UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2006
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-25675
PATRON SYSTEMS, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-3055158
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
5775 FLATIRON PARKWAY, SUITE 230 80301
BOULDER, CO
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(303) 541-1005
(ISSUER'S TELEPHONE NUMBER)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act.). Yes |_| No |X|
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 14,462,260 shares of common stock
outstanding as of November 13, 2006.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
------------------------------ ----
ITEM 1. FINANCIAL STATEMENTS ..................................................3
Condensed Consolidated Balance Sheet at September 30, 2006 (unaudited).........3
Condensed Consolidated Statements of Operations for the Three and
Nine Months Ended September 30, 2006 (unaudited)......................4
Condensed Consolidated Statement of Stockholders' Equity for the
Nine Months Ended September 30, 2006 (unaudited)......................5
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2006 and September 30, 2005
(unaudited)...........................................................6
Notes to Condensed Consolidated Financial Statements (unaudited)...............7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS..................................34
ITEM 3. CONTROLS AND PROCEDURES...............................................47
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.....................................................49
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS...........49
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...................49
ITEM 6. EXHIBITS..............................................................50
SIGNATURES....................................................................51
FORWARD LOOKING STATEMENTS
The following discussion and explanations should be read in conjunction with the
financial statements and related notes contained elsewhere in this Form 10-QSB.
Certain statements made in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements can be identified by terminology such as "may,"
"will," "should," "expects," "intends," "anticipates," "believes," "estimates,"
"predicts," or "continue" or the negative of these terms or other comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these forward-looking statements. Although
Patron Systems believes that expectations reflected in the forward-looking
statements are reasonable, it cannot guarantee future results, performance or
achievements. Moreover, neither Patron Systems nor any other person assumes
responsibility for the accuracy and completeness of these forward-looking
statements. Patron Systems is under no duty to update any forward-looking
statements after the date of this report to conform such statements to actual
results.
2
PART I - FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
SEPTEMBER 30,
2006
------------
ASSETS
Current Assets
Cash ........................................................ $ 60,156
Accounts receivable, net .................................... 222,722
Other current assets ........................................ 58,004
------------
Total current assets ..................................... 340,882
Property and equipment, net ................................... 193,543
Intangible assets, net ........................................ 1,436,767
Goodwill ...................................................... 9,510,716
------------
Total assets ............................................. $ 11,481,908
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable ............................................ $ 659,030
Accrued payroll and related expenses ........................ 551,930
Accrued interest ............................................ 592,179
Dividends payable ........................................... 246,968
Demand note payable ......................................... 312,556
Bridge notes payable ........................................ 1,519,975
Notes payable (to creditors of acquired business,
including $554,202 to related parties) ................... 799,982
Expense reimbursements due to officers and stockholders ..... 4,458
Other current liabilities ................................... 555,043
Accrued registration rights penalty ......................... 90,488
Deferred revenue ............................................ 223,880
------------
Total current liabilities ................................ 5,556,489
Commitments and contingencies
Stockholders' Equity
Preferred stock, par value $0.01 per share, 75,000,000
shares authorized,
Series A convertible: 2,160 shares authorized;
964 shares issued and outstanding
liquidation preference of $6,334,337 ................ 10
Series A-1 convertible: 50,000,000 shares
authorized; no shares outstanding ................... --
Common stock, par value $0.01 per share, 150,000,000
shares authorized, 14,462,260 shares issued and
outstanding .............................................. 144,627
Additional paid-in capital .................................. 97,468,961
Accumulated deficit ......................................... (91,688,179)
------------
Total stockholders' equity ............................... 5,925,419
------------
Total liabilities and stockholders' equity ............... $ 11,481,908
============
See notes to condensed consolidated financial statements.
3
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Revenue ........................................... $ 857,570 $ 184,300 $ 276,825 $ 93,457
------------ ------------ ------------ ------------
Cost of Sales
Cost of products/services ....................... 39,580 2,003 9,683 --
Amortization of technology ...................... 99,980 280,855 44,936 133,124
------------ ------------ ------------ ------------
Total cost of sales .......................... 139,560 282,858 54,619 133,124
------------ ------------ ------------ ------------
Gross profit (loss) ............................. 718,010 (98,558) 222,206 (39,667)
------------ ------------ ------------ ------------
Operating Expenses
Salaries and related expenses ................... 3,700,443 2,306,118 1,252,255 1,229,681
Consulting expense (non-employee stock based
compensation) ................................ -- 1,239,083 -- 286,208
Professional fees ............................... 1,105,500 932,250 219,603 278,867
General and administrative ...................... 1,011,459 1,251,659 389,884 494,173
Amortization of intangibles ..................... 92,440 69,691 30,813 30,814
Stock based penalties under accomodation
agreements ................................... -- 745,500 -- 118,500
Stock based penalty under collateralized
financing arrangement ........................ 8,560 78,247 3,314 16,145
Loss on intrinsic value of put right ............ -- (300,000) -- (300,000)
Loss on collateralized financing arrangement .... -- 366,193 -- --
Loss/(gain) associated with settlement agreements (93,944) (343,571) (580,541) 45,532
------------ ------------ ------------ ------------
Total operating expenses ..................... 5,824,458 6,345,170 1,315,328 2,199,920
Operating loss .................................... (5,106,448) (6,443,728) (1,093,122) (2,239,587)
Other Income (Expense)
Interest income ................................. 2,770 19,250 809 --
Loss on sale of property and equipment .......... (125) (544) -- (544)
Interest expense ................................ (1,768,499) (12,355,249) (64,564) (10,158,714)
------------ ------------ ------------ ------------
Total other income (expense) ................. (1,765,854) (12,336,543) (63,755) (10,159,258)
------------ ------------ ------------ ------------
Loss from continuing operations before income taxes (6,872,302) (18,780,271) (1,156,877) (12,398,845)
Income taxes .................................... -- -- -- --
------------ ------------ ------------ ------------
Loss from continuing operations ................... (6,872,302) (18,780,271) (1,156,877) (12,398,845)
------------ ------------ ------------ ------------
Loss from discontinued operations ................. (104,962) (1,129,751) -- (278,877)
Loss on disposal of discontinued operations ....... (75,920) -- -- --
------------ ------------ ------------ ------------
(180,882) (1,129,751) -- (278,877)
------------ ------------ ------------ ------------
Net loss .......................................... (7,053,184) (19,910,022) (1,156,877) (12,677,722)
Preferred stock dividend .......................... (246,968) -- (122,184) --
------------ ------------ ------------ ------------
Net loss available to common stockholders ......... $ (7,300,152) $(19,910,022) $ (1,279,061) $(12,677,722)
============ ============ ============ ============
Net Loss Per Share - Basic and Diluted
- Continuing operations ......................... $ (1.44) $ (9.84) $ (0.12) $ (6.05)
- Discontinued operations ....................... (0.04) (0.59) -- (0.13)
------------ ------------ ------------ ------------
- Total Net Loss per share available to
common stockholders ........................ $ (1.48) $ (10.43) $ (0.12) $ (6.18)
============ ============ ============ ============
Weighted Average Number of Shares Outstanding
- Basic and diluted ............................. 4,945,846 1,909,483 10,490,543 2,049,970
============ ============ ============ ============
See notes to condensed consolidated financial statements.
4
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2006 2005
------------ ------------
Cash Flows from Operating Activities
Net loss from continuing operations .......................... $ (6,872,302) $(18,780,271)
============ ============
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization ............................. 236,845 367,974
Stock based compensation .................................. 307,629 1,239,083
Non-cash interest expense ................................. 901,438 1,927,374
Amortization of deferred financing charges ................ -- 1,825,606
Stock options issued to Chief Executive Officer ........... -- 16,000
Penalty warrants issued to bridge note holders ............ -- 8,000,000
Gain associated with settlement agreements ................ (93,943) (389,103)
Accrued registration penalty .............................. 8,560 --
Loss on disposition of discontinued operations ............ 75,920 --
Loss on sale of fixed assets .............................. 125 --
Reduction in intrinsic value of put right ................. -- (300,000)
Stock based penalty under accomodation agreements ......... -- 823,747
Gain on settlement of consulting agreement payable ........ -- (228,900)
Loss on collateralized financing arrangement .............. -- 366,194
Non-cash increase in notes payable to former officer ...... -- 17,399
Non-cash interest income .................................. -- (19,250)
Changes in assets and liabilities:
Restricted cash escrowed to settle liabilities assumed . 511,691 (517,003)
Prepaid expenses ....................................... -- 51,487
Accounts receivable .................................... 1,422 (32,634)
Other current assets ................................... 18,636 (95,682)
Accounts payable ....................................... (222,911) (320,797)
Accrued interest ....................................... 581,137 12,202
Deferred revenue ....................................... (108,201) 65,267
Accrued payroll and payroll related expenses ........... 24,366 (1,043,209)
Other current liabilities .............................. (157,401) 394,267
Consulting agreements payable .......................... -- (50,000)
Expense reimbursements due to officers and stockholders (32,335) (30,521)
Loss on sale of property and equipment ................. -- 544
Other accrued expenses ................................. -- (3,413)
------------ ------------
Total adjustments ............................................ 2,052,978 12,076,632
------------ ------------
NET CASH USED IN CONTINUING OPERATIONS ......................... (4,819,324) (6,703,639)
------------ ------------
NET CASH USED IN DISCONTINUED OPERATIONS ....................... (197,882) (1,077,769)
------------ ------------
NET CASH USED IN OPERATING ACTIVITIES .......................... (5,017,206) (7,781,408)
------------ ------------
CASH FLOWS USED IN INVESTING ACTIVITIES
Cash payments in purchase business combinations .............. -- (857,633)
Cash acquired in purchase business combinations .............. -- 406,834
Purchase and development of technology ....................... (396,428) (92,547)
Proceeds from sale of fixed assets ........................... 1,755 1,500
Purchase of fixed assets ..................................... (133,559) (43,608)
------------ ------------
NET CASH USED IN CONTINUING INVESTING ACTIVITIES ............... (528,232) (585,454)
------------ ------------
NET CASH USED IN DISCONTINUED INVESTING ACTIVITIES ............. (78,920) (14,284)
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES .......................... (607,152) (599,738)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Expenses repaid to officers and stockholders ................. -- (273,536)
Payments on settlement of accommodation agreements ........... (125,000) --
Deferred financing costs ..................................... (54,000) (627,739)
Proceed from issuance of Series A Preferred Stock ............ 4,640,501 --
Repayments of amounts due under settlement with former officer -- (200,000)
Proceeds from issuance of bridge notes ....................... 1,000,000 7,100,000
Repayments of notes payable .................................. (7,001) --
Proceeds from disposition of discontinued operations ......... 50,000 --
Proceeds received in connection with financing settlement .... 180,000 --
Proceeds from issuance of notes, less fees ................... -- 2,543,000
Repayments of advances from stockholders ..................... -- (32,774)
------------ ------------
NET CASH PROVIDED BY CONTINUING FINANCING ACTIVITIES ........... 5,684,500 8,508,951
------------ ------------
NET CASH USED BY DISCONTINUED FINANCING ACTIVITIES ............. -- (93,483)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ...................... 5,684,500 8,415,468
------------ ------------
NET INCREASE IN CASH ........................................... 60,142 34,322
CASH, beginning of period ...................................... 14 45,901
------------ ------------
CASH, end of period ............................................ $ 60,156 $ 80,223
============ ============
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Interest ..................................................... $ 285,091 $ 527,231
============ ============
Supplemental non-cash investing and finanical activity
Current tangible assets acquired ............................. $ -- $ 300,911
Non-current tangible assets acquired ......................... -- 2,756,470
Current liabilities assumed with acquisitions ................ -- (8,379,271)
Non-current liabilities assumed with acquisitions ............ -- (439,126)
Intangible assets acquired ................................... -- 3,101,000
Goodwill recognized on purchase business combinations ........ -- 22,433,752
Non-cash consideration ....................................... -- (19,332,500)
Cash acquired in purchase business combinations .............. -- 416,397
------------ ------------
Cash paid to acquire businesses .............................. $ -- $ 857,633
============ ============
See notes to condensed consolidated financial statements.
5
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006
(UNAUDITED)
SHARES OF PAR VALUE SHARES OF PAR VALUE
SERIES A SERIES A SERIES A-1 SERIES A-1 SHARES OF PAR VALUE
PREFERRED PREFERRED PREFERRED PREFERRED COMMON COMMON
STOCK STOCK STOCK STOCK STOCK STOCK
------------ ------------ ------------ ------------ ------------ ------------
Balance - January 1, 2006 ............ -- $ -- -- $ -- 1,978,655 $ 19,787
Issuance of Series A Preferred Stock
to investors ....................... 964 10 -- -- -- --
Issuance of warrants in connection
with bridge loan extension -
extension warrants ................. -- -- -- -- -- --
Conversion option penalty incurred
upon default of Bridge Financing III -- -- -- -- -- --
Issuance of Series A-1 Preferred stock
in settlement of debt .............. -- -- 36,993,054 369,930 (98,626) (983)
Issuance of shares in connection with
anti-dilution provision ............ -- -- -- -- 251,175 2,512
Amortization of deferred compensation -- -- -- -- -- --
Conversion of Preferred Series A-1 to
common stock ....................... -- -- (36,993,054) (369,930) 12,331,056 123,311
Series A dividends ................... -- -- -- -- -- --
Net Loss ............................. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE - SEPTEMBER 30, 2006 ......... 964 $ 10 -- $ -- 14,462,260 $ 144,627
============ ============ ============ ============ ============ ============
COMMON
ADDITIONAL STOCK
PAID IN REPURCHASE ACCUMULATED
CAPITAL OBLIGATION DEFICIT TOTAL
------------ ------------ ------------ ------------
Balance - January 1, 2006 ............ $ 65,593,772 $ (1,300,000) $(84,388,027) $(20,074,468)
Issuance of Series A Preferred Stock
to investors ....................... 4,820,490 -- -- 4,820,500
Issuance of warrants in connection
with bridge loan extension -
extension warrants ................. 48,129 -- -- 48,129
Conversion option penalty incurred
upon default of Bridge Financing III 550,000 -- -- 550,000
Issuance of Series A-1 Preferred stock
in settlement of debt .............. 25,904,834 1,300,000 -- 27,573,781
Issuance of shares in connection with
anti-dilution provision ............ (2,512) -- -- --
Amortization of deferred compensation 307,629 -- -- 307,629
Conversion of Preferred Series A-1 to
common stock ....................... 246,619 -- -- --
Series A dividends ................... -- -- (246,968) (246,968)
Net Loss ............................. -- -- (7,053,184) (7,053,184)
------------ ------------ ------------ ------------
BALANCE - SEPTEMBER 30, 2006 ......... $ 97,468,961 $ -- $(91,688,179) $ 5,925,419
============ ============ ============ ============
See notes to condensed consolidated financial statements.
6
PATRON SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2006
NOTE 1 - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems, Inc. and subsidiaries (the "Company," "Patron," "we," "us," or "our")
have been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information and the instructions to
Form 10-QSB. Accordingly, they do not include all the information and footnotes
required by accounting principles generally accepted in the United States for
complete financial statements. In the opinion of management, all adjustments
(which include only normal recurring adjustments) necessary to present fairly
the financial position, results of operations and cash flows for all periods
presented have been made. The results of operations for the three-month and
nine-month periods ended September 30, 2006 are not necessarily indicative of
the operating results that may be expected for the entire year ending December
31, 2006.
This form 10-QSB should be read in conjunction with the Company's 10-KSB for the
year ended December 31, 2005.
NOTE 2 - THE COMPANY
ORGANIZATION AND DESCRIPTION OF BUSINESS
Patron Systems, Inc. ("Systems") is a Delaware corporation formed in April 2002
to provide comprehensive, end-to-end information security solutions to global
corporations and government institutions.
Pursuant to an Amended and Restated Share Exchange Agreement dated October 11,
2002, Combined Professional Services ("CPS"), Systems and the stockholders of
Systems consummated a share exchange ("Share Exchange"). As a result of the
Share Exchange, the former stockholders of Systems became the majority
stockholders of CPS. Accordingly, Systems became the accounting acquirer of CPS
and the exchange was accounted for as a reverse merger and recapitalization of
Systems. CPS subsequently merged with Systems, with Systems surviving the
merger. The combined entity continued to use the name Patron Systems, Inc.
ANNUAL MEETING OF STOCKHOLDERS
On July 20, 2006, the Company held its annual meeting of stockholders. The
stockholders approved the election of three directors: Mr. Robert Cross to serve
until the annual meeting of stockholders in 2007; Mr. Braden Waverley to serve
until the annual meeting of stockholders in 2008; and Mr. George Middlemas to
serve until the annual meeting of stockholders in 2009. Additionally, the
stockholders approved the three other proposals made as part of the 2006 proxy
statement including the adoption of the Patron Systems, Inc. 2006 Stock
Incentive Plan which provides for the grant of up to 5.6 million shares of
common stock underlying stock options and other awards under the plan and the
approval of an amendment to the Second Amended and Restated Certificate of
Incorporation, as amended, to provide for a 1-for-30 reverse stock split of the
Company's issued and outstanding common stock.
REVERSE STOCK SPLIT AND AMENDMENT TO CERTIFICATE OF INCORPORATION
On July 20, 2006, the Company's stockholders approved an amendment to its Second
Amended and Restated Certificate of Incorporation, as amended, to provide for a
1-for-30 reverse stock split of our issued and outstanding Common Stock.
Effective July 31,2006, the Company's Second Amended and Restated Certificate of
Incorporation, as amended, to provide for a 1-for-30 reverse stock split of our
issued and outstanding Common Stock was declared effective. All share
information included in the accompanying financial statements and notes thereto
give retroactive effect to the reverse split.
7
CONSOLIDATION OF SUBSIDIARIES
Effective September 19, 2006, we merged our wholly-owned subsidiaries
Entelagent, CSSI and PILEC into our company through the filing with the
Secretary of State of the States of Delaware and California, a Certificate of
Ownership and Merger merging Entelagent Software Corp., (a California
corporation), Complete Security Solutions, Inc., (a Delaware corporation) and
PILEC Disbursement Company, (a Delaware corporation) into Patron Systems, Inc.,
(a Delaware corporation).
NOTE 3 - LIQUIDITY AND FINANCIAL CONDITION
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company incurred a net loss of
$7,053,184 for the nine months ended September 30, 2006, which includes an
aggregate of $1,436,574 of non-cash charges including the conversion option cost
for bridge note and subordinated note holders, non-cash interest expense, the
amortization of deferred compensation and the charge for stock option based
compensation. The Company used net cash in its operating activities of
$5,017,206 during the nine months ended September 30, 2006. The Company's
working capital deficiency at September 30, 2006 amounted to $5,215,607 and the
Company is continuing to experience shortages in working capital. The Company is
also involved in litigation and is being investigated by the Securities and
Exchange Commission with respect to certain of its press releases and its use of
form S-8 to register shares of common stock issued to certain consultants (Note
15). The Company cannot provide any assurance that the outcome of these matters
will not have a material adverse affect on its ability to sustain the business.
These matters raise substantial doubt about the Company's ability to continue as
a going concern. The accompanying financial statements do not include any
adjustments that may result from the outcome of this uncertainty.
The Company expects to continue incurring losses for the foreseeable future due
to the inherent uncertainty that is related to establishing the commercial
feasibility of technological products and developing a presence in new markets.
The Company's ability to successfully market its software products, grow revenue
and generate cash flows of certain businesses it acquired in 2005 is critical to
the realization of its business plan. The Company raised $5,640,501 of gross
proceeds ($5,301,450 net proceeds after the payment of certain transaction
expenses) in financing transactions during the nine months ended September 30,
2006. The Company used $5,017,206 of these proceeds to fund its operations and a
net of $607,152 in investing activities. On January 12, 2006, the Company
offered its creditors and claimants an agreement to receive Series A-1 Preferred
Stock, par value $0.01 per share ("Series A-1 Preferred") for amounts owed to
the holders of the Company's indebtedness (including lenders, past-due trade
accounts, and employees, consultants and other service providers with claims for
fees, wages or expenses) (Note 16). As of September 30, 2006, creditors
representing approximately 93% of the Company's outstanding claims accepted this
proposal by signing and returning to the Company the Stock Subscription
Agreement and Mutual Release. On July 21, 2006, the Company's Board of Directors
approved the completion of the creditor and claimant liabilities restructuring.
A total of $29,594,442 of debts, liabilities and other claims were settled by
the issuance of Series A-1 Preferred Stock. In addition, through July 21, 2006,
the Company settled $382,584 in claims for $12,140 in cash. The total of all the
settlements for Series A-1 Preferred and the cash settlements through July 21,
2006 represents 94% of the outstanding claims. The Company is currently unable
to provide assurance that the acceptance of the claims settlement will actually
improve the Company's ability to fund the further development of its business
plan or improve its operations.
On July 12, 2006, the Board of Directors ratified, approved and adopted the
indemnification and escrow agreements that the Company has entered into with its
legal counsel, Stubbs, Alderton & Markiles, LLP. Accordingly, cash that was
previously held in escrow for general working capital purposes, including the
repayment of outstanding obligations, under the Company's merger agreement with
Entelagent and the Series A Preferred Stock Financing documents was used to fund
general operating activities.
The Company is currently in the process of attempting to raise additional
capital and has taken certain steps to conserve its liquidity while it continues
to integrate the businesses acquired in 2005. Although management believes that
the Company has access to capital resources, the Company has not secured any
commitments for additional financing at this time nor can the Company provide
any assurance that it will be successful in its efforts to raise additional
capital and/or successfully execute its business plan.
8
NOTE 4 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, Entelagent Software Corporation, Complete
Security Solutions, Inc. and PILEC Disbursement Company, which were merged into
the Company on September 19, 2006. The accounts of LucidLine, Inc. have been
included in discontinued operations through April 18, 2006, the date on which
LucidLine was sold (Note 19). All significant inter-company transactions have
been eliminated.
CASH
The Company considers all highly liquid securities purchased with original
maturities of three months or less to be cash.
CONCENTRATION OF CREDIT RISK
The Company maintains cash with major financial institutions. Cash is insured by
the Federal Deposit Insurance Corporation ("FDIC") up to $100,000 at each
institution. From time to time amounts may exceed the FDIC limits. At September
30, 2006 the uninsured bank cash balances were $0. The Company has not
experienced any losses on these accounts.
REVENUE RECOGNITION
The Company derives revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) services, which include internet access, back-up,
retrieval and restoration services and professional consulting services.
The Company applies the revenue recognition principles set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and Exchange Commission Staff Accounting Bulletin ("SAB") 104 "Revenue
Recognition" with respect to its revenue. Accordingly, the Company records
revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has
occurred, (iii) the vendor's fee is fixed or determinable, and (iv)
collectability is reasonably assured.
The Company generates revenues through sales of software licenses and annual
support subscription agreements, which include access to technical support and
software updates (if and when available). Software license revenues are
generated from licensing the rights to use products directly to end-users and
through third party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of the Company's software sales are supported
by a written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post-contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. The Company uses the residual method
prescribed in SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition
With Respect to Certain Transaction" to allocate revenues to delivered elements
once it has established vendor-specific objective evidence of fair value for
such undelivered elements.
9
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. The Company
recognizes revenue under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19 "Reporting Revenue Gross as a Principal versus Net as Agent."
BUSINESS COMBINATIONS
In accordance with business combination accounting, the Company allocated the
purchase price of acquired companies to the tangible and intangible assets
acquired, liabilities assumed, as well as in-process research and development
based on their estimated fair values. The Company engaged a third-party
appraisal firm to assist management in determining the fair values of certain
assets acquired and liabilities assumed. Such a valuation requires management to
make significant estimates and assumptions, especially with respect to
intangible assets.
Management makes estimates of fair value based upon assumptions believed to be
reasonable. These estimates are based on historical experience and information
obtained from the management of the acquired companies. Critical estimates in
valuing certain of the intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements, customer
contracts and acquired developed technologies; expected costs to develop the
in-process research and development into commercially viable products; the
acquired company's brand awareness and market position, as well as assumptions
about the period of time the acquired brand will continue to be used in the
combined company's product portfolio; and discount rates. These estimates are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur which may
affect the accuracy or validity of such assumptions, estimates or actual
results.
ACCOUNTS RECEIVABLE
The Company adjusts its accounts receivable balances that it deems to be
uncollectible. The allowance for doubtful accounts is the Company's best
estimate of the amount of probable credit losses in the Company's existing
accounts receivable. The Company reviews its allowance for doubtful accounts on
a monthly basis and determines the allowance based on an analysis of its past
due accounts. All past due balances that are over 90 days are reviewed
individually for collectability. Account balances are charged off against the
allowance after all means of collection have been exhausted and the potential
for recovery is considered remote.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets (generally
three to five years). Maintenance and repairs are charged to expense as
incurred; cost of major additions and betterments are capitalized. When property
and equipment is sold or otherwise disposed of, the cost and related accumulated
depreciation are eliminated from the accounts and any resulting gains or losses
are reflected in the statement of operations in the period of disposal.
GOODWILL AND INTANGIBLE ASSETS
The Company accounts for Goodwill and Intangible Assets in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." Under
SFAS No. 142, goodwill and intangibles that are deemed to have indefinite lives
are no longer amortized but, instead, are to be reviewed at least annually for
impairment. Application of the goodwill impairment test requires judgment,
including the identification of reporting units, assigning assets and
liabilities to reporting units, assigning goodwill to reporting units, and
determining the fair value. Significant judgments required to estimate the fair
value of reporting units include estimating future cash flows, determining
appropriate discount rates and other assumptions. Changes in these estimates and
assumptions could materially affect the determination of fair value and/or
goodwill impairment for each reporting unit. We have recorded goodwill in
connection with the Company's acquisitions described in Note 5 amounting to
$22,440,412. The Company's annual impairment review of goodwill resulted in
goodwill impairment charges totaling $12,929,696 for the year ended December 31,
10
2005 (Note 5) resulting in $9,510,716 in goodwill at September 30, 2006.
Intangible assets continue to be amortized over their estimated useful lives.
The Company evaluated the carrying amounts of its goodwill and intangible assets
as of September 30, 2006 and determined that impairment charges are not
necessary.
LONG LIVED ASSETS
The Company periodically reviews the carrying values of its long lived assets in
accordance with SFAS 144, "Long Lived Assets" when events or changes in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their realizable value and records impairment charges when
necessary. The Company's review of the carrying values of its long lived assets
resulted in an impairment charge of $1,705,455 for the year ended December 31,
2005 (Note 8).
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheet for cash, accounts
receivable, accounts payable accrued expenses, advances from stockholders and
all note obligations classified as current liabilities approximate their fair
values based on the short-term maturity of these instruments.
CONVERTIBLE PREFERRED STOCK
The Company accounts for conversion options embedded in convertible preferred
stock in accordance with Statement of Financial Accounting Standard ("SFAS") No.
133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133")
and Emerging Issues Task Force Issue ("EITF") 00-19 "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock" ("EITF 00-19"). SFAS 133 generally requires companies to bifurcate
conversion options embedded in convertible notes and preferred shares from their
host instruments and to account for them as free standing derivative financial
instruments in accordance with EITF 00-19. SFAS 133 provides for an exception to
this rule when convertible notes and mandatorily redeemable preferred shares, as
host instruments, are deemed to be conventional as that term is described in the
implementation guidance provided in paragraph 61 (k) of Appendix A to SFAS 133
and further clarified in EITF 05-2 "The Meaning of Conventional Convertible Debt
Instrument" in Issue No. 00-19.
SFAS 133 provides for an additional exception to this rule when the economic
characteristics and risks of the embedded derivative instrument are clearly and
closely related to the economic characteristics and risks of the host
instrument.
The Company determined that the conversion option embedded in its Series A
Convertible Preferred Stock, par value $0.01 per share ("Series A Preferred"),
is not a free standing derivative in accordance with the implementation guidance
provided in paragraph 61 (l) of Appendix A to SFAS 133.
STOCK BASED COMPENSATION
Prior to January 1, 2006, the Company accounted for employee stock transactions
in accordance with Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees." The Company applied the proforma
disclosure requirements of SFAS No. 123 "Accounting for Stock-Based
Compensation."
Effective January 1, 2006, the Company adopted SFAS No. 123R "Share Based
Payment." This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, and its related implementation guidance. SFAS 123R addresses
all forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options, restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that is
11
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest. The Company adopted the modified
prospective method with respect to accounting for its transition to SFAS 123(R)
and measured unrecognized compensation cost as described in Note 18.
Accordingly, the Company recognized in salaries and related expense in the
statement of operations, $307,629 and $62,705 for the fair value of stock
options expected to vest during the nine and three month periods ended September
30, 2006, respectively.
In the current quarter we have reclassified certain components of our
stockholders' equity section to reflect the elimination of deferred compensation
arising from unvested share-based compensation pursuant to the requirements of
Staff Accounting Bulletin No. 107, regarding Statement of Financial Accounting
Standards No. 123(R), "Share-Based Payment." This deferred compensation was
previously recorded as an increase to additional paid-in capital with a
corresponding reduction to stockholders' equity for such deferred compensation.
This reclassification has no effect on net income or total stockholders' equity
as previously reported. The Company will record an increase to additional
paid-in capital as the share-based payments vest.
For the nine and three months ended September 30, 2005, the Company applied APB
Opinion No. 25, "Accounting for Stock Issued to Employees." As required under
SFAS No. 148, "Accounting for Stock-based Compensation - Transition and
Disclosure," the following table presents pro-forma net income and basic and
diluted earnings per share as if the fair value-based method had been applied to
all awards during that period.
NINE MONTHS THREE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2005 2005
------------ ------------
Net Loss, as reported ........................ $(19,910,022) $(12,677,722)
Stock-based employee compensation cost,
under fair value accounting ............... (375,000) (225,000)
------------ ------------
Pro-forma net loss under fair value method ... $(20,285,022) $(12,902,722)
============ ============
Net loss per share - basic and diluted,
as reported ............................... $ (10.43) $ (6.18)
Net loss per share - basic and diluted,
proforma .................................. $ (10.62) $ (6.29)
The fair value of all awards was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions: risk fee interest rate: 3.44% to 4.05%; expected dividend yield:
0%; expected option life: 3 to 4 years; volatility: 87% to 125%.
COMMON STOCK PURCHASE WARRANTS
The Company accounts for the issuance of common stock purchase warrants issued
with registration rights in accordance with the provisions of EITF 00-19,
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock."
Based on the provisions of EITF 00-19, the Company classifies as equity any
contracts that (i) require physical settlement or net-share settlement or (ii)
gives the company a choice of net-cash settlement or settlement in its own
shares (physical settlement or net-share settlement). The Company classifies as
assets or liabilities any contracts that (i) require net-cash settlement
(including a requirement to net cash settle the contract if an event occurs and
if that event is outside the control of the company) or (ii) give the
counterparty a choice of net-cash settlement or settlement in shares (physical
settlement or net-share settlement).
12
INCOME TAXES
The Company accounts for income taxes under SFAS No. 109, "Accounting for Income
Taxes." SFAS No. 109 requires the recognition of deferred tax assets and
liabilities for both the expected impact of differences between the financial
statements and tax basis of assets and liabilities and for the expected future
tax benefit to be derived from tax loss and tax credit carry forwards. SFAS No.
109 additionally requires the establishment of a valuation allowance to reflect
the likelihood of realization of deferred tax assets.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share, if required,
would be computed by dividing net loss by the weighted-average number of common
shares outstanding without an assumed increase in common shares outstanding for
common stock equivalents; as such common stock equivalents are anti-dilutive.
As a result of the consummation of the Share Exchange described in Note 2, the
Company included 40,001 stock options with an exercise price of $.30 per share
that it issued to certain employees during 2002 in its calculation of
weighted-average number of common shares outstanding for all periods presented.
Net loss per common share excludes the following outstanding options and
warrants as their effect would be anti-dilutive:
SEPTEMBER 30,
---------------------
2006 2005
--------- ---------
Options ............ 463,970 373,000
Warrants ........... 1,405,863 321,852
--------- ---------
1,869,833 694,852
========= =========
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets" (SFAS 153). SFAS 153 amends APB Opinion No. 29 to eliminate the
exception for non-monetary exchanges of similar productive assets and replaces
it with a general exception for exchanges of non-monetary assets that do not
have commercial substance. A non-monetary exchange has commercial substance if
the future cash flows of the entity are expected to change significantly as a
result of the exchange. The provisions of SFAS 153 are effective for
non-monetary asset exchanges occurring in fiscal periods beginning after June
15, 2005. Earlier application is permitted for non-monetary asset exchanges
occurring in fiscal periods beginning after December 16, 2004. The provisions of
this statement are intended be applied prospectively. The adoption of this
pronouncement did not have a material effect on the Company's financial
statements.
In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 154, "Accounting Changes and Error
Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS
154"). This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB
Statement No. 3, Reporting Accounting Changes in Interim Financial Statements,
and changes the requirements for the accounting for and reporting of a change in
accounting principle. This Statement applies to all voluntary changes in
accounting principle. It also applies to changes required by an accounting
pronouncement in the unusual instance that the pronouncement does not include
specific transition provisions. When a pronouncement includes specific
transition provisions, those provisions should be followed.
APB Opinion No. 20 previously required that most voluntary changes in accounting
principle be recognized by including in net income of the period of the change
the cumulative effect of changing to the new accounting principle. This
Statement requires retrospective application to prior periods' financial
13
statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. When it is impracticable to determine the period-specific effects of an
accounting change on one or more individual prior periods presented, this
Statement requires that the new accounting principle be applied to the balances
of assets and liabilities as of the beginning of the earliest period for which
retrospective application is practicable and that a corresponding adjustment be
made to the opening balance of retained earnings (or other appropriate
components of equity or net assets in the statement of financial position) for
that period rather than being reported in an income statement. When it is
impracticable to determine the cumulative effect of applying a change in
accounting principle to all prior periods, this Statement requires that the new
accounting principle be applied as if it were adopted prospectively from the
earliest date practicable. This Statement is effective for accounting changes
and corrections of errors made in fiscal years beginning after December 15,
2005. The adoption of this pronouncement did not have a material effect on the
Company's financial statements.
On June 29, 2005, the EITF ratified Issue No. 05-2, "The Meaning of
`Conventional Convertible Debt Instrument' in EITF Issue No. 00-19, `Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock.'" EITF Issue 05-2 provides guidance on determining whether
a convertible debt instrument is "conventional" for the purpose of determining
when an issuer is required to bifurcate a conversion option that is embedded in
convertible debt in accordance with SFAS 133. Issue No. 05-2 is effective for
new instruments entered into and instruments modified in reporting periods
beginning after June 29, 2005. The adoption of this pronouncement did not have a
material effect on the Company's financial statements.
In September 2005, the EITF ratified Issue No. 05-4, "The Effect of a Liquidated
Damages Clause on a Freestanding Financial Instrument Subject to EITF Issue No.
00-19, `Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock.'" EITF 05-4 provides guidance to
issuers as to how to account for registration rights agreements that require an
issuer to use its "best efforts" to file a registration statement for the resale
of equity instruments and have it declared effective by the end of a specified
grace period and, if applicable, maintain the effectiveness of the registration
statement for a period of time or pay a liquidated damage penalty to the
investor. The Company is currently in the process of evaluating the effect that
the adoption of this pronouncement may have on its financial statements.
In September 2005, the FASB ratified the Emerging Issues Task Force's ("EITF")
Issue No. 05-7, "Accounting for Modifications to Conversion Options Embedded in
Debt Instruments and Related Issues," which addresses whether a modification to
a conversion option that changes its fair value affects the recognition of
interest expense for the associated debt instrument after the modification and
whether a borrower should recognize a beneficial conversion feature, not a debt
extinguishment if a debt modification increases the intrinsic value of the debt
(for example, the modification reduces the conversion price of the debt). This
issue is effective for future modifications of debt instruments beginning in the
first interim or annual reporting period beginning after December 15, 2005. The
adoption of this pronouncement did not have a material effect on the Company's
financial statements.
In September 2005, the FASB also ratified the EITF's Issue No. 05-8, "Income Tax
Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature,"
which discusses whether the issuance of convertible debt with a beneficial
conversion feature results in a basis difference arising from the intrinsic
value of the beneficial conversion feature on the commitment date (which is
recorded in the stockholders' equity for book purposes, but as a liability for
income tax purposes), and, if so, whether that basis difference is a temporary
difference under FASB Statement No. 109, "Accounting for Income Taxes." This
Issue should be applied by retrospective application pursuant to Statement 154
to all instruments with a beneficial conversion feature accounted for under
Issue 00-27 included in financial statements for reporting periods beginning
after December 15, 2005. The adoption of this pronouncement did not have a
material effect on the Company's financial statements.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments - an amendment of FASB Statements No. 133 and 150." SFAS
No. 155 (a) permits fair value remeasurement for any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation,
(b) clarifies that certain instruments are not subject to the requirements of
SFAS 133, (c) establishes a requirement to evaluate interests in securitized
financial assets to identify interests that may contain an embedded derivative
requiring bifurcation, (d) clarifies what may be an embedded derivative for
certain concentrations of credit risk and (e) amends SFAS 140 to eliminate
certain prohibitions related to derivatives on a qualifying special-purpose
entity. SFAS 155 is applicable to new or modified financial instruments in
fiscal years beginning after September 15, 2006, though the provisions related
14
to fair value accounting for hybrid financial instruments can also be applied to
existing instruments. Early adoption, as of the beginning of an entity's fiscal
year, is also permitted, provided interim financial statements have not yet been
issued. We are currently evaluating the potential impact, if any, that the
adoption of SFAS 155 will have on our consolidated financial statements.
In March 2006, the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 156, Accounting for Servicing of Financial Assets (SFAS No. 156).
SFAS No. 156 amends SFAS No. 140 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," to require all separately
recognized servicing assets and servicing liabilities to be initially measured
at fair value, if practicable. SFAS No. 156 also permits servicers to
subsequently measure each separate class of servicing assets and liabilities at
fair value rather than at the lower of cost or market. For those companies that
elect to measure their servicing assets and liabilities at fair value, SFAS No.
156 requires the difference between the carrying value and fair value at the
date of adoption to be recognized as a cumulative effect adjustment to retained
earnings as of the beginning of the fiscal year in which the election is made.
SFAS No. 156 is effective for the first fiscal year beginning after September
15, 2006. We are currently evaluating the potential impact, if any, that the
adoption of SFAS 156 will have on our consolidated financial statements.
In July 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes. This
Interpretation prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. This Interpretation also provides guidance
on derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. The Interpretation is effective for fiscal
years beginning after December 15, 2006. We have not yet completed our analysis
of the impact this Interpretation will have on our financial condition, results
of operations, cash flows or disclosures.
In September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, Fair Value Measurements ("SFAS 157"). This Standard defines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles and expands disclosures about fair value measurements.
SFAS 157 is effective for financial statements issued for fiscal years beginning
after November 15, 2007 and interim periods within those fiscal years. The
adoption of SFAS 157 is not expected to have a material impact on the Company's
financial position, results of operations or cash flows.
Other accounting standards that have been issued or proposed by the FASB or
other standards-setting bodies that do not require adoption until a future date
are not expected to have a material impact on the consolidated financial
statements upon adoption.
NOTE 5 - BUSINESS COMBINATIONS
On February 25, 2005, the Company acquired Complete Security Solutions, Inc.
("CSSI") and LucidLine, Inc. ("LucidLine") in separate merger transactions.
Additionally, on March 30, 2005, the Company acquired Entelagent Software Corp.
("Entelagent") in a merger transaction. The Company accounted for these business
combinations in accordance with the provisions of SFAS 141 "Accounting for
Business Combinations."
In connection with these three merger transactions, the Company paid, $200,000
in cash, 496,667 shares of common stock with a fair market value of $12,665,000,
subordinated promissory notes in the aggregate principal amount of $4,500,000,
warrants to purchase up to 75,001 shares of common stock which were valued at
$1,912,500. Direct expenses incurred by the Company to complete these
transactions amounted to $912,663. The total purchase price for the three
companies amounted to $20,190,133.
The allocation of the purchase price was based upon a valuation study performed
by an independent outside appraisal firm. The purchase price allocation resulted
in the allocation of $3,101,000 to intangible assets, including $2,570,000 to
developed technology and $190,000 to in-process research and development.
Additionally, the purchase price allocation resulted in the allocation of
$22,440,412 to goodwill.
15
The Company performed its annual impairment test of goodwill at its designated
valuation date of December 31, 2005 in accordance with SFAS 142. As a result of
these tests, the Company determined that the recoverable amount of goodwill with
respect to its business amounted to $9,510,716. Accordingly, the Company
recorded a goodwill impairment charge in the amount of $12,929,696 for the year
ended December 31, 2005. Additionally, after reevaluating the resources
available to the Company, the strategic direction of the business as well as the
revised business plans and financial projections, the Company, during the
quarter ended December 31, 2005, recorded a $1,705,455 charge for the impairment
of the developed technology assets acquired in the CSSI and Entelagent
acquisitions. The remaining amount of goodwill and intangible assets is
presented net of such impairment charges recorded during the year ended December
31, 2005. There have been no new developments since December 31, 2005 which
would give rise to an impairment charge.
On April 18, 2006, the Company entered into a Stock Purchase Agreement with
Walnut Valley, Inc. pursuant to which the Company sold all of the outstanding
shares of LucidLine, Inc. As a result, LucidLine has been treated as a
discontinued operation in these financial statements (Note 19).
NOTE 6 - OTHER CURRENT ASSETS
Other current assets consist of the following:
SEPTEMBER 30,
2006
----------
Prepaid expenses ..... $ 27,365
Deposits ............. 30,639
----------
Other current assets $ 58,004
==========
NOTE 7 - PROPERTY AND EQUIPMENT
SEPTEMBER 30,
2006
----------
Computers ..................... $ 234,136
Furniture and fixtures ........ 31,962
Leasehold improvements ........ 4,490
----------
sub-total ................. 270,588
less: accumulated depreciation (77,045)
Property and equipment, net $ 193,543
==========
Depreciation expense amounted to $44,425 and $25,491 for the nine months ended
September 30, 2006 and 2005, respectively.
16
NOTE 8 - INTANGIBLE ASSETS
The components of intangible assets as of September 30, 2006 are set forth in
the following table:
SEPTEMBER 30,
2006
-----------
Developed technology ..................................... $ 2,570,000
Customer relationships ................................... 180,000
Trademarks and tradenames ................................ 161,000
In-process research and development ...................... 920,815
-----------
3,831,815
Amortization and impairment charge ....................... (2,395,048)
-----------
Intangible assets, net ................................ $ 1,436,767
===========
The amortization of intangible assets will result in the following additional
expense by year:
INTANGIBLE
YEARS ENDED DECEMBER 31, AMORTIZATION
----------------------- ------------
2006 $ 85,398
2007 367,070
2008 379,501
2009 310,666
2010 180,016
2011 101,686
2012 12,430
----------
$1,436,767
==========
During the year ended December 31, 2005, the Company recorded a $1,705,455
charge for the impairment of the developed technology assets acquired in the
CSSI and Entelagent acquisitions (Note 5).
The Company classifies amortization of developed technology as a component of
cost of sales and amortization of customer relationship and trademarks and
tradenames as a component of general and administrative expense. Amortization
expense amounted to $192,420 and $342,483 for the nine months ended September
30, 2006 and 2005, respectively. Included in these amounts is $99,980 and
$272,792 for the nine months ended September 30, 2006 and 2005, respectively,
which is classified as cost of sales.
NOTE 9 - DEMAND NOTES PAYABLE
Through December 31, 2004, the Company borrowed an aggregate amount of $695,000
from several unrelated parties. At September 30, 2006, all of the notes were
settled in the creditor and claimant liabilities restructuring. Interest expense
on the notes amounted to $20,750 and $52,125 for the nine months ended September
30, 2006 and 2005, respectively.
The remaining demand note at September 30, 2006, which amounts to $312,556, is
payable to Lok Technology and is secured by Entelagent's accounts receivable,
which approximate $86,000 and $106,000 at September 30, 2006 and 2005,
respectively. The note bears interest at 15% per annum. Interest on this demand
note amounted to $35,163 for the nine months ended September 30, 2006 and
$23,442 for nine months ended September 30, 2005. As described in Note 15, on
May 4, 2006, the Company became aware of a complaint that Lok Technologies, Inc.
had filed in the Superior Court of California, County of Santa Clara on or about
March 30, 2006 against the Company, Entelagent Software Corp. and unnamed
defendants.
17
As of September 30, 2006, $743,500 of the Demand Notes have been surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 16).
NOTE 10 - BRIDGE NOTES PAYABLE
INTERIM BRIDGE FINANCING I
On February 28, 2005, the Company completed a $3,500,000 financing (the "Interim
Bridge Financing I") through the issuance of 10% Senior Convertible Promissory
Notes (the "Bridge I Notes") and warrants to purchase up to 58,348 shares of the
Company's common stock ("Bridge I Warrants"). The warrants have a term of 5
years and an exercise price of $21.00 per share. The aggregate fair value of the
Bridge I Warrants amounts to $1,487,500. Prior to final maturity, the Bridge I
Notes may be converted into securities that would be issuable at the first
closing of a subsequent financing by the Company, for such number of offered
securities that could be purchased for the principal amount being converted. The
Bridge I Notes had an initial term of 120 days (due on June 28, 2005) with
interest at a contractual rate of 10% per annum and featured an option for the
Company to extend the term for an additional 60 days to August 27, 2005.
In accordance with APB 14, "Accounting for Convertible Debt and Debt Issued with
Stock Purchase Warrants," the Company allocated $2,456,140 of the proceeds to
the Bridge I Notes and $1,043,860 of proceeds to the Bridge I Warrants. The
difference between the carrying amount of the Bridge I Notes and their
contractual redemption amount was accreted as interest expense to June 28, 2005,
their earliest date of redemption.
On June 28, 2005, the Company elected to extend the contractual maturity date of
the Bridge I Notes for an additional 60 days to August 27, 2005, which caused
the contractual interest rate to increase to 12% per annum. In addition, the
Company was required to issue the 58,348 additional warrants (the "Bridge I
Extension Warrants") to purchase such number of shares of common stock equal to
1/60 of a share for each $1.00 of principal amount outstanding. The Bridge I
Extension Warrants have a term of 5 years and an exercise price of $21.00 per
share.
The Company did not redeem the Bridge I Notes on August 27, 2005 and, as a
result, the notes automatically became convertible into 0.128 shares of common
stock for each $1 of principal then outstanding in accordance with the original
note agreement. Accordingly, the Company recorded a charge of $3,500,000 in 2005
based upon the intrinsic value of this conversion option measured at the
original issuance date of the note in accordance with EITF 00-27. The Company
has filed with the SEC on July 24, 2006 a registration statement for the resale
of the restricted shares of the Company's common stock issuable upon exercise of
the conversion option that would be issued in this transaction.
Contractual interest expense on the Bridge I Notes amounted to $123,665 and
$204,167 for the nine months ended September 30, 2006 and 2005, respectively,
and is included as a component of interest expense in the accompanying statement
of operations.
As of September 30, 2006, $3,180,025 of the Bridge I Notes were surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 16). With the surrender of the Bridge I Notes in
payment for Series A-1 Preferred stock under the creditor and claimant
liabilities restructuring, conversion options associated with the surrendered
Bridge I Notes are no longer exercisable and have been cancelled. As of
September 30, 2006, $319,975 of Bridge I notes remain outstanding. The
registration statement filed on July 24, 2006 includes the resale of the 40,957
restricted shares of the Company's common stock issuable upon the exercise of
the conversion option associated with the Bridge I Notes.
INTERIM BRIDGE FINANCING II
On June 6, 2005, the Company completed a $2,543,000 financing (the "Interim
Bridge Financing II") through the issuance of (i) 10% Junior Convertible
Promissory Notes (the "Bridge II Notes") and (ii) warrants to purchase up to
18
42,388 shares of common stock (the "Bridge II Warrants"). The warrants have a
term of 5 years and an exercise price of $18.00 per share. The aggregate fair
value of the Bridge II Warrants amounts to $673,895. Prior to maturity, the
Junior Convertible Promissory Notes may be converted into the securities offered
by the Company at the first closing of a subsequent financing for the Company,
for such number of offered securities as could be purchased for the principal
amount being converted.
In accordance with APB 14, the Company allocated $2,010,277 of the proceeds to
the Bridge II Notes and $532,723 of proceeds to the Bridge II Warrants. The
difference between the carrying amount of the Bridge II Notes and their
contractual redemption amount is being accreted as interest expense to October
3, 2005, their earliest date of redemption.
The Bridge II Notes have an initial term of 120 days (due on various dates
beginning October 3, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an additional 60 days to various dates
beginning December 2, 2005. Upon the extension of the maturity date of the
Bridge II Notes, the contractual interest rate would increase to 12% per annum,
and the Company would be required to issue warrants (the "Bridge II Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to 1/60th of a share for each $1.00 of principal then outstanding. The Bridge II
Extension Warrants, issuable upon extension of the maturity date of the Junior
Convertible Promissory notes, feature a term of 5 years and an exercise price of
$18.00 per share. In addition, if the Bridge II Notes are not paid in full on or
before the extended maturity date, each note becomes convertible into .128
shares of the Company's common stock for each $1.00 of principal then
outstanding. The intrinsic value of this conversion option measured at the
issuance date of the notes amounts to $2,543,000 and would be recognized as
interest expense in accordance with EITF 00-27. The Company has agreed to file
with the SEC, a registration statement for the resale of the restricted shares
of its common stock issuable upon exercise of the conversion option that would
be issuable in this transaction, on a best efforts basis.
The Company sold these securities to seven accredited investors introduced by
Laidlaw, placement agent in the Interim Bridge Financing II. The Company
incurred $386,027 of fees in connection with this transaction including a cash
fee of $305,160 and $80,867 for the fair value of warrants to purchase 4,243
shares of the Company's common stock at an exercise price of $18.00 per share.
The Company elected to extend the due dates of these notes by an additional 60
days to various dates beginning December 2, 2005. In addition, the Company was
required to issue Bridge II Extension Warrants to purchase 42,388 shares of the
Company's common stock. The Bridge II Extension Warrants have at term of 5 years
and an exercise price of $18.00 per share.
The Company did not redeem the Bridge II Notes on December 2, 2005 and, as a
result, the notes automatically became convertible into 0.128 shares of common
stock for each $1 of principal then outstanding in accordance with the original
note agreement. Accordingly, the Company recorded a charge of $2,543,000 based
upon the intrinsic value of this conversion option measured at the original
issuance date of the note in accordance with EITF 00-27. The Company has filed
with the SEC on July 24, 2006 a registration statement for the resale of the
restricted shares of the Company's common stock issuable upon exercise of the
conversion option that would be issued in this transaction.
Contractual interest expense on the Bridge II Notes amounted to $117,261 and
$84,767 for the nine months ended September 30, 2006 and 2005, respectively and
is included as a component of interest expense in the accompanying statement of
operations.
As of September 30, 2006, $2,343,000 of the Bridge II Notes were surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 16). With the surrender of the Bridge II Notes
in payment for Series A-1 Preferred stock under the creditor and claimant
liabilities restructuring, the conversion options associated with the
surrendered Bridge II Notes are no longer exercisable and have been cancelled.
As of September 30, 2006, $200,000 of the Bridge II Notes remain outstanding.
The registration statement filed on July 24, 2006 includes the resale of the
25,600 restricted shares of the Company's common stock issuable upon the
exercise of the conversion option associated with the Bridge II Notes.
19
INTERIM BRIDGE FINANCING III
Beginning on July 1, 2005, and continuing through December 31, 2005, the Company
completed, through 12 separate fundings, a $5,234,000 financing (the "Interim
Bridge Financing III") through the issuance of (i) 10% Junior Convertible
Promissory Notes (the "Bridge III Notes") and (ii) warrants to purchase up to
87,235 shares of common stock (the "Bridge III Warrants"). The warrants have a
term of 5 years and an exercise price of $18.00 per share. Prior to maturity,
the Junior Convertible Promissory Notes may be converted into the securities
offered by the Company at the first closing of a subsequent financing for the
Company, for such number of offered securities as could be purchased for the
principal amount being converted.
In accordance with APB 14, the Company allocated $4,645,544 of the proceeds to
the Bridge III Notes and $587,595 of proceeds to the Bridge III Warrants. The
difference between the carrying amount of the Bridge III Notes and their
contractual redemption amount is being accreted as interest expense to various
dates from November 1, 2005, their earliest date of redemption. Accretion of the
aforementioned discount amounted to $20,909 for the three months ended March 31,
2006 and is included as a component of interest expense in the accompanying
statement of operations.
The Bridge III Notes had an initial term of 120 days (due on various dates
beginning October 28, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an additional 60 days to various dates
beginning December 28, 2005. Upon the extension of the maturity date of the
Bridge III Notes, the contractual interest rate would increase to 12% per annum,
and the Company would be required to issue warrants (the "Bridge III Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to 1/60th of a share for each $1.00 of principal then outstanding. The Bridge
III Extension Warrants, issuable upon extension of the maturity date of the
Junior Convertible Promissory Notes, feature a term of 5 years and an exercise
price of $18.00 per share. In addition, if the Bridge III Notes were not paid in
full on or before the extended maturity date, each note became convertible into
0.128 shares of the Company's common stock for each $1.00 of principal then
outstanding. The intrinsic value of this conversion option measured at the
issuance date of the notes amounts to $5,234,000 and would have been recognized
as interest expense in accordance with EITF 00-27. The Company agreed to file
with the SEC, a registration statement for the resale of the restricted shares
of its common stock issuable upon exercise of the conversion option that would
be issuable in this transaction, on a best efforts basis.
Beginning on October 29, 2005, the Company elected to extend the contractual
maturity date of the various Bridge III Notes for an additional 60 days to
various dates beginning December 28, 2005, which caused the contractual interest
rate to increase to 12% per annum. In addition, during the three month ended
March 31, 2006, the Company was required to issue 39,917 additional warrants
(the "Bridge III Extension Warrants"). The aggregate fair value of the warrants,
which amounted to $48,129 was recorded as a deferred financing cost and was
being amortized over the 60-day extension period or until March 27, 2006 when
the Bridge III Notes were surrendered as payment for the Series A-1 Preferred
stock under the creditor and claimant liabilities restructuring. The Bridge III
Extension Warrants have a term of 5 years and an exercise price of $18.00 per
share.
The Company did not redeem Bridge III Notes on contractual maturity dates that
occurred through January 12, 2006 (the date of the Series A-1 creditor and
claimant liabilities restructuring). As a result, $3,400,000 of the Notes
automatically became convertible into 0.128 shares of common stock for each $1
of principal then outstanding in accordance with the original note agreement.
This amounts to a total of 70,400 shares during the three months ended of March
31, 2006. Accordingly, the Company recorded a charge of $550,000, in the three
months ended March 31, 2006, based upon the intrinsic value of this conversion
option measured at the original issuance date of the notes in accordance with
EITF 00-27. With the surrender of the Bridge III Notes in payment for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring, these
conversion options are no longer exercisable and have been cancelled.
As of September 30, 2006, all of the Bridge III Notes were surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 16).
Contractual interest expense on the Bridge III Notes amounted to $153,036 and $0
for the nine months ended September 30, 2006 and 2005, respectively, and is
included as a component of interest expense in the accompanying statement of
operations.
20
The Company sold these securities to Apex, Northwestern, and Advanced Equities.
Funding for the Bridge III Notes included the conversion of $1,650,000 of
stockholder advances made during the period March 30, 2005 to June 30, 2005 into
Bridge III Notes.
2006 BRIDGE NOTES
On January 18, 2006, the Company completed a financing of approximately $540,000
in additional gross funds (the "2006 Bridge Note Financing") through the
issuance of Subordinated Convertible Promissory Notes (the "2006 Bridge Notes")
in the amount of $720,001. The 2006 Bridge Note agreement provided for these
notes to automatically convert into the same securities (consisting of shares of
Series A Preferred Stock and warrants to purchase shares of the Company's common
stock) offered by the Company in connection with its Series A Preferred
Financing (as defined below). On March 27, 2006 (the date of the first closing
of the Series A Preferred Financing), the 2006 Bridge Notes were converted into
7.2 Units in the Series A Preferred Financing described below. The $180,000
difference between the gross proceeds received upon the original issuance of the
notes and the redemption amount was recorded as an original issuance discount
that was fully expensed during the nine months ended September 30, 2006.
Additionally, the Company paid Laidlaw & Company (UK) Ltd. (Laidlaw), as
placement agent in the transaction, a fee of $54,000 in conjunction with the
2006 Bridge Note Financing. This fee was fully amortized and recognized as
interest expense during the nine months ended September 30, 2006.
INTERIM BRIDGE FINANCING IV
Beginning on July 18, 2006 and continuing through September 15, 2006, the
Company obtained interim financing ("Interim Bridge Financing IV") totaling
$1,000,000 from Apex. This Interim Bridge Financing IV automatically converts
into securities (consisting of shares of Series B Preferred Stock and warrants
to purchase shares of the Company's common stock) offered by the Company in
connection with its Series B Preferred Financing (see Note 20). On October 13,
2006, (the date of the first closing of the Series B Preferred Financing), the
Interim Bridge Financing IV was converted into 10 Units in the Series B
Preferred Financing described in Note 20 below.
NOTE 11 - RELATED PARTY TRANSACTIONS
EXPENSE REIMBURSEMENTS DUE TO OFFICERS AND STOCKHOLDERS
Certain stockholders and officers of the Company have paid expenses on the
Company's behalf since its inception, of which $4,458 remains outstanding at
September 30, 2006. The amounts payable to such officers and stockholders are
due on demand.
As of September 30, 2006, $135,535 of expense reimbursements were surrendered as
payment for Series A-1 Preferred stock as part of the creditor and claimant
liabilities restructuring (Note 16).
NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS
As of September 30, 2006, $284,212 of notes payable to officers and stockholders
were surrendered as payment for Series A-1 Preferred stock as part of the
creditor and claimant liabilities restructuring (Note 16).
CONSULTING AGREEMENT PAYABLE
On June 8, 2005, the Company negotiated a settlement regarding a consulting
agreement payable with a related party. The terms of the settlement agreement
terminated the prior agreement and reduced the remaining payments due under the
contract to $150,000 including a $50,000 payment that was made upon the
execution of the agreement and two additional $50,000 payments including one to
be made upon the completion of a follow-on-financing by the Company and one not
later than September 30, 2005. The $150,000 reduction in payments was recorded
21
as a reduction of general and administrative expense during the quarter ended
June 30, 2005. Additionally, the settlement agreement terminated an obligation
for the Company to issue 3,334 shares of unrestricted stock. The stock issuable
under this commitment was recorded in 2004 as common stock issued in lieu of
cash for services in the amount of $78,900. The rescission of the stock issuable
under this arrangement resulted in an additional reduction of $78,900 in general
and administrative expenses during the year ended December, 31, 2005.
The payment due on September 30, 2005 was not made by the Company. The $100,000
balance due under this arrangement has been surrendered as payment for Series
A-1 Preferred stock under the creditor and claimant liabilities restructuring
described in Note 16.
NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)
The notes issued to creditors of Entelagent (in connection with the acquisition
described in Note 5) include $554,202 that is payable to related parties for
settlements of accrued payroll, notes payable and other payables that remain
outstanding at September 30, 2006. The original amount of these notes amounted
to $2,602,913. Aggregate interest expense on these notes amounted to $74,184 and
$103,901 for the nine months ended September 30, 2006 and 2005, respectively.
During the nine months ended September 30, 2006, $1,795,930 of the notes payable
to creditors of acquired business were surrendered as payment for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring. As of
September 30, 2006, $799,982 of the notes payable remain outstanding.
NOTE 12 - OTHER CURRENT LIABILITIES
Other current liabilities principally consist of $439,146 of accrued payroll and
sales tax liabilities and estimated penalties that the Company assumed in its
acquisition of Entelagent (Note 5). The balance consists of various
miscellaneous other current liabilities.
NOTE 13 - DEFERRED REVENUE
Deferred revenue at September 30, 2006 includes (1) $153,348 for the fair value
of remaining service obligations on maintenance and support contracts and (2)
$70,532 for contracts on which the revenue recognition is deferred until
contract deliverables have been completed. Included in the contracts for which
revenue recognition has been deferred are two contracts with a value of $468,947
for which $159,321 of revenue has been recognized and for which the majority of
the remaining revenue is expected to be recorded during 2006.
NOTE 14 - ACCOMMODATION AGREEMENT
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the "Lender"), pursuant to which the Company would
borrow $950,000 under a note to be collateralized by the pledge of 31,667 shares
of registered stock from five different stockholders. In connection with this
arrangement, the Company executed a series of Accommodation Agreements with
these stockholders wherein each stockholder pledged their shares in return for
the right to receive on or before November 17, 2003 the return of the pledged
shares, or replacement shares in the event of foreclosure, and one additional
share of common stock for every four shares pledged as compensation. The Company
also agreed to use "best efforts" to register these shares with the Securities
and Exchange Commission 12 months from the date of issue.
In December 2002, the Company received approximately $450,000 of proceeds under
the note and provided the Lender the pledged shares. Since that date, no
additional proceeds were provided by the Lender and repeated attempts were made
by the Company to secure the additional proceeds. The Company has effectively
accounted for the Lender's failure to fund the facility and return the pledged
shares as a foreclosure on the loan collateral. Accordingly, the Company
recorded a $1,047,728 loss during the year ended December 31, 2002.
22
On March 13, 2003, the Company issued 40,000 replacement shares with an
aggregate fair value of $3,708,000 to the stockholders who pledged their shares
under the Accommodation Agreements. Accordingly, the Company recorded an
additional loss of $2,210,272 during the year ended December 31, 2003 for the
difference between the loss the Company recorded upon the Lender's foreclosure
of the collateral and the aggregate fair value of the replacement shares.
In addition, the Accommodation Agreements provided for the Company to pay a
penalty in the event of its failure to cause the replacement shares to be
registered on or before March 31, 2003. As a result, the Company has recorded
stock based penalties for the fair value of 15,000 shares per quarter through
December 31, 2005.
The total stock-based penalties associated with the Accommodation Agreements
from April 2003 to December 31, 2005 were $3,318,975. An aggregate of 165,000
shares were issuable through December 31, 2005 under the stock-based penalties
associated with the Accommodation Agreements.
On March 27, 2006, the Company entered into an agreement to release and resolve
all outstanding claims between the parties under the creditor and claimant
liabilities restructuring (Note 16).
STOCK PLEDGE ARRANGEMENT
In April 2004, a stockholder of the Company entered into a one-year stock loan
financing arrangement ("Stock Financing Facility") with a third party financial
institution (the "Lender I"), pursuant to which such stockholder committed to
obtain financing for the Company under a credit facility collateralized by the
pledge of 22,834 shares of registered stock (the "Pledged Stock") that was
pledged by a second stockholder (the "Pledging Stockholder"). In connection with
this arrangement, the Company executed an accommodation agreement with the
Pledging Stockholder committing to issue 22,834 shares of restricted stock (the
"Replacement Stock") on April 2, 2005 (the "Termination Date") in the event of a
loss of the Pledged Stock, plus a premium of 6,850 shares (the "Premium Shares")
for entering into the agreement. The Company also agreed to register 10,000
shares of restricted stock held by the Pledging Stockholder (the "Held Stock")
within thirty days of the agreement and to use its best efforts register with
the SEC, both the Replacement Stock and Premium Stock within 12 months from
their date of issue.
The Company received $40,012 of funds but was unable to recover the Pledged
Stock on the Termination Date. In addition, due to a delay in registering all of
the shares under this arrangement, the Company entered into a secondary
agreement with the Pledging Stockholder providing for: (1) the immediate
issuance of the Replacement Shares and Premium Shares; (2) registration of the
Replacement Shares, Premium Shares and Held Shares; (3) the retroactive accrual
of a penalty from May 2, 2004 through the date the registration statement is
filed payable in such number of shares that is equal to 15% of the Held Stock
(prorated for each fraction of a year); and (4) the accrual of an additional
penalty from April 2, 2005 through the date the registration statement is filed
equal to 15% of the Replacement Stock and Premium Stock (prorated for each
fraction of a year).
The Company recorded a charge of $406,205 for the fair value of the Replacement
Stock and Premium Stock (29,684 shares) issued to the Pledging Stockholder under
this arrangement. Such charge, net of $40,012 of advances received, is presented
as a loss on collateralized financing arrangement in the accompanying statement
of operations. The Company also recorded charges of $8,560 and $78,247 during
the nine months ended September 30, 2006 and 2005, respectively for the fair
value of 4,497 and 4,353 shares issuable during the nine months ended September
30, 2006 and 2005, respectively to the Pledging Stockholder as penalties for the
delays in registering the stock. The charges associated with the penalties are
included in stock based penalties under collateralized financing arrangement in
the accompanying statements of operations.
23
NOTE 15 - COMMITMENTS AND CONTINGENCIES
SEC INVESTIGATION
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating Officers to Take Testimony (C-03739-A, February 12, 2004)) (the
"Order") that a private investigation (the "SEC Investigation") be made to
determine whether certain actions of, among others, the Company, certain of its
former officers and directors and others violated Section 5(a) and 5(c) of the
Securities Act and/or Section 10 and Rule 10b-5 promulgated under the Exchange
Act. Generally, the Order provides, among other things, that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8, filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the resale of, in the aggregate, 145,834 shares of common stock issued to
various consultants of the Company, and (ii) whether in connection with the
purchase or sale of shares of common stock, certain officers and directors of
the Company and others (a) sold common stock in violation of Section 5 of the
Securities Act and/or, (b) made misrepresentations and/or omissions of material
facts and/or employed fraudulent devices in connection with such purchases
and/or sales relating to certain of the Company's press releases regarding,
among other items, proposed mergers and acquisitions that were never
consummated. If the SEC brings an action against the Company, it could result
in, among other items, a civil injunctive order or an administrative
cease-and-desist order being entered against the Company, in addition to the
imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely the Company's ability to
have its common stock become listed on a stock exchange and/or quoted on the
NASD Bulletin Board or NASDAQ, the Company being able to sell its securities
and/or have its securities registered with the SEC and/or in various states
and/or the Company's ability to implement its business plan. The Company's legal
counsel representing the Company in such matters has indicated that while the
SEC Investigation is ongoing and the Company has not received correspondence
from the SEC indicating that the matter is officially closed, the Staff has
indicated that it does not intend to request additional information from the
Company and that, at this time, it does not intend to recommend that the SEC
bring an enforcement action against the Company, its former officers and
directors.
LEGAL PROCEEDINGS
On January 5, 2006, Mark P. Gertz, Trustee in bankruptcy for Arter & Hadden,
LLP, filed an Adversary Complaint for Recovery of Assets of the Estate in the
United States Bankruptcy Court Northern District of Ohio Eastern Division,
against the Company as successor in merger to Entelagent. Mr. Gertz seeks
$32,278 plus interest accruing at the statutory rate since July 15, 2003 for
services rendered by Arter & Hadden, LLP to Entelagent. On September 11, 2006,
the Company entered into a settlement and release agreement with Mark P. Gertz,
Trustee in bankruptcy for Arter & Hadden, LLP which calls for the payment of
$32,500 in 13 installments of $2,500.
On May 4, 2006, Patron became aware that Lok Technologies, Inc. had filed a
complaint on or about March 30, 2006 against the Company, Entelagent Software
Corp. and unnamed defendants in the Superior Court of California, County of
Santa Clara alleging breach of contract, breach of duty of good faith and fair
dealing and unjust enrichment and seeking damages, interest, disgorgement of any
unjust enrichment, attorneys fees and cost. Prior to receipt of this notice of
litigation, the Company had recorded a liability of $320,000 plus accrued
interest of $159,432. The Company believes that it has defenses to these claims.
The Company cannot provide any assurance that the ultimate settlement of this
claim will not have a material adverse affect on its financial condition.
NOTE 16 - CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING
On January 12, 2006, the Company issued a Stock Subscription Agreement & Mutual
Release ("the Original Release") to each creditor and claimant ("Subscriber") of
the Company for purposes of entering into a final and binding settlement with
respect to any and all claims, liabilities, demands, causes of action, costs,
expenses, attorneys fees, damages, indemnities, and obligations of every kind
and nature that the creditor and/or claimant may have with the Company
("Subscriber Claims"). Under terms of this agreement, the Company sold to the
24
Subscriber and the Subscriber purchased from the Company shares ("Stock") of its
Series A-1 Preferred stock at a price of $0.80 per share. The aggregate purchase
price was equivalent to the value of the Subscriber Claims being settled through
this settlement and release. Subscriber was deemed to have paid for the Stock
through the settlement and release of Subscriber Claims. Each share of Stock was
automatically convertible into 1/3 share of the Company's common stock upon the
effectiveness of an amendment to the Company's certificate of incorporation
which provided for a sufficient number of authorized but unissued and unreserved
shares of the Company's common stock to permit the conversion of all issued and
outstanding shares of Series A-1 Preferred. The Company issued the Series A-1
Preferred shares following the final determination of the claims and acceptance
by the Company of each claimant submitted Stock Subscription Agreement and
Mutual Release through countersignature thereof.
The Original Release also provided that in the event that (a) a bona fide sale
or (series of related sales) by the Company of equity interests in the Company
in an amount equal to or in excess of $3,000,000 or (b) any merger,
consolidation, recapitalization, reclassification, reincorporation,
reorganization, share exchange, sale of all or substantially all of the assets
of the Company or comparable transaction, was not consummated on or before March
31, 2006 (the "Termination Date"), the Stock Subscription Agreement & Mutual
Release would terminate and be null and void, the Series A-1 Preferred issued to
Subscriber would be cancelled and the Subscriber Claims would remain in full
force and effect on their terms. Each Subscriber agreed not to transfer or sell
any portion of the Stock until the next business day after the Termination Date,
subject to (i) an effective registration under the Securities Act or in a
transaction which is otherwise in compliance with the Securities Act, (ii) an
effective registration under any applicable state securities statute or in a
transaction otherwise in compliance with any applicable state securities statue,
and (iii) evidence of compliance with the applicable securities laws of other
jurisdictions. As described below, the Company completed the sale of $4.8
million in equity securities under the Series A Preferred Financing on March 27,
2006 thereby eliminating the provision for automatic termination of this
arrangement.
The Company has filed with the Securities and Exchange Commission on July 24,
2006 a registration statement ("Registration Statement") covering the resale of
the underlying Stock and has agreed to use its best efforts to cause such
Registration Statement to become effective as soon as practicable thereafter and
in any event no later than 180 days from the date that the Company countersigns
each Stock Subscription Agreement and Mutual Release. The Company shall keep the
Registration Statement continuously effective under the Securities Act until the
earlier of (i) the date when all shares of the Stock have been sold pursuant to
the Registration Statement or an exemption from the registration requirements of
the Securities Act, and (ii) two years from the effective date of the
Registration Statement.
Through July 21, 2006, the Company issued additional Stock Subscription
Agreements & Mutual Releases ("the Additional Release") to several creditors
that had not signed the January 12, 2006 Original Release by April 30, 2006. The
terms of the Additional Release were predominantly the same as the Original
Release with the exception of the 120 day requirement for filing the
Registration Statement.
On July 21, 2006, the Board of Directors authorized the completion of the
Creditor and Claimant Liabilities Restructuring program. Under this program,
claims totaling $29,594,442 have been settled for 36,993,054 shares of Series
A-1 Preferred Stock which were automatically converted, on July 31, 2006, into
12,331,056 shares of the Company's common stock. The total of all claims settled
represents 93% of the eligible claims. Additionally, the Company has settled
claims totaling $382,584 for $12,140. The Company is currently unable to provide
assurance that the acceptance of the claims settlement will actually improve the
Company's ability to fund the further development of its business plan or
improve its operations.
On July 31, 2006, following approval by the Company's stockholders, the Company
amended its Second Amended and Restated Certificate of Incorporation, as
amended, to affect a 1-for-30 reverse stock split.
LOSS (GAIN) ASSOCIATED WITH SETTLEMENT AGREEMENTS
During the nine months ended September 30, 2006 as part of the creditor and
claimant liabilities restructuring, the Company settled a number of disputed and
unresolved payables and outstanding claims resulting in a total net loss of
$505,910. Subsequent to the settlement of the creditor and claimant liabilities
25
restructuring for Series A-1 Preferred Stock, the Company also settled other
claims that resulted in a gain of $599,853, resulting in a net gain on
settlement of $93,944 for the nine months ended September 30, 2006.
Included among the claims settled for Series A-1 Preferred was a claim
associated with Accommodation Agreements (Note 14). Settlement of this matter
resulted in a gain of approximately $3,022,000 which was offset by, among
others, settlement losses associated with the Sherleigh Associates Profit
Sharing Plan complaint ($1,850,000), loss on the settlement of Richard Linting's
lawsuit against the Company ($1,129,000) and a loss associated with the
reinstatement and subsequent settlement of the claim associated with the lawsuit
brought by Marie Graul against the Company ($751,377).
During the nine months ended September 30, 2005, the Company entered into a
settlement agreement with Cook Associates to settle all claims related to a
lawsuit filed by Cook Associates filed against the Company. This settlement
resulted in the Company recognizing a gain on settlement of $389,103.
NOTE 17 - SERIES A AND SERIES A-1 PREFERRED STOCK
On March 1, 2006, the Company filed with the Delaware Secretary of State a
Certificate of Designation of Preferences, Rights and Limitations of Series A
Convertible Preferred Stock and Series A-1 Convertible Preferred Stock
designating the rights, preferences and privileges of 2,160 shares of Series A
Convertible Preferred Stock and 50,000,000 shares of Series A-1 Convertible
Preferred Stock.
SERIES A PREFERRED STOCK
The Series A Preferred Stock has a stated value of $5,000 per share and carries
a dividend of 10% per annum with such dividend accruing on a cumulative basis.
The dividend is payable only (i) at such time as declared payable by the Board
of Directors of the Company or (ii) in the event of liquidation, as part of the
liquidation preference amount ("Liquidation Preference Amount"). Accrued but
unpaid dividends on the Series A Preferred amount to $246,968 at September 30,
2006.
The Series A Preferred is convertible, at the option of the holder, into shares
of the Company's common stock ("Conversion Shares") at an initial conversion
price ("Initial Conversion Price") of $2.40 per share based on the stated value
of the Series A Preferred, subject to adjustment for stock splits, dividends,
recapitalizations, reclassifications, payments made to Common Stock holders and
other similar events and for issuances of additional securities at prices more
favorable than the conversion price at the date of such issuance. The Company
evaluated the conversion option at the commitment date of the financing in
accordance with APB 14 and EITF 00-27 and determined that conversion price was
not beneficial.
The Series A Preferred is mandatorily convertible into shares of the Company's
common stock at the Initial Conversion Price, which is subject to adjustment as
described above, on the date that: (i) there shall be an effective registration
statement covering the resale of the Conversion Shares, (ii) the average closing
price of the Company's common stock, for a period of 20 consecutive trading days
is at least 250% of the then applicable Conversion Price, and (iii) the average
daily trading volume of the Company's common stock for the same period is at
least 8,334 shares.
The potential adjustment to the conversion price that would occur upon the
completion of a subsequent financing transaction on terms more favorable than
that of the Series A Preferred (if any) is considered to be a contingent
conversion price in accordance with EITF 00-27. Accordingly, such adjustments
would be measured and accounted for at the effective time of such adjustment, if
any.
The Series A Preferred Liquidation Preference Amount is equal to 125% of the sum
of: (i) the stated value of any then unconverted shares of Series A Preferred
and (ii) any accrued and unpaid dividends thereon. An event of liquidation means
any liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, as well as any change of control of the Company which includes the
sale by the Company of either (x) substantially all its assets or (y) the
portion of its assets which comprises its core business technology, products or
services.
26
SERIES A-1 PREFERRED STOCK
The Series A-1 Preferred Stock has a stated value of $0.80 per share and carries
a non-cumulative dividend of 5% per annum, with such dividend payable only (i)
at such time as declared payable by the Board of Directors of the Company or
(ii) in the event of liquidation, as part of the liquidation preference amount
("Series A-1 Liquidation Preference Amount"). The Series A-1 Liquidation
Preference Amount is equal to the sum of: (i) the stated value of any then
unconverted shares of Series A-1 Preferred and (ii) any accrued and unpaid
dividends thereon. An event of liquidation means any liquidation, dissolution or
winding up of the Company, whether voluntary or involuntary, as well as any
change of control of the Company which includes the sale by the Company of
either (x) substantially all its assets or (y) the portion of its assets which
comprises its core business technology, products or services.
The Series A-1 Preferred is not convertible at the option of the holder. Each
share of Series A-1 Preferred automatically converts into the Company's common
stock, at a conversion price of $2.40 per share based on the stated value of the
Series A-1 Preferred, upon the effectiveness of an amendment to the Company's
certificate of incorporation which provides for a sufficient number of
authorized shares to permit the exercise or conversion of all issued and
outstanding shares of Series A Preferred, Series A-1 Preferred and all options,
warrants and other rights to acquire shares of the Company's common stock.
Through September 30, 2006, the Company has issued 36,993,054 shares of Series
A-1 Preferred Stock which converted upon the effectiveness of an amendment to
the Company's Second Amended and Restated Certificate of Incorporation to affect
a 1-for-30 reverse stock split, into 12,331,056 shares of the Company's newly
split common stock.
PRIVATE PLACEMENT OF SERIES A PREFERRED STOCK AND WARRANTS
In January 2006, the Company initiated a proposed $5,400,000 financing
transaction (the "Series A Preferred Financing") which would, for each $100,000
Unit purchased, result in the issuance of (i) 20 shares of Series A Preferred
Stock and (ii) warrants ("Investor Warrants") to purchase 13,888.9 shares of the
Company's common stock. The minimum amount of the Series A Preferred Financing
was $3,000,000 ("Minimum Amount") and the maximum amount was $5,400,000. Apex
agreed to purchase up to $1,500,000 which would all be available to fund the
Minimum Amount, provided however, in the event that the Series A Preferred
Financing was over-subscribed as to the Minimum Amount, then for each $1.00 of
such over subscription up to $250,000, the Apex funding commitment would be
reduced on a dollar for dollar basis, down to a minimum amount of $1,250,000.
Additionally, holders of the 2006 Bridge Notes were mandatorily obligated to
exchange their 2006 Bridge Notes for Units in the Series A Preferred Financing
upon consummation of the Series A Preferred Financing at the face value of their
2006 Bridge Notes. The issuance of Units to the holders of 2006 Bridge Notes
counted toward satisfying the Minimum Amount.
The Investor Warrants have a term of 5 years and an exercise price of $3.00 per
share. Each Investor Warrant entitles the holder thereof to purchase 13,888.9
shares of the Company's common stock (the "Warrant Shares"), subject to
anti-dilution provisions similar to those of the conversion rights of the Series
A Preferred. The Company was obligated to include the Conversion Shares and the
Warrant Shares in the Registration Statement originally filed on July 24, 2006.
The Conversion Shares and the Warrant Shares have piggyback registration rights.
In connection with the Series A Preferred Financing, the Company retained
Laidlaw as its non-exclusive placement agent ("Series A Preferred Placement
Agent"). Laidlaw received, in its role as Series A Preferred Placement Agent,
(i) a cash fee equal to 10% of all gross proceeds, excluding the Apex proceeds,
delivered at each Closing and (ii) a warrant (the "Agent Warrants") to purchase
the Company's common stock equal to 10% times the sum of (x) the Conversion
Shares to be issued upon conversion of the shares of Series A Preferred issued
at each Closing and (y) the number of shares of the Company's common stock
reserved for issuance upon the exercise of the Investor Warrants issued at each
closing. The Agent Warrants have a term of 5 years and an exercise price of
$3.00 per share. Additionally, the Company shall pay the Series A Preferred
Placement Agent a non-accountable expense allowance of $25,000.
27
On March 3, 2006, the investors in the Series A Preferred Financing agreed to a
modification of the terms of this financing arrangement to waive the requirement
for 100% completion of the creditor and claimant liabilities restructuring for
release of the net proceeds of the Series A Preferred Financing in order to
allow the Company to proceed with its business plan and to protect the investors
in the Series A Preferred Financing. The modifications provided for the net
proceeds of the Series A Preferred Financing to be deposited with an escrow
agent whereby funds would be released to the Company to cover payroll, rent and
other operating costs, including eligible payables not otherwise subject to the
creditor and claimant liabilities restructuring, on a bi-monthly basis.
On March 27, 2006, the Company consummated the Series A Preferred Financing with
the closing of funds totaling $4,465,501, resulting in the issuance of 893
shares of Series A Preferred Stock and 620,233 common stock purchase warrants to
the purchasers of the Series A Preferred Stock. This amount was comprised of
$720,001 associated with the conversion of the Bridge Notes, $895,000 provided
by Apex and $2,850,500 from parties made available by the Series A Preferred
Placement Agent. The Company also issued to Laidlaw 198,375 common stock
purchase warrants, the "Agent Warrants", as Series A Preferred Placement Agent.
On April 3, 2006, the Company consummated an additional closing of the Series A
Preferred Financing with the closing of funds totaling $355,000, resulting in
the issuance of 71 shares of Series A Preferred Stock and 49,306 common stock
purchase warrants.
The 964 shares of Series A Preferred Stock outstanding as of April 3, 2006 are
convertible, as described above, into 2,008,567 shares of the Company's newly
split common stock.
In order to affect the availability of these funds to the Company prior to the
completion of the creditor and claimant liabilities restructuring, the Company,
on March 27, 2006, entered into a post-closing restricted cash escrow agreement
("Post-Closing Escrow Agreement") with an escrow agent ("Escrow Agent"). As of
March 27, 2006, the Escrow Agent was provided $2,183,026 in net offering
proceeds. The escrow agent held the funds and made periodic disbursements to the
Company on or after the 15th of each calendar month and on or after the last day
of each calendar month. The Company was required to provide a detailed schedule
of the mid-month, month-end and maximum monthly disbursement amounts to
substantiate its request for a release of any funds. The Company is currently
unable to provide assurance that the securing of additional funding, the
completion of the creditor and claimant liabilities restructuring program and
the acceptance by individual creditors of the claims settlement will actually
improve the Company's ability to fund the further development of its business
plan or improve its operations.
NOTE 18 - STOCKHOLDERS' EQUITY
ADDITIONAL SHARES ISSUED UNDER ANTI-DILUTION PROVISION
Effective April 1, 2006, the Company issued 251,175 shares of common stock under
the provisions of an anti-dilution agreement associated with private placements
of common stock that occurred in March, August and September 2004.
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On January 28, 2006 the Company issued warrants for 20,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $20,316.
On February 13, 2006 the Company issued warrants for 6,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $6,634.
28
On February 21, 2006 the Company issued warrants for 1,250 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $1,382.
On March 1, 2006 the Company issued warrants for 6,417 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $10,029.
On March 17, 2006 the Company issued warrants for 3,750 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $5,861.
On March 22, 2006 the Company issued warrants for 2,500 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $3,907.
On March 27, 2006 the Company issued warrants for 620,233 shares at a $3.00 per
share exercise price to the investors in the Series A Preferred Financing in
connection with the Series A Preferred Financing. Additionally, the Company
issued 198,375 common stock purchase warrants at a $3.00 per share exercise
price to Laidlaw as placement agent in the Series A Preferred Financing.
On April 3, 2006 the Company issued warrants for 49,306 shares at a $3.00 per
share exercise price to Apex in connection with their investment in the Series A
Preferred Financing.
ISSUANCE OF EMPLOYEE STOCK OPTIONS
During the nine months ended September 30, 2006, the Company issued stock
options to employees to purchase 139,914 shares. These options include a grant
to purchase 73,371 shares at $1.65 per share, with a fair value of $96,850, to
the Chief Operating Officer of the Company, Mr. Braden Waverley, upon the
signing of his employment agreement with the Company. Additionally, the Company
granted options to purchase 26,204 shares at $1.65 per share, with a fair value
of $34,589, to Mr. Martin T. Johnson, the Company's Chief Financial Officer,
upon the signing of his employment agreement with the Company. On July 12, 2006,
the Board of Directors approved the grant of 40,339 non-qualified stock options
to 11 individuals. The exercise price for these options was $1.35, the closing
price for the Company's common stock on the date of grant, July 12, 2006.
The fair value of the unvested portion of stock options at September 30, 2006 is
$567,512 with a weighted-average remaining vesting period of 3.3 years.
SHARE-BASED COMPENSATION ARRANGEMENTS
The Company, since its inception has granted non-qualified stock options to
various employees and non-employees at the discretion of the Board of Directors.
Substantially all options granted to date have exercise prices equal to the fair
value of underlying stock at the date of grant and terms of ten years. Vesting
periods range from fully vested at the date of grant to four years.
As described in Note 4, the fair value of all awards was estimated at the date
of grant using the Black-Scholes option pricing model. Assumptions relating to
the estimated fair value of stock options that the Company granted prior to
January 1, 2006 that were accounted for and recorded under the intrinsic value
method prescribed under APB 25 are also described in Note 4.
On February 16, 2006, the Company issued an aggregate of 99,575 stock options to
two newly hired executives upon signing their employment agreements. These
options are exercisable at $1.65 per share and have a term of ten years. The
aggregate fair value of these options amounts to $131,439. Assumptions relating
to the estimated fair value of these stock options, which the Company is
accounting for in accordance with SFAS 123(R) are as follows: risk-free interest
rate of 4.45%; expected dividend yield zero percent; expected option life of
four years; and current volatility of 125%.
29
The risk-free rate is based on the U.S. Treasury yield curve in effect at the
time of grant. The Company has not paid dividends to date and does not expect to
pay dividends in the foreseeable future due to its substantial accumulated
deficit and limited capital resources. Accordingly, expected dividends yields
are currently zero. Historical cancellations and forfeitures of stock options
granted through December 31, 2004 have been insignificant. However, the
Company's operations and the nature of its business changed substantially during
2005 with the acquisition of businesses and the recruitment of a new Chief
Operating Officer in 2006. Accordingly, the Company considers more recent data
relating to employee turnover rates to be indicative of future vesting. Based on
available data, the Company has assumed that approximately 94% of outstanding
options will vest annually. Deferred compensation relating to options granted
through December 31, 2005 has been adjusted to reflect this assumption. No
options have been exercised to date. The Company will prospectively monitor
employee terminations, exercises and other factors that could affect its
expectations relating to the vesting of options in future periods. The Company
will adjust its assumptions relating to its expectations of future vesting and
the terms of options at such times that additional data indicates that changes
in these assumptions are necessary. Expected volatility is principally based on
the historical volatility of the Company's stock.
A summary of option activity for the nine months ended September 30, 2006 is as
follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
EXERCISE CONTRACTUAL
OPTIONS SHARES PRICE TERM
--------------------------------- ------------- ------------- -------------
Outstanding at January 1, 2006 428,022 $21.09 7.2 years
Granted 139,914 $ 1.56
Exercised -- --
Forfeited or expired (63,965) $ 9.88
Outstanding at September 30, 2006 503,971 $17.09 7.8 years
Exercisable at September 30, 2006 337,853 $23.31 5.9 years
At September 30, 2006, the aggregate intrinsic value of options outstanding and
options exercisable, based on the September 29, 2006 closing price of the
Company common stock ($2.00 per share) amounted to $68,000 and $68,000,
respectively. In addition the table includes 156,670 fully vested and
non-forfeitable stock options outstanding that it issued to non-employees
through December 31, 2005. As of September 30, 2006, these options have a
weighted average exercise price of $17.39, weighted average remaining
contractual term of 6.4 years and an aggregate intrinsic value of $0. The
Company did not enter into any stock based compensation arrangements with
non-employees during the nine months ended September 30, 2006. Stock based
compensation expense to non-employees amounted to $1,239,083 during the nine
months ended September 30, 2005, including $708,750 relating to stock options
and $530,333 relating to issuances of common stock for services. All
non-employee stock based compensation awards were accounted for in accordance
with the provisions of EITF 96-18.
The weighted-average grant-date fair value of the 139,914 stock options granted
during the nine months ended September 30, 2006 amounted to $1.25 per share. The
Company granted 175,513 stock options with a weighted average grant-date fair
value of $8.31 per share or a total fair value of $1,471,656 during the nine
months ended September 30, 2005. There have also not been any exercises of stock
options to date.
As of September 30, 2006, there was $567,512 of unrecognized compensation cost
related to non-vested share-based compensation arrangements including $1,214,907
for the fair value of stock options that the Company accounted for under APB 25
through December 31, 2005 and $175,368 for option granted during the nine months
ended September 30, 2006 that that the Company is accounting for in accordance
with SFAS 123(R). These costs are expected to be recognized over a
weighted-average period of 3.3 years.
The total fair value of options vested during the nine months ended September
30, 2006 amounted to $321,011. The Company did not modify any stock options
granted to employees or non employees under share based payment arrangements. In
addition, the Company did not capitalize the cost associated with stock based
compensation.
30
NOTE 19 - DISCONTINUED OPERATIONS/ SALE OF LUCIDLINE
LucidLine, Inc. ("LucidLine") was a provider of bundled and branded high speed
Internet access and synchronized remote data back-up, retrieval, and restoration
services. The acquisition of LucidLine was intended to supply the expertise to
establish the homeland security architecture, the risk and vulnerability
assessment evaluation services and the development and operation of the homeland
security data center solutions necessary to implement our former business plan
to offer model homeland security architecture with state-of-the-art prevention,
response and information management capabilities. The actual results were
substantially different. The Company was unable to find any parties interested
in its homeland security data center solutions, its risk and vulnerability
assessment services and its homeland security architecture business.
Additionally, LucidLine's commercial data backup and storage business was not
growing sufficiently to cover the costs of operating the business.
During the period from the acquisition of LucidLine on February 25, 2005 through
December 31, 2005, LucidLine generated revenue of almost $227,000, incurred a
net loss of approximately $1.4 million and used net cash of over $1.4 million.
For the period from January 1, 2006 to March 31, 2006, LucidLine had revenue of
nearly $99,000, a net loss of approximately $105,000 and used net cash of
approximately $194,000. Additionally, we recognized a loss on disposal of almost
$76,000.
Because of the Company's precarious financial position, the difficulty it was
experiencing in finding parties interested in pursuing the concept of homeland
security compliant data centers and the general lack of government funding for
municipalities and counties to address homeland security focused IT
infrastructure projects, the Company decided in the first quarter of 2006 to
abandon its focus on the homeland security market portion of its business plan
and to streamline its business to focus on enterprise level software and service
solutions designed to help customers create, manage and apply complex rule sets
that support business policies, enhance work flow processes, enforce regulatory
compliance, and reduce the time, cost and overhead of electronic message
management.
Having made this decision, the Company's management undertook a thorough review
of all areas of its business, including the revenue, pricing, supplier contracts
and all other aspects of the LucidLine business unit, in an attempt to further
cost-reduce the already cost-reduced business which had approximately $65,000
per month in negative cash flow. While this effort reduced the potential
negative cash flow to approximately $35,000 per month through additional cost
reductions, price increases and improved contract management, this negative cash
flow would still result in a substantial drain on the Company's very limited
cash resources. On the basis of this analysis, the Company decided to sell the
business to a party who would purchase LucidLine and assume LucidLine's customer
and supplier contract commitments. After approaching a number of parties, none
of whom were interested in acquiring a money losing and significantly negative
cash flow business, Walnut Valley, Inc. agreed to acquire the legal entity and
all of its customer and supplier contract commitments for a substantial discount
from the price the Company paid in February 2005. As the Company had found no
other interested buyers and would have incurred a cash cost to shutdown the
business far in excess of $50,000, the Company decided to sell the LucidLine
business to Walnut Valley.
On April 18, 2006, the Company entered into a Stock Purchase Agreement with
Walnut Valley, Inc., pursuant to which the Company sold all of the outstanding
shares of LucidLine to Walnut Valley, Inc. in consideration for a cash payment
of $25,000 and the issuance of a Promissory Note in the principal amount of
$25,000 by Walnut Valley in favor of the Company. The Company consummated the
sale of LucidLine as a strategic business transaction designed to enhance our
long-term profitability and strategic operations, and to further streamline its
business focus on electronic message management.
The Company sold LucidLine to Walnut Valley, Inc. for an aggregate consideration
of $50,000. In February 2005, the Company paid to LucidLine's stockholders cash
in the aggregate amount of $200,000 and issued an aggregate of 146,667 shares of
the Company's common stock valued at $3,740,000.
31
NOTE 20 - SUBSEQUENT EVENTS
PRIVATE PLACEMENT OF SERIES B PREFERRED STOCK AND WARRANTS
On August 29, 2006, the Company initiated a proposed $5,000,000 financing
transaction (the "Series B Preferred Financing") which would, for each $100,000
Unit purchased, result in the issuance of (i) 20 shares of Series B Preferred
Stock and (ii) warrants ("Investor Warrants") to purchase Company common stock
in an amount equal to 50% of the Conversion Shares. The minimum amount of the
Series B Preferred Financing is $3,000,000 ("Minimum Amount") and the maximum
amount is $5,000,000. Apex has agreed to purchase up to $1,000,000 which will
all be available to fund the Minimum Amount, provided however, in the event that
the Series B Preferred Financing is over-subscribed as to the Minimum Amount,
then for each $1.00 of such over subscription up to $2,000,000, the Apex funding
commitment will be increased by $0.333 to a maximum amount of $1,666,667.
The Investor Warrants have a term of 5 years and an exercise price of the
greater of i) $2.40 per share or ii) that price per share equal to the volume
weighted average closing price of the Company's common stock for the 10 trading
days prior to the Closing date. Each Investor Warrant entitles the holder
thereof to purchase up to 50% of the Conversion Shares in Company's common stock
(the "Warrant Shares"), subject to anti-dilution provisions similar to those of
the conversion rights of the Series B Preferred. The Conversion Shares and the
Warrant Shares have piggyback registration rights.
In connection with the Series B Preferred Financing, the Company retained
Laidlaw & Company (UK) Ltd. as its non-exclusive placement agent ("Series B
Preferred Placement Agent"). Laidlaw shall receive, in its role as Series B
Preferred Placement Agent, (i) a cash fee equal to 13% of all gross proceeds,
excluding the Apex proceeds, delivered at each Closing and (ii) a warrant (the
"Agent Warrants") to purchase the Company's common stock equal to 10% times the
sum of (x) the Conversion Shares to be issued upon conversion of the shares of
Series B Preferred issued at each Closing and (y) the number of shares of the
Company's common stock reserved for issuance upon the exercise of the Investor
Warrants issued at each closing. The Agent Warrants have a term of 5 years and
an exercise price of the greater of i) $2.40 per share or ii) that price per
share equal to the volume weighted average closing price of the Company's common
stock for the 10 trading days prior to the Closing date. Additionally, the
Company shall pay the Series B Preferred Placement Agent legal expenses not to
exceed $25,000.
On October 13, 2006, the Company consummated the first closing of the Series B
Preferred Financing with the closing of funds totaling $3,120,966. This amount
was comprised of $1,040,322 provided by Apex and $2,080,644 from parties made
available by the Series B Preferred Placement Agent. As part of this closing
cash fees equal to $280,484 were paid to the Series B Preferred Placement Agent.
SERIES B PREFERRED STOCK
The Series B Preferred Stock ("Series B Preferred") has a stated value of $5,000
per share, has no maturity date, carries a dividend of 10% per annum, with such
dividend accruing on a cumulative basis and payable only (i) at such time as
declared payable by the Board of Directors of the Company or (ii) in the event
of liquidation, as part of the liquidation preference amount ("Liquidation
Preference Amount"). The Liquidation Preference Amount is equal to 125% of the
sum of: (i) the stated value of any then unconverted shares of Series B
Preferred and (ii) any accrued and unpaid dividends thereon. An event of
liquidation means any liquidation, dissolution or winding up of the Company,
whether voluntary or involuntary, as well as any change of control of the
Company which includes the sale by the Company of either (x) substantially all
its assets or (y) the portion of its assets which comprises its core business
technology, products or services. The Series B Preferred Stock is junior to the
Series A Preferred Stock with respect to liquidation and dividend rights.
The Series B Preferred is convertible, at the option of the holder, into shares
of the Company's common stock ("Conversion Shares") at an initial conversion
price ("Initial Conversion Price) which shall be the lesser of i) $2.40 per
share or ii) that price per share equal to the volume weighted average closing
price of the Company's common stock for the 10 trading days prior to the
original issuance date of such shares, based on the stated value of the Series B
Preferred, subject to adjustment for stock splits, dividends, recapitalizations,
reclassifications, payments made to Common Stock holders and other similar
events and for issuances of additional securities at prices more favorable than
the conversion price at the date of such issuance.
32
The Series B Preferred is mandatorily convertible at the then applicable
conversion price ("Conversion Price") into shares of the Company's common stock
at the then applicable Conversion Price on the date that: (i) there shall be an
effective registration statement covering the resale of the Conversion Shares,
(ii) the average closing price of the Company's common stock, for a period of 20
consecutive trading days is at least 250% of the then applicable Conversion
Price, and (iii) the average daily trading volume of the Company's common stock
for the same period is at least 8,334 shares.
33
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SEPTEMBER 30, 2006
The following discussion and analysis should be read in conjunction with the
Annual Report on Form 10-KSB, including the consolidated financial statements,
and the related notes thereto, for the year ended December 31, 2005 of Patron
Systems, Inc. and subsidiaries (collectively referred to as "Patron," the
"Company," "we," "us," or "our"). Except for historical information contained
herein, the matters discussed below are forward-looking statements made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Such statements involve risks and uncertainties, including, but not
limited to, economic, governmental, political, competitive and technological
factors affecting our operations, markets, products, prices and other factors
discussed elsewhere in this report and other reports filed by us with the
Securities and Exchange Commission ("SEC"). These factors may cause results to
differ materially from the statements made in this report or otherwise made by
or on our behalf.
OVERVIEW
On February 25, 2005, we consummated the acquisitions of Complete Security
Solutions, Inc. ("CSSI") and LucidLine, Inc. ("LucidLine") pursuant to the
filings of Agreements and Plans of Merger with the Secretaries of State of the
States of Delaware and Illinois, respectively. On February 28, 2005, we
consummated a private placement with accredited investors in the amount of $3.5
million. On March 30, 2005, we consummated the acquisition of Entelagent
Software Corp. ("Entelagent") pursuant to the filing of an Agreement and Plan of
Merger with the Secretary of State of the State of California. We merged each of
CSSI, Entelagent and PILEC Disbursement Company, a wholly-owned non-operating
subsidiary into our company on September 19, 2006. From March 31, 2005 to
December 31, 2005, we borrowed $3,300,000 from a stockholder, Apex Investment
Fund V, LP. During the three months ended September 30, 2005 we raised
approximately $3,600,000 in additional gross funds in five capital financing
transactions, which includes converting $1,650,000 in advances from stockholders
into Bridge Notes. Net proceeds from all of these transaction amounted to
$3,594,000, which were used principally to fund operations and repay certain
liabilities. We discuss these transactions in further detail in this report.
During the nine months ended September 30, 2006, we raised $5,640,501 of gross
proceeds ($5,301,450 net proceeds after the payment of certain transaction
expenses) in various financing transactions. We used $5,017,206 of these
proceeds to fund operations and a net of $607,152 in investing activities.
Our strategic mission is to solve a set of enterprise-level customer problems
associated with electronic message management, whether in the form of e-mail,
eforms or instant messaging. Our software and services solutions are designed to
help our customers create, manage and apply complex rule sets that support
business policies, enhance work flow processes, enforce regulatory compliance,
and reduce the time, cost and overhead of message management. Our suite of
products addresses e-mail policy management, e-mail retention policies,
archiving and eDiscovery, proactive e-mail supervision, and the protection of
messages and their attachments in motion and at rest. Our eforms solution
enables customers to quickly and easily create forms, capture, share, and manage
data in an industry standard format.
We currently offer software solutions that fit into overall corporate compliance
and data protection initiatives by automatically finding, archiving and applying
persistent protection to sensitive data - beyond authentication - whenever,
wherever and however sensitive data is shared, accessed and stored. Additionally
we offer software solutions that support real-time secure collection, delivery
and sharing of field-based report information. This software allows law
enforcement and public-safety agencies to have real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system.
34
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the Condensed Consolidated Financial Statements and Notes thereto. Our
application of accounting policies affects these estimates and assumptions.
Actual results could differ from these estimates under different assumptions or
conditions.
REVENUE RECOGNITION
We derive revenues from the following sources: (1) sales of computer software,
which includes new software licenses and software updates and product support
revenues and (2) services, which include internet access, back-up, retrieval and
restoration services and professional consulting services.
We apply the revenue recognition principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff Accounting Bulletin ("SAB") 104 "Revenue Recognition" with
respect to all of our revenue. Accordingly, we record revenue when (i)
persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii)
the vendor's fee is fixed or determinable, and (iv) collectability is probable.
We generate revenues through sales of software licenses and annual support
subscription agreements which include access to technical support and software
updates (if and when available). Software license revenues are generated from
licensing the rights to use our products directly to end-users and through third
party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of our software sales are supported by a
written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. We use the residual method prescribed in
SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition With Respect to
Certain Transactions" to allocate revenues to delivered elements once it has
established vendor-specific evidence for such undelivered elements.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19 "Reporting Revenue Gross as a Principal versus Net as Agent."
BUSINESS COMBINATIONS
In accordance with business combination accounting, we allocate the purchase
price of acquired companies to the tangible and intangible assets acquired,
liabilities assumed, as well as in-process research and development based on
their estimated fair values. We have engaged a third-party appraisal firm to
assist management in determining the fair values of certain assets acquired and
liabilities assumed. Such a valuation requires management to make significant
estimates and assumptions, especially with respect to intangible assets.
35
Management makes estimates of fair value based upon assumptions believed to be
reasonable. These estimates are based on historical experience and information
obtained from the management of the acquired companies. Critical estimates in
valuing certain of the intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements, customer
contracts and acquired developed technologies; expected costs to develop the
in-process research and development into commercially viable products; the
acquired company's brand awareness and market position, as well as assumptions
about the period of time the acquired brand will continue to be used in the
combined company's product portfolio; and discount rates. These estimates are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur which may
affect the accuracy or validity of such assumptions, estimates or actual
results.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and
SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142,
goodwill and intangibles that are deemed to have indefinite lives are no longer
amortized but, instead, are to be reviewed at least annually for impairment.
Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assigning assets and liabilities to reporting
units, assigning goodwill to reporting units, and determining the fair value.
Significant judgments required to estimate the fair value of reporting units
include estimating future cash flows, determining appropriate discount rates and
other assumptions. Changes in these estimates and assumptions could materially
affect the determination of fair value and/or goodwill impairment for each
reporting unit. We have recorded goodwill in connection with the Company's
acquisitions described in Note 5 amounting to $22,440,412. The Company's annual
impairment review of goodwill identified that goodwill impairment charges
totaling $12,929,696 were necessary for the year ended December 31, 2005 (Note
5). Intangible assets continue to be amortized over their estimated useful
lives.
LONG LIVED ASSETS
The Company periodically reviews the carrying values of its long lived assets in
accordance with SFAS 144, "Long Lived Assets" when events or changes in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their realizable value and records impairment charges when
necessary. The Company determined that an impairment charge of $1,705,455 was
necessary for the year ended December 31, 2005 (Note 8).
INCOME TAXES
We account for income taxes pursuant to SFAS No. 109, Accounting for Income
Taxes. Deferred taxes arise from temporary differences, primarily attributable
to the use of the cash method for tax purposes and accrual method for book
purposes and net operating loss carry-forwards. The Company reserves for
deferred tax assets when more likely than not, the benefit of the asset will not
be realized in the future.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Actual results could differ from those estimates.
36
STOCK BASED COMPENSATION
Prior to January 1, 2006, the Company accounted for employee stock transactions
in accordance with Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees." The Company has adopted the proforma
disclosure requirements of SFAS No. 123 "Accounting for Stock-Based
Compensation."
Effective January 1, 2006, the Company adopted SFAS No. 123R "Share Based
Payment". This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, and its related implementation guidance. SFAS 123R addresses
all forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest that will result in a charge to operations.
NON-EMPLOYEE STOCK BASED COMPENSATION
We record the cost of stock based compensation awards that we have issued to
non-employees for services at either the fair value of the services rendered or
the instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in Emerging
Issues Task Force ("EITF") Issue 96-18, "Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2005.
For the three months ended September 30, 2006, our consolidated revenues
amounted to $276,825 compared to $93,457 for the three months ended September
30, 2005. The increase is principally the result of growth of our business,
principally with the FormStream product, since the combinations were consummated
with CSSI in February 2005 and Entelagent in March 2005.
Cost of Sales for the three months ended September 30, 2006 amounted to $54,619
compared to $133,124 for the three months ended September 30, 2005. Cost of
sales during the three months ended September 30, 2006 and September 30, 2005
includes $44,936 and $133,124, respectively, associated with the amortization of
developed technology that we acquired from CSSI and Entelagent.
Operating expenses amounted to $1,315,328 for the three months ended September
30, 2006 as compared to $2,199,920 for the three months ended September 30,
2005, a reduction of $884,592. The reduction in operating expenses includes an
increase of approximately $62,000 for employee stock option compensation
expense, approximately $300,000 associated with the reduction in value of a put
right in 2005 and an increase of approximately $3,000 associated with a
stock-based penalty under a collateralized financing arrangement. These
increases were offset by approximately $42,000 for reduced salaries associated
with an reduction in the number of employees, an approximately $286,000
reduction in expense associated with the amortization of stock-based
compensation arrangements, approximately $59,000 reduction in legal and
professional fees associated with the work performed in 2005 to bring the
Company's SEC filings into compliance and expenses associated with the 2005
acquisitions, a reduction of approximately $104,000 in general and
administrative expense, a $135,000 reduction in expense associated with 2005
penalties under stock-based accommodation agreements and an approximately
$625,000 reduction associated with gains related to settlement agreements.
Our consolidated loss from operations for the three months ended September 30,
2006 amounted to $1,156,877 compared to a loss of $12,677,722 for the same
period in 2005. Our loss was reduced as a result of the reductions in operating
expenses and the increased revenues discussed above.
Interest expense during the three months ended September 30, 2006 amounted to
$64,564 as compared to $10,158,714 for the three months ended September 30,
2005. The reduction is principally related to the issuance, in the three months
ended September 30, 2005, of the Bridge III Notes and the associated
37
amortization of deferred financing costs and the accretion of debt discounts
incurred with that financing not being incurred in the three months ended
September 30, 2006. Additionally, the interest expense associated with the
outstanding Acquisition Notes and the Bridge I, Bridge II and Bridge III Notes
in the three months ended September 30, 2005 was reduced with the exchange of a
substantial portion of these notes for Series A-1 Preferred Stock as of
September 30, 2006. Non-cash interest relating to the amortization of deferred
financing costs and the accretion of debt discounts during the three months
ended September 30, 2006 amounted to approximately $0 compared to $1,865,355 in
the same period in 2005. Amortization of deferred finance charges which have
been classified as interest expense was $0 in the three months ended September
30, 2006 compared to $750,334 in the same period in 2005. Accretion of debt
discounts during the three months ended September 30, 2006 were approximately $0
compared to $1,115,021 in the same period in 2005. Interest income, was $809 and
$0 in the three months ended September 30, 2006 and 2005, respectively. Interest
income represents the interest earned on cash balances.
During the three months ended September 30, 2006, the Company accrued dividends
on its Series A Preferred of $122,184.
For the three months ended September 30, 2006, the net loss available to common
stockholders was $1,279,061 or $(0.12) per share on 10,490,543 weighted average
common shares outstanding compared to a net loss available to common
stockholders of $12,677,722 or $(6.18) per share on 2,049,970 weighted average
common shares outstanding for the three months ended September 30, 2005.
NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER
30, 2005.
For the nine months ended September 30, 2006, our consolidated revenues amounted
to $857,570 compared to $184,300 for the nine months ended September 30, 2005.
The increase is principally the result of growth of our business, principally
with the FormStream product, since the combinations were consummated with CSSI
in February 2005 and Entelagent in March 2005.
Cost of Sales for the nine months ended September 30, 2006 amounted to $139,560
compared to $282,858 for the nine months ended September 30, 2005. Cost of sales
during the nine months ended September 30, 2006 and September 30, 2005 includes
$99,980 and $280,855, respectively, associated with the amortization of
developed technology that we acquired from CSSI and Entelagent.
Operating expenses amounted to $5,824,458 for the nine months ended September
30, 2006 as compared to $6,345,170 for the nine months ended September 30, 2005,
a reduction of $520,712. The reduction in operating expenses includes an
increase of approximately $1,086,000 for salaries associated with an increase in
the number of employees from acquired businesses, approximately $308,000 of
employee stock option compensation expense, approximately $173,000 for increased
legal and professional fees that we incurred principally in connection with the
year-end financial audit, the negotiation and settlement of various legal
matters under the creditor and claimant liabilities restructuring program and
the implementation of the Series A Preferred Stock private placement,
approximately $23,000 for amortization of acquired intangible assets,
approximately $251,000 in charges associated with the settlement of outstanding
litigation, liabilities and claims under the creditor and claimant liabilities
restructuring, approximately $300,000 associated with the reduction in value of
a put right in 2005 and approximately $8,000 associated with a stock-based
penalty under a collateralized financing arrangement. These increases were
partially offset by an approximately $1,239,000 reduction in expense associated
with the amortization of stock-based compensation arrangements, a reduction of
approximately $240,000 in general and administrative expense, an expense
reduction of $366,000 associated with a 2005 loss on a collateralized financing
arrangement and approximately $824,000 reduction in expense associated with a
penalty provision of an Accommodation Agreement.
Our consolidated loss from operations for the nine months ended September 30,
2006 amounted to $5,106,448 compared to a loss of $6,443,728 for the same period
in 2005. Our loss was reduced as a result of the reductions in operating
expenses and the increase in revenues discussed above.
Interest expense during the nine months ended September 30, 2006 amounted to
$1,768,499 as compared to $12,355,249 for the nine months ended September 30,
2005. The reduction is due to the issuance of Series A Preferred stock and its
associated amortization of deferred financing costs and the accretion of debt
38
discounts and the intrinsic value of the conversion option for bridge note
holders being lower in total during the nine months ended September 30, 2006
than the amortization of deferred financing costs and the accretion of debt
discounts incurred during the nine months ended September 30, 2005. Offsetting
this reduction was the increase in interest expense due to the increased level
of total debt financing during the nine months ended September 30, 2006 than
during the same period in 2005. Non-cash interest relating to the amortization
of deferred financing costs and the accretion of debt discounts during the nine
months ended September 30, 2006 amounted to approximately $303,038 compared to
$3,678,606 in same period in 2005. The intrinsic value of the conversion option
for bridge note holders, which has been classified as interest expense amounted
to $550,000 for the nine months ended September 30, 2006 compared to $0 in the
same period in 2005. Amortization of deferred finance charges which have been
classified as interest expense was approximately $282,129 in the nine months
ended September 30, 2006 compared to $1,751,232 in the same period in 2005.
Accretion of debt discounts during the nine months ended September 30, 2006 were
approximately $20,909 compared to $1,927,374 in the same period in 2005.
Interest income, was $2,770 and $19,250 in the nine months ended September 30,
2006 and 2005, respectively. Interest income represents the interest earned from
loans that we made to Entelagent prior to our acquisition of that business on
March 30, 2005 and interest on cash balances in the nine months ended September
30, 2006.
During the nine months ended September 30, 2006, the Company accrued dividends
on its Series A Preferred of $246,968.
For the nine months ended September 30, 2006, the net loss available to common
stockholders was $7,300,152 or $(1.48) per share on 4,945,846 weighted average
common shares outstanding compared to a net loss available to common
stockholders of $19,910,022 or $(10.43) per share on 1,909,483 weighted average
common shares outstanding for the nine months ended September 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss of $7,053,184 for the nine months ended September 30,
2006, which includes $1,436,574 of non-cash charges including non-cash charges
associated with the fair value of common stock we issued as penalties under
certain registration rights agreements ($8,560), fair value of a conversion
option in connection with bridge note holders ($550,000), accretion related to
warrants issued in conjunction with notes payable ($20,909), amortization of
deferred financing costs ($282,129), amortization of deferred compensation
($7,500), loss on disposal of discontinued operation ($75,920), gain on
settlements of outstanding debt ($93,943), non-cash increase in interest payable
to a former stockholder ($48,400), depreciation and amortization ($237,845), and
a charge for stock option based compensation ($307,629). We also used $511,691
of our restricted cash escrowed to settle liabilities assumed. Including the
amounts above, we used net cash flows in our operating activities of $5,017,206
during the nine months ended September 30, 2006. Our working capital deficiency
at September 30, 2006 amounts to $5,215,607 and we are continuing to experience
shortages in working capital. We are involved in litigation and are being
investigated by the Securities and Exchange Commission with respect to certain
of our press releases and our use of form S-8 to register shares of common stock
that we issued to certain consultants in prior periods. Our legal counsel
representing us in such matters has indicated that while the SEC Investigation
is ongoing and we have not received correspondence from the SEC indicating that
the matter is officially closed, the Staff has indicated that it does not intend
to request additional information from us and that, at this time, it does not
intend to recommend that the SEC bring an enforcement action against us, our
officers or directors. We cannot provide any assurance that the outcome of these
matters will not have a material adverse affect on our ability to sustain the
business. These matters raise substantial doubt about our ability to continue as
a going concern.
We expect to continue incurring losses for the foreseeable future due to the
inherent uncertainty that is related to establishing the commercial feasibility
of technological products and developing a presence in new markets. The
Company's ability to successfully integrate the acquired businesses described in
Note 5 is critical to the realization of its business plan. The Company raised
$5,460,501 of gross proceeds ($5,301,450 net proceeds after the payment of
certain transaction expenses) in financing transactions during the nine months
ended September 30, 2006. The Company used $5,017,206 of these proceeds to fund
its operations and a net of $607,152 in investing activities, principally for
the purchase and development of software technology. Additionally, the Company
made $125,000 in legal payments associated with the settlement of accommodation
agreements and incurred $54,000 in deferred financing costs. The Company
received $50,000 in proceeds from the disposition of discontinued operations and
received $180,000 in proceeds in connection with a financing settlement.
39
We are currently in the process of attempting to raise additional capital and
have taken certain steps to conserve our liquidity while we continue to
integrate the acquired businesses. Although we believe that we have access to
capital resources, we have not secured any commitments for additional financing
at this time nor can we provide any assurance that we will be successful in our
efforts to raise additional capital and/or successfully execute our business
plan. In an effort to secure additional financing, we completed a program
pursuant to which we offered our creditors and claimants an agreement to receive
shares of our capital stock for amounts owed to the holders of the Company's
indebtedness (including lenders, past-due trade accounts, and employees,
consultants and other service providers with claims for fees, wages or expenses)
(Note 16).
OFF-BALANCE SHEET ARRANGEMENTS
At September 30, 2006, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, variable interest or special purpose entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. As such, we are
not exposed to any financing, liquidity, market or credit risk that could arise
if we had engaged in such relationships.
CAUTIONARY STATEMENTS AND RISK FACTORS
The risks noted below and elsewhere in this report and in other documents we
file with the SEC are risks and uncertainties that could cause our actual
results to differ materially from the results contemplated by the
forward-looking statements contained in this report and other public statements
we make.
RISKS RELATED TO OUR COMMON STOCK
THERE IS SUBSTANTIAL DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. We are also
subject to substantial litigation and an investigation by the SEC described
elsewhere herein. If we cannot generate additional revenues or raise additional
capital in the near future, we may become insolvent. As of September 30, 2006,
our cash balance was $60,156 and we had a working capital deficit of $5,215,607.
This raises substantial doubt about our ability to continue as a going concern.
Historically, we have funded our capital requirements with debt and equity
financing. Our ability to obtain additional equity or debt financing depends on
a number of factors including our financial performance and the overall
conditions in our industry. If we are not able to raise additional financing or
if such financing is not available on acceptable terms, we may liquidate assets,
seek or be forced into bankruptcy, and/or continue operations but suffer
material harm to our operations and financial condition. These measures could
have a material adverse affect on our ability to continue as a going concern.
We have restructured approximately 93% of our previously outstanding claims,
liabilities, demands, causes of action, costs, expenses, attorneys' fees,
damages, indemnities, and obligations of every kind and nature that certain
creditors and claimants had with us pursuant to our creditor and claimant
liabilities restructuring described in Note 16. We are currently unable to
provide assurance that the acceptance of the claims settlement will actually
improve our ability to fund the further development of our business plan or
improve our operations. Our failure to fund the further development of our
business plan and operations would materially adversely affect our ability to
continue as a going concern.
INVESTORS MAY NOT BE ABLE TO ADEQUATELY EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR LIMITED OPERATING HISTORY, LACK OF REVENUES AND LACK OF PRODUCT
OFFERINGS.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. We were incorporated in Delaware in
2002. Significant business operations only began with the acquisitions completed
in February and March 2005. As a result of our limited history, it may be
difficult to plan operating expenses or forecast our revenues accurately. Our
assumptions about customer or network requirements may be wrong. The revenue and
40
income potential of these products is unproven, and the markets addressed by
these products are volatile. If such products are not successful, our actual
operating results could be below our expectations and the expectations of
investors and market analysts, which would likely cause the price of our common
stock to decline.
We generated no revenue from operations before December 31, 2004 and only
limited revenues in the year ended December 31, 2005. We have relied on
financing generated from our capital raising activities to fund the
implementation of our business plan. We have incurred operating and net losses
and negative cash flows from operations since our inception. As of September 30,
2006, we had an accumulated deficit of approximately $91,7 million. We may
continue to incur operating and net losses, due in part to implementing our
acquisitions strategy, engaging in financing activities and expansion of our
personnel and our business development capabilities. We will continue to seek
financing for the acquisition of other acquisition targets that we may identify
in the future. We continue to believe that we will secure financing in the near
future, but there can be no assurance of our success. If we are unable to obtain
the necessary funding, it will materially adversely affect our ability to
execute our business plan and to continue our operations.
In addition, we may not be able to achieve or maintain profitability, and, even
if we do achieve profitability, the level of any profitability cannot be
predicted and may vary significantly from quarter to quarter.
THE AUTOMATIC CONVERSION OF OUR SERIES A-1 PREFERRED STOCK HAS RESULTED IN
SIGNIFICANT DILUTION TO OUR EXISTING STOCKHOLDERS AND A CHANGE IN CONTROL OF OUR
COMPANY, AND COULD ALSO RESULT IN ADDITIONAL VOLATILITY IN THE PRICE OF OUR
COMMON STOCK.
The automatic conversion of our Series A-1 Preferred Stock on July 31, 2006
resulted in significant dilution to our existing stockholders and resulted in
our former creditors and claimants owning approximately 85.3% of our outstanding
shares of common stock. These creditors and claimants, to the extent they act in
concert, would be able to determine all actions brought before our stockholders.
Upon the registration of the shares of common stock issued upon the conversion
of our Series A-1 Preferred Stock, there will be a substantial amount of shares
eligible for sale in the public market. If former holders of our Series A-1
Preferred Stock decide to sell their shares of registered stock, such sales
could result in significant volatility in the market price of our common stock
and would likely cause the market price of our common stock to decline.
THERE CAN BE NO GUARANTY THAT A MARKET WILL DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.
We currently have a limited offering of products. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH MAY RESULT IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
41
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate fluctuations, could also cause the market price of our common stock to
decline. Our common stock has experienced, and is likely to continue to
experience, these fluctuations in price, regardless of our performance.
WE ARE CURRENTLY SUBJECT TO AN SEC INVESTIGATION WHICH COULD HAVE AN ADVERSE
AFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS.
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), the staff of
the SEC (the "Staff"), issued an order (In the Matter of Patron Systems, Inc. -
Order Directing a Private Investigation and Designating Officers to Take
Testimony (C-03739-A, February 12, 2004)) (the "Order") that a private
investigation (the "SEC Investigation") be made to determine whether certain of
our actions and certain of the actions of our former officers and directors and
others (as described below) violated Section 5(a) and 5(c) of the Securities Act
and/or Section 10 and Rule 10b-5 promulgated under the Exchange Act. Generally,
the Order provides, among other things, that the Staff is investigating (i) the
legality of two (2) separate Registration Statements filed by us on Form S-8,
filed on December 20, 2002 and on April 2, 2003, as amended on April 9, 2003
(collectively, the "Registration Statements"), covering the resale of, in the
aggregate, 4,375,000 shares of common stock issued to various of our
consultants, and (ii) whether in connection with the purchase or sale of shares
of common stock, certain of our officers, directors and others (a) sold common
stock in violation of Section 5 of the Securities Act and/or, (b) made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection with such purchases and/or sales relating to certain of
our press releases regarding, among other items, proposed mergers and
acquisitions that were never consummated. If the SEC brings an action against
us, it could result in, among other items, a civil injunctive order or an
administrative cease-and-desist order being entered against us, in addition to
the imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely our ability to have our
common stock listed on a stock exchange and/or quoted on the OTC Bulletin Board
or NASDAQ, our ability to sell our securities and/or have our securities
registered with the SEC and/or in various states and/or our ability to implement
our business plan. Our legal counsel representing us in such matters has
indicated that while the SEC Investigation is ongoing and we have not received
correspondence from the SEC indicating that the matter is officially closed, the
Staff has indicated that it does not intend to request additional information
from us and that, at this time, it does not intend to recommend that the SEC
bring an enforcement action against us or our former officers and directors.
There can be no assurance that the SEC will accept the Staff's recommendation
not to bring an enforcement action against us or that the Staff will not elect
at some future time to seek additional information from us with respect to these
matters.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of October 13, 2006, there were 14,462,260
shares of common stock outstanding, of which 5,527,432 shares were held by
directors, executive officers and other affiliates, the sale of which are
subject to volume limitations under Rule 144, various vesting agreements and our
quarterly and other "blackout" periods. Furthermore, shares subject to
outstanding options and warrants and shares reserved for future issuance under
our stock option plan will become eligible for sale in the public market to the
extent permitted by the provisions of various vesting agreements, the lock-up
agreements and Rule 144 under the Securities Act.
42
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
o the demand for our subsidiaries' current product offerings and
our future products;
o the length of sales cycles;
o the timing of recognizing revenues;
o new product introductions by us or our competitors;
o changes in our pricing policies or the pricing policies of our
competitors;
o variations in sales channels, product costs or mix of products
sold;
o our ability to develop, introduce and ship in a timely manner
new products and product enhancements that meet customer
requirements;
o our ability to obtain sufficient supplies of sole or limited
source components for our products;
o variations in the prices of the components we purchase;
o our ability to attain and maintain production volumes and
quality levels for our products at reasonable prices at our
third-party manufacturers;
o our ability to manage our customer base and credit risk and to
collect our accounts receivable; and
o the financial strength of our value-added resellers and
distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses.
OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES. THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.
If at any time a company has net tangible assets of $5,000,000 or less and the
common stock has a market price per share of less than $5.00, transactions in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:
o make a special written suitability determination for the
purchaser;
o receive the purchaser's written agreement to a transaction
prior to sale;
o provide the purchaser with risk disclosure documents which
identify certain risks associated with investing in "penny
stocks" and which describe the market for these "penny stocks"
as well as a purchaser's legal remedies; and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the
required risk disclosure document before a transaction in a
"penny stock" can be completed.
If our common stock becomes subject to these rules, broker-dealers may find it
difficult to effectuate customer transactions and trading activity in our
securities may be adversely affected. As a result, the market price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.
RISKS RELATED TO OUR BUSINESS
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.
43
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. To date we have experienced delays
in implementing our business plan as a result of limited capital resources,
which have had a material adverse effect on our business. Further delays in the
process of integrating could cause an interruption of, or loss of momentum in,
the activities of our business and the loss of key personnel. The diversion of
management's attention and any delays or difficulties encountered in connection
with our integration of acquired operations could have an adverse effect on our
business, results of operations, financial condition or prospects.
WE CURRENTLY DO NOT HAVE SUFFICIENT REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES
AND IF OPERATING LOSSES CONTINUE, WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL
THROUGH FINANCINGS WHICH WE MAY NOT BE ABLE TO SECURE.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like ours, remains
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Our inability to
obtain additional financing may require us to delay, scale back or eliminate
certain of our growth plans which could have a material and adverse effect on
our business, financial condition or results of operations or could cause us to
cease operations. Even if we are able to obtain additional financing, such
financing could be structured as equity financing that would dilute the
ownership percentage of any investor in our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for our current products and other products we intend to offer
depends on economic conditions affecting the broader Internet infrastructure,
network security and related markets. Downturns in these markets may cause
enterprises and carriers to delay or cancel security projects, reduce their
overall or security-specific information technology budgets or reduce or cancel
orders for our current products and other products we intend to offer. In this
environment, customers such as distributors, value-added resellers and carriers
may experience financial difficulty, cease operations and fail to budget or
reduce budgets for the purchase of our current products or other products we
intend to offer. This, in turn, may lead to longer sales cycles, delays in
purchase decisions, payment and collection, and may also result in price
pressures, causing us to realize lower revenues, gross margins and operating
margins. In addition, general economic uncertainty caused by potential
hostilities involving the United States, terrorist activities, the decline in
specific markets such as the service provider market in the United States, and
the general decline in capital spending in the information technology sector
make it difficult to predict changes in the purchase and network requirements of
our potential customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on information technology. A decline in capital spending in the markets we
intend to serve may adversely affect our future revenues, gross margins and
operating margins and make it necessary for us to gain significant market share
from our future competitors in order to achieve our financial goals and achieve
profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we currently offer or intend to
offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we have. In addition, some
of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we currently offer and intend to offer. If any of our larger
potential competitors were to commit greater technical, sales, marketing and
other resources to the markets we intend to serve, or reduce prices for their
44
products over a sustained period of time, our ability to successfully sell the
products we intend to offer, increase revenue or meet our or market analysts
expectations could be adversely affected.
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced
security capabilities into our intended product offerings. Some of these
products and enhancements may require us to develop new hardware architectures
that involve complex and time consuming processes. In developing and introducing
our intended product offerings, we have made, and will continue to make,
assumptions with respect to which features, security standards and performance
criteria will be required by our potential customers. If we implement features,
security standards and performance criteria that are different from those
required by our potential customers, market acceptance of our intended product
offerings may be significantly reduced or delayed, which would harm our ability
to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer deployments and, as a consequence, our revenues may be adversely
affected. In addition, the introduction of products embodying new technologies
could render existing products we intend to offer obsolete, which would have a
direct, adverse effect on our market share and revenues. Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating results to be below our expectations
and the expectations of investors and market analysts, which would likely cause
the price of our common stock to decline.
WE HAVE EXPERIENCED ISSUES WITH OUR FINANCIAL SYSTEMS, CONTROLS AND OPERATIONS
THAT COULD HARM OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. Through
the quarter ended December 31, 2005, our Chief Executive Officer and Acting
Chief Financial Officer evaluated the effectiveness of our disclosure controls
and procedures in accordance with Exchange Act Rules 13a-15 or 15d-15 and
identified material weakness in our internal controls. These material weaknesses
affected our ability to timely file our reports with the SEC and communicate
critical information to management that was needed to make business decisions.
Although we have taken steps to correct these previous deficiencies and are
currently in compliance with the SEC's reporting requirements, we have limited
capital resources and are still at risk for the loss of key personnel in our
finance department. The loss of key personnel in our finance department, or any
other conditions that could disrupt our operations in this area, could have a
material adverse affect on our ability to communicate critical information to
management and our investors, raise capital and/or maintain compliance with our
SEC reporting obligations. These circumstances, if they arise, could have a
material adverse affect on our business.
We have limited management resources to date and are still establishing our
management and financial systems. Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
45
IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Our future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not interoperate with those within our end customers' networks,
installations could be delayed or orders for our products could be cancelled,
which could significantly reduce our anticipated revenues.
AS A PUBLIC COMPANY, WE MAY INCUR INCREASED COSTS AS A RESULT OF RECENTLY
ENACTED AND PROPOSED CHANGES IN LAWS AND REGULATIONS RELATING TO CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.
Recently enacted and proposed changes in the laws and regulations affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased costs for us as we
evaluate the implications of these laws, regulations and standards and respond
to their requirements. These laws and regulations could make it more difficult
or more costly for us to obtain certain types of insurance, including director
and officer liability insurance, and we may be forced to accept reduced policy
limits and coverage or incur substantially higher costs to obtain the same or
similar coverage. The impact of these events could also make it more difficult
for us to attract and retain qualified persons to serve on our board of
directors, board committees or as executive officers. We cannot estimate the
amount or timing of additional costs we may incur as a result of these laws and
regulations.
WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY
CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR RETAIN
EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
Our future success depends upon the continued services of our executive
officers. The loss of the services of any of our key employees, the inability to
attract or retain qualified personnel in the future, or delays in hiring
required personnel, could delay the development and introduction of, and
negatively impact our ability to sell, our intended product offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
46
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
o stop or delay selling, incorporating or using products that
use the challenged intellectual property; and/or
o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology, which
license might not be available on reasonable terms or at all;
or redesign the products that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
OUR INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. Our inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and
domestic sales. The United States and various foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, especially encryption technology. In addition, from time
to time, governmental agencies have proposed additional regulation of encryption
technology, such as requiring the escrow and governmental recovery of private
encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might decrease demand for our intended product
offerings and services. In addition, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete more effectively than we can in the domestic and
international network security market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES
Members of our management, including our Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness of our disclosure controls and
procedures, as defined by paragraph (e) of Exchange Act Rules 13(a)-15 or
15(d)-15 for the fiscal quarter ended September 30, 2006, the period covered by
this report. Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that, as of September 30, 2006 our disclosure
controls and procedures were not effective.
47
DISCLOSURE CONTROLS AND INTERNAL CONTROLS
Disclosure controls and procedures are controls and other procedures that are
designed with the objective of ensuring that information required to be
disclosed in our reports filed under the Securities Exchange Act of 1934, as
amended, such as this Report, is recorded, processed, summarized and reported
within the time periods specified in the SEC's rules and forms. Disclosure
controls and procedures are also designed with the objective of ensuring that
such information is accumulated and communicated to our management, including
our Chief Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure. Internal controls are
procedures which are designed with the objective of providing reasonable
assurance that our transactions are properly authorized, recorded and reported
and our assets are safeguarded against unauthorized or improper use, to permit
the preparation of our financial statements in conformity with generally
accepted accounting principles.
Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not required to deliver management's report on control over our
financial reporting until our year ended December 31, 2007. Nevertheless, we
identified certain matters that constitute material weakness (as defined under
the Public Company Accounting Oversight Board Auditing Standard No. 2) in our
internal controls over financial reporting.
In previous periods, we reported that we had identified certain matters that
constituted material weakness (as defined under the Public Company Accounting
Oversight Board Auditing Standard No. 2) in our internal controls over financial
reporting. The material weaknesses that we identified related to the fact that
that our overall financial reporting structure and current staffing levels were
not sufficient to support the complexity of our financial reporting
requirements, we lacked the expertise we needed to apply complex accounting
principles relating to our business combinations and participation in equity
transactions and lacked the structure we need to ensure the timely filing of our
tax returns.
Prior to the second quarter 2005, we did not have any full time employees
including a Principal Accounting Officer assigned to perform any duties related
to our financial reporting obligations. Accordingly we were unable, until the
second quarter of 2005, to record, process and summarize all of the information
that we needed to close our books and records on a timely basis and deliver our
reports to the Securities and Exchange Commission within the time frames
required under the Commission's rules.
During the third quarter of 2005, under the direction of our Chief Executive
Officer, we addressed personnel changes necessary to review and analyze our
internal control over financial reporting by engaging the services of an outside
financial reporting specialist to conduct the review and analysis. During the
fourth quarter of 2005, this outside financial reporting specialist, together
with our Chief Executive Officer and our other full time personnel, undertook
the process of forming a system of internal controls which was reasonably likely
to materially affect and remedy the material weaknesses identified by our
management. During the fourth quarter of 2005, we hired additional personnel and
instituted various procedures that have enabled us to record, process and
summarize transactions within the time frames required to timely file our
reports under the Commission's rules. These improvements have enabled us to
resolve all previous delinquencies relating to the filing of our annual and
quarterly reports with the SEC. We also resolved the delinquent filing of our
Forms 8-K/A from the acquisitions of CSSI, Entelagent and LucidLine in December
2005. We have timely filed our quarterly and annual reports for each period from
and including the quarter ended June 30, 2005. We also assigned a key member of
the accounting department with the task of filing previously delinquent tax
returns and are undertaking a structure to ensure that our tax returns in the
future are filed on a timely basis. We have completed filing all delinquent tax
returns through the year ended December 31, 2004 and have filed on time our tax
returns for the year ended December 31, 2005.
Although the improvements we have made in our financial reporting processes have
enabled us to (a) record, process and summarize transactions within the
timeframes required to timely file our reports under the Commission's rules, (b)
better plan transactions that involve the application of complex accounting
principles and (c) improve our ability to comply with our tax reporting
obligations, additional time is still required to test and document our internal
and disclosure control processes to ensure their operating effectiveness.
We believe that the changes we have made in our financial reporting procedures
have enabled us to substantially reduce previous financial reporting risks that
existed as a result of our limited resources. We are continuing to evaluate our
48
risks and resources. We will seek to make additional changes in our financial
reporting systems and procedures wherever necessary and appropriate to ensure
their effectiveness in future periods.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On January 5, 2006, Mark P. Gertz, Trustee in bankruptcy for Arter & Hadden,
LLP, filed an Adversary Complaint for Recovery of Assets of the Estate in the
United States Bankruptcy Court Northern District of Ohio Eastern Division,
against the Company as successor in merger to Entelagent. Mr. Gertz seeks
$32,278.18 plus interest accruing at the statutory rate since July 15, 2003 for
services rendered by Arter & Hadden, LLP to Entelagent. On September 11, 2006,
the Company entered into a settlement and release agreement with Mark P. Gertz,
Trustee in bankruptcy for Arter & Hadden, LLP which calls for the payment of
$32,500 in 13 installments of $2,500.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following unregistered securities have been sold by us during the period
from July 1, 2006 to September 30, 2006:
TITLE AND AMOUNT OF SECURITIES NAME OF NAME OR CLASS OF
GRANTED/EXERCISE PRICE IF PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
DATE OF GRANT APPLICABLE UNDERWRITER SECURITIES RECEIVED
------------- ------------------------------ ----------- -------------------- -------------
July 2006 602,039/Series A-1 Preferred None 3 Accredited Creditors $481,631 in
Stock and Claimants in the cancelled
Company's Debt debt(1)
Restructuring
The above unregistered securities were issued pursuant to an exemption from the
registration requirements of the Securities Act under Section 4(2) of the
Securities Act as such securities were issued to accredited investors and were
not issued pursuant to any general solicitation or advertisement.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's 2006 Annual Meeting of Stockholders (the "Annual Meeting") was
held on July 20, 2006. Represented at the Annual Meeting, either in person or by
proxy, were 1,378,448 voting shares of common stock, 21,709,603 voting shares of
Series A-1 Preferred Stock and 638 voting shares of Series A Preferred Stock.
The total number of common stock voting shares on an as converted basis
represented at the meeting was 9,943,107 shares. The following actions were
taken by a vote of the Company's stockholders at the Annual Meeting:
- 1. Mr. George Middlemas, Mr. Robert Cross and Mr. Braden Waverley were
elected to serve as members of the Company's Board of Directors
receiving 9,925,614; 9,925,285; and 9,925,614 votes in favor of
election, respectively, and 17,492; 17,822; and 17,492 votes withheld,
respectively.
- 2. The proposal to adopt the Patron Systems, Inc. 2006 Stock Incentive
Plan was approved by stockholders. This proposal received 8,730,813
votes in favor of the adoption of the proposal; 395,467 votes against
the proposal and 47,268 votes abstaining.
- 3. The proposal to amend the Company's Second Amended and Restated
Certificate of Incorporation, as amended, to provide for a 1-for-30
reverse stock split of the Company's issued and outstanding Common
Stock was approved by each class of securities and by all classes of
securities taken as a group.
--------
(1) On July 18, 2006, we issued 602,039 shares of Series A-1 Preferred
Stock to three parties in consideration for $481,631 of debt
cancellation and claims settlement under the Creditor and Claimant
Liabilities Restructuring. Each share of Series A-1 Preferred Stock was
issued in consideration of the cancellation of $0.80 of debt.
49
Holders of common stock voted 1,354,263 votes in favor of the proposal,
20,729 votes against the proposal and 3,456 votes abstaining. Holders
of Series A-1 Preferred Stock voted 21,630,503 votes in favor of the
proposal and 29,453 votes against the proposal. Holders of Series A
Preferred Stock voted 632 votes in favor of the proposal and 6 votes
against the proposal. All classes of securities taken as a group voting
on an as converted basis voted a total of 9,880,055 votes in favor of
the proposal; 43,047 votes against the proposal and 3,456 votes
abstained.
- 4. The proposal to authorize the holder of any proxy solicited by the
Company's Board of Directors to have the discretionary authority to
vote to adjourn the Annual Meeting to a later date was approved by
stockholders. This proposal received 9,604,156 votes in favor of the
proposal; 159,379.votes against the proposal; and 163,044 votes
abstained.
ITEM 6. EXHIBITS
See attached Exhibit Index.
50
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: November 14, 2006 PATRON SYSTEMS, INC.
--------------------
(Registrant)
/s/ Robert Cross
-----------------------------------------
By: Robert Cross
Its: Chief Executive Officer
/s/ Martin T. Johnson
-----------------------------------------
By: Martin T. Johnson
Its: Chief Financial Officer
51
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------
10.1 Stock Purchase Agreement dated April 18, 2006 between Patron
Systems, Inc. and Walnut Valley, Inc.
31.1 Certification of Principal Executive Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Principal Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
52