UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB/A
(AMENDMENT NO. 1)
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2006
|_| 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)
5775 FLATIRON PARKWAY, SUITE 230 80301
BOULDER, CO
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(303) 541-1005
(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: 14,461,851 shares of common stock
outstanding as of August 4, 2006.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB/A QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
------------------------------ ----
ITEM 1. FINANCIAL STATEMENTS ..................................................4
Condensed Consolidated Balance Sheet at June 30, 2006 (unaudited)..............4
Condensed Consolidated Statements of Operations for the Three and
Six Months Ended June 30, 2006 (unaudited)............................5
Condensed Consolidated Statement of Stockholders' (Deficiency)
Equity for the Six Months Ended June 30, 2006 (unaudited).............6
Condensed Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2006 and June 30, 2005 (unaudited)..........7
Notes to Condensed Consolidated Financial Statements (unaudited)...............8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...................................35
PART II - OTHER INFORMATION
---------------------------
ITEM 6. EXHIBITS..............................................................49
SIGNATURES....................................................................50
2
EXPLANATORY NOTE
Patron Systems, Inc. is filing this Amendment No. 1 to its Quarterly Report on
Form 10-QSB (the "Form 10-QSB") for the quarterly period ended June 30, 2006
filed with the Securities and Exchange Commission on August 11, 2006. This
filing amends and restates our previously reported financial statements for the
six months ended June 30, 2006 to reflect the determination by the Company that,
during the six months ended June 30, 2006, it had recorded 1) a net loss of
$858,213 on the settlement of various liabilities under its creditor and
claimant liabilities restructuring program when it should have recorded a net
gain of approximately $906,987, 2) excess non-cash interest of $358,000 with
respect to a conversion option that became effective under two of its Interim
Bridge Financing III notes and 3) charged, as interest expense, a $285,050 fee
paid to the placement agent in its Series A Preferred stock financing
transaction that should have been recorded as a reduction of the offering
proceeds. For the three months and six months ended June 30, 2006, the Company
recorded a net gain of $371,616 on the settlement of various liabilities under
its creditor and claimant liabilities restructuring program when it should have
recorded a net gain of approximately $965,381. The nature of the adjustments
required in the creditor and claimant liabilities restructuring in the quarters
ended March 31, 2006 and June 20, 2006, relate to an overvaluation of the Series
A-1 preferred shares issued in the exchange offer offset by gains on the
extinguishment of liabilities that originated in connection with obligations to
issue or repurchase stock.
This Amendment No. 1 amends and restates the following items of our Form 10-QSB
as described above: (i) Part I, Item 1 - Financial Statements; (ii) Part I, Item
2 - Management's Discussion and Analysis of Result of Operations and Financial
Condition; and (iii) Part II, Item 6 - Exhibits.
All information in our Form 10-QSB, as amended by this Amendment No. 1, speaks
as to the date of the original filing of our Form 10-QSB for such period and
does not reflect any subsequent information or events except as noted in this
Amendment No. 1. All information contained in this Amendment No. 1 is subject to
updating and supplementing as provided in our reports, as amended, filed with
the Securities and Exchange Commission subsequent to the date of the initial
filing of our Form 10-QSB.
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/A. 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.
3
PART I - FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
JUNE 30,
2006
ASSETS (As Restated)
------------
Current Assets
Cash ........................................................ $ 195,432
Accounts receivable, net .................................... 571,248
Other current assets ........................................ 231,573
------------
Total current assets ..................................... 998,253
Property and equipment, net ................................... 125,608
Intangible assets, net ........................................ 1,399,618
Goodwill ...................................................... 9,510,716
------------
Total assets ............................................. $ 12,034,195
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable ............................................ $ 1,023,432
Accrued payroll and related expenses ........................ 280,673
Accrued interest ............................................ 604,444
Demand notes payable ........................................ 447,556
Bridge notes payable ........................................ 544,975
Notes payable (to creditors of acquired business,
including $554,202 to related parties) .................... 799,982
Expense reimbursements due to officers and stockholders ..... 130,201
Notes payable to officers and stockholders .................. 90,000
Other current liabilities ................................... 742,051
Accrued registration rights penalty ......................... 87,174
Deferred revenue ............................................ 498,780
------------
Total current liabilities ................................ 5,249,268
------------
Commitments and contingencies
Stockholders' Equity
Preferred stock, par value $0.01 per share, 75,000,000
shares authorized,
- Series A convertible: 2,160 shares authorized;
964 shares issued and outstanding .................... 10
liquidation preference of $6,151,091
- Series A-1 convertible: 50,000,000 authorized;
36,388,907 issued and outstanding .................... 363,889
liquidation preference of $29,111,126
Common stock, par value $0.01 per share, 150,000,000
shares authorized, 2,131,496 shares issued and
outstanding .............................................. 21,316
Additional paid-in capital .................................. 93,682,031
Accumulated deficit ......................................... (87,282,319)
------------
Total stockholders' equity ............................... 6,784,927
------------
Total liabilities and stockholders' equity ............... $ 12,034,195
============
See notes to condensed consolidated financial statements.
4
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
SIX MONTHS ENDED THREE MONTHS ENDED
-------------------------- --------------------------
June 30, June 30, June 30, June 30,
2006 2005 2006 2005
(As Restated) (As Restated)
----------- ----------- ----------- -----------
Revenue ........................................................ $ 580,745 $ 90,843 $ 318,960 $ 84,413
----------- ----------- ----------- -----------
Cost of Sales
Cost of products/services .................................... 29,897 2,003 -- --
Amortization of technology ................................... 55,044 147,731 27,522 128,501
----------- ----------- ----------- -----------
Total cost of sales ........................................ 84,941 149,734 27,522 128,501
----------- ----------- ----------- -----------
Gross profit (loss) .......................................... 495,804 (58,891) 291,438 (44,088)
----------- ----------- ----------- -----------
Operating Expenses
Salaries and related expenses ................................ 2,448,188 1,076,437 1,438,065 1,214,588
Consulting expense (non-employee stock based compensation) ... -- 952,875 -- 444,375
Professional fees ............................................ 885,897 653,383 227,782 511,982
General and administrative ................................... 621,575 757,486 297,666 35,422
Amortization of intangibles .................................. 61,627 38,877 30,813 30,814
Stock based penalties under accomodation agreements .......... -- 689,102 -- 320,102
Stock based penalty under collateralized financing arrangement 5,246 -- 2,394 --
Loss on collateralized financing arrangement ................. -- 366,193 -- 366,193
Loss/(gain) associated with settlement agreements ............ (1,872,368) (389,103) (965,381) (389,103)
----------- ----------- ----------- -----------
Total operating expenses .................................. 2,150,165 4,145,250 1,031,339 2,534,373
Operating loss ................................................. (1,654,361) (4,204,141) (739,901) (2,578,461)
Other Income (Expense)
Interest income .............................................. 1,961 19,250 1,961 --
Loss on sale of property and equipment ....................... (125) -- (187) --
Interest expense ............................................. (1,060,885) (2,196,535) (88,421) (1,701,547)
----------- ----------- ----------- -----------
Total other income (expense) .............................. (1,059,049) (2,177,285) (86,647) (1,701,547)
----------- ----------- ----------- -----------
Loss from continuing operations before income taxes ............ (2,713,410) (6,381,426) (826,548) (4,280,008)
Income taxes ................................................. -- -- -- --
----------- ----------- ----------- -----------
Loss from continuing operations ................................ (2,713,410) (6,381,426) (826,548) (4,280,008)
----------- ----------- ----------- -----------
Loss from discontinued operations .............................. (104,962) (850,874) -- (748,497)
Loss on disposal of discontinued operations .................... (75,920) -- (75,920) --
----------- ----------- ----------- -----------
(180,882) (850,874) (75,920) (748,497)
----------- ----------- ----------- -----------
Net loss ....................................................... (2,894,292) (7,232,300) (902,468) (5,028,505)
Preferred stock dividend ....................................... 124,784 -- 124,784 --
----------- ----------- ----------- -----------
Net loss available to common stockholders ...................... $(3,019,076) $(7,232,300) $(1,027,252) $(5,028,505)
=========== =========== =========== ===========
Net Loss Per Share - Basic and Diluted
- Continuing operations ...................................... $ (1.33) $ (3.47) $ (0.44) $ (2.11)
- Discontinued operations .................................... (0.09) (0.46) (0.03) (0.37)
----------- ----------- ----------- -----------
- Total Net Loss per share available to common stockholders .. $ (1.42) $ (3.93) $ (0.47) $ (2.47)
=========== =========== =========== ===========
Weighted Average Number of Shares Outstanding
- Basic and diluted ......................................... 2,127,543 1,838,106 2,170,653 2,032,823
=========== =========== =========== ===========
See notes to condensed consolidated financial statements.
5
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' (DEFICIENCY) EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2006
(UNAUDITED)
SHARES OF PAR VALUE SHARES OF PAR VALUE
SERIES A SERIES A SERIES A-1 SERIES A-1 SHARES OF
PREFERRED PREFERRED PREFERRED PREFERRED COMMON
STOCK STOCK STOCK STOCK STOCK
------------ ------------ ------------ ------------ ------------
Balance - December 31, 20056 .............. -- $ -- -- $ -- 1,978,655
Reclassification of deferred compensation
upon adoption of FAS 123 (R) ........... -- -- -- -- --
Issuance of Series A Preferred Stock to
investors .............................. 964 10 -- -- --
Issuance of warrants in connection with
bridge loan extension - extension
warrants ............................... -- -- -- -- --
Conversion option penalty incurred upon
default of Bridge Financing III ........ -- -- -- -- --
Cancellation of stock repurchase obligation
due to former officer .................. -- -- -- -- --
Issuance of Series A-1 Preferred stock in
settlement of debt ..................... -- -- 36,388,907 363,889 (98,334)
Issuance of shares in connection with
anti-dilution provision ................ -- -- -- -- 251,175
Stock-based compensation .................. -- -- -- -- --
Net Loss .................................. -- -- -- -- --
------------ ------------ ------------ ------------ ------------
BALANCE - JUNE 30, 2006 (AS RESTATED) ..... 964 $ 10 36,388,907 $ 363,889 2,131,496
============ ============ ============ ============ ============
ADDITIONAL COMMON
PAR VALUE PAID IN STOCK
COMMON CAPITAL REPURCHASE DEFERRED
STOCK (AS RESTATED) OBLIGATION COMPENSATION
------------ ------------ ------------ ------------
Balance - December 31, 20056 .............. $ 19,787 $ 65,601,272 $ (1,300,000) $ (7,500)
Reclassification of deferred compensation
upon adoption of FAS 123 (R) ........... -- (7,500) -- 7,500
Issuance of Series A Preferred Stock to
investors .............................. -- 4,535,440 -- --
Issuance of warrants in connection with
bridge loan extension - extension
warrants ............................... -- 48,129 -- --
Conversion option penalty incurred upon
default of Bridge Financing III ........ -- 192,000 -- --
Cancellation of stock repurchase obligation
due to former officer .................. -- 1,300,000 1,300,000 --
Issuance of Series A-1 Preferred stock in
settlement of debt ..................... (983) 21,770,278 -- --
Issuance of shares in connection with
anti-dilution provision ................ 2,512 (2,512) -- --
Stock-based compensation .................. -- 244,924 -- --
Net Loss .................................. -- -- -- --
------------ ------------ ------------ ------------
BALANCE - JUNE 30, 2006 (AS RESTATED) ..... $ 21,316 $ 93,682,031 $ -- $ --
============ ============ ============ ============
ACCUMULATED
DEFICIT TOTAL
(AS RESTATED) (AS RESTATED)
------------ ------------
Balance - December 31, 20056 .............. $(84,388,027) $(20,074,468)
Reclassification of deferred compensation
upon adoption of FAS 123 (R) ........... -- --
Issuance of Series A Preferred Stock to
investors .............................. -- 4,535,450
Issuance of warrants in connection with
bridge loan extension - extension
warrants ............................... -- 48,129
Conversion option penalty incurred upon
default of Bridge Financing III ........ -- 192,000
Cancellation of stock repurchase obligation
due to former officer .................. -- 2,600,000
Issuance of Series A-1 Preferred stock in
settlement of debt ..................... -- 22,133,184
Issuance of shares in connection with
anti-dilution provision ................ -- --
Stock-based compensation .................. -- 244,924
Net Loss .................................. (2,894,292) (2,894,292)
------------ ------------
BALANCE - JUNE 30, 2006 (AS RESTATED) ..... $(87,282,319) $ 6,784,927
============ ============
See notes to condensed consolidated financial statements.
6
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
SIX MONTHS ENDED
----------------------------
June 30, June 30,
2006 2005
(As Restated)
------------ ------------
Cash Flows from Operating Activities
Net loss from continuing operations ....................... $ (2,713,410) $ (6,381,426)
============ ============
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization ........................... 143,420 192,298
Stock based compensation ................................ 244,924 952,875
Non-cash interest expense ............................... 543,438 1,887,625
Gain associated with settlement agreements .............. (1,872,368) (389,103)
Accrued registration penalty ............................ 5,246 --
Loss on disposition of discontinued operations .......... 75,920 --
Loss on sale of fixed assets ............................ 125 --
Stock based penalty under accomodation agreements ....... -- 689,102
Gain on settlement of consulting agreement payable ...... -- (228,900)
Loss on collateralized financing arrangement ............ -- 366,194
Non-cash interest income ................................ -- (19,250)
Changes in assets and liabilities:
Restricted cash escrowed to settle liabilities assumed 511,691 (527,003)
Prepaid expenses ...................................... -- 51,487
Accounts receivable ................................... (974,319) 14,429
Other current assets .................................. (12,874) 44,299
Accounts payable ...................................... (489,363) (393,819)
Accrued interest ...................................... 517,268 (342,746)
Deferred revenue ...................................... 793,914 28,017
Accrued payroll and payroll related expenses .......... (246,891) (1,015,946)
Other current liabilities ............................. 29,607 367,897
Consulting agreements payable ......................... -- (50,000)
Expense reimbursements due to officers and stockholders (29,835) --
Other accrued expenses ................................ -- (3,413)
============ ============
Total adjustments ......................................... (760,097) 1,624,043
============ ============
NET CASH USED IN CONTINUING OPERATIONS .................... (3,473,507) (4,757,383)
============ ============
NET CASH USED IN DISCONTINUED OPERATIONS .................. (197,882) (844,222)
------------ ------------
NET CASH USED IN OPERATING ACTIVITIES ..................... (3,671,389) (5,601,605)
------------ ------------
CASH FLOWS USED IN INVESTING ACTIVITIES
Cash payments in purchase business combinations ......... -- (857,633)
Cash acquired in purchase business combinations ......... -- 406,834
Purchase and development of technology .................. (283,530) --
Proceeds from sale of fixed assets ...................... 1,755 --
Purchase of fixed assets ................................ (46,948) (37,634)
------------ ------------
NET CASH USED IN CONTINUING INVESTING ACTIVITIES .......... (328,723) (488,433)
============ ============
NET CASH USED IN DISCONTINUED INVESTING ACTIVITIES ........ (78,920) (10,182)
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES ..................... (407,643) (498,615)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Expenses repaid to officers and stockholders ............ -- (373,060)
Payments on settlement of accommodation agreements ...... (125,000) --
Advances from stockholders .............................. -- 1,650,000
Deferred financing costs ................................ (54,000) (621,739)
Proceed from issuance of Series A Preferred Stock ....... 4,355,451 --
Repayments of amounts due under settlement with former
officer ............................................... -- (200,000)
Proceeds from issuance of bridge notes .................. -- 3,500,000
Repayments of notes payable ............................. (7,001) --
Proceeds from disposition of discontinued operations .... 50,000 --
Proceeds received in connection with financing settlement 55,000 --
Proceeds from issuance of notes, less fees .............. -- 2,543,000
Repayments of advances from stockholders ................ -- (32,774)
------------ ------------
NET CASH PROVIDED BY CONTINUING FINANCING ACTIVITIES ...... 4,274,450 6,465,427
============ ============
NET CASH USED BY DISCONTINUED FINANCING ACTIVITIES ........ -- (93,483)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ................. 4,274,450 6,371,944
------------ ------------
NET INCREASE IN CASH ...................................... 195,418 271,724
CASH, beginning of period ................................. 14 45,901
------------ ------------
CASH, end of period ....................................... $ 195,432 $ 317,625
============ ============
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Interest ................................................ $ 285,517 $ 515,798
============ ============
Supplemental non-cash investing and finanical activity
Current tangible assets acquired ........................ $ 300,911
Non-current tangible assets acquired .................... 2,756,470
Current liabilities assumed with acquisitions ........... (8,379,271)
Non-current liabilities assumed with acquisitions ....... (439,126)
Intangible assets acquired .............................. 3,101,000
Goodwill recognized on purchase business combinations ... 22,433,752
Non-cash consideration .................................. (19,332,500)
Cash acquired in purchase business combinations ......... 416,397
------------
Cash paid to acquire businesses ......................... $ 857,633
============
Liabilities and claims settled in exchange for Series A-1
Preferred Stock ....................................... $ 24,005,552
See notes to condensed consolidated financial statements.
7
PATRON SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2006
NOTE 1 - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems, Inc. and subsidiaries (the "Company," "Patron," "we," "us," or "our")
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 three-month and
six-month periods ended June 30, 2006 are not necessarily indicative of the
operating results that may be expected for the entire year ending December 31,
2006.
This Form 10-QSB/A should be read in conjunction with the Company's 10-KSB for
the year ended December 31, 2005.
NOTE 2 - 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 merged with Systems, with Systems surviving the
merger. The combined entity continued to use the name Patron Systems, Inc.
REVERSE STOCK SPLIT AND AMENDMENT TO CERTIFICATE OF INCORPORATION
As described in Note 21, the Company's stockholders approved an amended to its
certificate of incorporation to effectuate a 1-for-30 reverse stock split and
certain other transactions intended to recapitalize the Company. All share
information included in the accompanying financial statements and notes thereto
give retroactive effect to the reverse split.
NOTE 3 - RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
The Company, while undergoing the audit of its consolidated financial statements
for the year ended December 31, 2006, became aware of possible misstatements in
its unaudited condensed consolidated interim financial statements filed with the
Securities and Exchange Commission during the year ended December 31, 2006. On
March 6, 2007, the Company's Board of Directors determined that certain amounts
reported in its unaudited condensed consolidated interim financial statements
for the quarters ended March 31, 2006, and June 30, 2006, and for the six months
ended June 30, 2006 and nine months ended September 30, 2006 needed to be
restated as described below.
The specific errors that came to management's attention relate to the Company's
accounting for certain transactions that occurred during the quarter ended March
31, 2006 and the quarter ended June 30, 2006. Upon review of these transactions,
Company management discovered that the accounting for these transactions
resulted in a $2,408,250 overstatement of its loss for the quarterly period
ended March 31, 2006 and a $593,765 overstatement of its loss for the quarterly
period ended June 30, 2006, which also resulted in an overstatement of the year
to date losses in the six and nine month periods ended June 30, 2006 and
September 30, 2006, respectively. For the six months ended June 30, 2006, a
reduction in the net loss of $3,002,015 ($0.61 per share) and a corresponding
reduction in accumulated deficit of $3,002,015 and a reduction of additional
paid in capital of $3,002,015 was recorded.
8
Specifically, the Company recorded for the three months ended March 31, 2006,
(1) a net loss of $858,213 on the settlement of various liabilities under its
creditor and claimant liabilities restructuring program when it should have
recorded a net gain of approximately $906,987, (2) excess non-cash interest of
$358,000 with respect to a conversion option that became effective under two of
its Interim Bridge Financing III notes and (3) charged, as interest expense, a
$285,050 fee paid to the placement agent in its Series A Preferred stock
financing transaction that should have been recorded as a reduction of the
offering proceeds. For the three months ended June 30, 2006, the company
recorded a net gain of $371,616 on the settlement of various liabilities under
its creditor and claimant liabilities restructuring program when it should have
recorded a net gain of approximately $965,381. The nature of the adjustments
required in the creditor and claimant liabilities restructuring in the quarters
ended March 31, 2006 and June 30, 2006, relate to an overvaluation of the Series
A-1 preferred shares issued in the exchange offer offset by gains on the
extinguishment of liabilities that originated in connection with obligations to
issue or repurchase stock.
The effect of the restatement on the Company's previously issued unaudited
condensed consolidated interim financial statements is as follows:
Three Months Six Months
ended ended
June 30, 2006 June 30, 2006
---------------------------- ----------------------------
As Previously As As Previously As
Reported Restated Reported Restated
------------ ------------ ------------ ------------
Loss/(Gain) associated with settlement
agreements ........................ $ (371,616) $ (965,381) $ 486,597 $ (1,872,368)
Interest expense ..................... $ (88,421) $ (88,421) $ (1,703,935) $ (1,060,885)
Net loss from continuing operations .. $ (1,420,313) $ (826,548) $ (5,715,425) $ (2,713,410)
Net loss available to common
stockholders ...................... $ (1,621,017) $ (1,027,252) $ (6,021,091) $ (3,019,076)
Net loss per share-continuing
operations ........................ $ (0.71) $ (0.44) $ (2.75) $ (1.33)
Net loss per share - total ........... $ (0.75) $ (0.47) $ (2.83) $ (1.42)
Additional paid in capital ........... $ 97,792,968 $ 93,682,031 $ 97,792,968 $ 93,682,031
Accumulated Deficit .................. $(90,409,118) $(87,282,319) $(90,409,118) $(87,282,319)
9
NOTE 4 - 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
$2,894,292 for the six months ended June 30, 2006, which includes an aggregate
of $1,013,073 of net non-cash charges including the conversion option cost for
bridge note and subordinated note holders, non-cash interest expense, the
amortization of deferred compensation and the charge for stock option based
compensation. These non-cash charges are offset by a non-cash gain of $1,872,368
associated with the settlement of outstanding liabilities, claims and litigation
for Series A-1 Preferred stock. The Company used net cash in its operating
activities of $3,671,389 during the six months ended June 30, 2006. The
Company's working capital deficiency at June 30, 2006 amounted to $4,251,015 and
the Company is continuing to experience shortages in working capital. The
Company is also involved in 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
consultants (Note 16). 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 market its software products, grow revenue
and generate cash flows of certain businesses it acquired in 2005 is critical to
the realization of its business plan. The Company raised $4,640,501 of gross
proceeds ($4,301,451 net proceeds after the payment of certain transaction
expenses) in financing transactions during the six months ended June 30, 2006.
The Company used $3,671,389 of these proceeds to fund its operations and a net
of $407,643 in investing activities. On January 12, 2006, the Company offered
its creditors and claimants an agreement to receive Series A-1 Preferred Stock,
par value $0.01 per share ("Series A-1 Preferred") 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 17). As of June 30, 2006, creditors representing
approximately $24.0 million of the Company's outstanding debts, claims and other
liabilities accepted this proposal by signing and returning to the Company the
Stock Subscription Agreement and Mutual Release. On July 21, 2006, the Company's
Board of Directors approved the completion of the creditor and claimant
liabilities restructuring. A total of $24,005,552 of debts, liabilities and
other claims were settled by the issuance of Series A-1 Preferred Stock. The
Company is currently unable to provide assurance that the acceptance of the
claims settlement will actually improve the Company's ability to fund the
further development of its business plan or improve its operations.
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 businesses acquired in 2005. 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 5 - 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, Complete
Security Solutions, Inc. and PILEC Disbursement Company. The accounts of
LucidLine, Inc. have been included in discontinued operations through April 18,
2006, the date on which LucidLine was sold (Note 20). 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.
10
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.
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 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 reasonably assured.
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, "Modification of SOP 97-2, Software Revenue Recognition
With Respect to Certain Transaction" to allocate revenues to delivered elements
once it has established vendor-specific objective evidence of fair value 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. These revenues are included in discontinued
operations as described in Note 20.
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.
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 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
11
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.
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.
GOODWILL
The Company accounts for Goodwill and Intangible Assets in accordance with
Statement of Financial Accounting Standards ("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. 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. The Company recorded goodwill in
connection with the Company's acquisitions described in Note 6 amounting to
$22,440,412. The Company's annual impairment review of goodwill resulted in
goodwill impairment charges totaling $12,929,696 for the year ended December 31,
2005 (Note 6) resulting in $9,510,716 in goodwill at June 30, 2006.
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's review of the carrying values of its long lived assets,
which principally consist of amortizable intangibles from acquired businesses,
resulted in an impairment charge of $1,705,455 for the year ended December 31,
2005 (Note 9). Amortizable intangible assets continue to be amortized over their
estimated useful lives. The Company evaluated the carrying amounts of its
goodwill and intangible assets as of June 30, 2006 and determined that
impairment charges are not necessary.
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. The Company's significant estimates principally include the valuation of
its intangible assets and goodwill and accrued liability for the Company's
estimate of the fair value of preferred stock issued upon the settlement of the
creditor and claimant liabilities restructuring in June 2006 (Note 17). Actual
results could differ from those estimates.
12
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.
PREFERRED STOCK
The Company applies the guidance enumerated in SFAS No. 150 "Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity" and EITF Topic D-98 "Classification and Measurement of Redeemable
Securities," when determining the classification and measurement of preferred
stock. Preferred shares subject to mandatory redemption (if any) are classified
as liability instruments and are measured at fair value in accordance with SFAS
150. All other issuances of preferred stock are subject to the classification
and measurement principles of EITF Topic D-98. Accordingly the Company
classifies conditionally redeemable preferred shares (if any), which includes
preferred shares that feature redemption rights that are either within the
control of the holder or subject to redemption upon the occurrence of uncertain
events not solely within the Company's control, as temporary equity. At all
other times, the Company classifies its preferred shares in stockholders'
equity.
The Company's preferred shares do not feature any redemption rights within the
holders control or conditional redemption features not within the Company's
control as of June 30, 2006. Accordingly all issuances of preferred stock are
presented as a component of stockholders equity.
CONVERTIBLE INSTRUMENTS
The Company evaluates and accounts for conversion options embedded in its
convertible instruments in accordance with SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133") and EITF 00-19
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock" ("EITF 00-19").
SFAS 133 generally provides three criteria that, if met, require companies to
bifurcate conversion options from their host instruments and account for them as
free standing derivative financial instruments in accordance with EITF 00-19.
These three criteria include circumstances in which (a) the economic
characteristics and risks of the embedded derivative instrument are not clearly
and closely related to the economic characteristics and risks of the host
contract, (b) the hybrid instrument that embodies both the embedded derivative
instrument and the host contract is not remeasured at fair value under otherwise
applicable generally accepted accounting principles with changes in fair value
reported in earnings as they occur and (c) a separate instrument with the same
terms as the embedded derivative instrument would be considered a derivative
instrument subject to the requirements of SFAS 133. SFAS 133 and EITF 00-19 also
provide an exception to this rule when the host instrument is deemed to be
conventional (as that term is described in the implementation guidance to SFAS
133 and further clarified in EITF 05-2 "The Meaning of "Conventional Convertible
Debt Instrument" in Issue No. 00-19).
The Company accounts for convertible instruments (when it has determined that
the embedded conversion options should not be bifurcated from their host
instruments) in accordance with the provisions of EITF 98-5 "Accounting for
Convertible Securities with Beneficial Conversion Features," ("EITF 98-5") and
EITF 00-27 "Application of EITF 98-5 to Certain Convertible Instruments."
Accordingly, the Company records when necessary discounts to convertible notes
for the intrinsic value of conversion options embedded in debt instruments based
upon the differences between the fair value of the underlying common stock at
the commitment date of the note transaction and the effective conversion price
embedded in the note. Debt discounts under these arrangements are amortized over
the term of the related debt to their earliest date of redemption. The Company
also records when necessary deemed dividends for the intrinsic value of
conversion options embedded in preferred shares based upon the differences
between the fair value of the underlying common stock at the commitment date of
the note transaction and the effective conversion price embedded in the note.
13
The Company evaluated the conversion option embedded in its convertible
instruments during each of the reporting periods presented and has determined,
in accordance with the provisions of these statements, that it does not meet the
criteria requiring bifurcation of these instruments.
The Company determined that the conversion option embedded in its Series A
Convertible Preferred Stock, par value $0.01 per share ("Series A Preferred"),
is not a free standing derivative in accordance with the implementation guidance
provided in paragraph 61 (l) of Appendix A to SFAS 133.
STOCK BASED COMPENSATION
Prior to January 1, 2006, the Company accounted for employee stock transactions
in accordance with Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees." The Company applied the proforma
disclosure requirements of SFAS No. 123 "Accounting for Stock-Based
Compensation."
Effective January 1, 2006, the Company adopted SFAS No. 123R "Share Based
Payment." This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, 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 that will result in a charge to operations.
The Company adopted the modified prospective method with respect to accounting
for its transition to SFAS 123(R) and measured unrecognized compensation cost as
described in Note 19. Accordingly, the Company recognized in salaries and
related expense on the statement of operations, $244,924 and $64,089 for the
fair value of stock options expected to vest during the six- and three-month
periods ended June 30, 2006, respectively.
For the six and three months ended June 30, 2005, the Company applied APB
Opinion No. 25, "Accounting for Stock Issued to Employees." As required under
SFAS No. 148, "Accounting for Stock-based Compensation - Transition and
Disclosure," the following table presents pro-forma net income and basic and
diluted earnings per share as if the fair value-based method had been applied to
all awards during that period.
Six Months Three Months
Ended Ended
June 30, June 30,
2005 2005
----------- -----------
Net Loss .............................................. $(7,232,300) $(5,028,505)
Stock-based employee compensation cost, under fair
value accounting ................................... (370,556) (185,278)
----------- -----------
Pro-forma net loss under fair value method ............ $(7,602,856) $(5,213,783)
=========== ===========
Net loss per share - basic and diluted ................ $ (3.93) $ (2.47)
Per share stock-based employee compensation cost, under
fair value accounting
Pro-forma net loss per share, basic and diluted ....... $ (4.14) $ (2.56)
The fair value of all awards was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions: risk fee interest rate: 3.44% to 4.05%; expected dividend yield:
0%; expected option life: 3 to 4 years; volatility: 87% to 125%.
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."
14
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) or (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 under SFAS No. 109, "Accounting for Income
Taxes." SFAS No. 109 requires the recognition of deferred tax assets and
liabilities for both the expected impact of differences between the financial
statements and tax basis of assets and liabilities and for the expected future
tax benefit to be derived from tax loss and tax credit carry forwards. SFAS No.
109 additionally requires the establishment of a valuation allowance to reflect
the likelihood of realization of 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 2, the
Company included 40,001 stock options with an exercise price of $0.30 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 and
warrants as their effect would be anti-dilutive:
June 30,
-----------------------------
2006 2005
---------- ----------
Options .................................. 438,090 197,505
Warrants ................................. 1,339,306 261,851
Series A Preferred Stock ................. 2,008,567
Series A-1 Preferred Stock ............... 12,129,674
Convertible Notes ........................ 66,557
---------- ----------
15,982,194 459,356
========== ==========
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets" (SFAS 153). 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 did not have a material effect on the Company's financial
statements.
15
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.
In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 154, "Accounting Changes and Error
Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS
154"). This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB
Statement No. 3, Reporting Accounting Changes in Interim Financial Statements,
and changes the requirements for the accounting for and reporting of a change in
accounting principle. This Statement applies to all voluntary changes in
accounting principle. It also applies to changes required by an accounting
pronouncement in the unusual instance that the pronouncement does not include
specific transition provisions. When a pronouncement includes specific
transition provisions, those provisions should be followed.
APB Opinion No. 20 previously required that most voluntary changes in accounting
principle be recognized by including in net income of the period of the change
the cumulative effect of changing to the new accounting principle. This
Statement requires retrospective application to prior periods' financial
statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. When it is impracticable to determine the period-specific effects of an
accounting change on one or more individual prior periods presented, this
Statement requires that the new accounting principle be applied to the balances
of assets and liabilities as of the beginning of the earliest period for which
retrospective application is practicable and that a corresponding adjustment be
made to the opening balance of retained earnings (or other appropriate
components of equity or net assets in the statement of financial position) for
that period rather than being reported in an income statement. When it is
impracticable to determine the cumulative effect of applying a change in
accounting principle to all prior periods, this Statement requires that the new
accounting principle be applied as if it were adopted prospectively from the
earliest date practicable. This Statement is effective for accounting changes
and corrections of errors made in fiscal years beginning after December 15,
2005. The adoption of this pronouncement did not have a material effect on the
Company's financial statements.
On June 29, 2005, the EITF ratified Issue No. 05-2, "The Meaning of
'Conventional Convertible Debt Instrument' in EITF Issue No. 00-19, 'Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock.'" EITF Issue 05-2 provides guidance on determining whether
a convertible debt instrument is "conventional" for the purpose of determining
when an issuer is required to bifurcate a conversion option that is embedded in
convertible debt in accordance with SFAS 133. Issue No. 05-2 is effective for
new instruments entered into and instruments modified in reporting periods
beginning after June 29, 2005. The adoption of this pronouncement did not have a
material effect on the Company's financial statements.
In September 2005, the EITF ratified Issue No. 05-4, "The Effect of a Liquidated
Damages Clause on a Freestanding Financial Instrument Subject to EITF Issue No.
00-19, `Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock.'" EITF 05-4 provides guidance to
issuers as to how to account for registration rights agreements that require an
issuer to use its "best efforts" to file a registration statement for the resale
of equity instruments and have it declared effective by the end of a specified
grace period and, if applicable, maintain the effectiveness of the registration
statement for a period of time or pay a liquidated damage penalty to the
investor. The Company is currently in the process of evaluating the effect that
the adoption of this pronouncement may have on its financial statements.
In September 2005, the FASB ratified the Emerging Issues Task Force's ("EITF")
Issue No. 05-7, "Accounting for Modifications to Conversion Options Embedded in
Debt Instruments and Related Issues," which addresses whether a modification to
a conversion option that changes its fair value affects the recognition of
interest expense for the associated debt instrument after the modification and
whether a borrower should recognize a beneficial conversion feature, not a debt
extinguishment if a debt modification increases the intrinsic value of the debt
(for example, the modification reduces the conversion price of the debt). This
issue is effective for future modifications of debt instruments beginning in the
first interim or annual reporting period beginning after December 15, 2005. The
adoption of this pronouncement did not have a material effect on the Company's
financial statements.
16
In September 2005, the FASB also ratified the EITF's Issue No. 05-8, "Income Tax
Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature,"
which discusses whether the issuance of convertible debt with a beneficial
conversion feature results in a basis difference arising from the intrinsic
value of the beneficial conversion feature on the commitment date (which is
recorded in the stockholders' equity for book purposes, but as a liability for
income tax purposes), and, if so, whether that basis difference is a temporary
difference under FASB Statement No. 109, "Accounting for Income Taxes." This
Issue should be applied by retrospective application pursuant to Statement 154
to all instruments with a beneficial conversion feature accounted for under
Issue 00-27 included in financial statements for reporting periods beginning
after December 15, 2005. The adoption of this pronouncement did not have a
material effect on the Company's financial statements.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments - an amendment of FASB Statements No. 133 and 150." SFAS
No. 155 (a) permits fair value remeasurement for any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation,
(b) clarifies that certain instruments are not subject to the requirements of
SFAS 133, (c) establishes a requirement to evaluate interests in securitized
financial assets to identify interests that may contain an embedded derivative
requiring bifurcation, (d) clarifies what may be an embedded derivative for
certain concentrations of credit risk and (e) amends SFAS 140 to eliminate
certain prohibitions related to derivatives on a qualifying special-purpose
entity. SFAS 155 is applicable to new or modified financial instruments in
fiscal years beginning after September 15, 2006, though the provisions related
to fair value accounting for hybrid financial instruments can also be applied to
existing instruments. Early adoption, as of the beginning of an entity's fiscal
year, is also permitted, provided interim financial statements have not yet been
issued. We are currently evaluating the potential impact, if any, that the
adoption of SFAS 155 will have on our consolidated financial statements.
In March 2006, the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 156, Accounting for Servicing of Financial Assets (SFAS No. 156).
SFAS No. 156 amends SFAS No. 140 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," to require all separately
recognized servicing assets and servicing liabilities to be initially measured
at fair value, if practicable. SFAS No. 156 also permits servicers to
subsequently measure each separate class of servicing assets and liabilities at
fair value rather than at the lower of cost or market. For those companies that
elect to measure their servicing assets and liabilities at fair value, SFAS No.
156 requires the difference between the carrying value and fair value at the
date of adoption to be recognized as a cumulative effect adjustment to retained
earnings as of the beginning of the fiscal year in which the election is made.
SFAS No. 156 is effective for the first fiscal year beginning after September
15, 2006. We are currently evaluating the potential impact, if any, that the
adoption of SFAS 156 will have on our consolidated financial statements.
Other accounting standards that have been issued or proposed by the FASB or
other standards-setting bodies that do not require adoption until a future date
are not expected to have a material impact on the consolidated financial
statements upon adoption.
NOTE 6 - BUSINESS COMBINATIONS
On February 25, 2005, the Company acquired Complete Security Solutions, Inc.
("CSSI") and LucidLine, Inc. ("LucidLine") in separate merger transactions.
Additionally, on March 30, 2005, the Company acquired Entelagent Software Corp.
("Entelagent") in a merger transaction. The Company accounted for these business
combinations in accordance with the provisions of SFAS 141 "Accounting for
Business Combinations."
In connection with these three merger transactions, the Company paid, $200,000
in cash, 496,667 shares of common stock with a fair market value of $12,665,000,
subordinated promissory notes in the aggregate principal amount of $4,500,000,
warrants to purchase up to 75,001 shares of common stock which were valued at
$1,912,500. Direct expenses incurred by the Company to complete these
transactions amounted to $912,663. The total purchase price for the three
companies amounted to $20,190,133.
The allocation of the purchase price was based upon a valuation study performed
by an independent outside appraisal firm. The purchase price allocation resulted
in the allocation of $3,101,000 to intangible assets, including $2,570,000 to
17
developed technology and $190,000 to in-process research and development.
Additionally, the purchase price allocation resulted in the allocation of
$22,440,412 to goodwill.
The Company performed its annual impairment test of goodwill at its designated
valuation date of December 31, 2005 in accordance with SFAS 142. As a result of
these tests, the Company determined that the recoverable amount of goodwill with
respect to its business amounted to $9,510,716. Accordingly, the Company
recorded a goodwill impairment charge in the amount of $12,929,696 for the year
ended December 31, 2005. Additionally, after reevaluating the resources
available to the Company, the strategic direction of the business as well as the
revised business plans and financial projections, the Company, during the
quarter ended December 31, 2005, recorded a $1,705,455 charge for the impairment
of the developed technology assets acquired in the CSSI and Entelagent
acquisitions. The remaining amount of goodwill and intangible assets is
presented net of such impairment charges recorded during the year ended December
31, 2005.
On April 18, 2006, the Company entered into a Stock Purchase Agreement with
Walnut Valley, Inc. pursuant to which the Company sold all of the outstanding
shares of LucidLine, Inc. As a result, LucidLine has been treated as a
discontinued operation in these financial statements (Note 20).
NOTE 7 - OTHER CURRENT ASSETS
Other current assets consist of the following:
JUNE 30, 2006
-------------
Employee receivables .......................................... $ 23,517
Prepaid expenses .............................................. 52,417
Deposits ...................................................... 30,639
Other current assets .......................................... 125,000
-------------
Other current assets ........................................ $ 231,573
=============
NOTE 8 - PROPERTY AND EQUIPMENT
JUNE 30, 2006
-------------
Computers ..................................................... $ 147,524
Furniture and Fixtures ........................................ 31,962
Leasehold improvements ........................................ 4,490
-------------
sub-total ................................................. 183,976
less: accumulated depreciation ................................ (58,368)
-------------
Property and equipment, net ............................... $ 125,608
=============
Depreciation expense amounted to $26,751 and $13,753 for the six months ended
June 30, 2006 and 2005, respectively.
NOTE 9 - INTANGIBLE ASSETS
The components of intangible assets as of June 30, 2006 are set forth in the
following table:
18
JUNE 30, 2006
-------------
Developed technology ......................................... $ 2,570,000
Customer relationships ....................................... 180,000
Trademarks and tradenames .................................... 161,000
In-process research and development .......................... 807,917
-------------
3,718,917
Amortization and impairment charge ........................... (2,319,299)
-------------
Intangible assets, net .................................... $ 1,399,618
=============
During the year ended December 31, 2005, the Company recorded a $1,705,455
charge for the impairment of the developed technology assets acquired in the
CSSI and Entelagent acquisitions (Note 6).
The Company classifies amortization of developed technology as a component of
cost of sales and amortization of customer relationship and trademarks and
tradenames as a component of general and administrative expense. Amortization
expense amounted to $116,669 and $178,545 for the six months ended June 30, 2006
and 2005, respectively. Included in these amounts is $55,044 and $147,731 for
the six months ended June 30, 2006 and 2005, respectively, which is classified
as cost of sales.
NOTE 10 - DEMAND NOTES PAYABLE
Through December 31, 2004, the Company borrowed an aggregate amount of $695,000
from several unrelated parties. At June 30, 2006, all but one note was settled
in the creditor and claimant liabilities restructuring. The outstanding balance
on this note amounts to $135,000. This note is payable on demand and bears
interest at the rate of 10% per annum. Interest expense on the notes amounted to
$20,750 and $35,750 for the six months ended June 30, 2006 and June 30, 2005,
respectively.
Other demand notes at June 30, 2006 total $312,556 and is associated with a note
payable to Lok Technology which is secured by Entelagent's accounts receivable
and bears interest at 15% per annum. Interest on this demand note amounted to
$23,442 for the six months ended June 30, 2006 and $0 for six months ended June
30, 2005. As described in Note 16, on May 4, 2006, the Company became aware of a
complaint that Lok Technologies, Inc. had filed in the Superior Court of
Californian, County of Santa Clara on or about March 30, 2006 against the
Company, Entelagent Software Corp. and unnamed defendants.
As of June 30, 2006, $608,500 of the Demand Notes have been surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 17).
NOTE 11 - 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 58,348 shares of the
Company's common stock ("Bridge I Warrants"). The warrants have a term of 5
years and an exercise price of $21.00 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
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, "Accounting for Convertible Debt and Debt Issued with
Stock Purchase Warrants," 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.
19
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 58,348 additional warrants (the "Bridge I
Extension Warrants") to purchase such number of shares of common stock equal to
1/60 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 $21.00 per
share. The Bridge I Extension Warrants have a fair value of $822,500.
Assumptions relating to the estimated fair value of these warrants are as
follows: fair value of common stock of $19.50; risk-free interest rate of 4.25%;
expected dividend yield zero percent; expected warrant life of three years; and
current volatility of 125%.
The Company did not redeem the Bridge I Notes on August 27, 2005 and, as a
result, the notes automatically became convertible into 0.128 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 in 2005
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 $113,883 and
$116,667 for the six months ended June 30, 2006 and 2005, respectively, and is
included as a component of interest expense in the accompanying statement of
operations.
As of June 30, 2006, $3,155,025 of the Bridge I Notes have been surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 17).
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
42,384 shares of common stock (the "Bridge II Warrants"). The warrants have a
term of 5 years and an exercise price of $18.00 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.
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 1/60th 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
$18.00 per share. The Bridge II Extension Warrants have a fair value of $65,388.
Assumptions relating to the estimated fair value of these warrants are as
follows: fair value of common stock $2.40; risk-free interest rate of 3.10%;
expected dividend yield zero percent; expected warrant life of five years; and
current volatility of 125%. In addition, if the Bridge II Notes are not paid in
full on or before the extended maturity date, each note becomes convertible into
..128 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.
20
The Company sold these securities to seven accredited investors introduced by
Laidlaw, placement agent in the Interim Bridge Financing II. 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 4,243
shares of the Company's common stock at an exercise price of $18.00 per share.
The Company elected to extend the due dates of these notes by an additional 60
days to various dates beginning December 2, 2005. In addition, the Company was
required to issue Bridge II Extension Warrants to purchase 42,388 shares of the
Company's common stock. The Bridge II Extension Warrants have at term of 5 years
and an exercise price of $18.00 per share.
The Company did not redeem the Bridge II Notes on December 2, 2005 and, as a
result, the notes became automatically convertible into 0.128 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 $2,543,000 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 II Notes amounted to $111,146 and
$21,192 for the six months ended June 30, 2006 and 2005, respectively and is
included as a component of interest expense in the accompanying statement of
operations.
As of June 30, 2006, $2,343,000 of the Bridge II Notes have been surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 17).
INTERIM BRIDGE FINANCING III
Beginning on July 1, 2005, and continuing through December 31, 2005, the Company
completed, through 12 separate fundings, a $5,234,000 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
87,235 shares of common stock (the "Bridge III Warrants"). The warrants have a
term of 5 years and an exercise price of $18.00 per share. 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 $4,645,544 of the proceeds to
the Bridge III Notes and $587,595 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 $20,909 for the three months ended March 31,
2006 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 1/60th 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 $18.00 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
0.128 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 $5,234,000 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.
21
Beginning on October 29, 2005, the Company elected to extend the contractual
maturity date of the various Bridge III Notes for an additional 60 days to
various dates beginning December 28, 2005, which caused the contractual interest
rate to increase to 12% per annum. In addition, during the three month ended
March 31, 2006, the Company was required to issue 39,917 additional warrants
(the "Bridge III Extension Warrants"). The aggregate fair value of the warrants,
which amounted to $48,129 was recorded as a deferred financing cost and was
being amortized over the 60-day extension period or until March 27, 2006 when
the Bridge III Notes were surrendered as payment for the Series A-1 Preferred
stock under the creditor and claimant liabilities restructuring. The Bridge III
Extension Warrants have a term of 5 years and an exercise price of $18.00 per
share. Assumptions relating to the estimated fair value of these warrants are as
follows: fair value of common stock $1.95 to $2.40; risk-free interest rate of
3.10% to 3.44%; expected dividend yield zero percent; expected warrant life of
three years; and current volatility of 125%.
The Company did not redeem Bridge III Notes on contractual maturity dates that
occurred through January 12, 2006 (the date of the Series A-1 creditor and
claimant liabilities restructuring). As a result, $3,400,000 of the Notes became
automatically convertible into 0.128 shares of common stock for each $1 of
principal then outstanding in accordance with the original note agreement. This
amounts to a total of 70,400 shares during the three months ended of March 31,
2006. Accordingly, the Company recorded a charge of $192,000, in the three
months ended March 31, 2006, based upon the intrinsic value of this conversion
option measured at the original issuance date of the notes in accordance with
EITF 00-27. With the surrender of the Bridge III Notes in payment for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring, these
conversion options are no longer exercisable and have been cancelled.
As of March 31, 2006, all of the Bridge III Notes have been surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 17).
Contractual interest expense on the Bridge III Notes amounted to $153,036 and $0
for the six months ended June 30, 2006 and 2005, respectively, and is included
as a component of interest expense in the accompanying statement of operations.
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.
2006 BRIDGE NOTES
On January 18, 2006, the Company completed a financing of approximately $540,000
in additional gross funds (the "2006 Bridge Note Financing") through the
issuance of Subordinated Convertible Promissory Notes (the "2006 Bridge Notes")
in the amount of $720,001. The 2006 Bridge Note agreement provided for these
notes to automatically convert into the same securities (consisting of shares of
Series A Preferred Stock and warrants to purchase shares of the Company's common
stock) offered by the Company in connection with its Series A Preferred
Financing (as defined below). On March 27, 2006 (the date of the first closing
of the Series A Preferred Financing), the 2006 Bridge Notes were converted into
7.2 Units in the Series A Preferred Financing described below. The $180,000
difference between the gross proceeds received upon the original issuance of the
notes and the redemption amount was recorded as an original issuance discount
that was fully expensed during the six months ended June 30, 2006.
Additionally, the Company paid Laidlaw & Company (UK) Ltd. (Laidlaw), as
placement agent in the transaction, a fee of $54,000 in conjunction with the
2006 Bridge Note Financing. This fee was fully amortized and recognized as
interest expense during the six months ended June 30, 2006.
22
NOTE 12 - 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 $130,201 remains outstanding at
June 30, 2006. The amounts payable to such officers and stockholders are due on
demand. The balance due under these arrangements is included in the liabilities
that the Company has offered to settle under the creditor and claimant
liabilities restructuring described in Note 17.
NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS
Notes payable to officers and stockholders amount to $90,000, bear interest at
10% per annum and are due on demand. Interest expense on these notes amounted to
$6,475 for the six months ended June 30, 2006. As of June 30, 2006, $145,712 of
the original notes which amounted to $235,712 have been surrendered as payment
for Series A-1 Preferred stock as part of the creditor and claimant liabilities
restructuring (Note 17). Subsequent to June 30, 2006, the remaining $90,000 of
this amount has been surrendered as payment for Series A-1 Preferred stock under
the creditor and claimant liabilities restructuring.
CONSULTING AGREEMENT PAYABLE
On June 8, 2005, the Company negotiated a settlement regarding a consulting
agreement payable with a related party. The terms of the settlement agreement
terminated the prior agreement and reduced 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 terminated an obligation
for the Company to issue 3,334 shares of unrestricted stock. The stock issuable
under this commitment was recorded in 2004 as common stock issued in lieu of
cash for services in the amount of $78,900. The rescission of the stock issuable
under this arrangement resulted in an additional reduction of $78,900 in general
and administrative expenses during the year ended December, 31, 2005.
The payment due on September 30, 2005 was not made by the Company. The $100,000
balance due under this arrangement has been surrendered as payment for Series
A-1 Preferred stock under the creditor and claimant liabilities restructuring
described in Note 17.
NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)
The notes issued to creditors of Entelagent (in connection with the acquisition
described in Note 6) include $554,202 that is payable to related parties for
settlements of accrued payroll, notes payable and other payables that remain
outstanding at June 30, 2006. The original amount of these notes amounted to
$2,602,913. Aggregate interest expense on these notes amounted to $77,370 and
$51,842 for the six months ended June 30, 2006 and 2005, respectively. The
balance due under these notes is included in the liabilities that the Company
has offered to settle under the creditor and claimant liabilities restructuring
described in Note 17.
During the six months ended June 30, 2006, $1,795,930 of the notes payable to
creditors of acquired business was surrendered as payment for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring.
NOTE 13 - OTHER CURRENT LIABILITIES
Other current liabilities principally consist of $439,769 of accrued payroll and
sales tax liabilities and estimated penalties that the Company assumed in its
acquisition of Entelagent (Note 6). The balance consists of various
miscellaneous other current liabilities.
23
NOTE 14 - DEFERRED REVENUE
Deferred revenue at June 30, 2006 includes (1) $128,093 for the fair value of
remaining service obligations on maintenance and support contracts and (2)
$370,687 for contracts on which the revenue recognition is deferred until
contract deliverables have been completed. Included in the contracts for which
revenue recognition has been deferred is one contract with contract value of
$272,610 for which no revenue has been recognized and for which the revenue is
expected to be recorded during 2006. Also included is a down payment of $53,202
received on a contract in the amount of $266,009 for which no revenue has yet
been reported and for which revenue is expected to be recognized during 2006 and
2007 and the non-cancelable portion of a $716,965 contract in the amount of
$89,750 less the revenue already recognized of $44,875.
NOTE 15 - 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 31,667 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.
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 40,000 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 recorded
stock based penalties for the fair value of 15,000 shares per quarter through
December 31, 2005.
The total stock-based penalties associated with the Accommodation Agreements
from April 2003 to December 31, 2005 were $3,318,975. An aggregate of 165,000
shares were issuable through December 31, 2005 under the stock-based penalties
associated with the Accommodation Agreements.
On March 27, 2006, the Company entered into an agreement to release and resolve
all outstanding claims between the parties under the creditor and claimant
liabilities restructuring (Note 17).
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 (the "Lender I"), pursuant to which such stockholder committed to
obtain financing for the Company under a credit facility collateralized by the
pledge of 22,834 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 22,834 shares of restricted stock (the
24
"Replacement Stock") on April 2, 2005 (the "Termination Date") in the event of a
loss of the Pledged Stock, plus a premium of 6,850 shares (the "Premium Shares")
for entering into the agreement. The Company also agreed to register 10,000
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 (29,684 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 charges of $5,246 and $62,102 during
the six months ended June 30, 2006 and 2005, respectively for the fair value of
2,952 and 2,853 shares issuable during the six months ended June 30, 2006 and
2005, respectively 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.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
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, 145,834 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. The Company's legal
counsel representing the Company in such matters has indicated that while the
SEC Investigation is ongoing and the Company has not received correspondence
from the SEC indicating that the matter is officially closed, the Staff has
indicated that it does not intend to request additional information from the
Company and that, at this time, it does not intend to recommend that the SEC
bring an enforcement action against the Company, its officers and directors.
25
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 33,334 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 sought rescission
of its purchase agreement and return of its $2,000,000 purchase price or
compensatory damages to be proven at trial. Mr. Allin 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. On April 24, 2006, the Company and the Sherleigh Associates Inc. Profit
Sharing Plan entered into a final and binding settlement of all claims as part
of the creditor and claimant liabilities restructuring (Note 17).
On January 5, 2006, Mark P. Gertz, Trustee in bankruptcy for Arter & Hadden,
LLP, filed an Adversary Complaint for Recovery of Assets of the Estate in the
United States Bankruptcy Court Northern District of Ohio Eastern Division,
against the Company as successor in merger to Entelagent. Mr. Gertz seeks
$32,278.18 plus interest accruing at the statutory rate since July 15, 2003 for
services rendered by Arter & Hadden, LLP to Entelagent. The Company and Mr.
Gertz have agreed to a settlement through mediation in the amount of $32,500 in
13 installments of $2,500. The Company is awaiting final documents from Mr.
Gertz.
On May 4, 2006, Patron became aware that Lok Technologies, Inc. had filed a
complaint on or about March 30, 2006 against the Company, Entelagent Software
Corp. and unnamed defendants in the Superior Court of California, County of
Santa Clara alleging breach of contract, breach of duty of good faith and fair
dealing and unjust enrichment and seeking damages, interest, disgorgement of any
unjust enrichment, attorneys fees and cost. Prior to receipt of this notice of
litigation, the Company had recorded a liability of $320,000 plus accrued
interest of $159,432. The Company believes that it has defenses to these claims.
The Company cannot provide any assurance that the ultimate settlement of this
claim will not have a material adverse affect on its financial condition.
NOTE 17 - CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING
On January 12, 2006, the Company issued a Stock Subscription Agreement & Mutual
Release ("the Original Release") to each creditor and claimant ("Subscriber") of
the Company for purposes of entering into a final and binding settlement with
respect to any and all claims, liabilities, demands, causes of action, costs,
expenses, attorneys fees, damages, indemnities, and obligations of every kind
and nature that the creditor and/or claimant may have with the Company
("Subscriber Claims"). Under terms of this agreement, the Company sold to the
Subscriber and the Subscriber purchased from the Company shares ("Stock") of its
Series A-1 Preferred stock at a price of $0.80 per share. The aggregate purchase
price was equivalent to the value of the Subscriber Claims being settled through
this settlement and release. Subscriber was deemed to have paid for the Stock
through the settlement and release of Subscriber Claims. Each share of Stock was
automatically convertible into 1/3 share of the Company's common stock upon the
effectiveness of an amendment to the Company's certificate of incorporation
which provided for a sufficient number of authorized but unissued and unreserved
shares of the Company's common stock to permit the conversion of all issued and
outstanding shares of Series A-1 Preferred. The Company issued the Series A-1
Preferred shares following the final determination of the claims and acceptance
by the Company of each claimant submitted Stock Subscription Agreement and
Mutual Release through countersignature thereof.
The Original Release also provided that in the event that (a) a bona fide sale
or (series of related sales) by the Company of equity interests in the Company
in an amount equal to or in excess of $3,000,000 or (b) any merger,
consolidation, recapitalization, reclassification, reincorporation,
reorganization, share exchange, sale of all or substantially all of the assets
26
of the Company or comparable transaction, was not consummated on or before March
31, 2006 (the "Termination Date"), the Stock Subscription Agreement & Mutual
Release would terminate and be null and void, the Series A-1 Preferred issued to
Subscriber would be cancelled and the Subscriber Claims would remain in full
force and effect on their terms. Each Subscriber agreed not to transfer or sell
any portion of the Stock until the next business day after the Termination Date,
subject to (i) an effective registration under the Securities Act or in a
transaction which is otherwise in compliance with the Securities Act, (ii) an
effective registration under any applicable state securities statute or in a
transaction otherwise in compliance with any applicable state securities statue,
and (iii) evidence of compliance with the applicable securities laws of other
jurisdictions. As described below, the Company completed the sale of $4.8
million in equity securities under the Series A Preferred Financing on March 27,
2006 thereby eliminating the provision for automatic termination of this
arrangement.
The following table provides a summary as of June 30, 2006 of all claims settled
by category with the (gain) loss recognized on the settlement:
Series A-1 Claim Fair Value
Settlement Category Stock Issued Amount of Stock Gain/(Loss)
------------------------------------------ ----------- ----------- ----------- -----------
General Creditors ........................ 21,957,892 $17,864,190 $13,054,575 $ 4,809,615
Former Officer/Stockholder ............... 1,549,526 $ 1,180,991 $ 929,716 251,275
Stockholders under Accommodation Agreement 3,000,000 2,400,000 2,400,000 --
Mr. Allin and the Allin Dynastic Trust ... 2,500,000 1,317,089 1,500,000 (182,911)
Other Claimants .......................... 7,381,489 1,243,282 4,248,893 (3,005,611)
----------- ----------- ----------- -----------
36,388,907 $24,005,552 $22,133,184 $ 1,872,368
=========== =========== =========== ===========
The fair value of the Series A-1 shares issued in settlements reached prior to
June 30, 2006 amounted to $0.60 per share, based on a comparison of the features
of these shares to similar shares sold in private placement transactions to
unrelated parties for cash and the trading price of the Company's shares at the
time of the settlements. These settlement agreements effectuated a complete
settlement of these debts, claims and liabilities and the mutual release of the
parties with respect thereto.
The Company accounted for the extinguishment of liabilities payable to general
creditors in accordance with SFAS 15 "Accounting by Debtors and Creditors for
Troubled Debt Restructurings," due to the fact that the holders of these notes
granted to Company concessions intended to alleviate its immediate liquidity
constraints. These concessions that the creditors granted to the Company enabled
it to (a) effectuate their settlement through an exchange of equity instead of a
use of cash and (b) consummate a private placement of equity securities (Note
18) that resulted in an infusion of cash that was needed to sustain operations.
Claimants other than Mr. Allin and the Allin Dynastic Trust that participated in
the settlement include certain parties that were previously engaged in
litigation with the Company including the Sherleigh Associates Profit Sharing
Plan to which the Company issued 2,312,500 shares for a settlement loss of
$1,387,500, Richard Linting to whom the Company issued 1,777,261 shares for a
settlement loss of approximately $773,000 and the holders of the Marie Graul
claim to whom the Company issued 1,164,461 shares for a settlement loss of
approximately $698,000.
LOSS (GAIN) ASSOCIATED WITH SETTLEMENT AGREEMENTS
During the six months ended June 30, 2006 as part of the creditor and claimant
liabilities restructuring, the Company settled a number of disputed and
unresolved payables and outstanding claims. Included among the claims settled
was a claim associated with Accommodation Agreements (Note 15). Settlement
losses associated with claims include the Sherleigh Associates Profit Sharing
Plan complaint ($1,387,500), loss on the settlement of Richard Linting's lawsuit
against the Company ($773,548) and a loss associated with the reinstatement and
subsequent settlement of the claim associated with the lawsuit brought by Marie
Graul against the Company ($698,485).
27
During the six months ended June 30, 2005, the Company entered into a settlement
agreement with Cook Associates to settle all claims related to a lawsuit filed
by Cook Associates filed against the Company. This settlement resulted in the
Company recognizing a gain on settlement of $389,103.
NOTE 18 - SERIES A AND SERIES A-1 PREFERRED STOCK
On March 1, 2006, the Company filed with the Delaware Secretary of State a
Certificate of Designation of Preferences, Rights and Limitations of Series A
Convertible Preferred Stock and Series A-1 Convertible Preferred Stock
designating the rights, preferences and privileges of 2,160 shares of Series A
Convertible Preferred Stock and 50,000,000 shares of Series A-1 Convertible
Preferred Stock.
SERIES A PREFERRED STOCK
The Series A Preferred Stock has a stated value of $5,000 per share, has no
maturity date, carries a dividend of 10% per annum, with such dividend
accumulating on a cumulative basis. The dividend is payable only (i) at such
time as declared payable by the Board of Directors of the Company or (ii) in the
event of liquidation, as part of the liquidation preference amount ("Liquidation
Preference Amount"). Accrued but unpaid dividends on the Series A Preferred
amount to $124,784 at June 30, 2006.
The Series A Preferred is convertible, at the option of the holder, into shares
of the Company's common stock ("Conversion Shares") at an initial conversion
price ("Initial Conversion Price") of $2.40 per share based on the stated value
of the Series A Preferred, subject to adjustment for stock splits, dividends,
recapitalizations, reclassifications, payments made to Common Stock holders and
other similar events and for issuances of additional securities at prices more
favorable than the conversion price at the date of such issuance. The Company
evaluated the conversion option at the commitment date of the financing in
accordance with APB 14 and EITF 00-27 and determined that conversion price was
not beneficial.
The Series A Preferred is mandatorily convertible into shares of the Company's
common stock at the Initial Conversion Price, which is subject to adjustment as
described above, on the date that: (i) there shall be an effective registration
statement covering the resale of the Conversion Shares, (ii) the average closing
price of the Company's common stock, for a period of 20 consecutive trading days
is at least 250% of the then applicable Conversion Price, and (iii) the average
daily trading volume of the Company's common stock for the same period is at
least 8,334 shares.
The potential adjustment to the conversion price that would occur upon the
completion of a subsequent financing transaction on terms more favorable than
that of the Series A Preferred (if any) is considered to be a contingent
conversion price in accordance with EITF 00-27. Accordingly, such adjustments
would be measured and accounted for at the effective time of such adjustment, if
any.
The Series A Preferred Liquidation Preference Amount is equal to 125% of the sum
of: (i) the stated value of any then unconverted shares of Series A Preferred
and (ii) any accrued and unpaid dividends thereon. An event of liquidation means
any liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, as well as any change of control of the Company which includes the
sale by the Company of either (x) substantially all its assets or (y) the
portion of its assets which comprises its core business technology, products or
services.
SERIES A-1 PREFERRED STOCK
The Series A-1 Preferred Stock has a stated value of $0.80 per share, has no
maturity date, carries a non-cumulative dividend of 5% per annum, with such
dividend payable only (i) at such time as declared payable by the Board of
Directors of the Company or (ii) in the event of liquidation, as part of the
liquidation preference amount ("Series A-1 Liquidation Preference Amount"). The
Series A-1 Liquidation Preference Amount is equal to the sum of: (i) the stated
value of any then unconverted shares of Series A-1 Preferred and (ii) any
accrued and unpaid dividends thereon. An event of liquidation means any
liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, as well as any change of control of the Company which includes the
sale by the Company of either (x) substantially all its assets or (y) the
portion of its assets which comprises its core business technology, products or
services.
28
The Series A-1 Preferred is not convertible at the option of the holder. Each
share of Series A-1 Preferred automatically converts into the Company's common
stock, at a conversion price of $2.40 per share based on the stated value of the
Series A-1 Preferred, upon the effectiveness of an amendment to the Company's
certificate of incorporation which provides for a sufficient number of
authorized shares to permit the exercise or conversion of all issued and
outstanding shares of Series A Preferred, Series A-1 Preferred and all options,
warrants and other rights to acquire shares of the Company's common stock.
Through June 30, 2006, the Company has issued 36,388,907 shares of Series A-1
Preferred Stock which are convertible, upon the effectiveness of an amendment to
the Company's Second Amended and Restated Certificate of Incorporation to affect
a 1-for-30 reverse stock split, into 12,129,674 shares of the Company's newly
split common stock.
PRIVATE PLACEMENT OF SERIES A PREFERRED STOCK AND WARRANTS
In January 2006, the Company initiated a proposed $5,400,000 financing
transaction (the "Series A Preferred Financing") which would, for each $100,000
Unit purchased, result in the issuance of (i) 20 shares of Series A Preferred
Stock and (ii) warrants ("Investor Warrants") to purchase 13,888.9 shares of the
Company's common stock. The minimum amount of the Series A Preferred Financing
is $3,000,000 ("Minimum Amount") and the maximum amount is $5,400,000. Apex
agreed to purchase up to $1,500,000 which will all be available to fund the
Minimum Amount, provided however, in the event that the Series A Preferred
Financing is over-subscribed as to the Minimum Amount, then for each $1.00 of
such over subscription up to $250,000, the Apex funding commitment will be
reduced on a dollar for dollar basis, down to a minimum amount of $1,250,000.
Additionally, holders of the 2006 Bridge Notes were mandatorily obligated to
exchange their 2006 Bridge Notes for Units in the Series A Preferred Financing
upon consummation of the Series A Preferred Financing at the face value of their
2006 Bridge Notes. The issuance of Units to the holders of 2006 Bridge Notes
counts toward satisfying the Minimum Amount.
The Investor Warrants have a term of 5 years and an exercise price of $3.00 per
share. Each Investor Warrant will entitle the holder thereof to purchase
13,888.9 shares of the Company's common stock (the "Warrant Shares"), subject to
anti-dilution provisions similar to those of the conversion rights of the Series
A Preferred. The Company is obligated to include the Conversion Shares and the
Warrant Shares in the Registration Statement which the Company has committed to
file in connection with the creditor and claimant liabilities restructuring
described above. The Conversion Shares and the Warrant Shares will also have
piggyback registration rights.
In connection with the Series A Preferred Financing, the Company retained
Laidlaw as its non-exclusive placement agent ("Series A Preferred Placement
Agent"). Laidlaw shall receive, in its role as Series A Preferred Placement
Agent, (i) a cash fee equal to 10% of all gross proceeds, excluding the Apex
proceeds, delivered at each Closing and (ii) a warrant (the "Agent Warrants") to
purchase the Company's common stock equal to 10% times the sum of (x) the
Conversion Shares to be issued upon conversion of the shares of Series A
Preferred issued at each Closing and (y) the number of shares of the Company's
common stock reserved for issuance upon the exercise of the Investor Warrants
issued at each closing. The Agent Warrants shall have a term of 5 years and an
exercise price of $0.10 per share. Additionally, the Company shall pay the
Series A Preferred Placement Agent a non-accountable expense allowance of
$25,000. The Agent Warrants have a fair value of $274,393. Assumptions relating
to the estimated fair value of these warrants are as follows: fair value of
common stock of $0.80; risk-free interest rate of 4.52%; expected dividend yield
zero percent; expected warrant life of five years; and current volatility of
125%.
On March 3, 2006, the investors in the Series A Preferred Financing agreed to a
modification of the terms of this financing arrangement to waive the requirement
for 100% completion of the creditor and claimant liabilities restructuring for
release of the net proceeds of the Series A Preferred Financing in order to
allow the Company to proceed with its business plan and to protect the investors
in the Series A Preferred Financing. The modifications provide for the net
proceeds of the Series A Preferred Financing to be deposited with an escrow
agent whereby funds will be released to the Company to cover payroll, rent and
other operating costs, including eligible payables not otherwise subject to the
creditor and claimant liabilities restructuring, on a bi-monthly basis.
29
As of March 27, 2006, the Company consummated the Series A Preferred Financing
with the closing of funds totaling $4,465,501, resulting in the issuance of 893
shares of Series A Preferred Stock and 620,233 common stock purchase warrants to
the purchasers of the Series A Preferred Stock. This amount is comprised on
$720,001 associated with the conversion of the Bridge Notes, $895,000 provided
by Apex and $2,850,500 from parties made available by the Series A Preferred
Placement Agent. The Company has also issued to Laidlaw 5,950,837 common stock
purchase warrants, the "Agent Warrants", as Series A Preferred Placement Agent.
.. The Investor Warrants have a fair value of $857,908. Assumptions relating to
the estimated fair value of these warrants are as follows: fair value of common
stock of $1.71; risk-free interest rate of 4.52%; expected dividend yield zero
percent; expected warrant life of five years; and current volatility of 125%.
On April 3, 2006, the Company consummated an additional Series A Preferred
Financing with the closing of funds totaling $355,000, resulting in the issuance
of 71 shares of Series A Preferred Stock and 49,306 common stock purchase
warrants.
The 964 shares of Series A Preferred Stock outstanding as of April 3, 2006 will
be convertible, as described above and following the effectiveness of an
amendment to the Company's Second Amended and Restated Certificate of
Incorporation to affect a 1-for-30 reverse stock split, into 2,008,567 shares of
the Company's newly split common stock. Additionally, upon the effectiveness of
the 1-for-30 reverse stock split, the 20,085,446 common stock purchase warrants
issued to holders of the Series A Preferred Stock will be exercisable for
669,539 shares of the Company's newly split common stock and the 5,950,837
common stock purchase warrants issued to Laidlaw as Series A Preferred Placement
Agent will be exercisable for 198,375 shares of the Company's newly split common
stock.
In order to affect the availability of these funds to the Company prior to the
completion of the creditor and claimant liabilities restructuring, the Company,
on March 27, 2006, entered into a post-closing restricted cash escrow agreement
("Post-Closing Escrow Agreement") with an escrow agent ("Escrow Agent"). As of
March 27, 2006, the Escrow Agent was provided $2,183,026 in net offering
proceeds. The escrow agent is holding the funds and making periodic
disbursements to the Company on or after the 15th of each calendar month and on
or after the last day of each calendar month. The Company is required to provide
a detailed schedule of the mid-month, month-end and maximum monthly disbursement
amounts to substantiate its request for a release of any funds. The Company
cannot provide assurance that the securing of additional funding, the completion
of the creditor and claimant liabilities restructuring program and the
acceptance by individual creditors of the claims settlement will actually
improve the Company's ability to fund the further development of its business
plan or improve its operations.
NOTE 19 - STOCKHOLDERS' EQUITY
ADDITIONAL SHARES ISSUED UNDER ANTI-DILUTION PROVISION
Effective April 1, 2006, the Company issued 251,175 shares of common stock under
the provisions of an anti-dilution agreement associated with private placements
of common stock that occurred in March, August and September 2004.
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On January 28, 2006 the Company issued warrants for 20,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $20,316.
On February 13, 2006 the Company issued warrants for 6,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $6,634.
30
On February 21, 2006 the Company issued warrants for 1,250 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $1,382.
On March 1, 2006 the Company issued warrants for 6,417 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $10,029.
On March 17, 2006 the Company issued warrants for 3,750 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $5,861.
On March 22, 2006 the Company issued warrants for 2,500 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $3,907.
On March 27, 2006 the Company issued warrants for 620,233 shares at a $3.00 per
share exercise price to the investors in the Series A Preferred Financing in
connection with the Series A Preferred Financing. Additionally, the Company
issued 198,375 common stock purchase warrants at a $3.00 per share exercise
price to Laidlaw as placement agent in the Series A Preferred Financing.
On April 3, 2006 the Company issued warrants for 49,306 shares at a $3.00 per
share exercise price to Apex in connection with Apex's investment in the Series
A Preferred Financing.
ISSUANCE OF EMPLOYEE STOCK OPTIONS
During the six months ended June 30, 2006, the Company issued stock options to
employees to purchase 99,575 shares. These options include a grant to purchase
73,371 shares at $1.65 per share, with a fair value of $96,850, to the Chief
Operating Officer of the Company, Mr. Braden Waverley, upon the signing of his
employment agreement with the Company. Additionally, the Company granted options
to purchase 26,204 shares at $1.65 per share, with a fair value of $34,589, to
Mr. Martin T. Johnson, the Company's Chief Financial Officer, upon the signing
of his employment agreement with the Company.
The fair value of the unvested portion of stock options at June 30, 2006 is
$706,601 with a weighted-average remaining vesting period of 3.3 years.
SHARE-BASED COMPENSATION ARRANGEMENTS
The Company, since its inception has granted non-qualified stock options to
various employees and non-employees at the discretion of the Board of Directors.
Substantially all options granted to date have exercise prices equal to the fair
value of underlying stock at the date of grant and terms of ten years. Vesting
periods range from fully vested at the date of grant to four years.
As described in Note 5, the fair value of all awards was estimated at the date
of grant using the Black-Scholes option pricing model. Assumptions relating to
the estimated fair value of stock options that the Company granted prior to
January 1, 2006 that were accounted for and recorded under the intrinsic value
method prescribed under APB 25 are also described in Note 5.
On February 16, 2006, the Company issued an aggregate of 99,575 stock options to
two newly hired executives upon signing their employment agreements. These
options are exercisable at $1.65 per share and have a term of ten years. The
aggregate fair value of these options amounts to $131,439. Assumptions relating
to the estimated fair value of these stock options, which the Company is
accounting for in accordance with SFAS 123(R) are as follows: risk-free interest
rate of 4.45%; expected dividend yield zero percent; expected option life of
four years; and current volatility of 125%.
31
The risk-free rate is based on the U.S. Treasury yield curve in effect at the
time of grant. The Company has not paid dividends to date and does not expect to
pay dividends in the foreseeable future due to its substantial accumulated
deficit and limited capital resources. Accordingly, expected dividends yields
are currently zero. Historical cancellations and forfeitures of stock options
granted through December 31, 2004 have been insignificant. However, the
Company's operations and the nature of its business changed substantially during
2005 with the acquisition of businesses and the recruitment of a new Chief
Operating Officer in 2006. Accordingly, the Company considers more recent data
relating to employee turnover rates to be indicative of future vesting. Based on
available data, the Company has assumed that approximately 84% of outstanding
options will vest annually. Deferred compensation relating to options granted
through December 31, 2005 has been adjusted to reflect this assumption. No
options have been exercised to date. The Company will prospectively monitor
employee terminations, exercises and other factors that could affect its
expectations relating to the vesting of options in future periods. The Company
will adjust its assumptions relating to its expectations of future vesting and
the terms of options at such times that additional data indicates that changes
in these assumptions are necessary. Expected volatility is principally based on
the historical volatility of the Company's stock.
A summary of option activity for the six months ended June 30, 2006 is as
follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
EXERCISE CONTRACTUAL
OPTIONS SHARES PRICE TERM
------------------------------- --------- --------- -----------
Outstanding at January 1, 2006 428,022 $21.09 7.2 years
Granted 99,575 $ 1.65 9.6 years
Exercised -- -- --
Forfeited or expired (59,506) $10.20 9.1 years
Outstanding at June 30, 2006 468,091 $18.34 7.5 years
Exercisable at June 30, 2006 319,886 $22.54 6.2 years
At June 30, 2006, the aggregate intrinsic value of options outstanding and
options exercisable, based on the June 30, 2006 split adjusted closing price of
the Company common stock ($.90 per share) amounted to $40,000 and $24,000,
respectively. In addition the table includes 156,670 fully vested and
non-forfeitable stock options outstanding that it issued to non-employees
through December 31, 2005. As of June 30, 2006, these options have a weighted
average exercise price of $17.39, weighted average remaining contractual term of
6.65 years and an aggregate intrinsic value $5,731,105. The Company did not
enter into any stock based compensation arrangements with non-employees during
the six months ended June 30, 2006. Stock based compensation expense to
non-employees amounted to $952,875 during the six months ended June 30, 2005,
including $472,500 relating to stock options and $480,375 relating to issuances
of common stock for services. All non-employee stock based compensation awards
were accounted for in accordance with the provisions of EITF 96-18.
A summary of the status of the Company's non-vested shares as of June 30, 2006,
and changes during the six months ended June 30, 2006 is presented below:
WEIGHTED-AVERAGE
NON-VESTED SHARES SHARES GRANT DATE FAIR VALUE
----------------------------- ------------ ---------------------
Non-vested at January 1, 2006 149,680 $8.12
Granted 99,575 $1.32
Vested (41,546) $3.80
Forfeited (59,506) $8.10
Non-vested at June 30, 2006 148,203 $4.42
The weighted-average grant-date fair value of options granted during the six
months ended June 30, 2006 amounted to $1.32 per share. The Company did not
grant any stock options to employees or non-employees during the six months
ended June 30, 2005. There have also not been any exercises of stock options to
date.
32
As of June 30, 2006, there was $1,108,922 of unrecognized compensation cost
related to non-vested share-based compensation arrangements including $1,014,724
for the fair value of stock options that the Company accounted for under APB 25
through December 31, 2005 and $94,198 for option granted during the six months
ended June 30, 2006 that that the Company is accounting for in accordance with
SFAS 123(R). These costs are expected to be recognized over a weighted-average
period of 3.3 years.
The total fair value of options vested during the six months ended June 30, 2006
amounted to $157,746. The Company did not modify any stock options granted to
employees or non employees under share based payment arrangements. In addition,
the Company did not capitalize the cost associated with stock based
compensation.
NOTE 20 - DISCONTINUED OPERATIONS/ SALE OF LUCIDLINE
During the three months ended March 31, 2006, the Company undertook a plan to
streamline its business. As a result, the Company redirected its focus on
providing enterprise level software and service solutions and is no longer
providing internet access, backup and retrieval services through LucidLine, a
former wholly-owned subsidiary acquired in 2005.
On April 18, 2006, the Company entered into a Stock Purchase Agreement with
Walnut Valley, Inc. pursuant to which the Company sold, effective April 1, 2006,
all of the outstanding shares of LucidLine, Inc. to Walnut Valley, Inc. for
$50,000 including $25,000 in cash and a $25,000 Promissory Note The loss on
discontinued operations for the six months ended June 30, 2006 and June 30, 2005
amounted to $104,962 and $850,874, respectively. During the six months ended
June 30, 2006, the Company recorded a $75,920 loss on the disposal of its
investment in LucidLine.
NOTE 21 - SUBSEQUENT EVENTS
RATIFICATION OF AGREEMENT WITH STUBBS, ALDERTON & MARKILES, LLP
On July 12, 2006, the Board of Directors ratified, approved and adopted the
indemnification and escrow agreements that the Company has entered into with its
legal counsel, Stubbs, Alderton & Markiles, LLP. Accordingly, cash that was
previously held in escrow for general working capital purposes, including the
repayment of outstanding obligations, under the Company's merger agreement with
Entelagent and the Series A Preferred Stock Financing documents was used to fund
general operating activities.
STOCK OPTION GRANT
On July 12, 2006, the Board of Directors approved the grant of 40,339
non-qualified stock options to 11 individuals. The strike price for these
options was $1.35, the closing price for the Company's common stock on the date
of grant, July 12, 2006.
ANNUAL MEETING OF STOCKHOLDERS
On July 20, 2006, the Company held its annual meeting of stockholders. The
stockholders approved the election of three directors: Mr. Robert Cross to serve
until the annual meeting of stockholders in 2007; Mr. Braden Waverley to serve
until the annual meeting of stockholders in 2008; and Mr. George Middlemas to
serve until the annual meeting of stockholders in 2009. Additionally, the
stockholders approved the three other proposals made as part of the 2006 proxy
statement including the adoption of the Patron Systems, Inc. 2006 Stock
Incentive Plan which provides for the grant of up to 5.6 million stock options
and other types of stock awards and the approval of an amendment to the Second
Amended and Restated Certificate of Incorporation, as amended, to provide for a
1-for-30 reverse stock split of the Company's issued and outstanding common
stock.
33
COMPLETION OF THE CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING PROGRAM
On July 21, 2006, the Board of Directors authorized the completion of the
Creditor and Claimant Liabilities Restructuring program. Under this program,
claims totaling $24,467,871 have been settled for 36,993,054 shares of Series
A-1 Preferred Stock. Additionally, the Company has settled claims totaling
$382,584 for $12,140.
FILING OF FORM 10-KSB FOR THE YEAR ENDED DECEMBER 31, 2006
On April 10, 2007, the Company filed its Form 10-KSB for the year ended December
31, 2006. The Form 10-KSB for the year ended December 31, 2006 should be
referred to for additional subsequent events which have occurred between the
original filing date (August 11, 2006) of the Form 10-QSB for the three month
and six month periods ended June 30, 2006 and the filing of the Form 10-KSB on
April 10, 2007.
34
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
JUNE 30, 2006
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 year ended December 31, 2005 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, we
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 December 31, 2005, we borrowed $3,300,000 from a stockholder, 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. During the six months ended June 30, 2006, we raised $4,640,501 of gross
proceeds ($4,301,450 net proceeds after the payment of certain transaction
expenses) in the Series A Preferred Stock Financing. The proceeds from this
transaction were used to fund operations.
Our strategic mission is to solve a set of enterprise-level customer problems
associated with electronic message management, whether in the form of e-mail,
eforms or instant messaging. Our software and services solutions are designed to
help our customers create, manage and apply complex rule sets that support
business policies, enhance work flow processes, enforce regulatory compliance,
and reduce the time, cost and overhead of message management. Our suite of
products addresses e-mail policy management, e-mail retention policies,
archiving and eDiscovery, proactive e-mail supervision, and the protection of
messages and their attachments in motion and at rest. Our eforms solution
enables customers to quickly and easily create forms, capture, share, and manage
data in an industry standard format.
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.
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CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to exercise its judgment. We exercise considerable judgment
with respect to establishing sound accounting polices and in making estimates
and assumptions that affect the reported amounts of our assets and liabilities,
our recognition of revenues and expenses, and disclosures of commitments and
contingencies at the date of the financial statements.
On an ongoing basis, we evaluate our estimates and judgments. Areas in which we
exercise significant judgment include, but are not necessarily limited to, our
valuation of accounts receivable, recoverability of long-lived assets, income
taxes, equity transactions (compensatory and financing) and contingencies. We
have also adopted certain polices with respect to our recognition of revenue
that we believe are consistent with the guidance provided under Securities and
Exchange Commission Staff Accounting Bulletin No. 104 and estimate values of
delivered and undelivered elements.
We base our estimates and judgments on a variety of factors including our
historical experience, knowledge of our business and industry, current and
expected economic conditions, the composition of our products, regulatory
environment, and in certain cases, the results of outside appraisals. We
constantly re-evaluate our estimates and assumptions with respect to these
judgments and modify our approach when circumstances indicate that modifications
are necessary.
While we believe that the factors we evaluate provide us with a meaningful basis
for establishing and applying sound accounting policies, we cannot guarantee
that the results will always be accurate. Since the determination of these
estimates requires the exercise of judgment, actual results could differ from
such estimates.
A description of significant accounting polices that require us to make
estimates and assumptions in the preparation of our consolidated financial
statements are as follows:
ACCOUNTS RECEIVABLE AND REVENUE RECOGNITION
We derive our revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) 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 its 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 reasonably
assured.
We also accrue unbilled revenue under software licenses and services delivered
under contractual arrangements which provide for billings to be made at
intervals that may differ from the periods of delivery or performance.
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 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
36
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, "Modification of SOP 97-2, Software Revenue Recognition With Respect
to Certain Transaction" to allocate revenues to delivered elements once it has
established vendor-specific objective evidence of fair value for such
undelivered elements.
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.
We adjust our accounts receivable balances that we deem to be uncollectible. The
allowance for doubtful accounts is our best estimate of the amount of probable
credit losses in our existing accounts receivable. We review our allowance for
doubtful accounts on a monthly basis to determine 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. An allowance for doubtful accounts
is not provided because in our opinion, all accounts recorded are deemed to be
collectible.
INCOME TAXES
We are required to determine the aggregate amount of income tax expense or loss
based upon tax statutes in jurisdictions in which we conduct business. In making
these estimates, we adjust our results determined in accordance with generally
accepted accounting principles for items that are treated differently by the
applicable taxing authorities. Deferred tax assets and liabilities, as a result
of these differences, are reflected on our balance sheet for temporary
differences loss and credit carry forwards that will reverse in subsequent
years. We also establish a valuation allowance against deferred tax assets when
it is more likely than not that some or all of the deferred tax assets will not
be realized. Valuation allowances are based, in part, on predictions that
management must make as to our results in future periods. The outcome of events
could differ over time which would require us to make changes in our valuation
allowance.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with Statement of
Financial Accounting Standards ("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.
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. During the year ended December, 31, 2005 we recorded $22,440,212
of goodwill in connection with the acquisitions of LucidLine, CSSI and
Entelagent. In accordance with SFAS 142, we conducted our annual impairment
review of goodwill for the year ended December 31, 2005, which resulted in a
goodwill impairment charge of $12,929,696 (Note 6). Intangible assets continue
to be amortized over their estimated useful lives.
We engaged an outside specialist to assist us with performing our annual
goodwill impairment tests. These tests were made using a discounted cash flow
model to value the business. This approach requires us to forecast our
expectation of revenues and cash flows in future periods and to work with an
independent specialist on developing assumptions relating to the risk that such
cash flows may or may not materialize in future periods.
SHARE BASED PAYMENTS AND OTHER EQUITY TRANSACTIONS
Prior to January 1, 2006, we accounted for employee stock based compensation in
accordance with Accounting Principles Board ("APB") Opinion No. 25 "Accounting
for Stock Issued to Employees." We applied the proforma disclosure requirements
of SFAS No. 123 "Accounting for Stock-Based Compensation."
37
Effective January 1, 2006, we adopted SFAS No. 123R "Share Based Payment." This
statement is a revision of SFAS Statement No. 123, and supersedes APB Opinion
No. 25, 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 is measured at fair
value on the awards' grant date, based on the estimated number of awards that
are expected to vest. We adopted the modified prospective method with respect to
accounting for our transition to SFAS 123(R) and measured unrecognized
compensation cost. Under this method of accounting, we are required to estimate
the fair value of share based payments that we make to our employees by
developing assumptions regarding expected holding terms of stock options,
volatility rates and expectation of forfeitures and future vesting that can
significantly impact the amount of compensation cost that we recognize in each
reporting period.
We are also required to apply complex accounting principles with respect to
accounting for financing transactions that we have consummated in order to
sustain our business. These transactions, which generally consist of convertible
debt and equity instruments, require us to use significant judgment in order to
assess the fair values of these instruments at their dates of issuance, which is
critical to making a reasonable presentation of our financing costs and how we
finance our business.
Formulating estimates in any of the above areas requires us to exercise
significant judgment. It is at least reasonably possible that the estimates of
the effect on the financial statements of a condition, situation, or set of
circumstances that existed at the date of the financial statements that we
considered in formulating our estimates could change in the near term due to one
or more future confirming events. Accordingly, the actual results regarding
estimates of any of the above items as they are presented in the financial
statements could differ materially from our estimates.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2006 COMPARED TO THE THREE MONTHS ENDED JUNE 30,
2005.
For the three months ended June 30, 2006, our consolidated revenues amounted to
$318,960 compared to $84,413 for the three months ended June 30, 2005. The
increase is principally the result of growth of our business, principally with
the FormStream product, since the combinations were consummated with CSSI in
February 2005 and Entelagent in March 2005.
Cost of Sales for the three months ended June 30, 2006 amounted to $27,522
compared to $128,501 for the three months ended June 30, 2005. Cost of sales
during the three months ended June 30, 2006 and June 30, 2005 is entirely
associated with the amortization of developed technology that we acquired from
CSSI and Entelagent.
Operating expenses amounted to $1,031,339 for the three months ended June 30,
2006 as compared to $2,534,373 for the three months ended June 30, 2005, a
reduction of $1,503,034. The reduction in operating expenses includes
approximately $159,000 for increased salaries associated with an increase in the
number of employees from acquired businesses, approximately $64,000 of employee
stock option compensation expense, an increase of approximately $263,000 in
general and administrative expense, and other settlement agreements and an
increase of approximately $2,000 associated with a stock-based penalty under a
collateralized financing arrangement. These increases were offset by an
approximately $576,000 increase in gains associated with the settlement of
outstanding liabilities, claims and litigation under the creditor and claimant
liabilities restructuring, approximately $444,000 reduction in expense
associated with non-employee of stock-based compensation arrangements,
approximately $284,000 reduction in legal and professional fees associated with
the work performed in 2005 to bring the Company's SEC filings into compliance
and an expense reduction of $366,000 associated with a 2005 loss on a
collateralized financing arrangement, a $320,000 reduction in expense associated
with 2005 penalties under stock-based accommodation agreements.
Our consolidated loss from operations for the three months ended June 30, 2006
amounted to $739,901 compared to a loss of $2,578,461 for the same period in
2005. Our loss was reduced as a result of the reductions in operating expenses
and the increased revenues discussed above.
38
Interest expense during the three months ended June 30, 2006 amounted to $88,421
as compared to $1,701,547 for the three months ended June 30, 2005. The
reduction is principally related to the issuance, in the three months ended June
30, 2005, of the Bridge II Notes and the associated amortization of deferred
financing costs and the accretion of debt discounts incurred with that financing
not being incurred in the three months ended June 30, 2006. Additionally, the
interest expense associated with the outstanding Acquisition Notes and the
Bridge I Notes in the three months ended June 30, 2005 was reduced with the
exchange of a substantial portion of these notes for Series A-1 Preferred Stock
during the quarter ended March 31, 2006. Non-cash interest relating to the
amortization of deferred financing costs and the accretion of debt discounts
during the three months ended June 30, 2006 amounted to $0 compared to
$1,473,140 in same period in 2005. Amortization of deferred finance charges
which have been classified as interest expense was $0 in the three months ended
June 30, 2006 compared to $557,065 in the same period in 2005. Accretion of debt
discounts during the three months ended June 30, 2006 were approximately $0
compared to $916,075 in the same period in 2005. Interest income, was $1,961 and
$0 in the three months ended June 30, 2006 and 2005, respectively. Interest
income represents the interest earned on cash balances.
During the three months ended June 30, 2006, the Company accumulated dividends
on its Series A Preferred of $124,784.
For the three months ended June 30, 2006, the net loss available to common
stockholders was $1,027,252 or $(0.47) per share on 2,170,653 weighted average
common shares outstanding compared to a net loss available to common
stockholders of $5,028,505 or $(2.47) per share on 2,032,823 weighted average
common shares outstanding for the three months ended June 30, 2005.
SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2005.
For the six months ended June 30, 2006, our consolidated revenues amounted to
$580,745 compared to $90,843 for the six months ended June 30, 2005. The
increase is principally the result of growth of our business, principally with
the FormStream product, since the combinations were consummated with CSSI in
February 2005 and Entelagent in March 2005.
Cost of Sales for the six months ended June 30, 2006 amounted to $84,941
compared to $149,734 for the six months ended June 30, 2005. Cost of sales
during the six months ended June 30, 2006 and June 30, 2005 includes $27,522 and
$19,230, respectively, associated with the amortization of developed technology
that we acquired from CSSI and Entelagent.
Operating expenses amounted to $2,150,165 for the six months ended June 30, 2006
as compared to $4,145,250 for the six months ended June 30, 2005, a decrease of
$1,995,085. The decrease in operating expenses includes an increase of
approximately $1,134,000 for salaries associated with an increase in the number
of employees from acquired businesses, an increase of approximately $237,000 of
employee stock option compensation expense, approximately $233,000 for increased
legal and professional fees that we incurred principally in connection with the
year-end financial audit and the negotiation and settlement of various
liabilities and legal matters under the creditor and claimant liabilities
restructuring program, approximately $23,000 for amortization of acquired
intangible assets and approximately $5,000 associated with a stock-based penalty
under a collateralized financing arrangement. These increases were offset by a
gain of approximately $1,872,000 associated with the settlement of outstanding
liabilities, claims and litigation under the creditor and claimant liabilities
restructuring, an approximately $953,000 reduction in expense associated with
the non-employee stock-based compensation arrangements, a reduction of
approximately $136,000 in general and administrative expense, an expense
reduction of $366,000 associated with a 2005 loss on a collateralized financing
arrangement and approximately $689,000 reduction in expense associated with a
penalty provision of an Accommodation Agreement.
Our consolidated loss from operations for the six months ended June 30, 2006
amounted to $1,654,361 compared to a loss of $4,204,141 for the same period in
2005. Our loss increased as a result of the increases in operating expenses
discussed above offset by the gain associated with the settlement of outstanding
liabilities, claims and litigation under the creditor and claimant liabilities
restructuring.
Interest expense during the six months ended June 30, 2006 amounted to
$1,060,885 as compared to $2,196,535 for the six months ended June 30, 2005. The
reduction is due to the accretion of debt discounts and the intrinsic value of
39
the conversion option for bridge note holders being lower in total during the
six months ended June 30, 2006 as compared to the six months ended June 30,
2005. Offsetting this reduction was the increase in interest expense due to the
increased level of total debt financing during the six months ended June 30,
2006 than during the same period in 2005. Non-cash interest relating to the
amortization of deferred financing costs and the accretion of debt discounts
during the six months ended June 30, 2006 amounted to approximately $303,038
compared to $1,887,625 in same period in 2005. The intrinsic value of the
conversion option for bridge note holders, which has been classified as interest
expense amounted to $192,000 for the six months ended June 30, 2006 compared to
$0 in the same period in 2005. Amortization of deferred finance charges which
have been classified as interest expense was approximately $282,129 in the six
months ended June 30, 2006 compared to $710,585 in the same period in 2005.
Accretion of debt discounts during the six months ended June 30, 2006 were
approximately $20,909 compared to $1,177,040 in the same period in 2005.
Interest income, was $1,961 and $19,250 in the six months ended June 30, 2006
and 2005, 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 and interest on cash balances in the six months ended June 30,
2006.
During the six months ended June 30, 2006, the Company accumulated dividends on
its Series A Preferred of $124,784.
For the six months ended June 30, 2006, the net loss available to common
stockholders was $3,019,076 or $(1.42) per share on 2,127,543 weighted average
common shares outstanding compared to a net loss available to common
stockholders of $7,232,300 or $(3.93) per share on 1,838,106 weighted average
common shares outstanding for the six months ended June 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss of $2,894,292 for the six months ended June 30, 2006,
which includes $1,013,073 of non-cash charges including non-cash charges
associated with the fair value of common stock we issued as penalties under
certain registration rights agreements ($5,246), fair value of a conversion
option in connection with bridge note holders ($192,000), loss on disposal of
discontinued operation ($75,920), non-cash interest ($543,438) depreciation and
amortization ($143,420), and a charge for stock based compensation ($244,924).
These non-cash charges were offset by a non-cash gain of $1,872,368 associated
with the settlement of outstanding liabilities, claims and litigation under the
creditor and claimant liabilities restructuring, We also used $511,691 of our
restricted cash escrowed to settle liabilities assumed. Including the amounts
above, we used net cash flows in our operating activities of $3,671,389 during
the six months ended June 30, 2006. Our working capital deficiency at June 30,
2006 amounts to $4,251,015 and we are continuing to experience shortages in
working capital. We are involved in 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. Our legal counsel representing us in such
matters has indicated that while the SEC Investigation is ongoing and we have
not received correspondence from the SEC indicating that the matter is
officially closed, the Staff has indicated that it does not intend to request
additional information from us and that, at this time, it does not intend to
recommend that the SEC bring an enforcement action against us, our officers or
directors. 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. Our ability
to successfully integrate the acquired businesses described in Note 6 is
critical to the realization of our business plan. We raised $4,640,501 of gross
proceeds ($4,301,451 net proceeds after the payment of certain transaction
expenses) in financing transactions during the six months ended June 30, 2006.
We used $3,671,389 of these proceeds to fund our operations and a net of
$407,643 in investing activities, principally for the purchase and development
of software technology. Additionally, we made $125,000 in legal payments
associated with the settlement of accommodation agreements and incurred $54,000
in deferred financing costs. We received $50,000 in proceeds from the
disposition of discontinued operations and received $55,000 in proceeds in
connection with a financing settlement.
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
40
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, we completed a program
pursuant to which we offered our creditors and claimants an agreement to receive
shares of our capital stock for amounts owed to the holders of our indebtedness
(including lenders, past-due trade accounts, and employees, consultants and
other service providers with claims for fees, wages or expenses).
OFF-BALANCE SHEET ARRANGEMENTS
At June 30, 2006, 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 SUBSTANTIAL 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. We are also
subject to substantial litigation and an investigation by the SEC described
elsewhere herein. If we cannot generate additional revenues or raise additional
capital in the near future, we may become insolvent. As of June 30, 2006, our
cash balance was $195,432 and we had a working capital deficit of $4,251,015.
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.
We have restructured approximately $24.0 million of our previously outstanding
claims, liabilities, demands, causes of action, costs, expenses, attorneys'
fees, damages, indemnities, and obligations of every kind and nature that
certain creditors and claimants had with the Company pursuant to our creditor
and claimant liabilities restructuring described in Note 17. We are currently
unable to provide assurance that the acceptance of the claims settlement will
actually improve our ability to fund the further development of our business
plan or improve its operations.
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. We were incorporated in Delaware in
2002. Significant business operations only began with the acquisitions completed
in February and March 2005. 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.
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We generated no revenue from operations before December 31, 2004 and only
limited revenues in the year ended December 31, 2005. We have 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 June 30,
2006, we had an accumulated deficit of approximately $87.4 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.
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 WHICH COULD HAVE AN ADVERSE
AFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS.
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 and certain of the actions of our officers and directors and others
42
(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, 145,834 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 OTC 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 our
business plan. The Company's legal counsel representing the Company in such
matters has indicated that while the SEC Investigation is ongoing and the
Company has not received correspondence from the SEC indicating that the matter
is officially closed, the Staff has indicated that it does not intend to request
additional information from the Company and that, at this time, it does not
intend to recommend that the SEC bring an enforcement action against the
Company, its officers and directors. There can be no assurance that the SEC will
accept the Staff's recommendation not to bring an enforcement action against us
or that the Staff will not elect at some future time to seek additional
information from the Company with respect to these matters.
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 August 3, 2006, there were 2,131,496
shares of common stock outstanding, of which 213,746 shares were 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.
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
43
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.
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. To date we have experienced delays
in implementing our business plan as a result of limited capital resources,
which have had a material adverse effect on our business. Further delays in 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. Our 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 could cause us 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.
44
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.
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
45
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 EXPERIENCED 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. Through
the quarter ended December 31, 2005, 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 weakness in our internal controls. These material weaknesses
affected our ability to timely file our reports with the SEC and communicate
critical information to management that was needed to make business decisions.
Although we have taken steps to correct these previous deficiencies and are
currently in compliance with the SEC's reporting requirements, we have limited
capital resources and are still at risk for the loss of key personnel in our
finance department. The loss of key personnel in our finance department, or any
other conditions that could disrupt our operations in this area, could have a
material adverse affect on our ability to communicate critical information to
management and our investors, raise capital and/or maintain compliance with our
SEC reporting obligations. These circumstances, if they arise, could have a
material adverse affect on our business.
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.
WE MAY NOT BE ABLE TO IMPLEMENT SECTION 404 OF THE SARBANES-OXLEY ACT ON A
TIMELY BASIS.
The SEC, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted
rules generally requiring each public company to include a report of management
on the company's internal controls over financial reporting in its annual report
on Form 10-KSB that contains an assessment by management of the effectiveness of
the company's internal controls over financial reporting beginning in the year
ended December 31, 2007. In addition, the company's independent registered
accounting firm must attest to and report on management's assessment of the
effectiveness of the company's internal controls over financial reporting. This
requirement will first apply to our annual report on Form 10-KSB for the fiscal
year ending December 31, 2008. We have not yet developed a Section 404
implementation plan. We have in the past discovered, and may in the future
discover, areas of our internal controls that need improvement. How companies
should be implementing these new requirements including internal control reforms
to comply with Section 404's requirements and how independent auditors will
apply these requirements and test companies' internal controls, is still
reasonably uncertain. We expect that we may need to hire and/or engage
additional personnel and incur incremental costs in order to complete the work
required by Section 404. We can not guarantee that we will be able to complete a
Section 404 plan on a timely basis. Additionally, upon completion of a Section
404 plan, we may not be able to conclude that our internal controls are
effective, or in the event that we conclude that our internal controls are
effective, our independent accountants may disagree with our assessment and may
issue a report that is qualified. Any failure to implement required new or
improved controls, or difficulties encountered in their implementation, could
negatively affect our operating results or cause us to fail to meet our
reporting obligations.
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
46
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 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. In addition, we will become subject to the internal
control reporting requirement specified in Section 404 of the Sarbanes-Oxley Act
of 2002 beginning in the year ended December 31, 2007, which will require us to
expend substantial financial resources in order to become compliant with these
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 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:
47
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.
OUR 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. Our 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.
48
PART II - OTHER INFORMATION
ITEM 6. EXHIBITS
See attached Exhibit Index.
49
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: May 21, 2007 PATRON SYSTEMS, INC.
(Registrant)
/s/ Braden Waverley
---------------------------------------
By: Braden Waverley
Its: Chief Executive Officer
/s/ Martin T. Johnson
---------------------------------------
By: Martin T. Johnson
Its: Chief Financial Officer
50
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------
3.1 Certificate of Amendment of Second Amended and Restated
Certificate of Incorporation of Patron Systems, Inc. Incorporated
by reference to Appendix B to the Definitive Proxy Statement
filed with the Securities and Exchange Commission on June 19,
2006.
10.1 Patron Systems, Inc. 2006 Stock Incentive Plan. Incorporated by
reference to Appendix A to the Definitive Proxy Statement filed
with the Securities and Exchange Commission on June 19, 2006.
31.1 Certification of Principal Executive Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Principal Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
51