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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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AMENDMENT NO. 1
TO
FORM 10-K
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(MARK ONE)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31,
2002.
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________.
COMMISSION FILE NUMBER 000-26227
SSP SOLUTIONS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 33-0757190
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
17861 CARTWRIGHT ROAD, IRVINE, CALIFORNIA 92614
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE): (949) 851-1085
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK
(TITLE OF CLASS)
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 or
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 check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [ ] NO [X]
Aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price of the common equity, as of
the close of business on June 28, 2002: $12,022,171. The registrant has no
non-voting common equity.
As of April 24, 2003, the number of outstanding shares of the registrant's
common stock was 25,280,405.
DOCUMENTS INCORPORATED BY REFERENCE: NONE.
PORTIONS AMENDED
The registrant hereby amends and restates its Form 10-K to add to note 4 of
the financial statements two tables that summarize information regarding
intangible assets contained in other parts of the report, to separate license
and service revenue and cost of sales into separate line items in the
consolidated statements of operations, to include the formal consent of the
registrant's former auditor that the registrant did not obtain when the
registrant filed its Form 10-K on April 15, 2003, and to fix various
typographical errors.
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PART I
PAGE
ITEM 1. BUSINESS......................................................................................... 3
ITEM 2. PROPERTIES.......................................................................................18
ITEM 3. LEGAL PROCEEDINGS................................................................................19
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..............................................20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS............................20
ITEM 6. SELECTED FINANCIAL DATA..........................................................................21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS............................................................................23
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.......................................51
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA......................................................51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.............................................................................52
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...............................................52
ITEM 11. EXECUTIVE COMPENSATION...........................................................................54
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS..................................................................61
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...................................................65
ITEM 14. CONTROLS AND PROCEDURES..........................................................................68
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.................................69
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE.................................F-1
INDEX TO EXHIBITS...........................................................................................70
SIGNATURES .................................................................................................75
CERTIFICATIONS..............................................................................................76
EXHIBITS FILED WITH THIS REPORT.............................................................................79
2
PART I
ITEM 1. BUSINESS
INTRODUCTORY NOTE
For purposes of this report, unless the context indicates otherwise,
references to "we," "us," "our," "SSP" and the "Company" shall mean or refer to
SSP Solutions, Inc. In addition, unless the text indicates otherwise, the term
"SSP" refers to SSP Solutions, Inc. and its subsidiaries.
CORPORATE OVERVIEW
We are a Delaware corporation that was formed on January 30, 1997 under
the name Litronic Inc. We did not engage in operations until we completed our
initial public offering of common stock in June 1999. Immediately prior to the
offering, we acquired Litronic Industries, Inc. in a stock-for-stock exchange.
Concurrently with the offering, we acquired Pulsar Data Systems, Inc.
("Pulsar"), a Delaware corporation, in a stock-for-stock exchange.
Litronic Industries, Inc. was formed in California in April 1970 and,
at the time we acquired it, Litronic Industries was engaged in the design and
production of high-grade information security solutions. Pulsar was formed in
Delaware in February 1984 and, at the time we acquired it, Pulsar was engaged in
the sale of computer hardware, software, peripheral equipment, and support
services to governmental agencies and commercial enterprises throughout the
United States.
In August 2001, we acquired BIZ Interactive Zone, Inc. ("BIZ"), a
corporation that was formed in Delaware in July 2000, in a transaction through
which we acquired all of the outstanding shares of BIZ common stock in exchange
for the issuance of shares of our common stock, and we changed our name to SSP
Solutions, Inc. At the time we acquired BIZ, BIZ had developed, designed, and
was in the process of marketing security solutions for the financial,
government, healthcare, education, and entertainment industries.
In January 2002, we formed SSP Gaming, LLC ("SSP Gaming"), a Nevada
limited liability company, to conduct all business and any required financing
activities relative to the gaming industry. In June 2002, SSP Gaming and the
Venetian Casino Resort, LLC, a Nevada limited liability company based in Las
Vegas, Nevada, executed an operating agreement to form Venetian Interactive, LLC
("VI"), a Nevada limited liability company. The purpose of VI is to provide
management services, consulting services, financial services, intellectual
property licensing services, and equipment to the online gaming industry in
venues where such activity complies with all regulatory requirements, and to
develop and operate Venetian Casino Resort branded casino Internet sites.
We currently operate in two business segments: the information security
segment and the network solutions segment. During 2002, we derived approximately
91% of our revenues from our information security segment operations and
approximately 9% of our revenues from our network solutions segment operations.
As of March 31, 2003, we had backlog of $4.0 million of which $3.8 million or
97% was related to licenses and services and $136,000 or 3% was related to data
security products. The license and service backlog consisted of $542,000 related
to our Fortezza(R) support contract, $148,000 related to our subcontract with
General Dynamics and $2.7 million related to development efforts underway to add
the Java operating system to our Forte(TM) card. As of December 31, 2001, we had
a backlog of approximately $1.1 million consisting of $218,000 related to data
security products and $910,000 related to network deployment products. Further
financial information regarding our business segments is contained in Note 11 of
our audited consolidated financial statements that are included in Item 8 of
this report.
INDUSTRY BACKGROUND
Consumers, businesses and government agencies are increasingly
dependent on the Internet and IP-based networks to conduct electronic commerce
and communications. The increasing reliance on shared electronic data has caused
data security to become a paramount concern for both government and private
industry. Continued expansion of electronic commerce and communications and
recent world events necessitate improved security measures to irrefutably verify
the identity of a party over a communication channel and to ensure the
3
maintenance of confidentiality when transmitting information. Many client
operating systems and Internet protocol-based networks lack fundamental, yet
critical, security features such as data privacy and integrity, identification,
authentication, non-repudiation, and auditing. Internet protocol, or IP, is a
protocol developed to enable the transmission of information as packets of data
from a source to a recipient using dynamically changing routes, with the data
being reassembled at the recipient's location into the original information
format.
End-to-end data security concerns can be addressed by a variety of
means. Traditionally, enterprises relied heavily on passwords to restrict access
to proprietary information and materials. However, because of the risk of loss
or theft, more advanced protective measures have been developed to include
combinations of passwords and tokens with message encryption and biometric
devices. Biometrics devices are hardware devices that incorporate fingerprint
identification, voice, hand geometry, facial recognition, iris scan or other
methods to positively identify an individual. A token can take any number of
forms (a ring, a key, a credit card size piece of plastic), into which an
electronic device can be embedded. The token carrying the electronic device can
then be used for any number of purposes: to access a facility; to access a
computer network or desktop; or to validate the identity of the token holder.
Regardless of the form of the data security device, the level of security
provided is evaluated based on a set of fundamental principles, which include
the following:
o IDENTIFICATION AND AUTHENTICATION. Verifies the identity of
the authorized users to prevent unauthorized access to
proprietary information and resources.
o CONFIDENTIALITY. Involves the encryption of data transmissions
so only the intended recipient can access the information to
ensure privacy.
o DATA INTEGRITY. Ensures that data is not compromised or
manipulated.
o NON-REPUDIATION. Prevents the sender of data transmissions
from disclaiming or repudiating authorship so that the sender
cannot deny the occurrence of the transaction.
o AUDIT CONTROL. Retraces information access and facilities use
over a particular time period at a system administration level
so an enterprise can monitor and record authorized and
unauthorized user activity.
o SECURED SYSTEM ADMINISTRATION. Maintains and controls
corporate intranets centrally through file encryption,
password maintenance, audit control, certificate and
cryptographic key management and device accessibility control.
The process of implementing appropriately stringent, best-in-class data
security solutions requires specialized skills that generally are not resident
within corporate information technology departments. We provide the technology,
products and services necessary for most companies to implement or manage their
data security infrastructure. The open architecture of our products makes them
compatible with virtually all commonly used network hardware and enables them to
operate independently of algorithms, platforms, applications and tokens. We
believe that as the use of the Internet and Internet-based networks continue to
grow the need for security solutions will fuel demand for our products and
services.
OUR SOLUTION
We provide data security solutions for network communication systems.
We have provided innovative data security solutions for government
communications systems for more than thirty years. We provide software, a secure
operating system and hardware products:
o for the authorization, authentication, and administration of
an organization's security protocols, and
o tokens and card reader products that can be used by an
organization and its members to protect digital data, thereby
securing the transmission of that digital data via encryption
or decryption of that data on a real-time basis.
4
In addition to selling hardware and software products, we provide
support and maintenance services for specific government communications
programs. Our products are designed and developed in the United States.
Our products are based upon open standards, public key infrastructure
("PKI") technology and encryption algorithms that provide strong and persistent
protection of digital content and information. Our tokens can take nearly any
form that meets a customer's requirements, but most often take the form of a
smart card, which makes the token portable. The smart card token combines a
secure operating system and software within the hardware device. Our card reader
products include software that allows secure communications between a smart card
and a client device, such as a desktop or laptop computer.
Our products target the authorization, authentication, and
administration security marketplace, which is referred to as the "AAA" market
space. For servicing AAA requirements, one product we developed is the Profile
Manager(TM) ("PM"). Originally developed for use within the federal government,
the PM product provides digital identity management administration for either a
public or private organization. This administration includes the ability to
verify the identity of an individual (authentication); assign the permitted
activities or access rights of that particular individual (authorization); and
track or modify the digital identity and authorizations of the individual
(administration).
To provide a high-level assurance token for use in government programs
and commercial markets, we developed the Forte(TM) chip that has recently been
delivered to several government and private sector customers for testing.
Combining our USA operating security system ("USA OSS(TM)") with the Forte(TM)
chip, we created an embedded security system on a chip that can decrypt and
encrypt streaming digital data, such as music or voice over IP. By placing the
Forte(TM) chip and the USA OSS(TM) onto a smart card, we created the Universal
Secure Access Card ("USA Card(TM)") that allows the streaming of audio content
to wireless devices and personal computers, or PCs, without the need for storage
and redundant data processing. Through the flexibility of its design, our USA
Card(TM) allows the management of multiple digital IDs, passwords, certificates
and credentials. This means our USA Card(TM) is programmable and addressable,
and can securely support and store multiple applications. Based upon an open
standards platform, our Forte/USA OSS technology can secure the transmission and
authorized access of digital content, regardless of the method of transmission
or method of encryption. Our USA Card(TM) contains our patented universal serial
bus ("USB") interface that recognizes and automatically adjusts to high-speed
USB data transmission or to the slower International Standards Organization
("ISO"), standard of legacy systems. In computerese, "bus" most commonly means
the data pathway that connects a processor to memory and to other "peripheral"
devices.
Building on our history of supplying robust security products for the
intelligence community, we believe our two core technologies, PM and the USA
Forte chip, are positioned to become a part of the standard for secure
government communications. PM and the USA Forte chip, together with the services
we provide to support government secure communications programs, form the
building blocks for the Department of Defense's ("DoD") next generation PKI
initiative. This DoD PKI initiative is a single framework for modernizing and
unifying the management of keys used to encode and decode information throughout
the entire national security community. We anticipate that over time, this next
generation PKI initiative will touch every application and security measure used
by members of the intelligence community - both inside and outside of federal
and state governments.
To communicate securely with governments in the future, non-government
organizations may need to utilize elements of security that we developed for
government programs. By building our products on open standard platforms, we
enable organizations to incorporate our security products in a manner much like
adding a utility function to their current application programs. Alternatively,
an organization may license and install the entire robust PKI-based system for
its internal secure communications as well as for its communications with
government entities. Organizations can use our USA Card(TM) with the Forte(TM)
chip as the security token used by their members, and our PM product can
administer and manage the card issuance, authorization and authentication
functions. Adoption by customers of our recently developed products is part of
the continuing migration of secure communications to ever increasing levels of
trust as outlined below.
We are a supplier of products and services to the Defense Messaging
System ("DMS") and Common Access Card ("CAC") programs described below. The
products we supply to those programs can be migrated without replacing entire
systems into planned evolutions to higher assurance level and more flexible
systems also outlined below.
5
DMS/FORTEZZA(R) PROGRAM
DMS is one of the largest PKI implementations in the world. DMS
messages travel over the Defense Information Systems Network, which distributes
voice, video and data messages. Fortezza(R), Italian for "fortress," is a family
of security encryption products trademarked by the U.S. government's National
Security Agency. DMS is a worldwide effort to secure DoD communications, and is
designed for sending classified and top-secret information and delivering
messages to DoD users as well as to other agencies and contractors.
Our hardware products that support DMS include the ARGUS line of
readers and smart cards. Products sold by us and other vendors for use in DMS
must be Fortezza(R) compliant, meaning the products must be based upon
Fortezza(R) encryption standards. We are the sole source of support services for
Fortezza(R) compliant products used in the DMS, whether the products are sold by
us or by any other vendor. While widely used by U.S. government agencies, the
U.S. government has identified the need to migrate many Fortezza(R) users to
more flexible levels of security developed under the next generation PKI
initiative outlined below.
CAC PROGRAM
The CAC is a DoD access card badge that provides government employees
with secure physical and logical access. The CAC also manages the individual
benefits, such as medical benefits, for government employees. Our NetSign(R) CAC
for the armed forces is a complete smart card client package that provides
network security and desktop protection for CAC users. To date, we have been
chosen by two branches of the armed services to deliver NetSign(R) CAC software
for smart card integration. We recently began shipments of this software for
initial deployment to one of the armed services. Based upon deployment within
the DoD, there are 6 million potential users of this product. We anticipate
there will be a demand to migrate many, if not all, CAC users to the next
generation PKI products.
DOD NEXT GENERATION PKI AND EXTENSION INITIATIVES:
We were selected to develop the architecture for the next generation
PKI and related extension initiatives for the DoD. This PKI initiative is a
single framework for modernizing and unifying the management of keys used to
encode and decode information for government departments and agencies, including
Homeland Security. The federal government's PKI initiative program uses our PM
and NetSign(R) solutions, and may eventually incorporate our USA Card(TM).
FORTE(TM) -BASED USA Card(TM)
Although the USA Card(TM) originally was developed to government
specifications, its power and flexibility will allow for a variety of government
and commercial applications. The USA Card(TM) will be compliant with our
NetSign(R) CAC product, which will allow migration of CAC users and Fortezza(R)
-based security users to higher assurance levels. At the same time, the flexible
design of the USA Card(TM) will allow for multiple uses of the card. For
example, while functioning as a CAC card, the USA Card(TM) can provide secure
processing of voice over IP and secure access to commercial functions, including
financial services. The USA Card(TM) can support multiple applications, all
partitioned or separated from other applications resident on the card. The USA
Card(TM) can provide an interface or crossover between processing government
security needs and serve as a platform for secure commercial applications.
When used in conjunction with biometrics, such as a fingerprint or an
iris scan, the USA Card(TM) provides three levels of authentication consisting
of identifying: something you have (the USA Card(TM)); something you know (a
personal identification number ("PIN")), and something you are (a biometric,
such as a thumbprint). An authentication occurs when all three items are present
simultaneously. This provides a high level of protection in the commercial and
government markets. We recently began work on a funded development program to
Java-enable the USA Card(TM), which will allow the USA Card(TM) to support
commercial users, which mostly use Java-based applications. Java is a high-level
programming language developed by Sun Microsystems. Adding Java to our USA
OSS(TM) will increase the number of potential USA Card(TM) users.
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PLANNED COMMERCIAL AND PUBLIC AGENCY INITIATIVES
Building on our success with secure government communications and in
organizations communicating with government agencies, we are developing
independent initiatives to take our products into commercial and public agency
markets.
We view future extension of our core technologies into the private
sector as follows:
o KEY MANAGEMENT ENTERPRISE ("KME"). KME is the extension of DoD
next generation PKI initiatives technology to commercial
enterprises.
o KEY MANAGEMENT SERVICES ("KMS"). KMS is the development of
managed security services, including a hosted application
service provider ("ASP") for security-enabled applications and
products.
o KEY MANAGEMENT CONSUMER ("KMC"). KMC is the extension of DoD
next generation PKI initiatives technology to the consumer
community.
o USA CARD(TM). The USA Card(TM) can serve as an identity card
and support multiple applications in disparate markets. The
USA Card(TM) combines a sophisticated operating system with a
tamper proof, patented USB Interface to transfer data at
speeds up to 12 megabits, or millions of bits, per second, and
automatically adjusts to the slower ISO standard if USB is not
available on the device connected to the USA Card(TM).
The following examples illustrate our digital security offerings in
government and commercial settings:
CASE 1: PKI PRODUCTS. The DoD's next generation PKI initiative involves
undertaking a comprehensive communications program to redesign a secure
infrastructure for both physical and virtual environments. This initiative is
designed to be deployed across a broad range of applications, including
financial transactions, e-commerce, personnel records, tactical operations, and
command and control functions. The DoD needs to secure its own internal
electronic communications activities, as well as electronic communications
activities with federal agencies, allies and coalition forces, military and
civilian personnel, and business partners in the U.S. and abroad. The next
generation PKI initiative elements include system hardware and software
architecture, cryptographic tokens and cards, and the management elements of
policies and procedures for issuing and managing the cryptographic keys and
cards. PKI is a major constituent of the program. The next generation PKI
initiative includes the rights to the application program interface ("API") to
communicate with organizations outside of government. Having to use the API to
communicate with government users may stimulate demand by the private sector for
the commercial versions of next generation PKI products based upon the same open
standards platform. This type of adoption of next generation PKI products should
bring a higher level of secure digital protection into the commercial market.
CASE 2: CAC MIDDLEWARE PRODUCTS. The CAC is the electronic
identification card for the DoD is designed to give employees and contractors
access, both physically and electronically, to DoD infrastructure such as
facilities and secure e-mail. Our CAC middleware allows the CAC to utilize a PKI
token in the DoD electronic infrastructure. The CAC middleware then interfaces
with the e-mail system to enable several key functions, including digital
signatures for e-mails and encryption of e-mail content. These products also
allow the CAC to be used for Web-based Secure Socket Layer, or SSL, sessions and
for PKI-based computer log-on. Under existing purchase contracts, our middleware
products may be used throughout the DoD and other government civilian agencies.
CASE 3: DIGITAL/SATELLITE SERVICE PROVIDERS AND THE USA CARD(TM).
Industry periodicals estimate there are over 200 million pay television
subscribers around the world and a large untapped market in China. Generating
billions of dollars in annual revenues, pay television has the associated
problem of widespread signal piracy. Industry periodicals also estimate that
more than $1.5 billion of revenue is lost each year due to piracy. To combat
this piracy, network operators have implemented a security technology known as
conditional access ("CA") to protect their networks. CA is implemented via smart
card technology. The USA Card(TM)'s high level of assurances and tamper
resistant design, and the ability to download secure upgrades to the previously
issued USA Cards(TM), creates a flexible platform for security. The addition of
Java to the USA Card(TM) will build a competitive advantage by allowing for
commercial applications that today are limited by slow speed transmission over
phone lines.
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CASE 4: ON-LINE GAMING, ENTERTAINMENT AND INTEGRATED HOSPITALITY. By
using KMC for authentication, authorization and administration, a resort can
issue to all or a portion of its guests a private-labeled form of the USA
Card(TM) to control physical access (to their rooms, clubs or other facilities),
offer the ability for charging purchases, and integrate the guest into affinity
programs and offers to selected guests. For qualified guests, the same card can
be used as a credit card. In conjunction with the purchase or issuance of a card
reader, upon leaving the resort guests can securely access affinity sites,
authorized and properly licensed on-line gaming sites and, when properly
authenticated, have the USA Card(TM) provide identifying information for site
log-on or on-line purchases.
Through a subsidiary, we have a joint ownership interest with Venetian
Casino Resort, LLC in an online venture that is described in Note 8 to our
consolidated financial statements.
PRODUCTS AND SERVICES
Our Internet data security products provide a high level of security
for secure e-mail, secure file transport, file protection, remote access,
authentication and authorization in an open multi-platform standards-based
framework. Our data security products are designed with an open architecture so
they can operate independently of algorithms, platforms, applications and
tokens. The following sections describe our individual products and their
functions. These products are used within the Fortezza(R) and CAC programs
described earlier in this report, and will be used as a migration tool for those
users that are upgraded into the DoD's next generation PKI initiative.
SOFTWARE
NETSIGN(R) CAC. NetSign(R) CAC is a complete smart card client package
that provides network security and desktop protection for users of the General
Services Administration ("GSA") CAC. With a NetSign(R) CAC-enabled system, users
can be assured of strong authentication, confidentiality and non-repudiation at
speeds substantially faster than competitors' products. Non-repudiation means
that the identity of the user is established on a basis such that the user
cannot deny the fact that they participated in or initiated a particular
transaction. NetSign(R) CAC allows users to digitally sign and encrypt e-mail
and access secure Web sites via Microsoft and Netscape e-mail and browser
packages. By supporting Windows 2000 certificate-based logon and workstation
locking using CAC smart cards issued by DoD, NetSign(R) CAC offers a high level
of desktop security. We have collaborated with prime contractors in bidding on
some CAC programs and have bid directly on other CAC programs. To date we have
been awarded one direct bid $9 million indefinite-delivery, indefinite-quantity
contract and one $9 million indefinite-delivery, indefinite-quantity contract as
a sub-contractor. The pricing of our products is the same under both bidding
processes.
NETSIGN(R) AND NETSIGN(R) GT (GLOBAL TRUST). These products are
software adapters that integrate smart cards and digital certificate technology
to enhance security in electronic commerce software systems. They are used for
e-mail, Internet access, file access, and Web browsers like Netscape
Communicator and Microsoft Explorer. NetSign(R) and NetSign(R) GT software
products are bundled, or packaged, with a smart card reader/writer and with
smart cards. NetSign(R) GT supports the Identrus bank security model, which is a
regulated policy framework that provides financial institutions and their
customers with a global standard for digital identity authentication and PM GT.
PM AND PM GT. PM is a complete PKI lifecycle management solution. PM
provides token-based security systems management from initialization to secure
archive and recovery of information. For the recovery of token-based
information, PM provides an optional integration with a secured database of
private keys and other user identification information, and the use of
third-party certificate authorities. PM integrates with NetSign(R), NetSign(R)
GT, and other token-enabled products to provide a complete solution for a
company's security requirements. PM includes secure Internet access, digitally
signed and encrypted e-mail, desktop file encryption and secure remote network
access. PM GT supports the Identrus bank security model and NetSign(R) GT.
8
MAESTRO CRYPTOGRAPHIC LIBRARY. Maestro is a multi-protocol
cryptographic library that enables software developers to incorporate secure
token-based, symmetric-key and asymmetric-key cryptography into their
application software. Maestro is a multi/concurrent access, cross-platform
system that supports multiple types of tokens such as smart cards, PCMCIA cards
and cryptographic algorithms. Coupled with token reader/writers, Maestro
supports devices over commonly used interfaces, including keyboard, serial,
small computer system interface, or SCSI, parallel port and universal serial
bus. Maestro currently supports two commonly used cryptographic interface
protocols. We are developing additional protocol adapters to expand the
functionality of Maestro. Maestro is compatible with Windows 95, 98, 2000 and NT
operating systems as well as all popular UNIX platforms.
TOKENS AND TOKEN READERS
THE USA CARD(TM) FAMILY. We have completed the development of next
generation PKI cards in cooperation with Atmel and the NSA. Forte, the newest
member of the USA Card(TM) family, is a high-speed 32-bit system on a chip
microprocessor that is designed with a high-speed USB interface in addition to
the ISO interface. The USA Card(TM)'s will have a larger storage capacity and
faster processing speed than existing smart cards. Forte offers Personal
Computer Memory Card International Association, or PCMCIA, level of performance
at a price competitive with PKI smart cards. We anticipate commercial shipments
of the Forte based USA Card(TM) to begin in 2003.
OTHER LEGACY SECURITY TOKENS. In addition to the USA family of smart
cards, we offer off-the-shelf ISO standard smart cards ranging from storage-only
cards to cards containing cryptographic capabilities. Because our products are
open-architecture, open-platform and open-token, as well as algorithm and API
independent, they work with third-party tokens, such as PCMCIA cards, smart
cards, rings, proximity cards and plastic keys and other commercially available
tokens that can be used with our reader/writers and application software.
SSP 210 SMART CARD READER. Our NetSignia 210 Smart Card Reader is an
ISO 7816-compliant device featuring direct communication between the host
computer and the smart card.
SSP 250 BIOMETRIC SMART CARD READER. Our 250 Biometric Smart Card
Reader integrates fingerprint biometrics to secure data transmissions, protect
communications and transactions, and prove identity in networked and physical
environments. With its embedded fingerprint verification system, our 250-card
reader represents a significant advance in digital security, bringing the same
level of protection, authentication and non-repudiation to virtual transactions.
Our 250 card reader also enables strong levels of physical access and
verification of identity, promising powerful security for employee verification,
funds transfer, encrypted communications and granting of physical and electronic
access to personal records, documents or transactions.
ARGUS 3015 DUAL CARD READER. Our 3015 Dual Card Reader is a USB device
that can simultaneously accommodate a DMS Fortezza(R) card and a CAC card. Our
3015 Dual Card Reader is plug-n-play solution that provides full functionality
for a variety of DMS applications and is available as an internal bay-mounted
unit and as an external freestanding device. Our 3015 Dual Card Reader supports
both DoD Fortezza(R) and CAC while providing an interface to PC systems. Our
3015 Dual Card Reader is forward compatible with 64K memory capacity smart cards
that have a USB connector, which is the next generation of secure USA Card(TM).
ARGUS 300. The ARGUS 300 consists of a tamper-resistant industry
standard architecture ("ISA") or peripheral component interconnect ("PCI") bus
board and external reader/writer and is connected to the keyboard. The ARGUS 300
incorporates data encryption standard ("DES") encryption technologies and offers
additional security features such as boot protection, electronic commerce
security and protected PIN path directly through the board rather than through
an external device that might be tampered with by an unauthorized user. The
ARGUS 300 is validated for electronic signature by the National Institute of
Standards and Technology, the U.S. Treasury Department and the U.S. General
Accounting Office.
PCMCIA CLIENT READER/WRITER. We offer a series of single and
dual-socket PCMCIA card reader/writers for both internal and external
application, that interface via various ports such as small computer systems
interface ("SCSI"), ISA bus, PCI bus, USB and parallel port. These
reader/writers incorporate our proprietary device drivers, which provide the
interface between the reader/writer and its application software, such as
Maestro and third-party application software.
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ARGUS 2108. We offer a reader/writer that contains sockets for up to
eight PCMCIA cards, is used on the enterprise's server side and incorporates the
device drivers and other technologies of our other PCMCIA readers. The Argus
2108 interfaces with the host server to enable the host server to provide
rapid/simultaneous processing of cryptographic functions received from numerous
clients.
HARDWARE
SSP XBOARD. We have developed a server accelerator, formerly called the
Cipherserver, which is designed to maximize the performance of secure Web
servers by eliminating the processor bottlenecks incurred by SSL. The XBoard
off-loads the public key functions to on-board processors, frees up central
processing unit ("CPU") resources, and provides almost instantaneous responses
to the customer.
SERVICES
HIGH ASSURANCE TOKEN DEVELOPMENT. We have a funded development program
to add the Java operating system to the USA Card(TM)'s USA OSS. Once complete,
the addition of a Java operating system will allow applications already
developed in Java to run in the secure USA Card(TM) environment. This will make
the USA Card(TM) interoperable for government or commercial markets, which will
broaden the status of USA Card(TM) as a flexible and secure standard for
identification and processing of encrypted digital data. Work on this program is
a fixed price milestone delivery contract with estimated completion during the
second quarter of 2004.
FORTEZZA(R) SUPPORT SERVICES. We are the sole source for support of the
cryptologic interface ("CI") Library that is a platform independent, C language
binding to the functionality of the Fortezza(R) cards. This library can be
linked into an application, giving Fortezza(R) cryptographic capabilities such
as encryption, hashing, and digital signatures. The CI Library hides from the
developer the complexity of interacting with the device drivers and PCMCIA
readers on the various platforms and input/output ("I/O") buses. Our
multiple-access library was designed to meet the needs of the most demanding
applications. These include sophisticated applications such as Web and database
servers, firewalls, mail transport agents, and other high-availability,
high-performance systems. The contract for these services is awarded annually,
with work performed on a cost-plus-award-fee basis.
NEXT GENERATION PKI INITIATIVE. We perform development work for this
program under firm-fixed price, cost-plus-award-fee, and time-and-materials
contracts. When the project is complete, we will sell site licenses for the
completed Web-enabled technology to both government users and users in the
private sector.
SUPPORT AND MAINTENANCE. Purchasers of site licenses will need to
separately purchase annual support contracts for those licenses in order to
maintain support services for the operating systems.
LICENSING
NEXT GENERATION PKI INITIATIVE. We license the Web-enabled software
package in two different forms of per site license: either an unlimited number
of users per server or 50,000 users per server. Each requires the separate
purchase of annual maintenance at the time a site license is executed or at a
later date. To date, we have sold two site licenses to federal government users.
USA OSS. Certain large-scale original equipment manufacturers ("OEMs")
may license this technology for inclusion in their design in lieu of purchasing
a chip set containing the USA OSS(TM). Potential users are in the wireless chip
manufacturing and design and hardware security module manufacturing areas.
Wireless can include cell phones, personal data assistants and wireless laptops
computers. To date, we have not entered into any licensing arrangements, but we
may do so in the future.
PKI PROFESSIONAL SERVICES. Designed to complement in-house resources
and meet an organization's security requirements, our professional services team
develops solutions that address the lifecycle of a security system from
planning, installation and training through deployment and maintenance. On a
contract basis, we periodically customize software or device drivers according
to a customer's needs.
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BUSINESS STRATEGY
Our objective is to become the leading provider of data security
solutions for the digital economy. We intend to build upon our two open
standards core technologies, Profile Manager and the Forte(TM) chip, developed
for government deployment. Organizations supporting or communicating with
government agencies that adopt the next generation PKI initiatives will be
heavily influenced to adopt those same standards for their own communications.
The ability of the Forte(TM) chip to add applications to a product already
deployed to millions of users will be of great appeal to providers of commercial
products and services, as they will be able to instantly present their products
or services to targeted markets. Key elements of our strategy include:
o MAINTAIN TECHNICAL LEADERSHIP IN SECURED COMMUNICATIONS. We
plan to continue to innovate and maintain a leadership
position in the digital security arena. We have provided
innovative data security solutions for several leading
government programs. For instance, our NetSign(R)CAC smart
card client package and Argus Fortezza(R)products have been
chosen by the U.S. DoD to provide network security and desktop
protection for many of its organizations. We were also
selected by General Dynamics to participate in developing the
next generation PKI driven identity management framework for
the U.S. government. By adapting current products produced
under these programs for commercial requirements, we believe
our open architecture approach can potentially become a
standard for the private sector.
o EXPAND OUR TARGETED CUSTOMER BASE. We have a long and
successful history of providing data security products and
services to the government sector. Our business strategy is to
continue our deployment of our core technology in the
government market. We will then leverage that deployment,
together with our expertise in driving Internet security
solutions, into various commercial and consumer markets.
o STRENGTHEN RELATIONSHIPS WITH STRATEGIC PARTNERS, SYSTEMS
INTEGRATORS, AND OEMS. We intend to continue developing
relationships with strategic partners, systems integrators,
and OEMs to further penetrate government and commercial data
security markets. As digital security becomes an imperative,
our leading solutions will enable systems integrators and OEMs
to create value-added solutions for their customers. We
believe that by leveraging these types of relationships, we
will have the greatest opportunity to be included in large
installations.
o PROMOTE SALES OF STAND-ALONE COMPONENTS. We have created the
first open embedded, portable security architecture that
simultaneously supports PKI and multiple standards of digital
rights management. Our open standards approach will enable our
various products to be sold as individual components. For
example, by connecting a smart card reader through a USB port,
a PC user can incorporate a secure device for accessing
records, paying for products, or securing the transmission of
information.
o ESTABLISH A BRAND NAME. It is our goal to establish a brand
name equated with assurance and security. We intend to build
our brand by emphasizing our assurance capabilities in our
sales message, and through joint marketing efforts with
strategic partners.
SALES, MARKETING AND DISTRIBUTION
We market, sell and distribute both data security products and services
via the Internet, direct sales force, manufacturers sales representatives and
other targeted sales channels. Our targeted channels include systems
integrators, value added resellers ("VARs"), OEMs, strategic alliances, and
international distributors. We intend to devote significant resources toward
marketing efforts and business development activities designed to build our
brand name and expand our business distribution channels.
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DIRECT MARKETING
As of March 31, 2003, we employed 10 full-time personnel to perform
direct sales, technical sales support, business development and marketing. This
sales force targets markets that include: enterprises, consumers, home
entertainment, various vertical markets, and federal, state, local, and foreign
government agencies. Our sales force is responsible for soliciting prospective
customers and providing technical and application advice and support for our
products and services. We intend to further penetrate these target markets by
using direct sales personnel with significant expertise. We have recently added
personnel experienced in chip and hardware sales to our sales staff, together
with sales representatives in several geographic areas. These personnel will
present the hardware and operating system capabilities of our Forte product line
that will be available in 2003.
INDIRECT MARKETING
An important component of our sales strategy is the development of
other targeted sales channels. These channels include systems integrators,
value-added network service providers, and OEMs. In addition to the efforts of
our direct sales force, a significant portion of the marketing and distribution
of our products in the future will be attributed to our strategic relationships
with third parties and their established distribution channels. We anticipate
that these third parties will provide us with contacts to prospective customers
to which we would not otherwise have access. As part of our expansion strategy,
we will seek to develop relationships with additional third-party sales
channels.
ADVERTISING AND PUBLIC RELATIONS
Our advertising efforts include our Website, print product materials,
events, sales presentation tools, and corporate marketing materials. Our public
relations efforts consists of press kits and press releases. These efforts are
strategically designed to complement our sales and marketing efforts. We
currently do not have a program for promoting industry analyst coverage and have
limited funding for advertising and promotion.
TRADE SHOWS AND PRESENTATION
We attend and exhibit our products and services at selected trade shows
in the U.S. and around the world. We intend to continue attending selected trade
shows and to join with strategic partners in presenting our products and
services to prospective customers.
DISTRIBUTION
To reach our potential customer base, we are pursuing several
distribution channels, including a direct sales force and strategic
relationships with systems integrators, VARs, and other third parties.
COMMERCIAL SALES
We plan to distribute our products to the commercial market via the
Internet, direct sales forces, manufacturer sales representatives, and other
sales channels. Our channels will include systems integrators, VARs, OEMs,
strategic alliances, chip manufacturers or designers and international
distributors. Our target market includes enterprises, consumers, home
entertainment, and various vertical markets. We are currently evaluating various
target markets and their potential return.
GOVERNMENT SALES
We distribute our data security and PKI based products to the federal,
state and international governments through our direct sales force. Our sales
force also works with key strategic accounts and programs, as well as with large
prime contractors and systems integrators such as General Dynamics, Micron PC,
Gateway, and Lockheed Martin Corporation.
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The government information technology market is highly structured, with
strict procurement rules and procedures. Government projects have large
contracts, a relatively long sales cycle, significant barriers to entry, and low
collection risks. Several of our products such as the Argus 300 reader and
NetSign(R) CAC have received high levels of government certifications. As a
result, we have created a highly respected and positive relationship with many
government agencies and their system integrators, OEMs, and preferred suppliers.
A significant amount of computer products and services purchased by the
federal government are made under contracts or purchase orders awarded through
formal competitive bids and negotiated procurements. Most bids are awarded based
on a number of factors that determine the best value to the government. These
factors are generally a combination of price, technical expertise, and past
performance on other government contracts. Major procurements can exceed
millions of dollars in total revenue for the supplier, systems integrator or
reseller, and can span many years.
In addition, the federal government purchases networking products
through open-market procurements. These procurements are separate from GSA
schedules and include simplified acquisition procedures, requests for quotes,
invitations for bids, and requests for proposals. Most purchases in the state
and local government market are made through individual competitive
procurements. State and local procurements typically require formal responses
and the posting of bid bonds or performance bonds to ensure complete and proper
service by a prospective bidder. Each state maintains a separate code of
procurement regulations.
CUSTOMERS
We work hard to appease the demands of our varied customers. Our
customers represent a wide range of enterprises, consumers and vertical markets,
as well as federal, state, local and foreign government agencies. A
representative list of our customers includes:
CDW Computer Centers, Inc. Micron PC, LLC
Booz Allen & Hamilton Inc. National Security Agency
Department of the Air Force Northrop Grumman Corp.
Department of Defense TRW Systems, Inc.
Department of the Navy University of Pennsylvania
Gateway Inc. U.S. Army Corps of Engineers
General Dynamics U.S. Department of State
Gradkell Computers, Inc. U.S. Joint Forces Command
Itochu Techno-Science Corp. Verisign
Lockheed Martin Corporation
During 2002, General Dynamics and Micron PC, LLC accounted for 26% and
15% of our revenues, respectively. No other individual customer accounted for
more than 10% of our revenues.
CUSTOMER SERVICE AND SUPPORT
As of March 31, 2003, our customer service and support staff consisted
of 48 persons, including 43 engineers and technical support personnel. Our
customer service department works closely with customers and prospective
customers to provide comprehensive service and support for our products and
systems.
SUPPLIERS
Third party vendors produce some of the components we incorporate into
our products. We also integrate third-party products and components into the
networks we design and develop for our customers. To maintain quality control
and enhance working relationships, we generally rely on multiple vendors for
these products. However, in some cases, products or services are procured from
single sources.
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STRATEGIC ALLIANCES
We plan to increase our vertical market penetration and enhance our
product line by continuing to develop strategic alliances with other companies
in the data security and network integration industries. We have developed
strategic alliances with companies in an effort to:
o incorporate our components into third party products;
o develop additional products and services;
o increase research and development efforts;
o generate more proposals and presentations for products and
services; and
o license technology.
We intend to pursue and develop strategic alliances with systems
integrators for the marketing, sale and distribution of our products in the data
security market. Strategic alliances assist in expanding our marketing and
technical capabilities. They are intended to increase the distribution and
market acceptance of our data security products.
We anticipate that strategic alliances will allow us to integrate
third-party products into our product offerings in a cost effective manner and
provide our clients with customized information technology solutions. We believe
that strategic alliances also will allow us to incorporate our products into
third parties' products thereby accelerating the adoption of our products into
the market. This enhances and helps to establish the SSP brand name. Our
strategic alliances currently include the following:
o NETSCAPE AND MICROSOFT. We provide enhanced e-mail security
features to Netscape and Microsoft browser programs through
integration of our NetSign(R)product lines;
o VERISIGN. We have a marketing agreement with VeriSign and act
as VeriSign's recommended PKI card partner;
o ATMEL AND THE NATIONAL SECURITY AGENCY. We have an alliance
with Atmel Corporation and the NSA. Through this alliance, we
jointly developed Forte(TM), an advanced 32-bit system on a
chip microprocessor, which will be embedded in our next
generation PKI cards. We signed a teaming agreement with Atmel
Corporation to further exploit the technologies incorporated
in the Forte(TM) product;
SSP GAMING, LLC - GAMING INDUSTRY
SSP Gaming was formed in January 2002 to deliver core technologies to
the gaming industry, which is a regulated industry that must have security built
into its future product offerings. Gaming industry analysts Christiansen Capital
Advisers, LLC predict that Internet gambling expenditures worldwide will reach
$10.6 billion annually by 2005. An important component of this growth market
will be the ability of online gaming operators to provide secure and
authenticated transaction processing systems. Our products are designed to
support the security infrastructure required for complex business processes and,
we believe, are ideally suited for the rigorous requirements of the gaming
industry. By combining AAA and USA Card(TM) technology, with professional
services provided by SSP Gaming, we offer the land-based casino operators a
security suite for an online business extension that meets or exceeds the
standards required by regulators. This turnkey implementation can tie disparate
databases and resort business processes into a unified customer service and
revenue generation engine.
Currently, due to state and federal regulatory restrictions, online
gaming cannot be conducted within the United States. Domestic gaming operators
anticipate that if and when regulations are changed to allow the conduct of
online gaming in the United States, security will be a critical element of any
licensing review process.
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We have the ability to create and support strategic plans for
e-commerce relationships and infrastructure for the development and operation of
secure authentication and transaction processing for virtual online gaming and
also for loyalty programs, hospitality and lodging services for hotels, resorts
and casinos. Our products and services that can be utilized in the gaming
industry include software, the USA Card(TM) products together with future
biometric and global positioning satellite designs for authenticating and
locating users, and a network of hardware devices enabling security from server
to user.
The Internet gaming market continues to grow with the launch of each
new online casino. SSP Gaming and the Venetian Casino Resort, LLC of Las Vegas,
Nevada have joined forces and created Venetian Interactive as their online
gaming company. VI is one of two major Las Vegas hotel and casino operators to
receive an online gaming license from a foreign licensing authority. Based on
the grant of the foreign license, operations for VI will be based and conducted
outside the United States.
RESEARCH AND DEVELOPMENT
We will continue to devote research and development ("R&D") resources
to enhance our data security product line. We conduct extensive research and
development focusing on cryptographic embedded systems, software, and hardware
products, including cryptographic token reader/writer devices and cryptographic
tokens such as smart cards. These products can be readily integrated and adapted
to meet the expanding security requirements of Internet, intranets and
extranets.
Our R&D team has broad expertise in the development of cryptographic
products, with an emphasis on products that meet leading industry security
standards for global markets. Furthermore, our R&D team is experienced in
implementing our data security hardware and software solutions for an extensive
family of Windows and Unix operating systems. We also have solid expertise in
bringing our products to a variety of industries, such as government, finance
and system integrators. During 2000, 2001 and 2002, respectively, we spent $5.8
million, 6.7 million and $4.9 million on research and development projects. The
development of the Forte(TM) chip constituted the major focus of our R&D
efforts, together with related operating system, and enhancements to other
software and hardware projects. In accordance with Generally Accepted Accounting
Principles ("GAAP"), these amounts have been expensed against operations and are
shown on separate line items in the consolidated statements of operations for
the respective years.
Our current R&D efforts include:
o We are a core technology provider under the contract awarded
to General Dynamics C4 Systems Next Generation PKI Initiative
Team for the DoD. Through our PM product, we will provide
smart card and digital certificate management software and
engineering services to implement the secure next generation
PKI initiative, a significant element of the DoD long-term
roadmap for a solid information assurance strategy. We have a
long history of developing PKI technology and open,
interoperable security products for the government sector.
This contract, known as CI-1, encompasses the first capability
increment of the DoD next generation PKI initiative and
includes the development and fielding of a system for
providing high-assurance digital certificates to the DoD and
other government agency users. Our PM, a comprehensive smart
card and digital certificate issuance and lifecycle management
application, will be used to satisfy certificate and token
management requirements, as the DoD high-grade digital
certificates have strict criteria for the distribution and use
of certificates, protection and recovery of keys, and
stringent auditing requirements.
o The R&D team will be supporting a product rollout of Forte
(TM). The pre-production run of the Forte'(TM) smartcard has
been delivered to both government and commercial users for
evaluation, and the production version is scheduled for
release in the second quarter of 2003. In addition to the
smart card version of our Forte product, we are investigating
other markets for the chip in various integrated circuit
form-factors for embedding in systems.
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o Under a funded program, we are developing a Java Card version
of Forte (TM). This design, "JForte", supports the standard
Java card and Visa open platform protocols. JForte is
scheduled for production release at the end of 2003.
o Based upon market request, we continue to develop a series of
USB interface reader/writers, some of which include
fingerprint biometric capability.
o We are developing technologies to incorporate a number of
biometric technologies (fingerprint, iris scan, voice
recognition, handwriting recognition) into our PKI products to
provide further advanced identification and authentication
protection.
o We are developing commercial versions of both the server and
client KME components. The KME server side is called Profile
Manager Enterprise, and the client side is called NetSign(R)
Enterprise. By leveraging our development work under the next
generation PKI initiative program, we believe that we can
bring commercial versions to market that will be
state-of-the-art in network-based PKI.
o We will be expanding Maestro to offer additional application
program interfaces, including an interface to the GSA CAC
protocol, enabling the Maestro to function on a number of Unix
operating system platforms, and adding to the suite of tokens
supported by Maestro.
INTELLECTUAL PROPERTY
To date, we have developed and protected a number of data security
products. Due to the rapid pace of technological innovation in the data security
market, our ability to maintain a position of technology leadership is dependent
upon the skills of our development personnel more than upon the legal
protections afforded to our existing and future technology. When protecting our
proprietary technology, we rely on a combination of trademarks, patents,
copyrights, trade secret laws, non-disclosure agreements, technical measures,
and other methods. In addition, we employ shrink-wrap license agreements with
end users. Since these license agreements are not signed, they may not always be
enforceable.
We currently have five patents issued by and eight patent applications
pending with the U.S. Patent and Trademark Office. All of our patents cover
aspects of our data security technology that enable competitive advantages. In
addition, we have two foreign patent applications pending approval. Prosecution
of these patent applications and any other patent applications that we may later
file may require us to expend substantial resources.
We initially developed Forte(TM) under a task order issued under a
contract with the NSA. The contract incorporates the standard licenses for
technical data and computer software from the DoD, commonly known as the data
rights clauses. Data rights clauses are only applicable to data or software
actually delivered to the federal government under a contract. If the data
rights clause, or the government purpose rights license, is applicable to our
agreement with the NSA, it would permit the federal government to create second
supply sources without paying us royalties. We do not believe the data rights
clause or the government purpose license applies to Forte(TM) because our
contract with the NSA does not provide for the delivery of this product to the
federal government. However, the task order does allow NSA to obtain detailed
design information about Forte(TM).
COMPETITION
We compete in numerous markets, including:
o Internet and intranet electronic security;
o access control and token authentication;
o smart card-based security applications and rights management;
and
o electronic commerce applications.
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The markets for our products and services are intensely competitive and
are characterized by rapidly changing technology and industry standards,
evolving user needs and frequent introduction of new products. We believe that
the main factors affecting competition in our key markets include:
o performance, product functionality and ease of use - our
products have been in the market place for over thirty years
and generally have performed to the expectations of their
users.
o flexibility and features - our products are designed with the
features needed and requested by our customers with the
functionality and flexibility to meet the operating
requirements of field personnel.
o use of open standards - by using open standards architecture,
our products are compatible with most operating platforms and
applications developed by other vendors.
o quality of service support - our services and products have
consistently received high ratings from post contract
reviewers.
o corporate reputation - based upon over thirty years of
operation we have a reputation for developing innovative and
sophisticated PKI solutions for next generation needs in
digital security.
o ease of installation - to the extent technologically possible,
we design products for ease of use and installation by the end
user.
o enterprise wide management of applications and tokens - our
products are scalable to service users located throughout the
world by Web-enabling client side products; and
o price - our products are priced to provide the best value to
our customers.
Based upon the combination of all these competitive factors, we believe
we maintain a strong position in the security market for government digital
communications. We are based in the U.S. whereas some competitors, such as
Activcard and Schlumberger, are foreign owned and foreign based despite having
offices in the U.S. In providing security solutions to sensitive U.S. government
agencies and branches of the armed forces, this may be a significant competitive
advantage. We face significant competition from a number of different sources.
We believe that the competition will likely increase as a result of higher
demand for security products and consolidation in the information security
technology market. Many of our competitors are large firms that have several
advantages, mainly having greater name recognition and substantially greater
financial, technical, and marketing resources.
Some of our significant data security competitors include: Datakey, RSA
Data Security, SCM Microsystems, and Activcard. In addition, there are several
start-up companies with whom we compete with from time-to-time.
We believe that our existing relationships and the relationships we
intend to pursue with systems integrators and OEMs provide us with an important
competitive advantage in the data security industry. We also have extensive
experience in developing hardened security solutions for government projects and
have been used in several leading government programs.
GOVERNMENT REGULATION
Because we sell our products internationally as well as domestically,
we must comply with federal laws regulating the export and applicable foreign
government laws regulating the import of our products. The U.S. government has
recently relaxed the export restrictions for our NetSign(R) and PM products.
However, the federal government may rescind these approvals at any time. Under
current regulations, these products can be exported without a license to most
countries for use by banks, healthcare and insurance organizations, and overseas
subsidiaries of U.S. companies.
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Additionally, we may apply for export approval, on a specific criteria
basis, for future products. Government export regulation for security products
is less stringent for products designed for banking and finance, e-commerce,
health and insurance, and for use by overseas subsidiaries of U.S. companies. It
is possible that we will not receive approval to export future products on a
timely basis, on the basis we request, or at all. As a result of government
regulation of our products, we may be at a disadvantage when competing for
international sales with foreign companies that are not subject to these
restrictions.
PULSAR PRODUCT RESELLING
Our wholly-owned subsidiary, Pulsar, operates independently as our
network solutions segment. Pulsar specializes in solutions that require the
deployment of large-scale networks and secure PCs. Pulsar offered secure
computers using elements of our product offering. Due to the intensive capital
requirements and low margin returns, subsequent to December 31, 2002, we decided
to exit this line of business and as a result, we are not accepting new orders
and we are currently in the final stages of completing a wind down of the Pulsar
operations. As our projections indicated inadequate cash flows from operations,
we recorded an impairment charge of $599,000 relative to Pulsar intangibles,
which represented the remaining balance of the intangible assets.
EMPLOYEES
As of March 31, 2003, we employed 69 people, of which 68 were full-time
and 1 was part-time, including 38 in research, development and support, 12 in
field operations including sales, MIS and customer management, 4 in technical
support and 15 in finance, human resources, business development, legal and
administration. Our employees are not represented by labor unions. While we have
reduced our staffing levels, if sales fail to materialize, we will need to
further reduce expenses through additional reductions in staff. We have
terminated all direct employees associated with our Pulsar operations.
ITEM 2. PROPERTIES
We are headquartered in Irvine, California, where we currently lease
approximately 20,702 square feet of office space for our executive offices under
a seven-year lease that expires on February 28, 2007, and we have an option to
renew the lease for a five-year period, which we may exercise by providing
notice to KRDS, Inc., the landlord, not less than six months prior to the
expiration of the initial seven-year term. The facility has an annual rent of
$429,000 and is leased to us by KRDS, Inc., an entity owned in part by Kris
Shah, our co-chairman. In April 2002, KRDS, Inc. and we entered into an
agreement whereby, upon 60 days notice, KRDS, Inc. or we may cancel the
remaining term of the lease of the corporate headquarters with no liability to
the terminating party.
During 2001, we arranged for the lease of two buildings located in the
Spectrum area of Irvine, California. The buildings, which approximated 63,000
square feet, were under construction and were subsequently completed. During
2001, our co-chairman, Mr. Shah, had a 25% ownership interest in Research
Venture, LLC, the entity that owned the two buildings. In August 2002, Mr. Shah
surrendered his 25% ownership interest in that entity. At the time of
surrendering his interest, the buildings were encumbered by one or more
construction loans for which the lender required personal guarantees for renewal
of the financing. Because there was little, if any, equity in the project and
Mr. Shah was unwilling to personally guarantee the loans, Mr. Shah chose to
surrender his membership interest.
The seven-year leases for the two buildings had an aggregate monthly
rental totaling approximately $115,000 plus common area costs. We sublet to a
company owned by our co-chairman and co-chief executive officer, Marvin Winkler,
one-half of the 23,000 square-foot building on the same terms and conditions as
the underlying lease. We received a lease deposit but did not receive any rental
payments under the sublease. We reserved in our 200l consolidated financial
statements all amounts due to us under the sublease. At the end of 2001, our
forecasted business needs did not justify our leasing of both new buildings.
Therefore, we began discussions with the landlord regarding the facility leases.
Based upon certain assumptions, in our 200l consolidated financial statements we
accrued approximately $2.2 million as an estimate for anticipated costs relative
to the disposition of one of the building leases, which was net of anticipated
offsetting sublease income.
In October 2002, we completed a restructuring of our lease obligations
to the landlord and settlement of proceedings instituted by the landlord to
recover possession of the buildings. The settlement required cancellation of the
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sublease. In addition, the settlement required us to issue to the landlord
959,323 shares of common stock, to pay to the landlord $500,000 in cash over a
one-year period, to cancel the lease on one building approximating 23,000 square
feet, and to take occupancy of the other building approximating 40,000 square
feet under a seven-year lease for an initial monthly rental rate of $55,000 plus
common area costs beginning in December 2002. The monthly rental rate on the
seven-year lease is scheduled to increase to $73,000 plus common area costs at
the beginning of the third year. At our option, a portion of the rent may be
paid either in stock or in cash during the first two years of the lease under
certain circumstances through conversion of a $360,000 subordinated convertible
promissory note that we issued to the landlord as prepaid rent. The note was
convertible into an aggregate of up to 276,923 shares of common stock. As of
March 31, 2003, we had converted $51,000 of the principal amount of the note
into 39,229 shares of common stock valued at an agreed upon value of $1.30 per
share as payment of rent.
We maintain a data security products sales office in Reston, Virginia
to service our government accounts located in the Washington, D.C. area. The
facility is in an executive suite complex and is rented on a month-to-month
basis.
We maintain a network solutions office in Lanham, Maryland under a
lease that is due to expire in October 2003.
ITEM 3. LEGAL PROCEEDINGS
Research Venture, LLC filed a complaint against us on June 4, 2002 and
filed first amended complaints against us on August 6 and August 7, 2002 in the
Superior Court for the State of California, County of Orange, Central Justice
Center (Case Nos. 02CC10109 and 02CC10111) alleging unlawful detainer and
seeking possession of two leased properties, alleged damages and lost rent. We
surrendered possession of both properties and negotiated a restructuring of our
obligations under the leases. The restructuring involved, among other terms, our
entry on October 23, 2002 into a stipulation for entry of judgment that will
permit Research Venture, LLC to file a judgment against us in the maximum
aggregate amount of $3.1 million, less consideration we pay prior to any entry
of the judgment, if we do not comply with the terms of the restructuring
arrangement for the next two years. We issued 959,323 shares of common stock
with an agreed upon value of $1.2 million as payment toward the maximum
aggregate amount, and agreed to pay $500,000 in cash over a one-year period, of
which $325,000 remains unpaid as of March 31, 2003. We also issued a $360,000
subordinated convertible promissory note as prepaid rent. At our option under
certain circumstances, we may pay a portion of the rent in stock during the
first two years of the lease. As of March 31, 2003, we had converted $51,000 of
the note into shares of common stock valued at an agreed upon value of $1.30 per
share as payment of rent.
G2 Resources, Inc. and Classical Financial Services, LLC have filed
complaints against Pulsar alleging that Pulsar breached a contract by failing to
make payments to G2 Resources, Inc. in connection with services allegedly
provided by G2 Resources, Inc. The contract provided that Pulsar pay G2 $500,000
in 30 monthly installments of $16,666 and an additional fee of 2% of the gross
dollar amount generated by awards. In its complaint, G2 alleged that Pulsar
failed to make payments under the contract and claimed damages in excess of
$525,000 plus interest, costs and attorneys fees. In the course of discovery G2
asserted that its losses/costs arising out of its claim amounted to
approximately $10.3 million. In April 2001, the court dismissed, for lack of
prosecution activity for more than twelve months, the original complaint that G2
Resources, Inc. had filed against Pulsar in January 1998. G2 Resources, Inc.
re-filed the action in May 2001. In 2002, the case was moved from Division AF to
Division AH (Case No. 01-5444 AH) of the Fifteenth Florida District Court in
Palm Beach County. We believe that the claims made by G2 and Classical against
Pulsar are without merit and we intend to vigorously defend against the
plaintiffs' claims and we have asserted defenses and counterclaims. If G2 or
Classical were to prevail in this lawsuit, our financial condition would be
adversely affected.
In May 2002, Contemporary Services Corporation filed an action against
us in Los Angeles Superior Court (Case No. BC 274206) alleging breach of
contract, fraud, negligent misrepresentation and violation of California
Corporations Code section 25400. The action relates to a term sheet agreement
that we entered into with the plaintiff in October 2001 in connection with a
potential strategic relationship between the plaintiff and us. We filed an
answer and cross-complaint. While we continued to believe we would prevail at
trial, in February 2003, we reached an agreement to settle the case. We accrued
an amount related to the settlement, which was not material, in our 2002
consolidated financial statements.
19
In May 2002, Integral Systems, Inc. filed an action against us in the
Circuit Court for Montgomery County, Maryland, Case No. 232706, alleging that we
breached a promissory note for the payment of $389,610. Integral Systems then
obtained a confessed judgment against us for approximately $327,250, and amounts
related the judgment have been accrued in the financial statements for the year
ending December 31, 2002. In March 2003, we executed settlement papers that
would permit Integral Systems to file a stipulated judgment against us in the
amount of the unpaid balance if we default on a payment schedule that requires
us to make payments of $20,000 per month until the balance is paid in full. In
April 2003 we also issued a warrant to purchase up to 150,000 shares of our
common stock at an exercise price of $1.30 per share as part of the settlement.
In July 2002, Synnex Technology ("Synnex") filed a lawsuit against us
in the Superior Court of Orange County, Case No. 02CC12380, alleging that we
failed to pay $120,986 for products purchased by us for resale. We and Synnex
agreed to settle the matter by payment of ten equal installments of $12,099,
pursuant to a stipulation for entry of judgment that is to be held by counsel
for Synnex and not filed with the court absent breach by us. The last payment is
due on or before June 9, 2003, at which time the action will be dismissed. To
date, all required payments have been made.
We currently hold multiple contracts with the federal government for
the resale of network deployment products. In particular, three of these
contracts permit us to provide goods and services to various federal government
agencies. An administrative agency recently informed us that one of the
contracts would not be renewed unless purchase activity was conducted under the
contract. We are negotiating with a party for the sale of the contract. It is
possible the other contracts may not be renewed or may be cancelled by the
federal government due to our inability to perform as required under the
contracts.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our stockholders during the
fourth quarter of 2002.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET PRICE AND HOLDERS
Our common stock is listed on The Nasdaq National Market under the
symbol "SSPX." The following table sets forth, for the quarters indicated, the
high and low closing sale prices per share of the common stock as reported on
The Nasdaq National Market.
HIGH LOW
---- ---
Quarter ended March 31, 2001.................... $ 6.59 $ 2.50
Quarter ended June 30, 2001..................... $ 4.60 $ 2.46
Quarter ended September 30, 2001................ $ 3.99 $ 2.01
Quarter ended December 31, 2001................. $ 6.60 $ 3.44
Quarter ended March 31, 2002.................... $ 4.40 $ 2.31
Quarter ended June 30, 2002..................... $ 1.93 $ .98
Quarter ended September 30, 2002................ $ 1.54 $ .95
Quarter ended December 31, 2002................. $ 1.05 $ .59
Quarter ended March 31, 2003.................... $ 1.06 $ .54
On March 31, 2003, the last reported sale price for our common stock on
The Nasdaq National Market was $0.60. As of March 31, 2003, the approximate
number of holders of record of our common stock was 94.
20
DIVIDEND POLICY
We have not paid dividends on our common stock to date. We do not
anticipate declaring dividends on our common stock in the foreseeable future.
Most of our debt instruments prohibit us from paying dividends on our common
stock.
RECENT SALES OF UNREGISTERED SECURITIES
In October 2002, we issued 127,035 shares of common stock to six
accredited holders of secured convertible promissory notes dated April 16, 2002
based upon a conversion price of $1.15 per common share as payment for interest
due for the third quarter of 2002. The conversion price was based upon a 20-day
moving average of the trading price of our common stock in September 2002.
In October 2002, under our Amended and Restated 1999 Stock Option Plan
we issued an option to purchase 20,000 common shares at an exercise price of
$1.30 per share to Joel K. Rubenstein for services on our board of directors.
In October 2002, we issued 1,600,000 shares of common stock and a
$270,000 non-interest bearing convertible note to Wave Systems Corp., an
accredited entity, under the terms of a termination and mutual release
settlement relating to a $5.0 million development agreement. In December 2002,
we exercised our right to convert the note into 200,000 shares of common stock.
The settlement is more fully described in Item 12 of this report under the
heading "Beneficial Ownership Table - Wave Systems Corp."
In October 2002, we issued 959,323 shares of common stock as payment
toward the settlement of proceedings instituted by Research Venture, LLC, an
accredited entity, to recover possession of two buildings leased to us by that
entity. We also issued to Research Venture, LLC as prepaid rent a $360,000
subordinated convertible promissory note. At our option, a portion of the rental
rate on the building that remains leased to us may be paid either in stock or in
cash during the first two years of the lease under certain circumstances through
conversion of the note. In December 2002, we issued 4,615 shares of common stock
as payment for a partial month's rent of $6,000 due in December 2002. As of
March 31, 2003, we had converted $51,000 of the note into 39,229 shares of
common stock at an agreed upon value of $1.30 per share as payment of rent.
As described in Item 13 of this report, in November 2002, we issued
$500,000 in principal amount of secured promissory notes and warrants to
purchase up to 100,000 shares of common stock to Crestview Capital Fund, L.P.,
Crestview Capital Fund II, L.P. and Richard P. Kiphart, three accredited
investors.
Exemption from the registration provisions of the Securities Act of
1933 for the transactions described above is claimed under Section 4(2) of the
Securities Act of 1933, among others, on the basis that such transactions did
not involve any public offering and the purchasers were sophisticated or
accredited with access to the kind of information registration would provide. In
each case, appropriate investment representations were obtained, stock
certificates were issued with restricted stock legends, and stop transfer orders
were placed with our transfer agent.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated historical financial data presented below
under the captions "Selected Statements of Operations Data" and "Selected
Balance Sheet Data" for, and as of the end of each of the years in the four-year
period ended December 31, 2001, are derived from the consolidated financial
statements of SSP Solutions, Inc. and subsidiaries, which consolidated financial
statements have been audited by KPMG LLP, independent certified public
accountants. For the one-year period ended December 31, 2002, Haskell & White
LLP audited the consolidated financial statements that serve as the basis for
the selected data presented below under the captions "Selected Statements of
Operations Data" and "Selected Balance Sheet Data" for the respective period
then ended. The consolidated financial statements as of December 31, 2002 and
2001, and for each of the years in the three-year period ended December 31,
2002, and the reports thereon, are included elsewhere in this report. The
historical results are not necessarily indicative of results to be expected for
any future periods.
21
YEARS ENDED DECEMBER 31,
SELECTED CONSOLIDATED STATEMENTS ---------------------------------------------------------------------------------
OF OPERATIONS DATA: 1998 1999 (1) 2000 2001 (2) 2002
------------- ------------- ------------- ------------- -------------
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Revenues:
Product ........................... $ 5,214 $ 29,587 $ 37,421 $ 21,145 $ 8,131
License and service ............... 1,041 1,270 1,935 1,575 4,427
Research and development .......... 398 798 -- -- --
------------- ------------- ------------- ------------- -------------
Total revenues ................. 6,653 31,655 39,356 22,720 12,558
------------- ------------- ------------- ------------- -------------
Cost of Sales:
Product ........................... 2,821 25,478 30,481 17,457 3,807
License and service ............... 950 590 679 537 820
------------- ------------- ------------- ------------- -------------
Total cost of sales ............ 3,771 26,068 31,160 17,994 4,627
------------- ------------- ------------- ------------- -------------
Gross margin ......................... 2,882 5,587 8,196 4,726 7,931
------------- ------------- ------------- ------------- -------------
Operating Expenses:
Selling, general, and
administrative ............... 2,631 7,194 9,559 10,645 7,515
Research and development .......... 1,334 3,906 5,800 6,739 4,895
Research and development - Wave
Systems Corp. ................... -- -- -- 1,111 1,041
Impairment of goodwill and
other intangibles ............... -- -- 31,415 36,299 599
Amortization of goodwill and
other intangibles ............... -- 1,448 2,828 746 92
In-process research and
development ..................... -- -- -- 1,600 --
------------- ------------- ------------- ------------- -------------
Total operating expenses ..... 3,965 12,548 49,602 57,140 14,142
------------- ------------- ------------- ------------- -------------
Operating loss ....................... (1,083) (6,961) (41,406) (52,414) (6,211)
Non-operating expenses (income)
Realized loss on trading securities -- -- -- 530 130
Interest expense, net ............. 418 168 65 163 782
Non-cash interest and financing
expense .............................. -- -- -- -- 1,287
Equity loss from Affiliate ........... -- -- -- -- 248
Other (income) expense, net .......... -- -- (72) -- (104)
------------- ------------- ------------- ------------- -------------
Total non-operating expenses
(income) ..................... 418 168 (7) 693 2,343
------------- ------------- ------------- ------------- -------------
Earnings (loss) from continuing
operations before income taxes ..... (1,501) (7,129) (41,399) (53,107) (8,554)
Provision for (benefit from) income
taxes .............................. (95) (43) 6 53 2
------------- ------------- ------------- ------------- -------------
Earning (loss) from continuing
operations ......................... $ (1,406) $ (7,086) $ (41,405) $ (53,160) $ (8,556)
============= ============= ============= ============= =============
Net earnings (loss) .................. $ (1,406) $ (7,086) $ (41,405) $ (53,160) $ (8,556)
============= ============= ============= ============= =============
Earnings (loss) from continuing
operations per share: basic and
diluted ............................ $ (.36) $ (1.00) $ (4.20) $ (3.91) $ (.40)
============= ============= ============= ============= =============
Net earnings (loss) per share: basic
and diluted ........................ $ (.36) $ (1.00) $ (4.20) $ (3.91) $ (.40)
============= ============= ============= ============= =============
Shares used in per share
computations: basic and diluted .... 3,870,693 7,055,882 9,862,472 13,585,202 21,647,707
============= ============= ============= ============= =============
------------
(1) On June 14, 1999, we completed the acquisition of Pulsar Data Systems,
Inc. All outstanding shares of Pulsar were exchanged for 2,169,938
shares of our common stock. The acquisition of Pulsar was accounted for
using the purchase method of accounting. Accordingly, the results of
operations of Pulsar have been included in our consolidated financial
22
statements from June 14, 1999. We have determined that the integration
of Pulsar will not be completed as planned. Based on the results of an
independent valuation, in the 2000 we recorded an impairment charge of
$31.4 million related to unamortized intangible assets acquired in
connection with our acquisition of Pulsar. In December 2002, we wrote
off the remaining intangible asset balance of $599,000 related to
Pulsar.
(2) On August 24, 2001, we completed an acquisition in which Litronic
Merger Corp., a Delaware corporation and one of our wholly-owned
subsidiaries, was acquired by merging with and into BIZ. BIZ survived
the transaction as our wholly-owned subsidiary. Upon consummation of
the BIZ acquisition, all outstanding shares of BIZ were exchanged for
10,875,128 shares of our common stock. The BIZ acquisition was
accounted for using the purchase method of accounting. Accordingly, the
results of operations of BIZ have been included in our consolidated
financial statements from August 24, 2001. We have determined that the
other intangible assets and a portion of the goodwill related to the
BIZ acquisition will not be realized. As a result, we analyzed the
recoverability of the other intangibles and goodwill relating to the
BIZ acquisition. Based on the results of our analysis, in 2001 we
recorded an impairment charge of $36.3 million.
DECEMBER 31,
---------------------------------------------------------
SELECTED CONSOLIDATED BALANCE SHEET DATA: 1998 1999 2000 2001 2002
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
Cash and cash equivalents....................... $ 898 $ 6,441 $ 4,120 $ 3,257 $ 553
Working capital (deficit)....................... 758 12,592 4,858 (5,779) (5,949)
Total assets.................................... 2,791 51,104 11,768 37,423 30,011
Current installments of long-term debt.......... 580 481 1,986 1,695 2,826
Long-term debt, less current installments....... 5,200 -- 19 2,500 --
Total liabilities............................... 6,998 3,171 5,220 19,845 8,888
Total shareholders' equity (deficit)............ (4,207) 47,933 6,548 17,578 21,123
We did not pay dividends on our common stock during the periods
presented. Most of our debt instruments prohibit us from paying cash dividends
on our common stock.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with our audited consolidated financial statements and notes to financial
statements included elsewhere in this report. This report contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, or the Securities Act, and Section 21E of the
Securities Exchange Act of 1934, as amended, or the Exchange Act. We intend that
the forward-looking statements be subject to the safe harbors created by those
sections.
The forward-looking statements generally include our management's plans
and objectives for future operations, including plans, objectives and
expectations relating to our future economic performance, business prospects,
revenues, working capital, liquidity, ability to obtain financing, generation of
income and actions of secured parties not to foreclose on our assets. The
forward-looking statements may also relate to our current beliefs regarding
revenues we might earn if we are successful in implementing our business
strategies. The forward-looking statements generally can be identified by the
use of the words "believe," "intend," "plan," "expect," "forecast," "project,"
"may," "should," "could," "seek," "pro forma," "estimates," "continues,"
"anticipate" and similar words. The forward-looking statements and associated
risks may include, relate to, or be qualified by other important factors,
including, without limitation:
o anticipated trends in our financial condition and results of
operations (including expected changes in our gross margin and
general, administrative and selling expenses);
o the projected growth or contraction in the information
security products and services markets in which we operate;
o our ability to finance our working capital and other cash
requirements;
23
o our business strategy for expanding our presence in the
Internet data security market; and
o our ability to distinguish ourselves from our current and
future competitors.
We do not undertake to update, revise or correct any forward-looking
statements. The forward-looking statements are based largely on our current
expectations and are subject to a number of risks and uncertainties. Actual
results could differ materially from these forward-looking statements. Important
factors to consider in evaluating forward-looking statements include:
o the shortage of reliable market data regarding the Internet
data security market;
o changes in external competitive market factors or in our
internal budgeting process that might impact trends in our
results of operations;
o changes in our business strategy or an inability to execute
our strategy due to unanticipated changes in the contract
support services markets; and
o various other factors that may prevent us from competing
successfully in the marketplace.
The information contained in this report is not a complete description
of our business or the risks associated with an investment in our common stock.
Before deciding to buy or maintain a position in our common stock, you should
carefully review and consider the various disclosures we made in this report,
and in our other materials filed with the Securities and Exchange Commission
that discuss our business in greater detail and that disclose various risks,
uncertainties and other factors that may affect our business, results of
operations or financial condition. In particular, you should review the "Risk
Factors" section of this report.
Any of the factors described above or in the "Risk Factors" section of
this report could cause our financial results, including our net income (loss)
or growth in net income (loss) to differ materially from prior results, which in
turn could, among other things, cause the price of our common stock to fluctuate
substantially.
OVERVIEW
We provide professional Internet data security services and develop and
market software and microprocessor-based products needed to secure electronic
commerce and communications over the Internet and other communications networks
based on Internet protocols. Our primary technology offerings use PKI, which is
the standard technology for securing Internet-based commerce and communications.
In addition, Pulsar, one of our wholly-owned subsidiaries, is an established
computer and networking product reseller that focuses on resales to government
agencies, large corporate accounts and state and local governments. We acquired
Pulsar in June 1999 in exchange for 2,169,938 shares of our common stock. Due to
the intensive capital requirements and low margin returns, subsequent to
December 31, 2002, we decided to exit the Pulsar line of business and as a
result, we are not accepting new orders and we are currently in the final stages
of completing a wind down of the Pulsar operations.
Before 1990, we were solely a provider of electronic interconnect
products to government and commercial entities. In 1990, we formed our data
security division, which is the basis of our operations today. The data security
division was engaged primarily in research and development until 1993, when it
began to generate meaningful revenue. In September 1997, we sold our Intercon
division, which consisted of the assets relating to our interconnect operations,
for cash to Allied Signal Inc., an unrelated publicly traded company.
Our lack of liquidity and shortage of working capital has limited our
operations. If we do not raise additional capital within the next several
months, we face the prospect of filing for protection to reorganize our debts
and financial obligations. To date, creditors and vendors generally have
cooperated with us, which has given us time to reduce our operating expenses and
realize increases in revenues in our core business. We have done both in the
last two quarters of our operations. If we are unable to make payments on the
extended term agreements or pay our current vendors, or if holders of our notes
declare us in default and call their notes, we would not have the financial
resources to satisfy all of these obligations. The results of our operations and
24
liquidity discussions in this section of this report contain further comments on
our limited resources and our dependency on continued creditor cooperation for
us to continue our operations.
To meet our existing obligations, we will need to continue improving
our sales and continue controlling our operating expenses. We will also require
time to realize the financial benefits of improved operating results together
with the continued cooperation of our creditors. We are in discussions with
several financing sources regarding additional capital and have executed a term
sheet for a minimum financing of $10 million that would have a dilutive effect.
However, the investors may fail to provide the financing or may wish to change
the terms, called for in the term sheet. There is no assurance that the
investors will close the transaction, or if the transaction does close, that it
will be on the terms outlined in the executed term sheet. If this proposed
transaction does not close, we will seek other sources of funding, explore the
sale of product lines or intellectual property rights, or evaluate merger
partners. We may be forced to sell company assets or merge at a price below what
we might otherwise realize. We are at a critical juncture for the continued
survival of our company.
CRITICAL ACCOUNTING POLICIES
This "Management's Discussion and Analysis of Financial Condition and
Results of Operations" section of this report discusses our audited consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and assumptions that affect
the reported amounts of assets and liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities at the date of our
financial statements.
We based our estimates and judgments on historical experience and on
various other factors that we believe to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.
Critical accounting policies are defined as those that are reflective
of significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. We believe the
following critical accounting policies, among others, affect significant
judgments and estimates used in the preparation of our consolidated financial
statements. For a detailed discussion of the application of these and other
accounting policies, see the notes to our audited consolidated financial
statements included in this report.
REVENUE RECOGNITION
Some of our data security hardware products contain embedded software,
the sale of which is incidental to the hardware product sale. Data security
license revenue is recognized upon delivery if an executed license exists, a
delivery as defined under the license has occurred, the price is fixed and
determinable, and collection is probable. Prior to 2002, post-contract customer
support revenue was not separately identified and priced. Therefore, sufficient
vendor specific objective evidence could not be established for the value or
cost of such services. Furthermore, prior to 2002, revenue for the entire
license, including bundled post-contract customer support was recognized ratably
over the life of the license. Commencing in 2002, software delivered under a
license requires a separate annual maintenance contract that governs the
conditions of post-contract customer support. Post-contract customer support
services can be purchased under a separate contract on the same terms and at the
same pricing, whether purchased at the time of sale or at a later date. Revenue
from these separate maintenance support contracts is recognized ratably over the
maintenance period.
Revenue from cost-plus-award-fee support and development contracts is
recognized on the basis of hours incurred plus other reimbursable contract costs
incurred during the period. Prior to 2002, any award fee earned under a
cost-plus-award-fee contract was not recognized until the award fee notice was
received. Beginning in 2002, for a cost-plus-award-fee support contract, we
exercised the contract clause to bill and collect one-half of the award fee
ratably over the term of the contract. Revenue is recognized concurrently with
billings based on the performance of the contract requirements and reasonable
assurance of collection. Based upon historical results, we have received final
awards in excess of one-half of the full award fees. A post-contract period
performance review conducted by the customer determines the remaining amount of
the award fee to be received, which amount is then recognized as earned revenue,
together with interest paid on the unpaid balance. Award fees under development
contracts are recognized when confirmed by the customer.
25
Revenue from network deployment products is recognized upon transfer of
title, generally upon verification of delivery to the customer, which represents
evidence delivery has occurred, under a sales order represented by a government
purchase order that contains a fixed purchase price. When we fulfill the
elements of the government purchase order, collection of the revenue recorded is
reasonably assured.
Product and service revenues from our electric security systems
contracts were recognized in accordance with SOP 81-1, "Accounting for
Performance of Construction-Type and Certain Production-Type Contracts." We
recognized this revenue on a percentage of completion method, based on estimated
labor dollars incurred. The electric security systems product line was
discontinued in the year ended December 31, 2000.
The Company's revenue recognition policies are in accordance with the
Securities and Exchange Commission's Staff Accounting Bulletin No. 101.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make payments for services. We
analyze accounts receivable, customer credit-worthiness, current economic trends
and changes in our customer payment terms when evaluating the adequacy of the
allowance for doubtful accounts. If the financial condition of our customers
deteriorates, resulting in an impairment of their ability to make payments,
additional allowances may be required.
VALUATION OF GOODWILL AND OTHER INTANGIBLE ASSETS
We assess the impairment of goodwill and other intangible assets
annually, or whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors we consider important that could
trigger an impairment review include significant underperformance relative to
projected future operating results, significant changes in the manner of our use
of the acquired assets or the strategy for our overall business, and significant
negative industry or economic trends. The net carrying value of goodwill and
other intangible assets not recoverable is reduced to fair value.
During the fourth quarter of 2001, we determined that certain
identifiable technology and developed technology acquired in connection with the
BIZ acquisition were no longer going to be pursued. Additionally, we anticipated
a delay or indefinite reduction in projected revenues from the BIZ acquisition.
Accordingly, we performed an impairment analysis.
As a result of that analysis, we recorded an impairment charge of $36.3
million in the fourth quarter of 2001 related to the unamortized balances of
$2.6 million in identifiable technology, $5.8 million in developed technology
and $53.9 million in goodwill acquired in connection with the BIZ acquisition.
After this impairment charge, goodwill in the amount of $25.9 million is the
only remaining intangible asset relative to the BIZ acquisition. - Subsequent to
December 31, 2002, we decided to exit the Pulsar line of business. As our
projections indicated inadequate cash flows from operations, we recorded an
impairment charge of $599,000 relative to Pulsar intangible assets, which
represented the remaining balance of the intangible assets.
RESULTS OF OPERATIONS -- COMPARISON OF YEARS ENDED DECEMBER 31, 2000, 2001 AND
2002
We acquired BIZ in August 2001. Our results of operations for 2001 and
2002 include the results of BIZ's operations since August 25, 2001. Therefore,
revenue and expenses are not comparable from period to period.
TOTAL REVENUES
Total revenues decreased 42% from $39.4 million during the year ended
December 31, 2000 to $22.7 million during the year ended December 31, 2001, and
decreased 45% from $22.7 million during 2001 to $12.6 million during the year
ended December 31, 2002. The decrease from 2000 to 2001 consisted of a $17.5
million decrease in network solutions market revenues primarily because of our
inability to accept and fulfill a large number of customer orders due to reduced
26
accounts receivable financing availability. Our primary vendors were unwilling
to sell additional product to us on open account because of significant past due
amounts for goods we had previously purchased from them. The decrease was offset
by an $822,000 increase in data security products and services revenues
primarily attributable to an increase in sales volume of existing data security
products and services.
The decrease from 2001 to 2002 consisted of a $13.3 million decrease in
network solutions market revenues that was partially offset by a $3.2 million
increase in information security products and services market revenues. Due to
the lack of working capital, we began to limit the acceptance of orders within
our Pulsar operations, the source of the network solutions market revenues,
during the fourth quarter of 2002 while we were evaluating various options with
respect to the Pulsar operations. As of March 31, 2003, we had effectively
terminated all remaining employees at Pulsar and shut down Pulsar's operations.
Our continued focus on our core business of information security products and
services resulted in an increase of $2.9 million in license and service revenue
from 2001 to 2002 and an increase in data security products revenue of $307,000
from 2001 to 2002. We expect continued increases in revenues from our core
business of information security products and services in 2003 at a rate
comparable to the increases in core business revenues experienced in 2002. We
anticipate such an increase based on signed development contracts and pending
contracts that we are currently negotiating, coupled with expected increases in
data security product revenues as we concentrate all of our sales and marketing
efforts in this area. We do not expect any significant revenues from the network
solutions market segment in 2003.
During 2000, 42% of total revenues was generated from sales to the
United States Immigration and Naturalization Service. During 2001, 20% of
revenue was generated from sales to the United States Immigration and
Naturalization Service. During 2002, 26% and 15% of total revenues was generated
from sales to General Dynamics and Micron PC, LLC, respectively. Sales to
federal government agencies accounted for approximately 79%, 67% and 25% of
total revenues during 2000, 2001 and 2002, respectively.
PRODUCT REVENUES
Product revenues decreased 43% from $37.4 million during 2000 to $21.1
million during 2001, and decreased 62% from $21.1 million during 2001 to $8.1
million during 2002. The decrease from 2000 to 2001 consisted of a $17.2 million
decrease in network deployment products revenues that was partially offset by a
$918,000 increase in data security products revenues. The decrease from 2001 to
2002 consisted of a $13.3 million decrease in network solutions market revenues
that was partially offset by a $307,000 increase in data security products
revenues. We do not expect any significant network deployment revenues in 2003.
As noted above, we do expect continued increases in data security products
revenues.
SERVICE REVENUES
Service revenues decreased 13% from $1.2 million during 2000 to $1.0
million during 2001, and increased 156% from $1.0 million during 2001 to $2.6
million during 2002. The decrease from 2000 to 2001 was primarily attributable
to a $264,000 decrease in electric security systems revenues, and a decrease in
engineering and repair service revenues of $161,000, which was offset by an
increase of $168,000 relative to our Fortezza(R) support contract, and an
increase of $103,000 related to a new service contract with General Dynamics.
The increase from 2001 to 2002 was primarily attributable to a $1.6 million
increase in revenues associated with a higher margin subcontract with General
Dynamics to develop the architecture for the next generation PKI and related
extension initiatives for the DoD. We expect service revenues to increase in
2003 as a result of newly signed and existing service contracts.
LICENSE REVENUES
License revenues decreased 27% from $768,000 during 2000 to $561,000
during 2001, and increased 227% from $561,000 to $1.8 million during 2002. The
decrease from 2000 to 2001 was primarily attributable to fewer sales of licenses
for our Profile Manager software. The increase from 2001 to 2002 was primarily
attributable to an increase of $949,000 related to our subcontract with General
Dynamics whereby licenses for our PM software were sold, coupled with an
increase of $326,000 related to sales of other software licenses. We expect
licensing revenues to increase in 2003 based on incremental sales under the CAC
program coupled with increased sales of our PM software.
PRODUCT GROSS MARGIN
Product gross margin decreased as a percentage of net product revenues
from 19% during 2000 to 17% during 2001, and increased from 17% during 2001 to
53% during 2002. The decrease from 2000 to 2001 was primarily attributable to a
reduction in margins related to network deployment products, which reduction
resulted from our having to pay higher prices for product from secondary
suppliers because our primary vendors were unwilling to sell to us on open
account. During 2000, network deployment products represented 85% of total
product revenues as compared to data security products that represented 15% of
total product revenues. During 2001, network deployment products represented 68%
of total product revenues as compared to data security products that represented
32% of total product revenues. Margins from the sale of data security products
are significantly greater than the margins from the sale of network deployment
products. In addition, data security products margins also decreased, mainly due
to a significant reduction in the average selling price of our NetSign(R) 210
reader due to competitive pricing pressures. The increase from 2001 to 2002 was
27
primarily attributable to the overall reduction in revenues from our network
solutions market business, for which the margins are significantly lower than
margins from the information security products and services business segment.
During 2002, network solutions market business represented only 14% of total
product revenues compared to data security products that represented 86% total
of product revenues. We expect product gross margin to increase in 2003, as we
expect no network deployment product revenues in 2003. As previously stated,
margins from network deployment product revenues are substantially lower than
margins derived from our core business of data security product revenues.
SERVICE GROSS MARGIN
Service gross margin increased as a percentage of service revenues from
51% during 2000 to 62% during 2001, and increased from 62% during 2001 to 75%
during 2002. The margin percentage increase from 2000 to 2001 was primarily
attributable to discontinuing the low margin electric security system operation.
The margin percentage increase from 2001 to 2002 was primarily attributable to
new contracts that were entered into in 2002 that resulted in additional
revenues of $2.5 million associated with higher margin services related to our
subcontract with General Dynamics and government maintenance agreements. We
expect service gross margin percentages to decrease somewhat in 2003 due to the
addition of a lower margin government contract to add a Java operating system to
our USA Card(TM). We also expect that certain compensation costs that were
formerly considered research and development expense will be included as cost of
sales in 2002 due to a development contract for which we will provide services
under in 2003.
LICENSE GROSS MARGIN
License gross margin decreased as a percentage of license revenues from
85% during 2000 to 73% during 2001, and increased from 73% during 2001 to 90%
during 2002. The margin percentage decrease from 2000 to 2001 was primarily
attributable to more labor costs included within cost of sales relative to the
licensed products. The margin percentage increase from 2001 to 2002 was
primarily attributable to higher margin software licenses related to our
subcontract with General Dynamics. We expect license gross margin percentages
during 2003 to remain at 2002 levels based on our projected sales mix for 2003.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased 11% from $9.6
million during 2000 to $10.6 million during 2001, and decreased 29% from 2001 to
$7.5 million during 2002. The increase from 2000 to 2001 was primarily
attributable to the addition of approximately $1.2 million of personnel expenses
associated with the BIZ acquisition and a net loss on a lease for new operating
facilities of approximately $2.2 million, which were partially offset by a
reduction in compensation expense of approximately $900,000 and other net
reductions totaling approximately $1.3 million. The net loss on a lease was the
result of a lease we had entered into in October 2001 with a former related
party for new operating facilities. After entering into the lease, we determined
that we would not need all of the space contracted for and therefore we recorded
a loss on the lease net of estimated sublease income. Compensation expense
reductions included $807,000 related to Pulsar, which were primarily for
reductions in salary and commission expenses due to decreased revenues and the
need to adjust cost structures accordingly. Reductions not related to Pulsar
were primarily attributable to reductions in salary, travel, professional fees,
printing and office expenses. Expense reductions not related to Pulsar were done
in an effort to reduce current cash expenditures. The decrease from 2001 to 2002
was primarily attributable to the reversal of previously accrued restructuring
charges in the approximate amount of $700,000 as a result of the completion of
the restructuring of the lease obligations, for which an accrual of $2.2 million
was recorded in 2001 as discussed above. The net result was a reduction of $2.4
million in 2002 versus 2001. We also implemented staff reductions, reduced
compensation levels and initiated a wind down of the Pulsar operations in 2002,
which further reduced overall staffing. As a result, compensation and benefits
expense decreased by approximately $223,000 in 2002 from 2001. Additionally,
sales promotion expenses decreased by approximately $530,000, while other net
reductions totaling approximately $449,000 were offset by an increase in
professional fees of approximately $607,000 in 2002 versus 2001. As a percentage
of total revenues, selling, general and administrative expenses increased from
24% during 2000 to 47% during 2001 and increased to 60% during 2002. The
percentage increase for each of the years was primarily attributable to the
significant decrease in revenues related to network deployment products. We
expect selling, general and administrative expenses to decrease as a percentage
of total revenue in 2003 due to expected increases in overall revenue combined
with decreases in selling, general and administrative expenses associated with
the cessation of our Pulsar operations.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses increased 16% from $5.8 million
during 2000 to $6.7 million during 2001, and decreased 27% from $6.7 million
during 2001 to $4.9 million during 2002. The increase from 2000 to 2001 was
primarily attributable to significant increased staffing related to product
development, including development efforts related to the Forte(TM)
microprocessor, Maestro, PM, NetSign(R) and token reader/writers, coupled with
the addition of personnel expense from the BIZ acquisition. The decrease from
2001 to 2002 was primarily attributable to significant reductions in staffing.
As a percentage of total revenues, expenses increased from 15% during 2000 to
30% during 2001, and increased from 30% during 2001 to 39% during 2002. The
percentage increase from 2000 to 2001 was primarily attributable to the
continued expansion of our research and development efforts, combined with the
significant decrease in network deployment revenues. The percentage increase
from 2001 to 2002 was primarily attributable to the significant decrease in
network deployment revenues. We expect research and development expenses to
decrease in 2003 as expenses that were formerly considered research and
development, will be included within cost of sales for 2003 due to current
development contracts that we will be engaged in during 2003.
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RESEARCH AND DEVELOPMENT - WAVE SYSTEMS CORP.
In October 2000, BIZ signed a development agreement with Wave Systems
Corp. ("Wave") for the integration of EMBASSY-based systems with set-top box
master reference designs of Broadcom Corporation. The development agreement was
amended in May 2001. Under this agreement, as amended, we were required to pay a
total of $5.0 million beginning June 1, 2001 through December 1, 2002. In
January 2002, we provided written notice to suspend the work under the agreement
along with the related billings. We executed a settlement agreement with Wave
through which we terminated the development agreement effective as of August 31,
2002 and reached settlement terms. According to the terms of the settlement
agreement, in October 2002 we issued 1.6 million shares of common stock and a
$270,000 non-interest bearing note convertible into 200,000 shares of our common
stock. As a result of this settlement agreement, for the year ended December 31,
2002, we recorded a loss of approximately $1.0 million. We do not expect any
further Research and Development - Wave expenses in 2003.
IMPAIRMENT OF GOODWILL AND OTHER INTANGIBLES
In June 1999, we acquired Pulsar. All of the outstanding shares of
Pulsar were exchanged for 2,169,938 shares of our common stock. The acquisition
was accounted for using the purchase method of accounting. In the fourth quarter
of 2000, we determined the integration of Pulsar would not be completed as
planned and that the anticipated operating synergies would not be realized. As a
result, in accordance with Financial Accounting Standards Board's
("FASB's") Statement of Financial Accounting Standards ("Statement") No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," we analyzed the recoverability of the goodwill and other
intangibles relating to the acquisition of Pulsar. We performed an assessment of
the recoverability of the remaining goodwill and other intangible assets. In the
fourth quarter of 2000, based on the results of our assessment and valuation, we
recorded an impairment charge of $31.4 million related to unamortized intangible
assets acquired in the purchase of Pulsar. Based on our assessment and
valuation, we believed that after the impairment charge of $31.4 million, no
further impairment existed at December 31, 2000. As of December 31, 2001, the
remaining unamortized intangible assets of $691,000 acquired in the purchase of
Pulsar was to be amortized over the remainder of their 10-year life. Due to the
intensive capital requirements and low margin returns, subsequent to December
31, 2002, we decided to exit this line of business and as a result, we are not
accepting new orders and we are currently in the final stages of completing a
wind down of the Pulsar operations. As our projections indicated inadequate cash
flows from operations, we recorded an impairment charge of $599,000 relative to
Pulsar intangibles, which represented the remaining balance of the intangible
assets.
In August 2001, we acquired BIZ. All of the outstanding shares of BIZ
were exchanged for 10,875,128 shares of our common stock. The BIZ acquisition
was accounted for using the purchase method of accounting. As part of the BIZ
acquisition, we acquired $9.0 million of identifiable intangible assets. In the
fourth quarter of 2001, we determined that the other intangible assets and a
portion of goodwill related to the BIZ acquisition would not be realized. As a
result, we analyzed the recoverability of the intangible assets relating to the
BIZ acquisition. Based on the results of our analysis, we recorded an impairment
charge of $36.3 million related to unamortized identifiable intangible assets
and goodwill acquired in the BIZ acquisition. Based on our analysis, we believe
that after the impairment charge of $36.3 million, no further impairment existed
at December 31, 2001. The remaining identifiable intangible asset acquired in
the acquisition of BIZ is $25.9 million of goodwill that, in accordance with
Statement No. 142, will no longer be amortized but rather will be tested at
least annually for impairment.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT
During the year ended December 31, 2001, we recorded in-process
research and development ("IPR&D") charges of $1.6 million related to the BIZ
acquisition. The portion of the purchase price allocated to IPR&D for the BIZ
acquisition was approximately 2.5% of the total purchase price of $64.7 million.
An independent third party investment banking firm was retained to estimate the
fair value of purchased IPR&D. At the BIZ acquisition date, BIZ was in the
process of developing technology that would deliver security features to
customers, and developing a new platform for delivering its product. The IPR&D
had not yet reached technological feasibility, had no alternative uses, and may
not have achieved commercial viability. At the valuation date, the new
technology had not reached a completed prototype stage, although some beta
testing on portions of the technology had begun. At the valuation date, the
IPR&D ranged between 6% and 17% complete, based on costs incurred on the IPR&D
through the BIZ acquisition date as compared to the total costs estimated to
complete the project.
29
The IPR&D project was valued using the income forecast method. This
method took into consideration earnings remaining after deducting from cash
flows related to the in-process technology, the market rates of return on
contributory assets, including assembled workforce, merchant agreements, working
capital and fixed assets. The cash flows were then discounted to present value
at an appropriate rate. The discount rate was determined by an analysis of the
risks associated with each of the identified intangible assets. The resulting
net cash flows to which discount rates of 45% to 50% were applied were based on
management's estimates of revenues, operating expenses and income taxes from
such acquired in-process technology.
AMORTIZATION OF GOODWILL AND OTHER INTANGIBLES
Amortization expense decreased 74% from $2.8 million during 2000 to
$746,000 during 2001, and decreased 88% from $746,000 during 2001 to $92,000
during 2002. The decrease from 2000 to 2001 was primarily attributable to the
reduction of goodwill and other intangibles that resulted from the $31.4 million
impairment charge recorded in the fourth quarter of 2000. Amortization expense
in 2001 was comprised of $23,000 related to Pulsar intangibles and $495,000
related to BIZ identifiable intangible assets. Because we adopted Statement No.
142 effective January 1, 2002, amortization expense in 2002 was related solely
to Pulsar intangibles. As of December 31, 2002, we wrote off the remaining
$599,000 intangible asset balance related to Pulsar. Due to the adoption of
Statement No. 142, no amortization is expected in 2003.
REALIZED LOSS ON TRADING SECURITIES
Our realized loss on trading securities in 2001 and 2002 related to our
position in Wave. The reduction from 2001 to 2002 was primarily attributable to
our declining position in Wave. We do not expect significant realized losses on
trading securities in 2003, due to our current small position in Wave. As of
December 31, 2002, the market value of the common stock held in Wave
approximated $76,000.
INTEREST EXPENSE, NET
Interest expense, net increased 151% from $65,000 during 2000 to
$163,000 during 2001 and increased 380% from $163,000 during 2001 to $782,000
during 2002. The increase from 2000 to 2001 was primarily attributable to a
decrease in interest income of $188,000, a decrease in interest expense
associated with accounts receivable financing of $103,000, and an increase in
interest expense associated with vendor term-outs and notes of $13,000. The
increase from 2001 to 2002 was primarily attributable to a decrease in interest
income of $76,000, a decrease in interest expense associated with accounts
receivable financing of $117,000, an increase in interest expense of $102,000
associated with vendor term-outs due to the successful negotiation with certain
vendors to extend the payment of accounts payable over longer terms, and an
increase in accrued interest on notes payable of $558,000 due to increased
borrowing. We expect further increases in interest expense in 2003 due to our
need for increased borrowings.
NON-CASH INTEREST AND FINANCING EXPENSE
Non-cash interest and financing expense in 2002 was related to the
convertible secured promissory notes issued on April 16, 2002. There was no
non-cash interest and financing expense in 2000 or 2001. The non-cash charges
represent amortization of the relative fair value of warrants issued in
connection with the debt instruments in addition to the beneficial conversion
features of debt issued in 2002, which has been recorded as a discount relative
to the debt instrument, and the amortization of the value of warrants issued
with the debt instruments. We expect continued non-cash interest and financing
expense in 2003 related to the warrants and beneficial conversion features of
the debt issued in 2002, unless such debt is converted into equity. Further, we
may issue additional warrants in connection with future capital raises.
30
LOSS FROM EQUITY INVESTEE
In January 2002, we formed SSP Gaming to conduct all business and any
required financing activities relative to the gaming industry. In June 2002, SSP
Gaming and the Venetian executed an operating agreement to form Venetian
Interactive. The purpose of Venetian Interactive is to provide management
services, consulting services, financial services, intellectual property
licensing services, and equipment to the online gaming industry in venues where
such activity complies with all regulatory requirements, and to develop and
operate Venetian branded casino sites. In the year ended December 31, 2002, SSP
Gaming recorded $248,000 as loss from equity investee, which represents its pro
rata portion of the Venetian Interactive net loss. We expect a larger loss from
our equity investee in 2003, as the venture continues in its development stage.
OTHER (INCOME) EXPENSE, NET
Other (income) expense, net, in 2000 was related to a one time
non-operating credit in the amount of $72,000. There was no other (income)
expense, net in 2001. Other income (expense), net in 2002 was $104,000, which
consisted of gains resulting from settlements with vendors in the amount of
$296,000, $28,000 in expenses associated with the unoccupied Spectrum building,
$31,000 in income related to revisions of estimated liabilities, a $153,000 note
discount associated with the repayment of a note from our co-chairman and
$42,000 write-off of interest receivable associated with the same note. We
cannot predict other income (expense) for 2003, although we do believe we may
record additional gains as a result of further settlements with vendors.
INCOME TAXES
For 2000, the income tax expense of $6,000 was primarily attributable
to minimum California franchise taxes. For 2001, the income tax expense of
$53,000 was attributable to the reversal of previously recognized tax credits
because it was determined that they would not be realized. For 2002, the income
tax of $2,000 represents the minimum required amount for state franchise taxes.
We do not expect any substantial changes to income tax expense in 2003.
BACKLOG
At December 31, 2000, 2001 and 2002, total backlog was $1.3 million,
$1.1 million and $1.6 million, respectively. Orders are subject to cancellation
in certain circumstances, and backlog may therefore not be indicative of future
operating results. The backlog at December 31, 2001, was made up of $218,000
related to data security products and $910,000 related to network deployment
products. The $910,000 related to network deployment products was caused by our
inability to obtain product from our vendors to fulfill customer orders. During
2002, due to lack of available capital, we had to limit sales orders related to
our Pulsar operations, which were the sole source of network deployment product
revenues. As of December 31, 2002, the backlog was made up of $1.4 million
related to licenses and services and $169,000 related to data security products.
The license and service backlog primarily consisted of $840,000 related to our
Fortezza(R) support contract and $509,000 related to our subcontract with
General Dynamics.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 2002, the FASB issued Statement No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical
Corrections." Statement No.145 rescinds Statement No. 4, which required all
gains and losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. In
addition, Statement No. 145 amends Statement No. 13 on leasing to require that
certain lease modifications that have economic effects similar to sale-leaseback
transactions be accounted for in the same manner as sale-leaseback transactions.
Provisions of Statement No. 145 related to the rescission of Statement No. 4 are
effective for financial statements issued by the Company after January 1, 2003.
The provisions of the statement related to sale-leaseback transactions were
effective for any transactions occurring after May 15, 2002. All other
provisions of the statement were effective as of the end of the second quarter
of 2002. The changes required by Statement No. 145 are not expected to have a
material impact on the results of operations, financial position or liquidity of
the Company.
31
In July 2002, the FASB issued Statement No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." Statement No. 146 requires
companies to recognize costs associated with the exit or disposal of activities
as they are incurred rather than at the date a plan of disposal or commitment to
exit is initiated. Types of costs covered by Statement No. 146 include lease
termination costs and certain employee severance costs that are associated with
a restructuring, discontinued operation, facility closing, or other exit or
disposal activity. Statement No. 146 will apply to all exit or disposal
activities initiated after December 31, 2002. At this time, the Company does not
expect the adoption of the provisions of Statement No. 146 to have a material
impact on the Company's financial results.
In November 2002, the FASB issued Interpretation No. (Interpretation)
45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others." Interpretation 45
requires certain guarantees to be recorded at fair value. In general,
Interpretation 45 applies to contracts or indemnification agreements that
contingently require the guarantor to make payments to the guaranteed party
based on changes in an underlying that is related to an asset, liability, or an
equity security of the guaranteed party. The initial recognition and measurement
provisions of Interpretation 45 are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. Interpretation 45 also
requires new disclosures, even when the likelihood of making any payments under
the guarantee is remote. These disclosure requirements are effective for
financial statements of interim or annual periods ending after December 15,
2002. The changes required by Interpretation 45 are not expected to have a
material impact on the results of operations, financial position or liquidity of
the Company.
In January 2003, the FASB issued Interpretation 46, "Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51." Interpretation 46
addresses consolidation by business enterprises of variable interest entities
which have one or both of the following characteristics: (1) the equity
investment at risk is not sufficient to permit the entity to finance its
activities without additional support from other parties, which is provided
through other interests that will absorb some or all of the expected losses of
the entity; (2) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest: (a) the direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights, (b) the obligation to absorb the expected losses of the entity
if they occur, which makes it possible for the entity to finance its activities,
or (c) the right to receive the expected residual returns of the entity if they
occur, which is the compensation for the risk of absorbing expected losses.
Interpretation 46 does not require consolidation by transferors to qualifying
special purpose entities. Interpretation 46 applies immediately to variable
interest entities created after January 31, 2003, and to variable interest
entities in which an enterprise obtains an interest after that date. It applies
in the first fiscal year or interim period beginning after June 15, 2003, to
variable interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. The Company is currently assessing the
impact of Interpretation 46. The Company has, however, identified one entity
that may be required to be consolidated beginning in the third quarter of 2003
(see note 8 to the consolidated financial statements). At December 31, 2002, the
Company recorded a net investment in other assets on its balance sheet of
approximately $452 associated with these investments. The Company currently
adjusts the carrying value of these investments for any losses incurred by the
entity through earnings. While this entity may be considered a variable interest
entity, the Company has not yet determined if it will need to be consolidated.
In June 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations," which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. The standard applies to legal obligations
associated with the retirement of long-lived assets that result from the
acquisition, construction, development and/or normal use of the asset. Statement
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made. The fair value of the liability is added to
the carrying value of the associated asset, and this additional carrying amount
is depreciated over the life of the asset. The liability is accreted at the end
of each period through charges to operating expense. If the obligation is
settled for other than the carrying amount of the liability, the Company will
recognize a gain or loss on settlement. As required, the Company adopted the
provisions of Statement No. 143 for the quarter ended March 31, 2003. Management
does not believe adoption of this standard will have a material adverse effect
on the Company's consolidated financial position, results of operations or
liquidity.
32
We adopted Statement No. Statement 142, "Goodwill and Other Intangible
Assets" effective January 1, 2002. Pursuant to Statement No. 142, goodwill and
other indefinite lived intangible assets are no longer amortized, but must now
be tested for impairment at least annually. We have performed both the
transitional impairment test and the first annual impairment test required by
Statement No. 142 using certain valuation techniques, and have determined that
with the exception of the Pulsar write-off as previously discussed, no
impairment exists at December 31, 2002 to goodwill and other intangible asset
balances. Changes in assumptions and estimates included within the analysis
could result in significantly different results than those identified above and
those recorded in our consolidated financial statements. It is possible, but not
predictable, that a change in our business, market capitalization, operating
results, financing or other factors could affect the carrying value of goodwill
or other intangible assets and cause an impairment write-off in the future.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2002, we had a working capital deficit of $5.9 million.
We incurred a net loss of $8.6 million for the twelve months then ended. We
expect to continue to incur additional losses in the current year. Given our
December 31, 2002 cash balance of $553,000 and the projected operating cash
requirements, we anticipate that existing capital resources will not be adequate
to satisfy cash flow requirements through December 31, 2003. We will require
additional funding. Our cash flow estimates are based upon achieving certain
levels of sales, reductions in operating expenses, liquidity available under the
accounts receivable financing, as well as additional debt or equity financing.
Should sales be less than forecast, expenses be higher than forecast or the
liquidity not be available under the accounts receivable financing or through
additional financings of debt and/or equity, we will not have adequate resources
to fund our operations. We have executed a term sheet for a minimum investment
of $10 million that would have a dilutive effect. However, the closing of that
transaction is contingent upon certain conditions. There is no assurance that
the investors will close the transaction, or if the transaction does close that
it will be on the terms outlined in the executed term sheet. If this proposed
transaction does not close, we will seek other sources of funding, explore the
sale of product lines or intellectual property rights, or evaluate merger
partners.
During the past year, we incurred defaults under both our accounts
receivable financing with Wells Fargo Business Credit, Inc. and the long-term
convertible notes. We have requested waivers from the holders of the notes, but
such waivers have not yet been granted. This means the noteholders have the
right to declare us in default and call all of their debt due and immediately
payable. With the potential of the notes being called for payment, we
re-classified what would have otherwise been long-term debt as short-term debt
in the consolidated balance sheet as of December 31, 2002. In October, we
executed a new factoring agreement with Bay View Funding ("BVF"). The agreement
states among other things that a default occurs if we are generally not paying
debts as they become due or if we are left with unreasonably small capital. We
have notified BVF of our failure to make certain payments on a timely basis and
have therefore recently requested a waiver of such default.
Cash used in operations for the twelve months ended December 31, 2002
was $7.0 million compared to cash used in operations during the twelve months
ended December 31, 2001 of $2.5 million. The increase in cash used in operations
was primarily attributable to a larger reduction of accrued liabilities and
accounts payable. The increased uses of cash were partially offset by larger
reductions of accounts receivable and prepaid expenses. At December 31, 2002 the
balance in accounts receivable was $1.6 million and the balance in accounts
payable was $4.4 million, of which approximately $3.2 million has aged 90 days
or more. As of December 31, 2002, $314,000 in accounts receivable was factored
under our arrangement with BVF. As a result, significant reductions in accounts
receivable will not be available to provide us with cash to meet our future cash
needs and we will need to continue using cash to reduce accounts payable. We
expect to continue to use cash in operations due to existing current liabilities
that will need to be paid in 2003.
Cash provided by investing activities for the twelve months ended
December 31, 2002 was $430,000 compared to cash provided by investing activities
during the twelve months ended December 31, 2001 of $140,000. The increase in
cash provided by investing activities was attributable to proceeds from the sale
of trading securities of $1.4 million. The market value of trading securities
held at December 31, 2002 is approximately $76,000. We anticipate that these
trading securities will all be sold prior to December 31, 2003 and will no
longer be available to provide us with additional cash to meet our future cash
needs. We do not expect any significant increases or decreases from cash
provided by or used in investing activities in 2003.
33
Cash provided by financing activities for the twelve months ended
December 31, 2002 was $3.9 million compared to cash provided by financing
activities during the twelve months ended December 31, 2001 of $1.5 million. The
increase in cash provided by financing activities was primarily attributable to
the increase in proceeds from the issuance of convertible debt. We expect to
have increases in cash provided by financing activities in 2003 due to our need
for additional working capital.
As of December 31, 2002, the balance of trading securities decreased
from $1.4 million from December 31, 2001 to $76,000 as a result of selling of
approximately $1.2 million of Wave common shares, and recognizing approximately
$130,000 loss from sales and changes in the value of securities held. As of
December 31, 2002, accounts receivable totaled $1.6 million as compared to $4.4
million as of December 31, 2001. This decrease was mainly attributable to the
decreased revenues of the network deployment segment of the business. The
decrease was a source of cash in the amount of $2.8 million. As of December 31,
2001, accounts payable decreased from $9.5 million to $4.4 million as of
December 31, 2002. This accounts payable decrease was mainly attributable to the
decreased purchase of goods for re-sale by our network deployment business
segment and used cash in the amount of $4.3 million. The remainder of the
reduction in accounts payable was attributable to approximately $270,000 of
gains on settling vendor accounts, and issuance of $456,000 of notes in
settlement of vendor accounts. As compared to December 31, 2001, accrued
liabilities decreased from $3.3 million to $1.3 million as of December 31, 2002.
This decrease in accrued liabilities was mainly attributable to the elimination
of $1.4 million accrued under the Wave development contract, elimination of an
estimated $463,000 liability to a certain vendor, and approximately $208,000
reduction of accrued personnel costs due to a reduction in workforce. As of
December 31, 2002, the prior year balance of accrued rent in the amount of $2.2
million was eliminated in a settlement relative to facilities leases. We
anticipate the trend of lower accounts receivable, accounts payable and accrued
liabilities to continue until sales increase and the increased operations
require an expanded workforce.
We have experienced net losses and negative cash flows from operations
for the last several years, and as of December 31, 2002, had an accumulated
deficit of $108.1 million. We have financed our past operations principally
through the issuance of common stock in a public offering and the issuance of
convertible debt. The net proceeds from our public offering were approximately
$35.3 million. The proceeds from the issuance of convertible debt for the year
ended December 31, 2002 were $4.8 million. We raised $500,000 through the
issuance of secured promissory notes dated November 14, 2002. We raised $1.1
million through the issuance of secured convertible promissory notes in January
and March 2003. We have also issued notes and common stock to settle or
restructure previously executed agreements.
On July 31, 2001, Chase Manhattan Bank ("Chase") advanced to our
co-chairman, Mr. Winkler, $1.0 million that Mr. Winkler advanced to BIZ for the
re-purchase of preferred stock held by an investor in BIZ. Mr. Winkler executed
a $1.0 million demand note with Chase and BIZ executed a $1.0 million demand
note due September 15, 2001 with J.A.W. Financial, L.P. ("JAW"), an entity
controlled by Mr. Winkler. The demand note contained an interest charge of prime
plus 1% through the maturity date and prime plus 3% after the maturity date. On
October 11, 2001, we made a principal payment of $30,000, paid accrued interest,
and executed a new promissory note to JAW for $970,000. The terms of the
promissory note call for interest of prime plus 3% payable monthly, together
with five monthly payments of principal in the amount of $160,000 and one final
payment on April 15, 2002 in the amount of $170,000. The promissory note
provided Chase a security interest in the shares in Wave owned by us and,
subject to Chase's loan security guidelines, including the rights to proceeds
from any sales of those shares. The loan was paid in full on March 8, 2002,
ahead of the scheduled maturity.
In December 2001, our co-chairmen each purchased a $375,000 three-year
note bearing interest at 8.0% per annum in a $2.5 million private placement of
such notes. In connection with the issuance of these notes we incurred
approximately $25,000 of issuance costs primarily consisting of legal and other
professional fees, which were to be paid upon completion of the April 16, 2002
financing described below. On April 16, 2002, we closed a financing whereby,
with the exception of Mr. Winkler and Mr. Shah, the noteholders exchanged their
December Notes for 10% secured convertible promissory notes convertible at $1.00
per share, with detachable warrants. We issued a total of 3,477,666 warrants in
the offering. In June 2002 Mr. Shah and Mr. Winkler exchanged their December
notes together with accrued interest for 299,184 and 297,736 shares,
respectively, of our common stock based upon an exchange price of $1.30 per
common share, which represented a premium above the trading price of our common
stock.
34
On April 16, 2002, we raised $5.0 million through the issuance of $4.0
million in 10% secured convertible promissory notes, $653,000 in unsecured
non-convertible promissory notes ($153,000 held by co-chairman Mr. Shah and
$500,000 held by co-chairman Mr. Winkler) and the receipt of pre-payment of a
$500,000 note due from Mr. Shah, less a discount of $153,000. The discount was
based upon a present value using the rate of 20% for early payment and was
charged against earnings in the current year. In connection with the issuance of
the secured convertible promissory notes we incurred approximately $626,000 of
issuance costs, which primarily consisted of amortization of warrant costs,
investment banker fees, legal and other professional fees. All promissory notes
mature December 31, 2005; bear interest at a rate of 10% per annum to be paid
quarterly in cash, or at our discretion, in common shares based upon the
trailing 30-day average price per share prior to the interest due date; and the
$4.0 million secured convertible promissory notes are convertible, in whole or
in part, at the option of the holder into an aggregate of approximately 4.0
million shares of our common stock at any time prior to maturity, at a
conversion price of $1.00 per share, subject to adjustment under certain
conditions; and the secured convertible promissory notes have detachable
warrants exercisable for three years to purchase up to an additional 2.4 million
shares at $1.30 per share. In conjunction with the April 16 closing of the 10%
secured convertible promissory notes, $1.75 million principal and $46,000 of
accrued interest of the December notes were exchanged for the 10% secured
convertible promissory notes and detachable warrants to purchase 1.078 million
shares at $1.30 per share. The secured convertible promissory notes
automatically convert prior to maturity if our common shares trade at or above
$3.00 per share with average volume of 100,000 shares per day for 20 consecutive
trading days. We are subject to restrictive covenants related to the secured
convertible and unsecured non-convertible promissory notes that prevent us from
pledging intellectual property as collateral. In June 2002 Mr. Shah and Mr.
Winkler exchanged their unsecured non-convertible promissory notes together with
accrued interest for 119,935 and 392,521 shares, respectively, of our common
stock based upon an agreed upon price of $1.30 per common share.
Over the past three years, we have spent substantial sums on R&D
activities. During that time period, we incurred substantial losses from
continuing operations. While we believe the R&D expenditures created significant
future revenue producing opportunities, some of the related products are just
entering production. We are currently involved in sales pursuits relative to
these products that, if successful, will generate significant revenues. However,
unless we receive orders for these new products and receive significant
financing, we can no longer support the current level of R&D activity. While we
have reduced our staffing levels, if sales fail to materialize, we will need to
further reduce expenses through additional reductions in staff.
The combination of reduced accounts receivable financing availability
and the unwillingness of primary vendors of our network deployment business to
sell additional product to us on open account because of significant past due
amounts caused a substantial reduction in the sales and related cost of sales
during the year ended December 31, 2002, which in turn reduced cash flow. The
reduced cash flow impaired our ability to meet vendor commitments as they became
due. Due to the intensive capital requirements and low margin returns,
subsequent to December 31, 2002, we decided to exit the Pulsar line of business
and as a result, we are not accepting new orders and we are currently in the
final stages of completing a wind down of the Pulsar operations.
In October 2000, BIZ signed a development agreement with Wave for the
integration of EMBASSY-based systems with set-top box master reference designs
of Broadcom Corporation. The development agreement was amended in May 2001.
Under this agreement, as amended, we were required to pay a total of $5.0
million beginning June 1, 2001 through December 1, 2002. In January 2002, we
provided written notice to suspend the work under the agreement along with the
related billings. We executed a settlement agreement effective as of September
30, 2002 with Wave whereby we concluded the development agreement effective as
of August 31, 2002 and reached settlement terms. According to the terms of the
termination and mutual release agreement, in October 2002 we issued 1.6 million
shares of common stock and a $270,000 non-interest bearing note convertible into
200,000 shares of our common stock. As a result of this settlement agreement,
during the year ended December 31, 2002, we recorded a loss of approximately
$1.0 million. Additionally, based on the settlement agreement, we eliminated the
related $3.6 million in total liabilities from the balance sheet.
In November 2000, we executed an Alliance Agreement with EDS for the
marketing of our products to EDS customers. This alliance calls for a joint
working relationship between the two companies, is non-exclusive and has a term
of ten years. On August 27, 2001, EDS and we executed a letter of intent and
temporary working agreement whereby EDS supplied software and hardware for
re-sale to Pulsar customers. Under this agreement, as of December 31, 2002, $1.0
million remained outstanding and unpaid to EDS for purchases of hardware and
software. EDS and we executed a Master Services Agreement dated as of November
14, 2001 ("MSA") whereby beginning December 1, 2001 and ending December 31,
35
2006, we and EDS established a strategic teaming relationship to implement, sell
and deliver a set of secure transaction processing offerings based upon a trust
assurance network ("TAN"). The MSA task order requires that we pay a monthly fee
of $44,000 for account, test and lab management services beginning January 1,
2002. The obligations for these services can be terminated beginning January 1,
2003 by giving 90 days prior written notice and payment of $400,000, or
beginning January 1, 2004 by giving 90 days prior written notice and payment of
$200,000. Further, the MSA task order provides for EDS to provide TAN hosting
and implementation in exchange for an implementation fee of $45,000 payable
October 1, 2002. Once installation of the production environment TAN is
complete, EDS agrees to host the TAN in exchange for a monthly service fee of
$59,000 for 36 months and $60,000 per month for the remaining months of the MSA.
We may terminate the MSA task order without cause by paying $400,000 after
January 1, 2004 and providing 90 days prior written notice.
During 2001, we arranged for the lease of two buildings approximating
63,000 square feet that were under construction and were subsequently completed
in the Spectrum area of Irvine, California from an entity that was partially
owned by our co-chairman, Mr. Shah. On one building totaling approximately
23,000 square feet, we sublet one-half of the building on terms and conditions
matching the underlying lease. The sublease was with a related party company
owned by our co-chairman, Mr. Winkler. While that company made a lease deposit,
it did not make any monthly rent payments. In October 2002, we restructured our
lease obligations with our landlord, Research Venture, LLC, for the two
buildings. This restructuring and settlement revised the estimate of anticipated
costs relative to the disposition of one of the building leases that was
recorded in 2001 in the amount of $2.2 million, which was net of anticipated
offsetting sublease income. As a result of the restructuring and settlement, we
increased stockholders' equity by $1.7 million through the issuance of common
stock valued for financial reporting purposes at $956,000 and recorded a gain of
$700,000 for the year ended December 31, 2002. The settlement required us to
issue 959,323 shares of common stock, pay $500,000 in cash over a one-year
period, cancel the lease on one building approximating 23,000 square feet, and
take occupancy of the other building under a seven-year operating lease for the
facility with approximately 40,000 square feet for an initial monthly rental
rate of $55,000 plus common area costs beginning in December 2002. The monthly
rental rate on the seven-year lease is scheduled to increase to $73,000 plus
common area costs, at the beginning of the third year. We record rent expense on
a straight-line basis. At our option, a portion of the rental rate may be paid
either in stock or in cash during the first two years of the lease under certain
circumstances through conversion of a $360,000 subordinated convertible
promissory note that we issued as prepaid rent. In August 2002, Mr. Shah
surrendered his 25% ownership interest in the entity that owns the two
buildings. At the time of surrendering his interest, the buildings were
encumbered by one or more construction loans for which the lender required
personal guarantees for renewal of the financing. As there was little, if any,
equity in the project and Mr. Shah was unwilling to personally guarantee the
loans, Mr. Shah chose to surrender his membership interest.
In October 2002, we terminated our accounts receivable financing
arrangement with Wells Fargo Business Credit, Inc. and entered into a factoring
agreement with Bay View Funding ("BVF"). The new factoring agreement contains a
maximum advance of $750,000, was for an initial term of three months, and
automatically renews for successive three-month periods. We may terminate this
agreement at any time without the payment of any early termination fees,
provided that we give at least thirty days written notice to BVF prior to the
end of any renewal term. The agreement contains a factoring fee, which is based
on 1.25% of the gross face value of the purchased receivable for every 30-day
period from the date of purchase by BVF until the invoice is paid in full. For
invoices outstanding more than the 30-day period, a finance fee will be charged
at the rate of .063% of the gross face value of the purchased receivable for
every one day period beyond the 30th day from the original date of purchase. At
the time of purchase, terms call for BVF to advance 85% of the gross receivable,
with the balance remitted after collection of the invoice less the factoring and
finance fee, if applicable. The agreement contains representations, warranties,
and covenants and requires a monthly minimum fee, including the factoring and
financing fees, of .25% of the maximum advance of $750,000 or approximately
$2,000 per month. The agreement states among other things that a default occurs
if we are generally not paying debts as they become due or if we are left with
unreasonably small capital. We have notified BVF of our failure to make certain
payments on a timely basis and have therefore recently requested a waiver of
such default, but have not yet received such a waiver, and thus remain in
default.
36
Our significant fixed commitments with respect to leases and inventory
purchases as of December 31, 2002 were as follows:
PAYMENTS FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------------------
TOTAL 2003 2004 & 2005 2006 & 2007 2008 & AFTER
----- ---- ----------- ----------- ------------
CONTRACTUAL OBLIGATIONS
Convertible Notes Term Debt....... $ 7,372,459 $ 1,553,759 $ 5,818,699 $ -- $ --
Operating Leases.................. 6,870,140 $ 1,252,985 $ 2,490,592 2,282,659 843,905
Unconditional Purchase Obligations 947,970 947,970 -- -- --
------------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $15,190,569 $ 3,754,714 $ 8,309,291 $ 2,282,659 $ 843,905
We currently have a need for a substantial amount of capital to meet
our liquidity requirements. The amount of capital that we will need in the
future will depend on many factors including, but not limited, to:
o the ability to extend terms of payment to vendors;
o the market acceptance of our products and services;
o the levels of promotion and advertising that will be required
to launch new products and services and attain a competitive
position in the market place;
o research and development plans;
o levels of inventory and accounts receivable;
o technological advances;
o competitors' responses to our products and services;
o relationships with partners, suppliers and customers;
o projected capital expenditures;
o national and international economic conditions, and events;
o periodic analysis of our goodwill valuation that may require
us to take additional write-downs in future periods;
o defaults on financing that will impact the availability of
borrowings, or result in notes being declared immediately due
and payable; and
o reductions in the valuation of investment in trading
securities.
Our current financial condition is the result of several factors
including the following:
o our operating results were below expectations;
o sales of products into the commercial markets are taking
longer to develop than originally anticipated,
o lower than expected margins and reduced revenues from our
Pulsar subsidiary ultimately led us to limit sales orders ;
and
o continued research and development expenses due to further
enhancement of our products.
37
In addition to our current deficit working capital situation, current
operating plans show a shortfall of cash for the remainder of 2003. We intend to
mitigate our position through one or more of the following:
o ADDITIONAL EQUITY CAPITAL. We will seek additional equity
capital, if available. Equity capital will most likely be
issued at a discount to market and will require the issuance
of warrants, which will cause dilution to current
stockholders. In addition, providers of new equity capital may
require additional concessions.
o ADDITIONAL CONVERTIBLE DEBT. Depending upon the market
conditions, we may issue additional debt instruments. The
types of instruments available in the market would likely
contain a provision for the issuance of warrants and may also
be convertible into equity.
o OFF BALANCE SHEET FINANCING. If we need to add equipment or
decide to expand our facilities, we may use an operating lease
transaction to acquire the use of capital assets. An operating
lease would not appear on our balance sheet and would be
charged as an expense as payments accrue.
o FINANCING OF RECEIVABLES. We plan to generate cash by
financing receivables under with the new BVF agreement.
o SALE OF INVESTMENTS. We may sell investments to generate cash.
The market value of trading securities was $76,000 at December
31, 2002. Since that date, we have not generated any funds
through sale of investment securities.
o NEGOTIATE WITH VENDORS. We have executed settlement and/or
term-out agreements with a number of vendors. We will continue
to negotiate with vendors regarding payment of existing
accounts payable over extended terms of up to 48 months.
o DEFERRAL OF CASH PAYMENTS. We may defer cash payments through
suspension of certain development projects.
o ISSUANCE OF STOCK AS PAYMENT FOR EXISTING AND FUTURE
OBLIGATIONS. We may pay portions of accounts payable and
accrued liabilities through issuances of common stock.
o ISSUANCE OF STOCK TO PAY INTEREST. During 2002, we issued
105,861 shares and 127,035 shares as payment of interest due
on our April 16, 2002 secured convertible promissory notes for
the three months ended June 30, 2002 and September 30, 2002,
respectively. During the quarter ended March 31, 2003, we
issued 211,727 as payment for interest due for the three
months ended December 31, 2002. We may issue additional stock
in the future to pay interest on long-term debt.
o REDUCTIONS IN WORK FORCE. We reduced our work force in 2002
and decreased the cash compensation paid to the remaining
workforce. We may be forced to make similar reductions in the
future if we do not realize our projected sales plans.
If we do not receive adequate financing, we could be forced to merge
with another company or cease operations.
While we have a history of selling products in government markets, our
new products that are just entering production after years of development have
no sales history. Additionally, we are entering commercial markets with our
products and are still developing acceptance of our offerings. Considerable
uncertainty currently exists with respect to the adequacy of current funds to
support our activities beyond December 31, 2002. This uncertainty will continue
until a positive cash flow from operations is achieved. Additionally, we are
uncertain as to the availability of financing from other sources to fund any
cash deficiencies.
In order to reduce this uncertainty, we continue to evaluate additional
financing options and may therefore elect to raise capital, from time to time,
through equity or debt financings in order to capitalize on business
38
opportunities and market conditions and to insure the continued marketing of
current product offerings together with development of new technology, products
and services. There can be no assurance that we can raise additional financing
in the future.
Based upon forecasted sales and expense levels, we currently anticipate
that existing cash, cash equivalents, investments, term-out arrangements with
vendors and the current availability under our BVF factoring agreement will not
be sufficient to satisfy our contemplated cash requirements for the next twelve
months. However, our forecast is based upon certain assumptions, which may
differ from actual future outcomes. We have incurred defaults under our
financing agreements in the past. The BVF agreement states among other things
that a default occurs if we are generally not paying debts as they become due or
if we are left with unreasonably small capital. We have notified BVF of our
failure to make certain payments on a timely basis and have therefore recently
requested a waiver of such default. We therefore may not be able to draw funds
in the future, which would affect our ability to fund our operations.
Additionally, without a substantial increase in sales or a reduction in
expenses, we will continue to incur operating losses.
RISK FACTORS
AN INVESTMENT IN SHARES OF OUR COMMON STOCK INVOLVES A HIGH DEGREE OF
RISK. IN ADDITION TO THE OTHER INFORMATION CONTAINED OR INCORPORATED BY
REFERENCE IN THIS REPORT, YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK
FACTORS BEFORE DECIDING TO INVEST OR MAINTAIN AN INVESTMENT IN SHARES OF OUR
COMMON STOCK. THIS REPORT CONTAINS OR INCORPORATES BY REFERENCE FORWARD-LOOKING
STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER
MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A
RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH IN THE FOLLOWING RISK
FACTORS AND ELSEWHERE IN THIS REPORT. IF ANY OF THE FOLLOWING RISKS ACTUALLY
OCCURS, IT IS LIKELY THAT OUR BUSINESS, FINANCIAL CONDITION AND OPERATING
RESULTS WOULD BE HARMED. AS A RESULT, THE TRADING PRICE OF OUR COMMON STOCK
COULD DECLINE, AND YOU COULD LOSE PART OR ALL OF YOUR INVESTMENT.
WE HAVE A HISTORY OF LOSSES AND MAY INCUR FUTURE LOSSES THAT MAY ADVERSELY
IMPACT OUR BUSINESS AND OUR STOCKHOLDERS BY, AMONG OTHER THINGS, MAKING IT
DIFFICULT FOR US TO RAISE ADDITIONAL DEBT OR EQUITY FINANCING TO THE EXTENT
NEEDED FOR OUR CONTINUED OPERATIONS OR FOR PLANNED EXPANSION.
We may not become profitable or significantly increase our revenue. We
incurred net losses of $8.6 million, $53.2 million and $41.4 million, for the
years 2002, 2001 and 2000, respectively. To achieve profitability, we will need
to generate and sustain sufficient revenues while maintaining reasonable cost
and expense levels. We expect to continue to incur significant operating
expenses primarily to support research and development and expansion of our
sales and marketing efforts. These expenditures may not result in increased
revenues or customer growth. We do not know when or if we will become
profitable. We may not be able to sustain or increase profitability on a
quarterly or annual basis.
Our losses from operations, our use of cash in operating activities,
and our accumulated deficit and working capital deficiency at December 31, 2002
and 2001, among other factors, raised substantial doubt about our ability to
continue as a going concern and led our independent auditors to include in their
opinions contained in our consolidated financial statements as of December 31,
2002 and 2001 and for each of the years in the three-year period ended December
31, 2002 an explanatory paragraph related to our ability to continue as a going
concern. Analysts and investors generally view reports of independent auditors
questioning a company's ability to continue as a going concern unfavorably.
These reports may make it difficult for us to raise additional debt or equity
financing to the extent needed for our continued operations or for planned
expansion, particularly if we are unable to attain and maintain profitable
operations in the future. Consequently, future losses may adversely affect our
business, prospects, financial condition, results of operations and cash flows.
We urge potential investors to review the reports of our independent auditors
and our consolidated financial statements before making a decision to invest in
our company.
WE MAY BE UNABLE TO OBTAIN ADDITIONAL FUNDING ON SATISFACTORY TERMS, WHICH
COULD INTERFERE WITH OUR EXISTING AND PLANNED OPERATIONS, DILUTE OUR
STOCKHOLDERS OR IMPOSE BURDENSOME FINANCIAL RESTRICTIONS ON OUR BUSINESS.
39
Historically, we have relied upon cash from financing activities to
fund a significant portion of the cash requirements of our operating and
investing activities, and there is no assurance we will be able to generate
sufficient cash from our operating activities in the future. We do not expect
future fixed obligations to be paid from operations during 2003 and intend to
satisfy fixed obligations by obtaining additional debt and/or equity financing,
using accounts receivable financing, extending vendor payments, selling
investments and issuing stock as payment on obligations.
Some of our secured convertible promissory notes contain the grant of a
continuing security interest in substantially all of our assets and restrict our
ability to obtain debt and/or equity financing. In addition, deteriorating
global economic conditions and the effects of military actions may cause
prolonged declines in investor confidence in and accessibility to capital
markets.
Any future financing may cause significant dilution to existing
stockholders. Any debt financing or other financing of securities senior to
common stock will likely include financial and other covenants that will
restrict our flexibility. At a minimum, we expect these covenants to include
restrictions on our ability to pay dividends on our common stock. Any failure to
comply with these covenants would adversely affect our business, prospects,
financial condition, results of operations and cash flows. Financing
arrangements to raise additional funds may require us to relinquish rights to
certain technologies, products or marketing territories. Our failure to raise
capital when needed and on terms acceptable to us could adversely affect our
business, operating results, financial condition and prospects by impairing our
ability to fund our existing and planned operations.
DEFAULTS UNDER OUR SECURED CREDIT ARRANGEMENTS COULD RESULT IN A
FORECLOSURE ON OUR ASSETS BY OUR CREDITORS.
All of our assets are pledged as collateral to secure portions of our
debt. We were not able to obtain waivers for past covenant defaults, and we may
in the future default under certain covenants of these credit arrangements. This
means that if we are unable to obtain waivers in the future or if we incur a
monetary default on our secured debt obligations, our indebtedness could become
immediately due and payable and the lenders could foreclose on our assets.
WE HAVE NOT GENERATED ANY SIGNIFICANT SALES OF OUR PRODUCTS WITHIN THE
COMPETITIVE COMMERCIAL MARKET NOR HAVE WE ESTABLISHED A SUFFICIENT SALES
AND MARKETING FORCE TO PROMOTE OUR PRODUCTS TO POTENTIAL COMMERCIAL
CUSTOMERS, WHICH MAKES IT DIFFICULT TO EVALUATE OUR CURRENT BUSINESS
PERFORMANCE AND FUTURE PROSPECTS.
Although we have had some success in selling our security solutions to
government agencies, we are just beginning to enter the complex and competitive
commercial market for digital commerce and communications security solutions. We
believe that many potential customers in our target markets are not fully aware
of the need for security products and services in the digital economy.
Historically, only enterprises that had substantial resources developed or
purchased security solutions for delivery of digital content over the Internet
or through other means. Also, there is a perception that security in delivering
digital content is costly and difficult to implement. Therefore, we will not
succeed unless we can educate our target markets about the need for security in
delivering digital content and convince potential customers of our ability to
provide this security in a cost-effective and easy-to-use manner.
Even if we convince our target markets about the importance of and need
for such security, we do not know if this will result in the sale of our
products. We may be unable to establish sales and marketing operations at levels
necessary for us to grow this portion of our business, especially if we are
unsuccessful at selling this product into vertical markets. We may not be able
to support the promotional programs required by selling simultaneously into
several markets. If we are unable to develop an efficient sales system, or if
our products or components do not achieve wide market acceptance, then our
operating results will suffer and our earnings per share will be adversely
affected.
WE FACE INTENSE COMPETITION AND PRICING PRESSURES FROM A NUMBER OF SOURCES,
WHICH MAY REDUCE OUR AVERAGE SELLING PRICES AND GROSS MARGINS.
40
The markets for our products and services are intensely competitive. As
a result, we face significant competition from a number of sources. We may be
unable to compete successfully because many of our competitors are more
established, benefit from greater name recognition and have substantially
greater financial, technical and marketing resources than we have. In addition,
there are several smaller and start-up companies with which we compete from time
to time. We expect competition to increase as a result of consolidation in the
information security technology and product reseller industries.
The average selling prices for our products may decline as a result of
competitive pricing pressures, promotional programs and customers who negotiate
price reductions in exchange for longer term purchase commitments. The pricing
of products depends on the specific features and functions of the products,
purchase volumes and the level of sales and service support required. We expect
competition to increase in the future. As we experience pricing pressure, we
anticipate that the average selling prices and gross margins for our products
will decrease over product lifecycles. These same competitive pressures may
require us to write down the carrying value of any inventory on hand, which
would adversely impact our operating results and adversely affect our earnings
per share.
WE DERIVE A SUBSTANTIAL PORTION OF OUR REVENUE FROM A SMALL NUMBER OF
CUSTOMERS, AND THE LOSS OF ONLY ONE OF THOSE CUSTOMERS COULD ADVERSELY
IMPACT OUR OPERATING RESULTS.
We depend on a limited number of customers for a substantial portion of
our revenue. During the years ended December 31, 2002, 2001 and 2000, we derived
26%, 20% and 42%, respectively, of our consolidated net revenue for that year
from an individual customer. Many of our contracts with our significant
customers are short-term contracts. The non-renewal of any significant contract
upon expiration, or a substantial reduction in sales to any of our significant
customers, would adversely affect our business unless we were able to replace
the revenue we received from those customers.
OUR RELIANCE ON THIRD PARTY TECHNOLOGIES FOR THE DEVELOPMENT OF SOME OF OUR
PRODUCTS AND OUR RELIANCE ON THIRD PARTIES FOR MANUFACTURING MAY DELAY
PRODUCT LAUNCH, IMPAIR OUR ABILITY TO DEVELOP AND DELIVER PRODUCTS OR HURT
OUR ABILITY TO COMPETE IN THE MARKET.
Our ability to license new technologies from third parties is and will
continue to be critical to our ability to offer a complete suite of products
that meets customer needs and technological requirements. Some of our licenses
do not run for the full duration of the third party's patent for the licensed
technology. We may not be able to renew our existing licenses on favorable
terms, or at all. If we lose the rights to a patented technology, we may need to
stop selling or may need to redesign our products that incorporate that
technology, and we may lose a competitive advantage. In addition, competitors
could obtain licenses for technologies for which we are unable to obtain
licenses, and third parties may develop or enable others to develop a similar
solution to digital communication security issues, either of which events could
erode our market share. Also, dependence on the patent protection of third
parties may not afford us any control over the protection of the technologies
upon which we rely. If the patent protection of any of these third parties were
compromised, our ability to compete in the market also would be impaired.
THIRD PARTIES COULD OBTAIN ACCESS TO OUR PROPRIETARY INFORMATION OR COULD
INDEPENDENTLY DEVELOP SIMILAR TECHNOLOGIES BECAUSE OF THE LIMITED
PROTECTION FOR OUR INTELLECTUAL PROPERTY.
Despite the precautions we take, third parties may copy or obtain and
use our proprietary technologies, ideas, know-how and other proprietary
information without authorization or may independently develop technologies
similar or superior to our technologies. In addition, the confidentiality and
non-competition agreements between us and our employees, distributors and
clients may not provide meaningful protection of our proprietary technologies or
other intellectual property in the event of unauthorized use or disclosure.
Policing unauthorized use of our technologies and other intellectual property is
difficult, particularly because the global nature of the Internet makes it
difficult to control the ultimate destination or security of software or other
data transmitted. Furthermore, the laws of other jurisdictions may afford little
or no effective protection of our intellectual property rights. Our business,
financial condition and operating results could be adversely affected if we are
unable to adequately protect our intellectual property rights.
41
WE MAY FACE HARMFUL CLAIMS OF INFRINGEMENT OF PROPRIETARY RIGHTS, WHICH
COULD REQUIRE US TO DEVOTE SUBSTANTIAL TIME AND RESOURCES TOWARD MODIFYING
OUR PRODUCTS OR OBTAINING APPROPRIATE LICENSES.
There is a risk that our products infringe the proprietary rights of
third parties. Regardless of whether our products infringe on proprietary rights
of third parties, infringement or invalidity claims may be asserted or
prosecuted against us and we could incur significant expenses in defending them.
If any infringement claims or actions are asserted against us, we may be
required to modify our products or seek licenses for these intellectual property
rights. We may not be able to modify our products or obtain licenses on
commercially reasonable terms, in a timely manner or at all. Our failure to do
so could adversely affect our business by preventing us from selling some or all
of our products.
OUR INABILITY TO MAINTAIN AND DEVELOP NEW STRATEGIC RELATIONSHIPS WITH
PARTNERS AND SUPPLIERS COULD IMPACT OUR ABILITY TO OBTAIN OR SELL OUR
PRODUCTS, AND PREVENT US FROM GENERATING SALES REVENUES.
We obtain and sell many of our products through strategic alliance and
supplier agreements. The loss of any of our existing strategic relationships, or
the inability to create new strategic relationships in the future, could
adversely affect our ability to develop and market our products.
We depend upon our partners to develop and market products and to fund
and perform their obligations as contemplated by our agreements with them. We do
not control the time and resources devoted by our partners to these activities.
These relationships may not continue or may require us to spend significant
financial, personnel and administrative resources from time to time. We may not
have the resources available to satisfy our commitments, which may adversely
affect our strategic relationships. Further, our products and services may
compete with the products and services of our strategic partners. This
competition may adversely affect our relationships with our strategic partners,
which could adversely affect our business.
If alliance or supplier agreements are cancelled, modified or delayed,
if alliance or supplier partners decide not to purchase our products or to
purchase only limited quantities of our products, or if we are unable to enter
into additional alliance or supplier agreements, our ability to produce and sell
our products and to generate sales revenues could be adversely affected.
ANY COMPROMISE OF PKI TECHNOLOGY WOULD ADVERSELY AFFECT OUR BUSINESS BY
REDUCING OR ELIMINATING DEMAND FOR MANY OF OUR DATA SECURITY PRODUCTS.
Many of our products are based on public key infrastructure, or PKI,
technology, which is the standard technology for securing Internet-based
commerce and communications. The security afforded by this technology depends on
the integrity of a user's private key, which depends in part on the application
of algorithms, or advanced mathematical factoring equations. The occurrence of
any of the following could result in a decline in demand for our data security
products:
o any significant advance in techniques for attacking PKI
systems, including the development of an easy factoring method
or faster, more powerful computers;
o publicity of the successful decoding of cryptographic messages
or the misappropriation of private keys; and
o government regulation limiting the use, scope or strength of
PKI.
A SECURITY BREACH OF OUR INTERNAL SYSTEMS OR THOSE OF OUR CUSTOMERS DUE TO
COMPUTER HACKERS OR CYBER TERRORISTS COULD HARM OUR BUSINESS BY ADVERSELY
AFFECTING THE MARKET'S PERCEPTION OF OUR PRODUCTS AND SERVICES.
Since we provide security for Internet and other digital communication
networks, we may become a target for attacks by computer hackers. The ripple
effects throughout the economy of terrorist threats and attacks and military
activities may have a prolonged effect on our potential commercial customers, or
on their ability to purchase our products and services. Additionally, because we
42
provide security products to the United States government, we may be targeted by
cyber terrorist groups for activities threatened against United States
based-targets.
We will not succeed unless the marketplace is confident that we provide
effective security protection for Internet and other digital communication
networks. Networks protected by our products may be vulnerable to electronic
break-ins. Because the techniques used by computer hackers to access or sabotage
networks change frequently and generally are not recognized until launched
against a target, we may be unable to anticipate these techniques. Although we
have not experienced any act of sabotage or unauthorized access by a third party
of our internal network to date, if an actual or perceived breach of security
for Internet and other digital communication networks occurs in our internal
systems or those of our end-user customers, regardless of whether we caused the
breach, it could adversely affect the market's perception of our products and
services. This could cause us to lose customers, resellers, alliance partners or
other business partners.
WE MAY BE EXPOSED TO SIGNIFICANT LIABILITY FOR ACTUAL OR PERCEIVED FAILURE
TO PROVIDE REQUIRED PRODUCTS OR SERVICES.
Products as complex as those we offer may contain undetected errors or
may fail when first introduced or when new versions are released. Despite our
product testing efforts and testing by current and potential customers, it is
possible that errors will be found in new products or enhancements after
commencement of commercial shipments. The occurrence of product defects or
errors could result in adverse publicity, delay in product introduction,
diversion of resources to remedy defects, loss of or a delay in market
acceptance, or claims by customers against us, or could cause us to incur
additional costs, any of which could adversely affect our business.
Because our customers rely on our products for critical security
applications, we may be exposed to claims for damages allegedly caused to an
enterprise as a result of an actual or perceived failure of our products. An
actual or perceived breach of enterprise network or data security systems of one
of our customers, regardless of whether the breach is attributable to our
products or solutions, could adversely affect our business reputation.
Furthermore, our failure or inability to meet a customer's expectations in the
performance of our services, or to do so in the time frame required by the
customer, regardless of our responsibility for the failure, could:
o result in a claim for substantial damages against us by the
customer;
o discourage customers from engaging us for these services; and
o damage our business reputation.
IF USE OF THE INTERNET AND OTHER COMMUNICATION NETWORKS BASED ON INTERNET
PROTOCOLS DOES NOT CONTINUE TO GROW, DEMAND FOR OUR PRODUCTS MAY NOT
INCREASE.
Increased demand for our products largely depends on the continued
growth of the Internet and Internet protocol-based networks and the widespread
acceptance and use of these mediums for electronic commerce and communications.
Because electronic commerce and communications over these networks are evolving,
we cannot predict the size of the market and its sustainable growth rate. A
number of factors may affect market size and growth rate, including increases in
governmental regulation and the continued ability of the Internet infrastructure
and communications services to support growing demands, which ability could be
adversely affected by, among other things, delays in development or adoption of
new standards and protocols to handle increased levels of activity. If the use
of electronic commerce and communications does not increase, or increases more
slowly than we expect, demand for our products and services will be adversely
impacted.
IF WE DO NOT RESPOND TO RAPID TECHNOLOGICAL CHANGES, OUR PRODUCT AND
SERVICE OFFERINGS COULD BECOME OBSOLETE.
The markets we serve are characterized by rapidly changing technology,
emerging industry standards and frequent introduction of new products. The
introduction of products embodying new technologies and the emergence of new
43
industry standards may render our products obsolete or less marketable. The
process of developing our products and services is extremely complex and
requires significant continuing development efforts. If we are unable to modify
existing products and develop new products and services that are responsive to
changing technology and standards and to meet customer needs in a timely and
cost effective manner, our business could be adversely affected because we would
be unable to sell our product and service offerings that have become obsolete.
DOING BUSINESS WITH THE UNITED STATES GOVERNMENT ENTAILS MANY RISKS THAT
COULD ADVERSELY AFFECT US BY DECREASING THE PROFITABILITY OF GOVERNMENTAL
CONTRACTS WE ARE ABLE TO OBTAIN AND INTERFERING WITH OUR ABILITY TO OBTAIN
FUTURE GOVERNMENTAL CONTRACTS.
Sales to United States federal government agencies accounted for 25%,
66%, and 79% of our consolidated revenues for the years ended December 31, 2002,
2001 and 2000, respectively. Our sales to these agencies are subject to risks
that include:
o early termination of our contracts;
o disallowance of costs upon audit; and
o the need to participate in competitive bidding and proposal
processes, which are costly and time consuming and may result
in unprofitable contracts.
In addition, the government may be in a position to obtain greater
rights with respect to our intellectual property than we would grant to other
entities. Government agencies also have the power, based on financial
difficulties or investigations of their contractors, to deem contractors
unsuitable for new contract awards. Because we engage in the governmental
contracting business, we have been and will be subject to audits and may be
subject to investigation by governmental entities. Failure to comply with the
terms of any of our governmental contracts could result in substantial civil and
criminal fines and penalties, as well as our suspension from future governmental
contracts for a significant period of time, any of which could adversely affect
our business by requiring us to spend money to pay the fines and penalties and
prohibiting us from earning revenues from governmental contracts during the
suspension period.
DELAYS IN DELIVERIES FROM OUR SUPPLIERS OR DEFECTS IN GOODS OR COMPONENTS
SUPPLIED BY OUR VENDORS COULD CAUSE OUR REVENUES AND GROSS MARGINS TO
DECLINE.
We rely on a limited number of vendors for certain components for the
products we are developing. Any undetected flaws in components supplied by our
vendors could lead to unanticipated costs to repair or replace these parts. We
currently purchase some of our components from a single supplier, which presents
a risk that the components may not be available in the future on commercially
reasonable terms or at all. For example, Atmel Corporation has completed
development of a specially designed Forte microprocessor that we have
incorporated into a Forte PKI card. Commercial acceptance of the Forte
microprocessor will be dependent on continued development of applications to
service customer requirements. Any inability to receive or any delay in
receiving adequate supplies of the Forte microprocessor, whether as a result of
delays in development of applications or otherwise, would adversely affect our
ability to sell the Forte PKI card.
We do not anticipate maintaining a supply agreement with Atmel
Corporation for the Forte microprocessor. If Atmel Corporation were unable to
deliver the Forte microprocessor for a lengthy period of time or were to
terminate its relationship with us, we would be unable to produce the Forte PKI
card until we could design a replacement computer chip for the Forte
microprocessor. We anticipate this would take substantial time and resources to
complete, which could result in delays or reductions in product shipments that
could adversely affect our business by requiring us to expend resources while
preventing us from selling the Forte PKI card.
Also, if we are unable to obtain or generate sufficient funds to
sustain our operations, we may damage our relationships with our vendors. Slow
and delinquent payments may cause vendors not to sell products to us, or only
with advance payment. If this occurs, we will not have components and services
44
available for our products. We may not be able to replace any of our supply
sources on economically advantageous terms. Further, if we experience price
increases for the components for our products, we will experience declines in
our gross margins.
OUR SUCCESS DEPENDS ON OUR ABILITY TO RETAIN OUR CURRENT MANAGEMENT TEAM.
Our founder, co-chairman and co-chief executive officer, Kris Shah, has
been with us since 1970, and our co-chairman and co-chief executive officer,
Marvin Winkler, co-founded one of our wholly-owned subsidiaries. Their
experience, expertise, industry knowledge and historical company knowledge would
be extremely difficult to replace if we were to lose the services of either of
them. The precise impact of the loss of services of either of them is difficult
to predict, but would likely result in, at a minimum, significant costs to
recruit, hire and retain a successor and impaired operating results while the
successor was being recruited and transitioning into the position. We do not
currently maintain life insurance on the lives of either of these officers.
THERE IS SIGNIFICANT COMPETITION IN OUR INDUSTRY FOR HIGHLY SKILLED
EMPLOYEES, AND OUR FAILURE TO ATTRACT AND RETAIN TECHNICAL PERSONNEL WOULD
ADVERSELY AFFECT OUR BUSINESS BY IMPAIRING OUR ABILITY TO EFFICIENTLY
CONDUCT OUR OPERATIONS.
We may not be able to attract or retain highly skilled employees. Our
inability to hire or retain highly qualified individuals may impede our ability
to develop, install, implement and service our software and hardware systems, to
retain existing customers and attract new customers, or to efficiently conduct
our operations, all of which would adversely affect our business. A high level
of employee mobility characterizes the data security and networking solution
industries, and the market for highly qualified individuals in computer-related
fields is intense. This competition means there are fewer highly qualified
employees available to hire, and the costs of hiring and retaining these
individuals are high. Even if we are able to hire these individuals, we may be
unable to retain them. Furthermore, the hiring and retention of technical
employees necessitates the issuance of stock options and other equity interests,
which may dilute earnings per share.
OUR EFFORTS TO EXPAND OUR INTERNATIONAL OPERATIONS ARE SUBJECT TO A NUMBER
OF RISKS, ANY OF WHICH COULD ADVERSELY AFFECT OUR FUTURE INTERNATIONAL
SALES.
We plan to increase our international sales. Our inability to obtain or
maintain federal or foreign regulatory approvals relating to the import or
export of our products on a timely basis could adversely affect our ability to
expand our international business. Additionally, our international operations
could be subject to a number of risks, any of which could adversely affect our
future international sales, including:
o increased collection risks;
o trade restrictions;
o export duties and tariffs;
o uncertain political, regulatory and economic developments; and
o inability to protect our intellectual property rights.
WE ARE UNABLE TO PREDICT THE EXTENT TO WHICH THE RESOLUTION OF LAWSUITS
PENDING AGAINST US AND OUR SUBSIDIARY COULD ADVERSELY AFFECT OUR BUSINESS
BY, AMONG OTHER THINGS, SUBJECTING US TO SUBSTANTIAL COSTS AND LIABILITIES
AND DIVERTING MANAGEMENT'S ATTENTION AND RESOURCES.
G2 Resources, Inc. and Classical Financial Services, LLC have filed
complaints against Pulsar alleging that Pulsar breached a contract by failing to
make payments to G2 Resources, Inc. in connection with services allegedly
provided by G2 Resources, Inc. In April 2001, the court dismissed, for lack of
prosecution activity for more than twelve months, the original complaint that G2
Resources, Inc. had filed against Pulsar in January 1998. G2 Resources, Inc.
re-filed the action in May 2001. In 2002, the court moved this case into the
same division handling other matters related to G2 and Classic Financial
Services, LLC. Pulsar intends to vigorously defend against the plaintiffs'
claims and has asserted defenses and counterclaims.
45
In May 2002, Contemporary Services Corporation filed an action against
us alleging breach of contract, fraud, negligent misrepresentation and violation
of California Corporations Code section 25400. The action relates to a term
sheet agreement that we entered into with the plaintiff in October 2001 in
connection with a potential strategic relationship between the plaintiff and us.
We filed an answer and cross-complaint. While we continued to believe we would
prevail at trial, in February 2003, we reached an agreement to settle the case
for less than $50,000, which will be jointly paid by our insurance carrier and
us. Our estimated portion of the settlement has been accrued in the results of
the year ended December 31, 2002.
In May 2002, Integral Systems, Inc. filed an action against us alleging
that we breached a promissory note for the payment of $389,610 and then obtained
a confessed judgment for approximately $327,250. In March 2003 we executed
settlement papers that would permit Integral Systems to file a stipulated
judgment against us in the amount of the unpaid balance if we default on a
payment schedule that requires us to make payments of $20,000 per month until
the balance is paid in full.
In June 2002, Research Venture, LLC filed two lawsuits against us
alleging unlawful detainer and seeking possession of two leased properties,
alleged damages and lost rent. We surrendered possession of both properties and
negotiated a restructuring of our obligations under the leases. Under the
restructuring arrangement, we agreed to make cash payments to Research Venture
aggregating $500,000, and we issued 959,323 shares of common stock and a
subordinated convertible promissory note in the principal amount of $360,000
that represents prepaid rent on a property we are leasing from Research Venture
and is convertible into an aggregate of up to 276,923 shares of common stock.
Research Venture will be entitled to entry of the stipulated judgment in the
maximum aggregate amount of $3.1 million, less consideration we pay prior to any
entry of the judgment, if we do not comply with the terms of the restructuring
arrangement through December 2004.
In July 2002, Synnex Technology filed a lawsuit against us in the
Superior Court of Orange County, Case No. 02CC12380, alleging that we failed to
pay $120,986 for products purchased by us for resale. We and Synnex agreed to
settle the matter by payment of ten equal installments of $12,099, pursuant to a
stipulation for entry of judgment that is to be held by counsel for Synnex and
not filed with the court absent breach by us. The last payment is due on or
before June 9, 2003, at which time the action will be dismissed. To date, all
required payments have been made.
Any or all of these litigation matters could subject us to substantial
costs and liabilities and divert our management's attention and resources during
our current and future financial reporting periods. If we believe it is probable
that we will incur an estimable amount of expenses in connection with a
litigation matter, we will include the estimated amount of expenses in accounts
payable or accrued liabilities. If we feel unable to make a reasonable judgment
as to the ultimate outcome of, or to assess or quantify our exposure relating
to, a litigation matter, we will not include in our financial statements an
estimated amount of expenses for that matter. Consequently, if we are unable
during any financial reporting period to accurately estimate our potential
liability in connection with a litigation matter, our financial condition and
results of operations in future financial reporting periods may be adversely
affected when we record any unreserved costs or liabilities we actually have
incurred in connection with a litigation matter.
A NUMBER OF VENDORS HAVE FILED OR THREATENED TO FILE LAWSUITS TO COLLECT
AMOUNTS DUE FROM US. IF WE ARE UNABLE TO REACH A FAVORABLE RESOLUTION OF
THESE MATTERS, WE MAY HAVE TO DEFEND OURSELVES IN COSTLY LITIGATION AND BE
SUBJECT TO SUBSTANTIAL MONETARY JUDGMENTS.
During 2002, several vendors filed or threatened to file suits against
us related to outstanding account balances that are included within our accounts
payable. We reached oral agreement with several vendors, including one vendor
who had filed suit against us. We are making payments on the amount owed to the
vendor who filed suit against us and executed an agreement to extend the terms
of the existing accounts payable balance. The vendor has indicated that it will
execute and return the agreement to us, but as of March 28, 2003, we had not
received the executed agreement. If the collection suit goes to judgment, there
would be an adverse impact on our financial condition and liquidity.
46
GOVERNMENTAL REGULATIONS AFFECTING SECURITY OF INTERNET AND OTHER DIGITAL
COMMUNICATION NETWORKS COULD LIMIT THE MARKET FOR OUR PRODUCTS AND
SERVICES.
The United States government and foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, including encryption technology. Any additional
governmental regulation of imports or exports or failure to obtain required
export approval of encryption technologies could delay or prevent the acceptance
and use of encryption products and public networks for secure communications and
could limit the market for our products and services. In addition, some foreign
competitors are subject to less rigorous controls on exporting their encryption
technologies. As a result, they may be able to compete more effectively than us
in the United States and in international security markets for Internet and
other digital communication networks. In addition, governmental agencies such as
the Federal Communications Commission periodically issue regulations governing
the conduct of business in telecommunications markets that may negatively affect
the telecommunications industry and us.
BIZ ACQUISITION-RELATED ACCOUNTING CHARGES MAY CONTINUE TO DELAY OR REDUCE
OUR PROFITABILITY.
We accounted for our August 2001 acquisition of BIZ as a purchase.
Under the purchase method of accounting, the purchase price was allocated to the
fair value of the identifiable tangible and intangible assets and liabilities
that we acquired from BIZ. The excess of the purchase price over BIZ's tangible
net assets resulted in goodwill and other intangible assets.
In July 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets." We adopted this statement effective January 1, 2002. Under
this statement, goodwill is no longer amortized and is subject to annual testing
for impairment beginning January 1, 2002. The provisions of this statement
require us to perform a two-step test to assess goodwill for impairment. In the
first step, we compare the fair value of each reporting unit to its carrying
value. If the fair value exceeds the carrying value, then goodwill is not
impaired and we need not proceed to the second step. If the carrying value of a
reporting unit exceeds its fair value, then we must determine and compare the
implied fair value of the reporting unit's goodwill to the carrying value of its
goodwill. If the carrying value of the reporting unit's goodwill exceeds its
implied fair value, then we will record an impairment loss in the amount of the
excess. With regard to a reporting unit's goodwill balance at January 1, 2002,
we were required to perform the first step of the annual testing for impairment
by June 30, 2002. If the results of that step indicated that goodwill may be
impaired, we would then be required to complete the second step as soon as
possible, but no later than December 31, 2002.
As of December 31, 2001, we assessed the fair value of our two
reporting units by comparing the book value of our equity interests to the fair
value of our equity interests based upon the terms of a financing we completed
in April 2002. Given consideration of this comparison and relevant factors, we
concluded that as of December 31, 2001, an impairment write-down of
approximately $36.3 million was required. We reviewed the assumptions used in
the original analysis performed as of December 31, 2001 for dates of March 31,
2002, June 30, 2002, and September 30, 2002 and concluded that such analyses
continued to be adequate and no additional write-down was required.
We later performed an assessment of our Information Security Products
and Services reporting unit. The assessment was performed to measure the fair
value of the remaining goodwill as of December 31, 2002 using a multi-period
discounted cash flow method. The results of the analysis indicated that no
additional write-down was required as of December 31, 2002.
We are required to perform tests for impairment at least annually.
Tests for impairment between annual tests may be required if events occur or
circumstances change that would more likely than not reduce the fair value of
the net carrying amount. We cannot predict whether or when there will be
additional impairment charges, or the amount of any such charges. If the charges
are significant, they could cause the market price of our common stock to
decline.
47
A RELOCATION OF OUR SOFTWARE DEVELOPMENT TO INDIA COULD PROVE TO BE
UNPROFITABLE DUE TO RISKS INHERENT IN INTERNATIONAL BUSINESS ACTIVITIES.
We may relocate portions of our software development activities to
India in an effort to reduce our operating expenses. We are subject to a number
of risks associated with international business activities that could adversely
affect any operations we may develop in India and could slow our growth. These
risks generally include, among others:
o difficulties in managing and staffing our Indian operations;
o difficulties in obtaining or maintaining regulatory approvals
or in complying with Indian laws;
o reduced or less certain protection for intellectual property
rights;
o differing technological advances, preferences or requirements;
o trade restrictions;
o foreign currency fluctuations; and
o general economic conditions, including instability, in the
Indian market.
Any of these risks could adversely affect our business and results of
operations.
CONFLICTS INVOLVING INDIA COULD ADVERSELY AFFECT ANY OPERATIONS WE MAY
ESTABLISH IN INDIA, WHICH COULD INTERFERE WITH OUR ABILITY TO CONDUCT ANY
OR ALL OF OUR OTHER OPERATIONS.
South Asia has from time to time experienced civil unrest and
hostilities among neighboring countries, including India and Pakistan. In April
1999, India and Pakistan conducted long-range missile tests. Since May 1999,
military confrontations between India and Pakistan have occurred in disputed
regions. In October 1999, the leadership of Pakistan changed as a result of a
coup led by the military. Additionally, recent events have significantly
heightened the tensions between India and Pakistan. If a major armed conflict or
nuclear war involving India and any of its neighboring countries occurs, it
could, among other things, prevent us from establishing or maintaining
operations in India. If the successful conduct of operations in India becomes
critical to any or all of our other operations, our business would be harmed to
the extent we are unable to establish or maintain operations in India.
WE ARE EXPOSED TO LIABILITY FOR ACTIONS TAKEN BY OUR DOMESTIC EMPLOYEES
WHILE ON ASSIGNMENT AND MAY ALSO BE EXPOSED TO LIABILITY FOR ACTIONS TAKEN
BY ANY FOREIGN EMPLOYEES WE MAY HIRE.
As a professional services provider, a portion of our business involves
employing people and placing them in the workplace of other businesses.
Therefore, we are exposed to liability for actions taken by our employees while
on assignment. In addition, to the extent we hire employees in India or other
foreign locations, we may also be exposed to liability for actions taken by
those employees in the scope of their employment.
NASDAQ MAY DELIST OUR COMMON STOCK, WHICH COULD DECREASE THE MARKET PRICE
OF OUR COMMON STOCK AND MAKE IT MORE DIFFICULT FOR OUR STOCKHOLDERS TO
DISPOSE OF OR OBTAIN QUOTATIONS FOR OUR COMMON STOCK AND FOR US TO OBTAIN
FINANCING. DELISTING ALSO WOULD ENTITLE A THIRD PARTY TO FILE A POTENTIALLY
SUBSTANTIAL STIPULATED JUDGMENT AGAINST US.
The quantitative listing standards of The Nasdaq National Market
require, among other things, that listed companies maintain a minimum bid price
of $1.00. In November 2002, we received a notice from Nasdaq indicating that our
common stock had failed to maintain the required minimum bid price of $1.00 for
the last 30 consecutive trading days and that, therefore, we had until February
20, 2003 to regain compliance with that requirement. We did not timely regain
compliance with that requirement. In March 2003, we received a notice from
48
Nasdaq that the period to regain compliance with the $1.00 minimum bid price has
been extended and additional 90 days, through May 21, 2003. If we fail to timely
regain compliance with that requirement, or if we fail to maintain compliance
with any other listing requirement, Nasdaq staff likely will provide written
notice to us that our common stock will be delisted. At that time, we intend to
appeal the staff's determination to a listing qualifications panel for
consideration. Alternatively, we may be permitted to submit an application to
transfer the listing of our common stock to The Nasdaq SmallCap Market if we
satisfy the continued inclusion requirements for The Nasdaq SmallCap Market. The
successful transfer of the listing of our common stock to The Nasdaq SmallCap
Market would make available an extended grace period through August 19, 2003 for
the minimum $1.00 bid price requirement and would make available an additional
180 calendar day grace period if we meet the initial listing criteria for The
Nasdaq SmallCap Market.
In addition to minimum bid price requirements, Nasdaq's qualification
standards require, among other things, that issuers apply for initial inclusion
on Nasdaq following a change of control. Nasdaq looks at many factors in
determining whether a change of control has occurred, including without
limitation, changes in the management, board of directors, voting power and
ownership of a company. Depending on the terms and conditions of any future
financings or other transactions we may enter into, if Nasdaq determines that a
change of control has occurred, we would need to file a new listing application
if we want to maintain our Nasdaq listing. We do not know whether, at the time,
if any, that we would file a new listing application with Nasdaq, we would meet
the initial listing standards of either The Nasdaq National Market or The Nasdaq
SmallCap Market.
If we are delisted from The Nasdaq National Market, our stock price
could decline further and the ability of any potential or future investors to
achieve liquidity from our common stock could be severely limited, particularly
if we are unable to transfer the listing of our common stock to The Nasdaq
SmallCap Market. This could inhibit, if not preclude, our ability to raise
additional working capital on acceptable terms, if at all. Also, if we are
delisted from The Nasdaq National Market, Research Venture, LLC, a party with
whom we have entered into a litigation settlement, would be entitled to entry of
a stipulated judgment against us in the maximum aggregate amount of $3.1
million, less consideration we pay prior to any entry of the judgment.
THE NON-CASH INTEREST EXPENSE REQUIRED IN CONNECTION WITH THE DETACHABLE
WARRANTS AND BENEFICIAL CONVERSION FEATURES OF OUR APRIL 2002 FINANCING MAY
ADVERSELY AFFECT OUR STOCK PRICE.
The secured convertible promissory notes we issued in April 2002 are
convertible into shares of our common stock at a conversion price below the
market price of our common stock at the commitment date for the notes. In
addition, the notes were accompanied by common stock purchase warrants with an
exercise price below the market price of our common stock at the commitment
date. Accordingly, under accounting guidelines, we were required to record a
substantial non-cash charge as interest expense, with an offsetting increase to
our paid-in-capital. While recording this entry had no effect on our
stockholders' equity, the entry substantially increased our reported loss for
the year ended December 31, 2002 and may cause a decline in our stock price.
OUR COMMON STOCK PRICE IS SUBJECT TO SIGNIFICANT VOLATILITY, WHICH COULD
RESULT IN SUBSTANTIAL LOSSES FOR INVESTORS AND IN LITIGATION AGAINST US.
The stock market as a whole and individual stocks historically have
experienced extreme price and volume fluctuations, which often have been
unrelated to the performance of the related corporations. During the 52-week
period ended March 28, 2003, the high and low closing sale prices of our common
stock were $2.60 and $0.54, respectively. The market price of our common stock
may exhibit significant fluctuations in the future in response to various
factors, many of which are beyond our control and which include:
o variations in our annual or quarterly financial results, which
variations could result from, among other things, the timing,
size, mix and customer acceptance of our product and service
offerings and those of our competitors, and the timing and
magnitude of required capital expenditures;
o company-issued earnings announcements that vary from consensus
analyst estimates;
o changes by financial research analysts in their
recommendations or estimates of our earnings;
49
o conditions in the economy in general or in the information
technology service sector in particular;
o announcements of technological innovations or new products or
services by us or our competitors; and
o unfavorable publicity or changes in applicable laws and
regulations, or their judicial or administrative
interpretations, affecting the information technology service
sector and us.
If our operating results in future quarters fall below the expectations
of market makers, securities analysts and investors, the price of our common
stock likely will decline, perhaps substantially. In the past, securities class
action litigation often has been brought against a company following periods of
volatility in the market price of its securities. We may in the future be the
target of similar litigation. Securities litigation could result in substantial
costs and liabilities and could divert management's attention and resources.
Consequently, the price at which you purchase shares of our common stock may not
be indicative of the price that will prevail in the trading market. You may be
unable to sell your shares of common stock at or above your purchase price,
which may result in substantial losses to you.
A SIGNIFICANT NUMBER OF SHARES OF OUR COMMON STOCK ARE OR WILL BECOME
ELIGIBLE FOR PUBLIC SALE, AND SALES OF LARGE NUMBERS OF OUR SHARES COULD
ADVERSELY AFFECT THEIR MARKET PRICE AND MAKE IT DIFFICULT FOR US TO RAISE
ADDITIONAL CAPITAL THROUGH SALES OF EQUITY SECURITIES.
As of March 31, 2003, we had issued and outstanding 25,067,576 shares
of common stock, a majority of which were unrestricted, were eligible for resale
without registration under Rule 144 of the Securities Act of 1933, or were
registered for resale or issued with registration rights. Our common stock
historically has been thinly traded. Our average daily trading volume between
March 18, 2002 and March 21, 2003 was 8,882 shares. If our stockholders seek to
sell numbers of shares significantly in excess of our typical volume, the market
price of our shares may decline. Any adverse effect on the market price for our
common stock could make it more difficult for us to sell equity securities at a
time and at a price that we deem appropriate.
FUTURE CONVERSIONS OR EXERCISES OF OUR OUTSTANDING DERIVATIVE SECURITIES,
PARTICULARLY THOSE THAT CONTAIN "FULL RATCHET" ANTI-DILUTION PROVISIONS,
COULD SUBSTANTIALLY DILUTE YOUR INVESTMENT BY CAUSING LARGE NUMBERS OF
SHARES OF OUR COMMON STOCK TO BE ISSUED IN THE FUTURE.
Convertible notes and warrants such as those that we issued in April
2002 contain "full ratchet" anti-dilution provisions that are in effect through
April 16, 2003. This means that if we issue any common stock or securities
convertible into or exercisable for common stock prior to April 16, 2003 for
consideration less than the conversion price of the notes (initially, $1.00 per
share) or the exercise price of the warrants (initially, $1.30 per share), then
the conversion price of the notes and/or the exercise price of the warrants
automatically will adjust down to the consideration per share in the new
issuance. So, for example, if we issue an option to purchase shares of our
common stock at $0.80 per share, both the conversion price of the notes and the
exercise price of the warrants will be reduced to $0.80 per share, and the
number of shares underlying the warrants will be increased in proportion to the
reduction in the warrant exercise price.
Declines in the market price of our common stock, future market
conditions and our present and future cash needs may require us to issue
securities at a lower price. If we do so without obtaining a waiver of the
anti-dilution provisions, then the new, lower effective conversion price of the
convertible notes would cause even more shares of our common stock to become
issuable upon conversion of the notes, and the number of shares underlying the
warrants would be adjusted upward in proportion to the downward adjustment to
the warrant exercise price, creating the possibility of significant dilution of
any future earnings per share.
IF OUR SECURITY HOLDERS ENGAGE IN SHORT SALES OF OUR COMMON STOCK,
INCLUDING SALES OF SHARES TO BE ISSUED UPON CONVERSION OR EXERCISE OF
DERIVATIVE SECURITIES, THE PRICE OF OUR COMMON STOCK MAY DECLINE.
Selling short is a technique used by a security holder to take
advantage of an anticipated decline in the price of a security. A significant
number of short sales or a large volume of other sales within a relatively short
period of time can create downward pressure on the market price of a security.
The decrease in market price would allow holders of our derivative securities
50
that have conversion or exercise prices based upon a discount on the market
price of our common stock to convert or exercise their derivative securities
into or for an increased number of shares of our common stock. Further sales of
common stock issued upon conversion or exercise of our derivative securities
could cause even greater declines in the price of our common stock due to the
number of additional shares available in the market, which could encourage short
sales that could further undermine the value of our common stock. You could,
therefore, experience a decline in the value of your investment as a result of
short sales of our common stock.
IF WE ARE UNSUCCESSFUL IN COMPLYING WITH OUR REGISTRATION OBLIGATIONS, WE
MAY BE IN DEFAULT UNDER OUR SECURED CONVERTIBLE PROMISSORY NOTES AND
LITIGATION SETTLEMENTS AND COULD FACE SIGNIFICANT PENALTIES AND A
SUBSTANTIAL STIPULATED JUDGMENT.
The agreements we entered into in connection with our issuance of
secured convertible promissory notes and related warrants and in connection with
settlement of litigation require us to, among other things, register for resale
the shares of common stock issued or issuable under those arrangements and to
maintain the effectiveness of the registration statements for an extended period
of time. If we are unable to timely obtain and maintain effectiveness of the
required registration statements, or if we default under the arrangements for
any other reason, then the holders of the notes could, among other things,
require us to pay substantial penalties, require us to repay the notes at a
premium and/or foreclose upon their security interest in our assets, and the
parties to the settlement arrangements could take action against us that could
include the filing of a substantial stipulated judgment. Any of these events
would adversely affect our business, operating results, financial condition, and
ability to service our other indebtedness by negatively impacting our cash
flows.
A SMALL NUMBER OF STOCKHOLDERS, WHO INCLUDE CERTAIN OF OUR OFFICERS AND
DIRECTORS, HAVE THE ABILITY TO CONTROL STOCKHOLDER VOTES AND TO TAKE ACTION
BY WRITTEN CONSENT WITHOUT A MEETING OF STOCKHOLDERS.
As of March 31, 2003, Kris Shah, Marvin Winkler and certain of their
family members and affiliates owned, in the aggregate, approximately 54.1% of
our outstanding common stock. Those stockholders, if acting together, have the
ability to elect our directors and to determine the outcome of corporate actions
requiring stockholder approval, irrespective of how our other stockholders may
vote. Further, those stockholders have the ability to take action by written
consent on those matters without a meeting of stockholders. Those matters could
include the election of directors, changes in the size and composition of the
board of directors, and mergers and other business combinations involving our
company. In addition, through control of the board of directors and voting
power, they may be able to control certain decisions, including decisions
regarding the qualification and appointment of officers, dividend policy, access
to capital (including borrowing from third-party lenders and the issuance of
additional equity securities), and the acquisition or disposition of our assets.
Also, the concentration of voting power in the hands of those individuals could
have the effect of delaying or preventing a change in control of our company,
even if the change in control would benefit our stockholders, and may adversely
affect the market price of our common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We own Class A Common Stock of Wave Systems Corp., which stock is
classified as trading securities. The stock is listed on The Nasdaq National
Market. The increase or decrease in value of the stock is included in our
statement of operations together with the gain or loss on sales of the stock. As
of December 31, 2002, we had approximately 57,000 shares with an aggregate value
of approximately $76,000. For the years ended December 31, 2001 and 2002, we
recorded realized loss on trading securities of approximately $530,000 and
$130,000, respectively.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the financial statements included in this report
beginning at page F-1.
51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
As disclosed in our Form 8-K filed August 1, 2002, on July 25, 2002, we
and our subsidiaries notified KPMG LLP, ("KPMG")the independent accounting firm
that was engaged as SSP's principal accountant to audit our financial
statements, that we intended to engage new certifying accountants, in effect
terminating our relationship with KPMG. Our decision to change accountants was
approved by our audit committee and board of directors. In connection with the
audits of the two years ended December 31, 2001, and during the subsequent
interim period through July 25, 2002, there were no disagreements with KPMG on
any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedures which disagreements, if not resolved
to KPMG's satisfaction, would have caused KPMG to make reference to the subject
matter of the disagreement in connection with its opinion. In addition, there
were no reportable events as described in Item 304(a)(1)(v) of Regulation S-K
under the Securities Act of 1933, as amended.
As disclosed in our Form 8-K filed August 6, 2002, on August 2, 2002,
we engaged Haskell & White LLP as our new certifying accountants. We had not
consulted with Haskell & White in the past regarding the application of
accounting principles to a specified transaction or the type of audit opinion
that might be rendered on our financial statements or as to any disagreement or
reportable event as described in Item 304(a)(1)(iv) and Item 304(a)(1)(v) of
Regulation S-K under the Securities Act of 1933.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS AND EXECUTIVE OFFICERS
Set forth below is information regarding our executive officers and
directors as of March 31, 2003:
NAME AGE POSITION
---- --- --------
Marvin J. Winkler........................ 48 Co-Chairman of the Board of Directors, Director and
Co-Chief Executive Officer
Kris Shah (3)............................ 63 Co-Chairman of the Board of Directors, Director, Co-Chief
Executive Officer, and Secretary
Richard M. Depew......................... 42 President and Chief Operating Officer
Thomas E. Schiff......................... 52 Executive Vice President and Chief Financial Officer
Gregg Amber (2).......................... 46 Director
Joel K Rubenstein (1) (2) ............... 66 Director
Ron R. Goldie (1) (2) ................... 51 Director
Gregory J. Clark (1) (3) ............... 59 Director
------------
(1) Member of audit committee (2) Member of compensation committee (3) Member of
technology committee
MARVIN J. WINKLER is our co-chairman of the board of directors,
director and co-chief executive officer, positions he has held since August 2001
following our acquisition of BIZ. Prior to August 2001 and since April 2000, Mr.
Winkler served as the chief executive officer and chairman of the board of
directors and as a director of BIZ. Mr. Winkler founded BIZ to address the
secure processing and applications required to ensure secure high-speed
knowledge and financial transactions across the Internet. He also established
the industry's first Core-To-Edge(TM) solution set of hardware, software and
firmware products and applications for security in electronic commerce. In June
1999, Mr. Winkler partnered with principals of Broadcom Corporation to co-found
Broadband Interactive Group ("BIG") to demonstrate the applications for
interactive television in a convergent broadband media industry. In November
2001, BIG made an assignment for the benefit of its creditors. In August 1996,
Mr. Winkler acquired Gotcha International, L.P., an apparel manufacturer, and
served as its president and chief executive officer until July 2002. In August
2002, Gotcha filed for Chapter 11 bankruptcy protection in order to terminate
the license of its domestic licensee. Gotcha has filed a reorganization plan to
re-pay creditors in full plus interest.
KRIS SHAH is our co-chairman of the board of directors, co-chief
executive officer, director and secretary. Mr. Shah has been our chairman of the
board of directors and a director since he founded our company in 1970. He has
been our chief executive officer since our founding and has shared that position
with Mr. Winkler from August 2001 until the present. Mr. Shah has served as our
secretary since May 2001. In addition, from September 2000 until August 2001,
Mr. Shah served as our president. Mr. Shah's career has involved every major
aspect of circuit design and chip packaging technology, including research and
development, manufacturing, engineering, marketing and strategic planning.
Before forming our company, Mr. Shah held management level positions at Hughes
Aircraft Co., Fiberite Inc. and Bell Industries, Inc. Mr. Shah holds B.S. and
M.S. degrees in mechanical engineering from the University of Southern
California.
52
RICHARD M. DEPEW was appointed as our president and chief operating
officer in August 2001. From July 1998 until he began serving in these
positions, Mr. Depew served as executive vice president of Certicom Inc. and as
president of its wholly-owned subsidiary Certicom International, a wireless
security company. From December 1995 until he joined Certicom, Mr. Depew served
as our vice president and general manager of information security. Mr. Depew
holds a BSEF (equivalent, engineer first class) in electronics engineering
technology from the United States Coast Guard and holds a certificate from the
Southern Methodist University M.B.A. program in entrepreneurial studies.
THOMAS E. SCHIFF has served as our executive vice president and chief
financial officer since our acquisition of BIZ in August 2001. Prior to that,
Mr. Schiff served as the executive vice president, chief financial officer,
treasurer and secretary and as a member of the board of directors of BIZ since
its inception in April 2000. From December 1998 to June 2001, he was an
executive vice president and chief financial officer for SW Gotcha Acquisition
Ltd and Gotcha International, L.P. From March 1996 to December 1998, Mr. Schiff
was executive vice president and chief financial officer of Pacific Eyes & T's.
Mr. Schiff was formerly a certified public accountant for the San Francisco
office of Peat, Marwick, Mitchell. He holds a degree in economics from Stanford
University and an M.B.A. degree from the Stanford Graduate School of Business.
GREGG AMBER joined our board in April 2000. From March 2000 until May
2001, Mr. Amber also served as our secretary. Mr. Amber is currently a partner
with the law firm of Rutan & Tucker, LLP. From December 1999 until July 2000,
Mr. Amber was the senior vice president, secretary and general counsel for
ZLand.com, Inc. From March 1998 through November 1999, Mr. Amber was a partner
with the law firm of Rutan & Tucker, LLP. Mr. Amber holds a B.A. degree in
political science and mathematics from Principia College and a J.D. degree from
Stanford Law School.
JOEL K. RUBENSTEIN joined our board in October 2002. Since January
1992, Mr. Rubenstein has been a principal of Oracle One Partners, Inc., a
strategic business and marketing company based in Newport Beach, California.
>From 1985 to 1990, Mr. Rubenstein served in the Office of the Commissioner,
Major League Baseball as executive vice president of marketing and corporate
sponsorships. From 1979 through 1984, Mr. Rubenstein served as vice president of
the Los Angeles Olympic Organizing Committee. Since June 1994, Mr. Rubenstein
has been a board member of Fotoball USA, a publicly traded company based in San
Diego, California (Nasdaq-NMS: FUSA). He serves on the board of directors of the
Yosemite National Institutes and is a director of Big Brothers/Sisters of Orange
County.
RON R. GOLDIE joined our board in January 2003. Mr. Goldie has served
domestically and internationally as both a senior business executive and an
attorney with several large law firms, with Mr. Goldie specializing in financial
transactions and managing the business law departments of those firms. From
November 2001 to February 2002, Mr. Goldie was the Chief Financial Officer of
ETC, plc, a London-based firm with operations in electronic payment processing
and encryption, in addition to technology investments both in the United States
and Europe. From October 2000 to September 2001, Mr. Goldie was the Chief
Operating Officer of GlobalNetFinancial ((Nasdaq-NMS: GLBN) (LSE/AIM:GLFA)), an
international dual-listed firm with holdings in numerous financial management
firms in the United States and Europe. Upon returning from London in September
2001, Mr. Goldie formed the Law Offices of Ron R. Goldie to serve both domestic
and European-based clients. Previously, Mr. Goldie served as a senior partner in
various firms, including Mitchell Silberberg & Knupp from March 1999 to April
2001, Stroock & Stroock & Lavan from January 1998 to March 1999, Coudert
Brothers from April 1997 to January 1998, and Jeffer Mangels Butler & Marmaro
from 1990 to 1997. Mr. Goldie earned a B.A. degree in history and a J.D. degree
from University of Southern California.
53
DR. GREGORY J. CLARK joined our board in January 2003. Dr. Clark has
served as vice chairman of Knowledge Universe, a private company that operates,
incubates and invests in companies in the technology, health and education
industries, since January 2000. He has served as a director of Nextera
Enterprises, Inc., a management consulting services company (Nasdaq-SCM: NXRA),
since January 2000. From January 1998 to January 2000, Dr. Clark served as
president and chief operating officer of Loral Space and Communications, LLC, a
satellite communications company. From March 1994 to December 1998, Dr. Clark
served as president of the News Technology Group, a division of News
Corporation, and was responsible for the worldwide integration of technical
strategies and operations in print, terrestrial and satellite television, film
and online and Internet services. From 1988 to 1994, Dr. Clark served as
director of science and technology for IBM in Australia. Dr. Clark holds a Ph.D.
degree in Physics from Australian National University and a B.Sc. degree in
Physics from University of Tasmania.
There are no family relationships among our officers and directors.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended, and
the regulations thereunder require the directors, executive officers and persons
who beneficially own more than 10% of a registered class of our equity
securities ("reporting persons") to file with the Securities and Exchange
Commission initial reports of ownership and reports of changes in ownership of
our common stock and other equity securities, and to furnish us with copies of
all reports that they file.
Based solely upon a review of copies of the reports furnished to us
during our fiscal year ended December 31, 2002 and thereafter, or any written
representations received by us from reporting persons that no other reports were
required, we believe that, all Section 16(a) filing requirements applicable to
our reporting persons during 2002 were met except that Wave Systems Corp. filed
two late Form 4s to report three transactions.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION OF EXECUTIVE OFFICERS
The following table provides information concerning the annual,
long-term and other compensation for 2002, 2001 and 2000 earned for services in
all capacities as an employee by our co-chief executive officers and each of our
other executive officers who received an annual salary and bonus of more than
$100,000 during 2002 (collectively, the "named executive officers"):
54
SUMMARY COMPENSATION TABLE
LONG-TERM
COMPENSATION
ANNUAL COMPENSATION AWARDS
------------------- ------
OTHER SECURITIES
NAME AND ANNUAL UNDERLYING ALL OTHER
PRINCIPAL POSITIONS YEAR SALARY BONUS COMPENSATION OPTIONS COMPENSATION
------------------- ---- ------ ----- ------------ ------- ------------
Kris Shah, 2002 $142,188 (1) -- $25,200 (2) 26,250 $3,281 (3)
Co-Chairman, 2001 $236,908 -- $25,200 (2) -- --
Co-Chief Executive 2000 $181,375 -- $25,200 (2) -- --
Officer and Secretary
Marvin J. Winkler, 2002 $130,954 (1) -- $17,979 (4) 26,250 --
Co-Chairman and 2001 $ 34,615 -- $ 6,400 (6) -- --
Co-Chief Executive 2000 -- -- -- -- --
Officer (1)
Richard M. Depew, 2002 $165,156 (1) -- $6,000 (5) 26,250 --
President and Chief 2001 $ 60,333 -- $2,500 (5) 220,000 --
Operating Officer (1) 2000 -- -- -- -- --
Thomas E. Schiff, 2002 $117,989 (1) -- $14,400 (5) 18,750 $ 729 (3)
Executive Vice 2001 $ 48,096 -- $7,200 (6) 47,512 --
President and Chief 2000 -- -- -- -- --
Financial Officer (1)
(1) Messrs. Shah, Winkler, Depew and Schiff had their annual salaries reduced
by 10% along with all other employees in August 2002, and they deferred
payment of additional salary amounts. Since August 1, 2002, their annual
salaries paid have been $87,500, $87,500, $148,750 and $112,500,
respectively. Messrs. Shah, Winkler and Depew deferred payment of salary in
the amounts of $29,200, $29,200 and $3,650, respectively, which are
included in accrued liabilities as of December 31, 2002 and are included in
the above table.
(2) Represents a $19,200 car allowance and $6,000 in health insurance premiums.
(3) Represents matching company contribution to 401(k) plan on the same terms
as were generally made available to all employees.
(4) Represents a $12,000 car allowance and $5,979 in health insurance premiums.
(5) Represents car allowance.
(6) Represents car allowance and $2,400 in health insurance premiums.
OPTION GRANTS IN LAST FISCAL YEAR
The following table provides information regarding options granted in
2002 to the named executive officers. We did not grant any stock appreciation
rights in 2002. This information includes hypothetical potential gains from
stock options granted in 2002. These hypothetical gains are based entirely on
assumed annual growth rates of 5% and 10% in the value of our common stock price
over the 10-year life of the stock options granted in 2002. These assumed rates
of growth were selected by the Securities and Exchange Commission for
illustrative purposes only and are not intended to predict future stock prices,
which will depend upon market conditions and our future performance and
prospects.
INDIVIDUAL GRANTS
PERCENT
OF TOTAL
OPTIONS POTENTIAL REALIZABLE VALUE
NUMBER OF GRANTED TO AT ASSUMED ANNUAL RATES OF STOCK PRICE
SECURITIES EMPLOYEES EXERCISE APPRECIATION FOR OPTION TERM (2)
GRANT UNDERLYING IN FISCAL PRICE PER EXPIRATION --------------------------------------
NAME DATE OPTIONS GRANTED YEAR (1) SHARE DATE 0% 5% 10%
------------------- ------- --------------- -------- --------- ---------- ----------- ---------- ----------
Kris Shah.......... 8/01/02 26,250 (3) 2.3% $1.30 8/01/12 -- 19,327 50,993
Marvin J. Winkler.. 8/01/02 26,250 (3) 2.3% $1.30 8/01/12 -- 19,327 50,993
Richard M. Depew... 8/01/02 26,250 (3) 2.3% $1.30 8/01/12 -- 19,327 50,993
Thomas E. Schiff .. 8/01/02 18,750 (3) 1.6% $1.30 8/01/12 -- 13,789 36,376
55
------------
(1) Based on options to purchase 1,151,177 shares granted to our employees
during 2002.
(2) Calculated using the potential realizable value of each grant.
(3) The option vests and become exercisable as to 20% of the underlying shares
of common stock upon issuance. The option vests and becomes exercisable as
to the remaining 80% of the underlying shares of common stock at the rate
of 1/48th of the total shares underlying the option per month, commencing
September 1, 2002.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR-END OPTION VALUES
The following table provides information regarding the number of shares
of common stock underlying exercisable and unexercisable stock options held by
the named executive officers at December 31, 2002. An option is in-the-money if
the fair market value for the underlying securities exceeds the exercise price
of the option. None of the options were in-the-money at December 31, 2002, and
no options were exercised by the named executive officers during 2002.
NUMBER OF
SECURITIES UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS AT
SHARES DECEMBER 31, 2002 DECEMBER 31, 2002(1)
ACQUIRED VALUE ----------------------------- ------------------------------
NAME ON EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- -------- ----------- ------------- ----------- -------------
Kris Shah......... -- -- 7,438 18,812 -- --
Marvin J. Winkler. -- -- 7,438 18,812 -- --
Richard M. Depew.. -- -- 67,438 178,813 -- --
Thomas E. Schiff.. -- -- 134,486 121,825 -- --
------------
(1) Based on the last reported sale price of our common stock of $0.59 on
December 31, 2002 (the last trading day during 2002) as reported by The
Nasdaq National Market, minus the exercise price of the options.
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
KRIS SHAH
Kris Shah entered into a three-year employment agreement with us,
effective as of June 9, 1999. The agreement automatically renews for successive
one-year terms unless it is terminated by us or by Mr. Shah through written
notice given to the other party 90 days before the expiration of the then
current term. Our board of directors may adjust Mr. Shah's salary. Mr. Shah is
entitled to receive an annual bonus award of $100,000 if we have earnings in
excess of $2,500,000 or more and an additional $37,500 for each additional
$1,000,000 of earnings in excess of $2,500,000. In making the calculation for
the bonus, we will measure earnings before interest and taxes and will add back
the amortization of goodwill and other intangibles. Mr. Shah's contract
automatically renewed in June 2002.
Mr. Shah's employment agreement provides that, in addition to being
terminated through the notice feature described above, employment may be
terminated as follows:
-- by Mr. Shah, if he has good reason to terminate the agreement.
Good reason exists if:
o Mr. Shah is relieved of his position as, or is not
reappointed as, an officer of our company;
o Mr. Shah's title, office or responsibilities change
substantially;
o Mr. Shah's base salary is reduced to an amount that
is less than $175,000 or by more than 10%. In August
2002, Mr. Shah voluntarily participated in a
company-wide 10% salary reduction program and waived
his right to terminate his contract based upon this
company-wide program;
o we fail to maintain our employee benefit plans;
56
o we sell or transfer our company and fail to obtain
the successor's assumption of the employment
agreement; or
o we fail to comply with a material term of the
employment agreement and fail to cure the default
after appropriate notice.
-- by us, if we determine that due cause for termination exists.
Due cause exists if we find that Mr. Shah:
o intentionally misapplied our money or property;
o committed an act of dishonesty that harmed us;
o was convicted of a felony or a crime involving moral
turpitude;
o has used a controlled substance, including alcohol,
which affects his ability to perform his job duties;
or
o breached the terms of the employment agreement.
-- Additionally, we can terminate the agreement upon Mr. Shah's:
o death;
o disability for more than 180 days, after we give 30
days' notice of our intention to terminate the
employment agreement; or
o retirement.
We may be obligated to make payments to Mr. Shah upon termination of
employment, depending on the circumstances surrounding the termination. If the
employment agreement is terminated by Mr. Shah after we give notice for due
cause, or by Mr. Shah in breach of the agreement, Mr. Shah will have the right
to exercise all vested stock options and we will not be obligated to pay any
compensation after the termination date, except:
o medical benefits for a period of 12 months; and
o unpaid base salary that Mr. Shah has earned.
If the employment agreement is terminated by Mr. Shah for good reason
or by us through a constructive termination, Mr. Shah will have the right to
exercise all vested stock options and we will be obligated to pay to Mr. Shah:
o his annual salary for a period of two years;
o a pro rata bonus for the fiscal year in which the
termination occurs; and
o continuing medical and life employee benefits for six
months after the termination.
Mr. Shah's employment agreement also contains non-compete,
confidentiality and non-disclosure clauses designed to protect our intellectual
property. Additionally, the agreement contains a provision designed to preclude
Mr. Shah from claiming rights to any products or technologies he developed while
in our employ or for a two-year period following his termination.
On March 6, 2003, we executed a new three-year employment agreement
with Mr. Shah that becomes effective upon closing of a new round of equity
financing of $1 million or more. The terms of the contract are substantially the
same as the terms of the 1999 agreement, with the following differences:
57
o Base salary of $210,000 per year;
o Vehicle allowance and expense reimbursements have
been eliminated;
o We will fund the costs of medical benefit plans,
dental, disability and life insurance premiums for
Mr. Shah and his dependents;
o Mr. Shah is entitled to receive bonuses between 0%
and 100% of his base salary on a sliding scale based
upon annual revenue and earnings achievement; and
o Should employment be terminated other than for due
cause, we will pay severance at the salary rate then
in effect for the remainder of the contract or two
years, whichever is greater.
MARVIN J. WINKLER
On March 6, 2003, we executed a contract with Mr. Winkler that contains
the same terms and conditions as Mr. Shah's new contract.
RICHARD M. DEPEW
Richard M. Depew entered into an employment agreement with us,
effective as of August 16, 2001 and terminating on August 31, 2003, pursuant to
which Mr. Depew agreed to act as our president and chief operating officer. In
exchange for his services as our president and chief operating officer, Mr.
Depew is entitled to an annual base salary of $175,000 and to an incentive bonus
payable each year in an amount equal to the product of $100,000 multiplied by a
percentage calculated by our board of directors, which percentage shall be based
upon our stock price, total revenues and net income before taxes. However,
effective August 1, 2002, Mr. Depew's base salary was reduced to $148,750 in
connection with a reduction of annual salaries of all employees. Subsequent to
August 1, 2002, we accrued deferred compensation related to Mr. Depew that
totaled $3,650 as of December 31, 2002 and is included in accrued liabilities.
Mr. Depew also received an option to purchase up to 220,000 shares of
common stock under our Amended and Restated 1999 Stock Option Plan at an
exercise price equal to $3.14 per share, the closing price of a share of our
common on August 16, 2001. A total of 20,000 of these shares vested on August
16, 2001, and the remaining shares vest 20% annually over five years commencing
one year from the grant date.
In addition, Mr. Depew is entitled to:
o reimbursement of costs and expenses incurred by him
in the performance of his services and duties as our
president and chief operating officer;
o an automobile allowance of $500 per month;
o participate in our medical, dental, life and
disability insurance plans;
o participate in any additional compensation, benefit,
pension, stock option, stock purchase, 401(k) or
other plan or arrangement of our company; and
o such vacation, holiday and other paid and unpaid
leaves of absence to which our other senior executive
officers are entitled.
Mr. Depew's employment agreement provides that, other than by
expiration of the term of the agreement, employment may be terminated as
follows:
-- by Mr. Depew, at any time upon proper notice to us;
58
-- by us if our co-chairmen determine that the termination is for
due cause. Due cause exists if Mr. Depew:
o intentionally misapplies any of our funds, or commits
any other act of dishonesty that injures us;
o is convicted of a felony involving moral turpitude;
o uses or possesses any controlled substance or
chronically abuses alcoholic beverages and, after
providing Mr. Depew with proper notice and a
reasonable period of time to cure the deficiencies,
our co-chairmen determine that Mr. Depew is unfit to
serve as our president and chief operating officer;
or
o persistently and materially breaches, does not
perform and does not observe the terms of his
employment agreement, provided that our co-chairmen
provide Mr. Depew with proper notice and a reasonable
period of time to cure the deficiencies;
-- by us, if Mr. Depew is physically incapable of performing his
duties as our president and chief operating officer because of
an accident, sickness or other cause for a period of 90
consecutive days;
-- automatically upon Mr. Depew's death;
-- by us, upon proper notice of termination to Mr. Depew;
-- by Mr. Depew, for good reason. Good reason exists if:
o Mr. Depew is relieved of his position as, or is not
reappointed as, an officer of our company;
o Mr. Depew's title, office or responsibilities change
substantially;
o Mr. Depew's base salary is reduced; in August 2002,
Mr. Depew voluntarily participated in a company-wide
10% salary reduction program and waived his right to
terminate his contract based upon this company-wide
program;
o we relocate Mr. Depew to a location more than 20
miles from Irvine, California without his prior
written consent;
o we fail to pay Mr. Depew amounts due or benefits,
including vacation days, to be provided to him under
his employment agreement;
o we fail to comply with a material term of the
employment agreement and fail to cure the default
after appropriate notice; or
o we are subjected to any proceeding involving
insolvency or the protection of or from creditors for
more than 90 days;
-- by Mr. Depew, upon reaching the age of 65.
We may have the following obligations to Mr. Depew upon termination of
employment if the employment agreement is terminated by us, other than for due
cause, due to Mr. Depew's disability or death or due to Mr. Depew having reached
the age of 65, or by Mr. Depew, with good reason:
o to pay his base salary in effect as of the date of
termination through the end of the month during which
such termination occurs plus credit for any vacation
earned but not taken;
o to pay 50% of his annual base salary;
59
o to pay a prorated bonus for the calendar year during
which termination occurs;
o to pay his automobile allowance for the six-month
period after the date of termination; and
o to maintain, at our expense, Mr. Depew's employee
benefits for the lesser of the six-month period after
termination or until prohibited by the applicable
benefit plan.
If the employment relationship is terminated by Mr. Depew, with proper
notice, or by us, for due cause or because Mr. Depew refuses to continue his
employment and fails to give proper notice, Mr. Depew will have the right to
exercise any stock options that have vested as of the date of termination, and
we will not be obligated to pay any compensation after the termination date,
except:
o those benefits that are provided by retirement and
benefit plans and programs specifically adopted and
approved by us for Mr. Depew that are earned and
vested by the date of termination;
o Mr. Depew's pro rata annual salary through the date
of termination; and
o accrued vacation as required by California law.
If Mr. Depew's employment relationship is terminated due to his
incapacity or death, we are obligated to provide those benefits that are
provided by retirement and benefits plans and programs specifically adopted and
approved by us for Mr. Depew that are earned and vested at the date of
termination, and a prorated bonus for the calendar year in which incapacity or
death occurs.
If there is a change in control of our company and Mr. Depew is
subsequently terminated without due cause or Mr. Depew resigns his employment
for good reason, then 75% of any unvested options or other rights to acquire
securities of our company granted to Mr. Depew will immediately vest and become
exercisable.
The employment agreement with Mr. Depew also contains non-competition
and non-solicitation clauses, as well as representations and warranties from Mr.
Depew that in performing his duties as our president and chief operating
officer, he has not and will not violate any agreements of confidentiality into
which he has entered with any third parties. These clauses and representations
and warranties are designed to protect our intellectual property.
THOMAS E. SCHIFF
On April 15, 2003, we executed a contract with Mr. Schiff that contains
substantially the same terms and conditions as Mr. Shah's and Mr. Winkler's new
contracts, with the following differences:
o His base salary will be $160,000 per year; and
o Mr. Schiff's employment is "at will" but his employment agreement
contains a severance provision that provides that if Mr. Schiff's
employment is terminated other than for cause, we are obligated to
pay to him his annual salary for a period of one year.
COMPENSATION OF DIRECTORS
In June 2002, each of our non-employee directors received an option to
purchase up to 20,000 shares of common stock, with 5,000 shares vesting
quarterly starting in September 2002 based upon continuing service on our board
of directors. Non-employee directors received reimbursement of travel expenses,
but did not receive any cash compensation.
Since February 1, 2003, our non-employee directors have been entitled
to receive the following annual cash compensation for serving on our board of
directors and committees of our board of directors:
Annual
Name Compensation Committee Positions
---- ------------ -------------------
Mr. Goldie $18,000 Audit Committee Chairman; Compensation Committee Member
Mr. Clark $12,000 Audit Committee Member; Technology Committee Member
Mr. Rubenstein $15,000 Audit Committee Member; Compensation Committee Member
Mr. Amber $10,000 Compensation Committee Member
Directors are reimbursed for expenses incurred in attending board and
committee meetings. No additional compensation is paid for attending meetings of
committees of our board of directors on which directors serve.
60
In January 2003, our board of directors determined that non-employee
directors should be eligible to receive stock options under our existing stock
option plans in the following amounts:
Shares
Position Underlying Options
-------- ------------------
Director 100,000
Audit Committee 25,000
Compensation Committee 25,000
Technology Committee 25,000
Accordingly, based on these amounts, and taking into account options
that previously had been granted to Messrs. Amber and Rubenstein, the board of
directors granted the following options on January 27, 2003:
Shares
Underlying
Name Options Committee Positions
---- ------- -------------------
Mr. Goldie 150,000 Audit Committee Chairman; Compensation Committee Member
Mr. Clark 150,000 Audit Committee Member; Technology Committee Member
Mr. Rubenstein 120,000 Audit Committee Member; Compensation Committee Member
Mr. Amber 95,000 Compensation Committee Member
The January 27, 2003 options vested and became exercisable as to 25% of
the underlying shares immediately upon the date of grant. The remaining shares
underlying the options vest and become exercisable in 1/3 increments immediately
following our 2004, 2005 and 2006 annual stockholders' meetings.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION
DECISIONS
Messrs. Amber and Rubenstein, and then directors Matthew Medeiros and
Bruce Block, served as members of the compensation committee at varying times
during 2002. Since January 27, 2003, Messrs. Amber, Rubenstein and Goldie have
comprised the compensation committee. Mr. Amber served as our secretary from
March 2000 until May 2001. Mr. Amber is a partner in the law firm of Rutan &
Tucker, LLP which firm acts as our outside legal counsel but did not receive
more than 5% of its 2002 gross revenues from us. None of Messrs. Rubenstein,
Medeiros, Block or Goldie has served as an officer or employee of SSP. Prior to
joining the board of directors in October 2002, Mr. Rubenstein performed limited
consulting services for us, but did not receive more than 5% of his 2002 gross
income from us.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
BENEFICIAL OWNERSHIP TABLE
As of March 31, 2003, a total of 25,067,576 shares of our common stock
were outstanding. The following table sets forth information as of that date
regarding the beneficial ownership of our common stock by:
o each of our directors;
o each of our executive officers named in the summary
compensation table;
o all of our directors and executive officers as a group; and
o each person known by us to beneficially own 5% or more of the
outstanding shares of our common stock as of the date of the
table.
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Except as indicated below, the address for each named beneficial owner
is the same as ours. The inclusion of shares in this table as beneficially owned
is not an admission of beneficial ownership. Percentages shown as an asterisk
represent less than 1.00%.
BENEFICIAL OWNERSHIP
OF COMMON STOCK
----------------------------
NUMBER PERCENTAGE OF
NAME OF BENEFICIAL OWNER OF SHARES COMMON STOCK
------------------------ --------- -------------
Kris Shah.......................................................... 5,787,609 23.06%
Marvin J. Winkler.................................................. 7,463,457 29.76%
Thomas E. Schiff................................................... 155,199 *
Gregg Amber........................................................ 81,545 *
Richard M. Depew................................................... 71,172 *
Joel K. Rubenstein................................................. 46,000 *
Ron R. Goldie...................................................... 37,500 *
Gregory J. Clark................................................... 37,500 *
Wave Systems Corp.................................................. 4,883,083 19.48%
Richard P. Kiphart................................................. 1,303,770 4.99%
Kingsport Capital Partners, LLC.................................... 1,313,013 4.99%
All directors and executive officers as a group (8 persons)........ 13,679,981 53.59%
GENERAL
Beneficial ownership is determined in accordance with Rule 13d-3
promulgated by the Securities and Exchange Commission, and generally includes
voting or investment power with respect to securities. Except as indicated
below, we believe each holder possesses sole voting and investment power with
respect to all of the shares of common stock owned by that holder, subject to
community property laws where applicable. In computing the number of shares
beneficially owned by a holder and the percentage ownership of that holder,
shares of common stock subject to options or warrants or underlying notes held
by that holder that are currently exercisable or convertible or are exercisable
or convertible within 60 days after the date of the table are deemed
outstanding. Those shares, however, are not deemed outstanding for the purpose
of computing the percentage ownership of any other person or group.
KRIS SHAH
The shares beneficially owned by Kris Shah include:
o 435,301 shares held by the Chandra L. Shah Trust, of which Mr.
Shah is the trustee;
o 435,301 shares held by the Leena Shah Trust, of which Mr. Shah
is the trustee;
o 4,891,835 shares held by the Kris and Geraldine Shah Family
Trust, of which Mr. Shah and his wife are the trustees and
beneficiaries; and
o 25,172 shares underlying common stock purchase options and
warrants.
MARVIN J. WINKLER
The shares beneficially owned by Marvin J. Winkler include:
o 7,448,285 shares held of record by JAW Financial, L.P., a
limited partnership of which JAW Lending, Inc. is the general
partner; Mr. Winkler is the vice president, secretary and
beneficial owner of all of the outstanding securities of JAW
Lending, Inc.; Mr. Winkler is deemed to share with JAW
Lending, Inc. and JAW Financial, L.P. the voting and
dispositive power over the shares held of record by JAW
Financial, L.P; and
o 15,172 shares underlying common stock purchase options and
warrants.
62
OTHER EXECUTIVE OFFICERS AND DIRECTORS
The shares beneficially owned by all of our directors and executive
officers as a group include the shares listed above as beneficially owned by Mr.
Shah and Mr. Winkler and 421,421 shares underlying options that are beneficially
owned as follows:
o Thomas E. Schiff - 154,999 shares underlying options;
o Gregg Amber - 76,250 shares underlying options;
o Richard M. Depew - 70,172 shares underlying options;
o Joel K. Rubenstein - 45,000 shares underlying options;
o Ron R. Goldie - 37,500 shares underlying options; and
o Gregory J. Clark - 37,500 shares underlying options.
WAVE SYSTEMS CORP.
Power to vote or dispose of the shares beneficially owned by Wave
Systems Corp., or Wave, is held by each of Peter Sprague, as Chairman, Steven
Sprague, as President, and Gerard Feeney, as Chief Financial Officer. The
address for Messrs. Sprague and Mr. Feeney is c/o Wave Systems Corp., 480
Pleasant Street, Lee, Massachusetts 01238. The table does not reflect any shares
of common stock that Wave may in the future become entitled to receive under
anti-dilution provisions relating to a Termination Agreement and Mutual Release
dated as of September 30, 2002 by and among us, BIZ Interactive Zone, Inc., and
Wave. The Termination Agreement documented the mutual termination effective as
of August 31, 2002 of a Purchase, Development and Deployment Agreement, or the
Wave Agreement, between BIZ and Wave dated October 2, 2000, as amended on May
10, 2001.
Under the Termination Agreement, the Wave Agreement was terminated as
of August 31, 2002, and we issued to Wave a non-negotiable, non-interest
bearing, subordinated convertible promissory note due December 31, 2005 in the
principal amount of $270,000 and 1,600,000 shares of common stock. The
conversion rate of the note initially was $1.35 and was subject to adjustments
for stock splits, stock dividends, reclassifications, reorganizations and the
like. On December 13, 2002, we converted the entire principal balance of the
note into 200,000 shares of common stock at the initial conversion rate of
$1.35.
The number of shares issued under the Termination Agreement and upon
conversion of the note are subject to anti-dilution adjustments if, and
whenever, before April 16, 2003 we issue or sell, or are deemed to have issued
or sold, any shares of common stock at a price below the dilution rate then in
effect. These anti-dilution adjustments do not apply, however, to the issuance
of shares of common stock underlying exercisable or convertible securities that
were outstanding on or prior to September 30, 2002, shares of common stock
underlying any rights, warrants or options granted pursuant to any of our stock
option or stock purchase plans, or shares of common stock issued or deemed to
have been issued pursuant to stock splits, stock dividends, reclassifications,
reorganizations and the like.
The initial dilution rate is $1.00. If a dilutive issuance occurs, then
the dilution rate will be reduced to a price equal to the consideration per
share paid for the common stock in the dilutive issuance. A dilution percentage
equal to the percentage by which the dilution rate in effect immediately prior
to the dilutive issuance is reduced in connection with the dilutive issuance
will be calculated. Wave will then be entitled to receive a number of shares of
common stock equal to the dilution percentage multiplied by the aggregate number
of shares of common stock issued under the Termination Agreement and the note
prior to the dilutive issuance.
Contractual conversion restrictions prohibit the issuance of shares of
common stock under the Termination Agreement and the note to the extent that we
have not first made or obtained any necessary notifications to and/or approvals
of The Nasdaq Stock Market and our stockholders. In addition, we may not issue
to Wave under the Termination Agreement and the note an aggregate number of
shares of common stock that would result in Wave, together with its affiliates,
beneficially owning 20% or more of the then issued and outstanding shares of
common stock. We agreed to endeavor to make the required notifications and/or
obtain the required approvals.
63
RICHARD P. KIPHART AND KINGSPORT CAPITAL PARTNERS, LLC
As described in Item 13 of this report under the heading "Certain
Relationships and Related Transactions," each of Richard P. Kiphart and
Kingsport Capital Partners, LLC beneficially owns shares of common stock
underlying notes and warrants that we issued in private placement transactions
on April 16, 2002, November 14, 2002, January 22, 2003, March 18, 2003 and March
28, 2003.
The shares shown in the table above as beneficially owned by Mr.
Kiphart represent shares issuable upon conversion of notes and upon exercise of
warrants held of record by Mr. Kiphart. The address for Mr. Kiphart is c/o
William Blair & Company, 222 West Adams Street, Chicago, Illinois 60606.
The shares shown in the table above as beneficially owned by Kingsport
Capital Partners, LLC represent shares issuable upon conversion of notes and
upon exercise of warrants held of record by three funds of which Kingsport
Capital Partners, LLC is the general partner. Power to vote or dispose of the
shares beneficially owned by Kingsport Capital Partners, LLC is held by Stewart
Flink and Richard Levy. The address for Mr. Flink and Mr. Levy is c/o Kingsport
Capital Partners, LLC, 95 Revere Drive, Suite F, Northbrook, Illinois 60062.
The notes and warrants dated April 16, 2002 that are beneficially owned
by Mr. Kiphart and Kingsport Capital Partners, LLC prohibit conversion of the
notes or exercise of the warrants to the extent that conversion of a note or
exercise of a warrant would result in the holder, together with its affiliates,
beneficially owning in excess of 4.999% of our outstanding shares of common
stock. A beneficial owner of one of those notes or warrants may waive the 4.999%
limitations after 61 days' prior written notice to us or immediately upon
written notice to us if we are or may become subject to a change in control as
defined in those notes and warrants. Also, these limitations do not preclude a
holder from converting or exercising a note or warrant and selling shares
underlying the note or warrant in stages over time where each stage does not
cause the holder and its affiliates to beneficially own shares in excess of the
limitation amounts.
At the initial conversion and exercise prices, the notes and warrants
beneficially owned by each of Mr. Kiphart and Kingsport Capital Partners, LLC
would be convertible for or exercisable into more than 5% of our outstanding
shares of common stock if those beneficial owners were to waive beneficial
ownership limitations. However, as of the date of the table, neither of those
beneficial owners had made such a waiver. In light of the limitations contained
in the notes and warrants, the numbers of shares shown in the table as
beneficially owned by Mr. Kiphart and Kingsport Capital Partners, LLC have been
limited to 4.999% of the shares of our common stock outstanding as of the date
of the table.
POTENTIAL CHANGE IN CONTROL
Under a Securities Purchase, Registration Rights and Security Agreement
dated as of April 16, 2002, we issued an aggregate of approximately $5.8 million
of secured convertible promissory notes due December 31, 2005 and warrants to
purchase an aggregate of 3,477,666 shares of our common stock to six accredited
investors in a private offering. The notes and warrants contain anti-dilution
and protective provisions that provide for adjustments to their conversion
prices upon issuances, through April 16, 2003, of securities below the
then-applicable conversion or exercise price, and upon the occurrence of certain
other events such as a distribution of assets. Those notes and warrants prohibit
conversion of those notes or exercise of those warrants to the extent that
conversion of a note or exercise of a warrant would result in the holder,
together with its affiliates, beneficially owning in excess of 4.999% of our
outstanding shares of common stock. A holder of one of the notes or warrants may
waive the 4.999% limitations after 61 days' prior written notice to us or
immediately upon written notice to us if we are or may become subject to a
change of control as defined in the notes and warrants.
As of March 31, 2003, none of the holders had waived the beneficial
ownership limitations. However, the beneficial ownership limitations do not
preclude a holder from converting a note or exercising a warrant and selling
shares underlying the note or warrant in stages over time where each stage does
not cause the holder and its affiliates to beneficially own shares in excess of
the limitation amounts. Also, if in the future the beneficial ownership
64
limitations are waived or are inapplicable, and if the conversion and exercise
prices of the notes and warrants are adjusted downward due to the operation of
the anti-dilution provisions, then the holders of the notes and warrants may
collectively be in a position to effectuate a change of control by converting
their notes into, and exercising their warrants for, a number of shares of our
common stock that represents in excess of 50% of our voting power.
EQUITY COMPENSATION PLAN INFORMATION
The following table gives information about our common stock that may
be issued upon the exercise of options, warrants and rights under all of our
existing equity compensation plans as of December 31, 2002.
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE FUTURE ISSUANCE UNDER
BE ISSUED UPON EXERCISE EXERCISE PRICE EQUITY COMPENSATION
OF OUTSTANDING OF OUTSTANDING OPTIONS, PLANS (EXCLUDING
OPTIONS, WARRANTS WARRANTS SECURITIES REFLECTED
PLAN CATEGORY AND RIGHTS AND RIGHTS IN COLUMN (a))
------------- ---------- ---------- --------------
(a) (b) (c)
Equity compensation plans approved 2,038,888 (1) $2.40 3,094,269 (2)
by security holders
Equity compensation plans not -- -- --
approved by security holders
Total 2,038,888 $2.40 3,094,269
------------
(1) Represents shares of common stock underlying options that are
outstanding under our 1998 Stock Option Plan, our Amended and Restated
1999 Stock Option Plan, and the BIZ Interactive Zone, Inc. 2000 Stock
Option Plan.
(2) Represents shares of common stock available for issuance under options
that may be issued under our 1998 Stock Option Plan, our Amended and
Restated 1999 Stock Option Plan, the BIZ Interactive Zone, Inc. 2000
Stock Option Plan, and the 2001 Employee Stock Purchase Plan.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
On January 2, 2000, we entered into a lease agreement for our principal
executive offices with KRDS, Inc. Kris Shah, our co-chief executive officer,
co-chairman of the board and secretary, is the majority stockholder and a
director of KRDS, Inc. The lease agreement is described in Item 2 of this
report.
Mr. Shah owned 1,400,000 shares of common stock of BIZ that were
converted into 665,174 shares of our common stock upon consummation of the
acquisition of BIZ on August 24, 2001. Prior to the BIZ acquisition, Mr. Shah
purchased shares of BIZ common stock. Part of the consideration consisted of a
promissory note from Mr. Shah with a stated interest rate of 5% per annum and a
maturity date of July 24, 2005. On April 12, 2002, in a transaction approved by
our board of directors, Mr. Shah prepaid the note by paying $347,224. We
recorded a discount of $152,776 that was charged against income in the second
quarter of 2002. The discount was computed based upon a present value
calculation using a discount rate of 20%.
In October 2000, we signed a development agreement with Wave, for the
integration of EMBASSY-based systems with set-top box master reference designs
of Broadcom Corporation. Wave owned approximately 19.5% of our issued and
outstanding common stock as of March 28, 2003. To conserve cash and settle our
liability under the development agreement, we entered into termination and
mutual release agreement under which we issued to Wave 1.6 million shares of our
65
common stock, and a $270,000 convertible note that we converted into 200,000
shares of common stock on December 13, 2002. The termination and mutual release
agreement is described in Item 12 of this report under the heading "Beneficial
Ownership Table - Wave Systems Corp."
In October 2002, we restructured our lease obligations with landlord,
Research Venture, LLC, for the two Spectrum buildings located in Irvine,
California. Until August 2002, Mr. Shah had an ownership interest in Research
Venture, LLC. The restructuring arrangement is described in Item 2 of this
report.
On July 31, 2001, Chase Manhattan Bank, or Chase, advanced $1.0 million
to Marvin J. Winkler, who was the founder of BIZ and who later became our
co-chairman. Mr. Winkler then advanced that amount to BIZ for the re-purchase of
preferred stock held by an investor in BIZ. Mr. Winkler executed a $1.0 million
demand note with Chase and BIZ executed a $1.0 million demand note due September
15, 2001 with JAW, an entity controlled by Mr. Winkler. The demand note
contained an interest charge of prime plus 1% through the maturity date and
prime plus 3% after the maturity date. On October 11, 2001, we made a principal
payment of $30,000, paid accrued interest, and executed a new promissory note to
JAW for $970,000. The terms of the promissory note called for interest at prime
plus 3% payable monthly, together with five monthly payments of principal in the
amount of $160,000 and one final payment on April 15, 2002 in the amount of
$170,000. The promissory note provided Chase a security interest in the shares
of Class A Common Stock of Wave owned by us and, subject to Chase's loan
security guidelines, the rights to proceeds from any sales of those shares. On
March 8, 2002, the promissory note was paid in full ahead of scheduled maturity.
On April 16, 2002, we issued to Messrs. Shah and Winkler
non-convertible unsecured promissory notes due December 31, 2005 in the
principal amounts of $152,776 and $500,000, respectively, in connection with
loans to us made by each of them. These notes paid interest at an annual rate of
10%.
On December 18, 2001, we issued and sold convertible promissory notes
to four individuals, in the aggregate principal amount of $2.5 million. Messrs.
Shah and Winkler, each purchased a note in the principal amount of $375,000 in
this transaction. Their $375,000 notes bore interest at 8% per annum, were
convertible into shares of our common stock at $3.60 per share and were due and
payable on December 31, 2005. In June 2002, Messrs. Shah and Winkler exchanged
all of these notes, together with accrued but unpaid interest, into 419,119 and
690,257 shares of our common stock, respectively, at an above-market price of
$1.30 per share.
Mr. Amber, one of our directors, served as our secretary from March
2000 until May 2001. Mr. Amber is a partner in the law firm of Rutan & Tucker,
LLP, which firm acts as our outside legal counsel but did not receive more than
5% of its 2002 gross revenues from us.
Under a Securities Purchase, Registration Rights and Security Agreement
dated as of April 16, 2002, we issued an aggregate of approximately $5.8 million
of secured convertible promissory notes due December 31, 2005 and warrants to
purchase an aggregate of 3,477,666 shares of our common stock to six accredited
investors in a private offering. The investors included, among others, Richard
P. Kiphart together with Crestview Capital Fund, L.P., Crestview Capital Fund
II, L.P. and Crestview Offshore Fund, Inc., which are three investments funds of
which Kingsport Capital Partners, LLC is the general partner. We issued the
notes and warrants in exchange for $4.0 million in cash and the cancellation of
approximately $1.8 million of our outstanding 8% subordinated convertible notes
dated December 18, 2001, which cancelled notes included a $1.5 million note held
by Mr. Kiphart.
The notes issued on April 16, 2002 are secured by all of our assets and
mature on December 31, 2005. The notes bear interest at an annual rate of 10%.
Interest is payable quarterly in arrears beginning on July 1, 2002 in cash, or
at our discretion, in shares of common stock at a price based upon the average
of the closing sale prices of our common stock for the 30-day period ending on
the day prior to the interest due date. The principal balance of each note is
convertible into shares of our common stock at the election of the holder at the
initial conversion price of $1.00 per share. The outstanding principal balances
of the notes and, at our option, any accrued and unpaid interest, automatically
will convert into shares of common stock at the then-applicable conversion price
if:
o the closing sale price of a share of our common stock equals
or exceeds $3.00 for 20 consecutive trading days;
66
o the average daily trading volume during the 20 trading day
period equals or exceeds 100,000 shares; and
o the registration statement that we filed to cover the resale
of shares of common stock underlying the notes and warrants
remains effective throughout each day of the 20 trading day
period.
The warrants are three-year warrants that have an initial exercise
price of $1.30 per share and contain a cashless exercise provision. The notes
and warrants contain anti-dilution and protective provisions that provide for
adjustments to their conversion and exercise prices upon issuances of common
stock or securities convertible into or exercisable for common stock prior to
April 16, 2003 at prices below the then-applicable conversion or exercise price
and upon the occurrence of certain other events such as a distribution of
assets.
At the initial conversion and exercise prices, the notes and warrants
beneficially owned by each of Mr. Kiphart and Kingsport Capital Partners, LLC
would be convertible for or exercisable into more than 5% of our outstanding
shares of common stock. However, the notes and warrants prohibit conversion of
the notes or exercise of the warrants to the extent that conversion of a note or
warrant would result in the holder, together with its affiliates, beneficially
owning in excess of 4.999% of our outstanding shares of common stock. A holder
of one of those notes or warrants may waive the 4.999% limitations after 61
days' prior written notice to us or immediately upon written notice to us if we
are or may become subject to a change in control as defined in the notes and
warrants. As of March 31, 2003, neither of the holders had waived the beneficial
ownership limitations. However, the beneficial ownership limitations do not
preclude a holder from converting a note or exercising a warrant and selling
shares underlying the note or warrant in stages over time where each stage does
not cause the holder and its affiliates to beneficially own shares in excess of
the limitation amounts.
On November 14, 2002, we issued $500,000 in principal amount of secured
subordinated promissory notes to Mr. Kiphart, Crestview Capital Fund, LP. and
Crestview Capital Fund II, L.P. The notes are secured by all unencumbered assets
of SSP and its subsidiaries. The notes bear interest in an amount equal to the
following percentage of the principal balance: 15%, if the notes are repaid
within six months; 20%, if the notes are repaid within nine months; 25%, if the
notes are repaid within twelve months; and 30%, if the notes are repaid after
twelve months. Principal and interest under the notes are due upon the sooner of
November 13, 2003 and our raising of at least $3.5 million in equity or debt
financing.
After May 14, 2003, the principal balance of each November 14, 2002
note will be convertible at the option of the holder into shares of our common
stock at an initial conversion price of $1.30 per share. The notes were
accompanied by three-year warrants to purchase up to an aggregate of 100,000
shares of our common stock at an initial exercise price of $1.30 per share. We
will be required to issue to the holders warrants to purchase up to an
additional 400,000 shares of common stock at an initial exercise price of $1.30
per share upon repayment or conversion of the notes, depending upon the date of
repayment or conversion. The exercise price of the warrants and the number of
shares underlying the warrants are subject to anti-dilution adjustments in
connection with dividends or distributions of assets to holders of our common
stock and subdivisions or combinations of our common stock. The warrants contain
a cashless exercise provision.
On January 22, 2003, we issued to Mr. Kiphart a $500,000 promissory
note that bears interest at a rate of 15% per year, with a minimum interest
charge of $50,000. Accrued interest is payable quarterly in arrears beginning
March 31, 2003. Principal and accrued but unpaid interest are due upon
the earlier of December 31, 2005 and our closing of a $5.0 million or more
equity or debt financing. Mr. Kiphart has the right to exchange the principal
and outstanding interest on the note for securities that we issue in such an
equity or debt financing. If we do not repay the note prior to June 30, 2003, we
will be required to issue to Mr. Kiphart a three-year warrant to purchase up to
125,000 shares of common stock at an exercise price of $1.30 per share and to
register for resale the shares of common stock underlying the warrant. The note
is secured by all of our previously unencumbered assets of SSP and its
subsidiaries, including without limitation, intellectual property assets and any
and all receivables due to us from our SSPG subsidiary.
On March 18, 2003 and March 19, 2003, we issued to each of Crestview
Capital Fund II, L.P. and Mr. Kiphart $100,000 promissory notes that are secured
by all of our assets, including SSPG and any rights belonging to SSPG. In
addition, on March 28, 2003, Mr. Winkler agreed to pledge 350,000 shares of
67
common stock held by JAW. Financial, L.P. as security for the notes we issued on
March 18, March 19 and March 28, 2003. The notes bear interest in an amount
equal to the following percentage of the principal balance: 10%, if the notes
are repaid within 30 days; 12%, if the note are repaid within 60 days; 15%, if
the notes are repaid within 90 days; and 20%, if the notes are repaid at
maturity. Principal and interest under the notes are due upon the sooner of 120
days from the dates of the notes and our raising of at least $3.5 million in
equity and debt financing. Each note was accompanied by a five-year warrant to
purchase up to 50,000 shares of common stock at an exercise price of $0.60. We
will be required to issue to each holder warrants to purchase up to an
additional 50,000 shares of common stock upon repayment of the notes, depending
upon the date of repayment. The exercise price of the warrants and the number of
shares underlying the warrants are subject to anti-dilution adjustments in
connection with dividends or distributions of assets to holders of our common
stock and subdivisions or combinations of our common stock. The warrants contain
a cashless exercise provision. The shares of common stock underlying the
warrants bear registration rights. The warrants contain a cashless exercise
provision.
On March 28, 2003, we issued to Mr. Kiphart, Crestview Capital Fund II,
L.P., Mr. Shah and Mr. Winkler promissory notes in the aggregate principal
amount of $440,000. The notes are secured by all of our assets and the assets of
SSPG. In addition, Mr. Winkler agreed to pledge 350,000 shares of common stock
held by JAW as security for the notes we issued on March 18, March 19 and March
28, 2003. The notes bear interest at the rate of 18% per year, with interest
payable in cash monthly in arrears. We are required to use the proceeds of the
notes only for payment of operating expenses. Principal and accrued but unpaid
interest under the notes are due upon the sooner of July 26, 2003 or our raising
of $3.5 million in equity and debt financing. The notes were accompanied by
five-year warrants to purchase up to an aggregate of 230,000 shares of common
stock. The exercise price of the warrants has not yet been fixed. The exercise
price will be equal to the greater of $0.70 per share or the conversion price of
securities we issue in a proposed financing, not to exceed $1.30 per share. The
exercise price of the warrants and the number of shares underlying the warrants
will be subject to anti-dilution adjustments in connection with dividends or
distributions of assets to holders of our common stock and subdivisions or
combinations of our common stock. The warrants contain a cashless exercise
provision.
In January 2003, holders of the notes from the April 16, 2002 financing
and Wave executed a waiver and acknowledgment that approved grants of stock
options to non-employee members of our board of directors at a price equal to
85% of the last sale price of our common stock on the day preceding the grant
date. The investors acknowledged that the option grants would not conflict with
or violate our agreements together with any related instruments or agreements
with those investors. Additionally, the investors acknowledged that the grant
and exercise of the options would not trigger any anti-dilution or other
adjustment or penalty provisions contained in their agreements with us.
We are or have been a party to employment and consulting arrangements
with related parties, as more particularly described in Item 11 of this report.
The interest of the particular director, executive officer or security
holder in each matter described above was disclosed to our board of directors
before our board of directors approved the matter.
ITEM 14. CONTROLS AND PROCEDURES
Our co-chief executive officers and chief financial officer (our
principal executive officers and principal financial officer, respectively) have
concluded, based on their evaluation as of March 28, 2003, that the design and
operation of our "disclosure controls and procedures" (as defined in Rules
13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended
("Exchange Act")) are effective to ensure that information required to be
disclosed by us in the reports filed or submitted by us under the Exchange Act
is accumulated, recorded, processed, summarized and reported to our management,
including our principal executive officer and our principal financial officer,
as appropriate to allow timely decisions regarding whether or not disclosure is
required.
68
There were no significant changes in internal controls or in other
factors that could significantly affect internal controls subsequent to March
28, 2003, nor were there any significant deficiencies or material weaknesses in
our internal controls. As a result, no corrective actions were required or
undertaken.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1), (a)(2) and (d) Financial Statements and Financial Statement Schedules
------------------------------------------------------
Reference is made to the financial statements and financial statement
schedule listed on and attached following the Index to Financial Statements and
Financial Statement Schedule contained at page F-1 of this report.
(a)(3) and (c) Exhibits
--------
Reference is made to the exhibits listed on the Index to Exhibits that
follows the financial statements and financial statement schedule.
(b) Reports on Form 8-K
-------------------
On October 23, 2002 we filed a Form 8-K that contained information on
the settlement and restructuring facilities leases with Spectrum Venture. The
Form 8-K contained Item 5 - Other Events, and Item 7 - Financial Statements and
Exhibits.
On October 8, 2002, we filed a Form 8-K, which contained information on
the resignation of director, Bruce J. Block and the appointment of Joel K.
Rubenstein as a director. The Form 8-K also reported the Termination Agreement
and Mutual Release agreement with Wave Systems Corp.
69
SSP SOLUTIONS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE
PAGE
----
Independent Auditors' Reports.............................................................................. F-2
Consolidated Balance Sheets as of December 31, 2001 and 2002............................................... F-4
Consolidated Statements of Operations for the years ended December 31, 2000, 2001 and 2002................. F-5
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2000, 2001 and 2002....... F-6
Consolidated Statements of Cash Flows for the years ended December 31, 2000, 2001 and 2002................. F-7
Notes to Consolidated Financial Statements................................................................. F-9
Schedule II-- Valuation and Qualifying Accounts for the years ended December 31, 2000, 2001 and 2002....... S-1
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders
SSP Solutions, Inc.
We have audited the accompanying consolidated financial statements of
SSP Solutions, Inc. and subsidiaries as of December 31, 2002 and for the year
then ended as listed in the accompanying index. In connection with our audit of
the consolidated financial statements, we have also audited the information for
the year ended December 31, 2002 in the financial statement schedule as listed
in the accompanying index. These consolidated financial statements and financial
statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe our audit provides a reasonable
basis for our opinion.
In our opinion, the consolidated financial statements referred to
above, present fairly, in all material respects, the financial position of SSP
Solutions, Inc. and subsidiaries as of December 31, 2002 and the results of
their operations and their cash flows for the year then ended, in conformity
with accounting principles generally accepted in the United States of America.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements have been prepared
assuming the Company will continue as going concern. As discussed in Note 3 to
the consolidated financial statements, the Company has incurred recurring
operating losses, used cash in operating activities, is in default on certain
debt obligations, and has an accumulated deficit and a working capital
deficiency, all of which raise substantial doubt about its ability to continue
as a going concern. Management's plans in regard to these matters are also
described in Note 3. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
/s/ HASKELL & WHITE LLP
Irvine, California
March 28, 2003
F-2
INDEPENDENT AUDITORS' REPORT
The Board of Directors
SSP Solutions, Inc.:
We have audited the accompanying consolidated financial statements of
SSP Solutions, Inc. and subsidiaries (formerly Litronic Inc.) as of December 31,
2001 and for each of the years in the two-year period ended December 31, 2001 as
listed in the accompanying index. In connection with our audit of the financial
statements, we also have audited the information for each of the years in the
two-year period ended December 31, 2001 in the financial statement schedule as
listed in the accompanying index. These consolidated financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to
above, present fairly, in all material respects, the financial position of SSP
Solutions, Inc. and subsidiaries as of December 31, 2001 and the results of its
operations and its cash flows for each of the years in the two-year period ended
December 31, 2001, in conformity with accounting principles generally accepted
in the United States of America. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
3 to the consolidated financial statements, the Company has incurred significant
operating losses, has used cash in operating activities, and has an accumulated
deficit and deficit working capital. These matters raise substantial doubt about
its ability to continue as a going concern. Management's plans in regard to
these matters are also described in Note 3. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
/s/ KPMG LLP
Costa Mesa, California
April 16, 2002
F-3
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER 31,
2001 2002
---------- ----------
ASSETS (note 9)
Current assets:
Cash and cash equivalents ........................................................ $ 3,257 $ 553
Investment in trading securities ................................................. 1,360 76
Accounts receivable (net of allowance for doubtful accounts of $254 and $187 as of
December 31, 2001 and 2002, respectively) ...................................... 4,358 1,584
Inventories ...................................................................... 436 238
Prepaid expenses ................................................................. 601 315
Other current assets ............................................................. 401 173
---------- ----------
Total current assets ................................................. 10,413 2,939
Property and equipment, net ...................................................... 361 90
Other assets ..................................................................... 28 600
Equity investment in affiliate ................................................... -- 452
Other intangibles, net ........................................................... 691 --
Goodwill ......................................................................... 25,930 25,930
---------- ----------
$ 37,423 $ 30,011
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current installments of long-term debt (note 9) .................................. $ 1,695 $ 2,826
Accounts payable ................................................................. 9,495 4,413
Accrued liabilities .............................................................. 3,343 1,300
Notes payable to related party ................................................... 392 --
Deferred revenue ................................................................. 203 349
Accrued rent ..................................................................... 1,064 --
---------- ----------
Total current liabilities ..................................................... 16,192 8,888
Long-term debt, less current installments (note 9) ............................... 2,500 --
Deferred revenue ................................................................. 46 --
Accrued rent, less current ....................................................... 1,107 --
---------- ----------
Total liabilities ....................................................... 19,845 8,888
Commitments and contingencies (notes 3,8,9,14,17 and19)
Subsequent events (note 20)
Shareholders' equity:
Preferred stock, $0.01 par value; Authorized 5,000,000 shares; no shares issued
or outstanding ................................................................. -- --
Common stock, $0.01 par value; Authorized 100,000,000 shares; issued or issuable
20,630,754 and 24,821,235 shares at December 31, 2001 and 2002, respectively ... 206 248
Additional paid-in capital ....................................................... 118,608 129,298
Note receivable from shareholder ................................................. (500) --
Deferred compensation ............................................................ (1,193) (324)
Accumulated deficit .............................................................. (99,543) (108,099)
---------- ----------
Total shareholders' equity ................................................. 17,578 21,123
---------- ----------
$ 37,423 $ 30,011
========== ==========
See accompanying notes to consolidated financial statements
F-4
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
YEARS ENDED DECEMBER 31,
-------------------------------------------------
2000 2001 2002
------------- ------------- -------------
Revenues:
Product ............................................. $ 37,421 $ 21,145 $ 8,131
Service.............................................. 1,167 1,014 2,591
License.............................................. 768 561 1,836
------------- ------------- -------------
Total revenues ................................... 39,356 22,720 12,558
------------- ------------- -------------
Cost of Sales:
Product ............................................. 30,481 17,457 3,807
Service ............................................. 566 384 639
License.............................................. 113 153 181
------------- ------------- -------------
Total cost of sales .............................. 31,160 17,994 4,627
------------- ------------- -------------
Gross margin ........................................... 8,196 4,726 7,931
Operating Expenses:
Selling, general and administrative ................. 9,559 10,645 7,515
Research and development ............................ 5,800 6,739 4,895
Research and development - Wave Systems Corp. ....... -- 1,111 1,041
Impairment of goodwill and other intangibles ........ 31,415 36,299 599
Amortization of goodwill and other intangibles ...... 2,828 746 92
In-process research and development ................. -- 1,600 --
------------- ------------- -------------
Total operating expenses ......................... 49,602 57,140 14,142
------------- ------------- -------------
Operating loss ......................................... (41,406) (52,414) (6,211)
Non-operating Expenses (Income):
Realized loss on trading securities ................. -- 530 130
Interest expense, net ............................... 65 163 782
Non-cash interest and financing expense ............. -- -- 1,287
Loss from equity investee ........................... -- -- 248
Other (income) expense, net ......................... (72) -- (104)
------------- ------------- -------------
Total non-operating expenses (income) ............ (7) 693 2,343
------------- ------------- -------------
Loss before income taxes ............................ (41,399) (53,107) (8,554)
Provision for income taxes ............................. 6 53 2
------------- ------------- -------------
Net loss ............................................... $ (41,405) $ (53,160) $ (8,556)
============= ============= =============
Net loss per share--basic and diluted .................. $ (4.20) $ (3.91) $ (.40)
============= ============= =============
Shares used in per share computations--basic and diluted 9,862,472 13,585,202 21,647,707
============= ============= =============
See accompanying notes to consolidated financial statements
F-5
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)
NOTE TOTAL
COMMON STOCK ADDITIONAL RECEIVABLE SHAREHOLDERS'
------------------------ PAID IN FROM DEFERRED ACCUMULATED EQUITY
SHARES AMOUNT CAPITAL SHAREHOLDER COMPENSATION DEFICIT (DEFICIT)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 1999 ... 9,857 $ 99 $ 52,812 $ -- $ -- $ (4,978) $ 47,933
Stock options exercised ...... 28 -- 20 -- -- -- 20
Treasury stock retired ....... (141) (2) 2 -- -- -- --
Net loss ..................... -- -- -- -- -- (41,405) (41,405)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 2000 ... 9,744 97 52,834 -- -- (46,383) 6,548
Common shares issued,
warrants, and options assumed deferred stock compensation, and note receivable
from shareholder for acquisition of Biz Interactive Zone, Inc.
("BIZ") ..................... 10,875 109 65,807 (500) (1,471) -- 63,945
Deferred compensation
related to issuance of
stock options ............... -- -- 122 -- (122) -- --
Reversal of deferred
compensation related to
terminated employees ........ -- -- (201) -- 201 -- --
Amortization of deferred
stock compensation .......... -- -- -- -- 199 -- 199
Common stock issued for
services .................... 8 -- 36 -- -- -- 36
Stock options exercised ...... 4 -- 3 -- -- -- 3
Stock options issued for
services .................... -- -- 7 -- -- -- 7
Net loss ..................... -- -- -- -- -- (53,160) (53,160)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 2001 ... 20,631 206 118,608 (500) (1,193) (99,543) 17,578
Note Receivable from
shareholder ................. -- -- -- 500 -- -- 500
Warrants issued in
conjunction with
Convertible Notes ........... -- -- 2,798 -- -- -- 2,798
Beneficial conversion
feature related to
convertible debt ............ -- -- 3,152 -- -- -- 3,152
Deferred compensation
related to issuance of
stock options ............... -- -- (29) -- 376 -- 347
Reversal of deferred
compensation related to
terminated employees ........ -- -- (574) -- 483 -- (91)
Amortization of deferred
stock compensation .......... -- -- -- -- 10 -- 10
Common stock issued for
services .................... 26 -- 34 -- -- -- 34
Common stock issued under
Employee Stock Purchase Plan 24 -- 17 -- -- -- 17
Stock options exercised ...... 39 -- 63 -- -- -- 63
Common stock issued in
restructuring of lease
obligations ................. 959 10 946 -- -- -- 956
Common stock issued in
settlement of development
contract .................... 1,800 18 2,406 -- -- -- 2,424
Warrants issued to
underwriter ................. -- 182 -- -- -- 182
Common stock issued in
conversion of notes payable . 1,079 11 1,392 -- -- -- 1,403
Payment of interest in
common stock ................ 263 3 303 -- -- -- 306
Net loss ..................... -- -- -- -- -- (8,556) (8,556)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 2002 ... 24,821 $ 248 $ 129,298 $ -- $ (324) $(108,099) $ 21,123
========== ========== ========== ========== ========== ========== ===========
See accompanying notes to consolidated financial statements.
F-6
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
----------------------------------
2000 2001 2002
---------- ---------- ----------
Cash flows from operating activities:
Net loss.................................................................. $ (41,405) $ (53,160) $ (8,556)
Adjustments to reconcile net loss to net cash used in operating activities:
Provision for losses on receivables....................................... 286 401 --
Impairment of goodwill and other intangibles............................... 31,415 36,299 599
Depreciation and amortization.............................................. 3,514 1,450 386
Amortization of non-cash debt issuance costs -- -- 147
Non-cash interest and warrant costs........................................ -- -- 1,141
Gain on vendor settlements................................................. -- -- (270)
Revision of estimated liability............................................ -- -- (463)
Settlement of Wave Systems Corp. contract.................................. -- -- 1,041
Settlement of Spectrum..................................................... -- -- (694)
Discount on notes to related party......................................... -- -- 153
Loss from equity investee.................................................. -- -- 248
In process research and development........................................ -- 1,600 --
Deferred compensation...................................................... -- 199 266
Realized loss on trading securities........................................ -- 530 130
Stock and options issued for services...................................... -- 43 34
Changes in assets and liabilities net of effects of the acquisition:
Accounts receivable........................................................ 2,718 (622) 2,774
Inventories................................................................ 101 259 199
Prepaid expenses........................................................... (182) (59) 286
Other current assets....................................................... 18 (536) 228
Notes receivable-- related party........................................... 70 -- --
Other assets............................................................... (343) 410 (557)
Accounts payable........................................................... 142 6,275 (4,316)
Accrued liabilities........................................................ (376) 2,448 116
Accrued rent............................................................... -- 2,171 --
Deferred revenue........................................................... 428 (208) 101
---------- ---------- ----------
Net cash used in operating activities........................................ (3,614) (2,500) (7,007)
---------- ---------- ----------
Cash flows from investing activities:
Purchases of property and equipment........................................ (863) (118) (24)
Restricted cash relating to line of credit................................. 612 -- --
Proceeds from the sale of trading securities............................... -- 933 1,154
Investment in equity investee.............................................. -- -- (700)
Net cash paid for acquisition of BIZ....................................... -- (675) --
---------- ---------- ----------
Net cash (used in) provided by investing activities.......................... (251) 140 430
---------- ---------- ----------
Cash flows from financing activities:
Stock options exercised.................................................... 20 3 81
Proceeds from insurance financing.......................................... 748 205 --
Proceeds from convertible debt............................................. -- 2,500 4,750
Net borrowings on revolving note payable................................... 23,666 14,155 2,328
Net repayments on revolving note payable................................... (22,469) (14,142) (3,666)
Proceeds from note payable to related party................................ -- (696) --
Proceeds from issuance of non-convertible debt ............................ -- -- 653
Repayment of note payable to related party................................. -- -- (392)
Proceeds from note receivable from related party........................... -- -- 347
Repayment on long-term debt................................................ (421) (528) (228)
---------- ---------- ----------
Net cash provided by financing activities.................................. 1,544 1,497 3,873
---------- ---------- ----------
Net decrease in cash....................................................... (2,321) (863) (2,704)
Cash and cash equivalents at beginning of year............................... 6,441 4,120 3,257
---------- ---------- ----------
Cash and cash equivalents at end of year..................................... $ 4,120 $ 3,257 $ 553
========== ========== ==========
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest................................................................ 63 197 200
Income taxes............................................................ 6 2 2
========== ========== ==========
See accompanying notes to consolidated financial statements.
F-7
SSP SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
--------------------------------
2000 2001 2002
-------- --------- ---------
Supplemental disclosure of non-cash investing and financing activities:
The Company issued 10,875,128 shares of common in connection with the
acquisition of BIZ. In connection with the acquisitions, net assets
purchased were as follows (note 4):
BIZ acquisition costs.................................................... -- (750) --
Fair value of net assets acquired less liabilities assumed............... (331) 184 --
Goodwill and other intangible assets..................................... -- 62,882 --
In-process research and development...................................... -- 1,600 --
Deferred compensation.................................................... -- 29 --
-------- --------- ---------
Market value of common stock issued.......................................... (331) 63,945 --
======== ========= =========
Settlement of Wave Systems Corp. contract....................................
Issuance of common stock............................................... -- -- 2,424
Beneficial conversion feature................................................ -- -- 3,152
Value of warrants issued..................................................... -- -- 2,798
Warrants issued to underwriters.............................................. -- -- 182
Payment of interest in common stock.......................................... -- -- 306
Exchange of notes payable for common stock................................... -- -- 1,403
Payment of lease restructuring obligation in common stock.................... -- -- 956
See accompanying notes to consolidated financial
statements.
F-8
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(1) GENERAL INFORMATION
GENERAL
SSP Solutions, Inc. (formally Litronic Inc.) ("SSP" or the "Company")
provides data security solutions for network communication systems. Through our
government systems division, we have provided innovative data security solutions
for government communications systems for more than thirty years. We provide
software, a secure operating system and hardware products for 1) the
authorization, authentication, and administration of an organization's security
protocols, and 2) card reader products and tokens that can be used by an
organization and its members to protect digital data, thereby securing the
transmission of that digital data via encryption or decryption of that data on a
real-time basis. In addition to selling hardware and software products, we
provide support and maintenance services for specific government communications
programs. Our products are designed and developed in the United States.
Through a wholly-owned subsidiary Pulsar Data Systems, Inc. ("Pulsar"),
the Company engaged in the sale of computer hardware, software, peripheral
equipment, and support services to governmental agencies and commercial
enterprises throughout the United States. Subsequent to December 31, 2002, the
Company has terminated all remaining employees of Pulsar and is currently in the
final stages of winding down its operations
BIZ Interactive Zone, Inc. ("BIZ"), a wholly-owned subsidiary of the
Company, was acquired in August 2001.
BIZ ACQUISITION
In August 2001, the Company acquired BIZ, a Delaware Corporation, as a
wholly-owned subsidiary. BIZ had developed, designed, and was in the process of
marketing security solutions for the financial, government, healthcare,
education, and entertainment industries (see note 4). The combined Company will
continue to focus on a complete range of solutions for physical access,
electronic commerce, and communications, from the core to the edge. Concurrent
with the BIZ acquisition, the Company changed its name from Litronic Inc., to
SSP Solutions, Inc. The Company combined the business of SSP and BIZ into a
single operating unit under the name SSP Solutions, Inc.
In connection with the BIZ acquisition, the Company issued an aggregate
of 10,875,128 shares of SSP common stock in exchange for all of the outstanding
shares of BIZ common stock and preferred stock. In addition, the Company
reserved for issuance an aggregate of approximately 860,000 shares of its common
stock for issuance upon exercise of BIZ options and warrants assumed by the
Company (see note 4).
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF FINANCIAL STATEMENT PRESENTATION AND PRINCIPLES OF CONSOLIDATION
The consolidated financial statements and related notes presented
herein have been retroactively adjusted to reflect the Reorganization. The
capital structure presented in these consolidated financial statements is that
of SSP. The consolidated financial statements include the accounts of SSP and
its wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
F-9
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
LOSS PER SHARE
Basic earnings (loss) per share includes no dilution and is computed by
dividing earnings (loss) available to common shareholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share reflect the potential dilution of securities that could share in the
earnings of an entity. Such shares are not included when there is a loss as the
effect would be anti-dilutive.
REVENUE RECOGNITION
Revenue from some data security hardware products contains embedded
software. However, the embedded software is incidental to the hardware product
sale. Data security license revenue is recognized upon delivery if an executed
license exists, a delivery as defined under the license has occurred, the price
is fixed and determinable, and collection is probable. Prior to 2002,
post-contract customer support revenue was not separately identified and priced.
Therefore, sufficient vendor specific objective evidence could not be
established for the value or cost of such services. Furthermore, prior to 2002,
revenue for the entire license, including bundled post-contract customer support
was recognized ratably over the life of the license. Commencing in 2002,
software delivered under a license requires a separate annual maintenance
contract that governs the conditions of post-contract customer support.
Post-contract customer support services can be purchased under a separate
contract on the same terms and at the same pricing, whether purchased at the
time of sale or at a later date. Revenue from these separate maintenance support
contracts is recognized ratably over the maintenance period.
Revenue from cost-plus-award-fee support and development contracts is
recognized on the basis of hours incurred plus other reimbursable contract costs
incurred during the period. Prior to 2002, any award fee earned under a
cost-plus-award-fee contract was not recognized until the award fee notice was
received. Beginning in 2002, for a cost-plus-award-fee support contract, the
Company exercised the contract clause to bill and collect one-half of the award
fee ratably over the term of the contract. Revenue is recognized concurrently
with the billings based on the performance of the contract requirements and
reasonable assurance of collection. Based upon historical results, the Company
has received final awards in excess of one-half of the full award fees. A
post-contract period performance review conducted by the customer determines the
remaining amount of the award fee to be received, which amount is then
recognized as earned revenue together with interest paid on the unpaid balance.
Award fees under development contracts are recognized when confirmed by the
customer.
Revenue from network deployment products is recognized upon transfer of
title, generally upon verification of delivery to the customer, which represents
evidence delivery has occurred, under a sales order represented by a government
purchase order that contains a fixed purchase price. When the Company fulfills
the elements of the government purchase order, collection of the revenue
recorded is reasonably assured.
Product and service revenues from the Company's electric security
systems contracts were recognized in accordance with SOP 81-1, `Accounting for
Performance of Construction-Type and Certain Production-Type Contracts.' The
Company recognized this revenue on a percentage of completion method, based on
estimated labor dollars incurred. The electric security systems product line was
discontinued in the year ended December 31, 2000.
The Company's revenue recognition policies are in accordance with the
Securities and Exchange Commission's Staff Accounting Bulletin No. 101.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with maturities of
three months or less at the date of purchase to be cash equivalents.
INVESTMENTS
The Company's investments are classified as trading securities. The
securities are comprised of Class A Common Stock of Wave Systems Corp. received
in the BIZ acquisition.
F-10
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Securities are carried at fair value with the unrealized gains and
losses, net of applicable taxes, reported in the statement of operations. The
cost of securities sold is based upon the specific identification method.
INVENTORIES
Inventories are stated at the lower of first-in, first-out cost or
market using net realizable value.
EQUITY INVESTMENT IN AFFILIATE
The Company's investment in an affiliate is accounted for on the equity
method as management does not control the affiliate.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Furniture and equipment are
depreciated by the straight-line method over the useful lives of the assets,
generally 2-3 years. Leasehold improvements are amortized by straight-line
method over the term of the related lease or the estimated useful lives of the
assets, whichever is shorter. Property and equipment sold or retired is
eliminated from the accounts in the year of disposition and the resulting gain
or loss is reflected in the consolidated statement of operations.
GOODWILL AND OTHER INTANGIBLES ASSETS
The Company amortizes definite lived intangible assets relating to
businesses acquired using the straight-line method over the estimated useful
lives of intangible assets.
The Company has adopted the Financial Accounting Standards Board's
(FASB's) Statements of Financial Accounting Standards (Statements) No. 141 and
No. 142, "Business Combinations" and "Goodwill and Other Intangible Assets" for
the BIZ acquisition that was completed on August 24, 2001. In accordance with
Statement No. 142, goodwill is not amortized for business acquisitions that were
completed after June 30, 2001 but rather will be evaluated at least annually for
impairment. Other identifiable intangible assets acquired from business
acquisitions that were completed after June 30, 2001, are amortized on a
straight-line basis over their estimated useful lives of between one and three
years. Accordingly, the Company has not recorded amortization of goodwill
related to the BIZ acquisition.
On January 1, 2002, the Company adopted Statement No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets". Statement No. 144
supersedes Statement No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of," and provides a single
accounting model for long-lived assets to be disposed of. Although retaining
many of the fundamental recognition and measurement provisions of Statement No.
121, the new rules significantly change the criteria that would have to be met
to classify an asset as held for sale. Statement No. 144 also supersedes the
provisions of Accounting Principles Board (APB) Opinion 30 with regard to
reporting the effects of a disposal of a segment of a business and requires
expected future operating losses from discontinued operations to be displayed in
discontinued operations in the period(s) in which the losses are incurred
(rather than as of the measurement date as presently required by APB Opinion 30,
"Reporting the Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions.". In addition, more dispositions will qualify for
discontinued operations treatment in the income statement. The adoption of
Statement No. 144 did not have a material impact on the Company's financial
condition or results of operations.
Through December 31, 2001, the Company applied Statement No. 121.
Statement No. 121 requires that long-lived assets and certain identifiable
intangibles be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Under the provisions of Statement No. 121, if the sum of the
expected future cash flows (undiscounted and without interest charges) is less
than the carrying value of
F-11
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
the asset, an impairment loss is recognized. The amount of impairment, if any,
is measured as the amount by which the carrying amount of the asset exceeds the
fair value of the asset. The estimate of fair value considers prices for similar
assets and the results of valuation techniques to the extent available in the
circumstances.
During 2000, the Company performed an assessment and valuation of
Pulsar. This valuation was undertaken because the Company determined the
integration of Pulsar would not be completed as planned, and the anticipated
operating synergies would not be realized. Based on the results of the
valuation, the Company recorded an impairment charge of $31,415 in the fourth
quarter of 2000, related to unamortized goodwill and other intangible assets
acquired in the purchase of Pulsar. The remaining unamortized intangible assets
of $783 as of the date of impairment, acquired in the purchase of Pulsar were
being amortized over the remainder of the original 10-year useful life.
Subsequent to December 31, 2002, the Company decided to exit this line of
business as or projections indicated inadequate cash flows from operations, and
the Company recorded an impairment charge of $599 relative to Pulsar
intangibles, which represented the remaining balance of the intangible assets.
During the fourth quarter of 2001, the Company determined that certain
identifiable technology and developed technology acquired in connection with the
BIZ acquisition were no longer going to be pursued. Additionally, the Company
delayed or indefinitely reduced the projected revenues from the BIZ acquisition.
Accordingly, the Company performed a Statement No. 121 analysis for identifiable
intangible assets and APB Opinion No. 17 for goodwill.
In evaluating identifiable intangibles assets, the Company utilized a
discount cash flow and, due to the uncertainties surrounding the company's
ability to fund its operations concluded all identified intangibles assets
associated with the BIZ acquisition should be written-off. In evaluating the
goodwill associated with the BIZ acquisition, the Company utilized a fair value
approach. The fair value was measured utilizing the most recent indicator of
fair value, which was the secured convertible promissory notes entered into in
April 2002. Consequently, the Company recorded an impairment charge of $36,299
in the fourth quarter of 2001 related to all identifiable intangible assets and
developed technology, as well as a portion of the goodwill acquired in
connection with the BIZ acquisition. After this impairment charge, goodwill is
the only remaining intangible asset related to the BIZ acquisition.
Amortization of goodwill and other intangibles was $2,828, $746 and
$92, respectively, for the years ended December 31, 2000, 2001 and 2002.
SEGMENT REPORTING
The Company applies Statement No. 131, "Disclosures about Segments of
an Enterprise and Related Information," which requires entities to report
financial and descriptive information about their reportable operating segments.
The Company had historically operated in two business segments: information
security solutions and electronic interconnect products. The Company disposed of
its electronic interconnect products business in 1997. On June 14, 1999, with
the acquisition of Pulsar, the Company expanded into the network solutions
business segment. The Company combined the businesses of SSP and BIZ into a
single reportable operating segment referred to as "Information Security
Products and Services" (see note 11).
STOCK-BASED COMPENSATION FOR EMPLOYEES AND NON-EMPLOYEES
The Company accounts for its employee stock option plans using the
intrinsic value method. When stock options are granted to employees with
exercise prices less than the fair value of the underlying common stock at the
date of grant, the difference is recognized as deferred compensation expense,
which is amortized over the vesting period of the options.
The Company accounts for stock options issued to non-employees using
the fair value method. The associated cost is recorded in the same manner as if
cash were paid.
F-12
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
At December 31, 2002, the Company has three stock-based employee
compensation plans, which are described more fully in note 16. The Company
accounts for those plans under the recognition and measurement principles of APB
Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations. The following table illustrates the effect on net loss and
earnings per share if the company had applied the fair value recognition
provisions of Statement No. 123:
YEAR ENDED
DECEMBER 31,
------------
2000 2001 2002
-------- -------- --------
Net loss, as reported ................................ $41,405 $53,160 $ 8,556
Add: Stock compensation cost reported in accordance
with APB No. 25 ...................................... -- 199 266
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax
effect........................................ 259 779 1,363
-------- -------- --------
Pro forma net loss ................................... $41,664 $53,740 $ 9,653
======== ======== ========
Earnings per share
Net loss per share as reported--basic and diluted $ 4.20 $ 3.91 $ 0.40
======== ======== ========
Pro forma net loss per share--basic and diluted . $ 4.22 $ 3.96 $ 0.45
======== ======== ========
The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model with the following assumptions in
2000, 2001 and 2002: risk-free interest rate of 6.08%, 5.41% and of 3.92%,
respectively; dividend yield of 0.00%; and volatility of 138%, 103% and 129%,
respectively. The Black-Scholes model, as well as other currently accepted
option valuation models, was developed to estimate the fair value of
freely-tradable, fully-transferable options without vesting restrictions, which
significantly differ from the Company's stock option plans. These models also
require highly subjective assumptions, including future stock price volatility
and expected time until exercise, which greatly affect the calculated fair value
on the grant date.
FAIR VALUE OF FINANCIAL INSTRUMENTS
As of December 31, 2001 and 2002, management believes the fair value of
all financial instruments approximated carrying value.
INCOME TAXES
The Company provides for federal income taxes recognized for the future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. A valuation allowance will be provided
where it is more likely than not that the deferred tax assets will not be
realized.
COMPREHENSIVE INCOME
The Company has no transactions, other than net loss, that would be
considered other comprehensive income.
F-13
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
ACCOUNTS RECEIVABLE FINANCING
The Company adopted Statement No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." Statement No.
140 is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001, and it is
effective for recognition and reclassification of collateral and for disclosures
relating to securitization transactions and collateral. Statement No. 140
outlines the standards for accounting for securitizations and other transfers of
financial assets and collateral and requires certain disclosures (see note 9).
USE OF ESTIMATES
The consolidated financial statements have been prepared in conformity
with accounting principles generally accepted in the United States of America.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the dates of the balance sheets and revenues and expenses for
the periods. Actual results could differ from those estimates.
NEW ACCOUNTING STANDARDS
In April 2002, the FASB issued Statement No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical
Corrections." Statement No. 145 rescinds Statement No. 4, which required all
gains and losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. In
addition, Statement No. 145 amends Statement No. 13 on leasing to require that
certain lease modifications that have economic effects similar to sale-leaseback
transactions be accounted for in the same manner as sale-leaseback transactions.
Provisions of Statement No. 145 related to the rescission of Statement No. 4 are
effective for financial statements issued by the Company after January 1, 2003.
The provisions of the statement related to sale-leaseback transactions were
effective for any transactions occurring after May 15, 2002. All other
provisions of the statement were effective as of the end of the second quarter
of 2002. The changes required by Statement No. 145 are not expected to have a
material impact on the results of operations, financial position or liquidity of
the Company.
In July 2002, the FASB issued Statement No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." Statement No. 146 requires
companies to recognize costs associated with the exit or disposal of activities
as they are incurred rather than at the date a plan of disposal or commitment to
exit is initiated. Types of costs covered by Statement No. 146 include lease
termination costs and certain employee severance costs that are associated with
a restructuring, discontinued operation, facility closing, or other exit or
disposal activity. Statement No. 146 will apply to all exit or disposal
activities initiated after December 31, 2002. At this time, the Company does not
expect the adoption of the provisions of Statement No. 146 to have a material
impact on the Company's financial results.
In November 2002, the FASB issued Interpretation No. (Interpretation)
45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others." Interpretation 45
requires certain guarantees to be recorded at fair value. In general,
Interpretation 45 applies to contracts or indemnification agreements that
contingently require the guarantor to make payments to the guaranteed party
based on changes in an underlying that is related to an asset, liability, or an
equity security of the guaranteed party. The initial recognition and measurement
provisions of Interpretation 45 are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. Interpretation 45 also
requires new disclosures, even when the likelihood of making any payments under
the guarantee is remote. These disclosure requirements are effective for
financial statements of interim or annual periods ending after December 15,
2002. The changes required by Interpretation 45 are not expected to have a
material impact on the results of operations, financial position or liquidity of
the Company.
In January 2003, the FASB issued Interpretation 46, "Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51." Interpretation 46
addresses consolidation by business enterprises of variable interest entities
which have one or both of the following characteristics: (1) the equity
investment at risk is not sufficient to permit the entity to finance its
F-14
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
activities without additional support from other parties, which is provided
through other interests that will absorb some or all of the expected losses of
the entity; (2) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest: (a) the direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights, (b) the obligation to absorb the expected losses of the entity
if they occur, which makes it possible for the entity to finance its activities,
or (c) the right to receive the expected residual returns of the entity if they
occur, which is the compensation for the risk of absorbing expected losses.
Interpretation 46 does not require consolidation by transferors to qualifying
special purpose entities. Interpretation 46 applies immediately to variable
interest entities created after January 31, 2003, and to variable interest
entities in which an enterprise obtains an interest after that date. It applies
in the first fiscal year or interim period beginning after June 15, 2003, to
variable interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. The Company is currently assessing the
impact of Interpretation 46. The Company has, however, identified one entity
that may be required to be consolidated beginning in the third quarter of 2003
(see note 8). At December 31, 2002, the Company recorded a net investment in
other assets on its balance sheet of approximately $452 associated with these
investments. The Company currently adjusts the carrying value of these
investments for any losses incurred by the entity through earnings. While this
entity may be considered a variable interest entity, the Company has not yet
determined if it will need to be consolidated.
In June 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations," which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. The standard applies to legal obligations
associated with the retirement of long-lived assets that result from the
acquisition, construction, development and/or normal use of the asset. Statement
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made. The fair value of the liability is added to
the carrying value of the associated asset, and this additional carrying amount
is depreciated over the life of the asset. The liability is accreted at the end
of each period through charges to operating expense. If the obligation is
settled for other than the carrying amount of the liability, the Company will
recognize a gain or loss on settlement. As required, the Company adopted the
provisions of Statement No. 143 for the quarter ended March 31, 2003. Management
does not believe adoption of this standard will have a material adverse effect
on the Company's consolidated financial position, results of operations or
liquidity.
RECLASSIFICATIONS
Certain reclassifications were made to the 2000 and 2001 consolidated
financial statements to conform to the 2002 presentation.
(3) LIQUIDITY AND CAPITAL RESOURCES
These consolidated financial statements have been prepared assuming
that the Company will continue as a going concern, which contemplates the
realization of assets and satisfaction of liabilities in the normal course of
business. The Company has incurred significant operating losses, has used cash
in operating activities, has an accumulated deficit, and working capital
deficiency. The Company currently anticipates that existing resources will not
be sufficient to satisfy contemplated working capital requirements for the next
twelve months.
At December 31, 2002, the Company had deficit working capital of
$5,949, and the Company had incurred a loss from operations for the year then
ended. The Company expects to continue to incur substantial additional losses in
2003. Given the December 31, 2002 cash balance and the projected operating cash
requirements, the Company anticipates that existing capital resources will not
be adequate to satisfy cash flow requirements through December 31, 2003. The
Company will require additional funding. The Company's cash flow estimates are
based upon achieving certain levels of sales, reductions in operating expenses
and liquidity available under its accounts receivable financing, new debt and/or
equity financing. Should sales be less than forecast, expenses be higher than
forecast or the liquidity not be available through additional financings of debt
and/or equity, the Company will not have adequate resources to fund its
operations. During 2002, the Company incurred defaults under both the Company's
F-15
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
WFBC accounts receivable financing and the Company's long-term convertible
notes. The Company was not able to obtain waivers for defaults on the long-term
convertible notes and has therefore classified such notes as short-term on the
balance sheet as of December 31, 2002. The Company does not expect future fixed
obligations to be paid from operations and the Company intends to satisfy fixed
obligations from additional financings, use of the accounts receivable
financing, extending vendor payments and issuing stock as payment on
obligations.
The Company's current financial condition is the result of several
factors including the following:
o Operating results were below expectations.
o Reduced credit line availability affected the sales volume of
our Pulsar subsidiary.
The Company currently has a need for a substantial amount of capital to
meet its liquidity requirements. The amount of capital that the Company will
need in the future will depend on many factors including, but not limited, to:
o the ability to extend terms received from vendors
o the market acceptance of products and services
o the levels of promotion and advertising that will be required
to launch new products and services and attain a competitive
position in the market place
o research and development plans
o levels of inventory and accounts receivable
o technological advances
o competitors' responses to our products and services
o relationships with partners, suppliers and customers
o projected capital expenditures
o reduction in the valuation of marketable investment securities
o downturn in economy
o defaults on financing which will impact the availability of
borrowings
In addition to the Company's current deficit working capital situation,
current operating plans show a shortfall of cash during 2003. The Company
intends to mitigate its position through one or more of the following:
o Additional equity capital -- The Company will seek additional
equity capital, if available. Equity capital will most likely
be issued at a discount to market, and require the issuance of
warrants causing a dilution to current shareholders. In
addition, providers of new equity capital may require
additional concessions in order for them to provide needed
capital to the Company.
o Additional convertible debt -- Depending upon the market
conditions, the Company may issue an additional debt
instrument. The types of instruments available in the market
would likely contain a provision for the issuance of warrants
and may also be convertible into equity.
F-16
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
o Off balance sheet financing -- The Company's operations are
not relatively capital intensive. However, should the Company
need to add equipment or decide to expand the facilities, the
Company may use an operating lease transaction to acquire the
use of capital assets. An operating lease would not appear on
our balance sheet and would be charged as an expense as
payments accrue. The Company plans to use third party
financing for a subsidiary whereby the subsidiary would become
less than wholly-owned.
o Receivables financing - Effective in October 2002, the Company
executed a new factoring agreement with Bay View Funding
("BVF") for the financing of the Company's accounts
receivable. The Company also terminated its remaining
agreement with Wells Fargo Business Credit ("WFBC"). The
Company plans to continue to finance receivables in
conjunction with its BVF agreement to generate cash.
o Liquidate investments - The Company will sell its remaining
investments to generate cash. The market value of trading
securities was approximately $76 at December 31, 2002.
o Vendor negotiations - The Company has successfully negotiated
extended payment terms with a number of vendors. The Company
will continue to negotiate term-out agreements with vendors to
extend the payment terms of existing accounts payable.
o Advance payments - Under current or future contracts the
Company may obtain cash deposits toward work to be performed
or products to be delivered. In addition, the Company may
offer early payment discounts to customers whose receivables
are not financed under the BVF agreements.
o Project suspensions - The Company may defer cash payments
through suspension of development projects.
o Issuance of stock as payment for existing and future
obligations - The Company may pay some of its accrued
liabilities or accounts payable through the issuance of common
stock. In 2002, the Company issued 959,323 shares of its
common stock as part of a settlement and restructuring
agreement with Research Venture relative to facilities leases.
We also issued 1.8 million shares to Wave Systems Corp
relative the termination and mutual release under a
development agreement.
o Issuance of stock to pay interest - The Company may issue
common stock to pay interest on long-term debt.
o Reductions in work force - The Company has already reduced its
workforce and decreased the cash compensation paid to the
remaining workforce. The Company may be forced to make further
reductions in the future if sales plans are not achieved.
Should the Company not receive adequate financing, it could be forced
to merge with another company or cease operations.
Ultimately, the Company's ability to continue as a going concern is
dependent upon its ability to successfully launch its new products, grow
revenue, attain operating efficiencies, sustain a profitable level of operations
and attract new sources of capital.
(4) BUSINESS COMBINATIONS
BIZ ACQUISITION
On August 24, 2001, pursuant to an Agreement and Plan of Reorganization
dated July 3, 2001 with BIZ, the Company completed the BIZ acquisition, whereby
BIZ became a wholly-owned subsidiary of the Company. In connection with the BIZ
acquisition, the Company issued an aggregate of 10,875,128 shares of SSP common
F-17
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
stock in exchange for all of the outstanding shares of BIZ common stock and
preferred stock. In addition, the Company reserved for issuance an aggregate of
approximately 860,000 shares of its common stock for issuance upon exercise of
BIZ options and warrants assumed by the Company.
As discussed in the paragraphs below, a valuation process determined
that a large portion of the BIZ acquisition price should be allocated to
goodwill. Litronic viewed the BIZ acquisition as a means by which Litronic could
expand both its product line and its target markets for already developed
Litronic products into the commercial area more quickly than it otherwise would
without the benefit of BIZ's relationships. Management believed the opportunity
to sell into commercial markets Litronic products already developed for
government markets represented a significant opportunity for Litronic and was
the reason for the price paid for BIZ.
The BIZ acquisition has been accounted for under the purchase method of
accounting in accordance with generally accepted accounting principles. The
Company recorded a one-time charge for purchased in-process research and
development ("IPR&D") expenses of $1,600.
The Company assessed and allocated values to the IPR&D. The values
assigned to these projects were determined by identifying projects that have
economic value but that had not yet reached technological feasibility and that
have no alternative future use. These products had not been released to the
market as of the date of the BIZ acquisition, but the features and functionality
of the products had been defined.
The value assigned to acquired IPR&D was determined by using the income
forecast method of estimating costs to develop the purchased IPR&D into
commercially viable products and service offerings, estimating the resulting net
cash flows from the products and service offerings and discounting the net cash
flows to their present value.
Adjustments were made to provide for a fair return to fixed assets,
working capital, and other assets that contribute to value. The estimates were
based on the following assumptions:
o The estimated revenues assume average compound annual revenue
growth rates of 44% to 197% during fiscal years 2002 through
2007, depending on the product line. These projections were
based on management's estimates over the expected remaining
economic lives of the technologies. The IPR&D value was
comprised of three on-going projects. The estimated cost of
revenues as a percentage of revenues was expected to be
approximately 55%. The projects were terminated between 2001
and 2002. No further costs were incurred in 2002.
o The discount rates used in the valuation reflect the relative
risk for the IPR&D projects. For IPR&D projects, the discount
rates ranged from 45% to 50%. These discount rates took into
consideration both the time value of money and the nature of
the forecast and risks associated with the projected growth
and profitability of the developmental projects. Discount
rates were selected based on each project's stage of
development and the risk associated with the stage of
completion of technology.
The Company believes that the foregoing assumptions used in determining
the income forecast associated with the IPR&D products are reasonable. No
assurance can be given, however, that the underlying assumptions used to
estimate the income forecast, the ultimate revenues and costs on such projects,
or the events associated with such projects, will transpire as estimated. During
the fourth quarter of 2001, the Company terminated its development on one of the
technologies classified as IPR&D. The remaining projects were terminated in
2002. Prior to the suspension, the Company spent approximately $1,112 on those
projects.
In addition to IPR&D acquired, the BIZ acquisition included completed
technology and strategic relationships. Estimated fully burdened operating
expenses were deducted from the revenue estimates to arrive at operating income
in order to determine the valuation of the IPR&D. The valuation of completed
technology used estimated fully burdened operating expenses, including the cost
of revenue, selling and marketing expenses, and general and administrative
expenses, together with payments to technology partners for development work and
F-18
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
payments to outside service providers. Regarding the valuation of strategic
relationships acquired, the valuation was determined to be the difference
between the present value of anticipated cash flows with the agreements in place
and the anticipated cash-flows based on a time-lag to cultivate the same type of
agreements with additional time required to capture market share, plus the
associated expense required to secure the strategic relationships.
At the time of the BIZ acquisition, the estimated percentage of
completion for the Company's IPR&D ranged from 6% to 18%. Due to the fact that
completion of several of the IPR&D projects were contingent upon the Company
receiving purchase orders for the projects from its development partners,
thereby receiving funding for completion, the expected completion time for the
projects in management's estimates remained uncertain as the Company had
suspended or cancelled development projects.
The total purchase price and allocation among the fair value of
tangible and intangible assets and liabilities (including purchased in-process
research and development) are summarized as follows:
Tangible assets........................................ $ 3,231
Liabilities............................................ 3,047
----------
Net tangible assets.................................... 184
Identifiable intangible assets:
In-process research and development................. 1,600
Completed technology................................ 6,200
Strategic relationships............................. 2,800
Goodwill............................................... 53,882
Deferred compensation.................................. 29
----------
$ 64,695
==========
A preliminary purchase price allocation was performed, and the
resulting amounts were included in the Company's September 30, 2001 Form 10-Q.
The preliminary purchase price allocation differed from the final purchase price
allocation as follows: the in-process research and development was valued at
$3,300, and the completed technology was valued at $5,900. The total purchase
price did not change, and the difference was an increase in goodwill.
The other intangible assets will be amortized on a straight-line basis
over the following estimated useful lives, in years:
Completed technology..................................... 5
Strategic relationships.................................. 1 to 5
The operating results of BIZ have been included in the Company's
consolidated statements of operations since the acquisition date, August 24,
2001.
Following are the summarized unaudited pro forma combined results of
operations for the twelve months ended December 31, 2000 and December 31, 2001,
assuming the BIZ acquisition had taken place at the beginning of each of those
fiscal years. The unaudited pro forma combined statement of operations for the
twelve months ended December 31, 2000 was prepared based on the statement of
operations of SSP for the twelve months ended December 31, 2000 and the
statement of operations for BIZ from April 30, 2000 (inception) to December 31,
2000. Accordingly, eight months of amortization of the intangibles was included.
The unaudited pro forma combined statement of operations for the twelve months
ended December 31, 2001 was prepared based upon the statement of operations of
SSP for the twelve months ended December 31, 2001 and the statement of
operations of BIZ for the period from January 1, 2001 through August 24, 2001.
The unaudited pro forma results exclude the effects of the IPR&D charge but
include the amortization of other intangibles and deferred compensation. The
unaudited pro forma results are not necessarily indicative of the future
operations or operations that would have been reported had the BIZ acquisition
been completed when assumed. See discussion on impairment of goodwill and other
intangibles at note 2.
F-19
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
TWELVE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2000 2001
---------- ----------
Net revenues.............................. $ 39,356 $ 22,720
========== ==========
Net loss.................................. $ (46,106) $ (68,661)
========== ==========
Net loss per share........................ $ (2.22) $ (3.33)
========== ==========
In accordance with Statement No. 142, the Company had up until June 30,
2002 to complete the initial test for impairment as of January 1, 2002, the
adoption date of Statement No. 142. In accordance with the transition provisions
of Statement No. 142, the Company conducted the first step of the impairment
tests. The Company assessed the fair value of its two reporting units by
considering their projected cash flows, using risk-adjusted discount rates.
Given consideration of relevant factors, the Company concluded that, as of
December 31, 2001, an impairment write-down of $36,299 was required related to
the BIZ acquisition. Subsequently, the Company reviewed the assumptions used in
the original analysis as of March 31, 2002, June 30, 2002, and September 30,
2002 and concluded that such analyses continued to be adequate and that no
additional write-down was required. In accordance with Statement No. 142, the
Company stopped amortizing goodwill in 2002. Accordingly, the Company does not
anticipate there to be any amortization expense for the next five periods
related to intangible assets. The following table provides a reconciliation of
the reported net loss adjusted for goodwill amortization charges for
each respective year:
YEARS ENDED
DECEMBER 31,
----------------------------------
2000 2001 2002
---------- ---------- ----------
Reported net (loss)............................................ $ (41,405) $(53,160) $(8,556)
Add back goodwill amortization:............................ 803 - -
--------- ---------- ----------
Adjusted net loss........................................... $ (40,602) $ (53,160) $ (8,556)
========== ========== ==========
Basic earnings per share:
Reported net (loss)........................................... $ (4.20) $ (3.91) $ (.40)
Add back goodwill amortization:............................ .08 - -
--------- ---------- ----------
Adjusted net loss........................................... $ (4.12) $ (3.91) $ (.40)
========== ========== ==========
The Company performed an assessment of the fair value of its
Information Security Products and Services reporting units. The Company
performed an assessment of the fair value of the goodwill as of December 31,
2002 using a multi-period discounted cash flow method, a variation of the income
forecast approach. The process is used to determine the fair value of an asset
by estimating its future cash flows and then discounting the cash flows to
present day utilizing a discount rate that reflects the time value of money and
the risk inherent in the asset. The present value of the cash flows was
determined using a discount rate of 30%, which was found to be the weighted
average cost of capital for the Company. The results of the analysis indicated
that there was no impairment as of the valuation date of December 31, 2002.
The Company is required to perform reviews for impairment at least
annually that may result in future write-downs. Tests for impairment between
annual tests may be required if events occur or circumstances change that would
more likely than not reduce the fair value of the net carrying amount.
As the markets for the Company's products are characterized by rapidly
changing technology, evolving industry standards, and the frequent introduction
of new products and enhancements, it is reasonably possible in the near-term
that the estimates of the anticipated future gross revenues, the remaining
estimated economic life, or both will be reduced. Reasonably possible is defined
as more than remote but less than likely. As a result, the remaining goodwill of
$25,930 at December 31, 2002, may be reduced within the next year.
Intangible assets consisted of the following as of:
December December
31, 2001 31, 2002
--------- ---------
Customer base
Gross carrying amount $ 3,846 $ 3,846
Accumulated amortization (3,155) (3,247)
Impairment -- (559)
--------- ---------
Net customer base $ 691 $ --
--------- ---------
Strategic relationships
Gross carrying amount $ 2,800 $ --
Accumulated amortization (241) --
Impairment (2,559) --
--------- ---------
Net strategic relationships $ -- $ --
--------- ---------
Completed technology
Gross carrying amount $ 6,200 $ --
Accumulated amortization (412) --
Impairment (5,788) --
--------- ---------
Net completed technology $ -- $ --
--------- ---------
Goodwill
Gross carrying amount $ 53,882 $ 53,882
Impairment (27,952) (27,952)
--------- ---------
Net completed technology $ 25,930 $ 25,930
--------- ---------
(5) INVESTMENTS
The Company has an investment that is classified as trading securities.
The securities are comprised of Class A Common Stock of Wave Systems Corp., par
value $0.01, received in the BIZ acquisition. As of December 31, 2002, the
Company had 57 shares with an aggregate value of $76. For the years ended
December 31, 2001 and 2002, the Company recorded realized loss on trading
securities of $530 and $130, respectively.
(6) INVENTORIES
A summary of inventories follows:
DECEMBER 31,
2001 2002
-------- --------
Raw materials...................................... $ 112 $ 23
Work-in-process.................................... 8 82
Finished goods..................................... 316 133
-------- --------
$ 436 $ 238
======== ========
F-20
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(7) PROPERTY AND EQUIPMENT
A summary of property and equipment follows:
DECEMBER 31,
2001 2002
-------- --------
Leasehold improvements............................. $ 65 $ 65
Machinery and equipment............................ 68 68
Furniture and fixtures............................. 2,383 2,406
-------- --------
2,516 2,539
Less accumulated depreciation and amortization..... 2,155 2,449
-------- --------
$ 361 $ 90
======== ========
(8) EQUITY INVESTMENT IN AFFILIATE
In January 2002, the Company formed a wholly-owned subsidiary, now
known as SSP Gaming, LLC, a Nevada limited liability company ("SSP Gaming"). The
entity was formed to conduct all business and any required financing activities
relative to the gaming industry. In June 2002, SSP Gaming and the Venetian
Casino Resort, LLC, a Nevada limited liability company based in Las Vegas,
Nevada, ("Venetian"), executed an operating agreement to form Venetian
Interactive, LLC, a Nevada limited liability company ("VI"). The purpose of VI
is to provide management services, consulting services, financial services,
intellectual property licensing services, and equipment to the online gaming
industry in venues where such activity complies with all regulatory
requirements, and to develop and operate Venetian branded casino sites.
To begin the process of developing online casino sites, engage vendors
to construct the sites and obtain the required licenses in the regulated venues
where such operations are authorized, VI began hiring employees in July 2002,
including one employee from the Company who was subsequently terminated by VI in
January 2003. The VI staff has forecast development and operational costs, which
are updated as new information becomes available. A VI related entity, V.I.
Ltd., was awarded both an Interactive Gaming License and an Electronic Betting
Center License by the Alderney Gambling Control Commission. The licenses permit
V.I. Ltd. to conduct Internet gaming activities under the name "Venetian
Interactive." The Venetian Casino site is currently under development and is
anticipated to go live before the end of the third quarter of 2003.
The current VI development budget estimates costs of $4,000 to bring
the Venetian Casino to live status, and an additional $2,200 to support startup
operations. Since beginning development in July 2002, VI has expensed all
operating costs and capitalized third party software development costs incurred
under a fixed price contract. As of December 31, 2002 development costs
capitalized totaled $560. The VI operating agreement calls for SSP Gaming to
fund two-thirds of the development costs and for Venetian to fund the remaining
one-third of the costs. As of December 31, 2002, SSP had invested $700 in SSP
Gaming, with those funds being invested in VI. In the year ended December 31,
2002, SSP Gaming recorded $248 as loss from equity investee, which represents
its pro rata portion of the VI net loss. This amount is included in
non-operating expenses in the consolidated statement of operations for the year
ended December 31, 2002, and as a reduction of the equity investment in
affiliate.
F-21
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The following represents summarized financial information for the VI:
BALANCE SHEET
DECEMBER 31, 2002
(UNAUDITED)
Current Assets $139 Current Liabilities $ -
Site Development 560 Members' Equity 699
----- -----
Total Members' Equity
Total Assets $699 & Liabilities $699
===== =====
STATEMENT OF OPERATIONS
PERIOD FROM JUNE 7 (INCEPTION) TO DECEMBER 31, 2002
(UNAUDITED)
Selling, general & admin $372
------
Net Loss ($372)
======
SSP Gaming's ownership interest decreases over time based upon the
distribution of cashflow from VI. The operating agreement provides for SSP
Gaming to receive two-thirds of the distributable cashflow until SSP Gaming
receives the return of the full amount of capital invested in VI. After
receiving the return of its invested capital SSP Gaming is to receive the
following portions of distributable cashflow: 50% of the first $2,000, 40% of
the next $2,000 and 20% thereafter. Based upon forecasted operations, the
ownership and distribution percentage held by SSP Gaming should be reduced to
the 20% level within the first two full years of operation. Venetian and SSP
Gaming each are to appoint three managers to oversee general management of VI,
with an additional Manager appointed by mutual consent of the parties. Members
owning at least 75% of the percentage interests of VI must approve defined major
decisions. Based upon this forecasted scenario and the fact that Venetian will
have voting control upon achieving forecasted operations, the Company deems
control to be temporary and therefore, the Company is accounting for SSP
Gaming's interest in VI using the equity method, and is not consolidating VI
operating results into the records of SSP Gaming. The operating agreement
commits SSP Gaming to fund up to $2,000. As of December 31, 2002, SSP Gaming has
funded $700. However, the future commitments are not directly guaranteed by SSP.
On May 31, 2002, the Company amended the SSP Gaming operating agreement
to admit Game Base of Nevada, Inc. ("GBI") as a new member in exchange for a
cash investment of $2,000. The amended operating agreement required no further
capital investment in SSP Gaming by the Company. In September 2002, the Company
served a notice of default to GBI for failure to fund the investment commitment,
and thereafter negotiated the settlement and return of GBI's ownership interest
in SSP Gaming in exchange for repayment on extended terms of $250 invested by
GBI. The note related to the repurchase of the GBI interest is included in
long-term debt (see note 9).
SSP Gaming is currently in negotiations with financial sources to
provide interim and long-term funding to satisfy the VI investment requirements.
If the negotiations are successful, SSP Gaming would become a less than
wholly-owned subsidiary,. If the negotiations are not successful, SSP Gaming's
percentage interest in the VI may be reduced and amounts invested by SSP in SSP
Gaming will be at risk.
F-22
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(9) LONG-TERM DEBT
A summary of long-term debt follows:
DECEMBER 31,
------------
2001 2002
------- -------
Secured convertible promissory notes with an interest rate of 10% per annum,
interest payable quarterly, due December 31, 2005 $ -- $5,796
Secured convertible promissory notes with an interest rate of 30% per annum,
interest payable quarterly, due November 14, 2003 -- 500
Note payable related to restructuring of facilities leases due in
installments on or before September 19, 2003, without interest -- 425
Promissory note due July 18, 2003 with interest at 6.75% per annum, interest
payable at maturity -- 429
Promissory note due July 18, 2003 without interest -- 27
Note payable secured by interest in SSP Gaming, payable in monthly
installments of $15,000, including interest at 6% per annum............... -- 196
Bay View Funding accounts receivable financing, discount rate of 1.25% of
the receivables factored, interest payable upon payment of receivable -- 259
Note payable for insurance financing due in eighteen monthly payments
beginning July 9, 2000 at an annual percentage rate of 8.18%.............. 173 --
Well Fargo Business Credit accounts receivable financing, discount rate of
1.25% of the receivables factored, interest payable upon payment of
receivable................................................................ 1,522 --
Subordinated convertible note due December 17, 2004 with interest rate at
8.0% per annum compounded annually, interest payable quarterly............ 2,500 --
------- -------
4,195 7,632
Less unamortized value of warrants related to debt issued................... -- 4,806
Long-term debt, net of debt discounts of $0 in 2001 and $4,806 in 2002 4,195 2,826
Less current installments.................................................... 1,695 2,826
------- -------
Long-term debt, net of debt discounts of $0 in 2001 and $4,806 in 2002 $2,500 $ --
======= =======
SUBORDINATED CONVERTIBLE NOTES
During December 2001, the Company issued four separate subordinated
convertible notes (the "Subordinated Notes") totaling $2,500 with similar terms
and conditions. The Subordinated Notes were due on December 17, 2004 and bear 8%
interest per annum payable quarterly. In connection with the issuance of the
Subordinated Notes, the Company incurred approximately $28 of issuance costs,
which primarily consisted of legal and other professional fees, which were to be
paid at a later date. All Subordinated Notes were to mature December 17, 2004
and bear interest at a rate of 8% per annum, which was payable quarterly in
cash. The Subordinated Notes were convertible at the election of the holders, at
any time, into such number of shares of the Company's common stock that was to
be determined by dividing the outstanding principal amount of the note being
converted by the conversion price in effect at that time. The initial conversion
price provided for in the in the notes is $3.60 per share and was subject to
adjustment under certain conditions. In addition, upon the closing of a
"qualified financing" as defined in the Subordinated Notes, the then outstanding
principal and any accrued and unpaid interest on the Subordinated Notes was to
automatically convert into such number of shares of the type of equity
securities sold in that qualified financing as determined by dividing the amount
of principal and interest remaining on the note being converted by the lesser of
(a) the price at which the equity securities were being sold in the qualified
financing or (b) the conversion price provided in the note being converted in
effect at the time. After December 17, 2003, the Company could call for
mandatory conversion of the Subordinated Notes prior to maturity if the
F-23
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Company's common shares trade at or above an average price of 300% of the
conversion price for twenty (20) consecutive trading days and average volume of
200,000 share per day for twenty (20) consecutive trading days. Two of the
Subordinated Notes totaling $750 were issued to the Company's co-chairmen and
co-chief executive officers. All the subordinated convertible notes were
converted into secured subordinated convertible notes or common stock in 2002 as
outlined below.
SECURED SUBORDINATED CONVERTIBLE NOTES
On April 16, 2002, the Company raised $5,000 in cash through the
issuance of $4,000 in 10% secured convertible promissory notes ("10% Convertible
Notes"), $653 in unsecured non-convertible promissory notes ("Non-convertible
Notes", $153 held by co-chairman Kris Shah and $500 held by co-chairman Marvin
Winkler) and the pre-payment of a $500 note receivable due to the Company from
Kris Shah, less a discount of $153 (see note 6). In connection with the issuance
of the 10% Convertible Notes, the Company incurred approximately $626 of
issuance costs, which primarily consisted of amortization of warrant costs,
investment banking fees and legal and other professional fees. These notes
mature December 31, 2005 and bear interest at a rate of 10% per annum to be paid
quarterly in cash, or at the Company's discretion, in common shares based upon
the trailing 30-day average prior to the interest due date. The $4,000 in 10%
Convertible Notes are convertible, in whole or in part, at the option of the
holder into an aggregate of 4,000,000 shares of the Company's common stock at
any time prior to maturity, at a conversion price of $1.00 per share, subject to
adjustment under certain conditions, and have detachable warrants exercisable
for three years to purchase up to an additional 2,400,000 shares at $1.30 per
share, subject to adjustment under certain conditions. In conjunction with the
closing of the sale of the 10% Convertible Notes, $1,750 of principal and $46 of
accrued interest of the Subordinated Notes were exchanged for the 10%
Convertible Notes and detachable warrants to purchase 1,077,667 shares at $1.30
per share.
The 10% Convertible Notes automatically convert prior to maturity if
the Company's common shares trade at or above $3.00 per share with average
volume of 100,000 shares per day for 20 consecutive trading days. The Company is
subject to restrictive covenants related to the Convertible Notes and
Non-convertible Notes that prevent the Company from pledging intellectual
property as collateral. In June 2002, Kris Shah and Marvin Winkler exchanged
their Non-convertible Notes, together with accrued interest, for 119,000 and
391,000 shares, respectively, of the Company's common stock based upon an
above-market exchange price of $1.30 per common share.
The 10% Convertible Notes contain a beneficial conversion feature. When
a convertible security contains a conversion price that is less than the quoted
trading price of a company's common stock at the date of commitment, then the
difference between the conversion price and the common stock price is called a
beneficial conversion feature. Emerging Issues Task Force ("EITF") Issue No.
00-27, which amends EITF Issue No. 98-5, requires both recordation of a discount
to recognize the intrinsic value of the conversion feature and amortization of
the amount recorded over the term of the security.
Of the aggregate $5,796 in 10% Convertible Notes issued, the Company
allocated approximately $2,644 to the value of the warrants and the remaining
$3,152 to the beneficial conversion feature of the debt instruments, which were
ascribed to these components on a pro rata basis of fair values calculated for
the warrants using a Black Scholes valuation model and the intrinsic value of
the beneficial conversion feature. These amounts have been recorded as discounts
from the face value of the debt, with an equal increase to additional paid-in
capital. Based on EITF No. 00-27, the governing accounting pronouncement, the
discounts are being amortized over the period from the date of issuance to the
maturity date of the notes. Amortization of the discounts totaled $1,107 for the
year ended December 31, 2002.
In connection with issuances of the 10% Convertible Notes and warrants,
the Company incurred approximately $741 of debt issuance costs comprised of
legal and professional fees, in addition to $182 in value calculated for the
110,000 warrants issued to the underwriter in the transaction. These costs,
which are included in other assets, are being amortized over the term of the 10%
Convertible Notes. Amortization of these costs totaled $142 for the year ended
December 31, 2002.
F-24
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
As of December 31, 2002, the Company was in violation of certain
provisions of the 10% Convertible Notes. These violations are related to the
Company's failure to pay debts and obligations as they become due. During the
first quarter of 2003, the Company requested waivers for each of the
aforementioned violations for past and for anticipated future events of default
through June 30, 2003, but has not been granted such waivers. While waivers have
been granted in the past, the holders of the 10% Convertible Notes have not
granted such waivers and may declare the principal and unpaid interest
immediately due and payable.
On April 16, 2002, with the exception of Mr. Winkler and Mr. Shah, the
holders of the Subordinated Notes converted their Subordinated Notes into 10%
Subordinated Notes (see note 9). In June 2002, Mr. Winkler and Mr. Shah
exchanged their Non-convertible Notes and their Subordinated Notes, together
with accrued but unpaid interest, for shares of the Company's common stock at an
above market per shares price of $1.30.
NOTE PAYABLE FOR RESTRUCTURING FACILITY LEASE
In restructuring existing facility lease agreements, the Company agreed
to pay $500 in installments without interest. The first payment of $75 was made
as scheduled in December 2002, with additional payments scheduled of $100 due in
March 2003, $150 due in June 2003 and a final payment of $175 due in September
2003. The Company has not made the $100 payment that was due in March 2003.
NOTE TO REPURCHASE INTEREST IN SSP GAMING
In October 2002, the Company entered into a mutual settlement and
release regarding the default by a party that had contracted to finance the
investment of SSP Gaming, a then wholly-owned subsidiary. The party defaulted
under the financing agreement. To preserve the underlying business
relationships, the Company and the other party executed an agreement whereby the
Company repurchased the party's interest by issuing a note for $250, the amount
invested by the party, and agreed to repay such amount by making an initial $40
payment and additional monthly payments of $15 per month, including interest at
6%, until paid in full. The note is secured by the Company's interest in SSP
Gaming, and includes an acceleration clause whereby the then principal balance
will be paid upon separate SSP Gaming financing of $2,000 or more.
SECURED CONVERTIBLE NOTE
In November 2002, the Company issued three one-year notes totaling
$500, bearing interest at 30% per annum ("Secured Convertible Notes"), which
have detachable warrants exercisable for five years to purchase up to an
additional 500,000 shares (depending upon the date of repayment) at $1.30 per
share subject to adjustment under certain conditions, as discussed in the
paragraph above under the heading "Subordinated Convertible Notes." SSP Gaming
used the proceeds for investment into the joint venture with Venetian. After
they have been outstanding for more than six months, the Secured Convertible
Notes may be converted into the Company's common stock at a conversion price of
$1.30 per share. The Secured Convertible Notes are due upon a Company financing
of $3,500 or more, and are secured behind the Secured Subordinated Notes
described above.
The fair value of the detachable warrants associated with the Secured
Convertible Notes were estimated at $154 using the Black Scholes valuation
model, based on the following assumptions: risk-free interest rate of 4.85%;
dividend yield of 0.00%; and volatility of 119%. The amounts have been recorded
as discounts from the face value of the debt with an equal increase to
additional paid-in capital. The relative fair value of the warrants have been
allocated as a debt discount and is being amortized over the period from the
date of issuance to the maturity date of the Secured Convertible Notes.
Amortization of the discounts totaled $38 for the year ended December 31, 2002.
PROMISSORY NOTES
In April 2002, the Company issued two promissory notes due in July 2003
as payment for goods sold by Pulsar's network solutions business. The note, with
an original balance of $679, bears interest at 6.75% per annum, with interest
payable at maturity. The note in the amount of $27 does not bear interest.
F-25
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
ACCOUNTS RECEIVABLE FINANCING
During November 2001, both the Company and its wholly-owned subsidiary,
Pulsar, entered into separate financing agreements with Wells Fargo Business
Credit, Inc. ("WFBC"), which provided for the factoring of accounts receivable.
The agreements contained no limit on the dollar volume of receivable financing,
but provided for WFBC's approval of credit limits for non-government customers.
The agreements contained a discount rate of 1.25% of the gross receivable
factored, which would be increased by .0625% per day for accounts that extended
beyond the 30-day period from the date the account was purchased. At the time of
purchase, terms called for WFBC to advance 85% of the gross receivable, with the
balance remitted after collection of the invoice less the discount and any other
charges. The combined agreements contained minimum quarterly fees and discounts
totaling $63. In July 2002, the Company signed amendments to the financing
agreements, which increased the discount rate charged to 1.95% of the gross
receivable and revised the daily rate to .063% for accounts extending beyond 30
days. The minimum quarterly fees and discounts were also reduced to $15. All
other terms and conditions remained. During the third quarter of 2002, the
Company terminated the WFBC agreement related to Pulsar.
In October 2002, the Company terminated its remaining financing
arrangement with WFBC and entered into a new financing arrangement with Bay View
Funding ("BVF"). The new factoring agreement contains a maximum advance of $750,
and was for an initial term of three months, which at the Company's option, is
renewable for additional three-month periods, which has been renewed by the
Company. The agreement contains a factoring fee, which is based on 1.25% of the
gross face value of the purchased receivable for every thirty day period from
the date of purchase by BVF until the invoice is paid in full. For invoices
outstanding more than the thirty day period, a finance fee will be charged at
the rate of .063% of the gross face value of the purchased receivable for every
one day period beyond the 30th day from the original date of purchase. At the
time of purchase, terms call for BVF to advance 85% of the gross receivable,
with the balance remitted after collection of the invoice less the factoring and
finance fee, if applicable. The agreement contains certain representations,
warranties and covenants and requires a monthly minimum fee, including the
factoring and financing fees, of .25% of the maximum advance of $750, or
approximately $2 per month. The BVF states among other things that a default
occurs if we do not pay debts as they become due or if maintain unreasonably
small capital. We have notified BVF of our failure to make certain payments on a
timely basis and have therefore recently requested a waiver of such default.
Gross receivables transferred to WFBC and WFBC/BVF amounted to $2,105
and $2,873 in 2001 and 2002, respectively. The Company is obligated to
repurchase certain accounts receivable under the program and, therefore, the
transaction does not qualify as a sale under the terms of Statement No. 140.
Factored receivables included in the accounts receivable balance as of
December 31, 2001 and 2002 were $1,817 and $314, respectively.
DECEMBER 31,
------------------
2001 2002
------- -------
Receivables assigned to factor............................................. $2,105 $2,873
Payments received from factored accounts receivable........................ 288 2,559
------- -------
Factored accounts receivable............................................... 1,817 314
Advances from factor (85% of accounts receivable).......................... 1,544 267
------- -------
Amounts due from factor.................................................... 273 47
======= =======
Unfactored accounts receivable............................................. 2,795 1,457
Factored accounts receivable............................................... 1,817 314
Allowances for returns and allowances...................................... (254) (187)
------- -------
$4,358 $1,584
======= =======
F-26
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
INSURANCE FINANCING
The Company maintains insurance premium financing agreements with
Cananwill, Inc. for the payment of certain insurance premiums. The premiums that
were being financed covered policy periods from 12 to 24 months. The BIZ
acquisition caused the amendment of some of the policies carried by the Company.
As a result, the premium financing agreements were amended to provide for five
monthly installments covering policy periods ended June 30, 2002, which extended
the existing policy for the remaining three months. These insurance premium
financing agreements are secured by the proceeds of the policies being financed.
REVOLVING LINE OF CREDIT
On April 18, 2001, the terms of the Company's revolving line of credit
were amended. Under the terms of the amended agreement, the maximum borrowings
were $5,000, eligible collateral excluded inventory, and the advance rate was
35%. In addition, certain of the financial covenants and requirements were
adjusted. The amended $5,000 revolving credit facility contained various
covenants and restrictions. Under the terms of the amended agreement, the
Company was required to obtain the lender's consent for any merger, acquisition
or consolidation. The lender was not willing to give its consent to the BIZ
acquisition and discontinued making advances under the terms of the amended
agreement effective with the BIZ acquisition. The lender applied all collections
subsequent to the BIZ acquisition to outstanding borrowings until such
borrowings and related interest charges were paid in full. All amounts due to
the lender were paid in full on October 2, 2001. Once all amounts were paid in
full, the lender released its security interest in the Company's assets.
(10) ACCRUED LIABILITIES
A summary of accrued liabilities follows:
DECEMBER 31,
------------------
2001 2002
-------- --------
Professional fees................................ $ 161 $ 113
Accrued vacation................................. 457 363
Accrued compensation............................. 384 270
Wave Development Agreement ...................... 1,389 --
Other............................................ 952 554
-------- --------
$ 3,343 $ 1,300
======== ========
In October 2000, BIZ signed a development agreement with Wave Systems
Corp. ("Wave") for the integration of EMBASSY-based systems with set-top box
master reference designs of Broadcom Corporation. The development agreement was
amended in May 2001. Under this amended agreement, the Company was required to
pay Wave $278 per month beginning June 1, 2001 through December 1, 2002 for work
to be performed, or a total of $5,000. As of December 31, 2001, as reflected in
accrued liabilities, the Company owed $1,389 to Wave for which Wave had tendered
monthly notices of default. The default notices converted the obligation for
payment for the delinquent installments from a cash obligation into a stock
acquisition right.
On September 30, 2002, the Company executed a Termination Agreement and
Mutual Release ("Termination Agreement") by and among the Company, BIZ and Wave.
The Termination Agreement documents the mutual termination effective as of
August 31, 2002. In late August 2002, the Company, BIZ and Wave began
discussions regarding entry into the Termination Agreement. Based upon the
average 20-day trading price of the common stock during the period of
discussions, the Company and Wave agreed to use $1.35 as the conclusive value of
a share of common stock for purposes of the Termination Agreement.
Under the Termination Agreement, the Company issued to Wave a
non-negotiable, non-interest bearing, subordinated convertible promissory note
due December 31, 2005 in the principal amount of $270 ("Note") and issued to
F-27
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Wave 1,600,000 shares of common stock. The conversion rate of the Note was
initially $1.35 and was called for redemption in December 2002. In December
2002, the Company exercised its right to convert the Note into an additional
200,000 shares of common stock.
The number of shares issued under the Termination Agreement are subject
to anti-dilution adjustments if, and whenever, before April 16, 2003 the Company
issues or sells, or is deemed to have issued or sold, any shares of common stock
at a price below the dilution rate then in effect. These anti-dilution
adjustments do not apply, however, to the issuance of shares of common stock
underlying exercisable or convertible securities that were outstanding on or
prior to September 30, 2002, shares of common stock underlying any rights,
warrants or options granted pursuant to any Company stock option or stock
purchase plan, or shares of common stock issued or deemed to have been issued
pursuant to stock splits, stock dividends, reclassifications, reorganizations
and the like.
The initial dilution rate is $1.00. If a dilutive issuance occurs, then
the dilution rate will be reduced to a price equal to the consideration per
share paid for the common stock in the dilutive issuance. A dilution percentage
equal to the percentage by which the dilution rate in effect immediately prior
to the dilutive issuance is reduced in connection with the dilutive issuance
will be calculated. Wave will then be entitled to receive a number of shares of
common stock equal to the dilution percentage multiplied by the aggregate number
of shares of common stock issued under the Termination Agreement prior to the
dilutive issuance.
Under the Termination Agreement the Company may not issue to Wave an
aggregate number of shares of common stock that would result in Wave, together
with its affiliates, beneficially owning 20% or more of the then issued and
outstanding shares of common stock. The Company agreed to endeavor to make the
required notifications and/or obtain the required approvals, and to register the
shares of common stock issuable pursuant to the Termination Agreement.
In accounting for the Termination Agreement, for the year ended
December 31, 2002, the Company recorded a $1,041 loss on settlement. The Company
issued common stock valued in the Termination Agreement at $2,160 and the Note
in the principal amount of $270, which was converted as of December 31, 2002 as
disclosed above. The amounts recorded in connection with the Termination
Agreement increased the Company's shareholders' equity by $1,389. The Company
does not anticipate recording any further expenses in connection with the Wave
Agreement.
(11) BUSINESS SEGMENTS AND PRODUCT LINES
The Company operates in two industry segments: the information security
segment and the network solutions segment. Following are the revenues, cost of
sales and identifiable assets of these segments as of and for the years ended
December 31, 2001 and 2002.
F-28
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
TWELVE MONTHS ENDED
DECEMBER 31,
-------------------------
2001 2002
---------- ----------
Revenue
Information Security Products and Services.............................. $ 8,246 $ 11,405
Network Solutions Market................................................ 14,474 1,153
---------- ----------
Total Revenue $ 22,720 $ 12,558
========== ==========
Cost of sales
Information Security Products and Services.............................. $ 4,497 $ 3,526
Network Solutions Market................................................ 13,497 1,101
---------- ----------
Total Cost of Sales $ 17,994 $ 4,627
========== ==========
Identifiable assets
Information Security Products and Services - Goodwill................... $ 25,930 $ 25,930
Information Security Products and Services - Other Assets............... 1,623 1,674
Network Solutions - Intangibles, net.................................... 691 --
Network Solutions Market................................................ 3,171 --
Corporate - Other....................................................... 6,008 2,407
---------- ----------
Total assets $ 37,423 $ 30,011
========== ==========
As the Company's chief operating decision maker does not review
operating expenses by segment beyond cost of sales or assets, except as
identified, additional segment information is not available.
During the years ended December 31, 2000, 2001 and 2002 the Company had
four distinct product lines: network deployment products, data security
products, license and service, and electric security systems. In 2000, the
Company discontinued the electric security systems product line. Therefore,
there is no activity related to the electric security product line in 2001 and
2002. Following is a summary of total revenues by product line.
TWELVE MONTHS ENDED
DECEMBER 31,
----------------------------------
2000 2001 2002
---------- ---------- ----------
Network deployment products........................................ $ 31,668 $ 14,474 $ 1,153
Data security products............................................. 5,753 6,671 6,978
Service............................................................ 903 1,014 2,591
License............................................................ 768 561 1,836
Electric security systems.......................................... 264 - -
---------- ---------- ----------
Total net product, license and
service revenues................................................ $ 39,356 $ 22,720 $ 12,558
========== ========== ==========
(12) RELATED PARTY TRANSACTIONS
KRDS REAL PROPERTY LEASE
In 1999, the primary shareholders of Litronic, Inc. formed KRDS, Inc.,
(KRDS) for the sole purpose of purchasing real estate property. KRDS's
operations primarily consisted of a mortgage obligation, interest, depreciation
and rental income from the Company related to the real estate property.
In February 2000, KRDS leased a building to the Company for its
corporate headquarters. The lease expires in February 2007 (see note 14). The
facility has an annual rent of approximately $429. In April 2002, the Company
and KRDS entered into an agreement whereby upon 60 days' notice, either party
may cancel the remaining balance of the facility lease with no future liability.
Neither party has exercised the exit clause.
F-29
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
NOTE RECEIVABLE FROM SHAREHOLDER
The note receivable from shareholder consists of a note acquired as
part of the BIZ acquisition. The $500 note was received by BIZ from the
Company's co-chairman, Kris Shah, in conjunction with the issuance of BIZ common
shares prior to the BIZ acquisition, and therefore was shown as a reduction of
shareholders' equity until paid. The note had a stated interest rate of 5% per
annum and was due on July 24, 2005. On April 12, 2002, in a transaction approved
the Company's board of directors, Mr. Shah prepaid the note by paying to the
Company $347, and the Company recorded a discount of $153 which was charged
against income in the second quarter of 2002. The discount was computed based
upon a present value calculation using a discount rate of 20%.
NOTES RECEIVABLE -- RELATED PARTY
The notes receivable primarily consists of two promissory notes that
were acquired as part of the BIZ acquisition. As part of a hiring package, an
employee received a $10 advance and executed a demand promissory note that
accrued interest at 6% per annum. Subsequently, as part of a loan agreement, the
same employee executed a separate promissory note for $37 including interest at
8% per annum and was due May 3, 2002. The Company and the employee executed an
extension of the due date of this note to May 3, 2003. Subsequent to June 30,
2002, the employee terminated his employment with the Company to join the
workforce of a joint venture in which the Company holds an economic interest
(see Note 8). In January 2003, the employee was terminated from the joint
venture. As part of the employee's termination agreement, the Company agreed to
forgive all amounts due under the two notes. Therefore, while the balance of the
related party notes including accrued interest and are included in other current
assets at December 31, 2001, the Company reserved all amounts in the year ended
December 31, 2002.
NOTES PAYABLE TO RELATED PARTY
On July 31, 2001, Chase Manhattan Bank ("Chase") advanced $1,000 to
Marvin Winkler, who was a founder of BIZ and who later became co-chairman of the
Company following the BIZ acquisition in August 2001. Mr. Winkler then advanced
that amount to BIZ for the re-purchase of preferred stock held by an investor in
BIZ. Mr. Winkler executed a $1,000 demand note with Chase, and BIZ executed a
$1,000 demand note due September 15, 2001 with JAW Financial, L.P. ("JAW"), an
entity controlled by Mr. Winkler. The demand note contained an interest charge
of prime plus 1% through the maturity date and prime plus 3% after the maturity
date. On October 11, 2001, the Company made a principal payment of $30, paid
accrued interest, and executed a new promissory note to JAW for $970. The terms
of the promissory note called for interest of prime plus 3% payable monthly,
together with five monthly payments of principal in the amount of $160 and one
final payment on April 15, 2002 in the amount of $170. The promissory note
provided Chase a security interest in the shares in Wave Systems Corp. owned by
the Company, and subject to Chase's loan security guidelines the rights to
proceeds from any sales of those shares. At December 31, 2001, the note payable
to related party was $304. On March 8, 2002, the promissory note was paid in
full ahead of scheduled maturity.
During 2001, a related party periodically advanced amounts required for
the operations of BIZ, which was acquired in the BIZ acquisition. As of December
31, 2001, the Company owed the related party a balance of $88 for such advances,
which was repaid in January 2002. No interest has been paid, accrued or due on
such advances.
The combined total payable to the related party at December 31, 2001
and 2002 totaled $392 and $0, respectively.
SUBORDINATED CONVERTIBLE 8% NOTES
In December 2001, the Company's co-chairmen each purchased a three-year
$375, 8% subordinated convertible note, in a total private placement of $2,500
of such notes. In April 2002, the subordinated convertible notes of the
co-chairmen were amended to provide that their notes could only be converted
upon a financing of $5,000 or more in equity or convertible securities in a
private placement to institutional investors at a conversion price that
F-30
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
represents a 25% or less discount to trading price of the Company's common
stock. As of December 31, 2002, the Company was in violation of certain
provisions of the Notes. The Company requested and received a waiver for these
violations, see note 9. On April 16, 2002, the Company closed a financing
whereby with the exception of Co-Chairmen, the note holders exchanged their
subordinated convertible notes for 10% secured convertible promissory notes (see
note 9).
FACILITIES RELATED PARTY LEASING
During 2001, the Company arranged for the lease of two buildings
approximating 63 square feet that were under construction and were subsequently
completed. In October 2002, the Company restructured its lease obligations with
landlord, Research Venture, LLC, for the two buildings located in the Spectrum
area of Irvine, California. This restructuring and settlement provided the basis
for revising the estimate of costs relative to resolving the liability incurred
under the original leases. In 2001 the Company recorded an estimated liability
of $2,171, which was net of then anticipated offsetting sublease income. As a
result of the restructuring and settlement, the Company increased stockholders'
equity by $1,650 through the issuance of common stock valued for financial
reporting purposes at $956 and recorded a reversal of previously accrued
restructuring charges of $700 for the year ended December 31, 2002. The
settlement required the Company to issue 959,323 shares of common stock, pay
$500 in cash over a one-year period, cancel the lease on one building
approximating 23 square feet, and take occupancy of the other building under a
seven-year operating lease for the facility with approximately 40 square feet
for an initial monthly rental rate of $55, plus common area costs beginning in
December 2002. The monthly rental rate on the seven-year lease is scheduled to
increase to $73, plus common area costs, at the beginning of the third year. The
Company records rent expense on a straight-line basis. At the Company's option,
a portion of the rental rate may be paid either in stock or in cash during the
first two years of the lease under certain circumstances through conversion of a
$360 subordinated convertible promissory note that the Company issued as prepaid
rent. In August 2002, Mr. Shah surrendered his 25% ownership interest in the
entity that owns the two buildings. At the time of surrendering his interest,
the buildings were encumbered by one or more construction loans for which the
lender required personal guarantees for renewal of the financing. As there was
little, if any, equity in the project and Mr. Shah was unwilling to personally
guarantee the loans, Mr. Shah chose to surrender his membership interest.
(13) CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS
Financial instruments that potentially subject the Company to
concentration of credit risk are trade receivables. Credit risk on trade
receivables is limited as a result of the Company's customer base and their
dispersion across different industries and geographic regions. As of December
31, 2001 and 2002, accounts receivable included $3,498 and $185, respectively,
due from the U.S. government and related agencies. Sales to the U.S. government
and related agencies accounted for 81%, 72% and 25% of total revenues for the
years ended December 31, 2000, 2001 and 2002, respectively.
The Company had sales to one customer that represented 42% of 2000
total revenue. The Company had sales to one customer that represented 20% of
2001 total revenue. The Company had sales to two customers that accounted for
41% of total revenue in 2002. General Dynamics and Micron PC, LLC accounted for
26% and 15% of total revenue in 2002, respectively. No other customers accounted
for more than 10% of total revenue in 2000, 2001 or 2002. Trade accounts
receivable aggregated $1,577 and $1,001 from the aforementioned major customers
as of December 31, 2001 and 2002, respectively.
Some key components used in the manufacture of the Company's products
can only be obtained from single sources.
F-31
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(14) COMMITMENTS AND CONTRACTUAL OBLIGATIONS
The Company leases office space under noncancelable operating leases.
The terms of the leases range up to seven years. The following summarizes the
future minimum lease payments under all noncancelable operating lease
obligations:
Year ending December 31,
2003............................................ $ 1,249
2004............................................ 1,118
2005............................................ 1,342
2006............................................ 1,360
2007 and thereafter............................. 1,765
--------
$ 6,834
========
Rental expense under noncancelable operating leases was $668, $667, and
$960 for the years ended December 2000, 2001 and 2002, respectively. Rental
expense for the years 2000, 2001 and 2002 includes offsetting income from
subleases in the amounts of $126, $131 and $0, respectively.
The corporate headquarters are leased from a related party (see note
12). In April 2002, the Company and KRDS entered into an agreement whereby upon
sixty (60) days notice, the Company or KRDS may cancel the remaining term of the
corporate headquarters lease with no future liability. The exit clause is
available provided that all amounts due under the lease are paid current through
the date of termination.
As of December 31, 2002, the Company had unconditional purchase
obligations of $948 for purchases during 2003, which consisted of the following
and are for hardware products purchased for resale, licenses and software used
in contract development programs:
Sun Microsystems $ 177
Rational (3-month periods) 31
Valicore 371
JNET Technologies 200
Infogard 47
Hardware for resale 122
-------------------------- ---------
Total Purchase Obligations $ 948
========================== =========
(15) LOSS PER SHARE
The calculation of diluted net loss per share excludes potential common
shares if the effect is anti-dilutive. Potential common shares are composed of
incremental shares of common stock issuable upon the exercise of stock options
and warrants. The following table sets forth potential common shares that were
excluded from the diluted net loss per share calculation for the years ended
December 31, 2000, 2001 and 2002 because they are anti-dilutive for the periods
indicated (shares in thousands):
2000 2001 2002
------ ------ ------
Warrants............................... 370 394 4,081
Stock options.......................... 490 1,543 2,039
------ ------ ------
860 1,937 6,120
====== ====== ======
F-32
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(16) SHAREHOLDERS' EQUITY
Under the Company's 1998 and 1999 Stock Option Plans ("the Plans"),
which were established in April 1998 and February 1999, respectively, options
granted were either qualified or nonqualified options. Qualified options must
have an exercise price of not less than 100% of the fair market value of a share
of common stock on the date of grant, except that qualified options granted to
an optionee who owns more than 10% of the total voting securities of the Company
on the date of grant must have an exercise price of not less than 110% of the
fair market value of a share of common stock on the date of grant. Nonqualified
options must have an exercise price of not less than 85% of the fair market
value of a share of common stock on the date of grant. The total number of
shares of common stock that were available for grant under each of the Plans was
1,500,000 shares. All stock options granted under the Plans had ten-year terms.
Unless otherwise provided by the board of directors or the committee of the
board that administers the Plans, each option granted under the 1998 Plan vested
on December 31, 1998 as to 10-15%, plus an additional 2.5% for each year of
service with the Company, and vested as to 20% each December 31 thereafter until
fully vested. Prior to 2002, unless otherwise provided by the board of directors
or the committee of the board that administers the Plans, each option granted
under the 1999 Plan vested 20% on each anniversary of the date of grant.
On August 23, 2001, the Company's stockholders approved the amendment
and restatement of the 1999 Stock Option Plan. The Amended and Restated 1999
Stock Option Plan ("Restated Plan") increased the number of shares of common
stock available for grant under that plan from 1,500,000 to 4,000,000. Starting
in 2002, unless otherwise provided by the board of directors or the committee of
the board that administers the Plans, new options issued by the Company under
the Restated Plan to employees generally vest and become exercisable 25% upon
the first anniversary the grant issuance, and thereafter vest as to 1/48 of the
total number of shares underlying the option each month until vested and
exercisable in full. The option exercise price requirements for the Restated
Plan are the same as those for the Plans. In the discretion of the board of
directors or the committee that administers the Restated Plan, payment of the
purchase price for the shares of common stock acquired through the exercise of
an option may be made in cash, shares of our common stock or a combination of
cash and shares of our common stock. Options may be exercised during a period of
time fixed by the board of directors or the committee that administers the
Restated Plan, except that no option may be exercised more than ten years after
the date of grant and, in the case of a qualified stock option granted to an
optionee who owns more than 10% of the total voting securities of the Company on
the date of grant, the option exercise period may not exceed five years.
Options to purchase approximately 920,926 shares of common stock under
the Restated Plan were made to all Company employees in August 2002. Subject to
continued service and other provisions of the grants, each option is scheduled
to vest and become exercisable 20% upon issuance on August 1, 2002 and 1/48 of
the total shares underlying the option each month thereafter until vested and
exercisable in full. The August 2002 employee options expire on July 31, 2012.
The Company does not intend to grant options in the future under the
1998 Stock Option Plan.
During the year ended December 31, 2001, the Company increased its
authorized number of common shares from 25,000,000 to 100,000,000 based on
approval of the share increase by the Company's shareholders on August 23, 2001.
In conjunction with the BIZ acquisition, the Company issued approximately
10,875,128 common shares.
BIZ INTERACTIVE ZONE, INC. 2000 STOCK OPTION PLAN
The BIZ Plan was assumed as part of the BIZ acquisition. The BIZ Plan
is closed and no additional options can be granted. As of December 31, 2002,
there were options outstanding to purchase approximately 377,718 shares. Under
the BIZ Plan, and subject to continued service and other provisions of the
employee options, each option vests and becomes exercisable as to 25% of the
underlying shares of common stock upon the first anniversary the date of
F-33
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
issuance, and vests as to 1/48 of the underlying shares of common stock each
month thereafter until vested and exercisable in full. The options are
exercisable for ten years from their dates of grant.
2001 EMPLOYEE STOCK PURCHASE PLAN ("ESPP")
During the year ended December 31, 2001, the Company established the
ESPP, which was approved by the Company's shareholders on August 23, 2001. A
total of 1,000,000 shares of common stock is currently authorized for issuance
under the ESPP. If a right expires or becomes unexercisable without having been
exercised in full, the shares of common stock that were subject to that right
will again become available for grant under the ESPP. The number of shares
issuable under the ESPP, and the purchase price per share, is subject to
proportional adjustments to reflect stock splits, stock dividends, mergers,
consolidations and similar events. Through December 31, 2002, 23,916 shares have
been issued under the ESPP.
DEFERRED COMPENSATION
The deferred compensation consists of amounts related to stock options
and warrants assumed as part of the BIZ acquisition, as well as non-employee
stock option grants and issuances of stock.
Equity instruments issued to non-employees are measured using the fair
value of the equity instrument based on using the stock price and other
measurement assumptions as of the earlier of the date at which a performance
commitment to earn the equity instruments is reached or the date on which the
performance is complete.
During 2001 and 2002, the Company granted 25,211 and 47,250 stock
options to non-employees, respectively. The vesting terms of the options ranged
from immediate to one year and from immediate to four years from the date of
grant for options issued in 2001 and 2002, respectively. In connection with the
granting of these options the Company recorded deferred compensation of $54 and
$0 and recognized compensation expense of $67 and $2 related to options granted
in the prior year for the years ended December 31, 2001 and 2002, respectively.
The terms of these options range from two to four years.
Additionally, in conjunction with the BIZ acquisition, the Company
assumed 837,396 options under the BIZ stock option plan of which 377,718 options
remained outstanding as of December 31, 2002. Selected employee stock options
were granted to employees with exercise prices at less than the fair value of
the underlying common stock at the date of grant. Accordingly, compensation
expense will be recognized and recorded over the vesting period. The options
generally vest 25% upon the completion of one year of service and the remaining
75% in equal monthly installments over the next three years from the date of
grant. As the Company granted the options to employees at below fair market
value, the Company recorded deferred compensation and compensation expense as of
and for the year ended December 31, 2001. The term of the options is ten years.
In addition, BIZ granted 118,779 stock options to non-employees in
exchange for services prior to the BIZ acquisition. The stock options generally
vest over one year and the term of these options is one year.
Using the Black Scholes valuation model, the Company recorded deferred
compensation related to the BIZ options of $1,139 at December 31, 2001,
compensation expense of $132 and $264 and reversal of deferred compensation
related to terminated employees of $201 and $484 for the years ended December
31, 2001 and 2002, respectively.
WARRANTS
In conjunction with the issuance of the 10% Convertible Notes in April
2002, the Company issued detachable warrants to purchase 3,477,666 shares at
$1.30 per share. The exercise price of and number of shares underlying the
warrants are subject to adjustment under certain conditions. The warrants are
F-34
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
exercisable at any time prior to the third anniversary of their issuance, in
whole or in part, and contain a cashless exercise provision. The warrants were
valued at approximately $2,644 using a Black Scholes valuation model. The
amounts have been recorded as discounts from the face value of the debt with an
equal increase to additional paid-in capital. Based on EITF No. 00-27, the
governing accounting pronouncement, the discounts are being amortized over the
period from the date of issuance to the maturity date of the notes. Accretion of
the discounts totaled $1,107 for the year ended December 31, 2002.
The Company also issued a placement warrant in conjunction with the 10%
Convertible Notes issued in April 2002. The warrant provides for the purchase of
110,000 shares at $1.00 per share. The exercise price of and number of shares
underlying the warrants are subject to adjustment under certain conditions. The
warrant is exercisable at any time prior to the third anniversary of its
issuance, in whole or in part, and contains a cashless exercise provision. The
warrant was valued at approximately $182 using a Black Scholes valuation model.
The amount has been recorded as debt issuance cost carried under other long term
assets with an equal increase in additional paid-in capital. These costs are
being amortized over the term of the 10% Convertible Notes, with the
amortization totaling $142 for the year ended December 31, 2002.
In conjunction with the issuance of the Secured Convertible Notes in
November 2002, the Company issued to the note holders warrants to purchase up to
500,000 shares of common stock at $1.30 per share. The exercise price of and
number of shares underlying the warrants are subject to adjustment under certain
conditions. The warrants are exercisable at any time prior to the third
anniversary of their issuance, in whole or in part, and contain a cashless
exercise provision. The warrants were valued at approximately $154 using a Black
Scholes valuation model. The amounts have been recorded as discounts from the
face value of the debt with an equal increase to additional paid-in capital. The
discounts are being amortized over the period from the date of issuance to the
maturity date of the notes. Accretion of the discounts totaled $38 for the year
December 31, 2002.
A summary of the status of the Company's warrants as of December 31,
2000, 2001 and 2002 and changes during the years ended on those dates is
presented below (shares in thousands):
2000 2001 2002
---- ---- ----
WEIGHTED- WEIGHTED- WEIGHTED-
NUMBER OF AVERAGE NUMBER OF AVERAGE NUMBER OF AVERAGE
UNDERLYING EXERCISE UNDERLYING EXERCISE UNDERLYING EXERCISE
WARRANTS SHARES PRICE SHARES PRICE SHARES PRICE
-------- ------ ----- ------ ----- ------ -----
Outstanding at beginning of 370 $18.15 370 $14.58 394 $14.58
year
Granted -- $ -- 24 $ 2.11 3,687 $ 1.30
Cancelled -- $ -- -- $ -- -- $ --
Exercised -- $ -- -- $ -- -- $ --
------- ------- -------
Outstanding at end of year 370 $18.15 394 $17.17 4,081 $ 2.29
======= ======= =======
Warrants exercisable at 370 394 4,081
year-end
Weighted-average fair value $ -- $ 1.89 $0.98
of warrants granted
during the year
F-35
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The following table summarizes information about warrants outstanding
at December 31, 2002 (shares in thousands):
WARRANTS OUTSTANDING WARRANTS EXERCISABLE
-------------------- --------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF EXERCISE OUTSTANDING AT REMAINING WEIGHTED-AVERAGE EXERCISABLE AT WEIGHTED-AVERAGE
PRICES 12/31/02 CONTRACTUAL LIFE EXERCISE PRICE 12/31/02 EXERCISE PRICE
------ -------- ---------------- -------------- -------- --------------
$1.30 - $18.14 3,711 2.3 $ 1.31 3,711 $1.31
$18.15 370 1.4 $18.15 370 $18.15
OPTIONS
A summary of the status of the Company's stock option plans as of
December 31, 2000, 2001 and 2002 and changes during the years ending on those
dates is presented below (shares in thousands):
2000 2001 2002
---- ---- ----
WEIGHTED- WEIGHTED- WEIGHTED-
NUMBER OF AVERAGE NUMBER OF AVERAGE NUMBER OF AVERAGE
UNDERLYING EXERCISE UNDERLYING EXERCISE UNDERLYING EXERCISE
OPTIONS SHARES PRICE SHARES PRICE SHARES PRICE
------- ------ ----- ------ ----- ------ -----
Outstanding at beginning of 236 $4.17 490 $5.05 1,614 $3.26
year
Granted 347 $5.43 1,239 $2.60 1,151 $1.44
Cancelled (65) $5.73 (111) $4.25 (687) $2.80
Exercised (28) $0.70 (4) $0.70 (39) $1.63
------- ------- -------
Outstanding at end of year 490 $5.05 1,614 $3.26 2,039 $2.40
======= ======= =======
Options exercisable at 57 $0.70 456 $2.88 920 $2.49
year-end
Weighted-average fair value $4.85 $3.33 $1.20
of options granted
during the year
The options granted in fiscal 2001 to purchase 1,239 shares include
options to purchase 837 shares that were assumed by the Company in the BIZ
acquisition. As of December 31, 2002, there were 2,118 shares available for
grant.
The following table summarizes information about stock options
outstanding at December 31, 2002 (shares in thousands):
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------- -------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF EXERCISE OUTSTANDING AT REMAINING WEIGHTED-AVERAGE EXERCISABLE AT WEIGHTED-AVERAGE
PRICES 12/31/02 CONTRACTUAL LIFE EXERCISE PRICE 12/31/02 EXERCISE PRICE
------ -------- ---------------- -------------- -------- --------------
$0.70 - $1.60 981 10.3 $1.27 353 $1.21
$1.61 - $2.51 480 15.5 $2.08 336 $2.09
$2.52 - $3.41 311 9.2 $3.08 89 $3.02
$3.42 - $7.03 220 10.2 $5.69 114 $5.65
$7.94 - $9.75 48 11.3 $9.12 28 $9.12
------- ------- ------- -------
2,039 11.4 $2.39 920 $2.49
======= ======= ======= =======
F-36
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The weighted average remaining contractual life of stock options
outstanding at December 31, 2002, 2001 and 2000 was 11.4 years, 8.9 years and
8.3 years, respectively.
(17) EMPLOYEE RETIREMENT SAVINGS PLAN
Effective January 1, 1998, the Company established a retirement plan
that is intended to qualify under Section 401(k) of the Internal Revenue Code.
Under the plan, eligible employees are able to contribute up to 20% of their
compensation not to exceed the maximum IRS deferral amount. The Company may also
match employee contributions at its discretion. During 2000, 2001 and 2002, the
Company made contributions of $142, $143 and $90 to this plan, respectively.
(18) INCOME TAXES
The provision (benefit) for income taxes from continuing operations is
comprised of the following for the respective years ended:
DECEMBER 31,
---------------------
2000 2001 2002
----- ----- -----
Current:
Federal................................. $ -- $ -- $ --
State................................... 6 53 2
Foreign................................. -- -- --
----- ----- -----
Total................................ $ 6 $ 53 $ 2
===== ===== =====
Deferred tax assets and liabilities result from differences between the
financial statement carrying amounts and the tax basis of existing assets and
liabilities. The significant components of deferred income taxes are as follows:
DECEMBER 31,
------------------------------------
2000 2001 2002
---------- ----------- -----------
Deferred tax assets:
Net operating loss carry forward............ $ 3,686 $ 9,086 $ 11,851
Credit carry forward........................ 314 237 237
Accrued expenses............................ 433 -- --
Start-up cost............................... -- 6,444 6,444
---------- ----------- -----------
Total deferred tax assets...................... 4,433 15,767 18,532
Less valuation allowance.................... (4,433) (15,767) (18,532)
---------- ----------- -----------
Net deferred tax assets..................... $ -- $ -- $ --
========== =========== ===========
The Company has recorded a valuation allowance in the amount set forth
above for certain deductible temporary differences, net operating loss carry
forwards and credit carry forwards where it is more likely than not that the
Company will not receive future tax benefits. The net change in the valuation
allowance for the year ended December 31, 2001 and 2002 was $11,334 and $2,765,
respectively.
Subsequently recognized tax benefits relating to the valuation
allowance for deferred tax assets as of December 31, 2002 will be allocated as
follows:
Income tax benefit that would be reported in
the consolidated statements of operations.................. $ 11,940
Goodwill..................................................... 6,592
----------
Total..................................................... $ 18,532
==========
As of December 31, 2002, the Company had federal and state net
operating losses ("NOL") carry forwards of approximately $32,362 and $14,129,
respectively. These NOL carry forwards will expire through year 2021 for the
federal NOL and 2006 for the state NOL. Additionally, the Company has federal
and state research and experimentation ("R&E") credit carry forwards of
approximately $237. These R&E Credit carry forwards expire through 2021 for the
federal R&E Credit and indefinitely for the state R&E Credit.
F-37
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Income tax expense differs from the amount computed by applying the
federal corporate income tax rate of 34% to income (loss) before income taxes as
follows:
YEAR ENDED DECEMBER 31,
------------------------------
2000 2001 2002
------ ------ ------
Statutory tax rate............................................... (34)% (34)% (34)%
Goodwill amortization and impairment of goodwill and other
Intangibles.................................................... 32% 27% %
In-process research and development.............................. -- 1% %
Change in valuation allowance.................................... 7% 9% 34%
State income taxes, net.......................................... (5)% (4)% %
Research and experimentation credit.............................. -- -- --
Other............................................................ -- 1% %
------ ------ ------
Effective tax rate............................................. --% --% --%
====== ====== ======
(19) CONTINGENT LIABILITIES
Because the Company provides engineering and other services to various
government agencies, it is subject to retrospective audits, which may result in
adjustments to amounts recognized as revenues, and the Company may be subject to
investigation by governmental entities. Failure to comply with the terms of any
governmental contracts could result in civil and criminal fines and penalties,
as well as suspension from future government contracts. The Company is not aware
of any adjustments, fines or penalties, which could have a material adverse
effect on its financial position or results of operations.
The Company had cost reimbursable type contracts with the federal
government. Consequently, the Company is reimbursed based upon the direct
expenses attributable to the contract, plus a percentage based upon overhead,
material handling, and general administrative expenses. The overhead, material
handling, and general administrative rates are estimates. Accordingly, if the
actual rates as determined by the Defense Contract Audit Agency are below the
Company's estimates, a refund for the difference would be due to the federal
government. It is management's opinion that no material liability will result
from any contract audits.
The Company is involved from time to time in various litigation matters
that arise in the ordinary course of business. The Company is unable to estimate
a potential loss or potential range of loss associated with any of the pending
claims described herein.
In November 2000, the Company executed an Alliance Agreement with
Electronic Data Systems Corporation ("EDS") for the marketing of Company
products to EDS customers ("Alliance"). The Alliance calls for a joint working
relationship between the two companies, which is non-exclusive and has a term of
ten (10) years. In February 2001, the Company and EDS executed an engagement
letter for EDS to provide certain information technology and consulting services
for both the Company's organizational structure and for a specific customer
project.
On August 27, 2001, EDS and the Company executed a letter of intent and
temporary working agreement whereby EDS supplied software and hardware for
re-sale to Pulsar customers ("Pulsar Agreement"). Under the Pulsar Agreement, as
of December 31, 2002, $1,049 remained outstanding and unpaid to EDS for
purchases of hardware and software and is recorded in accounts payable in the
consolidated balance sheet.
The Company and EDS executed a Master Services Agreement ("MSA") dated
as of November 14, 2001, whereby beginning December 1, 2001 and ending December
31, 2006, the Company and EDS established a strategic teaming relationship to
implement, sell and deliver a set of secure transaction processing offerings
based upon a Trust Assurance Network ("TAN"). The MSA task order ("Task Order")
requires that the Company to pay a monthly fee of $44 for account, test and lab
management services beginning January 1, 2002. The obligations for these
services can be terminated beginning January 1, 2003 by giving ninety (90) days
prior written notice and payment of $400, or beginning January 1, 2004 by giving
F-38
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
ninety (90) days prior written notice and payment of $200. Further, the Task
Order provides for EDS to provide TAN hosting and implementation in exchange for
an implementation fee of $45 payable October 1, 2002. Once installation of the
production environment TAN is complete, EDS agrees to host the TAN in exchange
for a monthly service fee of $59 for thirty-six (36) months and $60 per month
for the remaining months of the MSA. The Company may delay implementation of the
TAN by paying a fee of $200 prior to January 31, 2003. The Company may terminate
the Task Order without cause by paying $400 after January 1, 2004 and providing
ninety (90) days prior written notice. In the event the Company is unable to
obtain intellectual property rights or licensing consents that may be required,
if any, prior to January 1, 2003, and the parties determine there are no
software alternatives, then after giving ninety (90) days prior written notice
the Company may terminate the Task Order by paying $450. As of December 31,
2002, $221 remained outstanding and unpaid to EDS relative to the Task Order.
The Company has not made any payments since December 31, 2002 relative to the
balance outstanding as of that date.
The Company is currently in discussions with EDS regarding the
restructuring of its relationship with EDS relative to the MSA and Task Order.
The above amounts are not listed in contractual obligations as the Company and
EDS have held substantial discussion regarding the cancellation of the MSA and
Task Order. EDS has not provided services as outlined in the agreements and
there is no prospect of such services being required in the near future.
However, the Company cannot predict the outcome of these discussions as they
pertain to the fees associated with early termination of the contract, and
portions of the charges may be incurred.
On January 16, 1998, G2 Resources Inc. (G2) filed a complaint against
Pulsar in the Fifteenth Judicial Circuit in Palm Beach County, Florida. G2
claimed that Pulsar breached a contract under which G2 agreed to provide
services related to the monitoring of government contracts available for bid and
the preparation and submission of bids on behalf of Pulsar. The contract
provided that Pulsar pay G2 $500 in 30 monthly installments of $16 and an
additional fee of 2% of the gross dollar amount generated by awards. In its
complaint, G2 alleged that Pulsar failed to make payments under the contract and
claimed damages in excess of $525 plus interest, costs and attorneys fees. In
the course of discovery G2 asserted that its losses/costs arising out of its
claim amounted to approximately $10,300. Pulsar asserted that G2 failed to
perform the services required under the contract and Pulsar filed a claim for
compensatory damages, interest and attorneys fees against G2. Classical
Financial Services, LLC intervened in the case. Classical claimed that G2
assigned its accounts receivable to Classical under a financing program and that
Pulsar breached its obligations to Classical by failing to make payments under
the contract with G2. Pulsar asserted defenses to Classical's claim. On April
20, 2001, a court hearing was held and G2's complaint against Pulsar was
dismissed without prejudice on the basis of no prosecution activity for more
than 12 months. On May 22, 2001, G2 filed a new complaint against Pulsar. In
August 2002 the case was moved from Division AF to Division AH of the Fifteenth
Judicial Circuit in Palm Beach County Court, Civil Division. The Company
believes that the claims made by G2 and Classical against Pulsar are without
merit and intends to vigorously defend against these claims.
In May 2002, Contemporary Services Corporation filed an action against
us alleging breach of contract, fraud, negligent misrepresentation and violation
of California Corporations Code section 25400. The action relates to a term
sheet agreement that we entered into with the plaintiff in October 2001 in
connection with a potential strategic relationship between the plaintiff and us.
We filed an answer and cross-complaint. While we continued to believe we would
prevail at trial, in February 2003, we reached an agreement to settle the case
for less than $50,000, which will be jointly paid by our insurance carrier and
us. Our estimated portion of the settlement has been accrued in the results of
the year ended December 31, 2002.
In July 2002, Synnex Technology ("Synnex") filed a lawsuit against the
Company in the Superior Court of Orange County, alleging that the Company failed
to pay $120,986 for products purchased by us for resale. The Company and Synnex
agreed to settle the matter by payment of ten equal installments of $12,099,
pursuant to a stipulation for entry of judgment that is to be held by counsel
for Synnex and not filed with the court absent breach by the Company. The last
payment is due on or before June 9, 2003, at which time the action will be
dismissed. To date, all required payments have been made.
F-39
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
In restructuring existing facility lease agreements, the Company agreed
to pay $500 in installments without interest. The first payment of $75 was made
as scheduled in December 2002, with additional payments scheduled of $100 due in
March 2003, $150 due in June 2003 and a final payment of $175 due in September
2003. The Company has not made the $100 payment that was due in March 2003,
which means the Company is currently in default under the settlement facilities
settlement agreement and the landlord could enter it stipulated judgment. Also,
if we are delisted from The Nasdaq National Market, Research Venture, LLC would
be entitled to entry of a stipulated judgment against us in the maximum
aggregate amount of $3,100, less consideration we pay prior to any entry of the
judgment.
During the second quarter of 2001 Microsoft notified the Company
regarding the alleged sales of unlicensed copies of Microsoft Office. The
software in question was purchased from a major computer hardware manufacturer
and was resold to one of the Company's customers in a package that included both
hardware and software. The Company is currently investigating the matter, and
does not anticipate that the outcome will have a material impact on its results
of operations, financial condition or liquidity.
The Company currently holds multiple contracts with the federal
government for the resale of network deployment products. In particular, three
of these contracts permit the Company to provide goods and services to various
federal government agencies. An administrative agency recently informed the
Company that one of the contracts would not be renewed unless purchase activity
was conducted under the contract. The Company is negotiating with a party for
the sale of the contract. It is possible the other contracts may not be renewed
or may be cancelled by the federal government due to the Company's inability to
perform as required under the contracts.
The Company is currently in negotiations with the various government
agencies that it contracts with to initiate and implement the corrective
measures necessary to insure the uninterrupted continuity of the contracts.
Although there is no assurance that the contracts will be renewed or that they
will not be cancelled, the Company has reason to believe they will be renewed.
However, if the contracts are not renewed or if they are cancelled, then a
significant portion of the Company's revenues will be lost which would have a
significant impact on the Company's financial condition, results of operations
and liquidity.
As of December 31, 2002, accounts payable totaled $4,413. Of that
amount, $3,191 is aged at least 90 days. Unless payment is made or satisfactory
payment plans agreed to, it is likely that the vendors will eventually initiate
legal actions to collect the amounts owed to them. Currently, the Company has
the intent to satisfy its vendor obligations through a combination of payment
negotiations, which include extending the terms over time, partial payments of
the obligations due as payment in full and converting obligations to long term
notes payable.
The Company requested default waivers from the holders of notes under
which we incurred a default relative to the timely payment of obligations as
they come due. The noteholders did not grant the requested waivers. This means
the noteholders have the right to declare the Company in default and call all of
their debt due and immediately payable. With the potential of the notes being
called for payment, the Company re-classified what would have otherwise been
long-term debt as short-term debt in the consolidated balance sheet as of
December 31, 2002.
In late 2002 and early 2003, the Company received letters from the
staff of the Securities and Exchange Commission ("SEC Staff") making certain
comments and inquiries regarding the Company's Form 10-K for the year ended
December 31, 2001 and Form 10-Q's for the quarters ended March 31, 2002, June
30, 2002 and September 30, 2002. The Company submitted responses to all of the
comments of the SEC Staff. The SEC Staff have orally indicated that all of their
questions have been answered and that pending review of the Company's Form 10-K
for the year ended December 31, 2002, their comments have been fully addressed.
While the final effect of this inquiry cannot be determined until the SEC Staff
has reviewed Form 10-K for the year ended December 31, 2002, the Company
currently does not anticipate any material adjustments to the consolidated
financial statements reported for the periods involved.
F-40
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(20) SUBSEQUENT EVENTS
On January 22, 2003, the Company issued to Richard P. Kiphart a $500
promissory note that bears interest at a rate of 15% per year, with a minimum
interest charge of $50. Accrued interest is payable quarterly in arrears
beginning March 31, 2003. Principal and accrued but unpaid interest are due upon
the earlier of December 31, 2005 and the Company's closing of a $5,000 or more
equity or debt financing. Mr. Kiphart has the right to exchange the principal
and outstanding interest on the note for securities that the Company issues in
such an equity or debt financing. If the Company does not repay the note prior
to June 30, 2003, the Company will be required to issue to Mr. Kiphart a
three-year warrant to purchase up to 125,000 shares of common stock at an
exercise price of $1.30 per share and to register for resale the shares of
common stock underlying the warrant. The note is secured by all of the
unencumbered assets of SSP and its subsidiaries, including without limitation,
intellectual property assets and any and all receivables due to the Company from
SSP Gaming.
On March 18, 2003 and March 19, 2003, the Company issued to each of
Crestview Capital Fund II, L.P. and Richard P. Kiphart $100 promissory notes
that are secured by all of the Company's assets, including SSP Gaming and any
rights belonging to SSP Gaming. In addition, on March 28, 2003, Marvin Winkler
agreed to pledge 350,000 shares of common stock held by JAW Financial, L.P. as
security for the notes the Company issued on March 18, March 19 and March 28,
2003. The notes bear interest in an amount equal to the following percentage of
the principal balance: 10%, if the notes are repaid within 30 days; 12%, if the
note are repaid within 60 days; 15%, if the notes are repaid within 90 days; and
20%, if the notes are repaid at maturity. Principal and interest under the notes
are due upon the sooner of 120 days from the dates of the notes and the
Company's raising of at least $3,500 in equity or debt financing. Each note was
accompanied by a five-year warrant to purchase up to 50,000 shares of common
stock at an exercise price of $0.60. The Company will be required to issue to
each holder warrants to purchase up to an additional 50,000 shares of common
stock upon repayment of the notes, depending upon the date of repayment. The
exercise price of the warrants and the number of shares underlying the warrants
are subject to anti-dilution adjustments in connection with dividends or
distributions of assets to holders of our common stock and subdivisions or
combinations of our common stock. The warrants contain a cashless exercise
provision. The shares of common stock underlying the warrants bear registration
rights.
On March 28, 2003, the Company issued to Richard P. Kiphart, Crestview
Capital Fund II, L.P., Kris Shah and Marvin Winkler promissory notes in the
aggregate principal amount of $440. The notes are secured by all of the
Company's assets and the assets of SSP Gaming. In addition, Mr. Winkler agreed
to pledge 350,000 shares of common stock held of record by JAW. Financial, L.P.
as security for the notes the Company issued on March 18, March 19 and March 28,
2003. The notes bear interest at the rate of 18% per year, with interest payable
in cash monthly in arrears. The Company is required to use the proceeds of the
notes only for payment of operating expenses. Principal and accrued but unpaid
interest under the notes are due upon the sooner of July 26, 2003 and the
Company's raising of $3,500 in equity or debt financing. The notes were
accompanied by five-year warrants to purchase up to an aggregate of 230,000
shares of common stock. The exercise price of the warrants has not yet been
fixed. The exercise price will be equal to the greater of $0.70 per share or the
conversion price of securities the Company may issue in a proposed financing,
not to exceed $1.30 per share. The exercise price of the warrants and the number
of shares underlying the warrants will be subject to anti-dilution adjustments
in connection with dividends or distributions of assets to holders of the
Company's common stock and subdivisions or combinations of the Company's common
stock. The warrants contain a cashless exercise provision.
In March 2003, the Company executed documents to settlement the action
brought against the Company by Integral Systems, Inc. As part of the settlement,
the Company entered into a Forbearance Agreement dated March 12, 2003 with
Integral Systems that would allow Integral Systems to enter a judgment against
the Company should the Company default in payments due under the agreement. The
Company also issued to Integral Systems a warrant exercisable for three years to
purchase 150,000 at an exercise price of $1.30 per common share. Additionally,
if the Company does not payoff the agreed to obligation, at a discount, by June
30, 2003, we agreed to place 400,000 of our common stock in a third party escrow
as additional security for our performance under the Forbearance Agreement.
F-41
SSP SOLUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(21) QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data for 2002 and 2001 is as follows:
BASIC AND
NET GROSS NET DILUTED LOSS
REVENUES PROFIT LOSS PER SHARE
-------- ------ ---- ---------
2002:
Fourth quarter........................................ $ 3,662 $ 2,878 $ (386) $ (0.02)
Third quarter......................................... 3,932 2,494 (430) (0.02)
Second quarter........................................ 2,855 1,613 (3,713) (0.18)
First quarter......................................... 2,109 946 (4,027) (0.19)
--------- -------- ---------
Total................................................. $ 12,558 $ 7,931 $ (8,556)
========= ======== =========
2001:
Fourth quarter........................................ $ 6,738 $ 809 $(41,644) $ (2.02)
Third quarter......................................... 5,155 1,022 (7,355) (0.52)
Second quarter........................................ 6,349 1,616 (1,785) (0.18)
First quarter......................................... 4,478 1,279 (2,376) (0.24)
--------- -------- ---------
Total................................................. $ 22,720 $ 4,726 $(53,160)
========= ======== =========
F-42
SCHEDULE II
SSP SOLUTIONS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 2000, 2001 AND 2002
(IN THOUSANDS)
ADDITIONS
BALANCE AT CHARGED TO DEDUCTIONS-
BEGINNING COSTS AND AMOUNTS BALANCE AT
DESCRIPTION OF PERIOD EXPENSES WRITTEN OFF END OF PERIOD
----------- --------- -------- ----------- -------------
Year Ended December 31, 2000:
Allowance for doubtful accounts ... $ 390 $ 286 $ 408 $ 268
======== ======== ======== ========
Tax valuation allowance ........... $ 1,498 $ 2,935 $ -- $ 4,433
======== ======== ======== ========
Year Ended December 31, 2001:
Allowance for doubtful allowance . $ 268 $ 401 $ 415 $ 254
======== ======== ======== ========
Tax valuation assets ............. $ 4,433 $11,334 $ -- $15,767
======== ======== ======== ========
Year Ended December 31, 2002
Allowance for doubtful accounts ... $ 254 $ 18 $ 85 $ 187
======== ======== ======== ========
Tax valuation allowance ........... $15,767 $ 2,765 $ -- $18,532
======== ======== ======== ========
S-1
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
------ -----------
2.1 Reorganization Agreement dated February 9, 1999, by and among
Litronic Inc. and Kris Shah and Geraldine M. Shah, as Trustees
Ramesh R. Shah and Patricia L. Shah, as Trustees, Dilip R. Shah and
Shila D. Shah, as Trustees, Kris Shah, as the Trustee of the Leena
Shah, Kris Shah, as the Trustee of the Chandra L. Shah (1)
2.2 Stock Acquisition Agreement dated February 9,1999, by and among
Litronic Inc., William W. Davis, Sr. and Lillian A. Davis, and Kris
Shah and Geraldine M. Shah, as Trustees Ramesh R. Shah and Patricia
L. Shah, as Trustees, Dilip R. Shah and Shila D. Shah, as Trustees,
Kris Shah, as the Trustee of the Leena Shah, Kris Shah, as the
Trustee of the Chandra L. Shah (1)
2.3 Agreement and Plan of Reorganization entered into as of July 3,
2001, by and among Litronic Inc., Litronic Merger Corp., and BIZ
Interactive Zone, Inc. (15)
3.1 Amended and Restated Certificate of Incorporation filed with the
Secretary of State of Delaware on June 8, 1999 (1)
3.2 Certificate of Amendment of the Amended and Restated Certificate of
Incorporation of Litronic Inc. filed with the Secretary of State of
Delaware on August 24, 2001 (4)
3.3 Certificate of Amendment of the Amended and Restated Certificate of
Incorporation of SSP Solutions, Inc. filed with the Secretary of
State of Delaware on July 12, 2002 (14)
3.4 Bylaws of Litronic Inc. (1)
4.1 Form of Common Stock Certificate (2)
10.1 Employment Agreement dated June 9, 1999 between Litronic Inc. and
Kris Shah (1) (#)
10.2 Litronic Industries, Inc. 1998 Stock Option Plan and form of
Litronic Industries, Inc. 1998 Stock Option Plan Incentive Stock
Option Agreement (1) (#)
10.3 Form of Litronic Industries, Inc. 1998 Stock Option Plan Incentive
Stock Option Agreement (1) (#)
10.4 Warrant Agreement made by Litronic Inc. in favor of BlueStone
Capital Partners, L.P. and Pacific Crest Securities Inc. (3)
10.5 SSP Solutions, Inc. Amended and Restated 1999 Stock Option Plan (9)
(#)
10.6 Form of SSP Solutions, Inc. Amended and Restated 1999 Stock Option
Plan Incentive Stock Option Agreement (9) (#)
10.7 Form of SSP Solutions, Inc. Amended and Restated 1999 Stock Option
Plan Non-Qualified Stock Option Agreement (4) (#)
10.8 BIZ Interactive Zone, Inc. 2000 Stock Option Plan (9) (#)
10.9 Form of BIZ Interactive Zone, Inc. Stock Option Agreement (9) (#)
10.10 SSP Solutions, Inc. 2001 Employee Stock Purchase Plan (9) (#)
10.11 Form of SSP Solutions, Inc. 2001 Employee Stock Purchase Plan
Subscription Agreement (9) (#)
10.12 Deed of Lease Agreement between Pulsar Data Systems, Inc. and
Massachusetts Mutual Life Insurance Company dated August 11, 1998
(3)
10.13 Equipment Purchase, Software License and Maintenance Agreement dated
April 20, 1999 between Bank of America and Litronic Inc. (3)
10.14 Lease dated January 2, 2000 between KRDS, Inc. and Litronic Inc.
(10)
10.15 Amendment Right to Cancel dated April 11, 2002 relating to Lease
dated January 2, 2000 between KRDS, Inc. and Litronic Inc. (4)
70
10.16 Purchase, Development and Deployment Agreement dated October 2, 2000
between BIZ Interactive Zone, Inc. and Wave Systems Corp. (2)
10.17 Amendment No. 1, dated May 10, 2001, to Purchase, Development, and
Deployment Agreement dated October 2, 2000 between BIZ Interactive
Zone, Inc. and Wave Systems Corp. (2)
10.18 Lease dated October 10, 2001 between Litronic Inc. and Research
Venture, LLC, related to real property located at 9012 Research
Drive, Irvine, California 92618 (2)
10.19 Lease dated October 10, 2001 between Litronic Inc. and Research
Venture, LLC, related to real property located at 11 Cushing,
Irvine, California 92618 (2)
10.20 Account Purchase Agreement dated as of November 2, 2001 by and
between Pulsar Data Systems, Incorporated and Wells Fargo Business
Credit, Inc. for the sale and assignment of accounts receivable (11)
10.21 Account Purchase Agreement dated as of November 2, 2001 by and
between SSP Solutions, Inc. and Wells Fargo Business Credit, Inc.
for the sale and assignment of accounts receivable (11)
10.22 Guaranty dated as of November 2, 2001 by Kris Shah for the benefit
of Wells Fargo Business Credit, Inc. relative Pulsar Data Systems,
Inc. Purchase Agreement dated November 2, 2001 (11)
10.23 Guaranty dated as of November 2, 2001 by Kris Shah for the benefit
of Wells Fargo Business Credit, Inc. relative to SSP Solutions, Inc.
Purchase Agreement dated November 2, 2001 (11)
10.24 Guaranty dated as of November 2, 2001 by Marvin Winkler for the
benefit of Wells Fargo Business Credit, Inc. relative Pulsar Data
Systems, Inc. Purchase Agreement dated November 2, 2001 (11)
10.25 Guaranty dated as of November 2, 2001 by Marvin Winkler for the
benefit of Wells Fargo Business Credit, Inc. relative to SSP
Solutions, Inc. Purchase Agreement dated November 2, 2001 (11)
10.26 Master Services Agreement dated December 1, 2001 between SSP
Solutions, Inc., Electronic Data Systems Corp. and EDS Information
Services LLC (2)
10.27 Task Order Number 2001-001 dated December 1, 2001 between SSP
Solutions, Inc., Electronic Data Systems Corp. and EDS Information
Services LLC (2)
10.28 Reseller Agreement dated November 21, 2001 between Control Break
International Corp. and SSP Solutions, Inc. (2)
10.29 Securities Purchase, Registration Rights and Security Agreement
dated as of April 16, 2002 by and among SSP Solutions, Inc.,
Crestview Capital Fund, L.P., Crestview Capital Fund II, L.P.,
Crestview Offshore Fund, Inc., Robert Geras, Richard P. Kiphart and
Nefilim Associates, LLC (5)
10.30 Amendment Number 1 to OEM Agreement dated April 18, 2002 between
Control Break International Corp. and SSP Solutions, Inc. (12)
10.31 Waiver and Acknowledgment dated January 28, 2003 among Crestview
Capital Fund, L.P., Crestview Capital Fund II, L.P., Crestview
Offshore Fund, Inc., Robert Geras, Richard P. Kiphart and Nefilim
Associates, LLC, LLC Wave Systems Corp. (4)
10.32 Second Amended and Restated Operating Agreement of SSP Gaming, LLC
dated April 7, 2003 by SSP Solutions, Inc., the sole member of SSP
Gaming, LLC (4)
10.33 Employment Agreement dated August 16, 2001 between Litronic, Inc.
and Richard M. Depew (4) (#)
10.34 Independent Contractor Services Agreement dated December 3, 2001 by
and between SSP Solutions, Inc. and Nefilim Associates, LLC (12)
10.35 Letter dated May 23, 2002 from the registrant to Nefilim Associates,
LLC regarding termination of Independent Contractor Services
Agreement (12)
10.36 Engagement letter agreement dated November 26, 2001 by and between
the SSP Solutions, Inc. and William Blair & Company, L.L.C (12)
71
10.37 Termination Agreement and Mutual Release dated September 30, 2002
effective as of August 31, 2002 by and among SSP Solutions, Inc.,
BIZ Interactive Zone, Inc. and Wave Systems Corp. (7)
10.38 Factoring Agreement dated as of October 18, 2002 by and between SSP
Solutions, Inc. and Bay View Funding for the sale and assignment of
accounts receivable (13)
10.39 Validity Indemnification dated as of October 18, 2002 by Kris Shah
for the benefit of Bay View Funding relative to SSP Solutions, Inc.
Factoring Agreement dated October 18, 2002 (13)
10.40 Validity Indemnification dated as of October 18, 2002 by Marvin
Winkler for the benefit of Bay View Funding relative to SSP
Solutions, Inc. Factoring Agreement dated October 18, 2002 (13)
10.41 First Amendment to Standard Industrial/Commercial Single-Tenant
Lease--Net dated October 23, 2002 between SSP Solutions, Inc. and
Research Venture, LLC relating to real property located at 9012
Research Drive, Irvine, California (8)
10.42 Stipulation for Entry of Judgment dated October 23, 2002 between SSP
Solutions, Inc. and Research Venture, LLC (8)
10.43 Mutual Settlement and Release dated October 31, 2002 by and among
Game Base of Nevada, Inc., Robert V. Brazell, SSP Gaming, LLC,
Marvin Winkler and SSP Solutions, Inc. (4)
10.44 Memorandum of Understanding and Agreement dated November 26, 2002
between SSP Solutions, Inc., Pulsar Data Systems, Inc. and
Electronic Data Systems Corporation (4)
10.45 Venetian Interactive Operating Agreement dated June 7, 2002 between
SSP Gaming, LLC and Venetian Casino Resort, LLC (4)
10.46 Forbearance Agreement dated March 12, 2003 between SSP Solutions,
Inc. and Integral Systems, Inc., effective September 1, 2002 (4)
10.47 Employment Agreement dated March 6, 2003 between SSP Solutions, Inc.
and Kris Shah (4) (#)
10.48 Employment Agreement dated March 6, 2003 between SSP Solutions, Inc.
and Marvin J. Winkler (4) (#)
10.49 Employment Agreement dated April 14, 2003, between SSP Solutions,
Inc. and Thomas E. Schiff (4) (#)
10.50 SSP Solutions, Inc. Purchase Agreement, 8.0% Subordinated
Convertible Notes, dated December 17, 2001 (without schedules) among
SSP Solutions, Inc., Richard P. Kiphart, Sandy Tennant, Marvin J.
Winkler and Kris Shah (2)
10.51 Subordinated Convertible Note, dated December 17, 2001, between SSP
Solutions, Inc. and Richard P. Kiphart (2)
10.52 Subordinated Convertible Note, dated December 17, 2001, between SSP
Solutions, Inc. and Sandy Tennant (2)
10.53 Amended and Restated Subordinated Convertible Note dated December
18, 2001 made by SSP Solutions, Inc. in favor of Marvin J. Winkler
(2)
10.54 Amended and Restated Subordinated Convertible Note dated December
18, 2001 made by SSP Solutions, Inc. in favor of Kris Shah (2)
10.55 Form of Subordination Agreement dated as of October 18, 2002 by
Crestview Capital Fund, L.P., Crestview Offshore Fund, Inc.,
Crestview Capital Fund II L.P., Richard P. Kiphart, Robert Geras and
Nefilim Associates, LLC for the benefit of Bay View Funding relative
to SSP Solutions, Inc. Factoring Agreement dated October 18, 2002
(4)
10.56 Promissory Note and Pledge Agreement dated July 24, 2000 between
Kris Shah and BIZ Interactive Zone, Inc. (2)
10.57 Form of Secured Convertible Promissory Notes dated April 16, 2002
issued by SSP Solutions, Inc. in favor of Crestview Capital Fund,
L.P., Crestview Capital Fund II, L.P., Crestview Offshore Fund,
Inc., Robert Geras, Richard P. Kiphart and Nefilim Associates, LLC
in the principal amounts of $1,075,000, $400,000, $25,000, $250,000,
$3,789,667, and $256,444, respectively (5)
72
10.58 Form of Warrants to Purchase Common Stock dated April 16, 2002
issued by SSP Solutions, Inc. in favor of Crestview Capital Fund,
L.P., Crestview Capital Fund II, L.P., Crestview Offshore Fund,
Inc., Robert Geras, Richard P. Kiphart and Nefilim Associates, LLC
in the amounts of 645,000, 240,000, 15,000, 150,000, 2,273,800 and
153,866, respectively (5)
10.59 Promissory Note dated April 16, 2002 in the principal amount of
$152,776 made by SSP Solutions, Inc. in favor of Kris Shah (5)
10.60 Promissory Note dated April 16, 2002 in the principal amount of
$500,000 made by SSP Solutions, Inc. in favor of Marvin Winkler (5)
10.61 Promissory Note dated April 18, 2002 in the principal amount of
$679,193 made by SSP Solutions, Inc. in favor of Control Break
International Corp. (4)
10.62 Promissory Note dated April 18, 2002 in the principal amount of
$26,594.74 made by SSP Solutions, Inc. in favor of Control Break
International Corp. (4)
10.63 Subordinated Convertible Promissory Note dated as of September 30,
2002 in the principal amount of $270,000 made by SSP Solutions, Inc.
in favor of Wave Systems Corp. (7)
10.64 Subordinated Convertible Promissory Note dated October 23, 2002 in
the principal amount of $360,000 made by SSP Solutions, Inc. in
favor of Research Venture, LLC (8)
10.65 Form of Promissory Notes dated November 14, 2002 made by SSP
Solutions, Inc. and SSP Gaming, LLC in favor of Crestview Capital
Fund II, L.P., Crestview Capital Fund, L.P. and Richard P. Kiphart,
in the principal amounts of $100,000, $100,000, and $300,000,
respectively (4)
10.66 Form of Warrants to Purchase Common Stock dated November 14, 2002
issued by SSP Solutions, Inc. to Crestview Capital Fund II L.P.,
Crestview Capital Fund L.P., Richard P. Kiphart in the amounts of
20,000, 20,000, and 60,000 shares, respectively (4)
10.67 Promissory Note dated January 22, 2003 in the principal amount of
$500,000 made by SSP Solutions, Inc. in favor of Richard P. Kiphart
(4)
10.68 Form of Promissory Notes dated March 18, 2003 and March 19, 2003,
respectively, made by SSP Solutions, Inc. in favor of Crestview
Capital Fund, L.P. and Richard P. Kiphart, respectively, each in the
principal amount of $100,000 (4)
10.69 Form of Warrants to Purchase Common Stock dated March 18, 2003 and
March 19, 2003, respectively, issued by SSP Solutions, Inc. in favor
of Crestview Capital Fund L.P. and Richard P. Kiphart, respectively,
each in the amount of 100,000 shares (4)
10.70 Form of Promissory Notes dated March 28, 2003 made by SSP Solutions,
Inc. in favor of Richard P. Kiphart, Crestview Capital Fund II,
L.P., Marvin J. Winkler and the Kris and Geraldine Shah Family
Trust, respectively, in the principal amounts of $240,000, $160,000,
$10,000 and $30,000, respectively (4)
10.71 Form of Warrants to Purchase Common Stock dated March 28, 2003
issued by SSP Solutions, Inc. in favor of Crestview Capital Fund
L.P., Richard P. Kiphart, Marvin J. Winkler and the Kris and
Geraldine Shah Family Trust, respectively, in the amounts of
120,000, 80,000, 5,000 and 15,000 shares, respectively (4)
10.72 Warrant to Purchase Common Stock dated March 12, 2003 by SSP
Solutions, Inc. to Integral Systems, Inc. (4)
16.1 Letter dated August 6, 2002 from KPMG LLP regarding change in
certifying accountant (16)
21.1 Subsidiaries of SSP Solutions, Inc.
23.1 Consent of Haskell & White LLP, Independent Certified Public
Accountants
23.2 Consent of KPMG LLP, Independent Certified Public Accountants
99.1 Certification of Co-Chief Executive Officers and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
section 906 of the Sarbanes-Oxley Act of 2002
73
----------
(#) Management contract or compensatory plan, contract or
arrangement required to be filed as an exhibit.
(1) Incorporated by reference to our Form S-1 filed with the
Securities and Exchange Commission ("Commission") on February
11, 1999 (registration statement no. 333-72151).
(2) Incorporated by reference to our Form 10-K for the year ended
December 31, 2001 (file no. 000-26227).
(3) Incorporated by reference to Amendment No. 2 to our Form S-1
filed with the Commission on May 6, 1999 (registration
statement no. 333-72151).
(4) Incorporated by reference to the initial filing of our Form
10-K for the year ended December 31, 2002 (file no.
000-26227).
(5) Incorporated by reference to our Form 8-K report for April 16,
2002 (file no. 000-26227).
(6) Incorporated by reference to our Form S-3 filed with the
Commission on June 14, 2002 (registration statement no.
333-90574).
(7) Incorporated by reference to our Form 8-K report for September
27, 2002 (file no. 000-26227).
(8) Incorporated by reference to our Form 8-K report for October
23, 2002 (file no. 000-26227).
(9) Incorporated by reference to our Form S-8 filed with the
Commission on November 13, 2001 (registration statement no.
333-73204).
(10) Incorporated by reference to our Form 10-K for the year ended
December 31, 2000 (file no. 000-26227).
(11) Incorporated by reference to our Form 10-Q for the quarter
ended September 30, 2001 (file no. 000-26227).
(12) Incorporated by reference to our Form 10-Q for the quarter
ended June 30, 2002 (file no. 000-26227).
(13) Incorporated by reference to our Form 10-Q for the quarter
ended September 30, 2002 (file no. 000-26227).
(14) Incorporated by reference to Amendment No. 1 to our Form 10-Q
for the quarter ended June 30, 2002 (file no. 000-26227).
(15) Incorporated by reference to our Definitive Proxy Statement
filed with the Commission July 25, 2001 (file no. 000-26227).
(16) Incorporated by reference to Amendment No. 1 to our Form 8-K
report for July 25, 2002 (file no. 000-26227).
74
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Dated: April 25, 2003 SSP Solutions, Inc.
By: /s/ MARVIN J. WINKLER
-----------------------------------
Marvin J. Winkler
CO-CHIEF EXECUTIVE OFFICER
By: /s/ KRIS SHAH
-----------------------------------
Kris Shah
CO-CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Act of 1934, this report
is made by the following persons on behalf of the registrant and in the
capacities indicated.
NAME TITLE DATE
---- ----- ----
/s/ MARVIN J. WINKLER Co-Chairman of the Board of Directors, April 25, 2003
------------------------------------ Director and Co-Chief Executive Officer
Marvin J. Winkler (Principal Executive Officer)
/s/ KRIS SHAH Co-Chairman of the Board of Directors, April 25, 2003
------------------------------------ Director and Co-Chief Executive Officer
Kris Shah (Principal Executive Officer)
/s/ THOMAS E. SCHIFF Executive Vice President and Chief April 25, 2003
------------------------------------ Financial Officer (Principal Financial
Thomas E. Schiff Officer and Principal Accounting Officer)
/s/ GREGG AMBER Director April 25, 2003
------------------------------------
Gregg Amber
/s/ RON R. GOLDIE Director April 25, 2003
------------------------------------
Ron R. Goldie
/s/ JOEL K. RUBENSTEIN Director April 25, 2003
------------------------------------
Joel K. Rubenstein
/s/ GREGORY J. CLARK Director April 25, 2003
------------------------------------
Gregory J. Clark
75
CERTIFICATIONS
I, Marvin J. Winkler, certify that:
1. I have reviewed this amendment no. 1 to annual report on Form 10-K
of SSP Solutions, Inc.;
2. Based on my knowledge, this annual 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
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual 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
annual report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: April 25, 2003
/s/ MARVIN J. WINKLER
---------------------
Marvin J. Winkler, Co-Chief Executive Officer
(principal executive officer)
76
I, Kris Shah, certify that:
1. I have reviewed this amendment no. 1 to annual report on Form 10-K
of SSP Solutions, Inc.;
2. Based on my knowledge, this annual 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
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual 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
annual report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: April 25, 2003
/s/ KRIS SHAH
-------------
Kris Shah, Co-Chief Executive Officer
(principal executive officer)
77
I, Thomas E. Schiff, certify that:
1. I have reviewed this amendment no. 1 to annual report on Form 10-K
of SSP Solutions, Inc.;
2. Based on my knowledge, this annual 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
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual 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
annual report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: April 25, 2003
/s/ THOMAS E. SCHIFF
--------------------
Thomas E. Schiff, Chief Financial Officer
(principal financial officer)
78
EXHIBITS FILED WITH THIS REPORT
EXHIBIT
NUMBER DESCRIPTION
------ -----------
23.1 Consent of Haskell & White LLP, Independent Certified Public
Accountants dated April 25, 2003
23.2 Consent of KPMG LLP, Independent Certified Public Accountants dated
April 25, 2003
99.1 Certification of Co-Chief Executive Officers and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
section 906 of the Sarbanes-Oxley Act of 2002
79