SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-1004
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___ to ___
Commission File Number: 0-28403
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Avalon Digital Marketing Systems, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 77-0511097
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
19782 MacArthur Blvd., Suite 100, Irvine, CA 92612
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(Address of principal executive offices)
(949) 660-1700
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(Registrant's telephone number, including area code)
2120 Main Street, Suite 200, Huntington Beach, CA 92648
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(Former name, former address and former fiscal year,
if changed since last report)
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 [X] No [ ]
Indicate by checkmark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The number of shares outstanding of each of the Registrant's classes of
common stock, as of the latest practicable date:
Class Outstanding at June 25, 2003
----- ----------------------------
Common Stock, $.001 par value 7,348,279
Avalon Digital Marketing Systems, Inc.
Quarterly Report on Form 10-Q
For the three months ended March 31, 2003
INDEX
Part I. Financial Information
NOTE: Avalon Digital Marketing Systems, Inc. ("Avalon") was formed as a
result of a merger between MindArrow Systems, Inc. ("MindArrow") and
Category 5 Technologies, Inc. ("Category 5") on September 30, 2002.
MindArrow was the legal acquirer of Category 5, but because Category
5's business was larger than MindArrow's and because Category 5's
former stockholders obtained the majority of the outstanding shares of
Avalon at the time of the merger, generally accepted accounting
principles require that Category 5 be treated as the acquirer for
accounting and reporting purposes. Accordingly, the financial
statements in this report reflect the following:
o Consolidated Balance Sheet as of March 31, 2003 - reflects
post-merger Avalon.
o Consolidated Balance Sheet as of June 30, 2002 - reflects
Category 5 only.
o Statements of Operations for the Quarter and Nine Months Ended
March 31, 2002 - reflects Category 5 only. Statements of
Operations for the Nine Months Ended March 31, 2003 - reflects
one quarter of Category 5 only and two quarters of post-merger
Avalon. Statements of Operations for the Quarter Ended March
31, 2003 reflects operations of post-merger Avalon.
o Statements of Cash Flows for the Nine Months Ended March 31,
2002 - reflects Category 5 only. Statements of Cash Flows for
the Nine Months Ended March 31, 2003 - reflects one quarter of
Category 5 only and two quarters of post-merger Avalon.
o Pro forma combined information as if the merger had taken
place on July 1, 2002 is contained in the notes to financial
statements.
In addition, references to the "Company" for periods prior to September
30, 2002 are intended to refer to Category 5 and its business.
Page
----
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets - March 31, 2003 (unaudited) and
June 30, 2002.................................................................. 4
Consolidated Statements of Operations (unaudited) - Three and Nine Months
Ended March 31, 2003 and 2002.................................................. 5
Consolidated Statement of Changes in Stockholders' Equity (unaudited) -
Nine Months Ended March 31, 2003............................................... 6
Consolidated Statements of Cash Flows (unaudited) - Nine Months
Ended March 31, 2003 and 2002.................................................. 7
Notes to Consolidated Financial Statements (unaudited)......................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................... 23
Item 3. Quantitative and Qualitative Disclosures about Market Risk..................... 42
Item 4. Controls and Procedures........................................................ 42
2
Part II. Other Information
Page
----
Item 1. Legal Proceedings ............................................................. 43
Item 2. Changes in Securities and Use of Proceeds ..................................... 44
Item 3. Defaults Upon Senior Securities................................................ 44
Item 4. Submission of Matters to a Vote of Security Holders............................ 44
Item 5. Other Information.............................................................. 44
Item 6. Exhibits and Reports on Form 8-K............................................... 45
Signatures and certifications............................................................... 45
3
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
March 31, 2003 June 30, 2002
------------ ------------
(unaudited)
ASSETS
Current assets:
Cash $ 60,678 $ 298,272
Short term investments -- 1,000,000
Receivables, net
Contract 348,682 1,751,701
Trade 784,015 597,035
Retainages 186,387 272,782
Prepaid expenses and other current assets 101,368 265,629
------------ ------------
Total current assets 1,481,130 4,185,419
Fixed assets, net 1,163,193 1,111,356
Identifiable intangible assets, net -- 1,962,356
Goodwill -- 2,187,947
Contract receivables - long term, net 627,185 3,400,363
Retainage receivables - long term, net -- 1,664,548
Deposits 55,988 74,118
------------ ------------
Total assets $ 3,327,496 $ 14,586,107
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued liabilities $ 7,019,285 $ 1,669,997
Deferred revenue 1,349,792 299,537
Notes payable, current portion, net of unamortized discount 2,126,834 1,641,314
Estimated receivable repurchase obligation -- 757,677
Due to related parties, net of unamortized discount 277,200 198,867
Deferred taxes -- 136,000
------------ ------------
Total current liabilities 10,773,111 4,703,392
------------ ------------
Long-term liabilities:
Capital lease obligation -- 87,695
Deferred taxes -- 1,008,000
------------ ------------
Total long-term liabilities -- 1,095,695
------------ ------------
Stockholders' equity (deficit):
Common stock, $0.001 par value; 75,000,000 and 125,000,000 shares authorized,
7,348,279 and 1,659,286 shares issued and outstanding at
March 31, 2003 and June 30, 2002, respectively 7,348 1,659
Additional paid-in capital 27,220,307 6,960,164
Retained earnings (deficit) (34,673,270) 1,825,197
------------ ------------
Total stockholders' equity (deficit) (7,445,615) 8,787,020
------------ ------------
Total liabilities and stockholders' equity (deficit) $ 3,327,496 $ 14,586,107
============ ============
The accompanying notes are an integral part of these statements.
4
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Statements of Operations
Three Months Ended Nine Months Ended
March 31, 2003 March 31, 2002 March 31, 2003 March 31, 2002
------------ ------------ ------------ ------------
(unaudited) (unaudited)
Revenues $ 3,337,260 $ 7,908,122 $ 10,887,371 $ 19,344,139
Cost of revenues 1,227,043 3,542,173 2,466,934 7,444,772
------------ ------------ ------------ ------------
Gross profit 2,110,217 4,365,949 8,420,437 11,899,367
------------ ------------ ------------ ------------
Operating expenses:
Selling, general and administrative 3,710,319 3,574,856 13,585,152 9,031,288
Bad debt expense 245,001 -- 4,605,176 --
Depreciation and amortization 855,897 18,988 2,129,352 51,225
Write-down of intangible assets 24,306,611 -- 24,306,611 --
------------ ------------ ------------ ------------
Total operating expenses 29,117,828 3,593,844 44,626,291 9,082,513
------------ ------------ ------------ ------------
Income (loss) from operations (27,007,611) 772,105 (36,205,854) 2,816,854
Write-down of short-term investment -- -- (1,021,135) --
Interest income 79,137 -- 494,860 --
Interest expense (703,006) (80,165) (910,338) (108,690)
------------ ------------ ------------ ------------
Net income (loss) before income taxes (27,631,480) 691,940 (37,642,467) 2,708,164
(Provision) benefit for income taxes
Current -- (767,000) -- (1,997,000)
Deferred -- 543,000 1,144,000 1,073,000
------------ ------------ ------------ ------------
Net income (loss) $(27,631,480) $ 467,940 (36,498,467) $ 1,784,164
============ ============ ============ ============
Basic earnings (loss) per share $ (3.79) $ 0.16 $ (6.04) $ 0.63
============ ============ ============ ============
Diluted earnings (loss) per share $ (3.79) $ 0.13 $ (6.04) $ 0.51
============ ============ ============ ============
Shares used in computation of basic earnings
(loss) per share 7,290,601 2,981,260 6,043,702 2,819,570
============ ============ ============ ============
Shares used in computation of diluted earnings
(loss) per share 7,290,601 3,671,720 6,043,702 3,483,810
============ ============ ============ ============
The accompanying notes are an integral part of these statements.
5
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Statement of Changes in Stockholders' Equity (Deficit)
Common Stock Additional Retained
------------------------- Paid Earnings
Shares Amount In Capital (Deficit) Total
------------ ------------ ------------ ------------ ------------
Balance, June 30, 2002 1,659,286 $ 1,659 $ 6,960,164 $ 1,825,197 $ 8,787,020
Recapitalization of the common stock of
Category 5 Technologies, Inc. 2,157,072 2,157 (2,157) -- --
Issuance of common stock pursuant to
exercise of options and warrants 5,290 5 5,759 -- 5,764
Common stock issued for services 18,975 19 59,656 -- 59,675
Recapitalization and issuance of common
stock for reverse acquisition of MindArrow
Systems, Inc. 3,133,636 3,134 18,321,861 -- 18,324,995
Sale of common stock, net of issuance costs 71,250 71 174,929 -- 175,000
Common stock issued in acquisition of the
assets of AGEA Corporation 175,000 175 336,000 -- 336,175
Common stock issued in acquisition of the
assets of Mindwire, Inc. 46,700 47 63,465 -- 63,512
Issuance of common stock pursuant to
note conversions 81,070 81 280,630 -- 280,711
Proceeds from notes payable attributable to
warrants -- -- 1,020,000 -- 1,020,000
Net loss -- -- -- (36,498,467) (36,498,467)
------------ ------------ ------------ ------------ ------------
Balance, March 31, 2003 (unaudited) 7,348,279 $ 7,348 $ 27,220,307 $(34,673,270) $ (7,445,615)
============ ============ ============ ============ ============
The accompanying notes are an integral part of these statements.
6
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Nine Months Ended
March 31, 2003 March 31, 2002
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(unaudited)
Cash flows from operating activities:
Net income (loss) $(36,498,467) $ 1,784,164
Adjustments to reconcile net income (loss) to net cash used in operations:
Bad debt expense 4,605,176 2,594,254
Depreciation and amortization 2,129,352 51,224
Write-down of short-term investment 1,021,135 --
Write-down of intangible assets 24,306,611 --
Estimated receivable repurchase obligation (757,677) 523,776
Amortization of debt discount and loan fees 674,699 62,012
Issuance of stock and options for services 59,675 248,376
Issuance of warrants - debt costs -- 27,210
Deferred tax benefit (1,144,000) (1,073,000)
Changes in operating assets and liabilities, net of effects of reverse
acquisition of MindArrow Systems, Inc. and acquisition of assets of
AGEA Corporation and Mindwire, Inc.
(Increase) decrease in contract receivables 1,214,434 (6,669,626)
(Increase) decrease in trade receivables 618,939 (443,425)
(Increase) decrease in retainages receivable 86,395 (1,010,232)
(Increase) decrease in prepaid expenses 271,845 (75,326)
Decrease in due from shareholder -- (30,000)
(Increase) decrease in deposits 184,899 (62,500)
Increase in accounts payable and accrued expenses 1,636,509 879,256
Increase in income taxes payable -- 1,997,000
Increase in deferred revenue 351,002 75,846
------------ ------------
Net cash used in operations (1,239,473) (1,120,991)
------------ ------------
Cash flows from investing activities:
Purchases of fixed assets (45,235) (97,567)
Net cash acquired in acquisitions 426,485 --
------------ ------------
Net cash provided by (used in) investing activities 381,250 (97,567)
------------ ------------
Cash flows from financing activities:
Net borrowings on notes payable 229,865 1,408,686
Net (payments) borrowings on shareholder loan 210,000 (12,200)
Proceeds from issuance of common stock and option exercises 180,764 --
------------ ------------
Net cash provided by financing activities 620,629 1,396,486
------------ ------------
Net increase (decrease) in cash (237,594) 177,928
Cash, beginning of period 298,272 215,866
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Cash, end of period $ 60,678 $ 393,794
============ ============
Cash paid for interest $ 85,425 $ --
============ ============
The accompanying notes are an integral part of these statements.
7
Avalon Digital Marketing Systems, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note A--The Company and Summary of Significant Accounting Policies
1. Basis of Presentation
Avalon Digital Marketing Systems, Inc. ("Avalon") was formed as a
result of a merger between MindArrow Systems, Inc. ("MindArrow") and Category 5
Technologies, Inc. ("Category 5") on September 30, 2002. MindArrow was the legal
acquirer of Category 5, but because Category 5's business was larger than
MindArrow's and because Category 5's former stockholders obtained the majority
of the outstanding shares of Avalon at the time of the merger, generally
accepted accounting principles require that Category 5 be treated as the
acquirer for accounting and reporting purposes. Accordingly, the accompanying
financial statements reflect the following:
o Consolidated Balance Sheet as of March 31, 2003 - reflects
post-merger Avalon.
o Consolidated Balance Sheet as of June 30, 2002 - reflects
Category 5 only. o Statements of Operations for the Quarter
and Nine Months Ended March 31, 2002 - reflects Category 5
only. Statements of Operations for the Nine Months Ended March
31, 2003 - reflects one quarter of Category 5 only and two
quarters of post-merger Avalon. Statements of Operations for
the Quarter Ended March 31, 2003 reflects operations of
post-merger Avalon.
o Statements of Cash Flows for the Nine Months Ended March 31,
2002 - reflects Category 5 only. Statements of Cash Flows for
the Nine Months Ended March 31, 2003 - reflects one quarter of
Category 5 only and two quarters of post-merger Avalon.
o Pro forma combined information as if the merger had taken
place on July 1, 2002 is contained in the notes to financial
statements.
In addition, references to the "Company" for periods prior to September
30, 2002 are intended to refer to Category 5 and its business.
The accompanying consolidated financial statements have been prepared
by Avalon Digital Marketing Systems, Inc. and subsidiaries (the "Company")
pursuant to the rules and regulations of the Securities and Exchange Commission
(the "SEC") for interim financial reporting. These consolidated financial
statements are unaudited and, in the opinion of management, include all
adjustments (consisting of normal recurring adjustments and accruals) necessary
for a fair presentation of the balance sheets, operating results, and cash flows
for the periods presented. Operating results for the three and nine months ended
March 31, 2003 are not necessarily indicative of the results that may be
expected for the fiscal year ending June 30, 2003. Certain financial information
and footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been omitted in accordance with the rules and regulations of the
SEC. These consolidated financial statements should be read in conjunction with
the audited consolidated financial statements, and accompanying notes, included
in the Annual Report on Form 10-KSB for the fiscal year ended June 30, 2002 of
Category 5, our predecessor company. The consolidated balance sheet at June 30,
2002 has been derived from the audited consolidated financial statements at that
date.
The Company was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. in May 2000. On May 29, 2001, Network
Investor Communications, Inc. ("NWIC") acquired all of the outstanding shares of
ePenzio, and effective July 23, 2001, NWIC changed its name to Category 5
Technologies, Inc. For accounting purposes the business combination with NWIC
was treated as a reverse merger or a recapitalization of ePenzio, with ePenzio
being treated as the accounting acquirer. On September 30, 2002, MindArrow
Systems, Inc., a Delaware corporation, acquired all of the outstanding shares of
Category 5 and changed its name to Avalon Digital Marketing Systems, Inc. For
accounting purposes, the business combination with MindArrow was treated as a
reverse acquisition, with Category 5
8
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
being the acquirer. The results of operations of MindArrow Systems, Inc. are
included in the consolidated financial statements of the Company beginning
October 1, 2002. Accordingly, the accompanying consolidated statements of
operations and cash flows reflect information for Category 5 only from July 1,
2002 to September 30, 2002.
In addition, on September 30, 2002, the Company effected a reverse
stock split of the Company's common stock at a ratio of one-for-ten, causing
each outstanding share of common stock to convert automatically into one-tenth
of a share of common stock. In lieu of fractional shares, stockholders received
a cash payment based on the trading price of the common stock prior to the
effectiveness of the reverse split. Stockholders' equity has been restated to
give retroactive recognition to the reverse split for all periods presented by
reclassifying the excess par value resulting from the reduced number of shares
from common stock to paid-in capital. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split.
Certain prior year amounts in the consolidated financial statements
have been reclassified to conform to the current year presentation.
The Company develops and provides software and services that enable its
clients to communicate and sell more effectively and efficiently over the web,
via email, and through other digital channels.
The business is divided between the Small Business and Large Enterprise
sales channels. The Small Business channel has been the primary source of our
historical revenues, and provides small businesses with merchant services and
digital marketing software, primarily marketed through workshops. Small Business
operations consist primarily of Category 5's subsidiaries, Avalon Business
Direct, Inc., ePenzio, Inc., Bring it Home, Inc. and Olympus Financial, Inc. In
March 2003, the Company stopped selling its products through seminars operated
by our Bring it Home subsidiary, and refocused on selling software and services
through alternative distribution methods.
The Large Enterprise channel provides customized software and
professional services to large companies. The Large Enterprise channel consists
of the former MindArrow, MindArrow Asia, Ltd. and former Category 5 subsidiary,
CaptureQuest, Inc.
In May 2003, the Company entered into a non-binding letter of intent to
sell certain of the assets of the Large Enterprise operations to Silverpop
Systems, Inc. (Note L).
2. Principles of Consolidation
The consolidated financial statements include the accounts of the
Company and its subsidiaries. All significant intercompany balances and
transactions have been eliminated.
3. Basic and Diluted Net Earnings (Loss) Per Share
Basic net earnings (loss) per share is computed using the weighted
average number of common shares outstanding during the period. Diluted net
earnings (loss) per share is computed using the weighted average number of
common shares during the period plus dilutive potential common shares. Dilutive
potential common shares include the incremental common shares issuable upon the
exercise of stock options and warrants (using the treasury stock method) and the
incremental common shares issuable upon conversion of convertible preferred
stock and notes payable (using the if-converted method). Potential common shares
in the diluted net earnings (loss) per share computation are excluded where
their effect would be antidilutive.
9
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
In periods where a net loss was incurred, potential common shares were
excluded because their effect would be antidilutive. In addition, for the three
and nine months ended March 31, 2003, the following options were not included in
the computation of diluted EPS for the periods indicated because the options'
exercise price was greater than the average market price of the common shares:
Three Months Ended Nine Months Ended
March 31, 2003 March 31, 2003
-------------- --------------
Options to purchase shares of common stock 1,071,264 1,071,264
Exercise prices $1.09 to $250 $1.09 to $250
Expiration dates through June 2012
4. Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the amounts of revenues and expenses during the reported period.
Actual results could differ from those estimates.
5. Concentration of Credit Risk
Financial instruments that potentially subject the Company to
significant concentration of credit risk consist primarily of cash, cash
equivalents, and accounts receivable. Substantially all of the Company's cash
and cash equivalents are held in two financial institutions. As of March 31,
2003 and June 30, 2002, the carrying amounts of cash were $60,678 and $298,272,
respectively.
The write-down of short-term investment of $1.0 million relates to a
certificate of deposit account in the name of our CaptureQuest subsidiary that
arose from an investment in CaptureQuest by Omnicorp Bank. The account was held
at Omnicorp, which was declared insolvent by regulators in October 2002.
Omnicorp has asked account holders to convert their certificates of deposit into
an investment in preferred shares of Solara Ventures, Inc. a Canadian-based
investment company. As of September 30, 2002, the entire balance was written
down due to the uncertainty surrounding any recovery.
Accounts receivable are typically unsecured and derived primarily from
customers located in the United States and Hong Kong. The Company performs
ongoing credit evaluations of its customers and will maintain reserves for
potential credit losses as the need arises.
In the normal course of business the Company sold certain of its
receivables to financing companies. The Company's sales of receivables to
financing companies include recourse provisions, which are deemed non-hedging
derivatives pursuant to the provisions of Statement of Financial Accounting
Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and
Hedging." The purpose of the limited recourse provisions are normal in the
course of business and are meant to facilitate the sale of receivables to
financing companies. The fair value of the recourse liability has been
determined using a best estimate method, and the fair value estimate was based
on historical recourse rates experience by the Company. The fair value of the
recourse obligation at March 31, 2003 and June 30, 2002 is $0 and $757,677,
respectively. This change is due to the Company's decision to cease selling its
products under installment contracts.
6. Segments
The Company has adopted Statement of Financial Accounting Standards No.
131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS
131"). SFAS 131 establishes standards for reporting information regarding
operating segments in annual financial statements and requires selected
financial information for those segments to be presented in interim financial
reports. SFAS 131 also establishes standards for related disclosures about
products and services, and geographic areas. Prior to the acquisition of
CaptureQuest in April 2002, the Company has viewed their operations as
principally one segment. The business of the former CaptureQuest and MindArrow
constitute the Large Enterprise segment, and the historical Category 5
businesses constitute the Small Business segment.
10
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
The following is a summary of these segments:
Small Large
Business Enterprise
-------- ----------
For the nine months ended March 31, 2003:
Net revenues, actual $6,851,882 $4,035,489
Net revenues, pro forma/1/ 6,851,882 5,162,368
Long lived assets 592,958 570,235
Our Asia Pacific business adds a geographic segment to the business.
The following is a summary of significant geographic markets:
North Asia
America Pacific
------- -------
For the nine months ended March 31, 2003:
Net revenues, actual $10,531,777 $ 355,594
Net revenues, pro forma1 11,479,134 535,116
Long lived assets 1,163,193 --
/1/ Assumes the reverse acquisition of MindArrow, which occurred on September
30, 2002, had occurred on July 1, 2002.
7. Revenue Recognition
Revenues are recognized when the consulting or production services are
rendered and messages are delivered. The Company recognizes software license fee
revenue when persuasive evidence of an agreement exists, the product has been
delivered, we have no remaining significant obligations with regard to
implementation, the license fee is fixed or determinable and collection of the
fee is probable. Revenue from media sales is recognized upon placing
advertisements. Revenue from consulting is recognized as the services are
rendered. Revenues from products sold by the Small Business sales channel under
installment contracts are recognized net of amounts estimated to be
uncollectible (Note C1).
The Company records cash receipts from clients and billed amounts due
from clients in excess of revenue recognized as deferred revenue. The timing and
amount of cash receipts from clients can vary significantly depending on
specific contract terms and can therefore have a significant impact on the
amount of deferred revenue in any given period.
8. Intangible Assets
Identifiable intangible assets acquired in a business combination are
recorded separately from goodwill if they arise from contractual or other legal
rights or are separable from the acquired entity and can be sold, transferred,
licensed, rented or exchanged, either individually or as part of a related
contract, asset or liability. Goodwill, as well as other intangible assets with
indefinite lives, are not amortized and will be tested for impairment annually
and whenever there is an impairment indicator. All acquired goodwill is assigned
to reporting units for purposes of impairment testing and segment reporting.
During the quarter ended March 31, 2003, the Large Enterprise division
met its revenue projections, but it did not meet its cash flow projections, and
the losses of the expected cash flow from the Small Business division severely
impacted Avalon's ability to complete a fundraising. Also during the quarter
ended March 31, 2003, Avalon's share price continued to drop as the liquidity
situation became more dire, which further decreased the chances of obtaining
sufficient financing on acceptable terms. In light of these facts and
circumstances, and in accordance with SFAS Nos. 142 and 144, the Company has
11
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
re-evaluated the recovery of goodwill and other intangible assets. Such analysis
resulted in an impairment of goodwill of $16,820,601 and other intangible assets
of $7,486,010 at March 31, 2003.
9. Recent accounting pronouncements
SFAS No. 143, "Accounting for Asset Retirement Obligations," was issued
in June 2001. SFAS No. 143 addresses accounting and reporting for legal
obligations and related costs associated with the retirement of long-lived
assets. The Statement requires that the fair value of the liability for an asset
retirement obligation be recognized in the period incurred if a reasonable
estimate of fair value can be made. The estimated retirement costs are
capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143
is effective for financial statements issued for fiscal years beginning after
June 15, 2002. Adoption of this statement did not have a material effect.
In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" and the accounting and reporting provisions of APB
Opinion No. 30. SFAS No. 144 establishes accounting standards for the impairment
of long-lived assets, excluding goodwill, and for long-lived assets to be
disposed of. SFAS No. 144 requires that long-lived assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to future net cash flows expected to be generated by the asset. If such assets
are considered to be impaired, the impairment to be recognized is measured by
the amount by which the carrying amount of the assets exceeds the fair value of
the assets. Assets to be disposed of are reported at the lower of the carrying
amount or fair value less costs to sell. The statement retains the basic
provisions of APB Opinion No. 30 for the presentation of discontinued operations
in the statement of operations but broadens that presentation to include a
component of an entity (rather than a segment of a business).
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This Statement, among other things, rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The
Statement requires gains and losses from debt extinguishments that are used as
part of the Company's risk management strategy to be classified as part of
income from operations rather than as extraordinary items, net of tax. SFAS No.
145 is effective for fiscal years beginning after May 15, 2002 with earlier
adoption encouraged. Adoption of this statement did not have a material effect.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that a liability for costs associated with an exit or disposal activity be
recognized when the liability is incurred rather than when a company commits to
such an activity and also establishes fair value as the objective for initial
measurement of the liability. The Company will adopt SFAS No. 146 for exit or
disposal activities that are initiated after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure," which amends SFAS No. 123,
"Accounting for Stock-Based Compensation". SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation and is effective for fiscal
years ending after December 31, 2002. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in
annual and interim financial statements about the method of accounting for
stock-based compensation and the effect in measuring compensation expense. The
disclosure requirements of SFAS No. 148 are effective for interim periods
beginning after December 15, 2002. The Company has chosen to continue to account
for stock-based compensation using the intrinsic
12
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
value method prescribed in APB Opinion No. 25 and related interpretations.
Accordingly, compensation expense for stock options is measured as the excess,
if any, of the estimate of the market value of the Company's stock at the date
of the grant over the amount an employee must pay to acquire the stock. The
Company adopted the annual disclosure provisions of SFAS No. 148 in the quarter
ended March 31, 2003.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." Interpretation No. 45 requires a
guarantor to include disclosure of certain obligations, and if applicable, at
the inception of the guarantee, recognize a liability for the fair value of
other certain obligations undertaken in issuing a guarantee. The recognition
requirement is effective for guarantees issued or modified after December 31,
2002 and based on current operations, the Company does not expect the adoption
of the recognition requirements of this statement to have a material effect on
its financial position or results of operations. The disclosure requirements are
effective for financial statements of interim and annual periods ending after
December 31, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities." Interpretation No. 46 clarifies the application
of Accounting Research Bulletin No. 51 and applies immediately to any variable
interest entities created after January 31, 2003 and to variable interest
entities in which an interest is obtained after that date. This Interpretation
is applicable for the Company in the fiscal year beginning July 1, 2003, for
interests acquired in variable interest entities prior to February 1, 2003.
Based on current operations, the Company does not expect the adoption of
Interpretation No. 46 to have a material effect on its financial position or
results of operations.
Note B--Liquidity
The Company's liquidity is significantly impacted by credit and
collections issues. Its Small Business division formerly generated large
balances of receivables and, depending on the quality of the credit and the cash
needs, it sold certain of the receivables, at a discount, to financing sources.
Receivables that have not been sold are retained and the billing and collecting
administration have been outsourced. A large portion of the Small Business
division's customers have sub-prime credit. Accordingly, many of the receivables
generated by these customers may have high credit risk.
During the last six months of calendar 2002, the Company sold a
significant portion of its contracts receivable, at a discount, in order to
raise cash. The receivables sold were typically the highest quality in the
portfolio, so the remaining contracts receivable represented the lowest quality.
Accordingly, the Company experienced high delinquencies in the remaining
receivables portfolios through December 31, 2002. This, coupled with the
writedown of a certificate of deposit and the uncertainty experienced with the
funding of the East West investment, have severely impacted the Company's
liquidity and rendered it insolvent.
At March 31, 2003, the Company's cash balance was $60,678, which
requires that it actively seek additional sources of capital. As of March 31,
2003, the Company had current assets of approximately $1.5 million and current
liabilities of approximately $10.8 million. This represents a working capital
deficit of approximately $9.3 million. The negative working capital balance
includes as current liabilities approximately $1.3 million of deferred revenues
and is mitigated by approximately $627,000 in net contracts receivable included
in long-term assets.
The Company's line of credit facility with Zions Bank includes
covenants for tangible net worth and debt coverage ratios. As of March 31, 2003,
the balance on the line was $413,687, and the Company was in violation of these
covenants, and has sought waivers. As of the date hereof, the bank has not
waived the violations, and if it were to demand payment of the entire balance,
the Company's liquidity would suffer. In January 2003, in exchange for an
advance of $250,000 on the line, the Company designated a recurring revenue
stream in the amount of approximately $40,000 per month for repayment of the
outstanding balance on the line.
13
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 was not made. In February 2003, $150,000 of the note balance was
converted into 37,500 shares of common stock and warrants to purchase 43,125
shares of common stock at $2 per share (Note E3). The Company is seeking an
extension or conversion into equity of some or all of the remaining overdue
balance.
The Company had $820,000 of convertible notes payable that were due on
November 21, 2002. In November 2002, the note holders agreed to amend the
repayment terms of the notes to increase the interest rate to 14%, lower the
conversion price to $3 per share, establish payment terms calling for six equal
monthly principal payments beginning in January 2003 through June 2003. The note
holders also received 179,170 additional warrants to purchase common stock at $3
per share and an amendment to their original 179,170 warrants to reduce the
exercise price to $3 per share (Note G2). The grant of additional warrants and
repricing of old warrants, combined with the resulting beneficial conversion
feature resulted in a discount to the note of $820,000, thus yielding an
effective interest rate of 114%. The discount is being amortized over the term
of the bridge notes, therefore $528,858 of the discount has been amortized as
interest expense as of March 31, 2003. In January 2003, $130,667 of the notes
were converted into 43,570 shares of common stock. As of May 31, 2003, the
balance of the January payment that was not converted into common stock amounted
to $50,107 and has not been paid, nor have any other payments been made.
In February 2003, the Company obtained $200,000 in bridge financing
from an investor affiliated with a significant stockholder who is also a
director. The bridge loan accrues interest at the rate of 10% per annum, is
secured by fixed assets and intellectual property, and matured on June 18, 2003.
The bridge note is convertible into Avalon common stock at the lower of $1.375
per share or the price per share of common stock in an equity financing proposed
to be placed on behalf of the Company by its investment bankers, L.H. Friend,
Weinress, Frankson & Presson. As consideration for entering into the bridge loan
the Company repriced warrants issued in connection with the East West Capital
financing transactions (Note G2). This repricing, as computed using the
Black-Scholes option pricing model, resulted in a discount to the note of
$200,000, thus yielding an effective interest rate of 110%. $68,333 of the
discount has been amortized as interest expense as of March 31, 2003.
In May 2003, the Company received a $400,000 bridge loan from an
investor affiliated with a significant shareholder and who is a former director.
The bridge loan accrues interest at the rate of 25% per annum, is secured by all
assets of the Company, matures on the earlier of May 15, 2004, or the closing of
the sale of certain assets from the Large Enterprise operations. As
consideration for entering into the bridge loan the Company issued warrants to
purchase 495,000 shares of common stock at $0.33 per share.
The pending sale of assets to Silverpop is designed to raise cash to
pay off certain liabilities and allow the Company to reorganize around its Small
Business operations, which have recently released two new software products. The
sale of assets has not been completed, and there is no assurance that it will be
completed on terms that will be acceptable to the Company, or that the proceeds
will be sufficient to allow the Company to successfully restructure and continue
operations.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the company as a going concern.
In the view of the Company, recoverability of a major portion of the
recorded asset amounts shown in the accompanying balance sheet is dependent upon
continued operations of the Company, which in turn is dependent upon the
Company's ability to meet obligations on a continuing basis. The consolidated
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
Note C--Receivables
1. Contracts Receivable
Contracts receivable consist of amounts due from customers of the Small
Business sales channel. The customers have typically entered into 36-month
installment contracts and the portion of the balance that is due within one year
is included in the current balance. The allowance for doubtful accounts is
estimated using the Company's experience in collecting from these customers.
14
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
At March 31, 2003, contracts receivable consisted of the following:
Current Long-term
------- ---------
Contracts receivable $ 873,143 $1,694,926
Allowance for uncollectible accounts (524,461) (1,067,741)
--------- ----------
Net $ 348,682 $ 627,185
========= ============
2. Trade Accounts Receivable
Trade accounts receivable are comprised mainly of billings to customers
of the Large Enterprise sales channel, and are all due within one year. The
allowance for doubtful accounts is provided based on a specific review of
amounts due. At March 31, 2003, trade receivables consisted of the following:
Trade accounts receivable $ 939,015
Allowance for uncollectible accounts (155,000)
---------
Net $ 784,015
=========
3. Retainages Receivable
Current retainages receivable consist primarily of amounts held by the
Company's credit card merchant accounts and long-term retainage amounts held for
resale at their net realizable value. Long-term retainages receivable consist of
the reserves held by financing companies that have previously purchased
contracts receivable. As the Company sells its contracts receivable, the
financing companies retain portions of the funded amounts as reserves in the
event of default by the customer. These reserves are to be released to the
Company as customers make monthly payments. The amounts to be released are
determined periodically by the finance companies in accordance with the terms of
the receivables purchase agreements. At March 31, 2003, retainage receivable
consisted of the following:
Retainages receivable $540,715
Allowance for uncollectible accounts (354,328)
-----------
Net $186,387
=========
Note D--Commitments and Contingencies
1. Legal Proceedings
From time to time the Company is subject to legal proceedings and
claims in the ordinary course of business, including claims of alleged
infringement of trademarks, copyrights and other intellectual property rights.
The Company's liquidity position has resulted in it becoming party to lawsuits
for non-payment of liabilities. These amounts are included in "Accounts payable
and accrued liabilities" in the accompanying consolidated balance sheet. The
Company is working with the creditors to reach settlements and payment terms
that are acceptable.
In May 2003, the Company settled a dispute with MindArrow's former
landlord over amounts due under a lease for MindArrow's former facilities. The
settlement, in the amount of $803,000, is included in "Accounts payable and
accrued liabilities" on the accompanying consolidated balance sheet, and calls
for payments of $5,000 per month beginning in July 2003, increasing to $10,000
per month beginning in March 2004, and increasing to $100,000 per quarter
beginning in January 2005 until the balance is paid. In June 2003, a judgment
lien covering all of the assets of the Company was filed in connection with this
settlement.
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April
15
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
and July 2002, the perpetrators were ordered to pay to the Company $10.9 million
in restitution in addition to amounts already received. In addition, the Company
continues to pursue recovery of the loss it incurred as a result of the fraud
perpetrated against the Company, and the Audit Committee of the Company's Board
of Directors has retained special counsel to assist it in pursuing potential
sources of recovery. Eight individuals and twelve entities have been named as
defendants in lawsuits initiated by the Company. The Company cannot predict
whether or when it will obtain any additional recovery. Because of the
uncertainties surrounding recoveries, the Company will not record the impact of
recoveries until amounts or assets are received.
Note E--Notes Payable
1. Convertible Notes Payable
In November 2001, the Company issued $820,000 of convertible notes
payable to sixteen investors (the "Convertible Notes"). The Convertible Notes
bear interest at 8% per annum, were due on November 21, 2002, and were
convertible into shares of common stock at the option of the holders, for the
lower of $8.70 or the price of a private placement of the Company's common
stock. In December 2002, the note holders agreed to amend the repayment terms of
the notes to increase the interest rate to 14%, lower the conversion price to $3
per share, establish payment terms calling for six equal monthly principal
payments beginning in January 2003 through June 2003. The note holders also
received 179,170 additional warrants to purchase common stock at $3 per share
and an amendment to their original 179,170 warrants to reduce the exercise price
to $3 per share (Note G2). The grant of additional warrants and repricing of old
warrants, combined with the resulting beneficial conversion feature resulted in
a discount to the note of $820,000, thus yielding an effective interest rate of
114%. The discount is being amortized over the term of the bridge notes,
therefore $528,858 of the discount has been amortized as interest expense as of
March 31, 2003. In January 2003, $130,667 of the notes were converted into
43,570 shares of common stock. As of May 31, 2003, the balance of the January
payment that was not converted into common stock amounted to $50,107 and has not
been paid, nor any other payments made.
2. Line of Credit
In August 2002, the Company, through its wholly-owned subsidiary,
ePenzio, Inc., renewed its revolving line of credit with Zions First National
Bank (the "Zions Facility") and increased the amount of the credit facility to
$2 million. The annual interest rate applied to the unpaid principal balance of
the Zions Facility is 1% over Prime (4.25% at March 31, 2003). The Zions
Facility is secured by all inventory, chattel paper, accounts and general
intangibles owned by ePenzio on or after September 11, 2001. As of March 31,
2003, the Company had a balance of $413,687 under the Zions Facility. In
addition to customary affirmative and negative covenants, ePenzio must maintain
a tangible net worth not less than $1 million, and a debt coverage ratio
(defined as total earnings before interest, taxes, depreciation and amortization
to total debt service coverage) of 1.5 to 1.0, measured on a quarterly basis.
The Company is not in compliance with such covenants, and is currently pursuing
waivers. In January 2003, in exchange for an advance of $250,000 on the line,
the Company designated a recurring revenue stream in the amount of approximately
$40,000 per month for repayment of the outstanding balance on the line.
3. Radical Communication, Inc.
In September 2001, MindArrow issued an unsecured subordinated note
payable in the amount of $1 million to Radical Communication, Inc. ("Radical"),
in connection with MindArrow's acquisition of substantially all of the assets of
Radical. In August 2002, $250,000 of the principal balance was converted into
62,500 shares of common stock and warrants to purchase 71,875 shares of common
stock. The note bears interest at 5% per annum and is due in two principal
installments; $250,000 on October 1, 2002 and $500,000 on October 1, 2003. The
initial payment was not made when due, and in February 2003, $150,000 of this
note was converted into 37,500 shares of common stock and warrants to purchase
43,125 shares of common stock at $2 per share (Note G2). The Company is seeking
an extension or an agreement to convert some or all of the remaining balance.
4. Morrison & Foerster Note Payable
On March 18, 2003, the Company issued a promissory note and security
agreement in the amount of $715,000 to Morrison & Foerster LLP in consideration
of legal services previously provided and recorded in accounts payable and
accrued liabilities. The note bears interest at 10% per annum and is due upon
the receipt of gross proceeds from a debt or equity financing of $100,000 or
greater, in the amount of
16
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
15% of net proceeds from the financing, and on the tenth calendar day of each
month in the amount of ten percent of the Company's cash and short term
investments. This note payable is secured by substantially all of the assets of
the Company.
In June 2003, the note agreement was amended to release the security
interest in the assets of the Company upon the earlier of the closing of the
pending sale to Silverpop Systems, Inc. (Note L) or July 30, 2003. The amendment
calls for a cash payment of $150,000 and the issuance of 1,000,000 shares of
newly-created Series D preferred stock. If the payment is not made and issuance
of preferred stock not completed according to the terms of the amendment, then
the terms of the original note and security agreement will be reinstated. Each
share of Series D preferred stock, when issued, will be convertible into one
share of common stock and carry a liquidation preference of $0.25.
Note F--Due to Related Parties
Two stockholders of the Company have advanced amounts to the Company.
The advances do not bear interest and are non-secured. Both of the stockholders
who advanced the amounts are employees of the Company, and one is a former
member of the Board of Directors.
In February 2003, the Company obtained $200,000 in bridge financing
from an investor affiliated with a significant stockholder who is also a
director. The bridge loan accrues interest at the rate of 10% per annum, is
secured by fixed assets and intellectual property, and matured on June 18, 2003.
The bridge note is convertible into Avalon common stock at the lower of $1.375
per share or the price per share of common stock in an equity financing proposed
to be placed on behalf of the Company by its investment bankers, L.H. Friend,
Weinress, Frankson & Presson. As consideration for entering into the bridge loan
the Company repriced warrants issued in connection with the East West Capital
financing transactions (Note G2). This repricing, as computed using the
Black-Scholes option pricing model, resulted in a discount to the note of
$200,000, thus yielding an effective interest rate of 110%. $68,333 of the
discount has been amortized as interest expense as of March 31, 2003.
In May 2003, the Company received a $400,000 bridge loan from an
investor affiliated with a significant shareholder and who is a former director.
The bridge loan accrues interest at the rate of 25% per annum, is secured by all
assets of the Company, matures on the earlier of May 15, 2004, or the closing of
the sale of the assets of the Large Enterprise division.
Note G--Stockholders' Equity
1. Common Stock
During the quarter ended September 30, 2002, 18,975 shares of common
stock were issued for services, resulting in compensation expense of $59,675. In
addition, 5,290 shares were issued during the six months ended December 31, 2002
upon exercise of stock options. Proceeds amounted to $5,764.
On September 30, 2002, 3,133,636 shares were issued in the reverse
acquisition of MindArrow. (see Note H - Reverse Acquisition of MindArrow
Systems, Inc.)
In February 2003, a $50,000 advance from a stockholder was converted
into 40,000 shares of common stock. In connection with this investment, the
Company issued warrants to purchase 20,000 shares of common stock at $2 per
share.
In June 2002, MindArrow obtained a commitment for between $3 million
and up to $4 million in financing by offering up to 1 million shares of common
stock at a price of $4 per share from a group of investors led by East-West
Capital Associates, Inc. ("East-West Capital") and its affiliate, East West
Venture Group, LLC. The stock purchase agreement, as amended in February 2003
called for the remaining $175,000 of the minimum commitment to be funded by
providing $25,000 in cash in exchange for 6,250 shares of common stock and
warrants to purchase 7,188 shares of common stock at $2 per share, and $150,000
through the conversion of a portion of the note payable to Radical
Communication, Inc. into 37,500 shares of common stock and warrants to purchase
43,125 shares of common stock at $2 per share. In addition, the February 2003
amendment to the stock purchase agreement terminated the remaining financing
commitment of $800,000 in exchange for a cash investment of $200,000 in the
Company by
17
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
East-West Capital in the form of a convertible secured debenture, bearing
interest at 10% per annum, and maturing on the earlier of 120 days from the
funding date or the closing of a financing for at least an additional $500,000
or more of equity or debt. The debenture may be converted at the option of the
holder at the lesser of (i) $1.375 per share or (ii) the same terms and
conditions as a proposed new equity financing by the Company. The Company also
agreed to reprice previous warrants issued to East-West Capital and its
affiliates to $2 per share (Note G2). East-West Capital agreed to eliminate the
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
On September 30, 2002, the Company effected a reverse stock split of
the Company's common stock at a ratio of one-for-ten, causing each outstanding
share of common stock to convert automatically into one-tenth of a share of
common stock. In lieu of fractional shares, stockholders will receive a cash
payment based on the trading price of the common stock prior to the
effectiveness of the reverse split. Stockholders' equity has been restated to
give retroactive recognition to the reverse split for all periods presented by
reclassifying the excess par value resulting from the reduced number of shares
from common stock to paid-in capital. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split.
In January 2003, the Company issued 43,570 shares of common stock in
connection with the conversion of $130,667 of convertible notes payable (Note
E1).
2. Warrants
In connection with the reverse acquisition of MindArrow on September
30, 2002, MindArrow's outstanding warrants remained outstanding and thus became
an obligation of Avalon. As of September 30, 2002, there were 1,511,002 warrants
outstanding with exercise prices ranging from $1 to $300 per share, and with
expiration dates ranging from January 2003 through April 2010.
In addition, in connection with the reverse acquisition of MindArrow on
September 30, 2002, Category 5's stockholders received warrants to purchase one
share of Avalon common stock for every twenty shares of Category 5 common stock
that they owned immediately prior to the transaction for a total of 833,918
warrants. The exercise price of the warrants is $0.10 per share, and are
exercisable if the Company's Small Business division achieves certain financial
targets for the twelve months ending September 30, 2003.
In October 2002, the Company issued 28,750 warrants to purchase common
stock at prices ranging from $5 to $12.50 per share in connection with common
stock issued for financing (Note G1). The Company recognized financing costs of
$22,863 during the quarter ended December 31, 2002 based on the fair value of
the vested warrants as computed using the Black-Scholes option pricing model.
In December 2002, the Company issued 179,170 warrants to purchase
common stock at $3 per share, and reduced the price of 179,170 previously issued
warrants to $3 per share, in connection with amendments made to bridge notes
(Note E1). The value of the grant of additional warrants and repricing of old
warrants as computed using the Black-Scholes option pricing model, combined with
the resulting beneficial conversion feature resulted in a discount to the note
of $820,000, thus yielding an effective interest rate of 114%. The discount is
being amortized over the term of the bridge notes, therefore $528,858 of the
discount has been amortized as interest expense as of March 31, 2003. The
unamortized discount balance on the notes at March 31, 2003 was $291,142.
Additionally, the Company issued 17,500 warrants to purchase common
stock at $2.37 per share in December 2002 as partial consideration for the
acquisition of AGEA Corporation (Note K). The warrants were valued at $7,175
based on the fair value of the vested warrants as computed using the
Black-Scholes option pricing model.
In February 2003, the Company issued 20,000 warrants to purchase common
stock at $2 per share in connection with conversion of an advance from a
stockholder (Note G1). The Company recognized financing costs of $5,200 during
the quarter ended March 31, 2003 based on the fair value of the vested warrants
as computed using the Black-Scholes option pricing model.
18
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
In February 2003, the Company issued warrants to purchase 43,125 shares
of common stock at $2 per share in connection with the Radical note conversion
(Note E3). The Company recognized financing costs of $6,900 during the quarter
ended March 31, 2003 based on the fair value of the vested warrants as computed
using the Black-Scholes option pricing model.
In February 2003, the Company issued warrants to purchase 7,188 shares
of common stock at $2 per share in connection with the $25,000 cash investment
by East West Capital (Note G1). The Company recognized financing costs of $1,150
during the quarter ended March 31, 2003 based on the fair value of the vested
warrants as computed using the Black-Scholes option pricing model.
In February 2003, as consideration for entering into a bridge loan, the
Company repriced 723,437 warrants issued in connection with the East West
Capital financing transactions (Note G1) to $2 per share. This repricing, as
computed using the Black-Scholes option pricing model, resulted in a discount to
the note of $200,000, thus yielding an effective interest rate of 110%. $68,333
of the discount has been amortized as interest expense as of March 31, 2003..
The unamortized discount balance on the note at March 31, 2003 was $131,667.
3. Options
Following the completion of the reverse acquisition of MindArrow on
September 30, 2002, MindArrow's stock option plans became the stock option plans
of Avalon.
As amended, the 1999 Stock Option Plan (the "1999 Plan"), reserves
247,500 shares of common stock for option grants to employees, directors and
consultants to continue their service to the Company. At March 31, 2003, there
remained 55,470 shares available for grant under the 1999 Plan.
As amended, the 2000 Stock Incentive Plan (the "2000 Plan"), reserves
549,750 shares of common stock for option grants to employees, directors and
consultants to continue their service to the Company. At March 31, 2003, there
remained 96,605 shares available for grant under the 2000 Plan.
Options granted under Category 5's previous option plans, (the "C5
Plans") became obligations of Avalon, but the C5 Plans themselves were
discontinued. Accordingly, options granted under the C5 Plans to purchase
426,089 shares of common stock were outstanding as of March 31, 2003, all of
which became vested upon completion of the reverse acquisition of MindArrow.
During the quarter ended March 31, 2003, options to purchase 409,215
shares at $1.50 per share were granted and 77,790 options expired.
At March 31, 2003 and 2002, the Company has issued stock options to
certain of its employees. The Company accounts for these options under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related Interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted had an
exercise price equal to or greater than the market value of the underlying
common stock on the date of grant. Had compensation cost for the Company's stock
option plans been determined based on the fair value consistent with the
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", the
Company's net loss and loss per share would have been reduced to the pro forma
amounts indicated below for the three and nine months ended March 31, 2003 and
2002:
19
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
Three Months Ended Nine Months Ended
March 31, March 31,
--------------------------------- ---------------------------------
2003 2002 2003 2002
-------------- -------------- -------------- --------------
Net income (loss) as reported $ (27,631,481) $ 467,940 $ (36,498,468) $ 1,784,164
Deduct: total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effects (466,505) (237,667) (466,505) (713,001)
-------------- -------------- -------------- --------------
Net loss - pro forma $ (28,097,986) $ 230,273 $ (36,964,973) $ 1,071,163
============== ============== ============== ==============
Earnings (loss) per share:
Basic - as reported $ (3.79) $ 0.16 $ (6.04) $ 0.63
Diluted - as reported $ (3.79) $ 0.13 $ (6.04) $ 0.51
Pro forma:
Basic $ (3.85) $ 0.08 $ (6.12) $ 0.38
Diluted $ (3.85) $ 0.06 $ (6.12) $ 0.31
Note H--Reverse Acquisition of MindArrow Systems, Inc.
On September 30, 2002, all of the outstanding shares of Category 5 were
acquired by MindArrow. The former shareholders of Category 5 received shares
equal to 55% of the issued and outstanding common stock of Avalon, plus warrants
to purchase an additional 5% should the Small Business division achieve certain
financial targets for the twelve month period ending September 30, 2003.
The transaction has been accounted for as a reverse acquisition, with
Category 5 the acquirer. The total purchase price of the acquisition was
$18,324,995, which gives effect to the 3,133,636 outstanding shares of common
stock and all outstanding options and warrants of MindArrow. The purchase price
was allocated to the assets acquired and the liabilities assumed based on their
estimated fair values. Goodwill has resulted from the excess costs over fair
value of the net assets acquired.
Intangibles $ 21,447,474
Cash 36,485
Other tangible assets acquired 2,381,898
Liabilities assumed (5,490,862)
------------
$ 18,324,995
The Company performed an evaluation of the intangible assets arising
from the transaction, and identified the following:
Existing technology $ 2,800,000
Patents 1,200,000
Customer relationships 2,900,000
Goodwill 14,547,474
-----------
$21,447,474
All of these intangible assets were determined to be impaired at March
31, 2003 and written off (Note A8).
20
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
The following unaudited pro forma results of operations for the nine
months ended March 31, 2003, assume the acquisition discussed above occurred on
July 1, 2002:
Revenues $ 12,014,250
Net loss (38,492,539)
Basic and diluted loss per share $ (5.42)
Weighted average shares 7,095,872
The above pro forma financial information does not purport to be
indicative of the results of operations had the acquisition of MindArrow
actually had taken place on July 1, 2002, nor is it intended to be a projection
of future results or trends.
Note I--Income Taxes
Components of income tax benefit (expense) reflected in the
consolidated statements of operations for the nine months ended March 31, 2003
are as follows:
Three Months Ended Nine Months Ended
March 31, March 31,
2003 2002 2003 2002
------------ ------------ ------------ ------------
Expected tax benefit (expense) at federal rate $ 9,390,000 $ (240,000) $ 12,410,000 $ (920,000)
Nondeductible expenses (8,350,000) 16,000 (8,350,000) (4,000)
Net operating loss producing no current benefit (1,040,000) -- (2,916,000) --
------------ ------------ ------------ ------------
$ -- $ (240,000) $ 1,144,000 $ (924,000)
============ ============ ============ ============
The components of deferred taxes included in the accompanying
consolidated balance sheet as of March 31, 2003, are as follows:
Deferral of revenue related to contracts receivable $ (332,000)
Accrued vacation 89,000
Net operating loss carryforwards 16,354,000
------------
Deferred tax asset 16,111,000
Valuation allowance (16,111,000)
------------
Net $ --
============
As of March 31, 2003, the Company has approximately $48.1 million in
net operating loss carryforwards which are available to offset future taxable
income. These losses begin to expire in 2019. Utilization of these losses will
likely be significantly limited due to the impact of Internal Revenue Code
Section 382 and the regulations thereunder.
Note J--Supplemental Disclosure of Cash Flow Information
Noncash investing and financing activities included the reverse
acquisition of MindArrow described above, in exchange for 3,133,636 shares of
common stock, the acquisition of the assets of AGEA Corporation and the
acquisition of Mindwire, Inc. (Note K).
In addition, noncash investing and financing activities included the
conversion of a $150,000 portion of the note payable to Radical Communication,
Inc. into 37,500 shares of common stock and warrants to purchase 43,125 shares
of common stock.
21
Avalon Digital Marketing Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements - (Continued)
Note K--Acquisitions
On December 22, 2002 the Company acquired the assets of AGEA
Corporation in exchange for 175,000 shares of common stock valued at $1.88 per
share and warrants to purchase 17,500 shares of common stock at $2.37 per share
(Note G2). The consideration was valued at $336,175 and allocated to the assets
acquired and the liabilities assumed as follows:
Cash acquired $ 390,000
Liabilities assumed (53,825)
---------
$ 336,175
On January 31, 2003 the Company acquired Mindwire, Inc. in exchange for
46,700 shares of common stock valued at $1.36 per share. The consideration was
valued at $63,512 and allocated to the assets acquired and the liabilities
assumed as follows:
Assets acquired $ 3,361
Liabilities assumed (25,030)
Goodwill 85,181
--------
$ 63,512
Note L--Subsequent Events
In May 2003, the Company entered into a non-binding letter of intent to
sell certain of the assets from the Large Enterprise operations to Silverpop
Systems, Inc. These assets led to approximately $800,000 in revenue for the
quarter ended March 31, 2003. After the sale, if consummated, the Company will
focus on software-based solutions for Small Business customers. The Company had
not considered selling these assets until it received an offer in April 2003.
Accordingly, at March 31, 2003, these assets were considered as held and used.
The sale of assets from the Large Enterprise operations is designed to
raise cash to pay off certain liabilities and allow the Company to reorganize
around the Small Business software and services operations, which have recently
released two new software products. The sale of assets has not been completed,
and there is no assurance that it will be completed on terms that will be
acceptable, or that the proceeds will be sufficient to allow the Company to
successfully restructure and continue operations.
22
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read together with our consolidated
financial statements and related notes included elsewhere in this quarterly
report on Form 10-Q. All references to "pro forma" results for prior periods in
this Item 2 assume that the merger between MindArrow and Category 5 occurred in
such prior periods.
Overview
Avalon Digital Marketing Systems, Inc. was formed as a result of a
merger between MindArrow Systems, Inc. and Category 5 Technologies, Inc. on
September 30, 2002. MindArrow was the legal acquirer or Category 5, but because
Category 5's business was larger than MindArrow's and because Category 5's
former stockholders obtained the majority of the outstanding shares of the
combined company at the time of the merger, generally accepted accounting
principles require that Category 5 be treated as the acquirer for accounting and
reporting purposes. Accordingly, the financial statements included in this
report reflect the following:
o Consolidated Balance Sheet as of March 31, 2003 - reflects
post-merger Avalon.
o Consolidated Balance Sheet as of June 30, 2002 - reflects
Category 5 only.
o Statements of Operations for the Quarter and Nine Months Ended
March 31, 2002 - reflects Category 5 only. Statements of
Operations for the Nine Months Ended March 31, 2003 - reflects
one quarter of Category 5 only and two quarters of post-merger
Avalon. Statements of Operations for the Quarter Ended March
31, 2003 reflects operations of post-merger Avalon.
o Statements of Cash Flows for the Nine Months Ended March 31,
2002 - reflects Category 5 only. Statements of Cash Flows for
the Nine Months Ended March 31, 2003 - reflects one quarter of
Category 5 only and two quarters of post-merger Avalon.
o Pro forma combined information as if the merger had taken
place on July 1, 2002 is contained in the notes to financial
statements.
In addition, references to the "Company" for periods prior to September
30, 2002 are intended to refer to Category 5 and its business, except for
information provided on a "pro forma" basis.
Category 5 was founded in 1998 as Executive Credit Services LLC and
incorporated under the name ePenzio, Inc. in May 2000. On May 29, 2001, Network
Investor Communications, Inc. ("NWIC") acquired all of the outstanding shares of
ePenzio, and effective July 23, 2001, NWIC changed its name to Category 5
Technologies, Inc. ("Category 5"). For accounting purposes the business
combination with NWIC was treated as a reverse merger or a recapitalization of
ePenzio, with ePenzio being treated as the accounting acquirer. On September 30,
2002, MindArrow Systems, Inc., a Delaware corporation, acquired all of the
outstanding shares of Category 5 and changed its name to Avalon Digital
Marketing Systems, Inc. For accounting purposes, the business combination with
MindArrow was treated as a reverse acquisition, with Category 5 being the
acquirer.
Avalon develops and provides software and services that enable our
clients to communicate and sell more effectively and efficiently over the web,
via email, and through other digital channels.
The business is divided between the Small Business and Large Enterprise
sales channels. The Small Business channel has been the primary source of our
historical revenues, and provides small businesses with merchant services and
digital marketing software, primarily marketed through workshops. Small Business
operations consist primarily of Category 5's subsidiaries, Avalon Business
Direct, Inc., ePenzio, Inc., Bring it Home, Inc. and Olympus Financial, Inc. In
March 2003, we stopped selling our products through seminars operated by our
Bring it Home subsidiary, and refocused on selling software and services through
alternative distribution methods.
We also provide customized software and professional services to large
companies. These operations consist primarily of the former MindArrow, MindArrow
Asia, Ltd. and former Category 5
23
subsidiary, CaptureQuest, Inc. In May 2003, we entered into a non-binding letter
of intent to sell certain of the assets from our Large Enterprise operations to
Silverpop Systems, Inc. These assets led to approximately $800,000 in revenue
for the quarter ended March 31, 2003. After the sale, if consummated, we will
focus our business on software-based solutions for our Small Business customers.
Our revenues were derived from the production and delivery of rich
media messages and software license fees. Production services include theme
development, design and layout, video production, special effects, hyperlink
recommendations, hyperlink page design and creation, reporting and sales cycle
consultation.
We currently sell our products and services through a direct sales
force and a small network of sales affiliates.
Critical accounting policies
Revenues are recognized when the consulting or production services are
rendered and messages are delivered. We recognize software license fee revenue
when persuasive evidence of an agreement exists, the product has been delivered,
we have no remaining significant obligations with regard to implementation, the
license fee is fixed or determinable and collection of the fee is probable.
Revenue from media sales is recognized upon placing advertisements. Revenue from
consulting is recognized as the services are rendered. Revenues from products
sold by the Small Business sales channel under installment contracts are
recognized net of amounts estimated to be uncollectible.
We record cash receipts from clients and billed amounts due from
clients in excess of revenue recognized as deferred revenue. The timing and
amount of cash receipts from clients can vary significantly depending on
specific contract terms and can therefore have a significant impact on the
amount of deferred revenue in any given period.
Identifiable intangible assets acquired in a business combination are
recorded separately from goodwill if they arise from contractual or other legal
rights or are separable from the acquired entity and can be sold, transferred,
licensed, rented or exchanged, either individually or as part of a related
contract, asset or liability. Goodwill, as well as other intangible assets with
indefinite lives, are not amortized and will be tested for impairment annually
and whenever there is an impairment indicator. All acquired goodwill is assigned
to reporting units for purposes of impairment testing and segment reporting.
Recent accounting pronouncements
SFAS No. 143, "Accounting for Asset Retirement Obligations," was issued
in June 2001. SFAS No. 143 addresses accounting and reporting for legal
obligations and related costs associated with the retirement of long-lived
assets. The Statement requires that the fair value of the liability for an asset
retirement obligation be recognized in the period incurred if a reasonable
estimate of fair value can be made. The estimated retirement costs are
capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143
is effective for financial statements issued for fiscal years beginning after
June 15, 2002. Adoption of this statement did not have a material effect.
In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" and the accounting and reporting provisions of APB
Opinion No. 30. SFAS No. 144 establishes accounting standards for the impairment
of long-lived assets, excluding goodwill, and for long-lived assets to be
disposed of. SFAS No. 144 requires that long-lived assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to future net cash flows expected to be generated by the asset. If such assets
are considered to be impaired, the impairment to be recognized is measured by
the amount by which the carrying amount of the assets exceeds the fair value of
the assets. Assets to be disposed of are reported at the lower of the carrying
amount or fair value less costs to sell. The statement
24
retains the basic provisions of APB Opinion No. 30 for the presentation of
discontinued operations in the statement of operations but broadens that
presentation to include a component of an entity (rather than a segment of a
business).
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This Statement, among other things, rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The
Statement requires gains and losses from debt extinguishments that are used as
part of the Company's risk management strategy to be classified as part of
income from operations rather than as extraordinary items, net of tax. SFAS No.
145 is effective for fiscal years beginning after May 15, 2002 with earlier
adoption encouraged. Adoption of this statement did not have a material effect.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires
that a liability for costs associated with an exit or disposal activity be
recognized when the liability is incurred rather than when a company commits to
such an activity and also establishes fair value as the objective for initial
measurement of the liability. The Company will adopt SFAS No. 146 for exit or
disposal activities that are initiated after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure," which amends SFAS No. 123,
"Accounting for Stock-Based Compensation". SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation and is effective for fiscal
years ending after December 31, 2002. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in
annual and interim financial statements about the method of accounting for
stock-based compensation and the effect in measuring compensation expense. The
disclosure requirements of SFAS No. 148 are effective for interim periods
beginning after December 15, 2002. The Company has chosen to continue to account
for stock-based compensation using the intrinsic value method prescribed in APB
Opinion No. 25 and related interpretations. Accordingly, compensation expense
for stock options is measured as the excess, if any, of the estimate of the
market value of the Company's stock at the date of the grant over the amount an
employee must pay to acquire the stock. The Company adopted the annual
disclosure provisions of SFAS No. 148 in the quarter ended March 31, 2003.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." Interpretation No. 45 requires a
guarantor to include disclosure of certain obligations, and if applicable, at
the inception of the guarantee, recognize a liability for the fair value of
other certain obligations undertaken in issuing a guarantee. The recognition
requirement is effective for guarantees issued or modified after December 31,
2002 and based on current operations, the Company does not expect the adoption
of the recognition requirements of this statement to have a material effect on
its financial position or results of operations. The disclosure requirements are
effective for financial statements of interim and annual periods ending after
December 31, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities." Interpretation No. 46 clarifies the application
of Accounting Research Bulletin No. 51 and applies immediately to any variable
interest entities created after January 31, 2003 and to variable interest
entities in which an interest is obtained after that date. This Interpretation
is applicable for the Company in the second quarter of fiscal year 2004, which
ends September 30, 2003, for interests acquired in variable interest entities
prior to February 1, 2003. Based on current operations, the Company does not
expect the adoption of Interpretation No. 46 to have a material effect on its
financial position or results of operations.
25
We need additional financing
Our liquidity is significantly impacted by credit and collections
issues. Our small business seminar channel formerly generated large balances of
receivables and, depending on the quality of the credit and cash needs, we sold
certain of the receivables, at a discount, to financing sources. Receivables
that have not been sold are retained and billing and collecting administration
have been outsourced. A large portion of the seminar customers have historically
had sub-prime credit. Accordingly, many of the receivables generated by these
customers have high credit risk.
During the last six months of calendar 2002, the Company sold a
significant portion of its contracts receivable, at a discount, in order to
raise cash. The receivables sold were typically the highest quality in the
portfolio, so the remaining contracts receivable represented the lowest quality.
Accordingly, the Company experienced high delinquencies in the remaining
receivables portfolios through December 31, 2002. This, coupled with the
writedown of a certificate of deposit and the uncertainty experienced with the
funding of the East West investment, have severely impacted the Company's
liquidity and rendered it insolvent.
At March 31, 2003, we had $60,678 in cash, which requires that we seek
immediate additional capital. As of March 31, 2003, we had current assets of
approximately $1.5 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $9.3
million. The negative working capital balance includes as current liabilities
approximately $1.3 million of deferred revenues and is mitigated by
approximately $627,000 in net contracts receivables included in long-term
assets.
Our line of credit facility with Zions Bank includes covenants for
tangible net worth and debt coverage ratios. As of March 31, 2003, the balance
on the line was $413,687, and we were in violation of these covenants, and have
sought waivers. As of the date hereof, the bank has not waived the violations,
and if it were to demand payment of the entire balance, our liquidity would
suffer. In January 2003, in exchange for an advance of $250,000 on the line, we
designated a recurring revenue stream in the amount of approximately $40,000 per
month for repayment of the outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past due
amount, and $100,000 of the $500,000 remaining balance due was converted into
common stock at $4 per share. We are seeking an extension or conversion into
equity of some or all of the remaining past due balance.
We had $820,000 of convertible notes payable that were due on November
21, 2002. In November 2002, the note holders agreed to amend the repayment terms
of the notes to increase the interest rate to 14%, lower the conversion price to
$3 per share, establish payment terms calling for six equal monthly principal
payments beginning in January 2003 through June 2003. The value of the grant of
additional warrants and repricing of old warrants as computed using the
Black-Scholes option pricing model, combined with the resulting beneficial
conversion feature resulted in a discount to the note of $820,000, thus yielding
an effective interest rate of 114%. The discount is being amortized over the
term of the bridge notes, therefore $528,858 of the discount has been amortized
as interest expense as of March 31, 2003. In January 2003, $130,667 of the notes
were converted into 43,570 shares of common stock. As of May 31, 2003, the
balance of the January payment that was not converted into common stock amounted
to $50,107 and has not been paid, nor any other payments made.
In February 2003, a group of investors led by East-West Capital
Associates, Inc. ("East-West Capital") and its affiliate, East West Venture
Group, LLC agreed to fund the $175,000 remainder of its $3 million obligation to
purchase our common stock at $4 per share, by providing $25,000 in cash and
$150,000 through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. This repricing, as computed using the
Black-Scholes option pricing model, resulted in a discount to the note of
$200,000, thus yielding an effective interest rate of 110%. $68,333 of the
discount has been amortized as interest expense as of March 31, 2003. East-West
Capital agreed to eliminate the
26
protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
In May 2003, we received a $400,000 bridge loan from an investor
affiliated with a significant shareholder and who is a former director. The
bridge loan accrues interest at the rate of 25% per annum, is secured by all
assets of the Company, matures on the earlier of May 15, 2004, or the closing of
the sale of certain assets from the Large Enterprise operations.
The sale of assets from the Large Enterprise operations is designed to
raise cash to pay off certain liabilities and allow us to reorganize around the
Small Business software and services operations, which have recently released
two new software products. The sale of assets has not been completed, and there
is no assurance that it will be completed on terms that will be acceptable to
us, or that the proceeds will be sufficient to allow us to successfully
restructure and continue operations.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the company as a going concern.
In our view, recoverability of a major portion of the recorded asset
amounts shown in the accompanying balance sheet is dependent upon our continued
operations, which in turn is dependent upon our ability to meet obligations on a
continuing basis. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary
should we be unable to continue in existence.
Results of operations
Revenues from sales to the Large Enterprise customers increased to $1.9
million for the quarter ended March 31, 2003, a 61% increase over pro forma
combined revenues of MindArrow and CaptureQuest for the same period for the
previous year. The increase is primarily related to the addition of several
large clients. In May 2003, we entered into a non-binding letter of intent to
sell certain of the operating assets of the Large Enterprise division to
Silverpop Systems, Inc., representing nearly one-half of these revenues.
In recent months, we have introduced Axis(TM), a new software product
that enables small businesses to create, manage and host websites using
Macromedia, Inc.'s Flash(TM) technology, as well as Courier(TM), which is a
Flash-enabled email marketing tool designed for small business customers. These
products, together with professional services that will enable our customers to
make the best use of them, are central to our strategy going forward.
These new products allow us to shift our Small Business focus away from
selling third-party products through the third-party seminar channel, formerly
operated by our subsidiary, ePenzio, Inc. ("ePenzio"). At third-party workshops,
known as "lead sources," ePenzio customers generally entered into long-term
installment contracts to pay for the products and services they purchased, and
we have experienced high rates of payment default in these contracts in the past
several quarters. Accordingly, we have significantly reduced the number of
installment contracts we are accepting, and have begun to seek new lead sources
and other third-party sales channels. Quarterly revenues from our ePenzio
subsidiary have decreased from $5.6 million for the quarter ended March 31, 2002
to $0.3 million in the current quarter.
We have also shifted from selling through our direct seminar channels
operated by our subsidiary Bring it Home, Inc., ("BiH"). The seminars operated
by BiH required significant up-front cash investments in marketing in order to
be successful, and our deteriorating liquidity made it increasingly difficult to
operate the seminars profitably. Accordingly, in March 2003, we stopped selling
through the seminar channel. Revenues from BiH decreased to $1.0 million in the
quarter ended March 31, 2003, from $2.3 million in the same period of the prior
year.
27
Quarterly revenues totaled $3.3 million, a 58% decrease from the same
quarter in the previous year. Revenues for the nine months ended March 31, 2003
decreased to $10.9 million from $19.3 million for the nine months ended March
31, 2002, a 44% decrease. The decreases are primarily the result of management's
plan to reduce our dependency on lower quality ePenzio revenues.
Gross profit decreased from $4.4 million for the three months ended
March 31, 2002 to $2.1 million for the three months ended March 31, 2003. Gross
profit decreased from $11.9 million, or 62% of revenues, to $8.4 million, or 77%
of revenues, for the nine months ended March 31, 2003.
Selling, general and administrative expenses increased from $3.6
million, or 45% of revenues, and $9.0 million, or 47% of revenues, for the
quarter and nine months ended March 31, 2002, respectively, to $3.7 million, or
111% of revenues, and $13.6 million, or 125% of revenues, for the quarter and
nine months ended March 31, 2003, respectively. These increases were associated
with additional costs of integrating previously acquired companies and
professional service and other costs associated with the combination of
MindArrow and Category 5. During the quarter ended March 31, 2003, we completed
cost reductions which will reduce costs in subsequent quarters.
Bad debt expense increased to $245,001 and $4.6 million for the quarter
and nine months ended March, 31, 2003, respectively, compared to no bad debt
expense for the same periods from 2002. The increase resulted primarily from
defaults on ePenzio's contracts receivable and the discount taken when contracts
receivable were sold to financing companies. We have decreased our use of
long-term contracts receivable for revenues generated by ePenzio, and therefore
expect bad debt expense to decrease on both an absolute and relative basis in
future quarters.
We incurred a loss from operations of $27.0 million and $36.2 million
for the quarter and nine months ended March 31, 2003, respectively, compared to
income from operations of $772,105 and $2.8 million for the same periods from
2002. The loss resulted from a number of factors, including the factors
discussed in the foregoing paragraphs and the following factors:
o Writedown of goodwill and identifiable intangibles.
o The decrease in lead-source revenues and significant bad debt
expense.
o Costs associated with organizing and marketing Bring It Home
seminars;
o Increases in costs related to the acquisitions completed
during the year; and
Certain of these costs are nonrecurring, such as the costs associated
with integrating acquired companies, and the curtailing of entering into
installment contracts will significantly reduce bad debt expense in future
quarters.
The write-down of short-term investment of $1.0 million relates to a
certificate of deposit account in the name of our CaptureQuest subsidiary that
arose from an investment in CaptureQuest by Omnicorp Bank. The account was held
at Omnicorp, which was declared insolvent by regulators in October 2002.
Omnicorp has asked account holders to convert their certificates of deposit into
an investment in preferred shares of Solara Ventures, Inc. a Canadian-based
investment company. As of March 31, 2003, the entire balance was written down
due to the uncertainty surrounding any recovery.
We incurred a net loss of $27.6 million or $3.79 per share, and $36.5
million, or $6.04 per share, for the quarter and nine months ended March 31,
2003, respectively, compared to net income of $467,940, or $0.16 per share, and
$1.8 million, or $0.63 per share, for the same periods in 2002.
28
Liquidity and sources of capital
Our liquidity is significantly impacted by credit and collections
issues. Our Small Business channel formerly generated large balances of
receivables and, depending on the quality of the credit and cash needs, we sold
certain of the receivables, at a discount, to financing sources. Receivables
that have not been sold are retained and billing and collecting administration
have been outsourced. A large portion of the Small Business customers have
historically had sub-prime credit. Accordingly, many of the receivables
generated by these customers may have high credit risk.
During the last six months of calendar 2002, the Company sold a
significant portion of its contracts receivable, at a discount, in order to
raise cash. The receivables sold were typically the highest quality in the
portfolio, so the remaining contracts receivable represented the lowest quality.
Accordingly, the Company experienced high delinquencies in the remaining
receivables portfolios through December 31, 2002. This, coupled with the
writedown of a certificate of deposit and the uncertainty experienced with the
funding of the East West investment, have severely impacted the Company's
liquidity and rendered it insolvent.
At March 31, 2003, we had $60,678 in cash, which requires that we seek
immediate additional capital. As of March 31, 2003, we had current assets of
approximately $1.5 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $9.3
million. The negative working capital balance includes as current liabilities
approximately $1.3 million of deferred revenues and is mitigated by
approximately $627,000 in net contracts receivables included in long-term
assets.
Our line of credit facility with Zions Bank includes covenants for
tangible net worth and debt coverage ratios. As of March 31, 2003, the balance
on the line was $413,687, and we were in violation of these covenants, and have
sought waivers. As of the date hereof, the bank has not waived the violations,
and if it were to demand payment of the entire balance, our liquidity would
suffer. In January 2003, in exchange for an advance of $250,000 on the line, we
designated a recurring revenue stream in the amount of approximately $40,000 per
month for repayment of the outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past due
amount, and $100,000 of the $500,000 remaining balance due was converted into
common stock at $4 per share. We are seeking an extension or conversion into
equity of some or all of the past due balance.
We had $820,000 of convertible notes payable that were due on November
21, 2002. In November 2002, the note holders agreed to amend the repayment terms
of the notes to increase the interest rate to 14%, lower the conversion price to
$3 per share, establish payment terms calling for six equal monthly principal
payments beginning in January 2003 through June 2003. The value of the grant of
additional warrants and repricing of old warrants as computed using the
Black-Scholes option pricing model, combined with the resulting beneficial
conversion feature resulted in a discount to the note of $820,000, thus yielding
an effective interest rate of 114%. The discount is being amortized over the
term of the bridge notes, therefore $528,858 of the discount has been amortized
as interest expense as of March 31, 2003. In January 2003, $130,667 of the notes
were converted into 43,570 shares of common stock. As of May 31, 2003, the
balance of the January payment that was not converted into common stock amounted
to $50,107 and has not been paid, nor any other payments made.
In February 2003, a group of investors led by East-West Capital
Associates, Inc. ("East-West Capital") and its affiliate, East West Venture
Group, LLC agreed to fund the $175,000 remainder of its $3 million obligation to
purchase our common stock at $4 per share, by providing $25,000 in cash and
$150,000 through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. This repricing, as computed using the
Black-Scholes option pricing model, resulted in a discount to the note of
$200,000, thus yielding an effective interest rate of 110%. $68,333 of the
discount has been amortized as interest expense as of March 31, 2003. East-West
Capital agreed to eliminate
29
the protective provisions of the related investor rights agreement and provide
active assistance to the Company in its proposed new equity financing efforts.
In May 2003, we received a $400,000 bridge loan from an investor
affiliated with a significant shareholder and who is a former director. The
bridge loan accrues interest at the rate of 25% per annum, is secured by all
assets of the Company, matures on the earlier of May 15, 2004, or the closing of
the sale of certain assets of the Large Enterprise division. As consideration
for entering into the bridge loan the Company issued warrants to purchase
495,000 shares of common stock at $0.33 per share.
The sale of assets from the Large Enterprise operations is designed to
raise cash to pay off certain liabilities and allow us to reorganize around the
Small Business software and services operations, which have recently released
two new software products. The sale of assets has not been completed, and there
is no assurance that it will be completed on terms that will be acceptable to
us, or that the proceeds will be sufficient to allow us to successfully
restructure and continue operations.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the company as a going concern.
In our view, recoverability of a major portion of the recorded asset
amounts shown in the accompanying balance sheet is dependent upon our continued
operations, which in turn is dependent upon our ability to meet obligations on a
continuing basis. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary
should we be unable to continue in existence.
During the nine months ended March 31, 2003, we used $1,239,473 of cash
from operating activities, generated $381,250 of cash in investing activities
and generated $620,629 of cash in financing activities. During the nine months
ended March 31, 2002, we used $1,120,991 million of cash in operating
activities, used $97,567 of cash in investing activities and generated cash in
financing activities of $1,396,486.
Our liquidity has been significantly impacted by credit and collections
issues. ePenzio formerly generated large balances of installment contracts
receivable and, depending on the quality of the credit and the cash needs, we
sold certain of the receivables, at a discount, to financing sources. The
receivables that we did not sell were generated by these customers often had
high credit risk. We have recently undertaken steps designed to improve
collectibility and attempt to reclaim accounts that have been fully reserved or
written off.
We need additional capital to continue operations in the near term.
Additional capital may come from the sale of certain assets of the Large
Enterprise business or other available means, which may include debt and/or
equity financings. We cannot give assurance that any additional financing will
be available on acceptable terms, if at all. Any equity financing and debt
financing, if available, may include restrictive covenants. If we are unable to
raise additional capital and/or reach agreement with our creditors to forgive a
significant portion of the amounts owed to them, our operations will be severely
harmed.
30
Certain of the matters and subject areas discussed in this quarterly
report on Form 10-Q contain "forward-looking statements" that are subject to a
number of risks and uncertainties, many of which are beyond our control. All
statements, other than statements of historical fact included in this report
regarding our business strategy, future operations, financial position,
estimated revenues, projected costs, prospects, plans and objectives of
management as well as third parties are forward-looking statements. Generally,
when used in this report, the words "anticipate," "intend," "estimate,"
"expect," "project," and similar expressions are intended to identify
forward-looking statements, although not all forward-looking statements contain
such identifying words. All forward-looking statements speak only as of the date
of this report. Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we can give no assurance that such
expectations will prove to be correct. Important factors that could cause our
actual results to differ materially from our expectations are described below
and in our other filings with the SEC.
Risk Factors
We need additional financing
Our liquidity is significantly impacted by credit and collections
issues. Our Small Business channel formerly generated large balances of
receivables and, depending on the quality of the credit and cash needs, we sold
certain of the receivables, at a discount, to financing sources. Receivables
that have not been sold are retained and billing and collecting administration
have been outsourced. A large portion of the Small Business customers have
historically had sub-prime credit. Accordingly, many of the receivables
generated by these customers may have high credit risk.
During the last six months of calendar 2002, the Company sold a
significant portion of its contracts receivable, at a discount, in order to
raise cash. The receivables sold were typically the highest quality in the
portfolio, so the remaining contracts receivable represented the lowest quality.
Accordingly, the Company experienced high delinquencies in the remaining
receivables portfolios through December 31, 2002. This, coupled with the
writedown of a certificate of deposit and the uncertainty experienced with the
funding of the East West investment, have severely impacted the Company's
liquidity and rendered it insolvent.
At March 31, 2003, we had $60,678 in cash, which requires that we seek
immediate additional capital. As of March 31, 2003, we had current assets of
approximately $1.5 million and current liabilities of approximately $10.8
million. This represents a working capital deficit of approximately $9.3
million. The negative working capital balance includes as current liabilities
approximately $1.3 million of deferred revenues and is mitigated by
approximately $627,000 in net contracts receivables included in long-term
assets.
Our line of credit facility with Zions Bank includes covenants for
tangible net worth and debt coverage ratios. As of March 31, 2003, the balance
on the line was $413,687, and we were in violation of these covenants, and have
sought waivers. As of the date hereof, the bank has not waived the violations,
and if it were to demand payment of the entire balance, our liquidity would
suffer. In January 2003, in exchange for an advance of $250,000 on the line, we
designated a recurring revenue stream in the amount of approximately $40,000 per
month for repayment of the outstanding balance on the line.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 has not been made, and in February 2003, $50,000 of the past due
amount, and $100,000 of the $500,000 remaining balance due was converted into
common stock at $4 per share. We are seeking an extension or conversion into
equity of some or all of the remaining past due balance.
We had $820,000 of convertible notes payable that were due on November
21, 2002. In November 2002, the note holders agreed to amend the repayment terms
of the notes to increase the interest rate to 14%, lower the conversion price to
$3 per share, establish payment terms calling for six equal monthly principal
payments beginning in January 2003 through June 2003. The value of the grant of
additional warrants and repricing of old warrants as computed using the
Black-Scholes option pricing model, combined with the resulting beneficial
conversion feature resulted in a discount to the note of $820,000, thus yielding
an effective interest rate of 114%. The discount is being amortized over the
term of the bridge notes, therefore $528,858 of the discount has been amortized
as interest expense as of March 31, 2003. In January 2003, $130,667 of the notes
were converted into 43,570 shares of common stock. As of May 31, 2003, the
balance of the January payment that was not converted into common stock amounted
to $50,107 and has not been paid, nor any other payments made.
31
In February 2003, a group of investors led by East-West Capital
Associates, Inc. ("East-West Capital") and its affiliate, East West Venture
Group, LLC agreed to fund the $175,000 remainder of its $3 million obligation to
purchase our common stock at $4 per share, by providing $25,000 in cash and
$150,000 through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. In addition, the
February 2003 amendment to the stock purchase agreement terminated the remaining
financing commitment of $800,000 in exchange for a cash investment of $200,000
in the Company by East-West Capital in the form of a convertible secured
debenture, bearing interest at 10% per annum, and maturing on the earlier of 120
days from the funding date or the closing of a financing for at least an
additional $500,000 or more of equity or debt. The debenture may be converted at
the option of the holder at the lesser of (i) $1.375 per share or (ii) the same
terms and conditions as a proposed new equity financing by the Company. The
Company also agreed to reprice previous warrants issued to East-West Capital and
its affiliates to $2.00 per share. This repricing, as computed using the
Black-Scholes option pricing model, resulted in a discount to the note of
$200,000, thus yielding an effective interest rate of 110%. $68,333 of the
discount has been amortized as interest expense as of March 31, 2003. East-West
Capital agreed to eliminate the protective provisions of the related investor
rights agreement and provide active assistance to the Company in its proposed
new equity financing efforts.
In May 2003, we received a $400,000 bridge loan from an investor
affiliated with a significant shareholder and who is a former director. The
bridge loan accrues interest at the rate of 25% per annum, is secured by all
assets of the Company, matures on the earlier of May 15, 2004, or the closing of
the sale of certain assets of the Large Enterprise division.
The sale of assets from the Large Enterprise operations is designed to
raise cash to pay off certain liabilities and allow us to reorganize around the
Small Business software and services operations, which have recently released
two new software products. The sale of assets has not been completed, and there
is no assurance that it will be completed on terms that will be acceptable to
us, or that the proceeds will be sufficient to allow us to successfully
restructure and continue operations.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the company as a going concern.
In our view, recoverability of a major portion of the recorded asset
amounts shown in the accompanying balance sheet is dependent upon our continued
operations, which in turn is dependent upon our ability to meet obligations on a
continuing basis. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary
should we be unable to continue in existence.
THERE CAN BE NO ASSURANCE THAT THE PROPOSED SALE OF ASSETS WILL CLOSE
OR THAT ANY ADDITIONAL FINANCING WILL BE AVAILABLE ON ACCEPTABLE TERMS, IF AT
ALL. IF WE ARE UNSUCCESSFUL IN RAISING ADDITIONAL FUNDS, OUR LIQUIDITY POSITION
WILL BE MATERIALLY AND ADVERSELY AFFECTED AND WE COULD BE REQUIRED TO MAKE
DRASTIC COST REDUCTIONS, WHICH WOULD NEGATIVELY IMPACT OUR OPERATIONS.
Although we believe our assumptions underlying our operating plan to be
reasonable, we lack the operating history of a more seasoned company and there
can be no assurance that our forecasts will prove accurate. In the event that
our plans change, our assumptions change or prove inaccurate, if the committed
financing falls through, or if future private placements, other capital
resources and projected cash flow otherwise prove to be insufficient to fund
operations, we could be required to seek additional financing sooner than
currently anticipated. To the extent that we are able to raise additional funds
and it involves the sale of our equity securities, the interests of our
shareholders could be substantially diluted.
32
Recent actions that we have taken may negatively impact our ability to achieve
our business objectives
In order to manage our liquidity and cash position, over the past year
we have had to implement certain cost cutting measures, including significant
reductions in force. After these staff reductions, as of June 15, 2003, we had
52 full time employees. Although these cost cutting measures have improved our
short-term cash requirements, they may negatively impact our ability to grow our
business and achieve our business objectives.
Our limited operating history makes evaluation of our business difficult
We have a limited operating history on which to base our evaluation of
current business and prospects. Our short operating history makes it difficult
to predict future results, and there are no assurances that our revenues will
increase, or that we will achieve or maintain profitability or generate
sufficient cash from operations in future periods.
Our ability to achieve and sustain profitability would be adversely
affected if we:
o fail to effectively market and sell our services;
o fail to develop new and maintain existing relationships with
clients;
o fail to continue to develop and upgrade our technology and
network infrastructure;
o fail to respond to competitive developments;
o fail to introduce enhancements to our existing products and
services to address new technologies and standards; or
o fail to attract and retain qualified personnel.
Our operating results are also dependent on factors outside of our
control, such as strength of competition and the growth of the market for our
services. There is no assurance that we will be successful in addressing these
risks, and failure to do so could have a material adverse effect on our
financial performance.
We expect to incur losses in the near term, and if we are unable to
generate sufficient cash flow or raise the capital necessary to allow us to
continue to meet all of our obligations as they come due, our business could
suffer.
Our future revenues are not predictable, and our results could vary
significantly
Because of our limited operating history and the emerging nature of our
markets, we are unable to reliably forecast our revenues.
Our operating results may fluctuate significantly in the future as a
result of a variety of factors. These factors include:
o the demand for our services;
o the addition or loss of individual clients;
o the amount and timing of capital expenditures and other costs
relating to the expansion of our operations;
o the introduction of new products or services by us or our
competitors; and
o general economic conditions and economic conditions specific
to the Internet, such as electronic commerce and online media.
Any one of these factors could cause our revenues and operating results
to vary significantly. In addition, as a strategic response to changes in the
competitive environment, we may from time to time make certain pricing, service
or marketing decisions or acquisitions that could significantly hurt our
operating results in a given period.
Due to all of the foregoing factors, we believe that period-to-period
comparisons of our results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance. Furthermore, it
is possible that our operating results in one or more quarters will fail to meet
the expectations of investors. In such event, the market price of our common
stock could drop.
33
If we are unable to obtain funding, our customers and vendors may decide not to
do business with us
If we are unable to continue funding our operations at our current
levels, and if customers and vendors become concerned about our business
prospects, they may decide not to conduct business with us, or may conduct
business with us on terms that are less favorable than those customarily
extended by them. In that event, our revenues would decrease and our business
will suffer significantly.
We are not sure if the market will accept our product offerings
Our ability to succeed will depend on the following, none of which can
be assured:
o the effectiveness of our marketing and sales efforts;
o market acceptance of our current and future offerings; and
o the reliability of our networks and services.
We operate in a market that is in the early stage of development, is
rapidly evolving, and is characterized by an increasing number of competitors
and risk surrounding market acceptance of new technologies and services.
Potential customers must view our technologies as a viable alternative to
traditional commercial advertising and brochure distribution. Because this
market is so new, it is difficult to predict its size and growth rate. If the
market fails to develop as we expect, our growth will be slower than expected.
We may make acquisitions of complementary technologies or businesses, which may
disrupt our business and be dilutive to our existing stockholders.
We intend to consider acquisitions of businesses and technologies on an
opportunistic basis. Acquisitions of businesses and technologies involve
numerous risks, including the diversion of management attention, difficulties in
assimilating the acquired operations, loss of key employees from the acquired
company, and difficulties in transitioning key customer relationships. In
addition, these acquisitions may result in dilutive issuances of equity
securities, the incurrence of additional debt, large one-time expenses and the
creation of goodwill or other intangible assets that result in significant
amortization expense and impairment charges. Any acquisition may not provide the
benefits originally anticipated, and there may be difficulty in integrating the
service offerings and customer and supplier relationships gained through
acquisitions with our own. Although we attempt to minimize the risk of
unexpected liabilities and contingencies associated with acquired businesses
through planning, investigation and negotiation, such unexpected liabilities
nevertheless may accompany such acquisitions. We cannot guarantee that we will
successfully identify attractive acquisition candidates, complete and finance
additional acquisitions on favorable terms, or integrate the acquired businesses
or assets into our own. Any of these factors could materially harm our business
or our operating results in a given period.
Network and system failures could adversely impact our business
The performance, reliability and availability of our Web sites and
network infrastructure is critical to our reputation and ability to attract and
retain clients. Our systems and operations are vulnerable to damage or
interruption from earthquake, fire, flood, power loss, telecommunications
failure, Internet breakdowns, break-ins, tornadoes and similar events. We carry
business interruption insurance to compensate for losses that may occur, but
insurance is not guaranteed to remove all risk of loss. Services based on
sophisticated software and computer systems often encounter development delays
and the underlying software may contain errors that could cause system failures.
Any system failure that causes an interruption could result in a loss of clients
and could reduce the attractiveness of our services.
We are also dependent upon Web browsers, Internet service providers and
online service providers to provide Internet users access to our clients, users
and Web sites. Users may experience difficulties due to
34
system failures or delays unrelated to our systems. These difficulties may hurt
audio and video quality or result in intermittent interruptions in broadcasting
and thereby slow our growth.
Circumvention of our security measures and viruses could disrupt our business
Despite the implementation of security measures, our networks may be
vulnerable to unauthorized access, computer viruses and other disruptive
problems. Anyone who is able to circumvent security measures could steal
proprietary information or cause interruptions in our operations. Service
providers have occasionally experienced interruptions in service as a result of
the accidental actions of users or intentional actions of hackers. We may have
to spend significant capital to protect against security breaches or to fix
problems caused by such breaches. Although we have implemented security
measures, there can be no assurance that such measures will not be circumvented
in the future. Eliminating computer viruses and alleviating other security
problems may require interruptions, delays or cessation of service to users,
which could hurt our business.
We depend on continued growth in use of the Internet
Rapid growth in use of the Internet is a recent phenomenon and there
can be no assurance that use of the Internet will continue to grow or that a
sufficient base of users will emerge to support our business. The Internet may
not be accepted as a viable medium for broadcasting advertising and brochure
distribution, for a number of reasons, including:
o inadequate development of the necessary infrastructure;
o inadequate development of enabling technologies;
o lack of acceptance of the Internet as a medium for
distributing rich media advertising; and
o inadequate commercial support for Web-based advertising.
To the extent that Internet use continues to increase, there can be no
assurance that the Internet infrastructure will be able to support the demands
placed upon it, and especially the demands of delivering high-quality video
content.
Furthermore, user experiences on the Internet are affected by access
speed. There is no assurance that broadband access technologies will become
widely adopted. In addition, the Internet could lose its viability as a
commercial medium due to delays in the development or adoption of new standards
and protocols required to handle increased levels of Internet activity, or due
to increased government regulation. Our business could suffer if use of the
Internet grows more slowly than expected, or if the Internet infrastructure does
not effectively support the growth that does occur.
We may be unable to collect our receivables and retainages in amounts previously
estimated.
In accordance with United States generally accepted accounting
principles, we have established reserves against our retainages and receivables.
We believe that the established reserves adequately allow for the estimated
uncollectible portion of the retainages and receivables. However, we may
experience collection rates below established reserves, which could reduce the
amount of available funds and require additional reserves. Reduced available
funds could adversely affect our ability to successfully implement the
objectives of our business plan. There can be no assurance that we will be able
to collect retainages and receivables in sufficient amounts. Failure to collect
adequate amounts of retainages and receivables could materially adversely affect
our business and results of operations. There are low barriers to entry in our
small business market, which could result in increased competition in the
future.
The market for Internet-based services is relatively new, intensely
competitive and rapidly evolving. There are minimal barriers to entry, and
current and new competitors can launch new Internet products and services at a
relatively low cost within relatively short time periods. We expect competition
to persist and intensify and the number of competitors to increase significantly
in the future. Should we seek in the future to attempt to expand the scope of
our Internet services and product offerings, we will compete with a greater
number of Internet companies. Because the operations and strategic plans of
existing and
35
future competitors are undergoing rapid change, it is difficult for us to
anticipate which companies are likely to offer competitive products and services
in the future.
If we do not respond to technological change, we could lose or fail to develop
customers.
The development of our business entails significant technical and
business risks. To remain competitive, we must continue to enhance and improve
the functionality and features of our technology. The Internet and the ecommerce
industry are characterized by:
o rapid technological change;
o changes in client requirements and preferences;
o frequent new product and service introductions embodying new
technologies; and
o the emergence of new industry standards and practices.
The evolving nature of the Internet could render our existing systems obsolete.
Our success will depend, in part, on our ability to:
o develop and enhance technologies useful in our business;
o develop new services and technology that address the
increasingly sophisticated and varied needs of our current and
prospective clients; and
o adapt to technological advances and emerging industry and
regulatory standards and practices in a cost-effective and
timely manner.
Future advances in technology may not be beneficial to, or compatible
with, our business. Furthermore, we may not use new technologies effectively or
adapt our systems to client requirements or emerging industry standards on a
timely basis. Our ability to remain technologically competitive may require
substantial expenditures and lead time. If we are unable to adapt to changing
market conditions or user requirements in a timely manner, we will lose clients.
We could face liability for Internet content
As a distributor of Internet content, we face potential liability for
negligence, copyright, patent or trademark infringement, defamation, indecency
and other claims based on the content of our broadcasts. Such claims have been
brought, and sometimes successfully pressed, against Internet content
distributors. Our general liability insurance may not be adequate to indemnify
us for all liability that may be imposed. Although we generally require our
clients to indemnify us for such liability, such indemnification may be
inadequate. Any imposition of liability that is not covered by insurance or by
an indemnification by a client could harm our business.
Our operating results could be impaired if we become subject to burdensome
government regulations and legal uncertainties concerning the Internet
Due to the increasing popularity and use of the Internet, it is
possible that a number of laws and regulations may be adopted with respect to
the Internet, relating to:
o user privacy;
o pricing, usage fees and taxes;
o content;
o copyrights;
o distribution;
o characteristics and quality of products and services; and
o online advertising and marketing.
36
The adoption of any additional laws or regulations may decrease the
popularity or impede the expansion of the Internet and could seriously harm our
business. A decline in the popularity or growth of the Internet could decrease
demand for our products and services, reduce our revenues and margins and
increase our cost of doing business. Moreover, the applicability of existing
laws to the Internet is uncertain with regard to many important issues,
including property ownership, intellectual property, export of encryption
technology, libel and personal privacy. The application of laws and regulations
from jurisdictions whose laws do not currently apply to our business, or the
application of existing laws and regulations to the Internet and other online
services, could also harm our business.
Our stock price has been and may continue to be volatile
The trading price of our common stock has been and is likely to
continue to be highly volatile. For example, on May 1, 2003, our common stock
closed at $0.23 per share, and on November 12, 2002, our common stock closed at
$4.70 per share. Our stock price could be subject to wide fluctuations in
response to factors such as:
o the average daily trading volume of our common stock;
o actual or anticipated variations in quarterly operating
results and our need for additional financing to fund our
continuing operations;
o announcements of technological innovations, new products or
services by us or our competitors;
o the addition or loss of strategic relationships or
relationships with our key customers;
o conditions or trends in the Internet, streaming media, media
delivery, and online commerce markets;
o changes in the market valuations of other Internet, online
service, or software companies;
o announcements by us or our competitors of significant
acquisitions, strategic partnerships, joint ventures, or
capital commitments;
o sales of our common stock and legal or regulatory
developments;
o additions or departures of key personnel;
o our failure to obtain additional financing on satisfactory
terms, or at all; and
o general market conditions.
o need to file bankruptcy if we cannot restructure our debt
The historical volatility of our stock price may make it more difficult
for investors in our securities to resell shares at prices they find attractive.
In addition, the stock market in general, the Nasdaq SmallCap Market,
the market for Internet and technology companies in particular, have experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of these companies. These broad
market and industry factors may reduce our stock price, regardless of our
operating performance.
Failure to satisfy Nasdaq SmallCap Market listing requirements may result in our
stock being delisted from The Nasdaq SmallCap Market.
Our common stock is currently listed on The Nasdaq SmallCap Market
under the symbol "AVLN." For continued inclusion on The Nasdaq SmallCap Market,
we must maintain, among other requirements, a minimum bid price of $1.00 per
share. On April 8, 2003, Nasdaq notified us that we are not in compliance with
Nasdaq's minimum bid price per share required for continued listing on the
Nasdaq SmallCap Market. We have until October 6, 2003 to regain compliance with
Nasdaq's minimum bid requirement by maintaining the minimum closing bid price
per share for a minimum of 10 consecutive trading days by that date.
37
In addition, On May 27, 2003, Nasdaq notified us that we were not in
compliance with Nasdaq's requirement that we remain current in making all
required filings with the SEC and that we had not paid our annual listing fees.
We have been granted a hearing before Nasdaq's Listing Qualifications Panel on
June 26, 2003, where a determination will be made whether we have regained
compliance with the continued listing standards.
In the event that we fail to satisfy the listing standards on a
continuous basis, our common stock may be removed from listing on The Nasdaq
SmallCap Market. If our common stock was delisted from The Nasdaq SmallCap
Market, trading of our common stock, if any, may be conducted in the
over-the-counter market in the so-called "pink sheets" or, if available, the
"Bulletin Board." As a result, stockholders could find it more difficult to
dispose of, or to obtain accurate quotations as to the value of, our common
stock, and the trading price per share could be reduced.
Insiders own approximately 38% of our outstanding common stock and their
interests could conflict with those of other stockholders.
Our current directors and senior employees own approximately 38% of our
outstanding common stock. As a result, the directors and executive officers
collectively may be able to substantially influence all matters requiring
stockholder approval, including the election of directors and approval of
significant corporate transactions. Such concentration of ownership may also
have the effect of delaying or preventing a change in control.
Future sales of our common stock may depress our stock price
Sales of a substantial number of shares of our common stock in the
public market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. As of June 25, 2003, we
had 7,348,279 shares of common stock outstanding. A significant number of these
shares are not publicly traded but are available for immediate resale to the
public. We also have reserved shares of our common stock as follows:
o 2,987,509 shares are reserved for issuance upon the exercise
of warrants;
o 1,071,264 shares are reserved for issuance upon the exercise
of stock options.
Shares underlying vested options are generally eligible for immediate
resale in the public market.
Our efforts to protect our intellectual property rights may not sufficiently
protect us and we may incur costly litigation to protect our rights
We have filed nineteen patent applications and we plan to file
additional patent applications in the future with respect to various additional
aspects of our technologies. In addition, we have received patents on technology
we obtained in the Control Commerce and Radical Communication acquisitions. We
mark our software with copyright notices, and intend to file copyright
registration applications where appropriate. We have also filed several federal
trademark registration applications for trademarks and service marks we use.
There can, however, be no assurance that any patents, copyright registrations,
or trademark registrations applied for by us will be issued, or if issued, will
sufficiently protect our proprietary rights.
We also rely substantially on certain technologies that are not
patentable or proprietary and are therefore available to our competitors. In
addition, many of the processes and much of our technology are dependent upon
our technical personnel, whose skill, knowledge and experience are not
patentable. To protect our rights in these areas, we require all employees,
significant consultants and advisors to enter into confidentiality agreements
under which they agree not to use or disclose our confidential information as
long as that information remains proprietary. We also require that our employees
agree to assign to us all rights to any inventions made during their employment
relating to our activities, and not engage in activities similar to ours during
the term of their employment. There can be no assurance, however, that these
agreements will provide meaningful protection for our trade secrets, know-how or
other proprietary information in the event of any unauthorized use or disclosure
of such trade secrets, know-how or proprietary information. Further, in the
absence of patent protection, we may be exposed to competitors
38
who independently develop substantially equivalent technology or otherwise gain
access to our trade secrets, knowledge or other proprietary information.
Despite our efforts to protect our intellectual property, a third party
or a former employee could copy, reverse-engineer or otherwise obtain and use
our intellectual property or trade secrets without authorization or could
develop technology competitive to ours.
Our intellectual property may be misappropriated or infringed upon.
Consequently, litigation may be necessary in the future to enforce our
intellectual property rights, to protect our confidential information or trade
secrets, or to determine the validity or scope of the rights of others.
Litigation could result in substantial costs and diversion of management and
other resources and may not successfully protect our intellectual property.
Additionally, we may deem it advisable to enter into royalty or licensing
agreements to resolve such claims. Such agreements, if required, may not be
available on commercially reasonable or desirable terms or at all.
Our technology may infringe on the rights of others
Even if the patents, copyrights and trademarks we apply for are
granted, they do not confer on us the right to manufacture or market products or
services if such products or services infringe on intellectual property rights
held by others. If any third parties hold conflicting rights, we may be required
to stop making, using, or marketing one or more of our products or to obtain
licenses from and pay royalties to others, which could have a significant and
material adverse effect on us. There can be no assurance that we will be able to
obtain or maintain any such license on acceptable terms or at all.
We may also be subject to litigation to defend against claims of
infringement of the rights of others or to determine the scope and validity of
the intellectual property rights of others. If third parties hold trademark,
copyright or patent rights that conflict with our business, then we may be
forced to litigate infringement claims that could result in substantial costs to
us. In addition, if we were unsuccessful in defending such a claim, it could
have a negative financial impact. If third parties prepare and file applications
in the United States that claim trademarks used or registered by us, we may
oppose those applications and be required to participate in proceedings before
the United States Patent and Trademark Office to determine priority of rights to
the trademark, which could result in substantial costs to us. An adverse outcome
in litigation or privity proceedings could require us to license disputed rights
from third parties or to cease using such rights. Any litigation regarding our
proprietary rights could be costly, divert management's attention, result in the
loss of certain of our proprietary rights, require us to seek licenses from
third parties and prevent us from selling our services, any one of which could
have a negative financial impact. In addition, inasmuch as we broadcast content
developed by third parties, our exposure to copyright infringement actions may
increase because we must rely upon such third parties for information as to the
origin and ownership of such licensed content. We generally obtain
representations as to the origin and ownership of such licensed content and
generally obtain indemnification to cover any breach of such representations;
however, there can be no assurance that such representations will be accurate or
given, or that such indemnification will adequately protect us.
The length of our sales cycle increases our costs
Many of our potential customers conduct extensive and lengthy
evaluations before deciding whether to purchase or license our products. In our
experience to date we've seen the sales cycle range from a few days up to six
months. While the potential customer is making this decision, we continue to
incur salary, travel and other similar costs of following up with these
accounts. Therefore, the risk associated with our lengthy sales cycle is that we
may expend substantial time and resources over the course of the sales cycle
only to realize no revenue from such efforts if the customer decides not to
purchase from us. Any significant change in customer buying decisions or sales
cycles for our products could have a material adverse effect on our business,
results of operations, and financial conditions.
There are risks inherent in conducting international operations
There are many risks associated with our international operations in
eastern Asia, including, but not limited to:
39
o difficulties in collecting accounts receivable and longer
collection periods;
o changing and conflicting regulatory requirements;
o potentially adverse tax consequences;
o tariffs and general export and customs restrictions;
o difficulties in staffing and managing foreign operations;
o political instability;
o fluctuations in currency exchange rates;
o the need to develop localized versions of our products;
o national standardization and certification requirements;
o seasonal reductions of business activity; and
o the impact of local economic conditions and practices.
Any of the above-listed risks could have a material adverse effect on
our future business, financial condition, or results of operations.
International markets for online marketing are in their very early stages of
development
We distribute email messages globally. To date, we have developed or
modified into foreign language text and delivered rich media content to
recipients in the United Kingdom, France, Switzerland, Austria, Norway, Sweden,
Iceland, Finland, Denmark, Greece, Lebanon, Mexico, Panama, Peru, Philippines,
Australia, Singapore, Hong Kong, China, and Taiwan. The markets for online
advertising and direct marketing in these countries are generally in earlier
stages of development than in the United States, and we cannot assure you that
the market for, and use of online advertising and direct marketing in
international markets such as these and others will be significant in the
future. Factors that may account for slower growth in the online advertising and
direct marketing markets include, but are not limited to:
o slower growth in the number of individuals using the Internet
internationally;
o privacy concerns;
o a lower rate of advertising spending internationally than in
the United States; and
o a greater reluctance to use the Internet for advertising and
direct marketing.
Any of the above-listed risks could have a material adverse effect on
our future business, financial condition, or results of operations.
We are subject to risks associated with governmental regulation and legal
uncertainties
We are subject to general business laws and regulations. These laws and
regulations, as well as new laws and regulations that may be adopted in the
United States and other countries with respect to the Internet, may impede the
growth of the Internet. These laws may relate to areas such as advertising,
taxation, personal privacy, content issues (such as obscenity, indecency, and
defamation), copyright and other intellectual property rights, encryption,
electronic contracts and "digital signatures," electronic commerce liability,
email, network and information security, and the convergence of traditional
communication services with Internet communications, including the future
availability of broadband transmission capability. Other countries and political
organizations are likely to impose or favor more and different regulation than
that which has been proposed in the United States, thus furthering the
complexity of regulation. In addition, state and local governments may impose
regulations in addition to, inconsistent with, or stricter than, federal
regulations. The adoption of such laws or regulations, and uncertainties
associated with their validity, applicability, and enforcement, may affect the
available distribution channels for and costs associated with our products and
services, and may affect the growth of the Internet. Such laws or regulations
may therefore harm our business.
40
We do not know for certain how existing laws governing issues such as
privacy, property ownership, copyright and other intellectual property issues,
taxation, illegal or obscene content, retransmission of media, and data
protection, apply to the Internet. The vast majority of such laws were adopted
before the advent of the Internet and related technologies and do not address
the unique issues associated with the Internet and related technologies. Most of
the laws that relate to the Internet have not yet been interpreted. Changes to
or the interpretation of these laws could:
o limit the growth of the Internet;
o create uncertainty in the marketplace that could reduce demand
for our products and services;
o increase our cost of doing business;
o expose us to significant liabilities associated with content
distributed or accessed through our products or services, and
with our provision of products and services, and with the
features or performance of our products;
o lead to increased product development costs, or otherwise harm
our business; or
o decrease the rate of growth of our user base and limit our
ability to effectively communicate with and market to our user
base.
Any of the above-listed consequences could have a material adverse
effect on our future business, financial condition, or results of operations.
We may be subject to legal liability in connection with the data collection
capabilities of our products and services
Our products are interactive Internet applications that by their very
nature require communication between a client and server to operate. To provide
better consumer experiences and to operate effectively, our products
occasionally send information to servers at MindArrow. Many of the services we
provide also require that users provide information to us. We post privacy
policies concerning the use and disclosure of our user data. Any failure by us
to comply with our posted privacy policies could impact the market for our
products and services, subject us to litigation, and harm our business.
In addition, the Child Online Privacy Protection Act ("COPPA") became
effective as of April 21, 2000. COPPA requires operators of commercial Web sites
and online services directed to children (under 13), and general audience sites
that know that they are collecting personal information from a child, to:
o provide parents notice of their information practices;
o obtain verifiable parental consent before collecting a child's
personal information, with certain limited exceptions;
o give parents a choice as to whether their child's information
will be disclosed to third parties;
o provide parents access to their child's personal information
and allow them to review it and/or have it deleted;
o give parents the opportunity to prevent further use or
collection of information; not require a child to provide more
information than is reasonably necessary to participate in an
activity; and
o maintain the confidentiality, security, and integrity of
information collected from children.
We do not knowingly collect and disclose personal information from such
minors, and therefore believe that we are fully compliant with COPPA. However,
the manner in which COPPA may be interpreted and enforced cannot be fully
determined, and thus COPPA and future legislation such as COPPA could subject us
to potential liability, which in turn would harm our business.
41
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not believe that we currently have material exposure to interest
rate, foreign currency exchange rate or other relevant market risks.
Interest Rate and Market Risk. Our exposure to market risk for changes
in interest rates relates primarily to our investment profile. As of March 31,
2003, our investment portfolio consisted primarily of cash and cash equivalents,
substantially all of which were held at two financial institutions. We do not
use derivative financial instruments in our investment portfolio.
Foreign Currency Exchange Risk. We do not believe that we currently
have material exposure to foreign currency exchange risk because of the relative
insignificance of our foreign subsidiaries. We intend to assess the need to use
financial instruments to hedge currency exposures on an ongoing basis.
We do not use derivative financial instruments for speculative trading
purposes.
Item 4. CONTROLS AND PROCEDURES
(a.) Our Chief Executive Officer and Chief Financial Officer have evaluated
the effectiveness of our disclosure controls and procedures (as defined
in Rules 13(a) or 15(d), as applicable, of the Securities Exchange Act
of 1934) as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"). Based on such evaluation,
such officers have concluded that, as of the Evaluation Date, our
disclosure controls and procedures are effective in alerting our
management on a timely basis to material information required to be
disclosed in our reports filed under the Exchange Act.
(b.) There have been no significant changes in our internal controls or in
other factors that could significantly affect such controls since the
Evaluation Date.
42
PART II-OTHER INFORMATION
Item 1. Legal Proceedings
From time to time the Company is subject to legal proceedings and
claims in the ordinary course of business, including claims of alleged
infringement of trademarks, copyrights and other intellectual property rights.
In 1999 and 2000, MindArrow was a victim of a fraud perpetrated by its
former transfer agent and her accomplice, who were convicted of felonies arising
from the scheme. At sentencing hearings in April and July 2002, the perpetrators
were ordered to pay to the Company $10.9 million in restitution in addition to
amounts already received. In addition, the Company continues to pursue recovery
of the loss it incurred as a result of the fraud perpetrated against the
Company, and the Audit Committee of the Company's Board of Directors has
retained special counsel to assist it in pursuing potential sources of recovery.
Eight individuals and twelve entities have been named as defendants in lawsuits
initiated by the Company. The Company cannot predict whether or when it will
obtain any additional recovery. Because of the uncertainties surrounding
recoveries, the Company will not record the impact of recoveries until amounts
or assets are received.
In May 2003, the Company settled a dispute with MindArrow's former
landlord over amounts due under a lease for MindArrow's former facilities. The
settlement, in the amount of $803,000, is included in "Accounts payable and
accrued liabilities" on the accompanying consolidated balance sheet, and calls
for payments of $5,000 per month beginning in July 2003, increasing to $10,000
per month beginning in March 2004, and increasing to $100,000 per quarter
beginning in January 2005 until the balance is paid.
The Company settled a lawsuit filed by Sunrise International Leasing
Corporation with the District Court, Fourth Judicial District, in the County of
Hennepin, Minnesota, on May 6, 2002, for default of payment and breach of lease
on two equipment leases. The equipment has been returned and we agreed to pay a
net of $137,000 to Sunrise in settlement, the full amount of which has been
included in accounts payable and accrued liabilities at March 31, 2003.
The Company settled a lawsuit filed by EMC Corporation with the Orange
County Superior Court on July 11, 2002, for failure of payment on equipment. The
plaintiff is seeking monetary damages in the amount of $117,526. The Company has
agreed to a settlement of $9,564, to be paid by July 17, 2003. The full amount
of the claim has been included with accounts payable and accrued liabilities at
March 31, 2003.
The Company is a defendant in a lawsuit filed by RR Donnelley & Sons
Company with the Orange County Superior Court on March 25, 2003, for failure of
payment for services provided to Category 5 Technologies, Inc. The plaintiff is
seeking monetary damages in the amount of $82,324. The Company anticipates
settling for damages, the full amount of which have been included with accounts
payable and accrued liabilities at March 31, 2003.
The Company is a defendant in a lawsuit filed by Bowne of Los Angeles,
Inc. with the Los Angeles County Superior Court on March 13, 2003, for failure
of payment for services. The plaintiff is seeking monetary damages in the amount
of $141,169. The Company anticipates settling for damages, the full amount of
which have been included with accounts payable and accrued liabilities at March
31, 2003.
The Company is a defendant in a lawsuit filed by iMatcher, Inc. with
the Supreme Court of the State of New York, County of Suffolk on May 28, 2003,
for failure of payment for services. The plaintiff is seeking monetary damages
in the amount of $156,460. The Company anticipates settling for damages, the
$53,673 of which have been included with accounts payable and accrued
liabilities at March 31, 2003.
43
Item 2. Changes in Securities and Use of Proceeds
During the quarter ended March 31, 2003, the Company issued the
following equity securities in transactions not registered under the Securities
Act:
On January 31, 2003 the Company acquired Mindwire, Inc. in exchange for
46,700 shares of common stock valued at $1.36 per share, which were issued to
the stockholders of Mindwire, Inc.
In February 2003, a $50,000 advance made by Michael Ray was converted
into 40,000 shares of common stock and warrants to purchase an additional 20,000
shares at $2 per share.
In June 2002, MindArrow obtained a commitment for between $3 million
and up to $4 million in financing by offering up to 1 million shares of common
stock at a price of $4.00 per share from a group of investors led by East-West
Capital Associates, Inc. ("East-West Capital") and its affiliate, East West
Venture Group, LLC. Through December 31, 2002, the Company had received $2.825
million in proceeds towards the $3.0 million minimum commitment and $200,000
towards the $1 million portion subject to a demand by the Company's board of
directors. During the quarter ended December 31, 2002, 25,000 shares of common
stock were issued pursuant to partial closings under this commitment. The stock
purchase agreement, as amended in February 2003 called for the remaining
$175,000 of the minimum commitment to be funded by providing $25,000 in cash and
$150,000 through the conversion of a portion of the note payable to Radical
Communication, Inc. into common stock on the same terms. East-West Capital is
the owner of 20% of the capital stock of Radical Communication, Inc.
All of the foregoing issuances were without registration under the
Securities Act in reliance upon the exemption from the registration requirements
of the Securities Act set forth in Section 4(2) of the Securities Act and
Regulation D thereunder. The recipients of securities in each transaction
represented their intentions to acquire the securities for investment only and
not with a view to or for sale in connection with any distribution thereof.
These sales were made without general solicitation or advertising. Each
recipient was either an accredited or sophisticated investor and had adequate
access to relevant information about us.
Item 3. Defaults Upon Senior Securities
The Company is in default on $690,000 of convertible notes payable to
sixteen investors (the "Convertible Notes"). The terms of the notes, as amended
in November 2002, call for interest to be paid at the rate of 14% per annum, and
principal to be paid in six equal monthly principal payments beginning in
January 2003 through June 2003. As of May 31, 2003, the balance of the January
payment that was not converted into common stock amounted to $50,107 and has not
been paid, nor any other payments made. The total amount of past due principal
and interest as of that date is $605,527.
The $250,000 principal payment due to Radical Communication, Inc. on
October 1, 2002 was not made. In February 2003, $150,000 of the note balance was
converted into 37,500 shares of common stock and warrants to purchase 43,125
shares of common stock at $2 per share. The Company is seeking an extension or
conversion into equity of some or all of the remaining overdue balance.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
44
Item 6. Exhibits and Reports on Form 8-K
(A) EXHIBITS
10.10 Second Amendment to Agreements, dated February 18, 2003
(B) REPORTS ON FORM 8-K
On June 20, 2003, the Registrant filed a Report on Form 8-K disclosing
under Item 4 that it had made a change in certifying auditors, from Grant
Thornton LLP to Tanner + Co., P.C.
Signatures, and Certifications of the Chief Executive Officer and the Chief
Financial Officer of the Company.
The following pages include the Signatures page for this Form 10-Q, and two
separate Certifications of the Chief Executive Officer (CEO) and the Chief
Financial Officer (CFO) of the company.
The first form of Certification is required by Rule 13a-14 under the Securities
Exchange Act of 1934 (the Exchange Act) in accord with Section 302 of the
Sarbanes-Oxley Act of 2002 (the Section 302 Certification). The Section 302
Certification includes references to an evaluation of the effectiveness of the
design and operation of the company's "disclosure controls and procedures" and
its "internal controls and procedures for financial reporting". Item 4 of Part I
of this Quarterly Report presents the conclusions of the CEO and the CFO about
the effectiveness of such controls based on and as of the date of such
evaluation (relating to Item 4 of the Section 302 Certification), and contains
additional information concerning disclosures to the company's Audit Committee
and independent auditors with regard to deficiencies in internal controls and
fraud (Item 5 of the Section 302 Certification) and related matters (Item 6 of
the Section 302 Certification).
The second form of Certification is required by section 1350 of chapter 63 of
title 18 of the United States Code.
45
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Avalon Digital Marketing Systems, Inc.
--------------------------------------
(Registrant)
Date: June 26, 2003 /s/ ROBERT I. WEBBER
-------------------------------------
Robert I. Webber
Chief Executive Officer and President
(Principal Executive Officer)
Date: June 26, 2003 /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary, and
Treasurer (Principal Financial and
Accounting Officer)
46
CERTIFICATION
I, Robert I. Webber, certify that:
1) I have reviewed this quarterly report on Form 10-Q of Avalon Digital
Marketing Systems, Inc.;
2) Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4) The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5) The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6) The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: June 26, 2003, by /s/ ROBERT I. WEBBER
-------------------------------------
Robert I. Webber
Chief Executive Officer and President
(Principal Executive Officer)
47
CERTIFICATION
I, Michael R. Friedl, certify that:
1) I have reviewed this quarterly report on Form 10-Q of Avalon Digital
Marketing Systems, Inc.;
2) Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4) The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5) The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6) The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: June 26, 2003, by /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary, and
Treasurer (Principal Financial and
Accounting Officer)
48
CERTIFICATION (continued)
Each of the undersigned hereby certifies, for the purposes of section 1350 of
chapter 63 of title 18 of the United States Code, in his capacity as an officer
of Avalon Digital Marketing Systems, Inc. ("Avalon"), that, to his knowledge,
the Quarterly Report of Avalon on Form 10-Q for the period ended March 31, 2003,
fully complies with the requirements of Section 13(a) or 15(d), as applicable,
of the Securities Exchange Act of 1934 and that the information contained in
such report fairly presents, in all material respects, the financial condition
and results of operation of Avalon.
Date: June 26, 2003 /s/ ROBERT I. WEBBER
-------------------------------------
Robert I. Webber
Chief Executive Officer and President
(Principal Executive Officer)
Date: June 26, 2003 /s/ MICHAEL R. FRIEDL
--------------------------------------
Michael R. Friedl
Chief Financial Officer, Secretary, and
Treasurer (Principal Financial and
Accounting Officer)
49