substantial dilution to existing stockholders may
result.
Current market conditions have made it increasingly difficult for development
stage companies, such as Patron, to raise capital. To date, Patron has engaged
in discussions with various potential investors and is in active negotiations
with certain of these potential investors. Unless these negotiations result in
the timely completion of financing transactions, Patron is unlikely to be able
to complete its planned acquisitions. The failure to complete these acquisitions
will adversely affect Patron's ability to carry out its business plan and could
jeopardize Patron's ability to continue its corporate existence.
CONSULTING AGREEMENTS
Patron, in an attempt to generate merger and acquisition prospects quickly, has
issued shares of Common Stock which it has registered on registration statements
on Form S-8 to compensate consultants. On March 31, 2003, Patron entered into
consulting agreements with each M. Rashid Qajar, who currently holds more than
5% of our outstanding voting stock, and Paul Harary of Security Management
Partners. The term of each agreement is two years. The consulting services to be
provided by Mr. Qajar shall be to advise and consult with Patron regarding
general business matters including, but not limited to, development of an
international business strategy, the evaluation and analysis of management needs
and identifying and introducing Patron to prospective merger, asset, business or
other acquisition candidates. The consulting services to be provided by Mr.
Harary include, but are not limited to, the identification of potential
candidates in the enterprise security service and technology field for
acquisition by Patron. For and as consideration for the services provided
pursuant to the consulting agreements, Patron has agreed to issue to Mr. Qajar
2,050,000 shares of Patron Common Stock and Mr. Harary 200,000 shares of Patron
Common Stock. On April 2, 2003, Patron registered 2,250,000 shares of Patron
Common Stock on Form S-8. Mr. Qajar has agreed to refrain from transferring
1,500,000 of his shares of Patron common stock for a period of twelve months.
HISTORIC FINANCINGS
STOCKHOLDER ADVANCES
Patron has been financed to date by a group of stockholders and private
investors with "seed" capital. At March 31, 2003, the face amount of notes with
stockholders was $1,243,500 with related accrued interest of $44,260. Each of
these advances bears interest at rates ranging from 8 percent to 10 percent per
annum and is due on demand. In addition, certain of Patron's stockholders and
officers have incurred operating expenses totaling approximately $827,000. In
13
addition, through March 31, 2003, Patron borrowed an aggregate amount of
$230,000 from six unrelated parties. Four of the notes representing this debt
bear interest at a rate of 8 percent per annum and are convertible into shares
of Patron Common Stock, with the conversion price based on the fair market value
of such shares on the date on which the notes are converted. Two of the notes
representing this debt are demand notes accruing interest at a rate of 10
percent per annum.
ACCOMMODATION ARRANGEMENTS
In November 2002, Patron (as successor to Holdings) entered into a financing
arrangement with a third party (subsequently amended), which called for Patron
to borrow $950,000 pursuant to a note secured by a pledge by five of its
stockholders of 950,000 shares of Patron common stock. In connection with this
arrangement, Patron executed a series of Accommodation Agreements with the
pledging stockholders, whereby each pledgor pledged shares in return for the
right to receive, on or before March 31, 2003, the return of the pledged shares
plus additional shares, for a total of 1,200,000 shares of Patron Common Stock.
In December 2002, Patron received $450,000 of proceeds under the note, and
provided the lender with all of the pledged shares. To date, Patron has not
received the remaining $500,000 commitment. Patron intends to take all necessary
actions to either enforce the loan or secure the return of the pledged shares.
Patron issued the replacement shares of Patron Common Stock to the pledging
stockholders on March 13, 2003, for a total non-cash charge of $3,258,000.
MERCATUS & PARTNERS, LTD.
In December 2002, Patron entered into a collateral loan agreement and promissory
note with Mercatus & Partners, Ltd. ("Mercatus"), a financing group, in the
amount of $3 million. On January 2, 2003, Patron entered into a second
promissory note with Mercatus in the amount of $1.5 million. As of the date
here, Patron has not borrowed any amounts under these arrangements. Borrowings
on the $3 million note are collateralized by 8,823,529 shares of common stock,
which have been placed in a custodial account with UBS Bank in Switzerland for
the benefit of the lender as security for the loan. Borrowings on the $1.5
million note are collateralized by 5,769,231 shares of common stock, which have
also been placed in a custodial account for the benefit of the lender as
security to the loan. Interest on amounts borrowed accrues at 5.5 percent per
annum. Patron has agreed to pay fees of 3% to the lender and two months
principal and interest in advance. The term of the loan is five years. Interest
only payments will be due in the first year after funding of the loan. Aggregate
monthly principal payments of $93,750 will be due beginning February 2004. There
is an early termination charge for prepayment. Mercatus also requires a "key
man" life insurance policy naming it as beneficiary and matching the principal
balance of the loan on a decreasing basis. Patron is also required within 90
days of a loan drawdown to enter into good faith negotiations to establish a
warrant or option position.
As of the date hereof, Mercatus had not provided funding under the terms of the
collateral loan agreement and promissory note and is in breach of contract.
Patron sent notification to Mercatus on March 31, 2003, terminating the
agreement and requesting Mercatus to return all shares placed in the custodial
account with UBS Bank in Switzerland. Upon receipt of the shares, Patron intends
to cancel such shares.
Outside counsel has sent a second demand letter dated May 5, 2003, as the shares
have not yet been received. As Mercatus has not returned these shares to the
Company's transfer agent by May 20, 2003, the Company intends to take all
necessary actions to ensure the prompt return of the shares.
COMPLETED PRIVATE PLACEMENTS
On March 19, 2003 and March 28, 2003, Patron entered into two separate term
sheets, each with a private Profit Sharing Plan, for private placements totaling
1,000,000 shares of Patron Common Stock for aggregate proceeds of $2,000,000 at
$2.00 per share. The term sheets contain provisions for Patron to commit to file
a registration statement for these shares within two weeks of the closing of the
TrustWave Merger and to use best efforts to ensure that the registration
statement is declared effective within ninety days of the closing of the
TrustWave Merger.
On April 4, 2003, Patron entered into a term sheet with a private investor for a
private placement of 125,000 shares of Patron Common Stock for aggregate
proceeds of $250,000 at $2.00 per share. The term sheet contains provisions for
Patron to commit to file a registration statement for these shares within two
weeks of the closing of the TrustWave
14
Merger and to use best efforts to ensure that the registration statement is
declared effective within ninety days of the closing of the TrustWave Merger.
During the first quarter of 2003, the Company received additional private
placement proceeds of $650,000 at $4.00 per share for 162,500 shares of the
Company's common stock from two private investors.
FUNDS RECEIVED FROM COMPANY OFFICER
In March 2003, an officer of the Company (the "officer") borrowed $635,000 from
third parties and used these funds to pay certain legitimate business expenses
of the Company. This was done without the knowledge of the CEO and CFO.
Pending determination by Management and the Board as to whether the funds were
obtained personally by the officer and deposited in a Company account or whether
this officer obtained the funds on behalf of the Company, these transactions and
the related funds, as well as the subsequent disbursement of funds to pay
liabilities of the Company have been reflected in the financial statements as
they occurred inasmuch as the funds were received into and disbursed out of a
Company account. The Company's recognizes its obligation to repay the principal
due either to the officer or to the third parties.
The funds in the amount of $635,000 received by the officer were used to
reimburse certain creditors and officers of the Company for expenses paid on the
Company's behalf, to fund certain expenses of its start up operation in the
United Kingdom, and to advance additional funds to Entelagent Software
Corporation. The remaining cash balance in this account of $310 is reflected in
the accompanying March 31, 2003 financial statements. Because these transactions
were not known by or approved by the CEO or CFO, a breach of the Company's
internal controls occurred. Management, the Board and legal counsel are
evaluating actions necessary to prevent a similar breach in the future.
ADDITIONAL FINANCING OPPORTUNITIES
PROSPECTIVE PRIVATE EQUITY PLACEMENTS
PROSPECTIVE DEBT/EQUITY PLACEMENT - CMAX CORPORATE FINANCE
The company is currently renegotiating its financing arrangements with CMAX
Corporate Finance. While the company believes the terms and conditions will be
similar to the Term Sheets executed on January 13, 2003, there can
15
be no assurances that the terms and conditions will be as favorable, or that the
company will consummate a financing agreement with CMAX Corporate Finance.
Should the financing not close, the Company will be unable to complete its
intended acquisitions and pursue its business plan.
Patron and the Investors have also agreed to jointly pursue business development
opportunities in Europe and Asia related to wireless information security
initiatives.
RISK FACTORS
FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
LACK OF PROFITABILITY.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. We have generated no revenue from
operations as of March 31, 2003. We have incurred operating and net losses and
negative cash flows from operations since our inception. As of March 31, 2003,
we had an accumulated deficit of $16.3 million and net losses of $3.5 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 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.
LACK OF BUSINESS OPERATIONS.
Patron has generated no revenue from operations to date and relies on revenue
generated from our capital raising activities to fund the implementation of our
business plan. We will continue to seek financing for the acquisition of
Entelagent and 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 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.
OUR LIMITED HISTORY MAKES IT DIFFICULT TO EVALUATE OUR BUSINESS AND PROSPECTS.
Holdings (as CPS) was incorporated in Nevada in 1995 and Patron was incorporated
in Delaware in 2002. We have not had any 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.
LACK OF MARKET FOR PRODUCTS.
We do not have any current products or revenues. 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.
THE PRICE OF OUR COMMON STOCK IS LIKELY TO BE VOLATILE.
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
16
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.
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.
THE CONCENTRATION OF OUR CAPITAL STOCK OWNERSHIP WITH INSIDERS IS LIKELY TO
LIMIT THE ABILITY OF OTHER STOCKHOLDERS TO INFLUENCE CORPORATE MATTERS.
The executive officers, directors and entities affiliated with any of them
together beneficially own approximately 69% 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 March 31, 2003, there were
approximately 36,426,388 shares of common stock outstanding (which number does
not include the 14,592,760 shares of common stock pledged to Mercatus that have
been requested to be returned and cancelled, as more fully described in the
description of our Liquidity and Capital Resources under the caption
"Management's Discussion and Analysis or Plan of Operation"), of which all but
11,026,388 shares will be held by directors, executive officers and other
affiliates, the sale of which are subject to volume limitations under Rule 144,
various vesting agreements and 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.
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE.
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.
AVAILABILITY OF FUTURE CAPITAL.
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 Patron, 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.
17
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for 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
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 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 the 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 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 will 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 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.
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
and ASICs 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 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
18
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.
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 intended 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, including ASICs, and power supplies, 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 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. In this event, the price of our common stock would likely
decline.
WE MAY EXPERIENCE ISSUES WITH OUR FINANCIAL SYSTEMS, CONTROLS AND OPERATIONS
THAT COULD HARM OUR 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. We have
limited management resources today 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. Or future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
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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 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.
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.
We currently have only five employees. Our future success depends upon the
continued services of our executive officers, including in particular Patrick J.
Allin, Brett Newbold and Marie Meisenbach Graul. 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;
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
o 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.
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.
20
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 encryption technologies we intend to acquire 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.
Under the supervision and with the participation of Patron's management,
including Patron's Chief Executive Officer (CEO) and Chief Financial Officer
(CFO), Patron has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c)
within 90 days of the filing date of this quarterly report. Subsequent to the
initial filing of the Company's Form 10-QSB as of and for the period ended March
31, 2003 and prior to the filing of this Form 10-QSB/A, the Company's CEO and
CFO became aware of March 2003 transactions disclosed elsewhere in this amended
filing which occurred in a cash account of the Company involving the deposit of
funds into the account by an officer of the Company and the payment of Company
liabilities using those funds. Because these transactions were not known by or
approved by the CEO, CFO or its Board of Directors, a breach of the Company's
internal controls occurred. Management has since closed the cash account and
with legal counsel are evaluating actions necessary to prevent a similar breach
in the future. Based on that evaluation, except for the aforementioned breach of
internal controls, the Chief Executive Officer and Chief Financial Officer have
concluded that these disclosure controls and procedures are effective. Other
than the actions being taken to remedy the breach of internal controls disclosed
above, there were no significant changes in Patron's internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of their evaluation.
PART II -- OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 -- Chief Executive
Officer -- Patron Systems, Inc.
99.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 -- Chief Financial
Officer -- Patron Systems, Inc.
21
(b) Reports on Form 8-K.
On January 16, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing two press release issued on January 2, 2003
and January 15, 2003, announcing the appointment of Richard G. Beggs, Warren K.
Luke and Robert E. Yaw II to serve on the Board of Directors, and an increase in
the size of the Board to nine.
On January 16, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing a press release issued on January 15, 2003
announcing the execution of a term sheet with a private group of international
investors for an investment facility to Patron.
On January 28, 2003, we filed a current report on Form 8-K with the Securities
and Exchange Commission containing a press release issued on January 22, 2003
announcing the execution of a memorandum of understanding with TELSECURE (UK)
LTD, for the development by Patron of an information security platform and
broad-based suite of security products to support TELSECURE's wireless business
application development project, and a press release issued on January 24, 2003
announcing the progress of business combinations with TrustWave Corp. and with
Entelagent Software Corp.
On March 27, 2003, we filed a current report on Form 8-K with the Securities and
Exchange Commission announcing the consummation of the merger of Patron
Holdings, Inc., a Nevada corporation, with and into Patron Systems, Inc.
ITEMS 1 THROUGH 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.
22
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.
PATRON SYSTEMS, INC.
Date: August 18, 2003 /s/ Patrick J. Allin
-------------------------------
Patrick J. Allin
Chief Executive Officer
Date: August 18, 2003 /s/ Marie Meisenbach Graul
-------------------------------
Marie Meisenbach Graul
Chief Financial Officer
23
CERTIFICATIONS
I, Patrick J. Allin, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of Patron Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: August 18, 2003
/s/ Patrick J. Allin
---------------------------
Patrick J. Allin
Chief Executive Officer
24
I, Marie Meisenbach Graul, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of Patron Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: August 18, 2003
/s/ Marie Meisenbach Graul
-------------------------------
Marie Meisenbach Graul
Chief Financial Officer
25