U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
x QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
o TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE EXCHANGE ACT
For the Transition Period from to
Commission file number 1-13463
BIO-KEY INTERNATIONAL, INC.
(Exact Name of Small Business Issuer as Specified in Its Charter)
DELAWARE |
|
41-1741861 |
(State or Other
Jurisdiction of |
|
(IRS Employer |
3349 HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ 07719
(Address of Principal Executive Offices)
(732) 359-1100
(Issuers 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 o
APPLICABLE ONLY TO
ISSUERS INVOLVED IN
BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes o No o
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate by check mark whether the registrant is a shell company (as defined by rule 12b-2 of the Exchange Act) Yes o No x
State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date: There were 53,956,837 issued and outstanding shares of the registrants common stock, par value $.0001 per share, as of November 10, 2006.
Transitional Small Business Disclosure Format (check one): Yes o No x
BIO-KEY INTERNATIONAL, INC.
|
|
|||
|
|
3 |
||
|
|
Balance sheets as of September 30, 2006 (unaudited) and December 31, 2005 |
|
4 |
|
|
|
5 |
|
|
|
|
6 |
|
|
|
|
8 |
|
|
Managements Discussion and Analysis of Financial Conditions and Results of Operations |
|
25 |
|
|
|
39 |
||
|
|
|
|
|
|
|
|||
|
|
44 |
||
|
|
45 |
Restatement of Consolidated Financial Statements
As previously reported in our Annual Report on Form 10-KSB/A filed with the Securities and Exchange Commission on June 19, 2006, we have restated our previously reported financial information for the years ended December 31, 2003, 2004 and 2005 and our previously reported unaudited financial statements for the first, second and third quarters of 2003, 2004 and 2005 (the restatement).
Our Annual Reports on Form 10-KSB for the years ended 2003 and 2004 and our Quarterly Reports on Form 10-QSB for fiscal 2003 through the third quarter of fiscal 2005 have not been revised to reflect the restatement and the financial statements contained in those reports should not be relied upon. The restated financial statements for years ended December 31, 2003, 2004 and 2005 included in our Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005 should be relied upon.
The accompanying condensed consolidated financial statements for the three and nine months ended September 30, 2005 should be read in conjunction with the footnote entitled results by quarter (unaudited) contained in the Companys Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005.
2
FINANCIAL INFORMATION
3
BIO-KEY
INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
|
|
September 30, |
|
December 31, |
|
||
|
|
2006 |
|
2005 |
|
||
|
|
(Unaudited) |
|
|
|
||
ASSETS: |
|
|
|
|
|
||
Cash and cash equivalents |
|
$ |
1,293,599 |
|
$ |
1,422,827 |
|
Receivables |
|
|
|
|
|
||
Billed, less allowance for doubtful receivables of $184,074 and $160,000, respectively |
|
3,721,544 |
|
1,635,371 |
|
||
Unbilled |
|
38,776 |
|
201,942 |
|
||
Costs and earnings in excess of billings on uncompleted contracts |
|
1,448,905 |
|
4,321,392 |
|
||
Inventory |
|
26,588 |
|
8,760 |
|
||
Prepaid expenses |
|
163,332 |
|
137,000 |
|
||
Total current assets |
|
6,692,744 |
|
7,727,292 |
|
||
Equipment and leasehold improvements, net |
|
464,417 |
|
548,267 |
|
||
Deposits |
|
800,974 |
|
1,828,560 |
|
||
Intangible assetsless accumulated amortization |
|
2,703,659 |
|
3,301,823 |
|
||
Deferred financing costs, net |
|
231,879 |
|
1,562,338 |
|
||
Goodwill |
|
11,389,654 |
|
11,389,654 |
|
||
Total non-current assets |
|
15,590,583 |
|
18,630,642 |
|
||
TOTAL ASSETS |
|
$ |
22,283,327 |
|
$ |
26,357,934 |
|
LIABILITIES: |
|
|
|
|
|
||
Current maturities of long-term obligations and related obligations, net of discount |
|
$ |
1,481,611 |
|
$ |
6,584,437 |
|
Accounts payable |
|
1,151,100 |
|
833,608 |
|
||
Billings in excess of costs and earnings on uncompleted contracts |
|
78,343 |
|
32,385 |
|
||
Accrued liabilities |
|
4,393,872 |
|
5,520,515 |
|
||
Deferred rent |
|
485,163 |
|
443,603 |
|
||
Deferred revenue |
|
5,491,144 |
|
3,264,283 |
|
||
Total current liabilities |
|
13,081,233 |
|
16,678,831 |
|
||
Warrants and long-term obligations |
|
4,131,950 |
|
1,483,511 |
|
||
Redeemable preferred stock derivatives |
|
1,387,238 |
|
|
|
||
Deferred rent |
|
498,601 |
|
867,850 |
|
||
Deferred revenue |
|
137,879 |
|
1,163,738 |
|
||
Total non-current liabilities |
|
6,155,668 |
|
3,515,099 |
|
||
TOTAL LIABILITIES |
|
19,236,901 |
|
20,193,930 |
|
||
|
|
|
|
|
|
||
Commitments and contingencies |
|
|
|
|
|
||
|
|
|
|
|
|
||
Series B redeemable convertible preferred stock: authorized, 1,000,000 shares (liquidation preference of $1 per share); issued and outstanding 1,000,000 and 0 shares of $.0001par value respectively, net |
|
753,229 |
|
|
|
||
Series C redeemable convertible preferred stock: authorized, 600,000 shares (liquidation preference of $10 per share); issued and outstanding 592,032 and 0 shares of $.0001 par value respectively, net |
|
4,878,005 |
|
|
|
||
|
|
5,631,234 |
|
|
|
||
|
|
|
|
|
|
||
STOCKHOLDERS (DEFICIT)/EQUITY: |
|
|
|
|
|
||
Preferred stock authorized, 5,000,000 shares (liquidation preference of $100 per share) Series A 7% Convertible; issued and outstanding 35,557 and 44,557 shares of $.0001 par value, respectively |
|
4 |
|
4 |
|
||
Common stock authorized, 170,000,000 shares; issued and outstanding; 53,956,837 and 46,306,589 shares of $.0001 par value, respectively |
|
5,545 |
|
4,632 |
|
||
Additional paid-in capital |
|
51,399,062 |
|
48,921,316 |
|
||
Accumulated deficit |
|
(53,989,419 |
) |
(42,761,948 |
) |
||
TOTAL STOCKHOLDERS (DEFICIT)/EQUITY |
|
(2,584,808 |
) |
6,164,004 |
|
||
TOTAL LIABILITIES AND STOCKHOLDERS (DEFICIT)/EQUITY |
|
$ |
22,283,327 |
|
$ |
26,357,934 |
|
The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.
4
BIO-KEY
INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
|
|
Three months ended |
|
Nine months ended |
|
||||||||
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
|
||||
|
|
|
|
(As restated) |
|
|
|
(As restated) |
|
||||
Revenues |
|
|
|
|
|
|
|
|
|
||||
Services |
|
$ |
3,226,184 |
|
$ |
2,496,883 |
|
$ |
8,397,122 |
|
$ |
8,318,624 |
|
License fees and other |
|
973,914 |
|
735,588 |
|
2,784,937 |
|
2,538,990 |
|
||||
|
|
4,200,098 |
|
3,232,471 |
|
11,182,059 |
|
10,857,614 |
|
||||
Costs and other expenses |
|
|
|
|
|
|
|
|
|
||||
Cost of services |
|
612,441 |
|
503,843 |
|
2,024,655 |
|
2,373,535 |
|
||||
Cost of license fees and other |
|
148,275 |
|
125,633 |
|
361,334 |
|
658,875 |
|
||||
|
|
760,716 |
|
629,476 |
|
2,385,989 |
|
3,032,410 |
|
||||
Gross Profit |
|
3,439,382 |
|
2,602,995 |
|
8,796,070 |
|
7,825,204 |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Operating Expenses |
|
|
|
|
|
|
|
|
|
||||
Selling, general and administrative |
|
2,467,347 |
|
2,836,875 |
|
7,834,137 |
|
8,808,969 |
|
||||
Research, development and engineering |
|
1,653,238 |
|
1,799,845 |
|
4,830,186 |
|
5,545,386 |
|
||||
|
|
4,120,585 |
|
4,636,720 |
|
12,664,323 |
|
14,354,355 |
|
||||
Operating loss |
|
(681,203 |
) |
(2,033,725 |
) |
(3,868,253 |
) |
(6,529,151 |
) |
||||
Other income (deductions) |
|
|
|
|
|
|
|
|
|
||||
Derivative and warrant fair value adjustments |
|
547,752 |
|
3,210,057 |
|
5,548,604 |
|
8,160,305 |
|
||||
Interest income |
|
|
|
6,908 |
|
|
|
35,958 |
|
||||
Interest expense |
|
(586,689 |
) |
(1,605,771 |
) |
(4,915,445 |
) |
(2,992,780 |
) |
||||
Loss on extinguishment of debt |
|
(5,493,701 |
) |
|
|
(7,815,717 |
) |
|
|
||||
Other |
|
(18,891 |
) |
(24,816 |
) |
(51,185 |
) |
(45,348 |
) |
||||
|
|
(5,551,529 |
) |
1,586,378 |
|
(7,233,743 |
) |
5,158,135 |
|
||||
NET LOSS |
|
$ |
(6,232,732 |
) |
$ |
(447,347 |
) |
$ |
(11,101,996 |
) |
$ |
(1,371,016 |
) |
|
|
|
|
|
|
|
|
|
|
||||
Basic and Diluted Loss to Common Shareholders: |
|
|
|
|
|
|
|
|
|
||||
Net loss |
|
$ |
(6,232,732 |
) |
$ |
(447,347 |
) |
$ |
(11,101,996 |
) |
$ |
(1,371,016 |
) |
Convertible preferred stock dividends and accretion |
|
(369,200 |
) |
(72,632 |
) |
(581,877 |
) |
(261,152 |
) |
||||
Net loss attributable to common shareholders |
|
$ |
(6,601,932 |
) |
$ |
(519,979 |
) |
$ |
(11,683,873 |
) |
$ |
(1,632,168 |
) |
|
|
|
|
|
|
|
|
|
|
||||
Net Loss Per Share: |
|
|
|
|
|
|
|
|
|
||||
Basic |
|
$ |
(0.13 |
) |
$ |
(0.01 |
) |
$ |
(0.24 |
) |
$ |
(0.04 |
) |
Diluted |
|
$ |
(0.13 |
) |
$ |
(0.02 |
) |
$ |
(0.24 |
) |
$ |
(0.09 |
) |
|
|
|
|
|
|
|
|
|
|
||||
Weighted Average Shares Outstanding: |
|
|
|
|
|
|
|
|
|
||||
Basic |
|
50,733,960 |
|
45,476,802 |
|
48,752,262 |
|
45,129,000 |
|
||||
Diluted |
|
50,733,960 |
|
53,861,595 |
|
48,752,262 |
|
52,017,328 |
|
The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.
5
BIO-KEY
INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
|
|
Nine Months Ended September 30, |
|
||||
|
|
2006 |
|
2005 |
|
||
CASH FLOW FROM OPERATING ACTIVITIES: |
|
|
|
|
|
||
Net Loss |
|
$ |
(11,101,996 |
) |
$ |
(1,371,016 |
)) |
Adjustments to reconcile net loss to cash used in operating activities: |
|
|
|
|
|
||
Derivative and warrant fair value adjustments |
|
(5,548,604 |
) |
(8,160,305 |
) |
||
Loss on extinguishment of debt |
|
7,815,719 |
|
|
|
||
Depreciation |
|
203,288 |
|
179,642 |
|
||
Amortization |
|
|
|
|
|
||
Intangible assets |
|
647,640 |
|
1,474,979 |
|
||
Deferred financing costs |
|
167,275 |
|
29,621 |
|
||
Discounts on convertible debt related to warrants and beneficial conversion features |
|
2,515,875 |
|
1,067,927 |
|
||
Allowance for doubtful receivables |
|
24,073 |
|
22,440 |
|
||
Deferred rent |
|
(327,692 |
) |
(290,807 |
) |
||
Options and warrants issued for services and other |
|
529,055 |
|
542,758 |
|
||
Loss on sale of investment |
|
|
|
20,000 |
|
||
Change in assets and liabilities: |
|
|
|
|
|
||
Accounts receivable trade |
|
(1,947,080 |
) |
(862,889 |
) |
||
Costs and earnings in excess of billings on uncompleted contracts |
|
2,872,487 |
|
1,546,812 |
|
||
Inventory |
|
(17,829 |
) |
26,134 |
|
||
Prepaid expenses and other |
|
(26,332 |
) |
(221,842 |
) |
||
Accounts payable |
|
317,492 |
|
(418,332 |
) |
||
Billings in excess of costs and earnings on uncompleted contracts |
|
45,958 |
|
24,173 |
|
||
Accrued liabilities |
|
(315,427 |
) |
683,989 |
|
||
Deferred revenue |
|
1,201,003 |
|
1,174,224 |
|
||
Net cash used in operating activities |
|
(2,945,095 |
) |
(4,532,492 |
) |
||
CASH FLOWS FROM INVESTING ACTIVITIES: |
|
|
|
|
|
||
Capital expenditures |
|
(119,437 |
) |
(144,916 |
) |
||
Deposits |
|
1,027,585 |
|
1,004,097 |
|
||
Patent costs |
|
(49,477 |
) |
(56,610 |
) |
||
Proceeds from sale of marketable debt securities |
|
|
|
980,000 |
|
||
Proceeds from sale of trademark |
|
|
|
50,000 |
|
||
Net cash provided by investing activities |
|
858,671 |
|
1,832,571 |
|
||
CASH FLOW FROM FINANCING ACTIVITIES: |
|
|
|
|
|
||
Net advance to stockholders |
|
|
|
(12,753 |
) |
||
Issuance of long-term obligations |
|
988,000 |
|
4,920,251 |
|
||
Repayment of long term obligations |
|
(348,349 |
) |
(1,894,148 |
) |
||
Preferred stock dividends paid |
|
(59,303 |
) |
|
|
||
Issuance of common stock |
|
1,500,000 |
|
|
|
||
Issuance of bridge note |
|
|
|
250,000 |
|
||
Repayment of bridge note |
|
|
|
(250,000 |
) |
||
Exercise of warrants and options |
|
8,400 |
|
558,787 |
|
||
Financing costs |
|
(131,552 |
) |
(374,614 |
) |
||
Net refund of offering costs |
|
|
|
43,356 |
|
||
Net cash provided by financing activities |
|
1,957,196 |
|
3,240,879 |
|
||
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS |
|
(129,228 |
) |
540,958 |
|
||
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD |
|
1,422,827 |
|
956,230 |
|
||
CASH AND CASH EQUIVALENTS, END OF PERIOD |
|
$ |
1,293,599 |
|
$ |
1,497,188 |
|
The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.
6
BIO-KEY
INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION
|
|
Nine Months Ended September 30, |
|
||
|
|
2006 |
|
2005 |
|
|
|
|
|
|
|
Cash paid for: |
|
|
|
|
|
Interest |
|
1,061,157 |
|
1,025,873 |
|
|
|
|
|
|
|
Noncash Investing and Financing Activities: |
|
|
|
|
|
Conversion of convertible notes and related obligations, net of discount, and accrued interest into common stock |
|
894,123 |
|
2,126,196 |
|
Issuance of Series B redeemable preferred stock in exchange for debt and related obligations |
|
988,000 |
|
|
|
Issuance of Series C redeemable preferred stock in exchange for debt and related obligations |
|
5,920,320 |
|
|
|
Issuance of common stock in conjunction with refinancing |
|
189,000 |
|
788,284 |
|
Modification of warrants in conjunction with refinancing |
|
110,453 |
|
|
|
Issuance of common stock through conversion of dividends outstanding on Series A preferred stock |
|
541,398 |
|
|
|
Issuance of common stock in exchange for Series A and Series C preferred stock and cumulative dividends in arrears, thereon |
|
|
|
121,822 |
|
Origination of warrants in conjunction with debt financing |
|
308,376 |
|
1,335,000 |
|
Origination of warrants in conjunction with equity financing |
|
103,229 |
|
|
|
Origination of options in exchange for financing fees |
|
|
|
27,367 |
|
Cashless exercise of options and warrants |
|
|
|
164,075 |
|
Goodwill allocation adjustment |
|
|
|
946,852 |
|
Conversation of preferred stock dividends to common stock |
|
500,000 |
|
|
|
Conversion of preferred stock to common stock |
|
125,476 |
|
|
|
Origination of embedded derivatives in conjunction with debt financing |
|
679,624 |
|
|
|
Origination of embedded derivatives with preferred stock |
|
1,434,004 |
|
|
|
The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.
7
BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006 (Unaudited) and December 31, 2005
The accompanying unaudited interim consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly owned subsidiary (collectively, the Company) and are stated in conformity with accounting principles generally accepted in the United States, pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. Significant intercompany accounts and transactions have been eliminated in consolidation.
In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all necessary adjustments, consisting only of those of a recurring nature, and disclosures to present fairly the financial position and the results of its operations and cash flows for the periods presented. It is suggested that these unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the related notes thereto included in the Companys Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005, as amended (the Form 10-KSB).
Recently Issued Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS No. 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plans overfunded status and/or a liability for a plans underfunded status; (b) measure a plans assets and its obligations that determine its funded status as of the end of the employers fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. The implementation of SFAS 158 is not expected to have a material impact on the Companys financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which is effective for calendar year companies on January 1, 2008. The Statement defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. The Statement codifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company is currently assessing the potential impacts of implementing this standard.
In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), Financial Statements Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, Financial Statements Materiality, (SAB 99) should be applied to determine whether the misstatement is material. The implementation of SAB 108 is not expected to have a material impact on the Companys financial statements.
8
In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income TaxesAn Interpretation of FASB Statement No. 109, which 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. FIN 48 will be effective for the Companys first interim period beginning January 1 2007. The implementation of FIN 48 is not expected to have a material impact on the Companys financial statements.
Comprehensive loss consists of net loss and other gains and losses affecting shareholders' equity that, under generally accepted accounting principles, are excluded from net loss in accordance with Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." The Company, however, does not have any components of other comprehensive loss as defined by SFAS No. 130 and therefore, for the three and nine months ended September 30, 2006 and 2005, comprehensive loss is equivalent to the Company's reported net loss. Accordingly, a separate statement of comprehensive loss is not presented.
Reclassifications
Certain amounts in the 2005 consolidated financial statements have been reclassified to conform to the 2006 presentation. These reclassifications had no effect on the previously reported net loss or stockholders equity.
2. LIQUIDITY AND CAPITAL RESOURCE MATTERS
Broad commercial acceptance of the Companys technology is critical to the Companys success and ability to generate revenues. The Company has only recently begun to generate significant revenues, has suffered recurring losses from operations and has a working capital deficit.
During the three months ended September 30, 2006, the Company raised approximately $2,000,000 in gross proceeds through private issuances of equity securities (pursuant to the Securities Purchase Agreements with Trellus Partners L.P. and The Shaar Fund, Ltd.), of which $1,500,000 was received in cash and $500,000 was paid in declared and unpaid dividends.
The Company may still be in need of additional capital however, and is currently considering various alternatives related to raising additional capital including new funding from other sources. No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained to meet its needs, or that such financing would not be dilutive to existing shareholders.
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which contemplate continuation of the Company as a going concern. The matters described in the preceding paragraphs raise substantial doubt about the Companys ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet may be dependent upon the Companys ability to obtain additional financing, meet its financing requirements on a continuing basis, and succeed in its future operations. The accompanying financial statements do not include any adjustments that may result from the uncertainty regarding the Companys ability to continue as a going concern.
Effect of Adoption of SFAS 123R, Share-Based Payment
Prior to January 1, 2006, the Companys employee stock compensation plans were accounted for in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations. Under this method, no compensation expense was
9
recognized as long as the exercise price equaled or exceeded the market price of the underlying stock on the date of the grant. The Company elected the disclosure-only alternative permitted under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure (SFAS 148), for fixed stock-based awards to employees.
On December 31, 2005, the Company accelerated the vesting of certain of the outstanding options to purchase shares of the Companys common stock with option exercise prices greater than the fair market value of the Companys common stock on such date. The acceleration applied to all such options outstanding as of December 31, 2005 under the Companys 1996 Stock Option Plan, 1999 Stock Option Plan and 2004 Stock Option Plan, except for options held by the Companys executive officers subject to Section 16(b) of the Securities Exchange Act of 1934, as amended, and the members of the Companys Board of Directors. Options to purchase up to 897,614 shares of the Companys common stock, or 14% of the total shares of the Companys common stock subject to outstanding options, with a weighted average exercise price of approximately $1.09 and varying remaining vesting schedules, were subject to this acceleration and became immediately vested and exercisable as of December 31, 2005. The number of shares, exercise prices and other terms of the options subject to the acceleration remain unchanged.
As of January 1, 2006, the Company adopted SFAS 123R using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Accordingly, financial statement amounts for the prior periods presented in this Form 10-QSB have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS 123, as amended by SFAS 148, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the expected option term), the estimated volatility of our common stock price over the options expected term, the risk-free interest rate over the options expected term, and the Companys expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. The compensation expense recognized in connection with the adoption of SFAS 123R increased the Companys net loss by $239,136 with no effect per share for the three months ended September 30, 2006 and increased the Companys net loss for the nine months ended September 30, 2006 by $529,055, with a $0.01 effect per share. There was no impact on cash flows from operations, investment, or financing in connections with the adoptions of SFAS 123R. As the Company uses the full valuation allowance with respect to deferred taxes, the adoption of SFAS 123R had no impact on deferred taxes.
10
The following table presents share-based compensation expenses for continuing operations included in the Companys unaudited condensed consolidated statements of operations:
|
|
Three Months Ended |
|
Nine Months Ended |
|
||
|
|
2006 |
|
2006 |
|
||
|
|
|
|
|
|
||
Cost of services |
|
$ |
15,468 |
|
$ |
40,236 |
|
Selling, general and administrative |
|
167,769 |
|
370,165 |
|
||
Research, development and engineering |
|
55,899 |
|
118,654 |
|
||
|
|
$ |
239,136 |
|
$ |
529,055 |
|
Valuation Assumptions for Stock Options
For the nine months ended September 30, 2006, 324,000 stock options were granted. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
|
|
Three Months Ended |
|
||
|
|
2006 |
|
2005 |
|
Risk free interest rate |
|
4.91-5.08 |
% |
4.16 |
% |
Expected life of options (in years) |
|
4.0-7.0 |
|
7.0 |
|
Expected dividends |
|
0 |
% |
0 |
% |
Volatility of stock price |
|
92-118 |
% |
132 |
% |
|
|
Nine Months Ended |
|
||
|
|
2006 |
|
2005 |
|
Risk free interest rate |
|
4.53-5.08 |
% |
3.95-4.18 |
% |
Expected life of options (in years) |
|
4.0-7.0 |
|
6.5-7.0 |
|
Expected dividends |
|
0 |
% |
0 |
% |
Volatility of stock price |
|
72-129 |
% |
132-134 |
% |
The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical daily price changes of the Companys common stock over the expected option term. The expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.
Fair Value Disclosures Prior to SFAS 123R Adoption
The Company did not recognize compensation expense for employee stock option grants for the three and nine months ended September 30, 2005, when the exercise price of the Companys employee stock options equaled the market price of the underlying stock on the date of grant.
The Company had previously adopted the provisions of SFAS 123 as amended by SFAS No.148, Accounting for Stock-Based Compensation Transition and Disclosure through disclosure only. The following table illustrates the effects on net income and earnings per share for the three and nine months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards:
11
|
|
Three Months Ended |
|
Nine Months Ended |
|
||
|
|
2005 |
|
2005 |
|
||
|
|
|
|
|
|
||
Net loss |
|
|
|
|
|
||
|
$ |
(447,347 |
) |
$ |
(1,371,016 |
) |
|
Fair value-based expense, net of tax |
|
(218,054 |
) |
(654,162 |
) |
||
Proforma net loss |
|
$ |
(665,401 |
) |
$ |
(2,025,178 |
) |
|
|
|
|
|
|
||
Loss applicable to common Stockholders |
|
|
|
|
|
||
As reported |
|
$ |
(519,979 |
) |
$ |
(1,632,168 |
) |
Fair value-based expense, net of tax |
|
(218,054 |
) |
(654,162 |
) |
||
Proforma net loss |
|
$ |
(738,033 |
) |
$ |
(2,286,330 |
) |
|
|
|
|
|
|
||
Basic and diluted loss per common share |
|
|
|
|
|
||
As reported Basic |
|
$ |
(0.01 |
) |
$ |
(0.04 |
) |
As reported Diluted |
|
$ |
(0.02 |
) |
$ |
(0.09 |
) |
Proforma Basic |
|
$ |
(0.02 |
) |
$ |
(0.05 |
) |
Proforma Diluted |
|
$ |
(0.05 |
) |
$ |
(0.10 |
) |
1996 Stock Option Plan
During 1996, the Board of Directors and stockholders of the Company adopted the 1996 Stock Option Plan (the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 100% of fair market value for incentive stock options and 50% for all others. The term of stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The Plan expired in May 2005.
1999 Stock Option Plan
During 1999, the Board of Directors of the Company adopted the 1999 Stock Option Plan (the 1999 Plan). The 1999 Plan was not presented to stockholders for approval and thus incentive stock options are not available under the plan. Under the 1999 Plan, 2,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of nonstatutory stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 1999 Plan terminates in August 2009.
2004 Stock Option Plan
On October 12, 2004, the Board of Directors of the Company approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan has not yet been presented to stockholders for approval and thus incentive stock options are not available under this plan. Under the terms of this plan, 4,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The Plan terminates in October 2014.
12
Non-Plan Stock Options
Periodically, the Company has granted options outside of the 1996, 1999, and 2004 Plans to various employees and consultants. In the event of change in control, as defined, certain of the non-plan options outstanding vest immediately.
Stock Option Activity
The following table summarizes stock option activity for the nine months ended September 30, 2006:
|
|
1996 Plan |
|
1999 Plan |
|
2004 Plan |
|
Non Plan |
|
Total |
|
Range of |
|
Weighted |
|
Weighted |
|
Balance, as of December 31, 2005 |
|
150,000 |
|
1,062,125 |
|
2,052,860 |
|
3,082,850 |
|
6,347,835 |
|
|
|
|
|
4.52 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
|
|
|
748,000 |
|
1,050,000 |
|
1,798,000 |
|
0.67-0.75 |
|
0.72 |
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expired or cancelled |
|
|
|
|
|
(42,610 |
) |
(14,850 |
) |
(57,460 |
) |
0.93-1.17 |
|
1.04 |
|
|
|
Balance, as of March 31, 2006 |
|
150,000 |
|
1,062,125 |
|
2,758,250 |
|
4,118,000 |
|
8,088,375 |
|
0.19-6.42 |
|
0.87 |
|
5.41 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
|
|
|
92,000 |
|
|
|
92,000 |
|
0.61 |
|
0.61 |
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expired or cancelled |
|
|
|
(132,456 |
) |
(102,000 |
) |
|
|
(234,456 |
) |
0.35-1.10 |
|
0.62 |
|
|
|
Balance, as of June 30, 2006 |
|
150,000 |
|
929,669 |
|
2,748,250 |
|
4,118,000 |
|
7,945,919 |
|
0.19-6.42 |
|
0.88 |
|
4.96 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
|
135,000 |
|
97,000 |
|
|
|
232,000 |
|
0.38-0.40 |
|
0.39 |
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expired or cancelled |
|
|
|
(69,669 |
) |
(124,500 |
) |
|
|
(194,169 |
) |
0.60-1.17 |
|
0.92 |
|
|
|
Balance, as of September 30, 2006 |
|
150,000 |
|
995,000 |
|
2,720,750 |
|
4,118,000 |
|
7,983,750 |
|
0.19-6.42 |
|
0.86 |
|
4.81 |
|
Available for future grants September 30, 2006 |
|
|
|
714,257 |
|
1,279,250 |
|
|
|
1,993,507 |
|
|
|
|
|
|
|
The options outstanding and exercisable at September 30, 2006 were in the following exercise price ranges:
Options Outstanding |
|
Options Exercisable |
|
||||||||||||||||
Range of exercise prices |
|
Number |
|
Weighted |
|
Weighted |
|
Aggregate |
|
Number |
|
Weighted |
|
Weighted |
|
Aggregate |
|
||
$0.19 |
|
60,000 |
|
$0.19 |
|
$1.90 |
|
$15,000 |
|
60,000 |
|
$0.19 |
|
1.90 |
|
$15,000 |
|
||
.29-.40 |
|
937,000 |
|
0.34 |
|
3.15 |
|
98,380 |
|
840,000 |
|
0.33 |
|
2.72 |
|
94,500 |
|
||
.46-.69 |
|
2,566,000 |
|
0.58 |
|
4.71 |
|
|
|
1,360,332 |
|
0.53 |
|
3.67 |
|
|
|
||
.75-1.11 |
|
2,626,250 |
|
0.94 |
|
5.70 |
|
|
|
1,396,249 |
|
1.07 |
|
5.20 |
|
|
|
||
1.17-1.62 |
|
1,746,500 |
|
1.30 |
|
4.71 |
|
|
|
1,428,162 |
|
1.30 |
|
4.61 |
|
|
|
||
6.42 |
|
48,000 |
|
6.42 |
|
1.37 |
|
|
|
48,000 |
|
6.42 |
|
1.37 |
|
|
|
||
$0.19-6.42 |
|
7,983,750 |
|
|
|
|
|
$ |
113,380 |
|
5,132,743 |
|
|
|
|
|
$ |
109,500 |
|
The weighted average remaining contractual life of options exercisable at September 30, 2006 was 4.05 years.
The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Companys closing stock price of $0.44 as of September 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of September 30, 2006 was 900,000.
13
The weighted average fair value of options, as determined under SFAS No. 123R and SFAS 123, granted during the three months ended September 30, 2006 and September 30, 2005 was $0.31 and $0.84 per share, respectively, and during the nine months ended September 30, 2006 and September 30, 2005 was $0.53 and $1.09 per share respectively.
The total intrinsic value of options exercised during the three-month period ended September 30, 2006 and September 30, 2005 was $0 and $15,600, respectively. The aggregate intrinsic value of options exercised during the nine-month period ended September 30, 2006 and September 30, 2005 was $0 and $136,688 respectively.
As of September 30, 2006 future compensation cost related to nonvested stock options is approximately $688,791 and will be recognized over an estimated weighted average period of approximately 3.0 years.
4. EARNINGS PER SHARE COMMON STOCK (EPS)
The Companys basic EPS is calculated using net income (loss) and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuance of common stock, such as stock issuable pursuant to the exercise of stock options and warrants and the assumed conversion of convertible notes and preferred stock. For the three and nine months ended September 30, 2006, diluted per share computations are not presented since this effect would be antidilutive.
The reconciliation of the numerators and denominators of the basic and diluted EPS calculations was as follows for both of the following three and nine month periods ended September 30:
|
|
Three Months ended September |
|
Nine Months ended September |
|
||||||||
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Numerator: |
|
|
|
|
|
|
|
|
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Net income (loss) |
|
$ |
(6,232,732 |
) |
$ |
(447,347 |
) |
$ |
(11,101,996 |
) |
$ |
(1,371,016 |
) |
|
|
|
|
|
|
|
|
|
|
||||
Convertible preferred stock dividends and accretion |
|
(369,200 |
) |
(72,632 |
) |
(581,877 |
) |
(261,152 |
) |
||||
Income (loss) available to common stockholders (basic EPS) |
|
(6,601,932 |
) |
(519,979 |
) |
(11,683,873 |
) |
(1,632,168 |
) |
||||
|
|
|
|
|
|
|
|
|
|
||||
Adjustment for interest expense and debt conversion features |
|
|
|
(356,879 |
) |
|
|
(2,890,686 |
) |
||||
Loss as adjusted (diluted EPS) |
|
$ |
(6,601,932 |
) |
$ |
(876,858 |
) |
$ |
(11,683,873 |
) |
$ |
(4,522,854 |
) |
|
|
|
|
|
|
|
|
|
|
||||
Denominator: |
|
|
|
|
|
|
|
|
|
||||
Weighted-average shares used to compute basic EPS |
|
50,733,960 |
|
45,476,802 |
|
48,752,262 |
|
45,129,000 |
|
||||
Effect of dilutive securities: |
|
|
|
|
|
|
|
|
|
||||
Convertible notes |
|
|
|
8,384,793 |
|
|
|
6,888,328 |
|
||||
Weighted-average shares used to compute diluted EPS |
|
50,733,960 |
|
53,861,595 |
|
48,752,262 |
|
52,017,328 |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Earnings (loss) per share |
|
|
|
|
|
|
|
|
|
||||
Basic |
|
$ |
(0.13 |
) |
$ |
(0.01 |
) |
$ |
(0.24 |
) |
$ |
(0.04 |
) |
Diluted |
|
$ |
(0.13 |
) |
$ |
(0.02 |
) |
$ |
(0.24 |
) |
$ |
(0.09 |
) |
The following table summarizes the potential weighted average shares of common stock that were excluded
14
from the diluted per share calculation, because the effect of including these potential shares was antidilutive.
|
|
Three Months ended |
|
Nine Months Ended |
|
||||
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
Preferred Stock |
|
14,364,171 |
|
6,796,942 |
|
9,146,462 |
|
7,152,538 |
|
Convertible Debt |
|
11,952,895 |
|
|
|
13,250,644 |
|
|
|
Stock Options |
|
247,461 |
|
1,300,446 |
|
530,681 |
|
1,675,586 |
|
Warrants |
|
6,668 |
|
54,908 |
|
440,647 |
|
580,125 |
|
|
|
|
|
|
|
|
|
|
|
Potentially dilutive securities |
|
26,571,195 |
|
8,152,296 |
|
23,368,434 |
|
9,408,249 |
|
Items excluded from the diluted per share calculation because the exercise price was greater than the average market price of the common shares:
|
|
Three Months Ended |
|
Nine Months Ended |
|
||||
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
Stock options |
|
6,986,750 |
|
4,136,600 |
|
5,941,750 |
|
2,196,350 |
|
Warrants |
|
14,124,486 |
|
13,058,042 |
|
10,226,475 |
|
9,383,042 |
|
|
|
|
|
|
|
|
|
|
|
Total |
|
21,111,236 |
|
17,194,642 |
|
16,168,225 |
|
11,579,392 |
|
5. EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Equipment and leasehold improvements at September 30, 2006 and December 31, 2005 consisted of the following:
|
|
September 30, |
|
December 31, |
|
||
|
|
2006 |
|
2005 |
|
||
|
|
|
|
|
|
||
Equipment |
|
$ |
530,120 |
|
$ |
458,847 |
|
Furniture and fixtures |
|
187,984 |
|
179,349 |
|
||
Software |
|
116,011 |
|
104,414 |
|
||
Leasehold improvements |
|
198,888 |
|
170,955 |
|
||
|
|
1,033,003 |
|
913,565 |
|
||
|
|
|
|
|
|
||
Less accumulated depreciation and amortization |
|
(568,586 |
) |
(365,298 |
) |
||
|
|
|
|
|
|
||
Total |
|
$ |
464,417 |
|
$ |
548,267 |
|
6. GOODWILL AND OTHER INTANGIBLE ASSETS
The Companys goodwill resulted from the acquisition of Public Safety Group, Inc. and certain assets and assumed liabilities of the Mobile Government Division of Aether Systems, Inc. in 2004. As provided by SFAS No. 142, the Company has elected to perform the annual assessment of the carrying value of all goodwill as of September 30 of each year using a number of criteria, including the value of the overall enterprise. As of September 30, 2006, the Company believes no material impairment exists. Future impairment charges from existing operations or other acquisitions, if any, will be reflected as an operating expense in the statement of operations. As of September 30, 2006 and December 31, 2005 goodwill totaled $11,389,654.
15
Other intangible assets as of September 30, 2006 and December 31, 2005 consisted of the following:
|
|
September 30, |
|
December 31, |
|
||
|
|
2006 |
|
2005 |
|
||
Copyrighted software |
|
$ |
1,181,429 |
|
$ |
1,181,429 |
|
Customer relationships |
|
1,009,000 |
|
1,009,000 |
|
||
Trademarks |
|
807,872 |
|
807,872 |
|
||
Developed technology |
|
710,000 |
|
710,000 |
|
||
Marketing agreements |
|
605,340 |
|
605,340 |
|
||
Patents and patents pending |
|
333,255 |
|
283,779 |
|
||
|
|
4,646,896 |
|
4,597,420 |
|
||
|
|
|
|
|
|
||
Less: accumulated amortization |
|
(1,943,237 |
) |
(1,295,597 |
) |
||
|
|
|
|
|
|
||
Total |
|
$ |
2,703,659 |
|
$ |
3,301,823 |
|
Aggregate amortization expense for the nine months ended September, 2006 and 2005, was $647,640 and $1,474,979 respectively.
Deferred financing costs are amortized based upon the lives of the respective debt obligations. The gross carrying amount of deferred financing costs at September 30, 2006 and December 31, 2005 was $335,828 and $1,763,238 respectively, and accumulated amortization was $103,949 and $200,900, respectively. Amortization of deferred financing costs is included in interest expense, and was $46,633 and $14,999 for the three months ended September 30, 2006 and 2005 respectively, and was $167,275 and $29,621 for the nine months ended September 30, 2006 and 2005 respectively.
Long-term obligations consisted of the following as of:
|
|
September 30, |
|
December 31, |
|
||
|
|
2006 |
|
2005 |
|
||
2004 |
|
|
|
|
|
||
Convertible term notes |
|
$ |
3,016,655 |
|
$ |
5,992,304 |
|
Discount |
|
(553,812 |
) |
(2,134,340 |
) |
||
FMV of embedded derivatives |
|
580,575 |
|
421,317 |
|
||
FMV of warrants |
|
352,634 |
|
828,095 |
|
||
2005 |
|
|
|
|
|
||
Convertible term notes |
|
1,800,000 |
|
5,284,723 |
|
||
Discount |
|
(490,025 |
) |
(3,569,793 |
) |
||
FMV of embedded derivatives |
|
494,091 |
|
590,226 |
|
||
FMV of warrants |
|
290,721 |
|
655,416 |
|
||
2006 |
|
|
|
|
|
||
FMV of warrants |
|
122,722 |
|
|
|
||
|
|
5,613,561 |
|
8,067,948 |
|
||
|
|
|
|
|
|
||
Less current portion |
|
1,481,611 |
|
6,584,437 |
|
||
|
|
|
|
|
|
||
Total |
|
$ |
4,131,950 |
|
$ |
1,483,511 |
|
16
2004 and 2005 Senior Notes Amendment and Waivers
Effective as of January 23, 2006, the Company entered into an Amendment and Waiver (the January Secured Notes Amendment and Waiver) with Laurus Master Fund, Ltd (Laurus) in connection with the Secured Convertible Notes (the Secured Notes) then held by Laurus.
Under the January Secured Notes Amendment and Waiver, the Secured Notes issued by the Company to Laurus on September 29, 2004 in the aggregate principal amount of $5,000,000 (the September 2004 Note) and on June 8, 2005 in the aggregate principal amount of $2,000,000 (the June 2005 Note) were amended as follows: (i) the maturity date of the September 2004 Note was extended to January 1, 2008, (ii) the maturity date of the June 2005 Note was extended to December 1, 2008, and (iii) the fixed conversion price under each of the Secured Notes was reset from $1.35 to $0.85 per share. In addition, the exercise price of all warrants to purchase Common Stock of the Company held by Laurus was reset to $1.00 per share.
The Company also issued 150,000 shares (the Newly Issued Shares) of the Companys Common Stock to Laurus in connection with the January Secured Notes Amendment and Waiver. In connection with the issuance of these shares, Laurus agreed to waive the provisions of the Secured Notes regarding any adjustment of the fixed conversion price that would otherwise be triggered as a result of the issuance of these shares and certain other securities which have a conversion price of $0.70 per share.
Effective as of August 10, 2006, the Company entered into a further Amendment and Waiver (the August Secured Notes Amendment and Waiver) with Laurus in connection with the Secured Notes. Under the August Secured Notes Amendment and Waiver, the September 2004 Note and June 2005 Note were amended as follows: (i) the principal amounts due and payable under the September 2004 Note and the June 2005 Note for the months of August and September 2006, respectively, shall be paid in shares of the Companys Common Stock priced at $0.50 per share; and (ii) the principal amount due and payable under the September 2004 Note for the months of October, November and December 2006 is deferred until January 1, 2008, the final maturity date of the September 2004 Note, and the principal amount due and payable under the June 2005 Note for the months of October, November and December 2006 is deferred until December 1, 2008, the final maturity date of the June 2005 Note.
Pursuant to the August Secured Notes Amendment and Waiver, the Company issued 150,000 shares of its Common Stock to Laurus as consideration for the principal payment deferral.
2004 and 2005 Subordinated Notes
Effective as of January 23, 2006, the Company also entered into an Amendment and Waiver (the Subordinated Notes Amendment and Waiver) with certain holders (the Subordinated Note Holders) of its Subordinated Convertible Promissory Notes (the Subordinated Notes).
Under the Subordinated Notes Amendment and Waiver, the Subordinated Notes issued by the Company on September 29, 2004 in the aggregate principal amount of $5,288,221 (the September 2004 Notes) and on May 31, 2005 in the aggregate principal amount of $3,244,723 (the May 2005 Notes) were amended as follows: (i) the maturity dates were extended from September 29, 2007 and May 31, 2008, respectively, to January 1, 2009; (ii) the interest rate was fixed at fifteen percent (15%); (iii) all principal amounts are due at the maturity date and shall be paid in shares of Common Stock priced at $0.70 per share if the average closing price of the Common Stock for the thirty (30) trading days immediately preceding the maturity date is greater than $1.10; (iv) interest shall be paid, at the Companys election, in cash or shares of Common Stock, with the Common Stock priced at the average closing price of the Common Stock for the ten (10) trading days immediately preceding the repayment date; and (v) the currently applicable fixed conversion price was amended to $0.70 per share. In addition, the exercise price of all warrants to purchase Common Stock held by the Subordinated Note Holders that currently have an exercise price greater than $1.00 per share was reset to $1.00 per share.
17
Effective as of August 10, 2006, the Company also entered into a Securities Exchange Agreement (the Securities Exchange Agreement) with the Subordinated Note Holders. Under the Securities Exchange Agreement, the Subordinated Notes were exchanged for shares (the Series C Shares) of the Companys Series C Convertible Preferred Stock, which shares are initially convertible into Common Stock at $0.50 per share, having an aggregate value equal to the principal amount outstanding under the Subordinated Notes, plus accrued and unpaid interest thereon, and certain liquidated damages payments owed by the Company to the Subordinated Note Holders.
The Senior Notes contain features that are considered embedded derivative financial instruments: Principals conversion option: The Notes are convertible at the Holders option at any time at the fixed conversion price of $0.50 per share; Monthly Payments Conversion Option: Holders have the option to convert the Notes monthly payment at a $0.50 per share conversion price if the common stock price is higher than 110% of the conversion price ($0.55), as long as the amount converted is not higher than 25% of trading volume for the last 22 trading days. If the Notes monthly payments are not converted, the payments will be paid in cash at 102% of such amount; Interest Rate Adjustment provision: For every 25% increase in common stock value above $0.50 per share, the interest will be reduced by 2%. The interest rate may never be reduced below 0%; Default provision: In the event of default under the terms set forth above, the Senior Lenders will be entitled to specified remedies, including remedies under the Uniform Commercial Code. These features have been bifurcated and recorded on the Companys balance sheet at their fair value.
The accounting treatment of the derivatives and warrants requires that the Company record the derivatives and the warrant at their relative fair value as of the inception date of the agreement, and at fair value as of each subsequent balance sheet date. Any change in fair value will be recorded as non-operating, non-cash income or expense at each reporting date. If the fair value of the derivatives and warrants is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives and warrants is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income.
As of September 30, 2006 and December 31, 2005, respectively, the derivatives were valued at $1,074,666 and $1,011,543. Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 0%; annual volatility of 73% to 118%; and risk free annual interest rate of 2.89% to 4.9% as well as probability analysis related to trading volume restrictions. The remaining derivatives were valued using other binomial models and measuring the impact of the derivative on the expected interest payment amount over the life of the Note. The Warrants issued with the 2004 and 2005 debt financings classified as liabilities were valued at $643,355 and $1,483,511, as of September 30, 2006 and December 31, 2005 respectively, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 82%-88% and risk-free interest rate of 4.6%, and dividend yield of 0%; annual volatility of 98% to 111%% and risk-free interest rate of 4.4%, respectively.
The initial relative fair values of both the derivatives and the warrants were recorded as discounts to the Notes and are being amortized to interest expense over the expected term of the debt, using the effective interest method. At September 30, 2006, the unamortized discount on the Notes was $553,812 and $490,025 for 2004 and 2005 notes, respectively. The effective interest rate on the Notes for the periods ended September 30, 2006 and December 31, 2005 ranged between 15% and 136% based on the frequency of principal payments as well as actual payments made. At December 31, 2005, the unamortized discount on the Notes was $2,134,340 and $3,569,793 for 2004 and 2005 notes, respectively.
The Company entered into a Securities Purchase Agreement (the Securities Purchase Agreement), effective as of January 23, 2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance (collectively, the Purchasers).
18
Under the Securities Purchase Agreement, the Company issued to the Purchasers Convertible Term Notes (the Convertible Notes) in the aggregate principal amount of $1,000,000, bearing interest at 15% per annum. The Convertible Notes converted into shares of the Series B Preferred Stock of the Company on February 23, 2006 (see Note 10), which shares are convertible into shares of the Common Stock of the Company at a fixed conversion price of $0.50 per share.
In connection with the Purchasers purchase of the Notes, the Company also issued warrants to the Purchasers (the Warrants) to purchase up to an aggregate of 500,000 shares of the Companys Common Stock (subject to adjustment as set forth therein) at a per share exercise price of $0.50 per share. The proceeds from this transaction will be used for general working capital purposes.
The Warrants were classified as liabilities and were valued at $122,722 as of September 30, 2006, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 93% and risk-free interest rate of 4.6%.
The Company entered into an Amendment No. 1 to Subordinated Secured Promissory Note, dated as of January 23, 2006 (the Aether Note Amendment), with Aether Systems, Inc. (Aether). Pursuant to the Aether Note Amendment, the Subordinated Secured Promissory Note issued by the Company to Aether on September 30,2004 in the aggregate maximum principal amount of $6,884,588 (the Aether Note), was amended to increase such aggregate maximum principal amount to $7,884,588. The Aether Note evidences a contingent reimbursement obligation of the Company to Aether and a surety fee payable by the Company to Aether, in each case with respect to a letter of credit maintained by Aether for the Companys benefit in connection with the Companys acquisition of the Mobile Government Division of Aether on September 30, 2004. The Companys obligations under the Aether Note remain secured by a security interest granted to Aether in all or substantially all of the Companys assets subordinated to the security interest of Laurus pursuant to the Secured Notes.
Default on 2004 and 2005 Notes
With respect to the convertible notes issued in 2004 and 2005, the Company is required to make interest payments or issue registered shares in lieu of interest payments on a monthly basis.
During the nine-month period ended September 30, 2006, the Company failed to make such payments or issue such registered shares to subordinated debt holders. The failure to make the required monthly payments caused the subordinated debt to default, and in accordance with the provisions set forth in the subordinated convertible note agreements, the interest rate on the subordinated notes was increased by an additional 2.0% per annum.
In connection with the exchange of subordinated debt for Series C Convertible Preferred Stock pursuant to the Securities Exchange Agreement, as described above, the then current interest liability of the note holders was exchanged for Series C Convertible Preferred Stock.
During the nine-month period ended September 30, 2006, the Company made the required payments to the 2004 and 2005 senior debt holder, Laurus. However, due to the non-payment of subordinated interest described above, the Company incurred, in accordance with the cross-default provisions of the senior debt agreements, an additional 2% default interest penalty relating to the senior debt. Total accrued interest expense and default interest as at September 30, 2006 was $664,678 as related to the 2004 and 2005 senior convertible notes.
Total accrued interest for all convertible debt as for September 30, 2006 amounted to $664,878.
19
Accrued liabilities at September 30, 2006 and December 31, 2005 consisted of the following:
|
|
September 30, |
|
December 31, |
|
||
|
|
2006 |
|
2005 |
|
||
|
|
|
|
|
|
||
Contract costs not yet invoiced by vendors |
|
$ |
2,092,615 |
|
$ |
3,654,440 |
|
Compensation |
|
649,475 |
|
614,934 |
|
||
Royalties |
|
473,460 |
|
294,512 |
|
||
Interest |
|
845,932 |
|
684,253 |
|
||
Other |
|
332,390 |
|
272,376 |
|
||
|
|
|
|
|
|
||
Total |
|
$ |
4,393,872 |
|
$ |
5,520,515 |
|
10. REDEEMABLE PREFERRED STOCK
Series B Convertible Preferred Stock
The Company issued 1,000,000 shares of redeemable Series B Convertible Preferred Stock on February 23, 2006, upon the conversion of certain convertible term notes. Each share of Series B preferred stock has an Original Issue Price of $1.00 per share. The holder has the option to redeem the shares of Series B preferred stock at any time for a number of shares of the Companys common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.50 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series B preferred stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series B shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.10. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.10 the Company shall mandatorily redeem all remaining outstanding Series B preferred stock by paying cash equal to $1.00 per share with all accrued and unpaid dividends. The Company may, at its election, redeem any or all of the remaining outstanding Series B shares in cash at a conversion price equal to $1.20 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series B preferred stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly commencing April 1, 2006. In any liquidation of the Company, each share of preferred stock is entitled to a liquidation preference in pari passu with the Series A and Series C Preferred stock before any distribution may be made on the Companys common stock.
During the three months ended September 30, 2006, $52,603 of dividends ($0.053 per share) was declared payable to the holders of Series B Convertible Preferred Stock, of which $28,932 was paid in cash during the period. As of September 30, 2006, 1,000,000 preferred stock shares are authorized, issued and outstanding, at a par value of $0.0001 and a liquidation preference of $1.00 with accumulated dividends in arrears of $37,808, which have been accreted to the principal balance of the Series B preferred stock.
The Preferred Stock contains features that are considered embedded derivative financial instruments: Preferred Stocks conversion option: The Preferred Stock is convertible at the Holders option at any time at the fixed conversion price of $0.50 per share; Quarterly Dividends Conversion Option: Holders have the option to convert the Stocks quarterly dividend payment at a conversion price of the average 10 days
20
closing price prior to the dividend payment date. These features have been bifurcated and recorded on the Companys balance sheet at their fair value.
As of September 30, 2006 the derivatives were valued at $200,466. Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 39%; and risk free annual interest rate of 4.69% as well as probability analysis related to trading volume restrictions.
An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock. The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock. At September 30, 2006, the unamortized discount on the Preferred Stock was $284,579.
Series C Convertible Preferred Stock
The Company issued 592,032 shares of redeemable Series C Convertible Preferred Stock on August 10, 2006, upon the exchange of certain convertible term notes. Each share of Series C preferred stock has an Original Issue Price of $10.00 per share. The holder has the option to redeem the shares of Series C preferred stock at any time for a number of shares of the Companys common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.50 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series C preferred stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series C shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.20. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.20 the Company shall mandatorily redeem all remaining outstanding Series C preferred stock by paying cash equal to $10.00 per share with all accrued and unpaid dividends. The Company may, at its election, redeem any or all of the remaining outstanding Series C shares in cash at a conversion price equal to $12.00 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series C preferred stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly commencing September 1, 2006. In any liquidation of the Company, each share of preferred stock is entitled to a liquidation preference in pari passu with the Series A and Series B Preferred stock before any distribution may be made on the Companys common stock.
During the three months ended September 30, 2006, $51,093 of dividends ($0.086 per share) was declared payable to the holders of Series C Convertible Preferred Stock, of which $30,371 was paid in cash during the period. As of September 30, 2006, 600,000 preferred stock shares are authorized, issued and outstanding, at a par value of $0.0001 and a liquidation preference of $10.00 with accumulated dividends in arrears of $72,990, which have been accreted to the principal balance of the Series C preferred stock.
The Preferred Stock contains features that are considered embedded derivative financial instruments: Preferred Stocks conversion option: The Preferred Stock is convertible at the Holders option at any time at the fixed conversion price of $0.50 per share; Quarterly Dividends Conversion Option: Holders have the option to convert the Stocks quarterly dividend payment at a conversion price of the average 10 days closing price prior to the dividend payment date. These features have been bifurcated and recorded on the Companys balance sheet at their fair value.
As of September 30, 2006 the derivatives were valued at $1,186,772. Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 39%; and risk free annual interest rate of 4.69% as well as probability analysis related to trading volume restrictions.
An amount of $1,073,537 equal to the original value of the derivatives was recorded as discount to the
21
Preferred Stock. The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock. At September 30, 2006, the unamortized discount on the Preferred Stock was $1,011,250.
Together with the above transaction, the terms of certain warrants held by the Companys investment bankers and their associates were modified. The incremental value of the modification was calculated to be $110,453, and was allocated against the proceeds of the Series C Convertible Preferred Stock as a cost of financing, and will be accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock. At September 30, 2006, the net amount remaining to be accreted was $104,056.
During the three months ended September 30, 2006, investors converted accrued interest on convertible term notes of $27,806 into 55,950 shares of the Companys common stock.
Pursuant to the Amendment and Waiver with Laurus mentioned above in Note 8, the Company converted principal payments owing on the 2004 and 2005 Senior Notes for August and September 2006 to 1,016,141 shares of the Companys common stock.
Pursuant to the Securities Purchase Agreement with Trellus mentioned above in Note 2, the Company issued and sold 3,000,000 shares of its Common Stock to Trellus, at a purchase price of $0.50 per share, for an aggregate purchase price of $1,500,000.
Pursuant to the Securities Purchase Agreement with Shaar mentioned above in Note 2, the Company issued and sold 1,000,000 shares of its Common Stock to Shaar, at a purchase price of $0.50 per share, for an aggregate purchase price of $500,000, which was paid by exchanging Shaars rights in an aggregate amount of $500,000 in accrued and unpaid dividends on the shares of Series A Convertible Preferred Stock then held by Shaar. In addition, Shaar converted $67,201 of unpaid dividends owing on the shares of its Series A Convertible Preferred Stock into 134,402 shares of the Companys common stock during the period.
During the three months ended September 30, 2006, $606,968 of dividends ($17.070 per share) was declared payable to the holders of Series A Convertible Preferred Stock. $500,000 of the amount payable to Shaar was used to pay the purchase price of the 1,000,000 shares of Common Stock, as mentioned above, and $67,201 was converted into shares of the Companys common stock, also as mentioned above.
As of September 30, 2006, cumulative dividends in arrears related to the Series A preferred stock were approximately $14,320, which have been accreted to the principal balance of the Series A preferred stock.
22
The following table summarizes the warrant activity for the nine month period ending September 30, 2006:
Balance, December 31, 2005 |
|
13,188,280 |
|
|
|
|
|
Granted |
|
500,000 |
|
Exchanged |
|
|
|
Exercised |
|
|
|
Expired or cancelled |
|
(25,000 |
) |
|
|
|
|
Balance, March 31, 2006 |
|
13,663,280 |
|
|
|
|
|
Granted |
|
11,123 |
|
Exchanged |
|
|
|
Exercised |
|
(26,250 |
) |
Expired or cancelled |
|
|
|
|
|
|
|
Balance, June 30, 2006 |
|
13,648,153 |
|
|
|
|
|
Granted |
|
533,333 |
|
Exchanged |
|
|
|
Exercised |
|
|
|
Expired or cancelled |
|
|
|
|
|
|
|
Balance, September 30, 2006 |
|
14,181,486 |
|
In the fourth quarter of fiscal year 2005, the Companys consolidated operations were divided into three segments: Law, Fire and Biometric. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods have been estimated.
The Company evaluates performance and allocates resources based on revenues and operating loss. Operating loss for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues. The segmentation of operating loss as noted above and detailed below reflects how management evaluates its business. Assets for the Company are commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.
Geographically, North American sales accounted for approximately 100% of the Companys total sales for three and nine month periods ending September 30, 2006 and 2005.
23
Summarized financial information concerning our reportable segments is shown in the following table:
|
|
Three Months Ended |
|
Nine Months Ended |
|
||||||||
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Revenue: |
|
|
|
|
|
|
|
|
|
||||
Law |
|
$ |
2,864,104 |
|
$ |
2,357,086 |
|
$ |
7,764,316 |
|
$ |
8,261,127 |
|
Fire |
|
1,232,667 |
|
804,202 |
|
2,736,459 |
|
2,315,553 |
|
||||
Biometrics |
|
103,327 |
|
71,183 |
|
681,284 |
|
280,934 |
|
||||
Consolidated Revenue |
|
$ |
4,200,098 |
|
$ |
3,232,471 |
|
$ |
11,182,059 |
|
$ |
10,857,614 |
|
Segment operating profit/(loss) |
|
|
|
|
|
|
|
|
|
||||
Law |
|
308,709 |
|
(944,211 |
) |
(353,101 |
) |
(2,874,821 |
) |
||||
Fire |
|
(99,655 |
) |
(325,474 |
) |
(1,277,850 |
) |
(1,320,430 |
) |
||||
Biometrics |
|
(890,257 |
) |
(764,040 |
) |
(2,237,302 |
) |
(2,333,900 |
) |
||||
Total Segment Operating Loss |
|
(681,203 |
) |
(2,033,725 |
) |
(3,868,253 |
) |
(6,529,151 |
) |
||||
Reconciliation to net loss |
|
|
|
|
|
|
|
|
|
||||
Interest expense |
|
(586,689 |
) |
(1,605,771 |
) |
(4,915,445 |
) |
(2,992,780 |
) |
||||
Interest income |
|
|
|
6,908 |
|
|
|
35,958 |
|
||||
Loss on extinguishment of debt |
|
(5,493,701 |
) |
|
|
(7,815,717 |
) |
|
|
||||
Derivative and warrant fair value adjustments |
|
547,752 |
|
3,210,057 |
|
5,548,604 |
|
8,160,305 |
|
||||
Other expense |
|
(18,891 |
) |
(24,816 |
) |
(51,185 |
) |
(45,348 |
) |
||||
Net loss |
|
$ |
(6,232,732 |
) |
$ |
(447,347 |
) |
$ |
(11,101,996 |
) |
$ |
(1,371,016 |
) |
To address certain liquidity issues, on January 23, 2006, the Company issued convertible debt, common stock and warrants in consideration for certain modifications of its outstanding 2004 and 2005 Notes, as explained in Note 8.
In addition, the Company also entered into a Securities Purchase Agreement (the Securities Purchase Agreement), effective as of January 23, 2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance (collectively, the Purchasers), also as explained in Note 8.
In accordance with the Emerging Issues Task Force of the FASB No. 96-19, Debtors Accounting for Modification or Exchange of Debt Terms (EITF 96-19), the Company recorded a non-operating loss on extinguishment of debt of $2,322,016. The loss mainly relates to the accounting for the effect of the modification of certain embedded derivatives, extinguishment of previously recorded deferred financing fees and changes in the present value of debt. In accordance with EITF 96-19, the New Notes are recorded in the Companys balance sheet at fair value at the date of the modification.
Furthermore, on August 10, 2006, the Company exchanged convertible debt for preferred stock, and issued common stock and warrants in consideration for certain modifications of its outstanding 2004 and 2005 Notes, as explained in Note 8.
In accordance with the Emerging Issues Task Force of the FASB No. 96-19, Debtors Accounting for Modification or Exchange of Debt Terms (EITF 96-19), the Company recorded a non-operating loss on extinguishment of debt of $5,493,701. The loss mainly relates to the accounting for the effect of the modification of certain embedded derivatives, and changes in the present value of debt. In accordance with EITF 96-19, the New Notes are recorded in the Companys balance sheet at fair value at the date of the modification.
24
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS
The information contained in this Report on Form 10-QSB and in other public statements by the Company and Company officers include or may contain certain forward-looking statements. All statements other than statements of historical facts contained in this Report on Form 10-QSB, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words anticipate, believe, estimate, will, may, future, plan, intend and expect and similar expressions generally identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure that they will be achieved. Actual results may differ materially from the forward-looking statements contained herein due to a number of factors. Many of these factors are set forth in the Companys Annual Report on Form 10-KSB under the caption Risk Factors and other filings with the Securities and Exchange Commission. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies may be significant, presently or in the future. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.
The following should be read in conjunction with the financial statements of the Company included elsewhere herein.
We develop and market proprietary fingerprint identification biometric technology and software solutions. We also deliver advanced identification solutions and information services to law enforcement departments, public safety agencies and other government and private sector customers. Our mobile wireless technology provides first responders with critical, reliable, real-time data and images from local, state and national databases.
We pioneered the development of automated, finger identification technology that can be used without the aid of non-automated methods of identification such as a personal identification, password, token, smart card, ID card, credit card, passport, drivers license or other form of possession or knowledge based identification. This advanced BIO-key identification technology improves both the accuracy and speed of finger-based biometrics and is the only finger identification algorithm that has been certified by the International Computer Security Association (ICSA).
Since our inception in 1993, we have spent substantial time and effort in completing the development of what we believe is the most discriminating and effective finger biometric technology available. During the past two years, our focus has shifted to marketing and selling this technology and completing strategic acquisitions that can help us leverage our capability to deliver identification solutions. We have built a direct sale force of professionals with substantial experience in selling technology solutions to government and corporate customers.
For detailed information on our critical accounting policies and estimates, see our financial statements and notes thereto included in this Report and in our Annual Report on Form 10-KSB, as amended, for the fiscal year ended December 31, 2005. There have been no material changes to our critical accounting policies and estimates from those disclosed in our amended 10-KSB filed on June 19, 2006.
25
With the adoption of SFAS 123R at the beginning of the Companys first fiscal quarter of 2006, we added Stock-Based Compensation as a critical accounting policy.
As of January 1, 2006, the Company adopted SFAS 123R using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Accordingly, financial statement amounts for the prior periods presented in this Form 10-QSB have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS 123, as amended by SFAS 148, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the expected option term), the estimated volatility of our common stock price over the options expected term, the risk-free interest rate over the options expected term, and the Companys expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. The compensation expense recognized in connection with the adoption of SFAS 123R increased the Companys net loss by $239,136 with no effect per share for the three months ended September 30, 2006 and increased the Companys net loss for the nine months ended September 30, 2006 by $529,055, with a $0.01 effect per share. There was no impact on cash flows from operations, investment, or financing in connections with the adoptions of SFAS 123R. As the Company uses the full valuation allowance with respect to deferred taxes, the adoption of SFAS 123R had no impact on deferred taxes.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS No. 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plans overfunded status and/or a liability for a plans underfunded status; (b) measure a plans assets and its obligations that determine its funded status as of the end of the employers fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. The implementation of SFAS 158 is not expected to have a material impact on the Companys financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which is effective for calendar year companies on January 1, 2008. The Statement defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. The Statement codifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market
26
participants at the measurement date. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company is currently assessing the potential impacts of implementing this standard.
In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), Financial Statements Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, Financial Statements Materiality, (SAB 99) should be applied to determine whether the misstatement is material. The implementation of SAB 108 is not expected to have a material impact on the Companys financial statements.
In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income TaxesAn Interpretation of FASB Statement No. 109, which 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. FIN 48 will be effective for the Companys first interim period beginning January 1 2007. The implementation of FIN 44 is not expected to have a material impact on the Companys financial statements.
27
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006
AS COMPARED TO SEPTEMBER 30, 2005
In the fourth quarter of 2005, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety. Each segment is headed by a General Manager and organized to quickly respond to market needs as well as to drive down costs to achieve profitability. Management believes that this initiative will lead to increased opportunities throughout 2006 as the General Managers continue to develop their business units. During the quarter ended September 30, 2006 the Company continued to stay focused on its objectives of increasing revenue and managing expenses.
Consolidated Results of Operations - Percent Trend
|
|
Three Months Ended September 30, |
|
||
|
|
2006 |
|
2005 |
|
Revenues |
|
|
|
|
|
Services |
|
77 |
% |
77 |
% |
License fees and other |
|
23 |
% |
23 |
% |
|
|
100 |
% |
100 |
% |
Costs and other expenses |
|
|
|
|
|
Services |
|
15 |
% |
16 |
% |
Cost of license fees and other |
|
4 |
% |
4 |
% |
Selling, general and administrative |
|
59 |
% |
88 |
% |
Research, development and engineering |
|
39 |
% |
55 |
% |
|
|
117 |
% |
163 |
% |
Operating loss |
|
-17 |
% |
-63 |
% |
|
|
|
|
|
|
Other income (deductions) |
|
|
|
|
|
Total other income (deductions) |
|
-131 |
% |
49 |
% |
NET LOSS |
|
-148 |
% |
-14 |
% |
The Law Enforcement and Fire Safety segments were purchased during 2004. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods has been estimated.
28
The Company evaluates performance and allocates resources based on revenues and operating income (loss). Operating income (loss) for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues and other factors. The segmentation of operating income as noted above and detailed below reflects how management now evaluates its business. Assets for the Company are commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.
|
|
Three months ended |
|
|
|
|
|
|||||
|
|
September 30, |
|
|
|
|
|
|||||
|
|
2006 |
|
2005 |
|
$ Change |
|
% Change |
|
|||
|
|
|
|
|
|
|
|
|
|
|||
Revenues |
|
|
|
|
|
|
|
|
|
|||
Law Enforcement |
|
|
|
|
|
|
|
|
|
|||
Service |
|
$ |
2,352,940 |
|
$ |
1,730,843 |
|
$ |
622,097 |
|
36 |
% |
License & other |
|
511,164 |
|
626,243 |
|
(115,079 |
) |
-18 |
% |
|||
|
|
2,864,104 |
|
2,357,086 |
|
507,018 |
|
22 |
% |
|||
Fire Safety |
|
|
|
|
|
|
|
|
|
|||
Service |
|
849,369 |
|
727,288 |
|
122,081 |
|
17 |
% |
|||
License & other |
|
383,298 |
|
76,914 |
|
306,384 |
|
398 |
% |
|||
|
|
1,232,667 |
|
804,202 |
|
428,465 |
|
53 |
% |
|||
Biometrics |
|
|
|
|
|
|
|
|
|
|||
Service |
|
23,874 |
|
38,752 |
|
(14,878 |
) |
-38 |
% |
|||
License & other |
|
79,453 |
|
32,431 |
|
47,022 |
|
145 |
% |
|||
|
|
103,327 |
|
71,183 |
|
32,144 |
|
45 |
% |
|||
|
|
|
|
|
|
|
|
|
|
|||
Total Revenue |
|
$ |
4,200,098 |
|
$ |
3,232,471 |
|
$ |
967,627 |
|
30 |
% |
|
|
|
|
|
|
|
|
|
|
|||
Cost of goods sold |
|
|
|
|
|
|
|
|
|
|||
Law Enforcement |
|
|
|
|
|
|
|
|
|
|||
Service |
|
$ |
349,940 |
|
$ |
373,890 |
|
$ |
(23,950 |
) |
-6 |
% |
License & other |
|
100,521 |
|
101,350 |
|
(829 |
) |
-1 |
% |
|||
|
|
450,461 |
|
475,240 |
|
(24,779 |
) |
-5 |
% |
|||
Fire Safety |
|
|
|
|
|
|
|
|
|
|||
Service |
|
240,841 |
|
121,330 |
|
119,511 |
|
99 |
% |
|||
License & other |
|
7,419 |
|
18,665 |
|
(11,246 |
) |
-60 |
% |
|||
|
|
248,260 |
|
139,995 |
|
108,265 |
|
77 |
% |
|||
Biometrics |
|
|
|
|
|
|
|
|
|
|||
Service |
|
21,660 |
|
8,623 |
|
13,037 |
|
151 |
% |
|||
License & other |
|
40,335 |
|
5,618 |
|
34,717 |
|
618 |
% |
|||
|
|
61,995 |
|
14,241 |
|
47,754 |
|
335 |
% |
|||
|
|
|
|
|
|
|
|
|
|
|||
Total COGS |
|
$ |
760,716 |
|
$ |
629,476 |
|
$ |
131,240 |
|
21 |
% |
Revenues
Law Enforcement
Service revenue for the segment for the three month period ended September 30, 2006 included $773,430 from a long-term project that the Company had participated in as a subcontractor. The amount resulted from a cash payment of $570,546 along with $202,884 of revenue that was previously deferred until evidence of full acceptance by the end user was received by the Company. That increase was offset by a reduction in revenue from other longer-term project work that was present in 2005, as the Company moves to more of a license-based model.
29
Fire Safety
For the three months ended September 30, 2006, total revenue for the Fire Safety segment increased by 53%, over the same three months in 2005. The current year license revenue included $246,960 in license sales as part of a substantial county-wide implementation for one of our new customers. Both license and service revenue for the segment have shown steady growth quarter over quarter in 2006, and management expects to see continued growth in the Fire Safety segment.
Biometrics
For the three months ended September 30, 2006, the Biometric segment had revenues representing a 45% increase over the same period in 2005. However, sales in this segment continue to be choppy and less predictable as the market for the Biometrics products continues to develop at an inconsistent pace.
Costs of goods sold
Law Enforcement
License and other costs are attributable primarily to revenues derived from product sales, for which we are required to pay a royalty, and is primarily driven by the sales mix.
Due to the change in focus from long-term projects to licensing-based agreements, cost of goods sold in total for the segment decreased when compared to the same period in 2005 as labor costs, for both employees and consultants were eliminated as projects were completed.
Fire Safety
License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. These costs are solely dependent specifically on what products were sold.
Overall costs of goods sold for the Fire segment were higher in 2006 due to increased proportional sales volume in the period, which lead to a higher allocation of corporate expenses. Cost of goods sold are predominately employee salaries and associated expenses.
Biometrics
License and other costs are primarily related to the hardware costs related to sales of biometric fingerprint readers. The change in cost of goods sold is directly attributable to the product mix between types of readers sold and the volume of readers sold, as well as the addition of dedicated personnel for this segment.
Selling, general and administrative
|
|
Three months ended |
|
|
|
|
|
|||||
|
|
2006 |
|
2005 |
|
$ Change |
|
% Change |
|
|||
|
|
|
|
|
|
|
|
|
|
|||
Law Enforcement |
|
$ |
1,196,641 |
|
$ |
1,792,514 |
|
$ |
(595,873 |
) |
-33 |
% |
Fire Safety |
|
740,504 |
|
672,289 |
|
68,215 |
|
10 |
% |
|||
Biometrics |
|
530,202 |
|
372,072 |
|
158,130 |
|
42 |
% |
|||
|
|
|
|
|
|
|
|
|
|
|||
Total |
|
$ |
2,467,347 |
|
$ |
2,836,875 |
|
$ |
(369,528 |
) |
-13 |
% |
30
As discussed previously, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety in the fourth quarter of 2005. For 2005, SG&A costs were allocated to the segments based on several factors including managements estimates and percentage of revenue. For 2006, sales expenses are a direct cost to the segment and G&A costs are allocated between business segments on fixed percentages that were established by management during the budgeting process.
The overall decline in total SG&A costs for the quarter ended September 30, 2006 as compared to 2005 are primarily attributable to the continued focus by management on cost reduction initiatives taken during the fourth quarter of 2005 after the acquisitions of Public Safety Group and Aether Mobile Government were completed. Management believes the appropriate resources are in place to support its strategic goals but also continues to analyze the expense structure and continues to explore ways to further reduce costs, through synergies and increased system efficiencies. During the quarter ended September 30, 2006, these reductions have been partially offset by additional costs related to reporting and compliance that the Company has experienced due to the amendments of our previously filed registration statements.
Research, development and engineering
|
|
Three months ended |
|
|
|
|
|
||
|
|
September 30, |
|
|
|
|
|
||
|
|
2006 |
|
2005 |
|
$ Change |
|
% Change |
|
|
|
|
|
|
|
|
|
|
|
Law Enforcement |
|
$908,294 |
|
$1,033,543 |
|
$(125,249 |
) |
-12 |
% |
Fire Safety |
|
343,558 |
|
317,393 |
|
26,165 |
|
8 |
% |
Biometrics |
|
401,386 |
|
448,909 |
|