UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______ TO ______.
COMMISSION FILE NUMBER: 000-32319
ESSENTIAL REALITY, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)
NEVADA 33-0851302
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OR ORGANIZATION)
CHANGE OF ADDRESS 263 HORTON HIGHWAY
MINNEOLA, NEW YORK 11357
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
CHANGE OF PHONE NUMBER (516) 742-3100
(ISSUER'S TELEPHONE NUMBER)
INDICATE BY A CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS
REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH
FILING REQUIREMENTS FOR THE PAST 90 DAYS.
|X| YES |_| NO
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
CHECK WHETHER THE REGISTRANT FILED ALL DOCUMENTS AND REPORTS REQUIRED TO BE
FILED BY SECTION 12, 13 OR 15(D) OF THE EXCHANGE ACT AFTER THE DISTRIBUTION OF
SECURITIES UNDER A PLAN CONFIRMED BY A COURT.
|_| YES |_| NO
APPLICABLE ONLY TO CORPORATE ISSUERS:
AS OF APRIL 21, 2003 THERE WERE 18,588,110 SHARES OF THE ISSUER'S COMMON STOCK,
PAR VALUE $.001 PER SHARE, ISSUED AND OUTSTANDING.
TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT |_| YES |X| NO
PART I - FINANCIAL INFORMATION
PAGES
ITEM 1 - FINANCIAL STATEMENTS
CONDENSED BALANCE SHEET AS OF JUNE 30, 2003 (UNAUDITED) 1
CONDENSED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX
MONTHS ENDED JUNE 30, 2003 AND 2002 (UNAUDITED) 2
CONDENSED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS
ENDED JUNE 30, 2003 AND 2002 (UNAUDITED) 3-4
NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 5-13
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS 14-27
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS 27
ITEM 2 - CHANGES IN SECURITIES 28
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES 29
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 29
ITEM 5 - OTHER INFORMATION 29
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 32
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
CONDENSED BALANCE SHEET (UNAUDITED)
JUNE 30, 2003
ASSETS
CURRENT ASSETS:
Accounts receivable $ 13,581
Notes receivable, net 373,000
Inventories, net 246,110
Other current assets 50,304
------------
Total current assets 682,995
EQUIPMENT AND IMPROVEMENTS, net of accumulated depreciation
and amortization 317,373
INTANGIBLE ASSETS, net of accumulated amortization 213,599
OTHER ASSETS 58,050
------------
$ 1,272,017
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Book overdraft $ 22,579
Accounts payable and accrued expenses 2,282,701
Due to related parties 233,947
Loan Payable - unsecured 25,000
Accrued compensation 228,492
Secured convertible debenture (net of deferred interest of $69,992) 930,008
Notes payable (net of deferred interest of $7,482) 1,830,104
------------
Total current liabilities 5,562,039
COMMITMENTS AND CONTINGENCIES --
STOCKHOLDERS' DEFICIT:
Common stock, $0.001 par value; 50,000,000 shares authorized;
18,588,110 shares issued and outstanding 18,588
Additional paid-in capital 14,574,654
Deferred compensation expense (1,109,476)
Deferred consulting expense (126,000)
Accumulated deficit (17,638,580)
------------
Total stockholders' deficit (4,280,814)
------------
$ 1,272,017
============
See notes to condensed financial statements
1
ESSENTIAL REALITY, INC (FORMERLY JPAL, INC.)
CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- -----------------------------
2003 2002 2003 2002
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
------------ ------------ ------------ ------------
REVENUE $ 56,636 $ -- $ 100,158 $ --
COST OF REVENUE 21,325 -- 123,740 --
------------ ------------ ------------ ------------
GROSS INCOME (LOSS) 35,311 -- (23,582) --
------------ ------------ ------------ ------------
OPERATING EXPENSES:
Sales and marketing 94,859 328,935 355,127 616,523
Product development 313,581 400,288 458,656 881,110
General and administrative expenses 290,474 363,702 582,487 903,390
Depreciation and amortization 57,888 3,415 115,776 6,830
Severance compensation (forfeiture) -- -- 294,511 --
Stock-based compensation 358,806 118,499 1,165,548 118,499
------------ ------------ ------------ ------------
TOTAL OPERATING EXPENSES 1,115,608 1,214,839 2,972,105 2,526,352
------------ ------------ ------------ ------------
LOSS FROM OPERATIONS (1,080,297) (1,214,839) (2,995,687) (2,526,352)
OTHER INCOME (EXPENSE):
Interest income 148 2,851 1,213 2,851
Interest expense (278,845) (90,301) (1,018,359) (138,886)
Miscellaneous (25) -- (25) --
------------ ------------ ------------ ------------
Total other income (expense) (278,845) (87,450) (1,017,171) (136,035)
------------ ------------ ------------ ------------
LOSS BEFORE PROVISION FOR INCOME TAXES (1,359,142) (1,302,289) (4,012,858) (2,662,387)
PROVISION FOR INCOME TAXES -- -- -- --
------------ ------------ ------------ ------------
NET LOSS $ (1,359,142) $ (1,302,289) $ (4,012,858) $ (2,662,387)
============ ============ ============ ============
NET LOSS PER SHARE - BASIC AND DILUTED $ (0.07) $ (0.07) $ (0.22) $ (0.15)
============ ============ ============ ============
NUMBER OF WEIGHTED AVERAGE SHARES -
BASIC AND DILUTED 18,588,110 17,955,718 18,420,707 17,955,718
============ ============ ============ ============
See notes to condensed financials statements
2
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
STATEMENTS OF CASH FLOWS (UNAUDITED)
Six months ended June 30,
---------------------------
2003 2002
----------- -----------
CASH FLOWS PROVIDED BY (USED FOR) OPERATING ACTIVITIES:
Net loss $(4,012,858) $(2,662,387)
ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH
PROVIDED BY (USED FOR) OPERATING ACTIVITIES:
Depreciation and amortization 115,776 6,830
Amortization of deferred interest 641,732 23,081
Non-cash compensation 1,190,798 118,499
Imputed interest on conversion of debt instrument 263,093 --
Change in inventory reserve 99,979
CHANGES IN ASSETS AND LIABILITIES:
(INCREASE) DECREASE IN ASSETS:
Restricted cash -- (575,000)
Accounts receivable 25,098 --
Inventories (41,560) --
Deferred financing cost -- 217,755
Notes receivable 27,000 --
Other current assets 67,690 (83,580)
INCREASE (DECREASE) IN LIABILITIES:
Accounts payable and accrued expenses 723,522 185,907
Accrued compensation -- (13,366)
----------- -----------
Total adjustments 3,113,128 (119,874)
----------- -----------
Net cash used for operating activities (899,730) (2,782,261)
----------- -----------
CASH FLOWS USED FOR INVESTING ACTIVITIES:
Payments for purchases of equipment (7,823) (9,052)
----------- -----------
Net cash used for investing activities (7,823) (9,052)
----------- -----------
CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Book overdraft 22,579 --
Proceeds from sale of securities 100,000 --
Net proceeds from issuance of members' capital -- 6,227,364
Proceeds from bridge loans and notes payable 107,500 1,825,000
Proceeds from Secured Convertible Debenture 500,000 --
Proceeds from loan payable - unsecured 25,000 --
Repayment of bridge loans -- (550,000)
Repayment of notes payable (68,461) (550,000)
Net advances from LCG Capital, Inc. -- (3,000)
Repayments of advances from affiliated companies-net 32,077 (36,468)
----------- -----------
Net cash provided by financing activities 718,695 6,912,896
----------- -----------
NET INCREASE (DECREASE) IN CASH (188,858) 4,121,583
CASH AND CASH EQUIVALENTS, beginning of year 188,858 13,863
----------- -----------
CASH AND CASH EQUIVALENTS, end of June 30, 2003 $ -- $ 4,135,446
=========== ===========
See notes to condensed financials statements
3
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
STATEMENTS OF CASH FLOWS (CONTINUED) (UNAUDITED)
Six months ended June 30,
----------------------------
2003 2002
-------------- ----------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid $ 5,288 $ 22,500
============== ==========
Income tax paid $ -- $ --
============== ==========
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Bridge loans converted to member units $ -- $ 500,000
============== ==========
Elimination of bridge loans and accrued interest on merger $ -- $2,378,431
============== ==========
Assumption of notes on merger $ -- $2,517,070
============== ==========
Imputed interest on notes payable $ -- $1,158,380
============== ==========
Imputed interest on conversion of debt instruments $ 166,498 $ --
============== ==========
Discount recorded related to warrants and
Beneficial conversion feature of convertible debentures $ 175,706 $ --
============== ==========
Issuance of common stock for consulting fees $ 144,000 $ --
============== ==========
Deferred compensation expense $ -- $ 118,499
============== ==========
See notes to condensed financial statements
4
NOTES TO CONDENSED FINANCIAL STATEMENTS
June 30, 2003 (UNAUDITED)
1. BASIS OF PRESENTATION, ORGANIZATION AND OTHER MATTERS
The accompanying unaudited condensed financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America for interim financial information and pursuant to the rules and
regulations of the Securities and Exchange Commission ("SEC"). Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been omitted. These financial statements should be
read in conjunction with the financial statements and related notes included in
the Company's Annual report on Form 10 KSB for the year ended December 31, 2002.
In the opinion of management, all material adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation have been
included in the accompanying unaudited condensed financial statements.
The results of operations for the interim periods are not necessarily indicative
of the results that may be expected for the full year ending December 31, 2003.
Nature of Business
Essential Reality, LLC ("ER LLC" or the "Company") was formed as Freedom
Multimedia, LLC in the state of Delaware on July 9, 1998 and began active
operations on June 1, 1999. The Company changed its name to Essential Reality,
LLC ("ER, LLC") on December 29, 1999. On June 20, 2002, ER LLC completed a
business combination (recapitalization) with JPAL, Inc. ("JPAL"), a Nevada
Corporation (the "Transaction"). Whereby, all of the members of ER LLC
contributed their membership interests in ER LLC to JPAL in exchange for
16,874,784 shares of JPAL's common stock. The shareholders of JPAL canceled
7,564,326 of their shares of JPAL common stock and were left with 1,080,934
shares of common stock representing 6.02% of JPAL. Upon the business
combination, ER LLC was dissolved and all of its assets and liabilities were
transferred into JPAL. Following the Transaction, JPAL changed its name to
Essential Reality, Inc.
The Company was formed to develop, manufacture, and market computer peripheral
devices, with an initial emphasis on a product called "P5." However, due to less
than expected sales of the P5, the Company has expanded its focus and now aims
to become a leading developer and distributor of unique, technology-based
consumer electronics, gaming products, and consumer youth products targeted to
teenagers in the mass market.
Basis of Presentation:
The financial statements of the Company were prepared in conformity with
Statement of Financial Accounting Standards ("SFAS") No. 7, "Accounting and
Reporting by Development Stage Enterprises," through December 31, 2001.
Effective October 1, 2002, the Company no longer met the requirements of SFAS
No. 7 and, accordingly, all disclosures required under SFAS No. 7 have been
discontinued in these financial statements.
5
Going Concern:
The accompanying financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America that
contemplate continuation of the Company as a going concern. However, the Company
has reported a net loss of $4,012,858 and $2,662,387 for the six months ended
June 30, 2003 and 2002, respectively, has an accumulated deficit of $17,638,580,
and at June 30, 2003 the Company's current liabilities exceeded its current
assets by $4,489,836. Without realization of additional capital, it would be
unlikely for the Company to continue as a going concern. This factor raises
substantial doubt about the Company's ability to continue as a going concern.
The financial statements do not include any adjustments that might result from
the outcome of the uncertainty.
Management plans to take the following steps that it believes will be sufficient
to provide the Company with the ability to continue in existence:
Management intends to raise financing through the sale of its stock on the
public market as well as from bridge loans. Management believes that with this
financing, the Company will be able to generate additional revenues that will
allow the Company to continue as a going concern. This will be accomplished by
hiring additional personnel and focusing sales and marketing efforts on the
distribution of product through key marketing channels currently being developed
by the Company. The financial statements do not include any adjustments that
might result from the outcome of the uncertainty.
ACCOUNTING POLICIES
Inventories:
Inventories are valued at the lower of cost or market, with cost being
determined on the first-in first-out basis. The inventory represents
high-technology parts that may be subject to rapid technology obsolescence or
limited sales cycle and which are sold in a highly competitive industry. If the
actual product demand or selling prices are less than cost, the Company
establishes an allowance account based on net realizable value.
Inventory sold with the right of price protection and/or right of return is
reported as inventory on consignment. Consigned inventory amounted to $69,691 at
June 30, 2003 and is included as inventory on the balance sheet.
Inventory is net of a valuation allowance of $1,287,853 at June 30, 2003.
Research and Development:
Research and development costs are expensed in the year incurred. These costs
totaled $458,656 and $881,110 net of loan receivable of $373,000 for the six
months ended June 30, 2003 and 2002, respectively.
6
2. NOTES RECEIVABLE:
Notes receivable as of June 30, 2003 consisted of the following:
Due from former employee $ 50,000
Due from product developer 425,121
--------
475,121
Less: reserve for collectibility 102,121
--------
$373,000
========
In July 2001, the Company signed an agreement with a third party for the
development of the P5. In connection with the agreement, the Company agreed to
provide loan advances up to $2,000,000, later increased to $2,700,000, to cover
approved development costs. The loan is non-interest bearing and is reduced by
qualified development expenses incurred by the developer, and is further reduced
by tax credits from a division of the Canadian Government for research, earned
by the developer and passed through to the Company. The Company received a
General Security Agreement that created a security interest in the developer's
equipment, inventory, accounts receivable, intangibles, etc. The loan is payable
within two years after each advance unless on demand after the two years at the
discretion of ER.
As of June 30, 2003, the loan balance has been reduced by $1,960,012 of
qualified development expenses and $425,121 of research and development credits
from the Canadian Government. The remaining receivable of $373,000 is net of an
allowance for reduced tax credits of $52,121 at June 30, 2003.
On September 16, 2003 the Company executed a Settlement Agreement and Mutual
Release where the parties agreed to waive all rights and claims against each
other for its past and present services under the Agreement including severance
obligations assumed by the developer and the Company applied the outstanding Tax
Credit Receivable equal to the amount owed to the developer.
As of September 16, 2003, the loan balance had been reduced by $1,960,012 of
qualified development expenses and $418,773 of research and development credits
from the Canadian Government. The remaining receivable balance at September 16,
2003 of $366,642 was applied against the outstanding balance owed at that date.
3. SECURED CONVERTIBLE DEBENTURE:
In November 2002, the Company opened a Subscription Agreement to raise
$1,000,000 8% Secured Convertible Debenture (the "Debenture"). As of December
31, 2002, the Company raised $500,000. The remaining $500,000 was raised by June
30, 2003. The debentures for $1,000,000 contain a beneficial conversion feature
for six months at a conversion price of $1.00. The debenture also contains
detachable warrants to acquire 310,500 shares of common stock at an exercise
price of $1.00 per share expiring in five years. The Debenture is collateralized
by the Company's right, title, and interest in and to all present and future
rights to payment of goods and services.
7
3. SECURED CONVERTIBLE DEBENTURE, Continued:
In connection with the Debenture in accordance with EITF 00-27, the Company
first determined the value of the notes and the fair value of the detachable
warrants issued in connection with this convertible debenture. The estimated
value of the 310,500 warrants of $196,187was determined using the Black-Scholes
pricing model with the following assumptions: (i) no expected dividends; (ii) a
risk-free interest rate of 4.04%; (iii) expected volatility of 83%; and (iv) an
expected life of two years. The face amount of the notes payable of $1,000,000,
which has a conversion feature for six months, was proportionately allocated to
the note payable and the warrants in the amount of $840,087 and $159,913,
respectively. The amount allocated to the warrants of $159,913 was recorded as a
discount on the note payable. The value of the note payable was then allocated
between the note and the preferential conversion feature, which amounted to
$448,331 and $391,756, respectively. The combined total discount is $551,670, is
being accreted into notes payable as additional interest expense over the
remaining life of the note. Of the $551,670 discount, as of June 30, 2003,
$481,678 has been amortized to expense. None of the note balance under this
agreement has been converted into common stock as of June 30, 2003.
As of June 30, 2003, the Company has defaulted on the debt. The debt is no
longer convertible as the conversion feature expired on the maturity date of the
notes.
4. NOTES PAYABLE
As of June 30, 2003, the Company has $1,717,070 of notes payable that were
assumed during the Transaction (as described in Note 1, Nature of Business).
These notes bear interest at 8 1/2% per annum. As of June 30, 2003, the Company
has accrued $149,947 of interest and it is included in accounts payable and
accrued expenses at June 30, 2003. The Company has defaulted on these loans.
In May 2003, the Company issued an 8% Unsecured Convertible debenture for
$67,500. The debenture which matures in six months contains a beneficial
conversion feature at a conversion price $0.40. The debenture also contains
detachable warrants to acquire 42,188 shares of common stock at an exercise
price of $0.25 per share expiring in five years. In accordance with EITF 00-27,
the Company first determined the value of the notes and the fair value of the
detachable warrants issued in connection with this convertible debenture. The
estimated value of the 42,188 warrants of $3,746 was determined using the
Black-Scholes pricing model with the following assumptions: (i) no expected
dividends; (ii) a risk-free interest rate of 4.04%; (iii) expected volatility of
83%; and (iv) an expected life of two years. The proceeds were proportionately
allocated to the note payable and the warrants in the amount of $63,951 and
$3,549, respectively. The amount allocated to the warrants of $3,549 was
recorded as a discount on the note payable. Due to the market price being less
than the conversion price no preferential conversion exists. The discount is
being accreted into notes payable as additional interest expense over the
remaining life of the note. Of the $3,549 discount, as of June 30, 2003 $592 has
been amortized to expense. None of the note balance under this agreement has
been converted into common stock as of June 30, 2003. The debt and
convertibility featured expired without repayment or conversion.
8
4. NOTES PAYABLE, Continued:
In June 2003, the Company issued an 8% Unsecured Convertible Debenture for
$40,000. The debenture, which matures in six months, contains a beneficial
conversion feature at a conversion price of $0.40. The debenture contains
detachable warrants to acquire 33,000 shares of common stock at an exercise
price of $0.25 per share expiring in five years. In accordance with EITF 00-27,
the Company first determined the value of the notes and the fair value of the
detachable warrants issued in connection with this convertible debenture. The
estimated value of the 33,000 warrants of $5,631 was determined using the
Black-Scholes pricing model with the following assumptions: (i) no expected
dividends; (ii) a risk-free interest rate of 4.04%; (iii) expected volatility of
83%; and (iv) an expected life of two years. The proceeds were proportionately
allocated to the note payable and the warrants in the amount of $35,064 and
$4,936, respectively. The amount allocated to the warrants of $4,936 was
recorded as a discount on the note payable. Due to the market price being less
than the conversion price no preferential conversion exists. The discount is
being accreted into notes payable as additional interest expense over the
remaining life of the note. Of the $4,936 discount, as of June 30, 2003 $411 has
been amortized to expense. None of the note balance under this agreement has
been converted into common stock as of June 30, 2003.
5. EQUITY
On March 10, 2003, the Company entered into an Investment banking/Advisory
Agreement with First Securities USA, Inc. through its SBI USA division engaging
SBI as exclusive advisor and agreed to pay the Investment Banker a retainer of
25,000 shares of common stock of the Company.
On March 12, 2003, the Company sold 100,000 shares of common stock to a private
investor for $1.00 per share totaling $100,000.
On April 1, 2003, the Company issued 240,000 shares of common stock to a
consultant for services to be rendered over a two year period. The fair market
value of the stock of $144,000 was determined based on the closing price of the
stock on the date of issuance. The contract amount will be amortized over the
contract period. The amount has been offset against equity due to the stock
being issued before the services have been rendered.
6. STOCK OPTION PLANS:
The Company has elected to follow Financial Accounting Standards Board Statement
No. 123 (Accounting for Stock-Based Compensation) and accordingly the Company
determined compensation costs based on the fair value at the grant date for its
stock options.
As of June 30, 2003, 217,334 options were cancelled because of the termination
of certain employees.
9
6. STOCK OPTION PLANS, Continued:
A schedule of activity with respect to the Company's stock option plans is as
follows:
Weighted
Number Average of
of Shares Exercise Price
--------- --------------
Outstanding at December 31, 2002 1,357,000 $1.08
Granted -- --
Exercised -- --
Cancelled 217,334 .89
--------- -----
Outstanding at June 30, 2003 1,139,666 $1.29
========= =====
Options exercisable at June 30, 2003 468,236 $ --
========= =====
The following tables summarize information about stock options outstanding and
exercisable at June 30, 2002:
Weighted Outstanding Exercisable
Average Options Options
Range of Number of Remaining Weighted Number of Weighted
Exercise Outstanding Contractual Life Average Shares Average
Prices Options in Years Exercise Price Exercisable Exercise Price
------ ------- -------- -------------- ----------- --------------
$.65 to $1.00 1,023,266 9.36 $ .96 339,140 $ .96
$1.01 to $4.00 116,400 9.36 2.85 129,096 2.85
-------------- --------- ---- ----- ------- -----
1,139,666 9.36 $1.29 468,236 $1.29
========= ==== ===== ======= =====
7. WARRANTS:
A schedule of warrant activity as June 30, 2003 is as follows:
Weighted
Number Average of
of Shares Exercise Price
--------- --------------
Outstanding at December 31, 2002 1,286,211 $1.68
Granted 333,500
Exercised -- --
Cancelled --
--------- -----
Outstanding and exercisable at June 30, 2003 1,619,711 $1.68
========= =====
All of the warrants granted were granted in conjunction with secured convertible
debentures and notes payable. See Notes 3 and 4.
In connection with the termination of the CEO, the Company issued five year
warrants to purchase 250,000 shares of common stock. The fair value of the
warrants of $177,409 was determined using the Black-Scholes pricing model with
the following assumptions: (i) no expected dividends; (ii) a risk free interest
rate of 4%; (iii) expected volatility of 80%; and (iv) expected life of five
years.
10
7. WARRANTS, Continued:
In connection with the consulting contract for public relation services, the
Company issued five year warrants to purchase 250,000 shares of common stock.
The fair value of the warrants of $88,785 was determined using the Black-Scholes
pricing model with the following assumptions: (i) no expected dividends; (ii) a
risk free interest rate of 4%; (iii) expected volatility of 80%; and (iv)
expected life of five years.
8. RELATED PARTY TRANSACTIONS
The Company had the following related party transactions for the six months
ended June 30, 2003 as follows:
The Company received advances from affiliated companies which are from entities
that are affiliated with certain shareholders of the Company and totaled $1,712
at June 30, 2003 and are included in due to related party.
Non-interest bearing advances from an affiliate of certain shareholders, LCG
Capital Group, LLC, totaling $70,912 are outstanding at June 30, 2003 and are
included in due to related party.
Included in product and development expense is $25,000 and $26,700 for the six
months ended June 30, 2003 and 2002, respectively, owed to a company owned by
certain shareholders of the Company that have consulted with the Company in the
areas of product strategy, design, and development. The outstanding balance at
June 30, 2003 totaled $19,030 and is included in due to related party.
Included in general and administrative expenses are cost incurred of $1,323 and
$44,700 for the six months ended June 30, 2003 and 2002, respectively, by two
entities that are related to certain members of LCG Capital Group. Such costs
were determined to be allocable costs to the Company and include consulting fees
related to business development, employee salaries, occupancy, telephone, and
computer leases. In the case of employee salaries, costs are allocated to the
Company based on the time each employee conducts business specific to the
Company. In the case of the other expenses, costs are allocated based on a
percentage of resources used by the Company. Included in due to related parties
is $4,039 as of June 30, 2003.
Included in general and administrative expenses is $47,845 and $72,000 for the
six months ended June 30, 2003 and 2002, respectively of marketing expense
payable to a company owned by a person related to certain members of the Company
who assisted in establishing and executing its marketing programs. Included in
due to related parties is $100,345 at June 30, 2003.
An included in general and administrative expense is $37,500 and $7,500 for the
six months ended June 30, 2003 and 2002, respectively for directors' fees.
Included in due to related parties is $37,500 at June 30, 2003.
9. CONTRACTUAL OBLIGATIONS/GAME PUBLISHERS-LICENSING AGREEMENTS:
The Company has obligations under contracts entered into prior to December 31,
2002 for consulting, product development and royalties. At June 30, 2003
included in accounts payable and accrued expenses is $231,071 related to these
contracts.
11
10. COMMITMENTS:
Consulting Agreement:
On March 14, 2003, effective April 1, 2003, the Company retained a consultant
for institutional financial public relations for at least two years. The Company
may terminate this agreement at any time in the event of gross negligence. In
which case all shares of Common Stock distributed as discussed below that have
not been earned shall be forfeited by the consultant. After the first year,
either party may terminate the agreement upon thirty days' written notice. If
terminated after the first year, the consultant will return to the Company the
lesser of (i) $1.00 for each share of common stock which is unearned (i.e. the
number of months remaining to the term multiplied by 10,000) as of the date of
termination; or (ii) the actual value of the shares of common stock which are
unearned as if the date of termination.
As compensation, the Company will issue a five year warrant to purchase up to
250,000 shares of the Company's common stock at a strike price of $1.00 per
share. Expense of $117,409 has been recorded as it relates to the fair market
value of the warrants. The fair market value was determined using the Black
Scholes pricing model with the following assumptions: (i) no expected dividends;
(ii) risk-free interest rate of 4.04%; (iii) expected volatility of 83%; and
(iv) expected life of five years.
In addition the Company will pay a $10,000 retainer per month for 24 months in
the form of the Company's common stock for 240,000 shares in advance and to be
registered by the Company at its expense at the earliest possible time. The
value of the services to be performed was determined on the date of the issuance
using the closing price of the stock ($0.60 per share). The expense of $144,000
is being amortized over the life of the contract. No services have been
performed to date.
The Company will also reimburse the consultant for reasonable out-of pocket
expenses. The out-of pocket expenses will not exceed $250 with the consent of
the Company. The Company will prepay $5,000 and will replenish this account
monthly to maintain the $5,000 level. No payments have been made to date. The
balance owed is in included in account payable as of March 31, 2003.
Lease Agreement:
In April 2003, the Company entered into an operating lease for office and
warehouse space in Minneola, New York. The operating lease is effective for 5
years with and option to renew for 3 years. The minimum monthly base rental is
$4,500 with annual increases of two hundred per month plus 20% of the increase
in real estate taxes over the base year.
The Company moved from the New York location on July 1, 2003. The Company
forfeited the security deposit as payment for breaking the lease.
11. SUBSEQUENT EVENTS
For the period July 18, 2003 through October 31, 2003, pursuant to the
Subscription Agreement to raise $250,000 of 8% Unsecured Convertible Debenture
(the "Debenture"), the Company received an additional $106,000. The debenture
contains a beneficial conversion feature for six months at a conversion price of
$0.40. The debenture also contains detachable warrants to acquire 124,620 shares
of common stock at an exercise price of $1.25 per share expiring in five years.
12
11. SUBSEQUENT EVENTS, CONTINUED:
If the Company raises at least $3,000,000, to the extent the Debenture has not
been repaid or converted in full, the remaining outstanding amounts shall
automatically be deemed converted at the lower of $0.40 per share or 10% below
offering per security issued for future financing debt equity capital of
Company.
In June, 2003 the Company began negotiations with the developer of the P5 to
terminate the contract signed in July, 2001. The agreement provides for no
further cash compensation for services and to be paid for costs associated with
the termination of the Agreement including severance obligations. In addition,
the Company will provide for stock compensation for achieving its milestones in
completing the project in 2002. It is intended that the amount owed will be
completely funded by the note receivable to be remitted through research and
development credits from the Canadian Government.
On September 16, 2003 the Company executed a Settlement Agreement and Mutual
Release where the parties agreed to waive all rights and claims against each
other for its past and present services under the Agreement including severance
obligations assumed by the developer; and the Company applied the outstanding
Tax Credit Receivable equal to the amount owed to the developer.
As of September 16, 2003, the loan balance had been reduced by $1,960,012 of
qualified development expenses and $418,773 of research and development credits
from the Canadian Government. The remaining receivable of $366,642 was applied
to the outstanding balance owed at September 16, 2003. As of September 30, 2003,
the notes receivable in the amount of $351,295 was fully reserved.
On February 5, 2004 the Company announced that it had executed a binding term
sheet (the "Term Sheet"), which sets forth the preliminary terms and conditions
of a proposed merger transaction between Essential and Alliance. This Term Sheet
supersedes and replaces the Letter of Intent dated November 6, 2003. As
proposed, the shareholders of Alliance would exchange their shares of capital
stock in Alliance for shares of common stock of Essential.
Upon the closing of the merger, as currently contemplated, the shareholders of
Alliance will own common stock representing approximately 64.5% of the
outstanding capital stock of the Company on a fully-diluted basis.
The consummation of the transaction is contingent on a number of factors,
including but not limited to, the completion of due diligence and the execution
of a definitive agreement. There can be no assurance that the merger will be
consummated or, if consummated, that it will be consummated on the terms set
forth in the Term Sheet.
The change in business conditions in the fourth quarter and the execution of the
letter of intent resulted in the sale of the entire inventory on hand as of
December 31, 2003 at $6.00 per unit in the first quarter of 2004. In addition,
pursuant to FASB statement of SFAS No.144 "Accounting for the Impairment or
Disposal of Long -Lived Assets" the Company was not able to determine the future
impact on the financial position, results of operations and future cash flows,
as a result the Company recorded an impairment loss on the intangible assets,
web site development costs, capitalized development costs, and all the fixed
assets as of December 31, 2003.
13
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS of FINANCIAL CONDITION AND RESULTS
OF OPERATIONS FORWARD-LOOKING STATEMENTS
The following discussion and analysis should be read in conjunction with the
unaudited condensed financial statements and related notes and other financial
information included in this Quarterly Report on Form 10QSB. It is intended to
assist the reader in understanding and evaluating the financial position of the
Company. This report contains, in addition to historical information,
forward-looking statements that involve risks and uncertainties. Words such as
"may", "will"," should", "could", "expects", "plans", "intends", "anticipates",
"believes", "estimates", "potential", or "continue" or the negative of such
terms and other comparable terminology are intended to identify forward-looking
statements. The Company's actual results could differ materially from the
results discussed in the forward-looking statements. Risk factors that could
cause or contribute to such differences include those discussed in Essential
Reality, Inc.'s annual report on Form 10KSB for the year ended December 31,
2002, filed with the Securities and Exchange Commission.
OVERVIEW
On June 20, 2002, Essential Reality, LLC, a Delaware Limited Liability Company
("ER LLC"), completed a business combination with JPAL, Inc., a Nevada
corporation and an SEC registrant ("JPAL") pursuant to an Amended Contribution
Agreement between ER LLC and JPAL, whereby all of the members of ER LLC
contributed their membership interests in ER LLC to the Company in exchange for
an aggregate of 16,874,784 shares of the Company's common stock (the
"Transaction"). Concurrent with the Transaction, the shareholders of JPAL
canceled 7,564,326 of their shares of JPAL common stock and were left with
1,080,934 shares of common stock representing 6.02% of the Company. Following
the Transaction, JPAL changed its name to Essential Reality, Inc. (the
"Company") and ER LLC, a wholly owned subsidiary of the Company, was merged into
the Company.
The Transaction was accounted for as recapitalization of ER LLC. The management
of the ERLLC remained as the management of the Company. Since the Transaction
was accounted for as a recapitalization and not a business combination, no
goodwill has been recorded in connection with the Transaction and the costs
incurred in connection with the Transaction have been accounted for as a
reduction of additional paid-in capital. As a result of recapitalization (i) the
historical financial statements of the Company for periods prior to the date of
the Transaction are no longer the historical financial statements of JPAL, and,
therefore, JPAL's historical financial statements are no longer presented; (ii)
the historical financial statements of the Company for periods prior to the date
of the Transaction are those of ER LLC; (iii) all references to the financial
statements of the "Company" apply to the historical financial statements of ER
LLC prior to the Transaction and to the financial statements of the Company
subsequent to the Transaction; and (iv) any reference to the Company applies
solely to ER LLC and Essential Reality, Inc.
ER, LLC was organized in 1999 as a developer of real-time tracking and sensory
technologies. From its formation through the date of its dissolution as a result
of the business combination, it was involved in research and development,
marketing, entering into strategic relationships and hiring key employees in
connection with the final production, sale and distribution of the P5(TM). The
P5(TM), a virtual controller, is a glove-like peripheral device that enables
users to control the action on a screen through simple hand movements, rather
than complicated keystroke and mouse combinations. This product is based on
patented, and several patent-pending, technologies that address technological
limitations of current devices, such as the mouse, hand-held game controllers
and joysticks. The P5TM is engineered to capture five-finger bend sensitivity
enabling gesture recognition, combined with an optical tracking technology that
captures the movement of the hand in 3D space, without the use of a mouse,
joystick, keyboard or the like. For example, if a user is trying to open a door
while playing an adventure game, the P5(TM) allows the user to make the hand
motion of opening a door and see the door open simultaneously with the motion,
as opposed to the user pressing a button and seeing the door open immediately
thereafter. To date, the P5(TM) is the only product that we have developed and
marketed.
14
CRITICAL ACCOUNTING POLICIES
Revenue Recognition:
The Company recognizes under Staff Accounting Bulletin 101, gross revenue when
the earnings process is complete, as evidenced by an agreement with the
customer, transfer of title and the rights and risks of ownership have passed to
the customer, the product is delivered, the price is fixed and determinable, and
collection of the resulting receivable is reasonably assured. Because the
Company allows many of its distributors price protection and/or right of return,
recognition of revenue in the accompanying financial statements has been
deferred until the distributors sell the merchandise and the cash is collected
by the Company. Inventory at distributors is reported as consigned in the
balance sheet.
In cases where sales are made to certain distributors and title has transferred,
risks of ownership has passed and collection is assured, sales have been
recorded and an account receivable has been recorded.
The Company records an allowance for uncollectible accounts on a
customer-by-customer basis as appropriate.
The Company may bundle product offerings from third-party vendors along with the
P5 product or may sell the P5 independently. The software is incidental to the
product as a whole and according to Financial Accounting Standards Board No 86;
Accounting for the Costs of Computer Software To Be Sold, Leased or Marketed,
all revenue will be allocated to the P5. As such, the Company will record the
gross amount of the purchase price of the P5 product as revenue and will reflect
the royalty to be paid to the third-party vendor as a component of cost of
sales.
Inventory
Inventory is valued at the lower of cost or market, with cost being determined
on the first in-first out basis. The inventory represents high-technology parts
that maybe subject to rapid technology obsolescence and which are sold in a
highly competitive industry. If the actual product demand or selling prices are
less favorable than we estimate, the company establishes an allowance account
based on net realizable values. Inventory sold with the right of price
protection and or right of return is reported as inventory on consignment.
Use of Estimates:
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
15
RESULTS OF OPERATIONS:
For the three and six months ended June 30, 2003 compared to the three and six
months ended June 30, 2002
The unaudited financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America for
interim financial information. In our opinion, we have included all adjustments
(consisting only of normal recurring accruals) considered necessary for a fair
presentation.
Revenue. For the three and six months ended June 30, 2003, the Company
recognized product-related revenues in the amount of $56,636 and $100,158,
respectively, as compared to no revenues for the three and six months ended June
30, 2002. The increase in our revenue resulted from the launch of our first
product, the P5(TM) November 2002. Certain revenues will be deferred until
events have been resolved.
Cost of Revenue. For the three and six months ended June 30, 2003, cost of
revenue totaled $21,325 and $123,740 compared to no cost of revenue for the
three and six months ended June 30, 2002. The Company was a development stage
company through September 30, 2002. The increase in cost of revenue resulted
from the Company transitioning from a development stage company to an operating
company effective November 2002.
Product development expense. For the three and six months ended June 30 2003
product development expense totaled $313,581 and $458,656, respectively,
compared to $400,288 and $881,110 for the three and six months ended June 30,
2002, respectively. The decrease of $86,707 and $422,454, respectively, compared
to the three and six months ended June 30, 2002 was primarily due to a third
party developer which included materials used in the development and
manufacturing of the P5(TM) product since the manufacturing was completed by
December 31, 2002.
Sales and marketing expense. For the three and six months end June 30, 2003
sales and marketing expense totaled $94,859 and $355,127, respectively, compared
to $328,935 and $616,523 for the three and six months ended June 30, 2002,
respectively. The decrease of $234,076 and $261,396, respectively, compared to
the three and six months ended June 30, 2002 was primarily due to a decrease of
approximately $39,000 in advertising, decrease of $89,000 in marketing
consultants, decrease of $86,000 in travel and entertainment and a decrease on
$73,000 in trade shows.
General and administrative expenses. For the three and six months ended June 30,
2003 general and administrative expenses totaled $290,474 and $582,487,
respectively, compared to $363,702 and $903,390 for the three and six months
June 30, 2002, respectively. The decrease of $73,228 and $320,903, respectively,
compared to the three and six months ended June 30, 2002 was primarily due to a
decrease of approximately $166,000 in salaries and benefits, decrease in moving
expenses of $17,000, decrease in computer leases of $10,000, decrease in
consultants of $44,000, which was offset by increases in professional fee of
$130,000 and increase in insurance of $52,000. Included in general and
administrative expenses are costs incurred of approximately $33,000 and $64,000
for the three and six months ended June 30, 2003 respectively, compared to
$49,800 and $128,100 for the three and six months ended June 30, 2002,
respectively by Business Development.com and Hymax Group, LLC., companies that
are related to certain members of LCG Capital Group. Such costs include
consulting fees, employee salaries, occupancy, telephone and computer leases. In
the case of employee salaries, costs are allocated to us based on the time each
employee conducts business specific to us. In the case of the other expenses,
costs are allocated based on a percentage of resources used by us. In our
opinion, allocated expenses incurred from related parties approximate fair
market value.
16
Severance compensation for the three months and six months ended June 30, 2003
was $0 and $294,511 as compared to -0- for the three and six months ended June
30, 2002. The severance is due to six former employees. No payments have been
made to date.
Stock based compensation for the three months and six months ended June 30, 2003
totaled $358,806 and $1,165,548 respectively, compared to $118,499 for each of
the three and six months periods ended June 30, 2002. The non-cash charge was
related primarily to amortization of deferred compensation for stock options and
warrants issued to employees, directors, advisors and consultants and stock and
warrants issued to consultants for services rendered.
Other Income (Expense)
Interest income for the three and six months ended June 30, 2003 totaled $148
and $1,213 respectively, compared to $2,851 for each of the three and six months
period ended June 30, 2002. The decrease was due to a decrease of available cash
balances.
Interest expense for the three and six months ended June 30, 2003 totaled
$278,968 and $1,018,359 respectively, compared to $90,301 and $138,886 for the
three and six months ended June 30, 2002. The increase of $188,667 and $879,473
compared to the three and six months ended June 30, 2002, related primarily to
notes payable of $108,241 and another $904,825, to the warrants and the
convertible notes issued at the time of the merger and subsequent financing
during the three months and six months ended June 30, 2003 as described in
"Liquidity and Capital Resources" below.
Net loss for the three months and six months ended June 30, 2003 and 2002 were
$1,359,142, $4,012,858, $1,302,289 and $2,662,387, respectively.
Liquidity and Capital Resources
Since its inception through June 30, 2003 we had accumulated deficit of
$17,638,580 and expect to continue to incur losses for the foreseeable future.
We have financed our operations primarily through bridge loans and private
placements described in the overview.
For the six months ended June 30, 2003 net cash used in operating activities
decreased from $2,782,261 to $899,730 a net decrease of $1,882,531 as compared
to the six months ended June 30, 2002. Net cash and cash equivalents used in
operations for the year six months ended June 30, 2003 consisted of net loss
from continuing operations of $4,012,858, non-cash compensation of $1,190,798,
amortization of deferred interest of $641,442, imputed interest on conversion of
debt instrument $263,093, and increase in accounts payable of $723,522.
Interest expense for the three and six months ended June 30, 2003 totaled
$525,782 and $1,018,359 respectively, compared to $90,301 and $138,886 for the
three and six months ended June 30, 2002. The increase of $435,481 and $87,473
compared to the three and six months ended June 30, 2002, related primarily to
notes payable of $16,092 and $473,328, to the warrants and the convertible notes
issued at the time of the merger and subsequent financing during the three
months and six months ended June 30, 2003 as described in "Liquidity and Capital
Resources" below.
Net loss for the three months and six months ended June 30, 2003 and 2002 were
$1,605,956, $4,012,858, $1,302,289 and $2,662,387, respectively.
Liquidity and Capital Resources
Since its inception through June 30, 2003 we had accumulated deficit of
$17,638,583 and expect to continue to incur losses for the foreseeable future.
We have financed our operations primarily through bridge loans and private
placements described in the overview.
For the six months ended June 30, 2003 net cash used in operating activities
decreased from $2,782,261 to $899,730 a net decrease of $1,882,531 as compared
to the six months ended June 30, 2002. Net cash and cash equivalents used in
operations for the year six months ended June 30, 2003 consisted of net loss
from continuing operations of $4,012,858, non-cash compensation of $1,190,798,
amortization of deferred interest of $641,442, imputed interest on conversion of
debt instrument $263,383, and increase in accounts payable of $723,522.
Net cash used in investing activities for the six months ended June 30, 2003
decreased from $9,052 to $7,823 a net decrease of $1,229 as compared to the six
months ended June 30, 2003.
Net cash provided by financing activities for the six months ended June 30, 2003
decreased from $6,912,896 to $718,695 a net decrease of $6,194,201 as compared
to the six months ended June 30, 2002. Primarily as follows:
17
The Company completed a private placement, which generated cash proceeds of
$632,500 and a sale of 100,000 shares of restricted securities at $1.00 per
share. Repayments of note payable of $68,461 and a bank overdraft of $22,579
also contributed to the change in financing activities.
The Company will require additional funding in order to reach the point of
self-sufficiency. The Company hopes to raise the additional cash from the
exercise of certain warrants and/or through additional offerings of its
securities. The Company is unable to project cash requirements through December
31, 2003 until it more fully determines the level of projected revenue from the
sale of future products and the ability to raise additional funds through public
offerings or private placements.
RISK FACTORS
Information contained in this Form 10-QSB contains "forward-looking statements."
An investment in our common stock involves a high degree of risk. You should
carefully consider the factors described below, in addition to those discussed
elsewhere in this report, in analyzing an investment in our common stock. If any
of the risks described below materialize, our business, financial condition and
results of operations would likely suffer, the value of our common stock could
be adversely affected and you could lose all or part of the money you paid for
our common stock. In addition, the following factors could cause our actual
results to differ materially from those projected in our forward-looking
statements, whether made in this 10-QSB, our annual report on form 10-KSB,
future press releases SEC filings or orally, whether in presentations, responses
to questions or otherwise.
Unless otherwise described therein, or unless the context otherwise requires,
references to "the Company", "ER", "we", "our", "us", "it" or "its", refer to
the Company, together with its subsidiaries and affiliates, and their respective
predecessors.
Considerations and Risks Relating to Our Business and the Company
We have a limited operating history.
We were incorporated in 1999 and had no material operations between 1999 through
the third quarter 2003. We were in development stage from 1999 to September 30,
2002 and had no material operations until such time. Essential Reality, Inc.
commenced its operations in October 1, 2002. Accordingly, we have a limited
operating history. Investors must consider the risks and difficulties frequently
encountered by early stage companies, particularly in rapidly evolving markets
such as the virtual reality. Such risks include the following:
competition;
need for increased acceptance of products;
ability to continue to develop and extend our brand identity;
ability to anticipate and adapt to a competitive market;
ability to effectively manage rapidly expanding operations;
amount and timing of operating costs and capital expenditures relating to
expansion of our business, operations, and infrastructure;
ability to provide superior customer service; and
dependence upon key personnel.
18
We cannot be certain that our business strategy will be successful or that we
will successfully address these risks. In the event that we do not successfully
address these risks, our business, prospects, financial condition and results of
operations could be materially and adversely affected.
We do not have a history of profitability and, consequently, cannot predict
whether we will ever reach profitability.
Since we began operations in October 1, 2002, we have not generated profits.
Moreover, we will need to increase significantly our operating expenses to
implement our business plan. As a result of the foregoing factors, we could
incur significant losses on a quarterly and annual basis for the foreseeable
future. Our ability to generate revenues and profits in the long term will
depend primarily upon the successful implementation of our business plan. No
assurance can be given that we will be successful in implementing our business
plan or that we will generate sufficient revenues to achieve profitability.
If the anticipated cash generated by our operations are insufficient to fund
requirements and losses, we will need to obtain additional funds. There can be
no assurance that financing will be available in amounts or on terms acceptable
to us, if at all.
We anticipate that we will require additional financing in order to implement
our business plan. Such financing may be in the form of equity, debt or bank
financing. Particularly in light of our limited operating history, there can be
no assurance that we will be able to obtain the necessary additional capital on
a timely basis or on acceptable terms, if at all. In any of such events, our
business, prospects, financial condition, and results of operations would be
materially and adversely affected. As a result of any such financing, the
holders of our Common Stock may experience substantial dilution.
Fluctuations in operating results may affect our stock price.
Our operating results may fluctuate significantly in the future as a result of a
variety of factors, many of which are outside our control. These factors
include: (i) the amount and timing of capital expenditures and other costs
relating to the implementation of our business plan, including acquisitions of,
and investments in, competing or complementary companies or technologies; (ii)
our introduction of new products or services or by our competitors; (iii)
pricing changes in the printed circuit board manufacturing or assembly
industries; (iv) technical difficulties with respect to the use of our products;
(v) regulatory changes; and (vi) general economic conditions and economic
conditions specific to the printed circuit board manufacturing industry. As a
strategic response to changes in the competitive environment, we may from time
to time make certain pricing, service, or marketing decisions or acquisitions
that could have a material adverse effect on our business, prospects, financial
condition, and results of operations.
We do not expect to pay cash dividends in the foreseeable future.
We have not paid dividends or other distributions and do not intend to pay
dividends or other distributions for the foreseeable future, and we intend to
reinvest all of our earnings in the development of our business. In addition, we
may enter into agreements with lenders or other financing parties that restrict
or prohibit the payment of dividends or other distributions. Accordingly, no
assurance can be given that we will pay any dividend or other distributions to
the holders of our capital stock.
19
We are heavily dependent upon the electronics industry, and excess capacity or
decreased demand for products produced by this industry could result in
increased price competition as well as a decrease in our gross margins and unit
volume sales.
Our business is heavily dependent on the electronics industry. All our revenue
is generated from the only product the P5(TM) in the electronic industry, which
is characterized by intense competition, relatively short product life-cycles
and significant fluctuations in product demand. Furthermore, these segments are
subject to economic cycles and have experienced in the past, and are likely to
experience in the future, recessionary periods. A recession or any other event
leading to excess capacity or a downturn in these segments of the electronics
industry could result in intensified price competition, a decrease in our gross
margins and unit volume sales and materially affect our business, prospects,
financial condition and results of operations.
If we are unable to respond to rapid technological change and process
development, we may not be able to compete effectively.
The market for our products is characterized by rapidly changing technology and
continual implementation of new production processes. The future success of our
business will depend in large part upon our ability to maintain and enhance our
technological capabilities, to develop and market products that meet changing
customer needs and to successfully anticipate or respond to technological
changes on a cost-effective and timely basis. We expect that the investment
necessary to maintain our technological position will increase as customers make
demands for products and services requiring more advanced technology on a
quicker turnaround basis. We may not be able to borrow additional funds in order
to respond to technological changes as quickly as our competitors. In addition,
the printed circuit board industry could encounter competition from new or
revised manufacturing and production technologies that render existing
manufacturing and production technology less competitive or obsolete. We may not
respond effectively to the technological requirements of the changing market. If
we need new technologies and equipment to remain competitive, the development,
acquisition and implementation of those technologies and equipment may require
us to make significant capital investments. In the event that we do not
successfully address these risks, our business, prospects, financial condition
and results of operations would be materially and adversely affected.
We are dependent upon a small number of customers for a large portion of our net
sales, and a decline in sales to major customers could materially adversely
affect our results of operations.
A relatively small number of customers are responsible for a significant portion
of our net sales. Our principal customers may not continue to purchase products
from us at past levels and we expect a significant portion of our net sales will
continue to be generated by a small number of customers. Our customer
concentration could increase or decrease depending on future customer
requirements, which will depend in large part on market conditions in the
electronics industry segments in which our customers participate. The loss of
one or more major customers or a decline in sales to our major customers could
significantly harm our business and results of operations. In addition, we
generate significant accounts receivable in connection with providing services
to our customers. If one or more of our significant customers were to become
insolvent or were otherwise unable to pay for the services provided by us, our
business, prospects, financial condition and results of operations will be
materially and adversely affected.
20
Our results of operations are subject to fluctuations and seasonality, and
because many of our operating costs are fixed, even small revenue shortfalls
would materially decrease our gross margins.
Our results of operations vary for a variety of reasons, including:
timing of orders from and shipments to major customers;
the levels at which we utilize our manufacturing capacity;
changes in the pricing of our products or those of our competitors;
changes in our mix of revenues generated from quick-turn versus standard
lead time production;
expenditures or write-offs related to acquisitions; and
expenses relating to expanding the existing manufacturing facility.
A significant portion of our operating expenses is relatively fixed in nature
and planned expenditures are based in part on anticipated orders. Accordingly,
even a relatively small revenue shortfall would materially decrease our gross
margins. In addition, depending on the patterns in the capital budgeting and
purchasing cycles of our customers and our end-markets served and the
seasonality of the computer industry generally, our sales may be subject to
seasonal fluctuation. Such seasonal trends may cause fluctuations in our
quarterly operating results in the future. Results of operations in any period
should not be considered indicative of the results to be expected for any future
period. In addition, our future quarterly operating results may fluctuate and
may not meet the expectations of investors. If this occurs, our ability to raise
future equity financing from existing or new investors may be materially
adversely impacted.
Because we sell on a purchase order basis, we are subject to uncertainties and
variability in demand by our customers, which could decrease revenues and
materially adversely affect our operating results.
We sell to customers on a purchase order basis rather than pursuant to long-term
contracts and, consequently, our net sales are subject to short-term variability
in demand by our customers. Customers submitting a purchase order may cancel,
reduce or delay their order for a variety of reasons. The level and timing of
orders placed by our customers vary due to:
customer attempts to manage inventory;
changes in customers' manufacturing strategies, such as a decision by a
customer to either diversify or consolidate the number of printed circuit
board manufacturers used or to manufacture their own products internally;
and
variation in demand for our customers' products.
Significant or numerous terminations, reductions or delays in our customers'
orders could materially adversely impact our operating results. In the event
that we do not successfully address these risks, our business, prospects,
financial condition and results of operations will be materially and adversely
affected.
21
Our indebtedness could adversely affect our financial condition and the
restrictions imposed by the terms of debt instruments may severely limit our
ability to plan for or respond to changes in our business.
Our level of debt could have negative consequences. For example, it could:
require us to dedicate a substantial portion of our cash flow from
operations to repayment of debt, limiting the availability of cash for
other purposes;
increase our vulnerability to adverse general economic conditions by
making it more difficult to borrow additional funds to maintain our
operations if we suffer revenue shortfalls;
hinder our flexibility in planning for, or reacting to, changes in our
business and industry by preventing us from borrowing money to upgrade our
equipment or facilities; and
limit or impair our ability to obtain additional financing in the future
for working capital, capital expenditures, acquisitions or general
corporate purposes.
If we experience excess capacity due to variability in customer demand, our
gross margins may fall.
We generally schedule our quick-turn production facility at less than full
capacity to retain our ability to respond to unexpected additional quick-turn
orders. However, if these orders are not made, we may forego some production and
could experience excess capacity. When we experience excess capacity, our sales
revenues may be insufficient to fully cover our fixed overhead expenses and our
gross margins will fall. Conversely, we may not be able to capture all potential
revenue in a given period if our customers' demand for quick-turn services
exceeds our capacity during that period.
We are in the process of expanding our business into new products and services
and may not be able to compete effectively with other companies who have been in
these businesses longer than we have.
We will be competing with companies that have substantially greater financial
and manufacturing resources than we have and who have been providing these
services longer than us. We may not be able to successfully compete on this
basis with more established competitors.
To manage the expansion of our operations and any future growth, we will be
required to:
improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
hire, train and manage additional qualified personnel;
expand our direct and indirect sales channels; and
effectively transition our relationships with our customers, suppliers and
partners.
As part of our business strategy, we expect that we will continue to grow by
pursuing acquisitions, assets or product lines that complement or expand our
existing business.
22
Our acquisition of companies and businesses and expansion of operations involve
risks, including the following:
the potential inability to identify the company best suited to our
business plan;
the potential inability to successfully integrate acquired operations and
businesses or to realize anticipated synergies, economics of scale or
other expected value;
difficulties in managing production and coordinating operations at new
sites;
the potential need to restructure, modify or terminate customer
relationships of the acquired company; and
loss of key employees of acquired operations.
In addition, future acquisitions may result in dilutive issuances of equity
securities and the incurrence of additional debt, and, although we generally
endeavor to avoid them, large one-time write-offs and the creation of goodwill
or other intangible assets that could result in amortization expense.
Many of our competitors and potential competitors have a number of significant
advantages over us, including:
greater financial and manufacturing resources that can be devoted to the
development, production and sale of their products;
more established and broader sales and marketing channels;
more manufacturing facilities worldwide, some of which are closer in
proximity to original equipment manufacturers;
manufacturing facilities which are located in countries with lower
production costs; and
greater name recognition.
In addition, these competitors may respond more quickly to new or emerging
technologies, or may adapt more quickly to changes in customer requirements and
may devote greater resources to the development, promotion and sale of their
products than we do. We must continually develop improved manufacturing
processes to meet our customers' needs for complex products, and our
manufacturing process technology is generally not subject to significant
proprietary protection. Furthermore, increased production capacity by our
competitors can result in an excess supply of printed circuit boards, which
could also lead to price reductions. During recessionary periods in the
electronics industry, our competitive advantages in the areas of providing
quick-turn services, an integrated manufacturing solution and responsive
customer service may be of reduced importance to our customers who may become
more price sensitive. This may force us to compete more on the basis of price
and cause our margins to decline.
We rely on suppliers for the raw materials used in manufacturing our P5(TM) and
an increase in industry demand for these raw materials may increase the price of
these raw materials and reduce our gross margins.
23
Our manufacturing process depends on the collective industry experience of our
employees in our industry. If these employees were to leave us and take this
knowledge with them, our manufacturing process may suffer and we may not be able
to compete effectively.
We do not have patent or trade secret protection for our manufacturing process,
but instead rely on the collective experience of our employees in the
manufacturing process to ensure we continuously evaluate and adopt new
technologies in our industry. Although we are not dependent on any one employee,
if a significant number of our employees involved in our manufacturing process
were to leave our employment and we were not able to replace these people with
new employees with comparable experience, our manufacturing process may suffer
as we may be unable to keep up with innovations in the industry. As a result, we
may not be able to continue to compete effectively.
We may be exposed to intellectual property infringement claims by third parties,
which could be costly to defend, could divert management's attention and
resources and, if successful, could result in liability.
We could be subject to legal proceedings and claims for alleged infringement by
us of third party proprietary rights, such as patents, from time to time in the
ordinary course of business. Although we are not aware of any infringement
proceedings or claims against it, any claims relating to an alleged
infringement, even if not meritorious, could result in costly litigation and
divert management's attention and resources.
Our business may suffer if any of our key senior executives discontinues
employment with us or if we are unable to recruit and retain highly skilled
engineering and sales staff.
Our future success depends to a large extent on the services of our key
managerial employees, we may not be able to retain our executive officers and
key personnel or attract additional qualified management in the future. Our
business also depends on our continuing ability to recruit, train and retain
highly qualified employees, particularly engineering and sales and marketing
personnel. The competition for these employees is intense and the loss of these
employees could harm our business. In addition, it may be difficult and costly
for us to retain hourly skilled employees. Further, our ability to successfully
integrate acquired companies depends in part on our ability to retain key
management and existing employees at the time of the acquisition.
Our management team has only recently commenced working together as a combined
unit, which may make it more difficult to conduct and grow our business.
Our management team has only begun working together as a combined unit. If our
management team cannot successfully work together, we may not be able to execute
our business strategy successfully or compete effectively. Any failure to manage
our expansion effectively could harm our business.
Products we manufacture may contain design or manufacturing defects, which could
result in reduced demand for our services and liability claims against it.
We manufacture products to our customers' specifications, which are highly
complex and may contain design or manufacturing errors or failures despite our
quality control and quality assurance efforts. Defects in the products we
manufacture, whether caused by a design, manufacturing or component failure or
error, may result in delayed shipments, customer dissatisfaction, or a reduction
or cancellation of purchase orders. If these defects occur either in large
quantities or too frequently, our business reputation may be impaired. Since our
products are used in products that are integral to our customers' businesses,
errors, defects or other performance problems could result in financial or other
damages to our customers, for which we may be legally required to compensate
them. Although our purchase orders generally contain provisions designed to
limit our exposure to product liability claims, existing or future laws or
unfavorable judicial decisions could negate these limitation of liability
provisions. Product liability litigation against us, even if it were
unsuccessful, would be time consuming and costly to defend.
24
The limited market for our common stock will make their price more volatile.
No active trading market existed for our common stock prior to the Merger, and
we cannot assure potential investors that a larger market will ever develop or
be maintained. The market for our common stock is likely to be volatile and many
factors may affect the market. These include, for example:
our success, or lack of success, in marketing our products and services;
competition;
governmental regulations; and
fluctuations in operating results.
The stock markets generally have experienced, and will probably continue to
experience, extreme price and volume fluctuations, which have affected the
market price of the shares of many small capital companies. These fluctuations
have often been unrelated to the companies' operating results. These broad
market fluctuations, as well as general economic and political conditions, may
decrease the market price of our common stock in any market that develops.
Our common stock is considered to be "penny stock".
Our common stock may be deemed to be "penny stock" as that term is defined in
Rule 3a51-1 promulgated under the Exchange Act. Penny stocks are stocks:
with a price of less than $5.00 per share;
that are not traded on a "recognized" national exchange;
whose prices are not quoted on the NASDAQ automated quotation system; or
in issuers with net tangible assets less than $2,000,000 (if the issuer
has been in continuous operation for at least three years) or $5,000,000
(if in continuous operation for less than three years), or with average
revenues of less than $6,000,000 for the last three years.
Section 15(g) of the Exchange Act and Rule 15g-2 promulgated there under require
broker-dealers dealing in penny stocks to provide potential investors with a
document disclosing the risks of penny stocks and to obtain a manually signed
and dated written receipt of the document before effecting any transaction in a
"penny stock" for the investor's account. We urge potential investors to obtain
and read this disclosure carefully before purchasing any shares that are deemed
to be "penny stock."
25
Rule 15g-9 promulgated under the Exchange Act requires broker-dealers in penny
stocks to approve the account of any investor for transactions in such stocks
before selling any "penny stock" to that investor. This procedure requires the
broker-dealer to:
obtain from the investor information about his or her financial situation,
investment experience and investment objectives;
reasonably determine, based on that information, that transactions in
penny stocks are suitable for the investor and that the investor has
enough knowledge and experience to be able to evaluate the risks of "penny
stock" transactions;
provide the investor with a written statement setting forth the basis on
which the broker-dealer made his or her determination; and
receive a signed and dated copy of the statement from the investor,
confirming that it accurately reflects the investor's financial situation,
investment experience and investment objectives.
Compliance with these requirements may make it harder for investors in our
Common Stock to resell their shares to third parties. Accordingly, our common
stock should only be purchased by investors, who understand that such investment
is a long-term and illiquid investment, and are capable of and prepared to bear
the risk of holding the common stock for an indefinite period of time.
Forward Looking Statements
The foregoing Plan of Operation contains "forward looking statements" within the
meaning of Rule 175 under the Securities Act of 1933, as amended, and Rule 3b-6
under the Securities Act of 1934, as amended, including statements regarding,
among other items, the Registrant's business strategies, continued growth in the
Registrant's markets, projections, and anticipated trends in the Registrant's
business and the industry in which it operates. The words "believe," "expect,"
"anticipate," "intends," "forecast," "project," and similar expressions identify
forward-looking statements. These forward- looking statements are based largely
on the Registrant's expectations and are subject to a number of risks and
uncertainties that are beyond the Registrant's control. The Registrant cautions
that these statements are further qualified by important factors that could
cause actual results to differ materially from those in the forward looking
statements, including, among others, the following: reduced or lack of increase
in demand for the Registrant's products, competitive pricing pressures, changes
in the market price of ingredients used in the Registrant's products and the
level of expenses incurred in the Registrant's operations. In light of these
risks and uncertainties, there can be no assurance that the forward-looking
information contained in this document will in fact transpire or prove to be
accurate. The Registrant disclaims any intent or obligation to update "forward
looking statements."
26
Item 3. Controls and Procedures
As required by Rule 13a-15 under the Exchange Act, within the 90 days
prior to the filing date of this report, the Company carried out an evaluation
of the effectiveness of the design and operation of the Company's disclosure
controls and procedures. This evaluation was carried out under the supervision
and with the participation of the Company's management including acting Chief
Financial Officer. Based upon that evaluation and acting Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect internal controls subsequent to
the date the Company carried out its evaluation.
Disclosure controls and procedures are controls and other procedures that
are designed to ensure that information required to be disclosed in Company
reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission's rules and forms. Disclosure controls and procedures
include controls and procedures designed to ensure that information required to
be disclosed in Company reports filed under the Exchange Act is accumulated and
communicated to management and acting Chief Financial Officer as appropriate, to
allow timely decisions regarding required disclosure.
Critical Accounting Policies
The U.S. Securities and Exchange Commission ("SEC") recently issued Financial
Reporting Release No. 60, "CAUTIONARY ADVICE REGARDING DISCLOSURE ABOUT CRITICAL
ACCOUNTING POLICIES" ("FRR 60"); suggesting companies provide additional
disclosure and commentary on their most critical accounting policies. In FRR 60,
the SEC defined the most critical accounting policies as the ones that are most
important to the portrayal of a company's financial condition and operating
results, and require management to make its most difficult and subjective
judgments, often as a result of the need to make estimates of matters that are
inherently uncertain. Based on this definition, our most critical accounting
policies include: inventory valuation, which affects our cost of sales and gross
margin; and allowance for doubtful, which affects the general and administrative
expenses. The methods, estimates and judgments we use in applying these most
critical accounting policies have a significant impact on the results we report
in our consolidated financial statements.
PART II -- OTHER INFORMATION
Item 1. Legal Proceedings
On November 21, 2002, a complaint was filed by MC Squared in United States
District Court for the Southern District of New York against us, Humbert Powell,
Chairman of our Board of Directors, Steven Francesco, our ex-Chief Executive
Officer, David Devor, an officer and Brian Jedwab, a member of our Board of
Directors, alleging breach of a development agreement between us (originally
Essential Reality, LLC) and MC Squared. Specifically, the complaint alleges a
failure by us to provide a design credit to MC Squared on the packaging for the
P5(TM). The complaint seeks specific performance and a recall of all P5(TM)
products shipped to date without the design credits on the packaging. We have
submitted an answer with counterclaims and have made a motion to dismiss this
complaint. On October 15, 2003 the case was settled for $53,643 payable as
follows: $3,643 in full payment for royalties due as of July 30, 2003 and
$50,000 for "Non-Royalty Settlement" payable in consecutively monthly
installments of $2,000 commencing November 15, 2003. The Company may prepay the
outstanding balance within 4 months and deduct 25% or within 8 months and deduct
20%.
27
On January 21, 2003 a complaint was filed by RDA International, Inc. in the
Supreme Court of the State of New York against us seeking payment of $203,264
for work, labor and services performed in connection with advertising, marketing
and multimedia programs for the P5(TM). This amount has been accrued at December
31, 2002.
On February 28, 2003, a complaint was filed by Aaron Gavios, a former employee
of ours, in The United States District Court for the Southern District of New
York against us, Humbert Powell, Chairman of our Board of Directors and Brian
Jedwab, a member of our Board of Directors, alleging breach of a contract.
Specifically, the complaint alleges failure to provide for severance pay,
failure to provide stock options and failure to reimburse for automobile lease
totaling $120,000, plus interest and legal fees. The Company has accrued $50,000
as of June 30, 2003 for severance to this former employee.
On April 16, 2003, a complaint was filed by Ziff Davis Media, Inc. in the
Supreme Court of the State of New York against the Company (originally, ER, LLC)
seeking payment of $27,443 for print advertising for the P5(TM). On July 3, 2003
the case was settled for $10,000 payable in 4 installments as follows: $4,000
due July 10, 2003, and the balance of $6,000 in 3 equal installments of $2,000
each payable August 10, September 10, and October 10, 2003. The full amount is
included in accounts payable and accrued expenses at June 30, 2003 as no
payments have been made.
On October 10, 2003 a complaint was filed by the Future Network USA f/k/a/
Imagine Media Inc in the supreme court of the State of New York, County of New
York against Essential Reality, LLC seeking payment of $33,405 plus interest and
legal fees for advertising in one of their magazines. The face amount is
included in accounts payable and accrued expenses at June 30, 2003 as no
payments have been made.
On December 4, 2003 a complaint was filed by the CIT Communications Finance
Corporation d/b/a/ Avaya Financial Services in the Supreme Court of the State of
New York, County of New York against Essential Reality, Inc seeking payment of
$38,084 plus interest and legal fees for default in paying the Phone Equipment
Lease Agreement dated January 7, 2002.
On January 26, 2004 a compliant was filed by Empire Inter - Freight Corp. in the
Civil Court of the City of New York, County of New York against Essential
Reality, Inc. seeking payment of $12,419 plus interest and legal fees for
default in paying for freight services in December 2002. The full amount is
included in accounts payable and accrued expenses at June 30, 2003 as no
payments have been made.
We believe we have valid defenses to these claims and intend to vigorously
defend ourselves; however, there can be no assurance that we will be successful.
The costs associated with these litigations, including the time required to
defend ourselves, as well as the potential cost should there be an adverse
judgment against us, may have a material adverse effect on our financial
condition and results of operation.
Item 2. Changes in Securities
On March 10, 2003, the Company entered into an Investment banking/Advisory
Agreement with First Securities USA, Inc. through its SBI USA division engaging
SBI as exclusive advisor and agreed to pay the Investment Banker a retainer of
25,000 shares of common stock of the Company.
28
On March 12, 2003, the Company sold 100,000 shares of common Stock to a private
investor for $1.00 per share totaling $100,000.
Item 3. Defaults Upon Senior Securities
The Company has defaulted in payments of the principal and accrued interest on
$500,000 Convertible and Non-Convertible notes issued as result of the
Recapitalization with "JPAL".
The Company has requested a 90-day extension for all provisions relating to the
mandatory prepayments. None were granted.
Item 4. Submission of Matters to Vote of Security Holders
Not applicable.
Item 5. Other Information
On January 9, 2003, Stanley Friedman, Vice president of manufacturing was
terminated. The Company will pay severance to Mr. Friedman in the amount of
$37,500. The payment is contingent upon the Company obtaining one million in
financing excluding bridge loans by June 30, 2003. The Company executed a
confession of judgment to be filed by if the severance payment is not made by
June 30, 2003. No payment has been made to date. In addition, Mr. Friedman has
until January 9, 2004 to exercise stock options with an exercise price of $.75
per share for 85,666 shares of the Company's common stock, which have already
vested. If he fails to exercise, the options will be forfeited. The Company paid
the first months Cobra for January 2003.
On January 10, 2003, Aaron Gavios, Vice president of Sales was terminated. The
Company agreed to pay severance to Mr. Gavios in the amount of $50,000. The
payment is to be paid in equal installments contingent upon the Company
obtaining three million in financing excluding bridge loans. In the event that
the company fails to make any payments after receiving financing, then the
unpaid severance shall become immediately due and payable. In addition, Mr.
Gavios has until January 10, 2004 to exercise stock options for 43,000 shares of
the Company's common stock with an exercise of $1.04 per share, which have
already vested. If he fails to exercise, the options will be forfeited. The
contract was not signed and is in litigation.
On January 10, 2003 Rubin Levine, President and Chief Operating officer was
terminated. No severance is due and he has until January 10, 2004 to exercise
stock options with an exercise price of $0.80 per share for 80,400 shares of the
Company's common stock, which has already vested. If he fails to exercise the
options will be forfeited.
On February 6, 2003 Steven T. Francesco chief executive officer, was terminated.
The Company will pay severance to Mr. Francesco in the amount of $41,010. The
payment is contingent upon the Company obtaining financing in the amount of two
million dollars excluding bridge loans. The Company paid for the insurance
coverage for two months and issued a five-year warrant to purchase 250,000
shares of the Company's common stock at an exercise price of $0.75 with Mr.
Francesco, but it is the intent of the Registrant to enter into a written
agreement with Mr. Francesco in the near future.
29
On February 24, 2003, Richard Rubin, Vice president of Product Development was
terminated. The Company will pay severance to Mr. Rubin in the amount of
$47,500. The payment is contingent upon the Company obtaining financing in the
amount of two million dollars not including bridge loans. In addition, Mr. Rubin
has until February 24, 2005 to exercise stock options with an exercise price of
$.80 per share for 33,000 shares of the Company's common stock which have
already vested. If he fails to exercise, the options will be forfeited.
On April 7, 2003, Martin Currie, Vice President of marketing was terminated. As
noted in the employment agreement, Mr. Currie is eligible to receive $25,000 as
severance. In addition, Mr. Currie has until April 7, 2004 to exercise stock
options with an exercise price of $0.90 per share for 20,000 shares of the
Company's common stock, which have already vested. If he fails to exercise, the
options will be forfeited. No agreement has been signed to date.
On July 31, 2003, the Company settled with a former consultant for $20,000
payable as follows: $5,000 payable no later than August 30, 2003, $5,000 payable
no later than December 12, 2003 and the final payment of $10,000 payable no
later than January 30, 2004.
On February 6, 2004 - The Company executed a binding term sheet (the "Term
Sheet"), which sets forth the preliminary terms and conditions of a proposed
merger transaction between Essential and AllianceCorner Distributors Inc.
("Alliance"). This Term Sheet supersedes and replaces the Letter of Intent dated
November 6, 2003. As proposed, the shareholders of Alliance would exchange their
shares of capital stock in Alliance for shares of common stock of Essential.
The consummation of the transaction is contingent on a number of factors,
including but not limited to, the completion of due diligence and the execution
of a definitive agreement. There can be no assurance that the merger will be
consummated or, if consummated, that it will be consummated on the terms set
forth in the Term Sheet.
On November 20, 2003 $225,000 was deposited in the escrow account with Counsel
to Alliance. Alliance shall be entitled to draw on such funds to pay expenses
for accounting, legal and other expenses related to the merger.
If the transaction is terminated by any party for any reason, Alliance shall
direct the escrow agent to release to Essential Reality any remaining balance.
Alliance shall refund to the company any portion of the escrow released from
escrow to pay expenses if before December 31, 2003 Alliance withdraws from the
transaction due to any non-material adverse changes.
Alliance shall also refund to Essential Reality any portion of the $225,000 that
was released from escrow if both the following conditions have occurred:
1. After December 31, 2003 Alliance has withdraws from the transaction
due to any non-material adverse changes, and
2. Essential Reality has made securely funded arrangements to fund
Expenses that exceed the $225,000 deposited in escrow.
30
Pursuant to the Binding Term Sheet the Company signed an Investment Banking
Agreement with Sunrise Securities Corp. a registered broker/dealer with National
Association of Securities Dealers. Sunrise will use its "best efforts" to raise
the money provided for in the PPO a minimum of $2,500,000 million under the
terms and conditions of the PPO. We will pay the Investment Banker $25,000
nonrefundable retainer fee and financing fees equal to 10% of the gross proceeds
of such financing payable to Sunrise in cash and warrants issued to Sunrise to
purchase on the same terms 10% of the securities in such financing. Upon closing
of each Financing, the company shall pay Sunrise a financing fee payable in a
form at the sole election of Sunrise of either (i) cash fee equal to 10% of the
gross proceeds or (ii) the Company shall issue the number of shares of Common
Stock equal to 11% of the aggregate number of fully diluted and/or converted
shares of Common Stock and/or Common Stock equivalents (including but not
limited to Units) purchased by Investors. In addition, the Company shall issue
warrants to purchase Common Stock equal to 10% of the aggregate number of the
fully diluted and or converted shares of Common Stock equivalents. The warrants
shall be purchased for a nominal sum and shall be exercisable for a period five
years from the date of closing with an exercise price per share equal to the
effective per share price paid by the Investors for the Securities. In the event
the agreement is not renewed or terminated, Sunrise will be entitled to a full
fee for which discussions were conducted during the term of the agreement by the
Company or by Sunrise within twelve months. In addition to the fees, Sunrise
will be reimbursed for all reasonable fees and disbursements of Sunrise outside
counsel and Sunrise travel and out of pocket expenses associated with the
financing up to $25,000 without Company approval. The Company shall also
reimburse the reasonable fees and disbursements of small business investment
counsel, if any, incurred in connection with financing not to exceed 1% of the
SBIC's allocation in such financing.
The Company has signed retainer agreement with Gottlieb & Partners, LLP as its
special counsel for drafting and filing all required regulatory documents
pursuant to the terms and conditions set forth in the Binding Term Sheet dated
January 2004. The Company agrees to pay a flat fee for legal services in the
amount of $60,000 to be payable at the closing from the escrow of the Private
Placement Offering.
The Company has retained Jackson Steinem, Inc. for non-legal services in
connection with the Company's proposed reorganization transaction. The Company
agrees to deliver after the closing 30,000 shares of the Company's Common Stock
as compensation for services rendered.
31
Item 6. Exhibits and Reports on Form 10-QSB.
(a) Exhibits.
31 Certifications.
32 CEO and Acting CFO Certification Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 10-QSB.
SIGNATURES
In accordance with the requirements of the Securities Exchange Act of 1934, the
registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
Essential Reality, Inc., a Nevada corporation
(Registrant)
Date: April 21, 2004
By: /s/ John Gentile,
------------------------------------------
Its: Interim Officer
Chief Operating officer and Director
(Principal Executive Officer)
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Essential Reality, Inc. (the
"Company") on Form 10-QSB for the period ended March 31, 2003 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), the
undersigned, in the capacities and on the date indicated below, hereby certifies
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, that to his knowledge: 1. The Report fully complies
with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act
of 1934; and 2. The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operation of the
Company.
Dated: April 21, 2004 By: /s/ John Gentile
-------------------------------------
John Gentile, Interim President,
Chief Operating Officer and Director
32