Overview of Results of Operations for the SixNine Months Ended JuneSeptember 30, 2008 and JuneSeptember 30, 2007
Total revenues were $4,735,000 for the nine months ended September 30, 2008 compared to $3,576,000 for the same period in 2007, representing an increase of $1,159,000, or 32%. Gross profit increased $878,000, or 27%, to $4,098,000 from $3,220,000. Operating expenses increased $1,468,000, or 21%, to $8,508,000 from $7,040,000. Net loss increased $438,000, or 11%, to $4,525,000 from $4,087,000.
The following table showssets forth our consolidated statements of operations data expressed as a percentage of revenuerevenues for the periods indicated:
| | | Six Months Ended June 30, 2008 | | Six Months Ended June 30, 2007 | |
| REVENUES: | | | | | |
| Subscription Fees | | | 47 | % | | 57 | % |
| Professional Service Fees | | | 48 | % | | 28 | % |
| License Fees | | | 3 | % | | 13 | % |
| Other Revenues | | | 2 | % | | 2 | % |
| Total Revenues | | | 100 | % | | 100 | % |
| | | | | | | | |
| COST OF REVENUES | | | 13 | % | | 9 | % |
| | | | | | | | |
| GROSS PROFIT | | | 87 | % | | 91 | % |
| | | | | | | | |
| OPERATING EXPENSES: | | | | | | | |
| General and Administrative | | | 79 | % | | 101 | % |
| Sales and Marketing | | | 45 | % | | 44 | % |
| Development | | | 51 | % | | 59 | % |
| | | | | | | | |
| Total Operating Expenses | | | 175 | % | | 204 | % |
| | | | | | | | |
| LOSS FROM OPERATIONS | | | (88 | %) | | (113 | %) |
| | | | | | | | |
| OTHER INCOME (EXPENSE): | | | | | | | |
| Interest Income (Expense), Net | | | (12 | %) | | (12 | %) |
| Other Income | | | 1 | % | | 6 | % |
| | | | | | | | |
| Total Other Income (Expense) | | | (11 | %) | | (6 | %) |
| NET INCOME (Loss) | | | (99 | %) | | (119 | %) |
| | | Nine Months Ended September 30, 2008 | | Nine Months Ended September 30, 2007 | |
| | | | | | |
| REVENUES: | | | | | | | |
| Subscription fees | | | 45 | % | | 57 | % |
| Professional service fees | | | 45 | % | | 28 | % |
| License fees | | | 8 | % | | 1 | % |
| Other revenue | | | 2 | % | | 14 | % |
| | | | | | | | |
| Total revenues | | | 100 | % | | 100 | % |
| | | | | | | | |
| COST OF REVENUES | | | 13 | % | | 10 | % |
| | | | | | | | |
| GROSS PROFIT | | | 87 | % | | 90 | % |
| | | | | | | | |
| OPERATING EXPENSES: | | | | | | | |
| General and administrative | | | 81 | % | | 100 | % |
| Sales and marketing | | | 45 | % | | 44 | % |
| Research and development | | | 54 | % | | 53 | % |
| | | | | | | | |
| Total operating expenses | | | 180 | % | | 197 | % |
| | | | | | | | |
| LOSS FROM OPERATIONS | | | (93 | )% | | (107 | )% |
| | | | | | | | |
| OTHER INCOME (EXPENSE): | | | | | | | |
| Interest expense, net | | | (11 | )% | | (11 | )% |
| Legal reserve and debt forgiveness, net | | | 0 | % | | (1 | )% |
| Gain on legal settlements, net | | | 8 | % | | 0 | % |
| Other income | | | 0 | % | | 5 | % |
| | | | | | | | |
| Total other income (expense) | | | (3 | | | (7 | |
| | | | | | | | |
| NET LOSS | | | (96 | )% | | (114 | )% |
Comparison of the Results of Operations for the SixNine Months Ended JuneSeptember 30, 2008 and JuneSeptember 30, 2007
Revenues. Total revenues increased by $1,003,000, or 47%, to $3,149,000 for the first half ofnine months ended September 30, 2008 were $4,735,000 compared to $2,146,000$3,576,000 for the first half of 2007. Gross profit increased $778,000, or 40%, to $2,736,000 from $1,958,000. Operating expenses increased $1,145,000, or 26%, to $5,515,000 from $4,370,000. Net loss grew to $3,133,000 from $2,525,000, an increase of $608,000, or 24%.
Revenues
Revenues totaled $3,149,000 for the first half of 2008 compared to $2,146,000 for the first half ofsame period in 2007, representing an increase of $1,003,000,$1,159,000, or 47%32%. This overall increase in revenues was primarily attributable to an increase in professional service fees.
Subscription Fees – Subscription fees for the nine months ended September 30, 2008 were $2,133,000 compared to $2,040,000 for the same period in 2007, representing an increase of $93,000, or 5%. This increase is attributablewas due to increasesnew partnerships under which we began recognizing revenue in professional service fees and subscription revenues totaling $902,000 and $280,000, respectively.the second half of 2007.
Professional Service Fees - Professional service fees increased $902,000, or 149%, to $1,509,000 for the first half ofnine months ended September 30, 2008 from $606,000were $2,130,000 compared to $985,000 for the first halfsame period in 2007, representing an increase of 2007.$1,145,000, or 116%. This increase was due to existing customers requesting additional project consulting services for their web initiatives.initiatives as well as $465,000 associated with the recognition of consulting revenue from new customers added in fiscal 2008. Professional service fees accounted for approximately 48%45% of revenue for the first halfnine months of 2008 as compared to approximately 28% for the first halfnine months of 2007. Management expects thatWe expect professional service fees will continue to represent a greater portion of total revenues for fiscal 2008 as compared to fiscal 2007.
Subscription revenues increased $280,000, or 23%, to $1,490,000License Fees - License fees for the first sixnine months ofended September 30, 2008 from $1,210,000 for the first six months of 2007. This increase was due to new partnerships under which we began recognizing revenue in the second half of 2007.
License fees totaled $104,000 during the first half of 2008were $395,000 compared to $280,000$480,000 for the same period in 2007.2007, representing a decrease of $85,000, or 18%. The license revenue for the first nine months of 2008 revenuewas primarily related to a single license agreement signed during 2007 under which $100,000 of the fee was collected during the first quarter of 2008. This2008, but for which the revenue was deferred at December 31, 2007 in accordance with the provisions of SOP 97-2.97-2; the ratable recognition of $30,000 of a term license that commenced in June 2008; and the recognition of $280,000 in September 2008 relating to a perpetual license. The 2007 license revenue for the first nine months of 2007 related to a single perpetual license agreement entered into during the second quarter of 2007.
Other revenues totaled $46,000Revenue - Other revenue for the first half ofnine months ended September 30, 2008 and $50,000totaled $77,000 compared to $71,000 for the first halfsame period in 2007. This revenue is generated from non-core activities. We expect these revenue streams to continue to be insignificant in the future as we continue our strategy of 2007.focusing on the growth of our subscription and license revenues.
Cost of Revenues
Cost of revenues increased $225,000,for the nine months ended September 30, 2008 was $636,000 compared to $356,000 for the same period in 2007, representing an increase of $280,000, or 120%, to $413,000 in the first six months of 2008 from $188,000 in the first six months of 2007.79%. This increase was primarily the result of incremental costs incurred in connection with supporting several new customers acquired in the latter part of 2007 and first part of 2008 as well as a higher turnover rate of members of existing direct-selling organization customers. These incremental costs include additional call center personnel salaries and related payroll expenses of $100,000, hosting costs of $61,000, and credit card processing of $33,000. In addition, we incurred costs of $45,000 as a result of a $65,000 increasethe introduction of business card printing services to direct-selling organization members in hosting costs related to hosting for additional customers, an increase in personnel costs of approximately $90,000 related to the addition of call center staff during the second half of 2007, and a $31,000 increase in other fees associated with our increased subscription customer base.early 2008.
Operating Expenses
Operating expenses increased $1,145,000, or 26%, to $5,515,000 for the first halfnine months ended September 30, 2008 were $8,508,000 compared to $7,040,000 for the same period in 2007, representing an increase of 2008 from $4,370,000 during the first half of 2007.$1,468,000, or 21%. This increase is duewas primarily attributable to an increase in general and administrative expenses of approximately $318,000, an increaseincreases in sales and marketing expense of approximately $484,000, and an increase in research and development expenses of approximately $344,000.expenses.
General and Administrative- General and administrative expenses increased by $318,000, or 15%, to $2,482,000 for the first half ofnine months ended September 30, 2008 from $2,164,000were $3,823,000 compared to $3,567,000 for the first halfsame period in 2007, representing an increase of 2007.$256,000, or 7%. This increase is primarily attributable to increasesan increase in legal and professional fees, contract labor fees, and recruiting costs associated with our search for a new Chief Financial Officer, and accruals forcertain taxes associated with the vesting of restricted stock awards. Legal and professional fees increased $221,000$246,000 as we performed a review of our corporate and customer agreements, strengthened our internal controls and review procedures related to the legal function, and incurred fees in connection with the legal proceedings brought during the third quarter of 2007 against us, our former Chief Executive Officer, and a former employee.Additionally, during We also incurred higher professional services, contract labor costs, and recruiting fees in the first quarternine months of 2008 we engagedtotaling $171,000 as a result of our engagement of a contract Interim Chief Financial Officer and initiated aduring our search for a new full-time Chief Financial Officer resulting in a $30,000 increase in recruiting fees. DuringOfficer. In addition, during 2007 we began granting restricted stock, but failed to report certain taxes in connection with the vesting of restricted stock. We accrued $55,000 during the second quarter of 2008 to cover the estimated tax obligations and fees. We are self-reportingself-reported to the Internal Revenue Service regarding this matter and are implementinghave implemented procedures to ensure full tax compliance going forward. These increases were partially offset by a $120,000 reduction$233,000 decrease in stock-based compensation expense resulting from our decision in June 2007 decision(which was later reversed) to limit future stock option grants.
Sales and Marketing- Sales and marketing expense increasedexpenses for the nine months ended September 30, 2008 were $2,137,000 compared to $1,427,000$1,564,000 for the same period in the first half of 2008 from $943,000 in the first half of 2007, representing an increase of $484,000,$573,000, or 51%37%.This increase wasis primarily attributable to $291,000 in expense associated with new revenue sharing arrangements whichadded in the latter part of 2007, $44,000 in increased by $338,000wages resulting from additional sales and marketing personnel added during the first halfnine months of 2007,2008, increased sales commissions of $99,000, and a $106,000 increase$60,000 in personnelpublic relations expenses.
Research and Development- Research and development expense increasedexpenses for the nine months ended September 30, 2008 were $2,547,000 compared to $1,606,000$1,909,000 for the same period in the first six months of 2008 from $1,263,000 in the first six months of 2007, representing an increase of approximately $343,000,$638,000, or 27%33%. This increase is primarily due primarily to increased personnel expenses as we added research and development personneldevelopers during the last quarter of 2007 and first halfnine months of 2008 to enhance and customize our platforms and applications and to launch additional private labelprivate-label sites.
Other Income (Expense)
We incurred net interest expense of $369,000$520,000 for the nine months ended September 30, 2008 compared to net interest expense of $401,000 for the same period in 2007, representing an increase of $119,000, or 30%. Interest expense totaled $562,000 and $524,000 and interest income totaled $42,000 and $123,000 during the first halfnine months of 2008 as compared to $262,000 during the first half of 2007.and 2007, respectively. Interest expense increased as a direct result of increased indebtedness under lines of credit and $3.3 million and $1.5 million of secured subordinated convertible notes bearing interest at 8% per annum issued in November 2007. The convertible notes bear interest at 8% payable in quarterly installments that commenced on February 14, 2008. Interest income totaled $85,000 for the first half of 2007 as compared to $14,000 for the first half of 2008.and August 2008, respectively. The decrease in interest income is due to lower cash balances. Thebalances in the first half 2007 interest income was attributable to the interest earned onnine months of 2008 as the cash proceeds ofraised in the February 2007 private placement described in Note 5, “Stockholders’ Equity,” to the consolidated financial statements in this report.
report were depleted in operations.
During the first halfnine months of 2007,2008, we recognized $114,000 of$404,000 in other income, including an $86,000 adjustmenta $395,000 gain on legal settlements with our insurance carrier as described in Note 7, “Commitments and Contingencies,” to registration rights penalties previously expensed during 2006.the consolidated financial statements in this report.
Provision for Income Taxes
We have not recorded a provision for income tax expense because we have been generating net losses. Furthermore, we have not recorded an income tax benefit for the secondthird quarter of 2008 primarily due to continued substantial uncertainty based on objective evidence regarding our ability to realize our deferred tax assets. Based upon available objective evidence, there has been sufficient uncertainty regarding the ability to realize our deferred tax assets, which warrantsthereby warranting a full valuation allowance in our financial statements. We have approximately $46,000,000$47,000,000 in net operating loss carryforwards, which may be utilized to offset future taxable income.
Liquidity and Capital Resources
At JuneSeptember 30, 2008, our principal sources of liquidity were cash and cash equivalents totaling $183,000$31,000 and current accounts receivable of $742,000.$483,000. As of August 8,November 10, 2008, our principal sources of liquidity were cash and cash equivalents totaling approximately $130,000$45,000 and accounts receivable of approximately $651,000.$305,000. As of JuneSeptember 30, 2008, we had drawn approximately $1.84$1.52 million on our $2.47 million line of credit with Paragon, Commercial Bank (“Paragon”), leaving approximately $630,000$950,000 available under the line of credit for our operations. As of August 8,November 10, 2008, we had drawn approximately $2.26$2.15 million on the Paragon line of credit, leaving approximately $210,000$320,000 available under the line of credit for our operations, and we expect to continue to draw down on this line of credit as needed for working capital purposes. During the third quarter of 2008, management established automated sweeps among its accounts at Paragon whereby all available cash at the end of each day is used to pay down the line of credit with Paragon, the purpose of which is to reduce our interest expense. This line of credit expires in February 2009.2009 but is renewable if the underlying irrevocable standby letter of credit remains in force. This letter of credit is currently scheduled to expire in February 2010. As of August 8,November 10, 2008, we also hadhave the ability to call up to approximately $5.2$10.5 million of additional funding from our convertible noteholders. Subsequent changes innoteholders and, on November 12, 2008, we notified the convertible noteholders that we have exercised our option to sell $1.5 million aggregate principal of additional secured subordinated notes arein a closing to occur on or before December 31, 2008, as described below under “Recent Developments.”
During the quarter ended JuneSeptember 30, 2008, our working capital deficit increased by approximately $2,314,000$2,701,000 to approximately $1,427,000. This$1,814,000 compared to a working capital surplus of $887,000 at December 31, 2007. As described more fully below, the working capital deficit at JuneSeptember 30, 2008 is primarily attributable to negative cash flows from operations, including a $247,000$120,000 increase in accounts receivable, a $148,000 increase in notes receivable, and a $544,000 increase in prepaid expenses during the first halfnine months of 2008.
Cash Flow from Operations. Cash flows used in operations for the sixnine months ended JuneSeptember 30, 2008 totaled $2,840,000,$3,980,000, up from $2,182,000$3,319,000 for the six months ended June 30,same period in 2007. This increase is primarily due to paying down outstanding trade accounts payable, an increasethe prepayment of 36 months of rent at our new headquarterfacilities, a decrease in outstanding accounts receivable,deferred revenue, and a general increase in cash operating costs.
Cash Flow from Investing Activities. For the six months ended June 30, 2008, we utilized approximately $49,000Cash used in investing activities compared to $54,000for the nine months ended September 30, 2008 totaled $400,000, up from $89,000 for the same period in 2007, substantially all of which related2007. This increase is primarily due to the acquisition of furniture and upgrade of computer equipment and furniture.in connection with our relocation to new headquarter facilities, as well as the capitalization of software costs related to our new platform.
Cash Flow from Financing ActivityActivities. ForCash provided by financing activities for the sixnine months ended JuneSeptember 30, 2008 we utilized approximately $401,000 nettotaled $937,000, down from $5,309,000 for the same period in 2007. This decrease is primarily due to cash raised in financing activities principally to retire a line2007 from the issuance of credit as discussed below. For the six months ended June 30, 2007, we generated a total of $5,538,000 net cash from our financing activities through both equity and debt financing,common stock as described below.below, a portion of which was used to reduce debt borrowings. In the first nine months of 2008, the Company again relied upon debt borrowings to help fund operations.
Equity Financing. In a transaction that closed on February 21, 2007, we sold an aggregate of 2,352,941 shares of our common stock to two new investors, or the Investors. The private placement shares were sold at $2.55 per share pursuant to a Securities Purchase Agreement, or the SPA, between us and each of the Investors. The aggregate gross proceeds to us were $6 million, and we incurred issuance costs of approximately $637,000. Under the SPA, the Investors were issued warrants for the purchase of an aggregate of 1,176,471 shares of common stock at an exercise price of $3.00 per share. These warrants contain a provision for cashless exercise and must be exercised, if at all, by February 21, 2010.
Debt Financing. On February 15, 2008, we repaid the full outstanding principal balance of $2,052,000 and accrued interest of $2,890 outstanding under our revolving credit arrangement with Wachovia Bank, NA, or Wachovia. The line of credit advanced by Wachovia was $2.5 million to be used for general working capital purposes. Any advances made on the line of credit were to be paid off no later than August 1, 2008. The line of credit was secured by our deposit account at Wachovia and the irrevocable standby letter of credit issued by HSBC Private Bank (Suisse) SA, or HSBC, with Atlas Capital, SA, or Atlas, one of oura current stockholders,stockholder and affiliate, both of which were released by Wachovia.
On February 20, 2008, we entered into a revolving credit arrangement with Paragon that is subject to annual renewal subject to mutual approval. The line of credit advanced by Paragon is $2.47 million and can be used for general working capital. Any advances made on the line of credit must be paid off no later than February 19, 2009, subject to extension due to renewal, with monthly payments being applied first to accrued interest and then to principal. The interest shall accrue on the unpaid principal balance at the Wall Street Journal’s published prime rate minus one half percent. As of JuneSeptember 30, 2008, the line of credit was secured by an irrevocable standby letter of credit in the amount of $2.5 million issued by HSBC with Atlas as account party.party, expiring February 18, 2010. We also have agreed with Atlas that in the event of our default in the repayment of the line of credit that results in the letter of credit being drawn, we will reimburse Atlas any sums that Atlas is required to pay under such letter of credit. At our sole discretion, these payments may be made in cash or by issuing shares of our common stock at a set per share price of $2.50.
This line of credit replaces our line of credit with Wachovia. As an incentive for the letter of credit from Atlas to secure the Wachovia line of credit, we had entered into a stock purchase warrant and agreement with Atlas. Under the terms of the agreement, Atlas received a warrant to purchase up to 444,444 shares of our common stock at $2.70 per share within 30 business days of the termination of the Wachovia line of credit or if we are in default under the terms of the line of credit with Wachovia. In consideration for Atlas providing the Paragon letter of credit, we agreed to amend the agreement to provide that the warrant is exercisable within 30 business days of the termination of the Paragon line of credit or if we are in default under the terms of the line of credit with Paragon.
On November 14, 2007, in an initial closing, we sold $3.3 million aggregate principal amount of secured subordinated convertible notes due November 14, 2010, or the initial notes. In addition, the noteholders committed to purchase on a pro rata basis up to $5.2 million aggregate principal of secured subordinated notes in future closings upon approval and call by our Board of Directors. On August 12, 2008, we exercised our option to sell $1.5 million aggregate principal of additional secured subordinated notes due November 14, 2010, or the additional notes, and together with the initial notes, the notes, with substantially the same terms and conditions as the initial notes. In connection with the sale of the additional notes, the noteholders holding a majority of the aggregate principal amount of the notes outstanding agreed to increase the aggregate principal amount of secured subordinated convertible notes that they are committed to purchase from $8.5 million to $15.3 million, of which $4.8 million is currently outstanding.
We are obligated to pay interest on the initial notes and the additional notes at an annualized rate of 8% payable in quarterly installments commencing on February 14, 2008 and November 12, 2008, respectively. We are not permitted to prepay the notes without approval of the holders of at least a majority of the principal amount of the notes then outstanding.
On the earlier of the maturity date of November 14, 2010 or a merger or acquisition or other transaction pursuant to which our existing stockholders hold less than 50% of the surviving entity, or the sale of all or substantially all of our assets, or similar transaction, or event of default, each noteholder in its sole discretion shall have the option to:
| · | convert the principal then outstanding on its notes into shares of our common stock, or |
| · | receive immediate repayment in cash of the notes, including any accrued and unpaid interest. |
If a noteholder elects to convert its notes under these circumstances, the conversion price of notes:
| · | issued in the initial closing on November 14, 2007 shall be $3.05; and |
| · | issued on August 12, 2008 shall be the lower of $3.05 or the average of the closing bid and asked prices of shares of our common stock quoted in the Over-The-Counter Market Summary (or, if our shares are traded on the Nasdaq Stock Market or another exchange, the closing price of shares of our common stock quoted on such exchange) averaged over five trading days prior to the closing date of the sale of the additional notes. |
Payment of the notes will be automatically accelerated if we enter voluntary or involuntary bankruptcy or insolvency proceedings.
The notes and the common stock into which they may be converted have not been registered under the Securities Act or the securities laws of any other jurisdiction. As a result, offers and sales of the notes were made pursuant to Regulation D of the Securities Act and only made to accredited investors that were our existing stockholders. The investors in the initial notes include (i) The Blueline Fund, or Blueline, which originally recommended Philippe Pouponnot, one of our former directors, for appointment to the Board of Directors; (ii) Atlas, an affiliate that originally recommended Shlomo Elia, one of our current directors, for appointment to the Board of Directors; (iii) Crystal Management Ltd., which is owned by Doron Roethler, who subsequently became Chairman of our Board of Directors and serves as the noteholders’ bond representative; and (iv) William Furr, who is the father of Thomas Furr, who, at the time, was one of our directors and executive officers. The investors in the additional notes are Atlas and Crystal Management Ltd.
In addition, if we propose to file a registration statement to register any of its common stock under the Securities Act in connection with the public offering of such securities solely for cash, subject to certain limitations, we must give each noteholder who has converted its notes into common stock the opportunity to include such shares of converted common stock in the registration. We have agreed to bear the expenses for any of these registrations, exclusive of any stock transfer taxes, underwriting discounts, and commissions.
On November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held under its January 2007 engagement letter with us that it may have with respect to the convertible note offering, including the right to receive any fees in connection with the offering.
We have not yet achieved positive cash flows from operations, and our main sources of funds for our operations are the sale of securities in private placements, the sale of additional convertible notes, and bank lines of credit. We must continue to rely on these sources until we are able to generate sufficient revenue to fund our operations. We believe that anticipated cash flows from operations, funds available from our existing line of credit, and additional issuances of notes, together with cash on hand, will provide sufficient funds to finance our operations at least for the next 12 to 18 months, depending on our ability to achieve strategic goals outlined in our annual operating budget approved by our Board of Directors. Changes in our operating plans, lower than anticipated sales, increased expenses, or other events may cause us to seek additional equity or debt financing in future periods. There can be no guarantee that financing will be available on acceptable terms or at all. Additional equity financing could be dilutive to the holders of our common stock, and additional debt financing, if available, could impose greater cash payment obligations and more covenants and operating restrictions.
Recent Developments
Restructuring of Michigan Operations. On July 1, 2008, our management initiated a restructuring program that is aimed at reducing operating, general and administrative expenses in fiscal 2008 by consolidating significant operations in our location in Durham, North Carolina near Research Triangle Park. The plan includes severance of certain of our employees located in Grand Rapids, Michigan.
We initiated this program as part of our ongoing efforts to realign certain production and development functions and eliminate redundant administrative functions as well as proactively and prudently manage operating, general and administrative costs. We expect to record a one-time restructuring charge of approximately $53,000 during the third quarter of fiscal 2008, primarily as a result of certain one-time termination benefits that will be provided in connection with the plan as well as costs associated with the continued employment of three employees in Grand Rapids. In addition, we have initiated an impairment evaluation of goodwill and intangible assets related to the Grand Rapids operations. We have not completed this evaluation and therefore have not determined whether any portion of our recorded goodwill and/or intangible assets balance is impaired.
Suit Against Former Employee. On July 14, 2008, we filed a civil action against a former employee in the General Court of Justice, Superior Court Division, Durham County, North Carolina. The complaint alleges that the former employee embezzled funds from us in the amount of $105,600 and asserts claims for conversion and unfair trade practices. The lawsuit seeks recovery for the embezzled funds, plus punitive damages or treble damages, interest, and attorneys’ fees.
Appointment of Chief Financial Officer. On July 15, 2008, our Board of Directors unanimously appointed Timothy L. Krist as our Chief Financial Officer. Effective July 9, 2008, we notified George Cahill, our Interim Chief Financial Officer, that pursuant to Paragraph 3 of our Consulting Agreement with Mr. Cahill dated April 22, 2008, we were exercising our right to terminate his consulting services. As previously reported, Mr. Cahill was serving in this position on a temporary basis during our search for a permanent Chief Financial Officer.
In connection with the sale of the additional notes, the noteholders holding a majority of the aggregate principal amount of the notes outstanding agreed to increase the aggregate principal amount of secured subordinated convertible notes that they are committed to purchase from $8.5 million to $15.3 million, of which $4.8 million is currently outstanding.
Insurance Reimbursement. On August 7, 2008, we and our prior insurance carrier agreed that the carrier would reimburse us $300,000 for previously disputed legal expenses primarily related to our previously disclosed SEC matters. The reimbursement covered all disputed company expenses prior to September 11, 2007 as well as certain enumerated invoices in dispute for the balance of 2007.
Item 3.Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
Item 4.Controls and Procedures
Not applicable.
| Item 4T. | Controls and Procedures |
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) that are designed to provide reasonable assurances that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s, or the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
We have made the following changes to our internal controls over financial reporting during the second quarter of fiscal 2008:
| · | improved the reconciliation process for determining the weighted average earning per share and number of outstanding shares of common stock; |
| · | reviewed and modified the process for documenting outstanding equity awards and releasing restrictions on restricted stock; and |
| · | engaged an outside accounting consultant to assist us with improving our reconciliation and month end closing processes. |
Other than as described above, there have been no changes to our internal controls over financial reporting during the secondthird quarter of fiscal 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.reporting:
| · | hired a new permanent Chief Financial Officer; |
| · | implemented dual-control security on all cash transfers with our bank and established maximums that could be initiated by our Controller, with any transfer in excess of such maximums requiring initiation by one of our officers; |
| · | restricted check signing authority to our officers; |
| · | modified permission rights in our accounting software to ensure transactions could not be modified or deleted after posting; |
| · | implemented a structured vendor invoice approval process with multiple levels of approval required before the expense can be entered into our accounting system; |
| · | engaged an outside firm to conduct an ethics training course for all members of management; |
| · | with respect to our previously-identified controls regarding period closing, refined our internal checklist to ensure that all period closing procedures are recorded properly and completely, and that the financial statements are reviewed and approved by our Chief Financial Officer; and |
| · | with respect to our controls regarding stock option and restricted stock expense, implemented a process to track the vesting of restricted stock issued to employees and introduced a policy to allow the netting of shares as payment of the resulting employee tax obligation so that such taxes are paid timely to governmental agencies. |
During the thirdfourth quarter of 2008, we are developing a new general ledger chart of accounts to more closely align our 2009 budget with actual results and to assign accountability for expenses by department. We are also working to implement internal control procedures to address our failure to report certain taxes associated withon the vesting of restricted stock awardstesting and the recently discovered employee embezzlementremediation phases of our funds.compliance initiative with respect to the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley. As part of our ongoing efforts to improve our internal control over financial reporting, our new Chief Financial Officer is evaluatingcontinuing to evaluate certain financial and accounting functions,functions. As we previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, we have identified five critical control areas for improvement in fiscal 2008. As discussed above, we have adopted controls related to period closing and westock option and restricted stock expense. We expect to make several additional changes to our internal control over financial reporting during the remainder of fiscal 2008.2008, including full adoption of the remaining previously-identified controls relating to accrual analysis and journal entries, the adoption of which would be critical and material to our internal control environment.
PART II -– OTHER INFORMATION
Item 1.Legal Proceedings
Please refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and Part II, Item 1 of our Quarterly ReportReports on Form 10-Q for the quarterly periodperiods ended March 31, 2008 and June 30, 2008 for a description of material legal proceedings, including the proceedings discussed below.
On July 14, 2008, we filed a civil action against a former employee in the General Court of Justice, Superior Court Division, Durham County, North Carolina. The complaint allegesalleged that the former employee embezzled funds from us in the amount of $105,600 and assertsasserted claims for conversion and unfair trade practices. The lawsuit seekssought recovery for the embezzled funds, plus punitive damages or treble damages, interest, and attorneys’ fees. On August 25, 2008, we obtained a judgment against the former employee in the amount of $105,599.94, trebled to $316,799.82 pursuant to the North Carolina Unfair and Deceptive Trade Practice Statute, plus interest at 8% from the date of filing the complaint, and all court costs and reasonable attorneys’ fees existing as of the date of the judgment and as may accrue from time to time until the judgment is paid in full. We are in the process of attempting to collect on the judgment.
On October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the United States District Court for the Middle District of North Carolina naming us, certain of our current and former officers and directors, Maxim Group, LLC, and Jesup & Lamont Securities Corp. as defendants. The lawsuit was filed on behalf of all persons other than the defendants who purchased our securities from May 2, 2005 through September 28, 2007 and were damaged. The complaint asserts violations of federal securities laws, including violations of Section 10(b) of the Exchange Act and Rule 10b-5. The complaint asserts that the defendants made material and misleading statements with the intent to mislead the investing public and conspired in a fraudulent scheme to manipulate trading in the our stock, allegedly causing plaintiffs to purchase the stock at an inflated price. The complaint requests certification of the plaintiff as class representative and seeks, among other relief, unspecified compensatory damages including interest, plus reasonable costs and expenses including counsel fees and expert fees. On June 24, 2008, the court entered an order appointing a lead plaintiff for the class action. On September 8, 2008, the plaintiff filed an amended complaint which added additional defendants who had served as our directors or officers during the class period as well as our independent auditor.
At this time, we are not able to determine the likely outcome of our currently pending legal matters, nor can we estimate our potential financial exposure. Our management has made an initial estimate based upon its knowledge, experience and input from legal counsel, and we have accrued approximately $137,500 of legal reserves. Such reserves will be adjusted in future periods as more information becomes available. If an unfavorable resolution of any of these matters occurs, our business, results of operations, and financial condition could be materially adversely affected.
We operate in a dynamic and rapidly changing business environment that involves substantial risk and uncertainty, and these risks may change over time. The following discussion addresses some of the risks and uncertainties that could cause, or contribute to causing, actual results to differ materially from expectations. In evaluating our business, you should pay particular attention to the descriptions of risks and uncertainties described below and in other sections of this document and our other filings. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties not presently known to us, which we currently deem immaterial, or that are similar to those faced by other companies in our industry or business in general may also affect our business. If any of the risks described below actually occurs, our business, financial condition, or results of operations could be materially and adversely affected.
Historically, we have operated at a loss, and we continue to do so.
We have had recurring losses from operations and continue to have negative cash flows. If we do not become cash flow positive through additional financing or growth, we may have to cease operations and liquidate our business. Our working capital, including our line of credit with Paragon, February 2007 equity financing transaction, and convertible note financings, should fund our operations for the next 12 to 18 months. As of August 8,November 10, 2008, we have approximately $213,000$320,000 available on our revolving line of credit and approximately $5.2$10.5 million available through our convertible note financing. On November 12, 2008, we notified our convertible noteholders that we have exercised our option to sell $1.5 million aggregate principal of additional secured subordinated notes in a closing to occur on or before December 31, 2008. Factors such as the commercial success of our existing services and products, the timing and success of any new services and products, the progress of our research and development efforts, our results of operations, the status of competitive services and products, the timing and success of potential strategic alliances or potential opportunities to acquire technologies or assets, the charges filed against a former officer and a former employee filed by the SEC and the United States Attorney General, and the pending shareholder class action lawsuit may require us to seek additional funding sooner than we expect. If we fail to raise sufficient financing, we will not be able to implement our business plan and may not be able to sustain our business.
Current economic uncertainties in the global economy could adversely impact our growth, results of operations, and our ability to forecast future business.
In 2008, there has been a downturn in the global economy, slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions, and liquidity concerns. These conditions make it difficult for our customers and us to accurately forecast and plan future business activities, and they could cause our customers to slow or defer spending on our products and services, which would delay and lengthen sales cycles, or change their willingness to enter into longer-term licensing and support arrangements with us. Furthermore, during challenging economic times our customers may face issues gaining timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. If that were to occur, we may be required to increase our allowance for doubtful accounts and our results would be negatively impacted.
We cannot predict the timing, strength, or duration of any economic slowdown or subsequent economic recovery. If the downturn in the general economy or markets in which we operate persists or worsens from present levels, our business, financial condition, and results of operations could be materially and adversely affected.
Our business is dependent upon the development and market acceptance of our applications.
Our future financial performance and revenue growth will depend, in part, upon the successful development, integration, introduction, and customer acceptance of our software applications. Thereafter, other new products, either developed or acquired, and enhanced versions of our existing applications will be critically important to our business. Our business could be harmed if we fail to deliver timely enhancements to our current and future solutions that our customers desire. We also must continually modify and enhance our services and products to keep pace with market demands regarding hardware and software platforms, database technology, information security, and electronic commerce technical standards. Our business could be harmed if we fail to achieve the improved performance that customers want with respect to our current and future product offerings. There can be no assurance that our products will achieve widespread market penetration or that we will derive significant revenues from the sale or licensing of our platforms or applications.
We have not yet demonstrated that we have a successful business model.
We have invested significantly in infrastructure, operations, and strategic relationships to support our SaaS delivery model, which represents a significant departure from the delivery strategies that other software vendors and we have traditionally employed. To maintain positive margins for our small business services, our revenues will need to continue to grow more rapidly than the cost of such revenues. We anticipate that our future financial performance and revenue growth will depend, in large part, upon our Internet-based SaaS business model and the results of our sales efforts to reach agreements with syndication partners with small business customer bases, but this business model may become ineffective due to forces beyond our control that we do not currently anticipate. Although we currently have various agreements and continue to enter into new agreements, our success depends in part on the ultimate success of our syndication partners and referral partners and their ability to market our products and services successfully. Our partners are not obligated to provide potential customers to us and may have difficulty retaining customers within certain markets that we serve. In addition, some of these third parties have entered, and may continue to enter, into strategic relationships with our competitors. Further, many of our strategic partners have multiple strategic relationships, and they may not regard us as significant for their businesses. Our strategic partners may terminate their respective relationships with us, pursue other partnerships or relationships, or attempt to develop or acquire products or services that compete with our products or services. Our strategic partners also may interfere with our ability to enter into other desirable strategic relationships. If we are unable to maintain our existing strategic relationships or enter into additional strategic relationships, we will have to devote substantially more resources to the distribution, sales, and marketing of our products and services.
In addition, our end users currently do not sign long-term contracts. They have no obligation to renew their subscriptions for our services after the expiration of their initial subscription period and, in fact, they have often elected not to do so. Our end users also may renew for a lower-priced edition of our services or for fewer users. These factors make it difficult to accurately predict customer renewal rates. Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including when we begin charging for our services, their dissatisfaction with our services, and their capability to continue their operations and spending levels. If our customers do not renew their subscriptions for our services or we are not able to increase the number of subscribers, our revenue may decline and our business will suffer.
The SEC action against us, the SEC and criminal actions brought against certain former employees, and related stockholder and other lawsuits have damaged our business, and they could damage our business in the future.
The lawsuit filed against us by the SEC, the SEC and criminal actions filed against a former officer and a former employee, the class action lawsuit filed against us and certain current and former officers, directors, and employees, and the lawsuit filed by a former executive officer against us, all as described in our Annual Report on Form 10-K for the year ended December 31, 2007, have harmed our business in many ways, and may cause further harm in the future. Since the initiation of these actions, our ability to raise financing from new investors on favorable terms has suffered due to the lack of liquidity of our stock, the questions raised by these actions, and the resulting drop in the price of our common stock. As a result, we may not raise sufficient financing, if necessary, in the future.
Legal and other fees related to these actions have also reduced our available cash. We make no assurance that we will not continue to experience additional harm as a result of these matters. The time spent by our management team and directors dealing with issues related to these actions detracts from the time they spend on our operations, including strategy development and implementation. These actions also have harmed our reputation in the business community, jeopardized our relationships with vendors and customers, and decreased our ability to attract qualified personnel, especially given the media coverage of these events.
In addition, we face uncertainty regarding amounts that we may have to pay as indemnification to certain current and former officers, directors, and employees under our Bylaws and Delaware law with respect to these actions, and we may not recover all of these amounts from our directors and officers liability insurance policy carrier. Our Bylaws and Delaware law generally require us to indemnify, and in certain circumstances advance legal expenses to, current and former officers and directors against claims arising out of such person’s status or activities as our officer or director, unless such person (i) did not act in good faith and in a manner the person reasonably believed to be in or not opposed to our best interests or (ii) had reasonable cause to believe his conduct was unlawful. As of August 8,November 10, 2008, there are SEC and criminal actions pending against a former executive officer and a former employee who have requested that we indemnify them and advance expenses incurred by them in the defense of those actions. Also, a stockholder class action lawsuit has been filed against us and certain of our current and former officers, directors, and employees. The SEC, criminal, and stockholder actions are more fully described in Part I, Item 3, “Legal Proceedings,” in our Annual Report on Form 10-K for the year ended December 31, 2007.2007 and Part II, Item 1, “Legal Proceedings,” in this report and the Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2008 and June 30, 2008.
Generally, we are required to advance defense expenses prior to any final adjudication of an individual’s culpability. The expense of indemnifying our current and former directors, officers, and employees for their defense or related expenses in connection with the current actions may be significant. Our Bylaws require that any director, officer, employee, or agent requesting advancement of expenses enter into an undertaking with us to repay any amounts advanced unless it is ultimately determined that such person is entitled to be indemnified for the expenses incurred. This provides us with an opportunity, depending upon the final outcome of the matters and the Board’s subsequent determination of such person’s right to indemnity, to seek to recover amounts advanced by us. However, we may not be able to recover any amounts advanced if the person to whom the advancement was made lacks the financial resources to repay the amounts that have been advanced. If we are unable to recover the amounts advanced, or can do so only at great expense, our operations may be substantially harmed as a result of loss of capital.
Although we have purchased insurance that may cover these obligations, we can offer no assurances that all of the amounts that may be expended by us will be recovered under our insurance policy. It is possible that we may have an obligation to indemnify our current and former officers and directors under the terms of our Bylaws and Delaware law, but that there may be insufficient coverage for these payments under the terms of our insurance policy. Therefore, we face the risk of making substantial payments related to the defense of these actions, which could significantly reduce amounts available to fund working capital, capital expenditures, and other general corporate objectives.
In addition, our insurance policy provides that, under certain conditions, our insurer may have the right to seek recovery of any amounts it paid to the individual insureds or us. As of August 8,November 10, 2008, we do not know and can offer no assurances about whether these conditions will apply or whether the insurance carrier will change its position regarding coverage related to the current actions. Therefore, we can offer no assurances that our insurer will not seek to recover any amounts paid under its policy from the individual insureds or us. If such recovery is sought, then we may have to expend considerable financial resources in defending and potentially settling or otherwise resolving such a claim, which could substantially reduce the amount of capital available to fund our operations.
Finally, if our directors and officers liability insurance premiums increase as a result of the current actions, our financial results may be materially harmed in future periods. If we are unable to obtain coverage due to prohibitively expensive premiums, we would have more difficulty in retaining and attracting officers and directors and would be required to self-fund any potential future liabilities ordinarily mitigated by directors and officers liability insurance.
Our executive management team is critical to the execution of our business plan and the loss of their services could severely impact negatively on our business.
Our executive management team has undergone significant changes during late 2007 and the first halfnine months of 2008. Our success depends significantly on the continued services of our executive management personnel and attracting additional qualified personnel. Losing any of our officers could seriously harm our business. Competition for executives is intense. Although we have resolved the SEC charges filed against us, we may not be able to attract highly qualified candidates to serve on our executive management team. If we had to replace any of our officers, we would not be able to replace the significant amount of knowledge that they may have about our operations. If we cannot attract and retain qualified personnel and integrate new members of our executive management team effectively into our business, then our business and financial results may suffer. In addition, all of our executive team work at the same location, which could make us vulnerable to loss of our entire management team in the event of a natural or other disaster. We do not maintain key man insurance policies on any of our employees.
Failure to comply with the provisions of our debt financing arrangements could have a material adverse effect on us.
Our revolving line of credit from Paragon is secured by an irrevocable standby letter of credit issued by HSBC, with Atlas as account party. Our secured subordinated convertible notes are secured by a first-priority lien on all of our unencumbered assets.
If an event of default occurs under our debt financing arrangements and remains uncured, then the lender could foreclose on the assets securing the debt. If that were to occur, it would have a substantial adverse effect on our business. In addition, making the principal and interest payments on these debt arrangements may drain our financial resources or cause other material harm to our business.
Compliance with regulations governing public company corporate governance and reporting is uncertain and expensive.
As a public company, we have incurred and will continue to incur significant legal, accounting, and other expenses that we did not incur as a private company. We incur costs associated with our public company reporting requirements and with corporate governance and disclosure requirements, including requirements under Sarbanes-Oxley and new rules implemented by the SEC and the Financial Industry Regulatory Authority, or FINRA. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time consumingtime-consuming and costly.
For fiscal 2009, we will be required to comply with the requirements of Section 404 of Sarbanes-Oxley involving our independent accountant’s audit of our internal control over financial reporting. To comply with these requirements, we are evaluating and testing our internal controls, and where necessary, taking remedial actions, to allow our independent auditors to attest to our internal control over financial reporting. As a result, we have incurred and will continue to incur expenses and diversion of management’s time and attention from the daily operations of the business, which may increase our operating expenses and impair our ability to achieve profitability.
We have identified several significant deficiencies in our internal control over financial reporting. We are working to remediate these identified significant deficiencies, and we cannot give any assurances that all significant deficiencies or material weaknesses have been identified or that additional significant deficiencies or material weaknesses will not be identified in the future in connection with our compliance with the provisions of Section 404 of Sarbanes-Oxley. The existence of one or more material weaknesses would preclude a conclusion by management that we maintained effective internal control over financial reporting.
Our former Chief Financial Officer resigned at the end of the first quarter of 2008, resulting in our loss of his financial expertise and knowledge of our history and past transactions. We engaged an outside accounting consultant and an Interim Chief Financial Officer, each with a level of accounting knowledge, experience, and training in the application of generally accepted accounting principles commensurate with our financial reporting requirements to assist us during the transition period between permanent Chief Financial Officers. With their assistance, we have begun the process of restructuringWe appointed a new Chief Financial Officer on July 15, 2008 who has restructured our financial and accounting functions to address concerns regarding segregation of duties and to strengthen other areas in need of improvement. We appointed a new Chief Financial Officer on July 15, 2008.expense approval processes.
There can be no assurance that we will be able to maintain our schedule to complete all assessment and testing of our internal controls in a timely manner. Further, we cannot be certain that our testing of internal controls and resulting remediation actions will yield adequate internal control over financial reporting as required by Section 404 of Sarbanes-Oxley. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could adversely affect the market price of our common stock.
Officers, directors, and principal stockholders control us. This might lead them to make decisions that do not align with the interests of minority stockholders.
Our officers, directors, and principal stockholders beneficially own or control a large percentage of our outstanding common stock. Certain of these principal stockholders hold warrants and convertible notes, which may be exercised or converted into additional shares of our common stock under certain conditions. The convertible noteholders have designated a bond representative to act as their agent. We have agreed that the bond representative shall be granted access to our facilities and personnel during normal business hours, shall have the right to attend all meetings of our Board of Directors and its committees, and to receive all materials provided to our Board of Directors or any committee of our Board. In addition, so long as the notes are outstanding, we have agreed that we will not take certain material corporate actions without approval of the bond representative. The Chairman of our Board of Directors currently is serving as the bond representative.
Our officers, directors, and principal stockholders, acting together, would have the ability to control substantially all matters submitted to our stockholders for approval (including the election and removal of directors and any merger, consolidation, or sale of all or substantially all of our assets) and to control our management and affairs. Accordingly, this concentration of ownership may have the effect of delaying, deferring, or preventing a change in control of us, impeding a merger, consolidation, takeover, or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us, which in turn could materially and adversely affect the market price of our common stock.
Our failure to properly report certain taxes in connection with the vesting of restricted stock could result in tax penalties and interest from the Internal Revenue Service and state tax authorities.
During 2007, we began granting restricted stock, but failed to properly report certain taxes in connection with the vesting of restricted stock. We accrued $55,000 during the second quarter of 2008 to cover the estimated tax obligations and fees. We are self-reportingself-reported to the Internal Revenue Service regarding this matter and expect to paypaid estimated taxes and penalties and interest toof $28,655 in the Internal Revenue Service and state tax authoritiesthird quarter of 2008, with additional costs associated with this event expected in connection with these delinquent taxes.the fourth quarter of 2008. In addition, we are subject to a settlement offer in compromise order with the Internal Revenue Service regarding past tax obligations and could be subject to significant past penalties related to this order depending upon the Internal Revenue Service’s view of our approach to handling the current matter. Any such additional tax penalties could materially and adversely impact our financial condition and results of operations.
Any issuance of shares of our common stock in the future could have a dilutive effect on the value of our existing stockholders’ shares.
We may issue shares of our common stock in the future for a variety of reasons. For example, under the terms of our stock purchase warrant and agreement with Atlas, it may elect to purchase up to 444,444 shares of our common stock at $2.70 per share upon termination of, or if we are in breach under the terms of, our line of credit with Paragon. In connection with our private financing in February 2007, we issued warrants to the investors to purchase an additional 1,176,471 shares of our common stock at $3.00 per share and a warrant to our placement agent in that transaction to purchase 35,000 shares of our common stock at $2.55 per share. Upon maturity of their convertible notes, our noteholders may elect to convert all, a part of, or none of their notes into shares of our common stock at variable conversion prices. In addition, we may raise funds in the future by issuing additional shares of common stock or other securities.
If we raise additional funds through the issuance of equity securities or debt convertible into equity securities, the percentage of stock ownership by our existing stockholders would be reduced. In addition, such securities could have rights, preferences, and privileges senior to those of our current stockholders, which could substantially decrease the value of our securities owned by them. Depending on the share price we are able to obtain, we may have to sell a significant number of shares in order to raise the necessary amount of capital. Our stockholders may experience dilution in the value of their shares as a result.
Shares eligible for public sale could adversely affect our stock price.
Future sales of substantial amounts of our shares in the public market, or the appearance that a large number of our shares are available for sale, could adversely affect market prices prevailing from time to time and could impair our ability to raise capital through the sale of our securities. At August 8, 2008, 18,325,606 shares of our common stock were issued and outstanding and a significant number of shares may be issued upon the exercise of outstanding options, warrants, and convertible notes.
Our stock historically has been very thinly traded. The average daily trading volume for our common stock between January 2008 and JuneSeptember 2008 was approximately 44,25134,852 shares per day. The number of shares that could be sold during this period was restrained by previous contractual and other legal limitations imposed on some of our shares that are no longer applicable. This means that market supply may increase more than market demand for our shares. Many companies experience a decrease in the market price of their shares when such events occur.
We cannot predict if future sales of our common stock, or the availability of our common stock held for sale, will materially and adversely affect the market price for our common stock or our ability to raise capital by offering equity or other securities. Our stock price may decline if the resale of shares under Rule 144, in addition to the resale of registered shares, at any time in the future exceeds the market demand for our stock.
Our stock price is likely to be highly volatile and may decline.
The trading prices of the securities of technology companies have been highly volatile. Accordingly, the trading price of our common stock has been and is likely to continue to be subject to wide fluctuations. Further, our common stock has a limited trading history. Factors affecting the trading price of our common stock generally include the risk factors described in this report.
In addition, the stock market from time to time has experienced extreme price and volume fluctuations that have affected the trading prices of many emerging growth companies. Such fluctuations have often been unrelated or disproportionate to the operating performance of these companies. These broad trading fluctuations could adversely affect the trading price of our common stock.
Further, securities class action litigation has often been brought against companies that experience periods of volatility in the market prices of their securities. A securities class action was filed against us in October 2007 as more fully described in our Annual Report on Form 10-K for the year ended December 31, 2007.Part II, Item 1, “Legal Proceedings,” in this report. This securities class action litigation could result in substantial costs and a diversion of our management’s attention and resources. We may determine, like many defendants in such lawsuits, that it is in our best interest to settle the lawsuit, even if we believe that the plaintiffs’ claims have no merit, to avoid the cost and distraction of continued litigation. Any liability we incur in connection with this or any other potential lawsuit could materially harm our business and financial position and, even if we defend ourselves successfully, there is a risk that management’s distraction in dealing with this type of lawsuit could harm our results.
Our securities may be subject to “penny stock” rules, which could adversely affect our stock price and make it more difficult for our stockholders to resell their stock.
The SEC has adopted rules that regulate broker-dealer practices in connection with transactions in penny stocks. Penny stocks are generally equity securities with a price of less than $5.00 per share (other than securities registered on certain national securities exchanges or quotation systems, provided that reports with respect to transactions in such securities are provided by the exchange or quotation system pursuant to an effective transaction reporting plan approved by the SEC).
The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from those rules, to deliver a standardized risk disclosure document prescribed by the SEC and certain other information related to the penny stock, the broker-dealer’s compensation in the transaction, and the other penny stocks in the customer’s account.
In addition, the penny stock rules require that, prior to a transaction in a penny stock not otherwise exempt from those rules, the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written acknowledgment of the receipt of a risk disclosure statement, a written agreement related to transactions involving penny stocks, and a signed and dated copy of a written suitability statement. These disclosure requirements could have the effect of reducing the trading activity in the secondary market for our stock because it will be subject to these penny stock rules. Therefore, stockholders may have difficulty selling those securities.
If we fail to evaluate, implement, and integrate strategic opportunities successfully, our business may suffer.
From time to time we evaluate strategic opportunities available to us for product, technology, or business acquisitions or dispositions. If we choose to make acquisitions or dispositions, we face certain risks, such as failure of an acquired business to meet our performance expectations, diversion of management attention, retention of existing customers of our current and acquired business, and difficulty in integrating or separating a business’s operations, personnel, and financial and operating systems. We may not be able to successfully address these risks or any other problems that arise from our previous or future acquisitions or dispositions. Any failure to successfully evaluate strategic opportunities and address risks or other problems that arise related to any acquisition or disposition could adversely affect our business, results of operations, and financial condition.
Item 4. Submission of Matters to a Vote of Security Holders
Our Annual Meeting of Stockholders was held on June 19, 2008. The following matters were submitted to a vote of the stockholders with the results shown below:
(a) Election of six directors, each elected to serve until the later of the next Annual Meeting of Stockholders or until such time as his successor has been duly elected and qualified.
Name | Votes For | Votes Against | Votes Withheld |
| Doron Roethler | 11,286,688 | 200 | 497,279 |
| David E. Colburn | 11,298,888 | 200 | 485,079 |
| Thomas P. Furr | 11,298,688 | 200 | 485,279 |
| Shlomo Elia | 11,783,567 | 200 | 400 |
| C. James Meese, Jr. | 11,783,767 | 200 | 200 |
| Dror Zoreff | 11,783,567 | 200 | 400 |
(b) RatificationItem 2.Unregistered Sales of the appointmentEquity Securities and Use of Sherb & Co., LLP as independent auditors for the fiscal year ended December 31, 2008.Proceeds
Votes For | Votes Against | Abstained |
| 11,770,771 | 13,396 | 0 |
The matters listed above are described in detail infollowing table lists all repurchases during the third quarter of fiscal 2008 of any of our definitive proxy statement dated April 23, 2008 forsecurities registered under Section 12 of the Annual MeetingExchange Act by or on behalf of Stockholders held on June 19, 2008.us or any affiliated purchaser.
Issuer Purchases of Equity Securities
Period | | Total Number of Shares Purchased | | Average Price Paid Per Share | | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | | Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs | |
| July 1 – July 31, 2008 | | | - | | $ | - | | | - | | | - | |
| August 1 – August 31, 2008 | | | - | | $ | - | | | - | | | - | |
| September 1 – September 30, 2008 | | | 9,551 | (1) | $ | 3.25 | (2) | | - | | | - | |
| Total | | | 9,551 | | $ | 3.25 | | | - | | | - | |
| (1) | Includes 2,051 shares repurchased in connection with tax withholding obligations under the 2004 Plan and 7,500 shares of restricted stock forfeited by one of our directors in exchange for the grant of a stock option to purchase 15,000 shares of common stock at an exercise price of $3.25 per share. |
| |
| (2) | Represents the average price paid per share for the 2,051 shares repurchased in connection with tax withholding obligations under the 2004 Plan and does not reflect the grant of a stock option to purchase 15,000 shares at an exercise price of $3.25 per share in exchange for the forfeiture of 7,500 shares of restricted stock by one of our directors. |
Item 5.Other Information
Convertible Note FinancingIn connection with our increased focus on sales and marketing, on November 10, 2008, Neile King’s position was changed from Chief Operating Officer to Vice President of Sales and Marketing. Mr. King will oversee our sales and marketing function, and the operational functions will report directly to David Colburn, our President and Chief Executive Officer.
On AugustNovember 12, 2008, we notified all of our current convertible noteholders that we have exercised our option to sell $1.5 million aggregate principal amount of additional secured subordinated convertible notes due November 14, 2010, or the additionalnew notes, with substantially the same terms and conditions as the initial notes sold on November 14, 2007. For purposes of this discussion, the initial notes2007 and the additional notes sold on August 12, 2008, in a closing to occur on or before December 31, 2008. We will be referred to collectively as the notes.
We are obligated to pay interest on the additionalnew notes at an annualized rate of 8% payable in quarterly installments commencing three months after the closing date. All other terms and conditions of the new notes will be the same as the terms and conditions of the additional notes sold on NovemberAugust 12, 2008. 2008, described below.
We are not permitted to prepay the additional notes without approval of the holders of at least a majority of the principal amount of the notes then outstanding.
On the earlier of the maturity date of November 14, 2010 or a merger or acquisition or other transaction pursuant to which our existing stockholders hold less than 50% of the surviving entity, or the sale of all or substantially all of our assets, or similar transaction, or event of default, each noteholder in its sole discretion shall have the option to:
| | · | convert the principal then outstanding on its notes into shares of our common stock, or |
| | · | receive immediate repayment in cash of the notes, including any accrued and unpaid interest. |
If a noteholder elects to convert its notes under these circumstances, the conversion price of additional notes will be the lower of:
| | · | the average of the closing bid and asked prices of shares of our common stock quoted in the Over-The-Counter Market Summary (or, if ours shares are traded on the Nasdaq Stock Market or another exchange, the closing price of shares of our common stock quoted on such exchange) averaged over five trading days prior to the closing date of the sale of the additional notes. |
Upon the following events of default and at any time during the continuance of such an event of default, the noteholders have the right, with the consent of the agent appointed for such noteholders, to accelerate payment on their notes:
| | · | failure to pay any amounts when due; |
| | · | non-performance of any material covenant that remains uncured for 15 days; |
| | · | any of our representations and warranties prove to have been false or misleading in any material respect when made; |
| | · | one or more judgments, decrees, or orders (excluding settlement orders) for the payment of money in the aggregate of $1,000,000 or more is entered against us or a subsidiary and is not discharged or stayed for a period of 60 days; or |
| | · | default by us or a subsidiary under any agreement related to indebtedness resulting in the acceleration of more than $500,000 of indebtedness. |
In addition, payment of the notes will be automatically accelerated if we enter voluntary or involuntary bankruptcy or insolvency proceedings.
The notes are secured by a first-priority lien on all of our unencumbered assets.
The additional notes and the common stock into which they may be converted have not been registered under the Securities Act or the securities laws of any other jurisdiction. As a result, offers and sales of the additional notes were made pursuant to Regulation D of the Securities Act and only made to accredited investors that were our existing stockholders. The investors are (i) Atlas, which originally recommended Shlomo Elia, one of our directors, for appointment to the Board of Directors; and (ii) Crystal Management Ltd., which is owned by Doron Roethler, our Chairman of the Board of Directors and bond representative for the noteholders. Unless and until they are registered, the additional notes and the common stock into which they may be converted may not be offered or sold except pursuant to an exemption from, or in a transaction not subject to, the registration requirements of the Securities Act or applicable securities laws of other jurisdictions.
If notes are converted into our common stock and a demand for registration of the shares of common stock is made by a holder of a majority of the converted common stock, we have agreed, subject to certain limitations, to use our best efforts to file a registration statement with the SEC:
| | · | within 180 days of such demand if: |
| | o | we are eligible to use Form S-1, and |
| | o | the demand is made with respect to at least 40% of the converted common stock then outstanding (or a lesser percentage if the anticipated aggregate offering price, net of selling expenses, would exceed $5 million); and |
| | · | within 90 days of such demand if: |
| | o | we are eligible to use Form S-3, and |
| | o | the demand is made with respect to at least 30% of the converted common stock then outstanding and the anticipated aggregate offering price, net of selling expenses, would exceed $2 million. |
In addition, if we propose to file a registration statement to register any of our common stock under the Securities Act in connection with the public offering of such securities solely for cash, subject to certain limitations, we shall give each noteholder who has converted its notes into common stock the opportunity to include such shares of converted common stock in the registration. We have agreed to bear the expenses for any of these registrations, exclusive of any stock transfer taxes, underwriting discounts, and commissions.
The noteholders have designated Doron Roethler, our Chairman of the Board of Directors, as bond representative to act as their agent. We have agreed that the bond representative and his representatives shall be granted access to our facilities and personnel during normal business hours, shall have the right to have his representative attend all meetings of our Board of Directors and its committees, and to receive all materials provided to the Board of Directors or any committee of the Board of Directors. We have agreed to pay all reasonable travel and lodging expenses of the bond representative related to his access to our facilities and attendance at Board of Directors meetings. In addition, so long as the notes are outstanding, we have agreed that we will not take any of the following actions without approval of the bond representative:
| | · | make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by us, except that we may own securities of 1-800-Pharmacy, Inc. pursuant to an agreement we have with it without obtaining the bond representative’s consent; |
| | · | make any loan or advance to any person, except advances and similar expenditures in the ordinary course of business or under the terms of an employee stock or option plan approved by our Board of Directors; |
| | · | guarantee any indebtedness except for our trade accounts or those of a subsidiary arising in the ordinary course of business; |
| | · | make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of two years; |
| | · | incur any aggregate indebtedness in excess of $25,000, other than trade credit incurred in the ordinary course of business; |
| | · | increase or approve the compensation of our named executive officers, including benefits, bonuses, and issuances of equity compensation; |
| | · | change our principal business, enter new lines of business, or exit the current line of business; |
| | · | sell, transfer, exclusively license, pledge, or encumber technology or intellectual property; |
| | · | create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, other than issuances to employees pursuant to equity compensation plans approved by our Board of Directors; |
| | · | purchase or redeem or pay any dividend on any capital stock, other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost; or |
| | · | increase the number of shares authorized for issuance to officers, directors, employees, consultants, and advisors pursuant to equity incentive plans or arrangements. |
We plan to use the proceeds to meet ongoing working capital and capital spending requirements.
In connection with the sale of the additional notes, the noteholders holding a majority of the aggregate principal amount of the notes outstanding agreed to increase the aggregate principal amount of secured subordinated convertible notes that they are committed to purchase from $8.5 million to $15.3 million, of which $4.8 million is currently outstanding.
Item 6. Exhibits
The following exhibits are being filed herewith and are numbered in accordance with Item 601 of Regulation S-K:
Exhibit No. |
| Description |
| 4.1 | | First Amendment to Convertible Secured Subordinated Note Purchase Agreement, dated August 12, 2008, by and among Smart Online, Inc. and certain investors |
| 10.1 | Consulting | Sublease Agreement, dated July 30, 2008, between theAdvantis Real Estate Services Company and George Cahill, effective April 22, 2008 (incorporated herein by referenceSmart Online, Inc. (asterisks located within the exhibit denote information which has been deleted pursuant to Exhibit 10.1 to our Current Report on Form 8-K, asa request for confidential treatment filed with the SEC on April 23, 2008)Securities and Exchange Commission) |
| 31.1 | | Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | | Certification of Principal Financial Officer Pursuant to Rule 13a-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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be. |
| 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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| Smart Online, Inc. |
| |
| /s/ David E. Colburn |
| David E. Colburn |
| Date: November 12, 2008 | Principal Executive Officer |
| |
| /s/ Timothy L. Krist |
| Timothy L. Krist |
| Principal Financial Officer and |
| Date: November 12, 2008 | Principal Accounting Officer |
EXHIBIT INDEX
| Exhibit No. | | Description |
| 4.1 | | First Amendment to Convertible Secured Subordinated Note Purchase Agreement, dated August 12, 2008, by and among Smart Online, Inc. and certain investors |
| 10.1 | | Sublease Agreement, dated July 30, 2008, between Advantis Real Estate Services Company and Smart Online, Inc. (asterisks located within the exhibit denote information which has been deleted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission) |
| 31.1 | | Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | | Certification of Principal Financial Officer Pursuant to Rule 13a-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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be. |
| 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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| Smart Online, Inc.
|
| |
| /s/ David E. Colburn |
| David E. Colburn |
Date: August 12, 2008 | Principal Executive Officer |
| |
| |
| /s/ Timothy L. Krist |
| Timothy L. Krist |
| Principal Financial Officer and |
Date: August 12, 2008 | Principal Accounting Officer |
| |
EXHIBIT INDEX
Exhibit No.
| Description
|
10.1 | Consulting Agreement between the Company and George Cahill, effective April 22, 2008 (incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with the SEC on April 23, 2008) |
31.1 | Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
31.2 | Certification of Principal Financial Officer Pursuant to Rule 13a-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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be. |
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. This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.
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