UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2007
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-25675
PATRON SYSTEMS, INC.
(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-3055158
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
5775 FLATIRON PARKWAY, SUITE 230 80301
BOULDER, CO
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(303) 541-1005
(ISSUER'S TELEPHONE NUMBER)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act.). Yes |_| No |X|
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 14,512,260 shares of common stock
outstanding as of May 21, 2007.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
ITEM 1. FINANCIAL STATEMENTS ..................................................4
Condensed Consolidated Balance Sheet at March 31, 2006 (Unaudited).............4
Condensed Consolidated Statements of Operations for the Three Months
Ended March 31, 2006 and 2005 (Unaudited).............................5
Condensed Consolidated Statement of Stockholders' Equity for the
Three Months Ended March 31, 2006 (Unaudited).........................6
Condensed Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2006 and 2005 (Unaudited).............................7
Notes to Condensed Consolidated Financial Statements (Unaudited)...............8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS..................................27
ITEM 3. CONTROLS AND PROCEDURES...............................................39
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.....................................................40
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS...........41
ITEM 6. EXHIBITS..............................................................41
SIGNATURES....................................................................43
2
FORWARD LOOKING STATEMENTS
The following discussion and explanations should be read in conjunction with the
financial statements and related notes contained elsewhere in this Form 10-QSB.
Certain statements made in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements can be identified by terminology such as "may,"
"will," "should," "expects," "intends," "anticipates," "believes," "estimates,"
"predicts," or "continue" or the negative of these terms or other comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these forward-looking statements. Although
Patron Systems believes that expectations reflected in the forward-looking
statements are reasonable, it cannot guarantee future results, performance or
achievements. Moreover, neither Patron Systems nor any other person assumes
responsibility for the accuracy and completeness of these forward-looking
statements. Patron Systems is under no duty to update any forward-looking
statements after the date of this report to conform such statements to actual
results.
3
PART I - FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
PATRON SYSTEMS, INC.
CONDENSED BALANCE SHEET
(unaudited)
MARCH 31,
2007
-------------
ASSETS
Current Assets
Cash ...................................................... $ 120,004
Accounts receivable ....................................... 690,856
Other current assets ...................................... 102,803
-------------
Total current assets ................................... 913,663
Property and equipment, net ................................. 223,867
Capitalized software development costs, net ................. 444,071
Intangible assets, net ...................................... 112,603
Assets held for sale ........................................ 174,376
Goodwill .................................................... 9,300,000
-------------
Total assets ........................................... $ 11,168,580
=============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable .......................................... $ 502,261
Other current liabilities ................................. 1,918,805
Secured demand notes ...................................... 625,000
Demand notes payable ...................................... 312,557
Notes payable (to creditors of acquired business,
including $554,202 to related parties) .................. 799,982
Deferred revenue .......................................... 254,564
Bridge notes payable ...................................... 519,975
Derivative conversion liability ........................... 285,874
Liabilities of discontinued operations .................... 81,206
-------------
Total current liabilities .............................. 5,300,224
-------------
Commitments and Contingencies
Stockholders' Equity
Preferred stock, par value $0.01 per share,
75,000,000 shares authorized,
Series A convertible: 2,160 shares authorized;
964 shares issued and outstanding ................. 10
liquidation preference of $6,512,959
Series A-1 convertible: 50,000,000 authorized;
0 issued and outstanding ......................... --
liquidation preference of $0
Series B convertible: 2,000 shares authorized;
791 shares issued and outstanding;
liquidation preference of $5,159,535 .............. 8
Common stock, par value $0.01 per share, 150,000,000
shares authorized, 14,512,260 shares issued and
outstanding ............................................ 145,127
Additional paid-in capital ................................ 104,337,679
Accumulated deficit ....................................... (98,614,468)
-------------
Total stockholders' equity ............................. 5,868,356
-------------
Total liabilities and stockholders' equity ............. $ 11,168,580
=============
See notes to unaudited condensed financial statements.
4
PATRON SYSTEMS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(unaudited)
THREE MONTHS ENDED
MARCH 31,
----------------------------
2007 2006
------------ ------------
Revenue ..................................................... $ 171,218 $ 179,925
------------ ------------
Cost of Sales
Cost of products/services ................................. 37,620 29,897
Amortization of technology ................................ 27,015 27,522
------------ ------------
Total cost of sales ..................................... 64,635 57,419
------------ ------------
Gross profit .............................................. 106,583 122,506
------------ ------------
Operating Expenses
Salaries and related expenses ............................. 1,331,139 679,829
Professional fees ......................................... 204,958 658,115
General and administrative ................................ 237,934 320,576
Stock based penalties under financing arrangements ........ -- 2,852
Gain on settlements ....................................... -- (906,987)
------------ ------------
Total operating expenses ............................... 1,774,031 754,385
------------ ------------
Loss from operations ........................................ (1,667,448) (631,879)
------------ ------------
Other Income (Expense)
Interest income ............................................. 2,120 --
Interest expense ............................................ (505,925) (972,464)
Change in fair value of conversion option ................... 8,712 --
Gain on sale of property and equpment ....................... (42) 62
------------ ------------
Total Other Expense ......................................... (495,135) (972,402)
------------ ------------
Loss from continuing operations ........................ (2,162,583) (1,604,281)
------------ ------------
Income (loss) from discontinued operations .................. 4,541 (387,543)
------------ ------------
Net loss .................................................... (2,158,042) (1,991,824)
Preferred stock contractual dividend ........................ (216,325) --
------------ ------------
Net loss available to common stockholders ................... $ (2,374,367) $ (1,991,824)
------------ ------------
Net Loss Per Share - Basic and Diluted
- Continuing operations ................................... $ (0.16) $ (0.77)
- Discontinued operations ................................. -- (0.19)
------------ ------------
- Total net loss per share available to common stockholders $ (0.16) $ (0.96)
============ ============
Weighted Average Number of Common Shares Outstanding
- Basic and Diluted ...................................... 14,512,260 2,083,954
============ ============
See notes to unaudited condensed financial statements.
5
PATRON SYSTEMS, INC.
CONDENSED STATEMENT OF STOCKHOLDERS' EQUITY
(UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 2007
SHARES OF PAR VALUE SHARES OF PAR VALUE
SERIES A SERIES A SHARES OF PAR VALUE SERIES B SERIES B
CONVERTIBLE CONVERTIBLE SERIES A-1 SERIES A-1 CONVERTIBLE CONVERTIBLE
PREFERRED PREFERRED PREFERRED PREFERRED PREFERRED PREFERRED
STOCK STOCK STOCK STOCK STOCK STOCK
------------ ------------ ------------ ------------ ------------ ------------
Balance - January 1, 2007 .. 964 $ 10 -- $ -- 791 $ 8
Stock based compensation -
employees ............... -- -- -- -- -- --
Issuance of warrants to 2007
Bridge Note Investors ... -- -- -- -- -- --
Net Loss ................... -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE - MARCH 31, 2007 ... 964 $ 10 -- $ -- 791 $ 8
============ ============ ============ ============ ============ ============
SHARES OF PAR VALUE ADDITIONAL
COMMON COMMON PAID IN ACCUMULATED
STOCK STOCK CAPITAL DEFICIT TOTAL
------------ ------------ ------------ ------------ ------------
Balance - January 1, 2007 .. 14,512,260 $ 145,127 $103,743,111 $(96,456,426) $ 7,431,830)
Stock based compensation -
employees ............... -- -- 430,809 -- 430,809
Issuance of warrants to 2007
Bridge Note Investors ... -- -- 163,759 -- 163,759
Net Loss ................... -- -- -- (2,158,042) (2,158,042)
------------ ------------ ------------ ------------ ------------
BALANCE - MARCH 31, 2007 ... 14,512,260 $ 145,127 $104,337,679 $(98,614,468) $ 5,868,356
============ ============ ============ ============ ============
See notes to unaudited condensed financial statements.
6
PATRON SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(unaudited)
THREE MONTHS ENDED
MARCH 31,
----------------------------
2007 2006
------------ ------------
Cash Flows from Continuing Operating Activities
Net loss .................................................................. $ (2,162,583) $ (1,604,281)
============ ============
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization ........................................... 51,026 34,775
Stock based compensation ................................................ 430,809 180,835
Non cash interest expense ............................................... 458,345 543,438
Gain on derivative conversion valuation ................................. (8,712) --
Stock based penalty under financing arrangements ........................ -- 2,852
Loss on issuance of preferred stock in settlement of debt ............... -- (906,987)
(Gain)/Loss on sale of fixed assets ..................................... 42 (62)
Changes in assets and liabilities:
Restricted cash escrowed to settle liabilities assumed ................ -- (957,122)
Accounts receivable ................................................... 138,019 123,085
Other current assets .................................................. 31,038 17,809
Accounts payable ...................................................... (32,866) (268,700)
Accrued interest ...................................................... 40,949 429,027
Deferred revenue ...................................................... 90,269 (104,031)
Expense reimbursements due to officers and shareholders ............... (1,000) (7,354)
Accrued payroll and payroll related expenses .......................... 77,573 (311,041)
Other current liabilities ............................................. (57,595) (197,271)
============ ============
Total adjustments ......................................................... 1,217,897 (1,420,747)
============ ============
NET CASH USED IN CONTINUING OPERATING ACTIVITIES .......................... (944,686) (3,025,028)
============ ============
CASH FLOWS USED IN CONTINUING INVESTING ACTIVITIES
Purchase and development of technology .................................. (41,839) (29,660)
Proceeds from sale of fixed assets ...................................... -- 1,755
Purchase of fixed assets ................................................ (73,130) (12,689)
------------ ------------
NET CASH USED IN CONTINUING INVESTING ACTIVITIES .......................... (114,969) (40,594)
============ ============
CASH FLOWS FROM CONTINUING FINANCING ACTIVITIES
Payments on settlement of accommodation agreements ...................... -- (125,000)
Deferred financing costs ................................................ -- (54,000)
Net proceeds from issuance of Preferred Series A convertible stock ...... -- 4,000,451
Proceeds from issuance of bridge notes .................................. 625,000 --
------------ ------------
NET CASH PROVIDED BY CONTINUING FINANCING ACTIVITIES ...................... 625,000 3,821,451
============ ============
CASH FLOWS FROM DISCONTINUED OPERATIONS
Operating cash flows .................................................... 13,089 (429,779)
Investing cash flows .................................................... -- (184,634)
------------ ------------
NET CASH PROVIDED BY (USED IN) DISCONTINUED OPERATIONS .................... 13,089 (614,413)
------------ ------------
NET (DECREASE) INCREASE IN CASH ........................................... $ (421,566) $ 141,416
CASH, beginning of period ................................................. $ 541,570 $ 14
------------ ------------
CASH, end of period ....................................................... $ 120,004 $ 141,430
============ ============
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Interest ................................................................ $ 6,631 --
Non-cash Investing and Financing Activities
Liabilities and claims settled in exchange for Series A-1 Preferred
Convertible Stock .................................................... -- $ 21,258,875
See notes to unaudited condensed financial statements.
7
PATRON SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 2007
NOTE 1 - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited Condensed Financial Statements of Patron Systems,
Inc. (the "Company," "Patron," "we," "us," or "our") have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and the instructions to Form 10-QSB.
Accordingly, they do not include all the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. In the opinion of management, all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position, results of operations and cash flows for all periods
presented have been made. The results of operations for the three-month period
ended March 31, 2007 is not necessarily indicative of the operating results that
may be expected for the entire year ending December 31, 2007.
Amounts reflected herein for the three months ended March 31, 2006 represent the
restated financial information included in the Form 10-QSB/A which was filed
with the SEC on May 21, 2007.
This form 10-QSB should be read in conjunction with the Company's 10-KSB for the
year ended December 31, 2006.
NOTE 2 - THE COMPANY
ORGANIZATION AND DESCRIPTION OF BUSINESS
Patron Systems, Inc. ("Systems") is a Delaware corporation formed in April 2002
to provide comprehensive, end-to-end information security solutions to global
corporations and government institutions. The Company was recapitalized upon its
completion of a share exchange transaction with an inactive public company on
October 11, 2002.
On July 31, 2006, the Company effectuated a 1-for-30 reverse stock split of its
common stock following the effectiveness of the amendment to its Second Amended
and Restated Certificate of Incorporation which was approved by stockholders at
the 2006 Annual Meeting of Stockholders on July 20, 2006. The accompanying
financial statements give retroactive effect to the reverse split for all
periods presented.
NOTE 3 - RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
The Company, while undergoing the audit of its financial statements for the year
ended December 31, 2006, became aware of possible misstatements in its unaudited
condensed consolidated interim financial statements filed with the Securities
and Exchange Commission during the year ended December 31, 2006. On March 6,
2007, the Company's Board of Directors determined that certain amounts reported
in its unaudited condensed consolidated interim financial statements for the
quarters ended March 31, 2006, and June 30, 2006, and for the six months ended
June 30, 2006 and nine months ended September 30, 2006 needed to be restated as
described below.
The specific errors that came to management's attention relate to the Company's
accounting for certain transactions that occurred during the quarter ended March
31, 2006 and the quarter ended June 30, 2006. Upon review of these transactions,
Company management discovered that the accounting for these transactions
resulted in a $2,408,250 overstatement of its loss for the quarterly period
ended March 31, 2006 and a $593,765 overstatement of its loss for the quarterly
period ended June 30, 2006, which also resulted in an overstatement of the year
to date losses in the six and nine month periods ended June 30, 2006 and
September 30, 2006, respectively.
Specifically, the Company recorded for the three months ended March 31, 2006,
(1) a net loss of $858,213 on the settlement of various liabilities under its
creditor and claimant liabilities restructuring program when it should have
recorded a net gain of approximately $906,987, (2) recorded excess non-cash
interest of $358,000 with respect to a
8
conversion option that became effective under two of its Interim Bridge
Financing III notes and (3) charged, as interest expense, a $285,050 fee paid to
the placement agent in its Series A Preferred stock financing transaction that
should have been recorded as a reduction of the offering proceeds. The nature of
the adjustments required in the creditor and claimant liabilities restructuring
relate to an overvaluation of the Series A-1 preferred shares issued in the
exchange offer offset by gains on the extinguishment of liabilities that
originated in connection with obligations to issue or repurchase stock.
On May 18, 2007, the Board of Directors of the Company determined that certain
amounts reported in its audited financial statements for the year ended December
31, 2006 need to be restated as described below.
The Company, while undergoing a review of its financial statements for the three
month period ended March 31, 2007, became aware of a possible error in its
accounting for a deemed dividend it recorded during the fourth quarter of its
year ended December 31, 2006. Upon review of this transaction Company management
specifically determined that there was an error in the accounting for a deemed
dividend that was recognized upon a reduction in the conversion price of the
Company's Series A Preferred Stock that occurred on November 16, 2006. The
reduction in the conversion price occurred upon the Company's issuance of
additional convertible securities featuring a conversion price lower than the
conversion price embedded in the Series A Preferred. The Company, in calculating
the deemed dividend, originally determined that the net loss available to its
common stockholders should be increased by $589,175, The Company reevaluated its
computations during the quarter ended March 31, 2007 and determined that the net
loss available to its common stockholders should have been increased by
$3,759,059. The nature of the adjustment relates to the Company's use of an
incorrect price for the value of its common stock when it computed the intrinsic
value of the conversion feature embedded in the Series A Preferred stock at the
time of the reduction in the conversion price.
The effect of the restatement on the Company's previously issued audited
financial statements is as follows:
As Previously As
Reported Reported
------------- -------------
Additional paid in capital ................... $ 100,573,227 $ 103,743,111
Accumulated deficit .......................... (93,286,542) (96,456,426)
Preferred stock deemed divident .............. (2,413,606) (5,583,490)
Net loss available to common stockholders .... $ (9,344,431) $ (12,514,315)
Net Loss Per Share - Basic and Diluted
- Continuing operations .................... $ (0.98) $ (1.41)
- Discontinued operations .................. (0.29) (0.29)
------------- -------------
- Total Net Loss per share available to
common stockholders ...................... $ (1.27) $ (1.70)
============= =============
The effect on our financial statements for the year ended December 31, 2006 was
to increase additional paid in capital, accumulated deficit and net loss
available to common stockholders by $3,169,884, net loss per share for
continuing operations by $0.43 and total net loss per share available to common
stockholders by $0.43. There was no effect on the Company's net loss.
NOTE 4 - GOING CONCERN, LIQUIDITY AND FINANCIAL CONDITION
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company incurred a net loss from
continuing operations of $2,162,583 for the three months ended March 31, 2007,
which includes an aggregate of $931,468 of non-cash charges including non-cash
interest expense, depreciation and amortization, stock based compensation net of
a change in the fair value of a conversion option. The Company's working capital
deficiency at March 31, 2007 amounted to $4,386,561 and the Company is
continuing to experience shortages in working capital. The Company cannot
provide any assurance that the outcome of these matters will not have a material
adverse affect on its ability to sustain the business. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
The accompanying financial statements do not include any adjustments that may
result from the outcome of this uncertainty.
9
The Company expects to continue incurring losses for the foreseeable future due
to the inherent uncertainty that is related to establishing the commercial
feasibility of technological products and developing a presence in new markets.
The Company's ability to successfully market its software products, grow revenue
and generate cash flows is critical to the realization of its business plan. The
Company raised $625,000 of bridge financing through the issuance of secured
demand notes during the three months ended March 31, 2007 (Note 8). The Company
used $510,031 of these proceeds to fund its operations and a net of $114,969 in
investing activities. Subsequent to March 31, 2007, the Company has raised an
additional $417,000 of bridge financing through the issuance of secured demand
notes (Note 20).
The Company is currently in the process of attempting to raise additional
capital and has taken certain steps to conserve its liquidity. Although
management believes that the Company has access to capital resources, the
Company has not secured any commitments for additional financing at this time
nor can the Company provide any assurance that it will be successful in its
efforts to raise additional capital and/or successfully execute its business
plan.
NOTE 5 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONCENTRATION OF CREDIT RISK
The Company maintains cash with major financial institutions. Cash is insured by
the Federal Deposit Insurance Corporation ("FDIC") up to $100,000 at each
institution. From time to time amounts may exceed the FDIC limits. At March 31,
2007 the uninsured bank cash balances were approximately $35,000. The Company
has not experienced any losses on these accounts.
REVENUE RECOGNITION
The Company derives revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) services, which include internet access, back-up,
retrieval and restoration services and professional consulting services.
The Company applies the revenue recognition principles set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and Exchange Commission Staff Accounting Bulletin ("SAB") 104 "Revenue
Recognition" with respect to its revenue. Accordingly, the Company records
revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has
occurred, (iii) the vendor's fee is fixed or determinable, and (iv)
collectability is reasonably assured.
The Company generates revenues through sales of software licenses and annual
support subscription agreements, which include access to technical support and
software updates (if and when available). Software license revenues are
generated from licensing the rights to use products directly to end-users and
through third party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of the Company's software sales are supported
by a written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post-contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. The Company uses the residual method
prescribed in SOP 98-9, "Modification of SOP 97-2, Software
10
Revenue Recognition With Respect to Certain Transaction" to allocate revenues to
delivered elements once it has established vendor-specific objective evidence of
fair value for such undelivered elements.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. The Company
recognizes revenue under these arrangements as the service is performed.
GOODWILL
The Company accounts for Goodwill and Intangible Assets in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." Under
SFAS No. 142, goodwill and intangibles that are deemed to have indefinite lives
are no longer amortized but, instead, are to be reviewed at least annually for
impairment. Application of the goodwill impairment test requires judgment,
including the identification of reporting units, assigning assets and
liabilities to reporting units, assigning goodwill to reporting units, and
determining the fair value. Significant judgments required to estimate the fair
value of reporting units include estimating future cash flows, determining
appropriate discount rates and other assumptions. Changes in these estimates and
assumptions could materially affect the determination of fair value and/or
goodwill impairment. In accordance with SFAS 142, the Company conducted its
annual impairment review of goodwill for the year ended December 31, 2006, which
resulted in a goodwill impairment charge of $210,716. This 2006 charge, which
principally represents goodwill remaining from the PolicyBridge business the
Company acquired from Entelagent is classified in discontinued operations as a
result of its decision to exit that business. The remaining amount of goodwill,
which amounts to $9,300,000 at March 31, 2007, relates to the Company's
acquisition of CSSI in February 2005 from which the Company acquired the
FormStream software technology, its sole line of business. The Company engaged
an outside specialist to assist the Company with performing its annual goodwill
impairment tests. These tests were made using a discounted cash flow model to
value the business. This approach requires the Company to forecast its
expectation of revenues and cash flows in future periods and to work with an
independent specialist on developing assumptions relating to the risk that such
cash flows may or may not materialize in future periods.
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Critical accounting policies requiring the use of estimates are revenue
recognition for software products with multiple deliverables, allowance for
doubtful accounts, goodwill, intangibles other than goodwill, which are
associated with its continuing operations, impairment charges, convertible
instruments, freestanding derivatives, and share based payments.
CONVERTIBLE INSTRUMENTS
The Company evaluates and accounts for conversion options embedded in its
convertible instruments in accordance with SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133") and EITF 00-19
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock" ("EITF 00-19").
SFAS 133 generally provides three criteria that, if met, require companies to
bifurcate conversion options from their host instruments and account for them as
free standing derivative financial instruments in accordance with EITF 00-19.
These three criteria include circumstances in which (a) the economic
characteristics and risks of the embedded derivative instrument are not clearly
and closely related to the economic characteristics and risks of the host
contract, (b) the hybrid instrument that embodies both the embedded derivative
instrument and the host contract is not remeasured at fair value under otherwise
applicable generally accepted accounting principles with changes in fair value
reported in earnings as they occur and (c) a separate instrument with the same
terms as the embedded derivative instrument would be considered a derivative
instrument subject to the requirements of SFAS 133. SFAS 133 and EITF 00-19 also
provide an exception to this rule when the host instrument is deemed to be
conventional (as that term is described in the implementation guidance to SFAS
133 and further clarified in EITF 05-2 "The Meaning of "Conventional Convertible
Debt Instrument" in Issue No. 00-19).
11
The Company accounts for convertible instruments (when it has determined that
the embedded conversion options should not be bifurcated from their host
instruments) in accordance with the provisions of EITF 98-5 "Accounting for
Convertible Securities with Beneficial Conversion Features," ("EITF 98-5") and
EITF 00-27 "Application of EITF 98-5 to Certain Convertible Instruments."
Accordingly, the Company records when necessary discounts to convertible notes
for the intrinsic value of conversion options embedded in debt instruments based
upon the differences between the fair value of the underlying common stock at
the commitment date of the note transaction and the effective conversion price
embedded in the note. Debt discounts under these arrangements are amortized over
the term of the related debt to their earliest date of redemption. The Company
also records when necessary deemed dividends for the intrinsic value of
conversion options embedded in preferred shares based upon the differences
between the fair value of the underlying common stock at the commitment date of
the note transaction and the effective conversion price embedded in the note.
As described in Note 8, the Company completed a $625,000 interim bridge
financing transaction in which convertible notes were deemed to be
non-conventional instrument in accordance with SFAS 133 and EITF 05-2.
COMMON STOCK PURCHASE WARRANTS AND OTHER DERIVATIVE FINANCIAL INSTRUMENTS
The Company accounts for the issuance of common stock purchase warrants and
other free standing derivative financial instruments in accordance with the
provisions of EITF 00-19. The Company performs classification assessments of its
derivative financial instruments at each balance sheet date as required under
EITF 00-19. Based on the provisions of EITF 00-19, the Company classifies as
equity any contracts that (i) require physical settlement or net-share
settlement or (ii) gives the Company a choice of net-cash settlement or
settlement in its own shares (physical settlement or net-share settlement). The
Company classifies as assets or liabilities any contracts that (i) require
net-cash settlement (including a requirement to net cash settle the contract if
an event occurs and if that event is outside the control of the Company) or (ii)
gives the counterparty a choice of net-cash settlement or settlement in shares
(physical settlement or net-share settlement). The Company has determined that
its common stock purchase warrants, are equity instruments since they do not
provide any cash settlement alternatives outside of the Company's control.
As described in Note 8, the Company has determined that the conversion option
embedded in the 2007 Interim Bridge Financing notes is a derivative financial
instrument requiring liability classification in accordance with EITF 00-19
since it is exercisable for indeterminate number of shares. The note was amended
in May 2007 to establish a minimum conversion price of $.05 per share.
Accordingly, the Company intends to reclassify this derivative to stockholders
equity in its June 30, 2006 balance sheet assuming all other conditions for
equity classification under EITF 00-19 are met at that time.
STOCK BASED COMPENSATION
Effective January 1, 2006, the Company adopted SFAS No. 123R "Share Based
Payment." This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, and its related implementation guidance. SFAS 123R addresses
all forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options, restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that is
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest. The Company adopted the modified
prospective method with respect to accounting for its transition to SFAS 123(R)
and measured unrecognized compensation cost as described in Note 17.
Accordingly, the Company recognized in salaries and related expense in the
statement of operations, $430,809 and $180,835 for the fair value of stock
options expected to vest during the three month periods ended March 31, 2007 and
2006, respectively.
INCOME TAXES
The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109").
SFAS No. 109 requires the recognition of deferred tax assets and liabilities for
both the expected impact of differences between the financial statements and tax
basis of assets and liabilities and for the expected future tax benefit to be
derived from tax loss and tax credit carry forwards. SFAS No. 109 additionally
requires the establishment of a valuation allowance to reflect the likelihood of
realization of deferred tax assets.
12
The Company has not recognized any income tax expense (benefit) in the
accompanying financial statements for the three months ended March 31, 2007 and
2006. Deferred tax assets, which principally arise from net operating losses,
are fully reserved due to management's assessment that it is more likely than
not that the benefit of these assets will not be realized in future periods.
As describe in Note 16, the Company adopted FASB Interpretation No. 48 -
"Accounting for Uncertainty in Income Taxes - an interpretation of FASB
Statement No. 109" ("FIN 48"), effective January 1, 2007. A discussion of the
effect of having adopted FIN 48 is also described in Note 12.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share, if required,
would be computed by dividing net loss by the weighted-average number of common
shares outstanding without an assumed increase in common shares outstanding for
common stock equivalents; as such common stock equivalents are anti-dilutive.
The Company has included 40,001 stock options with an exercise price of $0.30
per share that it issued to certain employees during 2002 in its calculation of
weighted-average number of common shares outstanding for all periods presented
and 10,306 shares to-be-issued under a stock pledge agreement entered into in
2004.
Net loss per common share excludes the following outstanding options, warrants,
convertible preferred stock and convertible notes as their effect would be
anti-dilutive:
MARCH 31,
-----------------------------
2007 2006
---------- ----------
Options .................................. 5,734,519 438,090
Warrants ................................. 5,097,590 1,289,909
Series A Preferred Stock ................. 12,051,254 1,860,650
Series A-1 Preferred Stock ............... -- 11,140,063
Series B Preferred Stock ................. 4,820,417 --
Convertible Notes ........................ 1,202,921 --
---------- ----------
28,906,701 14,728,712
========== ==========
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS 157 - "Fair Value Measurements" ("SFAS
157"), which defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. The provisions of
SFAS 157 are effective for the first fiscal year beginning after November 2007.
The Company is currently evaluating the impact of adopting SFAS 157 on its
financial statements.
In November 2006, the EITF reached a final consensus in EITF Issue 06-6
"Debtor's Accounting for a Modification (or Exchange) of Convertible Debt
Instruments" ("EITF 06-6"). EITF 06-6 addresses the modification of a
convertible debt instrument that changes the fair value of an embedded
conversion option and the subsequent recognition of interest expense for the
associated debt instrument when the modification does not result in a debt
extinguishment pursuant to EITF 96-19, "Debtor's Accounting for a Modification
or Exchange of Debt Instruments." The consensus applies to modifications or
exchanges of debt instruments occurring in interim or annual periods beginning
after November 29, 2006. The adoption of EITF 06-6 did not have a material
impact on the Company's consolidated financial position, results of operations
or cash flows.
In November 2006, the FASB ratified EITF Issue No. 06-7, Issuer's Accounting for
a Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
the Conversion Option No Longer Meets the Bifurcation
13
Criteria in FASB Statement No. 133, Accounting for Derivative Instruments and
Hedging Activities ("EITF 06-7"). At the time of issuance, an embedded
conversion option in a convertible debt instrument may be required to be
bifurcated from the debt instrument and accounted for separately by the issuer
as a derivative under FAS 133, based on the application of EITF 00-19.
Subsequent to the issuance of the convertible debt, facts may change and cause
the embedded conversion option to no longer meet the conditions for separate
accounting as a derivative instrument, such as when the bifurcated instrument
meets the conditions of Issue 00-19 to be classified in stockholders' equity.
Under EITF 06-7, when an embedded conversion option previously accounted for as
a derivative under FAS 133 no longer meets the bifurcation criteria under that
standard, an issuer shall disclose a description of the principal changes
causing the embedded conversion option to no longer require bifurcation under
FAS 133 and the amount of the liability for the conversion option reclassified
to stockholders' equity. EITF 06-7 applies to all previously bifurcated
conversion options in convertible debt instruments that no longer meet the
bifurcation criteria in FAS 133 in interim or annual periods beginning after
December 15, 2006, regardless of whether the debt instrument was entered into
prior or subsequent to the effective date of EITF 06-7. The adoption of EITF
06-7 did not have a material impact on the Company's consolidated financial
position, results of operations or cash flows.
In December 2006, the FASB issued FSP EITF 00-19-2, "Accounting for Registration
Payment Arrangements." FSP EITF 00-19-2 addresses an issuer's accounting for
registration payment arrangements. This pronouncement specifies that the
contingent obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement, whether issued as a
separate agreement or included as a provision of a financial instrument, should
be separately recognized and accounted for as a contingency in accordance with
SFAS 5 "Accounting for Contingencies." FSP EITF 00-19-2 amending previous
standards relating to rights agreements became effective on December 21, 2006
with respect to arrangements entered into or modified beginning on such date and
for the first fiscal year beginning after December 15, 2006 with respect to
those arrangements entered into prior to December 21, 2006. The adoption of FSP
EITF 00-19-2 did not have a material effect on the Company's financial
statements.
In February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial
Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 provides companies with
an option to report selected financial assets and liabilities at fair value and
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities. SFAS 159 is effective for fiscal years
beginning after November 15, 2007. The Company is in the process of evaluating
the impact of the adoption of this statement on the Company's results of
operations and financial condition.
Other accounting standards that have been issued or proposed by the FASB or
other standards-setting bodies that do not require adoption until a future date
are not expected to have a material impact on the consolidated financial
statements upon adoption.
NOTE 6 - CAPITALIZED SOFTWARE
Capitalized software development costs are as follows:
Beginning of the year ............................ $ 414,560
Capitalized ...................................... 41,839
Amortization ..................................... (12,328)
---------
Balance at March 31, 2007 ...................... $ 444,071
=========
The Company classifies amortization of developed technology as a component of
cost of sales. Amortization expense amounted to $12,328 and $37,022 for the
three months ended March 31, 2007 and 2006, respectively.
AMORTIZATION OF CAPITALIZED SOFTWARE
The amortization of capitalized software for reporting subsequent to the quarter
ended March 31, 2007 is as follows:
14
SOFTWARE
AMORTIZATION
------------
Period of April 2, 2007 through December 31, 2007 $ 65,028
YEARS ENDED DECEMBER 31:
------------------------
2008 105,402
2009 105,403
2010 73,733
2011 66,460
2012 28,045
------------
$ 444,071
============
NOTE 7 - AMORTIZABLE INTANGIBLE ASSETS
The components of intangible assets as of March 31, 2007 are set forth in the
following table:
MARCH 31, 2007
--------------
Customer relationships ....................................... $ 180,000
Trademarks and tradenames .................................... 55,000
--------------
235,000
less: accumulated amortization ............................... (122,397)
--------------
Amortizable intangible assets, net ...................... $ 112,603
==============
Intangible amortization expense amounted to $14,687 and $21,312 for the three
months ended March 31, 2007 and 2006, respectively.
AMORTIZATION OF INTANGIBLE ASSETS
The amortization of intangible assets for reporting subsequent to the quarter
ended March 31, 2007 is as follows:
INTANGIBLE
AMORTIZATION
------------
Period of April 2, 2007 through December 31, 2007 $ 44,063
YEARS ENDED DECEMBER 31:
------------------------
2008 58,750
2009 9,790
------------
$ 112,603
============
NOTE 8 - SECURED DEMAND NOTES PAYABLE
On February 20, 2007, the Company signed a secured convertible promissory note
("2007 Interim Bridge Financing") with Apex Investment Fund V, LP in exchange
for working capital advances made to the Company. The Company received advances
of $200,000 on February 20, 2007; $100,000 on March 2, 2007; $160,000 on March
20, 2007; and $165,000 on March 27, 2007 for a total of $625,000 advanced as of
March 31, 2007.
The Company signed a Security Agreement granting Apex a security interest and
lien in and upon all of Debtors' assets including, without limitation, all of
Debtor's right, title and interest in and to all accounts, chattel paper,
15
documents, general intangibles, instruments, goods and money, whether now
existing or hereafter created and whether now owned or hereafter acquired, and
all proceeds of all of the foregoing.
The 2007 Interim Bridge Financing note is due on demand and bears interest at 9%
per annum ("2007 Bridge Note"). The 2007 Bridge Note can be converted at the
option of the Holder at any time, into that number of shares of the Company's
voting common stock (the "Conversion Shares"), either a) equal to the quotient
of the principal and accrued interest being converted, divided by the offering
price per share ("Offering Price") associated with any offering of equity
securities made by the Company or b) equal to the quotient of the principal and
accrued interest being converted, divided by the Fair Market Value of such
shares.
In conjunction with the 2007 Interim Bridge Financing, the Company issued common
stock purchase warrants to Apex. The Company issued 200,000 common stock
purchase warrants with an exercise price of $1.00 per share on February 20,
2007; 100,000 common stock purchase warrants with an exercise price of $1.25 per
share on March 2, 2007; 160,000 common stock purchase warrants with an exercise
price of $1.14 per share on March 19, 2007; and 168,000 common stock purchase
warrants with an exercise price of $0.69 per share on March 27, 2007. The
200,000 warrants issued on February 20, 2007 have a relative fair value of
$134,419; the 100,000 warrants issued on March 2, 2007 have a relative fair
value of $83,984; the 160,000 warrants issued on March 19, 2007 have a relative
fair value of $122,225; and the 165,000 warrants issued on March 27, 2007 have a
relative fair value of $76,167. The Company estimated the fair values of these
warrants using the Black-Scholes option pricing model with the following
assumptions: fair value of common stock from $1.00 to $0.55; risk-free interest
rate of 4.92% to 5.05%; expected dividend yield zero percent; expected warrant
life of five years; and current volatility of 125%.
In accordance with APB 14, the Company allocated $166,655 of the proceeds to the
2007 Bridge Note and $458,345 of proceeds to the warrants based upon the
relative fair values of these instruments. The portion of the proceeds allocated
to the warrants was recorded as an increase to additional paid in capital. The
difference between the carrying amount of the 2007 Bridge Note and their
contractual redemption amount ($458,345) was immediately charged as interest
expense in the accompanying statement of operations for the three months ended
March 31, 2007 since the notes are payable on demand. Accordingly, the 2007
Bridge Notes are presented in the accompanying balance sheet at their principal
amount. Contractual interest expense on the 2007 Bridge Note amounted to $2,903
during the three months ended March 31, 2007.
As described in Note 3, the Company evaluated the conversion options embedded in
the 2007 Bridge Notes and determined that since the conversion prices are not
fixed, such conversion options should be bifurcated from the notes and accounted
for as free standing derivatives in accordance with SFAS 133. The derivatives
have been classified as liability instruments in the accompanying balance sheet.
Apex has agreed that (i) in the event the holders of other derivative securities
elect to convert or exercise, Apex will permit the conversion or exercise of
such derivative securities prior to the conversion of the 2007 Bridge Notes and
(ii) in the event that the Company does not have a sufficient number of
authorized but unissued and unreserved share of common stock to permit the
conversion of all of the 2007 Bridge Notes, Apex will convert only such portion
of the 2007 Bridge Note that will result in the issuance of the available
authorized but unissued and unreserved shares of common stock, provided,
however, that the Company will take all reasonable steps to increase the
authorized but unissued and unreserved shares of common stock to permit the
conversion of the remaining portion of the 2007 Bridge Notes as soon as
practicable thereafter. The aggregate fair value of the derivative conversion
options, at their respective dates of issuance amounted to $294,586. The Company
estimated the fair values of these options using the Black-Scholes option
pricing model with the following assumptions: fair value of common stock from
$0.55 to $1.00; risk-free interest rate of from 4.90% to 5.04% expected dividend
yield zero percent, expected term of 0.9 to 1.0 year.; and current volatility of
125%.
The aggregate fair value of the derivative conversion option at March 31, 2007
amounts to $285,874. The Company recognized a gain of $8,712 at March 31, 2007
on the valuation of this derivative conversion option. The Company estimated the
fair values of these warrants using the Black-Scholes option pricing model with
the following assumptions: fair value of common stock from $0.55; risk-free
interest rate of 4.90%; expected dividend yield zero percent, expected term of
0.89 years. The change in fair value of the conversion option, which amounts to
$8,712, is presented as a change in fair value of conversion option in the
accompanying statement of operations for the three months ended March 31, 2007.
16
Subsequent to March 31, 2007, Apex agreed to establish a minimum conversion
price of $0.05 per share to be utilized in the calculation of the Conversion
Shares. This conversion floor explicitly limits the number of shares issuable
upon conversion of the notes to a maximum of 12,500,000 shares for which the
Company has sufficient authorized but unissued and unreserved capital available
to net share settle the derivative.
NOTE 9 -DEMAND NOTES PAYABLE
The demand note at March 31, 2007, which amounts to $312,557, is payable to Lok
Technology and is secured by Entelagent's accounts receivable, which approximate
$55,000 and $51,000 at March 31, 2007 and 2006, respectively. The note bears
interest at 15% per annum. Interest on this demand note amounted to $11,721 and
$11,721 for the three months ended March 31, 2007 and 2006, respectively. As
described in Note 14, on May 4, 2006, the Company became aware of a complaint
that Lok Technologies, Inc. had filed in the Superior Court of California,
County of Santa Clara on or about March 30, 2006 against the Company, Entelagent
Software Corp. and unnamed defendants.
NOTE 10 - BRIDGE NOTES PAYABLE
The Company completed three bridge note financing transactions in 2005 - the
Bridge I Notes were completed for $3,500,000; the Bridge II Notes were completed
for $2,543,000; and the Bridge III Notes were completed for $5,234,000.
During 2006, $3,180,025 of the Bridge I Notes were surrendered as payment for
3,975,031 shares of Series A-1 Preferred stock as part of the creditor and
claimant liabilities restructuring (Note 15). As of March 31, 2007, $319,975 of
Bridge I Notes remain outstanding. Contractual interest expense on the Bridge I
Notes amounted to $9,467 and $103,562 for the three months ended March 31, 2007
and 2006, respectively, and is included as a component of interest expense in
the accompanying statement of operations.
During 2006, $2,343,000 of the Bridge II Notes were surrendered as payment for
2,928,750 shares of Series A-1 Preferred stock as part of the creditor and
claimant liabilities restructuring (Note 15). As of March 31, 2007, $200,000 of
the Bridge II Notes remain outstanding. Contractual interest expense on the
Bridge II Notes amounted to $5,918 and $75,245 for the three months ended March
31, 2007 and 2006, respectively and is included as a component of interest
expense in the accompanying statement of operations.
During 2006, all of the Bridge III Notes were surrendered as payment for
6,542,500 shares of Series A-1 Preferred stock as part of the creditor and
claimant liabilities restructuring (Note 15). Contractual interest expense on
the Bridge III Notes amounted to $0 and $153,036 for the three months ended
March 31, 2007 and 2006, respectively, and is included as a component of
interest expense in the accompanying statement of operations.
NOTE 11 - RELATED PARTY TRANSACTIONS
NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)
The notes issued to creditors of Entelagent (in connection with the acquisition
of Entelagent Software Corp.) include $554,202 that is payable to related
parties for settlements of accrued payroll, notes payable and other payables
that remain outstanding at March 31, 2007. The original amount of these notes
amounted to $2,602,913. Aggregate interest expense on these notes amounted to
$16,000 and $52,058 for the three months ended March 31, 2007 and 2006,
respectively.
During 2006, $1,795,930 of the notes payable to creditors of acquired business
were surrendered as payment for Series A-1 Preferred stock under the creditor
and claimant liabilities restructuring (Note 15). As of March 31, 2007, $799,982
of the notes payable remain outstanding.
17
NOTE 12 - ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
Accrued expenses and other current liabilities consist of the following:
MARCH 31, 2007
--------------
Payroll and payroll related expenses .......................... $ 659,797
Accrued interest .............................................. 670,280
Reserve for preacquisition tax contingencies .................. 336,828
Other current liabilities ..................................... 242,942
Expense reimbursement payable ................................. 8,958
--------------
$ 1,918,805
==============
NOTE 13 - DEFERRED REVENUE
Deferred revenue at March 31, 2007 includes (1) $42,177 for the fair value of
remaining service obligations on maintenance and support contracts and (2)
$212,387 for contracts on which the revenue recognition is deferred until
contract deliverables have been completed.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
On January 5, 2006, Mark P. Gertz, Trustee in bankruptcy for Arter & Hadden,
LLP, filed an Adversary Complaint for Recovery of Assets of the Estate in the
United States Bankruptcy Court Northern District of Ohio Eastern Division,
against the Company as successor in merger to Entelagent. Mr. Gertz seeks
$32,278 plus interest accruing at the statutory rate since July 15, 2003 for
services rendered by Arter & Hadden, LLP to Entelagent. On September 11, 2006,
the Company entered into a settlement and release agreement with Mark P. Gertz,
Trustee in bankruptcy for Arter & Hadden, LLP which called for the payment of
$32,500 in 13 installments of $2,500.
On May 4, 2006, Patron became aware that Lok Technologies, Inc. had filed a
complaint on or about March 30, 2006 against the Company, Entelagent Software
Corp. and unnamed defendants in the Superior Court of California, County of
Santa Clara alleging breach of contract, breach of duty of good faith and fair
dealing and unjust enrichment and seeking damages, interest, disgorgement of any
unjust enrichment, attorneys fees and cost. Prior to receipt of this notice of
litigation, the Company had recorded a liability of $320,000 plus accrued
interest of $159,432. The Company believes that it has defenses to these claims.
The Company cannot provide any assurance that the ultimate settlement of this
claim will not have a material adverse affect on its financial condition.
NOTE 15 - CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING
On January 12, 2006, the Company issued a Stock Subscription Agreement & Mutual
Release ("the Original Release") to each creditor and claimant ("Subscriber") of
the Company for purposes of entering into a final and binding settlement with
respect to any and all claims, liabilities, demands, causes of action, costs,
expenses, attorneys fees, damages, indemnities, and obligations of every kind
and nature that the creditor and/or claimant may have with the Company
("Subscriber Claims"). Under terms of this agreement, the Company sold to the
Subscriber and the Subscriber purchased from the Company shares ("Stock") of its
Series A-1 Preferred stock at a price of $0.80 per share. The aggregate purchase
price was equivalent to the value of the Subscriber Claims being settled through
this settlement and release. Subscriber was deemed to have paid for the Stock
through the settlement and release of Subscriber Claims. Each share of Stock was
automatically convertible into 1/3 share of the Company's common stock upon the
effectiveness of an amendment to the Company's certificate of incorporation
which provided for a sufficient number of authorized but unissued and unreserved
shares of the Company's common stock
18
to permit the conversion of all issued and outstanding shares of Series A-1
Preferred. The Company issued the Series A-1 Preferred shares following the
final determination of the claims and acceptance by the Company of each claimant
submitted Stock Subscription Agreement and Mutual Release through
countersignature thereof.
The following table provides a summary as of March 31, 2006 of all claims
settled by category with the (gain) loss recognized on the settlement:
SERIES A-1 CLAIM FAIR VALUE
SETTLEMENT CATEGORY STOCK ISSUED AMOUNT OF STOCK GAIN/(LOSS)
------------------------------------------ ----------- ----------- ----------- -----------
General Creditors ........................ 20,358,589 $16,476,818 $12,201,308 $ 4,275,510
Stockholders under Accommodation Agreement 3,000,000 2,400,000 2,400,000 --
Mr. Allin and the Allin Dynastic Trust ... 2,500,000 1,317,089 1,500,000 (182,911)
Other Claimants .......................... 7,381,489 1,243,282 4,428,894 $(3,185,612)
----------- ----------- ----------- -----------
33,240,078 $21,437,189 $20,530,202 $ 906,987
----------- ----------- ----------- -----------
The fair value of the Series A-1 shares issued in settlements reached prior to
March 31, 2006 amounted to $0.60 per share, based on a comparison of the
features of these shares to similar shares sold in private placement
transactions to unrelated parties for cash and the trading price of the
Company's shares at the time of the settlements. Series A-1 shares issued in
settlements reached in July 2006, which principally includes the Company's
former non-executive chairman, were valued at $0.80 per share commensurate with
an increase in the trading price of the Company's common stock. These agreements
effectuated a complete settlement of these debts, claims and liabilities and the
mutual release of the parties with respect thereto.
The Company accounted for the extinguishment of liabilities payable to general
creditors in accordance with SFAS 15 "Accounting by Debtors and Creditors for
Troubled Debt Restructurings," due to the fact that the holders of these notes
granted to Company concessions intended to alleviate its immediate liquidity
constraints. These concessions that the creditors granted to the Company enabled
it to (a) effectuate their settlement through an exchange of equity instead of a
use of cash and (b) consummate a private placement of equity securities (Note
16) that resulted in an infusion of cash that was needed to sustain operations.
Claimants other than Mr. Allin and the Allin Dynastic Trust that participated in
the settlement include certain parties that were previously engaged in
litigation with the Company including the Sherleigh Associates Profit Sharing
Plan to which the Company issued 2,312,500 shares for a settlement loss of
$1,387,500, Richard Linting to whom the Company issued 1,777,261 shares for a
settlement loss of approximately $773,000 and the holders of the Marie Graul
claim to whom the Company issued 1,164,461 shares for a settlement loss of
approximately $698,000.
NOTE 16 - INCOME TAXES
As described in Note 5, the Company adopted FIN 48 effective January 1, 2007.
FIN 48 requires companies to recognize in the financial statements, the impact
of a tax position, if that position is more likely than not of being sustained
on audit, based on the technical merits of the position. FIN 48 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 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods and disclosure. The
Company's policy is to classify penalties and interest associated with uncertain
tax positions, if required as a component of its income tax provision.
The Company has filed federal and various state income tax returns for the
period ended December 31, 2002, and for the years ended December 31, 2003, 2004
and 2005 (for which the 2005 return was consolidated with the returns of
acquired businesses) during 2006. These income tax returns and returns of
acquired businesses filed prior to 2006 have not been examined by the applicable
Federal and State tax authorities. The Company's tax returns and certain of the
returns of the acquired business were not filed timely. Accordingly, statutes of
limitation with respect to certain of these returns commenced during 2006. The
Company has not yet filed its income tax returns for the year ended December 31,
2006.
19
Management does not believe that the Company has any material uncertain tax
position requiring recognition or measurement in accordance with the provision
of FIN 48. At December 31, 2006, the Company had approximately $30 million of
net deferred tax assets, of which $11.8 million relates to the tax effects of
net operating losses.
The Company's net operating losses amounted to approximately $31 million as of
December 31, 2006 and expire at various times through the year ended December
31, 2026. The Company's determination of the amount of its net operating losses
includes approximately $11 million associated with business acquired during
2005. In addition, the Company estimated that a substantial majority of the
remaining $20 million of NOL's are subject to limitations due to the change in
ownership provisions under Section 382 of the Internal Revenue Code. After
giving effect to such changes, the Company estimates that its net operating
losses available to offset future taxable income, if any, amount to
approximately $13 million. Accordingly, the Company reduced the carrying amount
of its net deferred tax asset and related reserve by approximately $6.7 million
for the tax effects having reduced net operating losses by approximately $18
million.
The utilization of the remaining net operating losses may be subject to
substantial limitations in future periods due to the change in ownership
provisions under Section 382 of the Internal Revenue Code and separate return
loss year limitations under Section 1502 of the Internal Revenue Code and
similar state provisions. The Company, as a result of having evaluated all
available evidence as required under SFAS 109, fully reserved for its net
deferred tax assets since it is more likely than not that the benefits of these
deferred tax assets will not be realized in future periods.
NOTE 17 - PREFERRED STOCK
AMENDMENT TO CERTIFICATE OF INCORPORATION AND AUTHORIZED SHARE CAPITAL
On March 1, 2006, the Company filed with the Delaware Secretary of State a
Certificate of Designation of Preferences, Rights and Limitations of Series A
Convertible Preferred Stock and Series A-1 Convertible Preferred Stock
designating the rights, preferences and privileges of 2,160 shares of Series A
Convertible Preferred Stock and 50,000,000 shares of Series A-1 Convertible
Preferred Stock.
On October 12, 2006, the Company filed with the Delaware Secretary of State a
Certificate of Designation of Preferences, Rights and Limitations of Series B
Convertible Preferred Stock designating the rights, preferences and privileges
of 2,000 shares of Series B Convertible Preferred Stock. The Certificate of
Designation of Preferences, Rights and Limitations of Series B Convertible
Preferred Stock was amended on January 24, 2007.
A description of each class of the Company's authorized capital stock following
the most recent amendment to its Certificate of Incorporation is as follows:
SERIES A PREFERRED STOCK
The Series A Preferred Stock has a stated value of $5,000 per share and carries
a dividend of 10% per annum with such dividend accruing on a cumulative basis.
The dividend is payable only (i) at such time as declared payable by the Board
of Directors of the Company or (ii) in the event of liquidation, as part of the
liquidation preference amount ("Liquidation Preference Amount"). Accumulated but
unpaid dividends on the Series A Preferred, which have not been declared by the
board of directors, amount to $487,333 of which $118,962 is presented in the
accompanying statement of operations as an increase in the net loss available to
common stockholders.
The Series A Preferred is convertible, at the option of the holder, into shares
of the Company's common stock ("Conversion Shares") at an initial conversion
price ("Initial Conversion Price") of $2.40 per share based on the stated value
20
of the Series A Preferred, subject to adjustment for stock splits, dividends,
recapitalizations, reclassifications, payments made to Common Stock holders and
other similar events and for issuances of additional securities at prices more
favorable than the conversion price at the date of such issuance. As described
below, the conversion price was reduced to $0.90 per share on November 16, 2006
when the Company's issued Series B Preferred Stock convertible at $0.90 per
share with warrants exercisable at $1.03 per share, and to $0.40 per share on
January 24, 2007 when the Company issued employee stock options exercisable at
$0.40 per share.
The Series A Preferred is mandatorily convertible into shares of the Company's
common stock at the Initial Conversion Price, which is subject to adjustment as
described above, on the date that: (i) there shall be an effective registration
statement covering the resale of the Conversion Shares, (ii) the average closing
price of the Company's common stock, for a period of 20 consecutive trading days
is at least 250% of the then applicable Conversion Price, and (iii) the average
daily trading volume of the Company's common stock for the same period is at
least 8,334 shares.
The Series A Preferred Liquidation Preference Amount is equal to 125% of the sum
of: (i) the stated value of any then unconverted shares of Series A Preferred
and (ii) any accrued and unpaid dividends thereon. An event of liquidation means
any liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, as well as any change of control of the Company which includes the
sale by the Company of either (x) substantially all its assets or (y) the
portion of its assets which comprises its core business technology, products or
services.
SERIES B PREFERRED STOCK
We have designated 2,000 shares of preferred stock as Series B Preferred Stock.
The Series B Preferred Stock has a stated value of $5,000 per share, has no
maturity date, carries a dividend of 10% per annum, with such dividend accruing
on a cumulative basis and is payable only (i) at such time as declared payable
by the board of directors or (ii) in the event of liquidation, as part of the
liquidation preference amount ("Liquidation Preference Amount"). The Liquidation
Preference Amount is equal to 125% of the sum of: (i) the stated value of any
then unconverted shares of Series B Preferred Stock and (ii) any accrued and
unpaid dividends thereon. An event of liquidation means any liquidation,
dissolution or winding up of the Company, whether voluntary or involuntary, as
well as any change of control of the Company which includes the sale by the
Company of either (x) substantially all its assets or (y) the portion of its
assets which comprises its core business technology, products or services. The
Series B Preferred Stock is junior to the Series A Preferred Stock with respect
to liquidation and dividend rights. Accumulated and unpaid dividends on the
Series B Preferred, which have not been declared by the board of directors,
amount to $174,912 of which $97,363 is presented in the accompanying statement
of operations as an increase in the net loss available to common stockholders.
The Series B Preferred Stock is convertible, at the option of the holder, into
shares of Common Stock ("Conversion Shares") at an initial conversion price
("Initial Conversion Price) of $0.82 based on the stated value of the Series B
Preferred Stock, subject to adjustment for stock splits, dividends,
recapitalizations, reclassifications, payments made to Common Stock holders and
other similar events and for issuances of additional securities at prices more
favorable than the conversion price at the date of such issuance. We are
obligated to register the Conversion Shares within 90 days of completion of the
issuance of the Series B Preferred Stock.
The Series B Preferred Stock is mandatorily convertible at the then applicable
conversion price ("Conversion Price") into shares of Common Stock at the then
applicable Conversion Price on the date that: (i) there shall be an effective
registration statement covering the resale of the Conversion Shares, (ii) the
average closing price of Common Stock, for a period of 20 consecutive trading
days is at least 250% of the then applicable Conversion Price, and (iii) the
average daily trading volume of Common Stock for the same period is at least
8,334 shares.
The Series B Preferred Liquidation Preference Amount is equal to 125% of the sum
of: (i) the stated value of any then unconverted shares of Series A Preferred
and (ii) any accrued and unpaid dividends thereon. An event of liquidation means
any liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, as well as any change of control of the Company which includes the
sale by the Company of either (x) substantially all its assets or (y) the
portion of its assets which comprises its core business technology, products or
services.
21
PRIVATE PLACEMENTS OF CONVERTIBLE PREFERRED STOCKS
PRIVATE PLACEMENT OF SERIES A CONVERTIBLE PREFERRED STOCK AND WARRANTS
Beginning on March 27, 2006 and completed on April 2, 2006, the Company
consummated the Series A Preferred Financing with the closing of funds totaling
$4,820,501, resulting in the issuance of 964 shares of Series A Preferred Stock
and 669,539 common stock purchase warrants to the purchasers of the Series A
Preferred Stock ("Investor Warrants"). The Company also issued common stock
purchase warrants to Laidlaw as placement agent in this financing ("Agent
Warrants") exercisable for 198,375 shares of common stock. The Investor Warrants
and the Agent Warrants have a term of 5 years and an exercise price of $1.46 per
share.
Pursuant to the Certificate of Designation for the Series A Preferred Stock, in
the event that additional shares of common stock are issued or deemed to be
issued at an effective price that is lower than the conversion price of the
Series A Preferred Stock, the conversion price for the Series A Preferred Stock
shall be reduced to the effective price of such issuance. On November 16, 2006,
the Series B Preferred Financing was completed at a conversion price of $0.82
per share as compared to the $2.40 per share conversion price for the Series A
Preferred Stock. Pursuant to the terms of the Certificate of Designation for the
Series A Preferred Stock the conversion price of the Series A Preferred Stock
was adjusted to $0.90 per share. This change resulted in an additional 3,347,571
shares of Common Stock being reserved for issuance upon the conversion of the
Series A Preferred Stock. The Company recorded $3,795,059 of deemed dividends
which is equal to the full amount of proceeds allocable to the preferred shares
based on computations made to determine the relative fair values of the
preferred shares and warrants and the effective conversion price of the shares
in accordance with EITF 00-27.
On January 24, 2007, the Company issued 5,270,553 stock options under the Patron
Systems Inc. 2006 Stock Incentive Plan. These options have an exercise price of
$0.40 per share. This issuance has resulted in the adjustment of the Series A
Preferred conversion price to $0.40 per share and has resulted in an additional
6,695,116 shares of Common Stock being reserved for issuance upon the conversion
of the Series A Preferred Stock. The Company was not required to record an
additional deemed dividend since the deemed dividend recorded in November 2006
was equal to the proceeds allocable to the preferred shares at their original
dates of issuance. As of March 31, 2007, the 964 shares of Series A Preferred
Stock outstanding are convertible, as described above, into 12,051,254 shares of
Common Stock.
PRIVATE PLACEMENT OF SERIES B CONVERTIBLE PREFERRED STOCK AND WARRANTS
On October 13, 2006 and November 16, 2006, the Company consummated two closings
of the Series B Preferred Financing through the sale of Units, at a per Unit
price of $100,000, consisting of (i) 20 shares of Series B Preferred Stock and
(ii) Series B Investor Warrants to purchase shares of Common Stock in an amount
equal to 50% of the shares issuable upon conversion of the Series B Preferred
Stock, in the aggregate amount of $3,952,716. The closings of the Series B
Preferred Financing resulted in the issuance of 790.54 shares of Series B
Preferred Stock with a conversion price of $0.82 and Series B Investor Warrants
to purchase 2,410,222 shares of Common Stock at an exercise price of $1.03 per
share. The Series B Investor Warrants have a term of 5 years.
In connection with the Series B Preferred Financing, the Company retained
Laidlaw as its non-exclusive placement agent ("Series B Preferred Placement
Agent"). The Company paid Laidlaw a fee of $352,569 and issued to Laidlaw common
stock purchase warrants, the Series B Agent Warrants, to purchase 723,065 shares
of Common Stock for its services as the Series B Preferred Placement Agent and
paid $32,750 of Laidlaw's legal expenses associated with the Series B Preferred
Financing. The Series B Agent Warrants have a term of 5 years.
The Company is obligated to register the shares of Common Stock issuable upon
exercise of the Series B Investor Warrants and the Series B Agent Warrants and
conversion of the Series B Preferred Stock within 90 days after the completion
of the Series B Preferred Financing.
As of November 16, 2006, the 790.54 shares of Series B Preferred are convertible
into 4,820,417 shares of Common Stock.
22
NOTE 18 - STOCKHOLDERS' EQUITY
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On February 20, 2007, the Company issued common stock purchase warrants for
200,000 shares at an exercise price of $1.00 per share to Apex in connection
with the 2007 Interim Bridge Financing. The aggregate fair value of these
warrants amounted to $134,419 (Note 8).
On March 2, 2007, the Company issued common stock purchase warrants for 100,000
shares at an exercise price of $1.25 per share to Apex in connection with the
2007 Interim Bridge Financing. The aggregate fair value of these warrants
amounted to $83,984 (Note 8).
On March 19, 2007, the Company issued common stock purchase warrants for 160,000
shares at an exercise price of $1.14 per share to Apex in connection with the
2007 Interim Bridge Financing. The aggregate fair value of these warrants
amounted to $122,225 (Note 8).
On March 27, 2007, the Company issued common stock purchase warrants for 165,000
shares at an exercise price of $0.69 per share to Apex in connection with the
2007 Interim Bridge Financing. The aggregate fair value of these warrants
amounted to $76,167 (Note 8).
SHARE-BASED COMPENSATION ARRANGEMENTS
The Company, since its inception has granted non-qualified stock options to
various employees and non-employees at the discretion of the Board of Directors.
Substantially all options granted to date have exercise prices equal to the fair
value of underlying stock at the date of grant and terms of ten years. Vesting
periods range from fully vested at the date of grant to four years.
On July 21, 2006, the stockholders of the Company approved the 2006 Patron
Systems, Inc. Stock Incentive Plan (the "2006 Stock Plan"). The 2006 Stock Plan
provides for the granting of incentive stock options to employees and the
granting of nonstatutory stock options to employees, non-employee directors,
advisors, and consultants. The 2006 Stock Plan also provides for grants of
restricted stock, stock appreciation rights and stock unit awards to employees,
non-employee directors, advisors and consultants. The 2006 Stock Plan authorizes
and reserves 5,600,000 shares for issuance of options that may be granted under
plan.
As described in Note 5, the fair value of all awards was estimated at the date
of grant using the Black-Scholes option pricing model.
During the three months ended March 31, 2007, the Company issued stock options
to employees to purchase 5,270,553 shares. These options include a grant to
purchase 2,047,121 shares at an exercise price of $0.40 per share, with a fair
value of $663,267, to the Chief Executive Officer of the Company, Mr. Braden
Waverley, to conform to his employment agreement requirements. Additionally, the
Company granted options to purchase 731,114 shares at an exercise price of $0.40
per share, with a fair value of $236,881, to Mr. Martin T. Johnson, the
Company's Chief Financial Officer, to conform with his employment agreement with
the Company. The Company granted options to purchase 757,318 shares at an
exercise price of $.40 per share, with a fair value of $245,371 to Robert Cross,
Chairman of the Board. The Company granted options to purchase 50,000 shares at
an exercise price of $.40 per share with a fair value of $16,200 to George
Middlemas, a director of the Company. The Company also granted options to 26
employees for a total of 1,685,000 shares at an exercise price of $0.40 per
share with a fair value of $545,940. Assumptions relating to the estimated fair
value of these warrants are as follows: fair value of common stock $0.40;
risk-free interest rate of 5.0%; expected dividend yield zero percent; expected
warrant life of four years; and current volatility of 125%.
The risk-free rate is based on the U.S. Treasury yield curve in effect at the
time of grant. The Company has not paid dividends to date and does not expect to
pay dividends in the foreseeable future due to its substantial accumulated
deficit and limited capital resources. Accordingly, expected dividends yields
are currently zero. Historical cancellations and forfeitures of stock options
granted through December 31, 2004 have been insignificant. However, the
Company's operations and the nature of its business changed substantially.
23
Accordingly, the Company considers more recent data relating to employee
turnover rates to be indicative of future vesting. Based on available data, the
Company has assumed that approximately 84% of outstanding options will vest
annually. No options have been exercised to date. The Company will prospectively
monitor employee terminations, exercises and other factors that could affect its
expectations relating to the vesting of options in future periods. The Company
will adjust its assumptions relating to its expectations of future vesting and
the terms of options at such times that additional data indicates that changes
in these assumptions are necessary. Expected volatility is principally based on
the historical volatility of the Company's stock.
A summary of option activity for the three months ended March 31, 2007 is as
follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
EXERCISE CONTRACTUAL
OPTIONS SHARES PRICE TERM
---------------------------------- ---------------- ------------- --------------
Outstanding at January 1, 2007 532,636 $16.34 6.5 years
---------------------------------- ---------------- ------------- --------------
Granted 5,270,553 $ 0.40
---------------------------------- ---------------- ------------- --------------
Exercised -- --
---------------------------------- ---------------- ------------- --------------
Forfeited or expired (28,669) $ 9.48
---------------------------------- ---------------- ------------- --------------
Outstanding at March 31, 2007 5,774,520 $ 1.83 9.5 years
---------------------------------- ---------------- ------------- --------------
Exercisable at March 31, 2007 1,546,692 $ 5.47 8.8 years
---------------------------------- ---------------- ------------- --------------
At March 31, 2007, the aggregate intrinsic value of options outstanding and
options exercisable, based on the March 30, 2007 closing price of the Company
common stock ($0.55 per share) amounted to $800,583 and $222,274, respectively.
In addition the table includes 206,670 fully vested and non-forfeitable stock
options outstanding that it issued to non-employees through March 31, 2007. As
of March 31, 2007, these options have a weighted average exercise price of
$13.77, weighted average remaining contractual term of 5.1 years and an
aggregate intrinsic value of $0. The fair value of the unvested portion of stock
options at March 31, 2007 is $1,677,013 with a weighted-average remaining
vesting period of 3.6 years.
The weighted-average grant-date fair value of the 5,270,553 stock options
granted during the three month period ended March 31, 2007 amounted to
$1,707,659 or $0.32 per share. There have also not been any exercises of stock
options to date. The total fair value of options vested during the three months
ended March 31, 2007 amounted to $430,303. Additionally, the Company did not
capitalize the cost associated with stock based compensation.
Aggregate stock based compensation to employees and non employees amounted to
$430,809 for the three months ended March 31, 2007.
NOTE 19 - DISCONTINUED OPERATIONS
LucidLine, Inc. ("LucidLine") was a provider of bundled and branded high speed
Internet access and synchronized remote data back-up, retrieval, and restoration
services. The acquisition of LucidLine was intended to supply the expertise to
establish the homeland security architecture, the risk and vulnerability
assessment evaluation services and the development and operation of the homeland
security data center solutions necessary to implement our former business plan
to offer model homeland security architecture with state-of-the-art prevention,
response and information management capabilities. The Company was unable to find
any parties interested in its homeland security data center solutions, its risk
and vulnerability assessment services and its homeland security architecture
business. The Company decided in the first quarter of 2006 to sell the LucidLine
business.
On April 18, 2006, the Company entered into a Stock Purchase Agreement with
Walnut Valley, Inc., pursuant to which the Company sold all of the outstanding
shares of LucidLine to Walnut Valley, Inc. in consideration for a cash payment
of $25,000 and the issuance of a Promissory Note in the principal amount of
$25,000 by Walnut Valley in favor of the Company.
24
JANUARY 1, 2006
THROUGH
MARCH 31, 2006
---------------
Revenue .................................................... $ 99,167
Cost of Sales .............................................. 91,601
---------------
Gross Profit ............................................ 7,566
Operating expenses ......................................... 111,992
---------------
Loss from operations .................................... (104,426)
Other expense .............................................. (538)
---------------
Loss before income taxes ................................ (104,964)
Income taxes ............................................... --
---------------
Net loss ................................................ $ (104,964)
===============
During December 2006, the Company made an affirmative decision to exit and
actively pursue a plan to sell its PolicyBridge software product business. As a
result of this decision, the Company has classified its PolicyBridge software
product business as a discontinued operation in its financial statements as of
March 31, 2007 and 2006 in accordance with SFAS 144. While management continues
to search for a buyer of this business, the Company will continue to provide
services under the existing maintenance and support agreements to its
PolicyBridge customers.
THREE MONTHS ENDED
MARCH 31, 2007 MARCH 31, 2006
-------------- --------------
Revenue ..................................... $ 61,751 $ 81,860
Cost of Sales ............................... -- 34,147
-------------- --------------
Gross Profit ............................. 61,751 47,713
Operating expenses .......................... 57,210 330,292
-------------- --------------
Gain (loss) from operations ................ 4,541 (282,579)
Other income/(expense)
-------------- --------------
Income (loss) before income taxes ........ 4,541 (282,579)
Income taxes ................................ -- --
-------------- --------------
Net income (loss) ........................ $ 4,541 $ (282,579)
============== ==============
NOTE 20 - SUBSEQUENT EVENTS
ENGAGEMENT OF FIRST ANALYSIS SECURITIES CORPORATION
On April 18, 2007, the Company announced that it has entered into an agreement
with First Analysis Securities Corporation ("FASC"), a research-driven
investment bank, to provide strategic counsel on identifying acquisition targets
and support for future capital raising activities. FASC shall be paid a $20,000
per month fee. In the event that FASC facilitates i) an equity, debt or other
capital investment in the Company by a third party; facilitates an alliance,
partnership, joint venture or other related event with a third party; or ii) a
merger, combination, reorganization, recapitalization, business combination, or
the purchase of all or substantially all of the assets of the Company by a third
party, then a cash transaction fee shall be paid equal to 6% of the transaction
value as defined in the agreement or $300,000 whichever is greater upon the
closing of a transaction. FASC shall be paid an Alliance Fee if FASC facilitates
an alliance, partnership, joint venture or other related event which generates
at least $2 million in additional revenues for the Company, warrants with a
value of $300,000 shall be issued to FASC.
MODIFICATION OF THE CERTIFICATE OF DESIGNATION OF THE SERIES A PREFERRED STOCK
AND THE SERIES B PREFERRED STOCK
On April 12, 2007, the Board of Directors approved the amendment of each of the
Certificate of Designation of Preferences, Rights and Limitations of Series A
Convertible Preferred Stock and Series A-1 Convertible Preferred Stock of Patron
Systems, Inc. (the "Series A Certificate of Designation"), and the Certificate
of Designation of Preferences, Rights and Limitations of Series B Convertible
Preferred Stock of Patron Systems, Inc. (the "Series B Certificate of
Designation" and together with the Series A Certificate of Designation, the
"Certificates of Designation"), to remove the limitation on the Company's
ability to issue funded debt over $1,000,000. On May 1,
25
2007, the Board of Directors approved the amendment of the Series A Certificate
of Designation to increase the limitation on the Company's ability to issue
funded debt to a limit of $3,000,000 from the current limit of $1,000,000.
MODIFICATION OF THE CERTIFICATE OF DESIGNATION OF THE SERIES B PREFERRED STOCK
On May 2, 2007, the Company filed with the Secretary of State of Delaware a
Certificate of Amendment of the Series B Certificate of Designation. On May 8,
2007 the Company filed a Certificate of Correction with the Secretary of State
of Delaware to correct an error in the previously filed Certificate of Amendment
of the Series B Certificate of Designation. The Amended Series B Certificate of
Designation removes the limitation on the Company's ability to issue funded debt
over $1,000,000.
ADDITIONAL ADVANCES UNDER THE 2007 INTERIM BRIDGE FINANCING
On April 4, 2007, April 19, 2007 and May 7, 2007 the Company was advanced
$168,000, $99,000, and $150,000 respectively, from Apex under the 2007 Interim
Bridge Financing (Note 8). In conjunction with the April 4, 2007 advance, the
Company issued to Apex 168,000 common stock purchase warrants at an exercise
price of $0.69 per share. In conjunction with the April 19, 2007 advance, the
Company issued to Apex 99,000 common stock purchase warrants at an exercise
price of $0.94 per share. In conjunction with the May 7, 2007 advance, the
Company issued to Apex 150,000 common stock purchase warrants at an exercise
price of $1.25 per share. These warrants have a term of 5 years.
26
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
PATRON SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
MARCH 31, 2007
The following discussion and analysis should be read in conjunction with the
Annual Report on Form 10-KSB, including the financial statements, and the
related notes thereto, for the year ended December 31, 2006 of Patron Systems,
Inc. (collectively referred to as "Patron," the "Company," "we," "us," or
"our"). Except for historical information contained herein, the matters
discussed below are forward-looking statements made pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. Such
statements involve risks and uncertainties, including, but not limited to,
economic, governmental, political, competitive and technological factors
affecting our operations, markets, products, prices and other factors discussed
elsewhere in this report and other reports filed by us with the Securities and
Exchange Commission ("SEC"). These factors may cause results to differ
materially from the statements made in this report or otherwise made by or on
our behalf.
OVERVIEW
From our inception through December 31, 2004, we were principally engaged in
developing our business plan, raising capital, identifying merger and
acquisition candidates and negotiating merger and acquisition transactions that
we closed during the first quarter of 2005.In 2005, we consummated the
acquisitions of Complete Security Solutions, Inc. ("CSSI") and LucidLine, Inc.
("LucidLine") and Entelagent Software Corp. ("Entelagent"). In April 2006,
LucidLine was sold and is classified as a discontinued operation for 2006. In
December 2006, management decided to exit the PolicyBridge business which was
acquired in the Entelagent acquisition and these assets and liabilities are held
for sale at March 31, 2007.
Patron Systems, Inc. provides application software and services focused on
business process management (BPM) in the public sector. Our current application
software offering, FormStream, is an open standards information sharing tool
that addresses the need for law enforcement and public safety agencies to share
information between local, state and federal law enforcement and homeland
security agencies. FormStream is a mobile electronic forms (e-forms) application
which provides a highly scalable, open standard, network independent method for
the distribution and synchronization of e-forms to mobile devices. The
implementation of FormStream allows its user agencies to update and modernize
their business processes to utilize the sophisticated form and user based
business rules and process routing capabilities of FormStream to increase
officer and supervisor productivity, increase officer availability in the field,
reduce back-office workloads involved with entry of data and review of data
entered, provide real-time information sharing of field generated reports and
other field generated information to officers and users within the agency(s)
served by a particular FormStream installation and provide the ability for an
agency to meet the federally mandated requirements to provided police reports
and other information to the state and federal governments in standard formats
for information sharing purposes. FormStream addresses mobile e-form creation,
capture and sharing over wireless networks and manages data in industry standard
formats (forms: .pdf, XDP and XML; law enforcement: Global Justice XML data
model (GJXDM) and National Information Exchange Model (NIEM)).
By improving the information flow and the business processes within law
enforcement and public safety agencies, FormStream allows these agencies to much
more cost effectively serve their constituents and provide improved local law
enforcement as well as enhanced local, regional and national homeland security.
27
CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to exercise its judgment. We exercise considerable judgment
with respect to establishing sound accounting polices and in making estimates
and assumptions that affect the reported amounts of our assets and liabilities,
our recognition of revenues and expenses, and disclosures of commitments and
contingencies at the date of the financial statements.
On an ongoing basis, we evaluate our estimates and judgments. Areas in which we
exercise significant judgment include, but are not necessarily limited to, our
valuation of accounts receivable, recoverability of long-lived assets, income
taxes, equity transactions (compensatory and financing) and contingencies. We
have also adopted certain polices with respect to our recognition of revenue
that we believe are consistent with the guidance provided under Securities and
Exchange Commission Staff Accounting Bulletin No. 104 and estimate values of
delivered and undelivered elements.
We base our estimates and judgments on a variety of factors including our
historical experience, knowledge of our business and industry, current and
expected economic conditions, the composition of our products, regulatory
environment, and in certain cases, the results of outside appraisals. We
constantly re-evaluate our estimates and assumptions with respect to these
judgments and modify our approach when circumstances indicate that modifications
are necessary.
While we believe that the factors we evaluate provide us with a meaningful basis
for establishing and applying sound accounting policies, we cannot guarantee
that the results will always be accurate. Since the determination of these
estimates requires the exercise of judgment, actual results could differ from
such estimates.
A description of significant accounting polices that require us to make
estimates and assumptions in the preparation of our consolidated financial
statements are as follows:
ACCOUNTS RECEIVABLE AND REVENUE RECOGNITION
We derive our revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) professional consulting services.
We apply the revenue recognition principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff Accounting Bulletin ("SAB") 104 "Revenue Recognition" with
respect to its revenue. Accordingly, we record revenue when (i) persuasive
evidence of an arrangement exists, (ii) delivery has occurred, (iii) the
vendor's fee is fixed or determinable, and (iv) collectability is reasonably
assured.
We also accrue unbilled revenue under software licenses and services delivered
under contractual arrangements which provide for billings to be made at
intervals that may differ from the periods of delivery or performance.
We generate revenues through sales of software licenses and annual support
subscription agreements, which include access to technical support and software
updates (if and when available). Software license revenues are generated from
licensing the rights to use products directly to end-users and through third
party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of our software sales are supported by a
written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post-contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by
28
an authorized level of management, if it is probable that the price, once
established, will not change before market introduction. We use the residual
method prescribed in SOP 98-9, "Modification of SOP 97-2, Software Revenue
Recognition With Respect to Certain Transaction" to allocate revenues to
delivered elements once it has established vendor-specific objective evidence of
fair value for such undelivered elements.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.
We adjust our accounts receivable balances that we deem to be uncollectible. The
allowance for doubtful accounts is our best estimate of the amount of probable
credit losses in our existing accounts receivable. We review our allowance for
doubtful accounts on a monthly basis to determine the allowance based on an
analysis of its past due accounts. All past due balances that are over 90 days
are reviewed individually for collectability. Account balances are charged off
against the allowance after all means of collection have been exhausted and the
potential for recovery is considered remote. An allowance for doubtful accounts
is not provided because in our opinion, all accounts recorded are deemed to be
collectible.
INCOME TAXES
We are required to determine the aggregate amount of income tax expense or loss
based upon tax statutes in jurisdictions in which we conduct business. In making
these estimates, we adjust our results determined in accordance with generally
accepted accounting principles for items that are treated differently by the
applicable taxing authorities. Deferred tax assets and liabilities, as a result
of these differences, are reflected on our balance sheet for temporary
differences loss and credit carry forwards that will reverse in subsequent
years. We also establish a valuation allowance against deferred tax assets when
it is more likely than not that some or all of the deferred tax assets will not
be realized. Valuation allowances are based, in part, on predictions that
management must make as to our results in future periods. The outcome of events
could differ over time which would require us to make changes in our valuation
allowance.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and
SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142,
goodwill and intangibles that are deemed to have indefinite lives are no longer
amortized but, instead, are to be reviewed at least annually for impairment.
Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assigning assets and liabilities to reporting
units, assigning goodwill to reporting units, and determining the fair value.
Significant judgments required to estimate the fair value of reporting units
include estimating future cash flows, determining appropriate discount rates and
other assumptions. Changes in these estimates and assumptions could materially
affect the determination of fair value and/or goodwill impairment. In accordance
with SFAS 142, we conducted our annual impairment review of goodwill for the
year ended December 31, 2006, which resulted in a goodwill impairment charge of
$210,716. This 2006 charge, which principally represents goodwill remaining from
the PolicyBridge business we acquired from Entelagent is classified in
discontinued operations as a result of our decision to exit that business. The
remaining amount of goodwill, which amounts to $9,300,000 at March 31, 2007,
relates to our acquisition of CSSI in February 2005 from which we acquired the
FormStream software technology, our sole line of business. We engaged an outside
specialist to assist us with performing our annual goodwill impairment tests.
These tests were made using a discounted cash flow model to value the business.
This approach requires us to forecast our expectation of revenues and cash flows
in future periods and to work with an independent specialist on developing
assumptions relating to the risk that such cash flows may or may not materialize
in future periods.
SHARE BASED PAYMENTS AND OTHER EQUITY TRANSACTIONS
Effective January 1, 2006, we adopted SFAS No. 123R "Share Based Payment." This
statement is a revision of SFAS Statement No. 123, and supersedes APB Opinion
No. 25, and its related implementation guidance. SFAS 123R addresses all forms
of share based payment ("SBP") awards including shares issued under employee
stock purchase plans, stock options, restricted stock and stock appreciation
rights. Under SFAS 123R, SBP awards result in a cost that is measured at fair
value on the awards' grant date, based on the estimated number of awards that
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are expected to vest. We adopted the modified prospective method with respect to
accounting for our transition to SFAS 123(R) and measured unrecognized
compensation cost. Under this method of accounting, we are required to estimate
the fair value of share based payments that we make to our employees by
developing assumptions regarding expected holding terms of stock options,
volatility rates and expectation of forfeitures and future vesting that can
significantly impact the amount of compensation cost that we recognize in each
reporting period.
We are also required to apply complex accounting principles with respect to
accounting for financing transactions that we have consummated in order to
sustain our business. These transactions, which generally consist of convertible
debt and equity instruments, require us to use significant judgment in order to
assess the fair values of these instruments at their dates of issuance, which is
critical to making a reasonable presentation of our financing costs and how we
finance our business.
Formulating estimates in any of the above areas requires us to exercise
significant judgment. It is at least reasonably possible that the estimates of
the effect on the financial statements of a condition, situation, or set of
circumstances that existed at the date of the financial statements that we
considered in formulating our estimates could change in the near term due to one
or more future confirming events. Accordingly, the actual results regarding
estimates of any of the above items as they are presented in the financial
statements could differ materially from our estimates.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2007 COMPARED TO THE THREE MONTHS ENDED MARCH 31,
2006.
For the three months ended March 31, 2007, our revenues amounted to $171,218
compared to $179,925 for the three months ended March 31, 2006.
Cost of Sales for the three months ended March 31, 2007 amounted to $64,635
compared to $57,419 for the three months ended March 31, 2006. Cost of sales
during the three months ended March 31, 2007 and March 31, 2006 includes $27,015
and $27,522, respectively, associated with the amortization of developed
technology.
Operating expenses amounted to $1,774,031 for the three months ended March 31,
2007 as compared to $754,385 for the three months ended March 31, 2006, an
increase of $1,019,646. The increase in operating expenses includes an increase
of approximately $250,000 for employee stock option compensation expense, an
increase of approximately $401,000 associated with increased staffing in the
Company's engineering, support and professional services functions and a
increase of approximately $907,000 associated with the 2006 gain associated with
the settlements under the creditor and claimant liabilities restructuring
program. These increases were offset by approximately $83,000 for reduced
salaries associated with a reduction in the number of employees, primarily in
general and administrative functions, an approximately $3,000 reduction in
expense associated with stock based penalties under financing arrangements and
an approximately $453,000 reduction in legal and professional fees.
Our loss from continuing operations for the three months ended March 31, 2007
amounted to $2,162,583 compared to a loss of $1,604,281 for the same period in
2006. Our loss increased as a result of the increased operating expenses and the
non-recurrence of settlement gains.
Interest expense during the three months ended March 31, 2007 amounted to
$505,925 as compared to $972,464 for the three months ended March 31, 2006. The
reduction is principally related to the issuance, in the three months ended
March 31, 2006, of the Bridge III Notes and the associated amortization of
deferred financing costs and the accretion of debt discounts incurred with that
financing being incurred in the three months ended March 31, 2007 at a reduced
total expense associated with the 2007 Interim Bridge Financing. Additionally,
the interest expense associated with the outstanding Acquisition Notes and the
Bridge I, Bridge II and Bridge III Notes in the three months ended March 31,
2006 was reduced with the exchange of a substantial portion of these notes for
Series A-1 Preferred Stock. Non-cash interest relating to the amortization of
deferred financing costs, valuation of a derivative conversion option and the
accretion of debt discounts during the three months ended March 31, 2007
amounted to $458,345 compared to $303,038 in the same period in 2006.
Amortization of deferred finance charges which have been classified as interest
expense was $0 in the three months ended March 31, 2007 compared to $282,129 in
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the same period in 2006. Accretion of debt discounts during the three months
ended March 31, 2007 were $163,759 compared to $20,909 in the same period in
2006. The change in the fair value of the derivative conversion option,
presented in the statement of operations for the three months ended March 31,
2007 amounted to $8,712. The Company did not have any free standing derivatives
requiring liability classification and periodic adjustment to market value
outstanding during the three months ended March 31, 2006. Interest income, was
$2,120 and $0 in the three months ended March 31, 2007 and 2006, respectively.
During the three months ended March 31, 2007, the Company's contractual
dividends on its Series A Preferred and Series B Preferred was $216,325.
For the three months ended March 31, 2007, the net loss available to common
stockholders was $2,374,367 or $(0.16) per share on 14,512,260 weighted average
common shares outstanding compared to a net loss available to common
stockholders of $1,991,824 or $(0.96) per share on 2,083,954 weighted average
common shares outstanding for the three months ended March 31, 2006.
LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss from continuing operations of $2,162,583 for the three
months ended March 31, 2007, which includes $931,510 of non-cash charges
including non-cash charges associated with the accretion related to warrants
issued in conjunction with notes payable ($458,345), depreciation and
amortization ($51,026), a charge for stock option based compensation ($430,809)
and a gain on the derivative conversion liability valuation of $8,712. Including
the amounts above, we used net cash in our operating activities of $944,686
during the three months ended March 31, 2007. Our working capital deficiency at
March 31, 2007 amounts to $4,386,561and we are continuing to experience
shortages in working capital. We cannot provide any assurance that the outcome
of these matters will not have a material adverse affect on our ability to
sustain the business. These matters raise substantial doubt about our ability to
continue as a going concern.
We expect to continue incurring losses for the foreseeable future due to the
inherent uncertainty that is related to establishing the commercial feasibility
of technological products and developing a presence in new markets. The Company
raised $625,000 of bridge financing through issuance of secured demand notes
during the three months ended March 31, 2007 The Company used $510,031 of these
proceeds to fund its operations and a net of $114,969 in investing activities.
We are currently in the process of attempting to raise additional capital and
have taken certain steps to conserve our liquidity. Subsequent to March 31,
2007, the Company has been advanced an additional $417,000 under the 2007
Interim Bridge Financing. Although we believe that we have access to capital
resources, we have not secured any commitments for additional financing at this
time nor can we provide any assurance that we will be successful in our efforts
to raise additional capital and/or successfully execute our business plan.
OFF-BALANCE SHEET ARRANGEMENTS
At March 31, 2007, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, variable interest or special purpose entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. As such, we are
not exposed to any financing, liquidity, market or credit risk that could arise
if we had engaged in such relationships.
CAUTIONARY STATEMENTS AND RISK FACTORS
The risks noted below and elsewhere in this report and in other documents we
file with the SEC are risks and uncertainties that could cause our actual
results to differ materially from the results contemplated by the
forward-looking statements contained in this report and other public statements
we make.
31
RISKS RELATED TO OUR COMMON STOCK
THERE IS SUBSTANTIAL DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
may become insolvent. As of March 31, 2007, our cash balance was $120,004 and we
had a working capital deficit of $4,386,561. This raises substantial doubt about
our ability to continue as a going concern. Historically, we have funded our
capital requirements with debt and equity financing. Our ability to obtain
additional equity or debt financing depends on a number of factors including our
financial performance and the overall conditions in our industry. If we are not
able to raise additional financing or if such financing is not available on
acceptable terms, we may liquidate assets, seek or be forced into bankruptcy,
and/or continue operations but suffer material harm to our operations and
financial condition. These measures could have a material adverse affect on our
ability to continue as a going concern.
We have restructured approximately $24.5 million of our previously outstanding
claims, liabilities, demands, causes of action, costs, expenses, attorneys'
fees, damages, indemnities, and obligations of every kind and nature that
certain creditors and claimants had with us pursuant to our creditor and
claimant liabilities restructuring described elsewhere in this annual report. We
are currently unable to provide assurance that the acceptance of the creditor
and claimant liabilities restructuring will actually improve our ability to fund
the further development of our business plan or improve our operations. Our
failure to fund the further development of our business plan and operations
would materially adversely affect our ability to continue as a going concern.
INVESTORS MAY NOT BE ABLE TO ADEQUATELY EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR LIMITED OPERATING HISTORY, LACK OF REVENUES AND LACK OF PRODUCT
OFFERINGS.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. We were incorporated in Delaware in
2002. Significant business operations only began with the acquisitions completed
in February and March 2005. As a result of our limited history, it may be
difficult to plan operating expenses or forecast our revenues accurately. Our
assumptions about customer or network requirements may be wrong. The revenue and
income potential of these products is unproven, and the markets addressed by
these products are volatile. If such products are not successful, our actual
operating results could be below our expectations and the expectations of
investors and market analysts, which would likely cause the price of our common
stock to decline.
We have generated limited revenues and have relied on financing generated from
our capital raising activities to fund the implementation of our business plan.
We have incurred operating and net losses and negative cash flows from
operations since our inception. As of March 31, 2007, we had an accumulated
deficit of approximately $98.6 million. We may continue to incur operating and
net losses, due in part to implementing our acquisitions strategy, engaging in
financing activities and expansion of our personnel and our business development
capabilities. We will continue to seek financing for the acquisition of other
acquisition targets that we may identify in the future. We continue to believe
that we will secure financing in the near future, but there can be no assurance
of our success. If we are unable to obtain the necessary funding, it will
materially adversely affect our ability to execute our business plan and to
continue our operations.
In addition, we may not be able to achieve or maintain profitability, and, even
if we do achieve profitability, the level of any profitability cannot be
predicted and may vary significantly from quarter to quarter.
THE AUTOMATIC CONVERSION OF OUR SERIES A-1 PREFERRED STOCK HAS RESULTED IN
SIGNIFICANT DILUTION TO OUR EXISTING STOCKHOLDERS AND A CHANGE IN CONTROL OF OUR
COMPANY, AND COULD ALSO RESULT IN ADDITIONAL VOLATILITY IN THE PRICE OF OUR
COMMON STOCK.
The automatic conversion of our Series A-1 Preferred Stock on July 31, 2006
resulted in significant dilution to our existing stockholders and resulted in
our former creditors and claimants owning approximately 85.0% of our outstanding
shares of common stock. These creditors and claimants, to the extent they act in
concert, would be able to determine all actions brought before our stockholders.
As a result of the automatic conversion of our Series A-1 Preferred Stock, each
32
of Per Gustafsson, Arco van Nieuwland and Sherleigh Associates, Inc. Profit
Sharing Plan became greater than five percent beneficial owners of our common
stock.
Upon the registration of the shares of common stock issued upon the conversion
of our Series A-1 Preferred Stock, there will be a substantial amount of shares
eligible for sale in the public market. If former holders of our Series A-1
Preferred Stock decide to sell their shares of registered stock, such sales
could result in significant volatility in the market price of our common stock
and would likely cause the market price of our common stock to decline.
THERE CAN BE NO GUARANTY THAT A MARKET WILL DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.
We currently have a limited offering of products. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH MAY RESULT IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate fluctuations, could also cause the market price of our common stock to
decline. Our common stock has experienced, and is likely to continue to
experience, these fluctuations in price, regardless of our performance.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of May 4, 2007, there were 14,512,260
shares of common stock outstanding, of which 1,365,601 shares were beneficially
held by directors, executive officers and other affiliates, the sale of which
are subject to volume limitations under Rule 144, various vesting agreements and
our quarterly and other "blackout" periods. Furthermore, shares subject to
outstanding options and warrants and shares reserved for future issuance under
our stock option plan will become eligible for sale in the public market to the
extent permitted by the provisions of various vesting agreements, the lock-up
arrangements and Rule 144 under the Securities Act.
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
33
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
o the demand for our subsidiaries' current product offerings and our
future products;
o the length of sales cycles;
o the timing of recognizing revenues;
o new product introductions by us or our competitors;
o changes in our pricing policies or the pricing policies of our
competitors;
o variations in sales channels, product costs or mix of products sold;
o our ability to develop, introduce and ship in a timely manner new
products and product enhancements that meet customer requirements;
o our ability to obtain sufficient supplies of sole or limited source
components for our products;
o variations in the prices of the components we purchase;
o our ability to attain and maintain production volumes and quality
levels for our products at reasonable prices at our third-party
manufacturers;
o our ability to manage our customer base and credit risk and to collect
our accounts receivable; and
o the financial strength of our value-added resellers and distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses.
OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES. THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.
If at any time a company has net tangible assets of $5,000,000 or less and the
common stock has a market price per share of less than $5.00, transactions in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:
o make a special written suitability determination for the purchaser;
o receive the purchaser's written agreement to a transaction prior to
sale;
o provide the purchaser with risk disclosure documents which identify
certain risks associated with investing in "penny stocks" and which
describe the market for these "penny stocks" as well as a purchaser's
legal remedies; and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the required
risk disclosure document before a transaction in a "penny stock" can be
completed.
As our common stock is subject to these rules, broker-dealers may find it
difficult to effectuate customer transactions and trading activity in our
securities may be adversely affected. As a result, the market price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.
RISKS RELATED TO OUR BUSINESS
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. To date we have experienced delays
in implementing our business plan as a result of limited capital resources,
which have had a material adverse effect on our business. Further delays in the
process of integrating could cause an interruption of, or loss of momentum in,
the activities of our business and the loss of key personnel. The diversion of
management's attention and any delays or difficulties encountered in connection
with our integration of acquired operations could have an adverse effect on our
business, results of operations, financial condition or prospects.
34
WE CURRENTLY DO NOT HAVE SUFFICIENT REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES
AND IF OPERATING LOSSES CONTINUE, WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL
THROUGH FINANCINGS WHICH WE MAY NOT BE ABLE TO SECURE.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like ours, remains
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Our inability to
obtain additional financing may require us to delay, scale back or eliminate
certain of our growth plans which could have a material and adverse effect on
our business, financial condition or results of operations or could cause us to
cease operations. Even if we are able to obtain additional financing, such
financing could be structured as equity financing that would dilute the
ownership percentage of any investor in our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for our current products and other products we intend to offer
depends on economic conditions affecting the broader Internet infrastructure,
network security and related markets. Downturns in these markets may cause
enterprises and carriers to delay or cancel security projects, reduce their
overall or security-specific information technology budgets or reduce or cancel
orders for our current products and other products we intend to offer. In this
environment, customers such as distributors, value-added resellers and carriers
may experience financial difficulty, cease operations and fail to budget or
reduce budgets for the purchase of our current products or other products we
intend to offer. This, in turn, may lead to longer sales cycles, delays in
purchase decisions, payment and collection, and may also result in price
pressures, causing us to realize lower revenues, gross margins and operating
margins. In addition, general economic uncertainty caused by potential
hostilities involving the United States, terrorist activities, the decline in
specific markets such as the service provider market in the United States, and
the general decline in capital spending in the information technology sector
make it difficult to predict changes in the purchase and network requirements of
our potential customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on information technology. A decline in capital spending in the markets we
intend to serve may adversely affect our future revenues, gross margins and
operating margins and make it necessary for us to gain significant market share
from our future competitors in order to achieve our financial goals and achieve
profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we currently offer or intend to
offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we have. In addition, some
of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we currently offer and intend to offer. If any of our larger
potential competitors were to commit greater technical, sales, marketing and
other resources to the markets we intend to serve, or reduce prices for their
products over a sustained period of time, our ability to successfully sell the
products we intend to offer, increase revenue or meet our or market analysts
expectations could be adversely affected.
35
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced
security capabilities into our intended product offerings. Some of these
products and enhancements may require us to develop new hardware architectures
that involve complex and time consuming processes. In developing and introducing
our intended product offerings, we have made, and will continue to make,
assumptions with respect to which features, security standards and performance
criteria will be required by our potential customers. If we implement features,
security standards and performance criteria that are different from those
required by our potential customers, market acceptance of our intended product
offerings may be significantly reduced or delayed, which would harm our ability
to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer deployments and, as a consequence, our revenues may be adversely
affected. In addition, the introduction of products embodying new technologies
could render existing products we intend to offer obsolete, which would have a
direct, adverse effect on our market share and revenues. Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating results to be below our expectations
and the expectations of investors and market analysts, which would likely cause
the price of our common stock to decline.
WE HAVE EXPERIENCED ISSUES WITH OUR FINANCIAL SYSTEMS, CONTROLS AND OPERATIONS
THAT COULD HARM OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. Through
the quarter ended March 31, 2007, our Chief Executive Officer and Chief
Financial Officer evaluated the effectiveness of our disclosure controls and
procedures in accordance with Exchange Act Rules 13a-15 or 15d-15 and identified
material weaknesses in our internal controls. These material weaknesses related
to the fact that that our overall financial reporting structure and current
staffing levels were not sufficient to support the complexity of our financial
reporting requirements. We currently lack the expertise we need to apply complex
accounting principles relating to our business combinations and equity
transactions and have experienced difficulty in applying income tax accounting
principles. Although we have taken steps to correct these previous deficiencies,
including the hiring of a Chief Financial Officer, and are currently in
compliance with the SEC's reporting requirements, additional time is still
required to test and document our internal and disclosure control processes to
ensure their operating effectiveness. In addition, we have limited capital
resources and are still at risk for the loss of key personnel in our finance
department. The loss of key personnel in our finance department, or any other
conditions that could disrupt our operations in this area, could have a material
adverse affect on our ability to communicate critical information to management
and our investors, raise capital and/or maintain compliance with our SEC
reporting obligations. These circumstances, if they arise, could have a material
adverse affect on our business.
We have limited management resources to date and are still establishing our
management and financial systems. Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
WE MAY NOT BE ABLE TO IMPLEMENT SECTION 404 OF THE SARBANES-OXLEY ACT ON A
TIMELY BASIS.
36
The SEC, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted
rules generally requiring each public company to include a report of management
on the company's internal controls over financial reporting in its annual report
on Form 10-KSB that contains an assessment by management of the effectiveness of
the company's internal controls over financial reporting beginning in the year
ended December 31, 2007. In addition, the company's independent registered
accounting firm must attest to and report on management's assessment of the
effectiveness of the company's internal controls over financial reporting. This
requirement will first apply to our annual report on Form 10-KSB for the fiscal
year ending December 31, 2008. We have not yet developed a Section 404
implementation plan. We have in the past discovered, and may in the future
discover, areas of our internal controls that need improvement. How companies
should be implementing these new requirements including internal control reforms
to comply with Section 404's requirements and how independent auditors will
apply these requirements and test companies' internal controls, is still
reasonably uncertain. We expect that we may need to hire and/or engage
additional personnel and incur incremental costs in order to complete the work
required by Section 404. We can not guarantee that we will be able to complete a
Section 404 plan on a timely basis. Additionally, upon completion of a Section
404 plan, we may not be able to conclude that our internal controls are
effective, or in the event that we conclude that our internal controls are
effective, our independent accountants may disagree with our assessment and may
issue a report that is qualified. Any failure to implement required new or
improved controls, or difficulties encountered in their implementation, could
negatively affect our operating results or cause us to fail to meet our
reporting obligations.
IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Our future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not interoperate with those within our end customers' networks,
installations could be delayed or orders for our products could be cancelled,
which could significantly reduce our anticipated revenues.
AS A PUBLIC COMPANY, WE MAY INCUR INCREASED COSTS AS A RESULT OF RECENTLY
ENACTED AND PROPOSED CHANGES IN LAWS AND REGULATIONS RELATING TO CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.
Recently enacted and proposed changes in the laws and regulations affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased costs for us as we
evaluate the implications of these laws, regulations and standards and respond
to their requirements. In addition, we will become subject to the internal
control reporting requirement specified in Section 404 of the Sarbanes-Oxley Act
of 2002 beginning in the year ended December 31, 2007, which will require us to
expend substantial financial resources in order to become compliant with these
requirements. These laws and regulations could make it more difficult or more
costly for us to obtain certain types of insurance, including director and
officer liability insurance, and we may be forced to accept reduced policy
limits and coverage or incur substantially higher costs to obtain the same or
similar coverage. The impact of these events could also make it more difficult
for us to attract and retain qualified persons to serve on our board of
directors, board committees or as executive officers. We cannot estimate the
amount or timing of additional costs we may incur as a result of these laws and
regulations.
WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY
CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR RETAIN
EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
Our future success depends upon the continued services of our executive
officers. The loss of the services of any of our key employees, the inability to
attract or retain qualified personnel in the future, or delays in hiring
37
required personnel, could delay the development and introduction of, and
negatively impact our ability to sell, our intended product offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
o stop or delay selling, incorporating or using products that use the
challenged intellectual property; and/or
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology, which license might not
be available on reasonable terms or at all; or redesign the products
that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
OUR INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. Our inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and
domestic sales. The United States and various foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies, especially encryption technology. In addition, from time
to time, governmental agencies have proposed additional regulation of encryption
technology, such as requiring the escrow and governmental recovery of private
encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might
38
decrease demand for our intended product offerings and services. In addition,
some foreign competitors are subject to less stringent controls on exporting
their encryption technologies. As a result, they may be able to compete more
effectively than we can in the domestic and international network security
market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES
Members of Company management, including the Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness of our disclosure controls and
procedures, as defined by paragraph (e) of Exchange Act Rules 13(a)-15 or
15(d)-15 for the three months ended March 31, 2007, the period covered by this
report. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of March 31, 2007 the Company's disclosure
controls and procedures were not effective.
DISCLOSURE CONTROLS AND INTERNAL CONTROLS
Disclosure controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934, as amended, such as this Report, is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Disclosure controls are also designed with the
objective of ensuring that such information is accumulated and communicated to
our management, including our Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure. Internal controls are procedures which are designed with the
objective of providing reasonable assurance that our transactions are properly
authorized, recorded and reported and our assets are safeguarded against
unauthorized or improper use, to permit the preparation of our financial
statements in conformity with generally accepted accounting principles.
Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not required to deliver management's report on control over our
financial reporting until our year ended December 31, 2007. Nevertheless, we
identified certain matters that constitute material weakness (as defined under
the Public Company Accounting Oversight Board Auditing Standard No. 2) in our
internal controls over financial reporting.
In previous periods, we reported that we had identified certain matters that
constituted material weakness (as defined under the Public Company Accounting
Oversight Board Auditing Standard No. 2) in our internal controls over financial
reporting. The material weaknesses that we identified related to the fact that
that our overall financial reporting structure and current staffing levels were
not sufficient to support the complexity of our financial reporting
requirements. We currently lack the expertise we need to apply complex
accounting principles relating to our business combinations and equity
transactions and have experienced difficulty in applying income tax accounting
principles. As a result, our internal controls have not reduced to a reasonably
low level, the risk of material misstatement to our financial statements. We
also, until recently, lacked the structure we needed to ensure the timely filing
of our tax returns.
Although we believe that we have made various improvements in our financial
reporting processes additional time is still required to test and document our
internal and disclosure control processes to ensure their operating
effectiveness. As a result, our internal controls have not reduced to a
reasonably low level, the risk of material misstatement to our financial
statements.
On March 6, 2007, our board of directors determined that certain amounts
reported in its unaudited condensed interim financial statements for the
quarters ended March 31, 2006 and June 30, 2006, and for the six months ended
June 30, 2006 and nine months ended September 30, 2006 needed to be restated as
described below.
39
While performing their audit of our financial statements for the year ended
December 31, 2006, Marcum & Kliegman LLP ("M&K"), our independent registered
public accounting firm, discovered that the accounting for certain transactions
occurring during the quarter ended March 31, 2006 and the quarter ended June 30,
2006, may have been in error. M&K informed our management of the possible
misstatements. Upon review of these transactions our management discovered that
the accounting for these transactions resulted in a $2,408,250 overstatement of
its loss for the quarterly period ended March 31, 2006 and a $593,765
overstatement of its loss for the quarterly period ended June 30, 2006, which
also resulted in an overstatement of the year to date losses in the six and nine
month periods ended June 30, 2006 and September 30, 2006, respectively.
Specifically, we recorded for the three months ended March 31, 2006, (1) a net
loss of $858,213 on the settlement of various liabilities under our creditor and
claimant liabilities restructuring program when we should have recorded a net
gain of approximately $906,987, (2) excess non-cash interest of $358,000 with
respect to a conversion option that became effective under two of our Interim
Bridge Financing III notes and (3) charged, as interest expense, a $285,050 fee
paid to the placement agent in our Series A Preferred stock financing
transaction that should have been recorded as a reduction of the offering
proceeds. For the three months ended June 30, 2006, we recorded a net gain of
$371,616 on the settlement of various liabilities under our creditor and
claimant liabilities restructuring program when we should have recorded a net
gain of approximately $965,381. The nature of the adjustments required in the
creditor and claimant liabilities restructuring in the quarters ended March 31,
2006 and June 20, 2006, relate to an overvaluation of the Series A-1 Preferred
shares issued in the exchange offer offset by gains on the extinguishment of
liabilities that originated in connection with obligations to issue or
repurchase stock.
On May 18, 2007, our board of directors determined that certain amounts reported
in our December 31, 2006 financial statements included in form 10KSB needed to
be restated as described below.
The specific error that came to management's attention relates to our accounting
for a deemed dividend that was recognized upon a reduction in the conversion
price of our Series A Preferred Stock that occurred on November 16, 2006. The
reduction in the conversion price occurred upon our issuance of additional
convertible securities featuring a conversion price lower than the conversion
price embedded in the Series A Preferred. In calculating the deemed dividend, we
originally determined that the net loss available to our common stockholders
should be increased by $589,175, We reevaluated this computation during the
quarter ended March 31, 2007 and determined that the net loss available to our
common stockholders should have be increased by $3,759,059. The nature of the
adjustment relates to our having used an incorrect price for the value of our
common stock when we computed the intrinsic value of the conversion feature
embedded in our Series A Preferred stock at the time of the reduction in the
conversion price.
We are continuing to evaluate potential changes to make in our financial
reporting procedures to enable us to reduce financial reporting risks that exist
as a result of our limited resources. We are continuing to evaluate our risks
and resources. We will seek to make additional changes in our financial
reporting systems and procedures wherever necessary and appropriate to ensure
their effectiveness in future periods.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On May 4, 2006, we became aware that Lok Technologies, Inc. had filed a
complaint on or about March 30, 2006 against us, Entelagent Software Corp. and
unnamed defendants in the Superior Court of California, County of Santa Clara
alleging breach of contract, breach of duty of good faith and fair dealing and
unjust enrichment related to a license agreement and certain promissory notes,
and seeking damages, interest, disgorgement of any unjust enrichment, attorneys'
fees and cost in an amount to be provided. Prior to receipt of this notice of
litigation, we had recorded a note payable of approximately $320,000 plus
accrued interest of $159,432. We believe that we have defenses to these claims.
We cannot provide any assurance that the ultimate settlement of this claim will
not have a material adverse affect on our financial condition.
The Company was previously subject to an investigation by the SEC. On February
1, 2007, the Securities and Exchange Commission issued a letter to the Company
indicating that the SEC's investigation of the Company has been terminated and
that no enforcement action has been recommended to the Commission.
40
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following unregistered securities have been sold by us during the period
from January 1, 2007 to March 31, 2007:
TITLE AND AMOUNT OF SECURITIES NAME OF NAME OR CLASS OF
DATE OF GRANT GRANTED/EXERCISE PRICE IF PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
APPLICABLE UNDERWRITER SECURITIES RECEIVED
------------- ------------------------------ ----------- ---------------------- -------------
February 2007 200,000/Common Stock Purchase None Apex Investment Fund V, $0.00(1)
Warrants L.P.
March 2007 100,000/Common Stock Purchase None Apex Investment Fund V, $0.00(2)
Warrants L.P.
March 2007 160,000/Common Stock Purchase None Apex Investment Fund V, $0.00(3)
Warrants L.P.
March 2007 165,000/Common Stock Purchase None Apex Investment Fund V, $0.00(4)
Warrants L.P.
The above unregistered securities were issued pursuant to an exemption from the
registration requirements of the Securities Act under Section 4(2) of the
Securities Act as such securities were issued to accredited investors and were
not issued pursuant to any general solicitation or advertisement.
ITEM 6. EXHIBITS
See attached Exhibit Index.
--------
(1) On February 20, 2007, we issued warrants to purchase up to 200,000
shares of our common stock to Apex Investment Fund V, L.P. in
conjunction with the 2007 Interim Bridge Financing transaction. The
warrants have a term of 5 years and an exercise price of $1.00 per
share. The aggregate fair value of these warrants amounted to $134,419.
(2) On March 2, 2007, we issued warrants to purchase up to 100,000 shares
of our common stock to Apex Investment Fund V, L.P. in conjunction with
the 2007 Interim Bridge Financing transaction. The warrants have a term
of 5 years and an exercise price of $1.25 per share. The aggregate fair
value of these warrants amounted to $83,984.
(3) On March 19, 2007, we issued warrants to purchase up to 160,000 shares
of our common stock to Apex Investment Fund V, L.P. in conjunction with
the 2007 Interim Bridge Financing transaction. The warrants have a term
of 5 years and an exercise price of $1.14 per share. The aggregate fair
value of these warrants amounted to $122,225.
(4) On March 27, 2007, we issued warrants to purchase up to 165,000 shares
of our common stock to Apex Investment Fund V, L.P. in conjunction with
the 2007 Interim Bridge Financing transaction. The warrants have a term
of 5 years and an exercise price of $0.69 per share. The aggregate fair
value of these warrants amounted to $76,167.
41
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- -----------------------------------------------------------------------
10.1 First Amendment to Executive Employment Agreement dated
Februaryf17,12006, entered into on January 24, 2007, between Patron
Systems, Inc. and Braden Waverley. Incorporated by reference to Exhibit
10.40 to the Annual Report on Form 10-KSB filed on April 10, 2007.*
10.2 First Amendment to Executive Employment Agreement dated February 17,
2006, entered into on January 24, 2007, between Patron Systems, Inc.
and Martin T. Johnson. Incorporated by reference to Exhibit 10.41 to
the Annual Report on Form 10-KSB filed on April 10, 2007.*
10.3 Secured Convertible Promissory note dated February 20, 2007, issued by
Patron Systems, Inc. in favor of Apex Investment Fund V, L.P.
Incorporated by reference to Exhibit 10.42 to the Annual Report on Form
10-KSB filed on April 10, 2007.
10.4 Security Agreement dated February 20, 2007, between Patron Systems,
Inc. and Apex Investment Fund V, L.P. Incorporated by reference to
Exhibit 10.43 to the Annual Report on Form 10-KSB filed on April 10,
2007.
10.5 Form of Warrant issued by Patron Systems, Inc. in favor of Apex
Investment Fund V, L.P. Incorporated by reference to Exhibit 10.44 to
the Annual Report on Form 10-KSB filed on April 10, 2007.
31.1 Certification of Principal Executive Officer pursuant to Securities
Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to Securities
Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
* Indicates a management contract or compensatory plan.
42
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: May 21, 2007 PATRON SYSTEMS, INC.
--------------------
(Registrant)
/s/ Braden Waverley
----------------------------------------
By: Braden Waverley
Its: Chief Executive Officer
/s/ Martin T. Johnson
----------------------------------------
By: Martin T. Johnson
Its: Chief Financial Officer
43