Crossroads Systems 10Q 2014 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED January 31, 2014

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER:001-15331

CROSSROADS SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE		74-2846643
	(State or other jurisdiction of		(I.R.S. Employer Identification No.)
	incorporation or organization)

11000 NORTH MOPAC EXPRESSWAY AUSTIN, TEXAS	78759
(Address of principal executive offices)	(Zip code)

(512) 349-0300

(Registrant's telephone number, including area code)

Indicate by check mark whether registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.x Yes¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).x Yes¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

¨ Large Accelerated Filer

¨ Accelerated Filer

¨ Non-Accelerated Filer

x Smaller Reporting Company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) ¨ Yes x No

As of March 7, 2014 Registrant had outstanding 12,883,023 shares of common stock, par value $0.001 per share.

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-Q

QUARTER ENDED January 31, 2014

TABLE OF CONTENTS

		PAGE
PART I FINANCIAL INFORMATION

Item 1.	Financial Statements	3

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24

Item 4.	Controls and Procedures	24

PART II OTHER INFORMATION

Item 1.	Legal Proceedings	25

Item 1A.	Risk Factors	25

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25

Item 3.	Defaults Upon Senior Securities	26

Item 4.	Mine Safety Disclosures	26

Item 5.	Other Information	26

Item 6.	Exhibits	26

	2

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS –

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

	October 31,		January 31,
	2013		2014
			(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	7,795	$	7,998
Accounts receivable, net of allowance for doubtful accounts of $94 and $100, respectively		2,301		3,001
Inventory		313		323
Prepaid expenses and other current assets		694		628

Total current assets		11,103		11,950

Property and equipment, net		1,031		841
Other assets		256		180

Total assets	$	12,390	$	12,971

LIABILITIES AND STOCKHOLDERS' DEFICIT

Current liabilities:
Accounts payable	$	1,066	$	904
Accrued expenses		2,095		1,394
Deferred revenue		1,090		1,215
Current portion of long term debt, net of debt discount		1,605		2,763

Total current liabilities		5,856		6,276

Long term debt, net of debt discount		6,984		5,902
Long term derivative liability		772		3,957
Other long term liabilities		299		384

Commitments and contingencies (See Note 7)		-		-

Convertible preferred stock, $0.001 par value, 25,000,000 shares authorized, 4,231,154 and 3,783,697 shares issued and outstanding, respectively, net		6,394		5,720

Stockholders' deficit:
Common stock, $0.001 par value, 75,000,000 shares authorized, 11,949,937 and 12,883,023 shares issued and outstanding, respectively		12		13
Additional paid-in capital		208,702		211,044
Accumulated other comprehensive loss		(51)		(50)
Accumulated deficit		(216,578)		(220,275)

Total stockholders' deficit		(7,915)		(9,268)

Total liabilities and stockholders' deficit	$	12,390	$	12,971

See accompanying notes to the condensed consolidated financial statements.

	3

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share and per share data)

	Three Months Ended
	January 31,
	2013		2014

Revenue:
Product	$	1,918	$	1,230
IP license, royalty and other		1,633		2,895

Total revenue		3,551		4,125

Cost of revenue:
Product		194		236
IP license, royalty and other		754		383

Total cost of revenue		948		619

Gross profit		2,603		3,506

Operating expenses:
Sales and marketing		1,960		1,032
Research and development		2,857		1,531
General and administrative		876		1,338

Total operating expenses		5,693		3,901

Loss from operations		(3,090)		(395)

Gain on settlement		-		1,050

(Loss) income before interest and derivative expense		(3,090)		655

Other expense:
Interest expense		(54)		(587)
Change in value of derivative liability		-		(3,400)
Other expense		(1)		-

Net loss	$	(3,145)	$	(3,332)

Dividends attributable to preferred stock	$	-	$	(155)
Net loss available to common stockholders, basic and diluted	$	(3,145)	$	(3,487)
Net loss per share available to common stockholders, basic and diluted	$	(0.27)	$	(0.28)

Shares used in computing net loss per share:
Available to common stockholders, basic and diluted		11,819,003		12,368,715

See accompanying notes to the condensed consolidated financial statements.

	4

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Three Months Ended
	January 31,
	2013		2014

Cash flows from operating activities:
Net loss	$	(3,145)	$	(3,332)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		201		198
Loss on change in value of derivative liability		-		3,400
Amortization of debt discount		-		341
Stock-based compensation		383		548
Provision for doubtful accounts receivable		(5)		6
Changes in assets and liabilities:
Accounts receivable		570		(707)
Inventory		(29)		(10)
Prepaid expenses and other assets		(37)		45
Accounts payable		(102)		(161)
Accrued expenses		(706)		(606)
Deferred revenue		264		213
Net cash used in operating activities		(2,606)		(65)
Cash flows from investing activities:
Purchase of property and equipment		(119)		(9)
Maturity of held-to-maturity investments		-		-
Net cash used in investing activities		(119)		(9)
Cash flows from financing activities:
Proceeds from issuance of common stock, net of expenses		2		488
Repayment of debt		(1,720)		(208)
Net cash (used in) provided by financing activities		(1,718)		280

Effect of foreign exchange rate on cash and cash equivalents		4		(3)
Net (decrease) increase in cash and cash equivalents		(4,439)		203
Cash and cash equivalents, beginning of period		6,895		7,795
Cash and cash equivalents, end of period	$	2,456	$	7,998

Supplemental disclosure of cash flow information:

Cash paid for interest	$	45	$	256
Cash paid for income taxes	$	1	$	-

Supplemental disclosure of non cash financing activities:

Conversion of preferred stock to common stock	$	-	$	674
Common stock dividends issued to preferred shareholders	$	-	$	366
Conversion of derivative liability to equity	$	-	$	215

See accompanying notes to the condensed consolidated financial statements.

	5

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements include the accounts of Crossroads Systems, Inc. and its wholly-owned subsidiaries (“Crossroads” or the “Company”). Headquartered in Austin, Texas, Crossroads Systems, a Delaware corporation, is a global provider of data archive solutions. Through the innovative use of new technologies, Crossroads delivers customer-driven solutions that enable proactive data security, advanced data archiving, optimized performance and significant cost-savings.

The accompanying unaudited condensed consolidated financial statements of Crossroads Systems, Inc. have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with United States generally accepted accounting principles (“GAAP”). The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto together with management’s discussion and analysis of financial condition and results of operations contained in the Company’s 2013 Annual Report on Form 10-K filed on January 23, 2014 (“2013 Form 10-K”). In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to fairly state the financial position of the Company at October 31, 2013 and January 31, 2014, the results of its operations for the three months ended January 31, 2013 and 2014, and its cash flows for the three months ended January 31, 2013 and 2014. The results of operations for the periods presented are not necessarily indicative of results that may be expected for the year ending October 31, 2014.

Principles of consolidation and presentation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has accumulated significant losses as it has been developing its current and next generation products. The Company believes that cash flow from operations, customer reimbursed expenses, and proceeds from the sale of equity will be sufficient to fund the anticipated operations for fiscal 2014. These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

The Company’s investment in KIP CR P1 LP (to which the Company refers as the partnership), of which the Company is a limited partner and of which an affiliate of Fortress Investment Group LLC is the general partner, is accounted for using the equity method. The current investment balance is nominal at January 31, 2014.

Use of Estimates

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates, and such differences may be material to the consolidated financial statements.

Computation of Net Loss Per Share

Basic loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed by giving effect to all dilutive potential common shares that were outstanding during the period. Basic earnings per share excludes the dilutive effect of common stock equivalents such as stock options and warrants, while earnings per share, assuming dilution, includes such dilutive effects. Future weighted-average shares outstanding calculations will be impacted by the following factors, among others: (i) the ongoing issuance of common stock associated with stock option and warrant exercises; (ii) any fluctuations in the Company’s stock price, which could cause changes in the number of common stock equivalents included in the earnings per share, assuming dilution computation; and (iii) the issuance of common stock to effect business combinations should the Company enter into such transactions.

The Company has excluded all outstanding common stock equivalents from the calculation of diluted net loss per share because all such common stock equivalents are antidilutive for all periods presented. The total number of common stock equivalents excluded from the diluted net loss per common share calculation was3,178,929 and11,932,823 for the three months ended January 31, 2013 and 2014, respectively. The dilutive common stock equivalents for the three months ended January 31, 2014 include warrants to purchase4,582,416 shares of common stock,3,783,697 shares of preferred stock, which are excluded until converted to common shares (Note 8), and stock options to purchase3,566,710 shares of common stock.

Net loss available to common stockholders is calculated by deducting from net income preferred dividends paid and accrued of $0.2 million.

	6

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Contracts to Modify or Customize Products

The Company periodically enters into contracts with certain customers to significantly modify or customize products. In accounting for such arrangements, the Company first looks to the guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 985-605,Software - Revenue Recognition (“ASC 985-605”), and then ASC Subtopic 605-25,Revenue Recognition – Multiple-Element Arrangements, to determine the appropriate accounting elements in the arrangement. The Company then considers the appropriate recognition model for each accounting element based on the nature of the element and applies the guidance in ASC Subtopic 605-35,Revenue Recognition – Construction-Type and Production-Type Contracts, ASC Subtopic 985-60, ASC Subtopic 605-15,Revenue Recognition – Products, or ASC Subtopic 605-20,Revenue Recognition – Services, as applicable. Amounts allocated to the modification/customization service element are evaluated for classification in the consolidated statement of operations as either revenue or reduction of research and development expense based on the following considerations: whether and in what circumstances the consideration received is refundable, ownership of the final product and intellectual property rights to develop the product, and exclusivity of the final product.

Recently Issued Accounting Pronouncements

On March 4, 2013, the FASB issued ASU 2013-05,Foreign Currency Matters (Topic 830) Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (“ASU 2013-05”). ASU 2013-05 updates accounting guidance related to the application of consolidation guidance and foreign currency matters. This guidance resolves the diversity in practice about what guidance applies to the release of the cumulative translation adjustment into net income. This guidance is effective for interim and annual periods beginning after December 15, 2013. The Company anticipates adopting ASU 2013-05 beginning November 1, 2014. The Company does not anticipate that these changes will have a material impact on its consolidated financial statements or disclosures.

FAIR VALUE MEASUREMENTS

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To increase the comparability of fair value measurements, a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies, is applied as follows:

Level 1 – Valuations based on quoted prices for identical assets and liabilities in active markets.

Level 2 – Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

Level 3 – Valuations based on unobservable inputs reflecting management’s assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment.

As of October 31, 2013 and January 31, 2014, the fair value of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximates book value due to the short maturity of these instruments. Based upon borrowing rates currently available to the Company for loans with similar terms, the principal balance of its debt obligations approximates fair value. The following table represents the Company’s fair value hierarchy for its financial instruments measured at fair value on a recurring basis as of January 31, 2014 (in thousands):

Fair Value Table

			Quoted Prices in Active		Significant Other		Significant
	Balance at January		Markets for Identical		Observable Inputs		Unobservable Inputs
	31, 2014		Liabilities (Level 1)		(Level 2)		(Level 3)

Derivative liability	$	3,957	$	-	$	-	$	3,957

	$	3,957	$	-	$	-	$	3,957

	7

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In accordance with ASC 815-40-25 and ASC 815-10-15Derivatives and Hedging and ASC 480-10-25Liabilities-Distinguishing Liabilities from Equity as approved by shareholders, the convertible preferred shares are accounted for net outside of stockholders’ equity at $5,720,000 with the warrants accounted for as liabilities at their fair value of $3,957,000 as of January 31, 2014. The value of the derivative warrant liability is re-measured at each reporting period with changes in fair value recorded as “Change in value of derivative liability”. To derive an estimate of the fair value of these warrants, the Company utilized a dynamic Black Scholes Merton formula that computes the impact of share dilution upon the exercise of the warrant shares. This process relies upon inputs such as shares outstanding, estimated stock prices, strike price, and volatility assumptions to dynamically adjust the payoff of the warrants in the presence of the dilution effect. In the event the convertible preferred shares are redeemed, any redemption price in excess of the carrying amount of the convertible preferred stock would be treated as a dividend. The changes in liabilities measured using significant unobservable inputs for three months ended January 31, 2014 was as follows (in thousands) (see Note 8 explaining the revaluation of Series-F Preferred Stock and Warrants):

Level 3 Roll-forward	Derivative Liability
Balance October 31, 2013	$	772
Change in fair value of derivative liability		3,400
Derivative liability converted to equity upon exercise		(215)
Balance January 31, 2014 (Unaudited)	$	3,957

During the three months ended January 31, 2014 there were approximately153,000 Series-F warrants exercised.

3. INVENTORY

Inventory, net consists of the following (in thousands):

	October 31,		January 31,
	2013		2014
			(Unaudited)

Raw materials	$	204	$	222
Finished goods		109		101
	$	313	$	323

4. PROPERTY AND EQUIPMENT

Property and equipment, net consist of the following (in thousands, except number of years):

			October 31,		January 31,
			2013		2014
	Life (years)				(Unaudited)
Equipment	1-3	$	18,390	$	18,373
Furniture and fixtures	5		789		788
Leasehold improvements	5		576		576
			19,755		19,737
Less: Accumulated depreciation			(18,724)		(18,896)
		$	1,031	$	841

Depreciation expense was approximately $201,000 and $198,000 for three months ended January 31, 2013 and 2014, respectively.

5. ACCRUED EXPENSES AND DEFERRED REVENUE

Accrued expenses consist of the following (in thousands):

	8

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

	October 31,		January 31,
	2013		2014
			(Unaudited)

Payroll related	$	1,470	$	730
Professional services		359		487
Warranty reserve		41		41
Other		225		136
	$	2,095	$	1,394

Included in payroll related accrued expenses as of October 31, 2013 was $202,000 related to bonus compensation, $135,000 of which was settled in January 2014 with66,081 shares of common stock. Also included in payroll related accrued expenses as of October 31, 2013 was $326,000 of unpaid severance, relating to the reduction in force which occurred October 24, 2013, and $142,000 of unpaid severance, relating to the termination of our previous CEO’s employment on May 8, 2013.

Warranty reserve activity, included in accrued expenses, during the year ended October 31, 2013 and three months ended January 31, 2014 was as follows (in thousands):

	Balance at		Charged to				Balance at
	Beginning		Costs and		Reserve		End of
	of Period		Expenses		Usage		Period

Year ended October 31, 2013
Warranty reserve	$	11	$	58	$	(28)	$	41

Three months ended January 31, 2014
Warranty reserve (Unaudited)	$	41	$	-	$	-	$	41

Deferred revenue, current portion, consists of the following (in thousands):

	October 31,		January 31,
	2013		2014
			(Unaudited)

Product	$	47	$	92
Services		1,043		1,123
	$	1,090	$	1,215

6. LINE OF CREDIT AND LONG TERM LIABILITIES

The Company had a revolving line of credit and term loan with Silicon Valley Bank. In July 2013, the Company entered into a Credit Agreement and security agreements with Fortress Credit Co. LLC, an affiliate of Fortress Investment Group LLC (such affiliates collectively, “Fortress”) (described below). The Company used a portion of the proceeds of the Fortress loans to repay the revolving line of credit and term loan with Silicon Valley Bank.

Effective July 22, 2013, the Company entered into a Credit Agreement with Fortress that provides for aggregate Term Loan commitments of up to $10 million. The Term Loan consists of a Term Loan A in the principal amount of $5 million, which maturesJuly 22, 2016 and a Term Loan B in the principal amount of $5 million, which maturesFebruary 1, 2016. The Company drew down the full $10 million of both Term Loans on July 24, 2013. Interest on the Fortress notes is due monthly in arrears and the remaining principal balance accrues interest at10% annually. Term Loan A is interest-only for the first 12 months and Term Loan B is interest-only for the first six months .

The accounting treatment of debt issuance costs is indicated in ASC 835-30-45-3 and ASC 470-50-40-17 to 19. Debt issuance costs should be recorded as a deferred charge and amortized over the term of the debt using the interest method. The effective interest rate of the combined Fortress loans is13.37%. The notes have a statutory interest rate of10%. The effective rate is higher due to the use of the effective interest method to calculate the monthly expense, which includes debt discount, and loan origination fee amortization.

	9

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In conjunction with the Credit Agreement with Fortress, the Company has agreed to certain financial covenants.The Company is required to maintain a minimum of $1.5 million of unrestricted cash at each month end and the Company is restricted from making certain cash distributions to equity security holders or from incurring additional indebtedness without prior written consent from Fortress. The Company has also agreed to certain reporting covenants and must supply monthly financial statements to Fortress within 30 days of the end of each month.

In connection with the Fortress Transactions, the Company transferred substantially all of its patents, other than its ’972 patent family, to a limited partnership KIP CR P1 LP of which the Company is a limited partner and of which an affiliate of Fortress is the general partner. The partnership now controls 117 pending or granted non-’972 patents. There was no licensing activity during fiscal year 2013 associated with these patents. The general partner cannot be removed without the consent of Fortress. The Company accounts for the investment in the partnership on a consolidated basis using the equity method of accounting.

As a condition to and in connection with the Credit Agreement, the Company issued to Fortress warrants to purchase1,454,545 shares of the Company’s common stock at an exercise price of $2.0625 per share (“Fortress Warrants”). See Note 8 for a discussion of the Fortress Warrants.

As of January 31, 2014, the carrying amount of the notes payable to Fortress and other, net of debt discounts, consists of the following (in thousands):

	October 31,		January 31,
	2013		2014
			(Unaudited)

Principal balance Fortress	$	10,000	$	9,792
Principal balance other		-		37
Unaccreted debt discount		(1,411)		(1,164)
Net carrying value of Fortress notes		8,589		8,665
Less current portion of debt		(1,605)		(2,763)
Long term portion of debt	$	6,984	$	5,902

7. COMMITMENTS AND CONTINGENCIES

Leases

The Company leases office space and equipment under long-term operating lease agreements that expire on various dates through August 31, 2016. Rental expense under these agreements was approximately $113,000 and $123,000 for the three months ended January 31, 2013 and 2014, respectively. The Company leases its headquarters, approximately 37,800 square feet of general office, laboratory, data center and administrative space in Austin, Texas. The original lease was effective October 31, 2005 and extended in accordance with an extension agreement through February 28, 2015.The term of the extension agreement is five years, from March 1, 2010 through February 28, 2015, and represents a lease commitment of approximately $382,000 per year through the lease term.

Legal Proceedings

Intellectual Property Litigation

The Company filed a lawsuit on September 11, 2013 against Dot Hill Systems Corp. ("Dot Hill") styled Crossroads Systems, Inc. v. Dot Hill Systems Corp., Civil Action No. 1:13-CV-800-SS alleging patent infringement and breach of the Amended Settlement and License Agreement dated June 27, 2006 between Crossroads and Dot Hill. Dot Hill filed a motion to dismiss and the Court denied Dot Hill’s motion. The action is proceeding in the Western District of Texas.

The Company filed a lawsuit on October 7, 2013 against Oracle Corporation alleging infringement by Oracle Corporation of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc., v. Oracle Corporation; Civil Action No. 1:13-CV-895-SS (W.D. Tex., Austin Division)). Oracle has answered the complaint. The action is pending.

The Company filed a lawsuit on November 26, 2013 against Tandberg Data Corporation alleging infringement by Tandberg Data Corporation of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Tandberg Data Corporation; Civil Action No. 1:13-cv-01026-SS (W.D. Tex., Austin Division)). Tandberg Data answered the complaint and the action is pending.

	10

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company filed a lawsuit on November 26, 2013 against Huawei Technologies Co. Ltd., Huawei Enterprise USA, Inc. & Huawei Technologies USA, Inc. alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Huawei Technologies Co., Ltd. et al; Civil Action No. 1:13-cv-01025-SS (W.D. Tex., Austin Division)). Huawei has answered the complaint and the action is pending.

The Company filed a lawsuit on November 26, 2013 against Dell Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Dell Inc.; Civil Action No. 1:13-cv-01023-SS (W.D. Tex., Austin Division)). Dell answered the complaint and the action is pending.

8. STOCKHOLDERS’ EQUITY

2010 Private Placement

On October 23, 2010 the Company sold3,125,000 shares of its common stock at $3.20 per share for gross proceeds to the Company of $10.0 million. In conjunction with this private placement, the Company also issued warrants to purchase an additional1,074,212 shares of common stock with an exercise price of $3.20 per share. Fees in the amount of $0.8 million relating to the stock placement were netted against proceeds. The warrants were valued at $1.3 million using the Black-Scholes model. The Black-Scholes inputs used were: expected dividend rate of0%, expected volatility of63%, risk free interest rate of1.47%, and expected term of5 years. The warrants were exercisable immediately upon issue, and expire October 22, 2015. As of January 31, 2014, there were998,096 warrants outstanding.

IronMountainPrivate Placement

On July 31, 2012, the Company issued and sold to Iron Mountain Incorporated (“IRM”)582,524 shares of its common stock at $5.15 per share, for an aggregate purchase price of $3 million. The Company also entered in a registration rights agreement with IRM, pursuant to which the Company agreed to prepare and file a registration statement with the Securities and Exchange Commission (“SEC”) at IRM’s request, no later than sixty days following such request, and to keep it continuously effective until the shares covered by the registration statement have been sold or become eligible for sale pursuant to SEC Rule 144 without restriction on the volume of securities that may be sold in any single transaction, assuming for this purpose that the security holders are not affiliates of the Company. On December 19, 2013, the Company and IRM mutually agreed to end their agreement involving co-promoted product development (refer to Note 11). As part of the settlement IRM also agreed that it would not transfer the shares without the Company’s prior written consent until the two-year anniversary date of the settlement, and that it would vote the shares consistent with the recommendation of the Company’s Board of Directors.

2013 Private Placement

On March 22, 2013, the Company entered into a Securities Purchase Agreement with certain accredited investors for the issuance and sale in a private placement of4,231,154 units at a purchase price of $2.0625 per unit, valued at $8.6 million, for net proceeds of approximately $7.9 million after related expenses. Each unit consists of one share of cumulative 5.0% Series F convertible preferred stock, par value $0.001 per share and a warrant to purchase one-half of a share of common stock equal per share of convertible preferred stock purchased, at an exercise price of $2.00 per whole share, subject to certain adjustments, resulting in the issuance of warrants to purchase an additional2,282,754 shares of common stock with an exercise price of $2.00 per share. The convertible preferred stock ranks senior to the common stock and each other class or series of the Company’s capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. The warrants were initially valued using the Black-Scholes pricing model at approximately $2,284,000. The relative fair value of these warrants, totaling $1,543,000, were initially allocated to additional paid in capital. The Black-Scholes inputs used were: expected dividend rate of0 %, expected volatility of63%, risk free interest rate of0.82%, and expected term of5 years. This valuation resulted in a beneficial conversion feature on the convertible preferred stock of approximately $1,090,000. This amount was recorded, upon issuance, as a deemed dividend. Fees in the amount of $0.7 million relating to the stock placement were netted against proceeds. The warrants became exercisable on June 21, 2013, and expire March 22, 2018. Stock dividends valued at $106,000 were issued in fiscal year 2013, by issuing57,097 shares of common stock. During the three months ended January 31, 2014, the Company issued150,703 dividend common shares valued at approximately $366,000.

	11

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The warrants related to the Series F Preferred Shares were revalued at October 31, 2013 using the Black-Scholes pricing model at approximately $772,000. The dynamic Black-Scholes inputs used were: expected dividend rate of0%, expected volatility of65%, risk free interest rate of1.10%, and expected term of4.4 years. At January 31, 2014 these warrants were revalued at approximately $3,957,000 using dynamic Black-Scholes inputs of: expected dividend rate of0%, expected volatility of74%, risk free interest rate of1.16%, and expected term of4.2 years.

The convertible preferred stock has the rights, qualifications, limitations and restrictions set forth in the Certificate of Designation (the “Certificate of Designation”) filed with the Secretary of State of the State of Delaware on March 28, 2013. The Certificate of Designation authorizes issuance of up to4,500,000 shares of convertible preferred stock, with3,750,000 shares designated as “Sub-Series F-1” and750,000 shares designated as “Sub-Series F-2.”The right of holders of convertible preferred stock to convert the convertible preferred stock is subject to a 9.99% beneficial ownership limitation for holders of Sub-Series F-1 and a 4.99% beneficial ownership limitation for holders of Sub-Series F-2.Such beneficial ownership limitations may be increased or decreased by a holder of Sub-Series F-1 to any percentage not in excess of 19.99% after providing notice of such increase or decrease to the Company. For as long as at least 90% of the aggregate number of shares of Sub-Series F-1 issued on the Original Issue Date are outstanding, the holders of such Sub-Series F-1, voting as a single class, will be entitled to elect two directors of the Company. If less than 90%, but at least 20%, of such shares of Sub-Series F-1 are outstanding, such holders, voting as a single class, will be entitled to elect one director of the Company.The holders of Sub-Series F-2 will not be entitled to vote on the directors elected by the holders of Sub-Series F-1. The holders of shares of the convertible preferred stock are entitled to a liquidation preference equal to the original issuance price plus any unpaid dividends.

The full ratchet anti-dilution provisions in the Company’s convertible preferred stock and warrants issued in its March 2013 private placement (discussed above) were not in effect until those provisions were approved by a vote of the Company’s stockholders at its 2013 annual meeting held on June 21, 2013. Upon approval of these provisions the warrants were reclassified as a derivative liability and recorded at fair value. Also upon approval of the full ratchet anti-dilution provision the Series F convertible preferred stock were potentially convertible into more shares of common stock than currently authorized, therefore those shares were classified in temporary equity. Upon the expiration of the full ratchet anti-dilution provisions on the one-year anniversary of the March 2013 private placement or approval of an amendment during the annual shareholders meeting on March 14, 2014, the Company expects the preferred stock and warrants to be reclassified back to permanent stockholders' equity.

In the event the convertible preferred shares are redeemed, any redemption price in excess of the carrying amount of the convertible preferred stock would be treated as a dividend. During the three months ended January 31, 2014, there were447,457 shares of Series-F Preferred shares converted to common shares with a value of approximately $674,000. The following table illustrates the carrying value of the Series-F Preferred shares; (in thousands)

Series F-Preferred Shares

Net proceeds from issuance of Series-F Preferred Shares	$	7,937
Discount related to allocation of relative fair value of warrants		(1,543)
Net Series-F Preferred Shares October 31, 2013		6,394
Conversion of preferred shares to common shares		(674)
Net Series-F Preferred Shares January 31, 2014 (Unaudited)	$	5,720

	12

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Dividends on the Series F convertible preferred stock will accrue at an annual rate of5.0% of the original issue price and will be payable on a semi-annual basis. The convertible preferred ranks senior to the common stock and each other class or series of the Company’s capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. Pursuant to a registration rights agreement entered into with the purchasers of the Series F convertible preferred stock, in the event that a registration statement for the resale of the common stock underlying the convertible preferred stock and March 2013 warrants was not declared effective prior to July 26, 2013 (120 days from the closing of the March 2013 private placement), then the rate at which dividends accrued on the convertible preferred stock would be increased to an annual rate of12.0% from that date until such time as a registration statement is declared effective, at which time the dividend rate reverts to an annual rate of 5.0%. The registration statement was not declared effective by July 26, 2013, and as a result the dividend rate on the convertible preferred stock increased to an annual rate of 12.0%, until September 19, 2013 when it was declared effective. The Company may elect to satisfy our obligation to pay semi-annual dividends in cash, by distribution of common stock or a combination thereof, in our discretion. During the three months ended January 31, 2014 the Company elected to issue 150,703 shares of common stock to satisfy accrued dividends. Accrued and unpaid dividends were valued at $33,000 as of January 31, 2014.

On February 28, 2013, in connection with the 2013 Private Placement, the Company issued convertible promissory notes to two investors, in the aggregate principal amount of $550,000.Pursuant to the terms of the notes, both note holders had the right to convert the outstanding amounts under their notes into Series F convertible preferred stock shares at a discount of 15% to the issue price of the Series F convertible preferred stock. This resulted in a beneficial conversion feature of $107,000. Each note holder exercised this right and received188,235 Series F convertible preferred stock shares, in the case of the note holder converting $330,000 of promissory notes and interest, and156,863 Series F convertible preferred stock shares, in the case of note holder converting $275,000 of promissory notes and interest.

The Company has the following common stock warrants outstanding at January 31, 2014:

Warrants Outstanding

Warrant Transaction	Warrants Outstanding	Exercise Price
2010 Private Placement	998,096	$	3.20
2013 Private Placement	2,129,775	$	2.00
2013 Fortress Credit Agreement	1,454,545	$	2.06
Total Warrants	4,582,416

2013 Fortress Credit Agreement

Effective July 22, 2013, the Company entered into a Credit Agreement with Fortress described above in Note 6. As a condition to and in connection with the Credit Agreement, the Company issued to Fortress the Fortress Warrant, pursuant to which Fortress is entitled to purchase1,454,545 shares of the Company’s common stock at an exercise price of $2.0625 per share.

The Fortress Warrants previously contained what is commonly referred to as “full-ratchet” anti-dilution protection pursuant to which, if the Company issued or was deemed to have issued additional shares of common stock without consideration or for a consideration per share less than the applicable exercise price, which is initially $2.0625 per share, then the exercise price of the Fortress Warrants would have been reduced, concurrently with such issue, to the consideration per share received by the Company for such issue or deemed issue of the additional shares of common stock.On January 23, 2014, the Company entered into a warrant amendment with the warrantholder, the sole purpose of which was to remove the “full-ratchet” anti-dilution provision of the warrant. This “full-ratchet” anti-dilution provision would have expired no later than July 22, 2014 under the original terms of the Warrant.

To derive an estimate of the fair value of these warrants, the Company utilized a dynamic Black Scholes Merton formula that computes the impact of share dilution upon the exercise of the warrant shares. This process relies upon inputs such as shares outstanding, estimated stock prices, strike price and volatility assumptions to dynamically adjust the payoff of the warrants in the presence of the dilution effect. The Fortress Warrant was recorded in shareholders’ equity at a fair value of $1,374,000 or $1.0625 per underlying warrant share.

The Fortress Warrant is exercisable on or after October 22, 2013 and will expire on the seventh anniversary of the effective date of the Fortress Transactions. If the Fortress Warrant is exercisable and there is no effective Registration Statement registering, or no current prospectus available for the resale of the shares of common stock issuable upon exercise of the Fortress Warrant, then the Fortress Warrant may also be exercised at such time by means of a “cashless exercise,” determined according to the terms of the Fortress Warrant.

STOCK OPTIONS AND STOCK BASED COMPENSATION

The Company has a stock-based compensation plan available to grant incentive stock options, non-qualified stock options and restricted stock to employees and non-employee members of the board of directors and advisors.

The Company’s 2010 Stock Incentive Plan (the “2010 Plan”) succeeded the 1999 Stock Option/Stock Issuance Plan (the “1999 Plan”). As of January 31, 2014, options to purchase693,217 shares of common stock were outstanding under the 1999 Plan, and no further grants can be made under the 1999 Plan.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The 2010 Plan was approved by the board of directors on May 26, 2010 and became effective on August 13, 2010, upon approval by shareholders. A maximum of3,500,000 shares of the Company’s common stock may be awarded, plus the automatic increase as detailed below. The total number of shares that will be reserved, and that may be issued, under the 2010 Plan will automatically increase on the first trading day of each calendar year, by a number of shares equal tofour percent (4%) of the total outstanding shares on the last day of the prior calendar year, subject to a maximum annual increase of 250,000. As of January 31, 2014, options to purchase3,576,998 shares of common stock were granted from the 2010 Plan, of which2,873,493 were outstanding. During the three months ended January 31, 2013 and 2014, common stock share grants of146,555 and66,081, respectively, were granted from the 2010 Plan.

As of January 31, 2014, options to purchase an aggregate of3,566,710 shares of common stock were outstanding under the 1999 Plan and the 2010 Plan, of which1,843,938 were vested. Under the 2010 Plan,233,274 shares of common stock were available for future grants as of January 31, 2014. The shares of common stock reserved for future grant are reduced by96,638 options previously exercised under the 2010 Plan, and296,595 shares of stock granted under the 2010 Plan. The Compensation Committee of the Board of Directors determines the exercise price, term and other conditions applicable to each stock option granted under the 2010 Plan. The exercise price of stock options is set on the grant date and may not be less than the fair market value per share of the Company’s stock on that date (at market close).The 2010 Plan options generally become exercisable over a four-year period (vesting 25% after one year, the remaining 75% vesting quarterly thereafter) and expire after ten years. During 2013, the majority of the employee incentive stock option grants vest on a schedule of 25% at the end of six months and 12.5% thereafter. Stock option exercises are fulfilled with new shares of common stock.

The Company realized stock-based compensation expense for all awards issued under the Company’s stock plans in the following line items in the consolidated statements of operations (in thousands):

	Three months ended January 31,
	2013		2014
			(Unaudited)

Cost of revenue	$	7	$	12
Sales and marketing		135		124
Research and development		120		201
General and administrative		121		211
Total stock-based compensation	$	383	$	548

During the year ended October 31, 2013 share based compensation expense of approximately $147,000 was accrued for67% of the total estimated management bonus for the fiscal year ended October 31, 2013. Accordingly,66,081 shares of common stock were granted in January 2014 to satisfy this liability.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatility is based on historical volatility of the Company’s stock. The expected term represents an estimate of the time options are expected to remain outstanding based upon historical analysis. The risk-free rate for periods within the contractual life of the option is based on the U.S. treasury yield curve in effect at the time of grant. The variables used in the Black-Scholes calculation are listed below for the respective periods:

	Three months ended January 31,
	2013		2014


Expected dividend yield	0	%	0	%
Expected volatility	69	%	73 - 74	%
Risk-free interest rate	0.7 - 0.8	%	1.4 - 1.6	%
Expected term (years)	6.1		4 - 5

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes information about stock option activity for the three months ended January 31, 2014 (unaudited):

	Number of Shares		Weighted Average Exercise Price	Weighted Average Remaining Contractual Term (years)		Aggregate Intrinsic Value ($M)

Outstanding at October 31, 2013	3,320,910	$	2.71	6.43	$	–
Granted	545,464	$	1.71
Forfeited	(183,798)	$	4.00
Exercised	(115,866)	$	1.55
Outstanding and expected to vest at January 31, 2014	3,566,710	$	2.53	7.09	$	3.2

Exercisable at January 31, 2014	1,843,938	$	3.09	4.94	$	1.3

The weighted average fair value per option granted during the three months ended January 31, 2013 and 2014 was $1.68 and $1.10 respectively. The total intrinsic value of options (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) exercised during the three months ended January 31, 2013 and 2014 was $1,000 and $127,000 respectively. During the three months ended January 31, 2013 and 2014, the amount of cash received from the exercise of stock options was approximately $1,600 and $180,000, respectively.

The Company granted40,000 options to non-employees during the three months ended January 31, 2013 with a fair value of approximately $67,000, and granted10,000 options during the three months ended January 31, 2014, with a fair value of approximately $14,000.

At January 31, 2014, there was approximately $1,158,000 of total unrecognized compensation cost related to non-vested stock option awards. This cost is expected to be recognized over a weighted-average period of1.0 year. There were119,369 and243,622 options that became vested during the three months ended January 31, 2013 and 2014, respectively, with the total fair value of these awards of approximately $233,000 and $340,000 respectively.

The following table shows information about outstanding stock options at January 31, 2014:

					Options Outstanding				Options Exercisable
						Weighted
						Average	Weighted			Weighted
Range of					Shares	Remaining	Average			Average
Exercise Prices					Outstanding	Contractual Term	Exercise Price		Shares	Exercise Price
$	0.64	-	$	1.21	579,606	9.17	$	1.11	184,606	$	0.89
$	1.21	-	$	1.54	521,506	9.76	$	1.50	127,756	$	1.38
$	1.54	-	$	1.56	359,977	4.38	$	1.56	331,609	$	1.56
$	1.56	-	$	2.04	108,981	6.31	$	1.80	83,556	$	1.79
$	2.04	-	$	2.10	864,368	9.36	$	2.10	166,095	$	2.10
$	2.10	-	$	3.98	359,896	5.44	$	3.14	269,129	$	3.29
$	3.98	-	$	4.75	498,065	3.19	$	4.62	433,861	$	4.61
$	4.75	-	$	10.64	274,311	3.59	$	5.76	247,326	$	5.86

$	0.64	-	$	10.64	3,566,710	7.09	$	2.53	1,843,938	$	3.09

10.

EMPLOYEE BENEFITS

In 1996, the Company established the Crossroads Systems, Inc. 401(k) Savings Plan (the “Savings Plan”), which is a qualified plan under section 401(k) of the Internal Revenue Code. All employees who have attained 18 years of age are eligible to enroll in the Savings Plan. The Company may make matching contributions to those employees participating in the Savings Plan based upon Company productivity and profitability. Company contributions vest over a period of six years. In October 2000, the Company adopted a new 401(k) Savings Plan that meets all of the criteria set forth above in the Savings Plan. The Company made matching contributions $75,000 and $45,000 during the three months ended January 31, 2013 and 2014, respectively.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

11. RELATED PARTY TRANSACTIONS

On December 19, 2013, the Company and IRM entered into a settlement agreement to end their contract involving the development of a co-branded product. The Company received $1.6 million in connection with the terminated contract in the first quarter of fiscal year 2014. The Company bifurcated the payment between amounts received for work performed on the development of the product of $550,000, and a gain from settlement of $1,050,000, included in“gain on settlement” income. Included in the settlement was the return of title and ownership of the product developed to date for IRM along with return of any and all equipment purchased. The Company recorded the amounts attributable to development as services revenue, and the gain on settlement was reflected as a reduction in operating expenses. IRM also agreed that it would not transfer any of its582,524 shares of the Company’s common stock without the Company's prior written consent until the two-year anniversary date of the settlement, and that it would vote the shares consistent with the recommendation of the Company’s Board of Directors.

12. SUBSEQUENT EVENTS

The Company filed a lawsuit on February 18, 2014 against Cisco Systems, Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Cisco Systems, Inc.; Civil Action No. 1:14-cv-00148-SS (W.D. Tex., Austin Division)). Cisco has not yet answered the complaint. The action is pending.

The Company filed a lawsuit on February 18, 2014 against NetApp, Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. NetApp, Inc.; Civil Action No. 1:14-cv-00149-SS (W.D. Tex., Austin Division)). NetApp has not yet answered the complaint. The action is pending.

The Company filed a lawsuit on February 18, 2014 against Quantum Corporation alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Quantum Corporation; Civil Action No. 1:14-cv-00150-SS (W.D. Tex., Austin Division)). Quantum has not yet answered the complaint. The action is pending.

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ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled “Risk Factors” included elsewhere in our filings with the Securities and Exchange Commission.

Forward-Looking Statements

Various statements contained in or incorporated by reference into this quarterly report that express a belief, expectation, or intention, or that are not statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may include projections and estimates concerning capital expenditures, our liquidity and capital resources, the timing and success of specific projects, outcomes and effects of litigation, claims and disputes, elements of our business strategy and other statements concerning our operations, economic performance and financial condition. When used in this quarterly report, the words “could,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “may,” “continue,” “predict,” “potential,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. In particular, the factors discussed below and detailed in our Form 10-K for the year ended October 31, 2013, as well as those discussed in the section entitled “Risk Factors” included elsewhere in our filings with the Securities and Exchange Commission, could affect our actual results and cause our actual results to differ materially from expectations, estimates, or assumptions expressed in, forecasted in, or implied in such forward-looking statements.

Forward-looking statements may include statements about our:

ability to implement our business strategy, including the transition from a hardware storage company to a software solutions and services provider;

anticipated trends and challenges in our business and the markets in which we operate;

expected future financial performance;

expectations regarding our operating expenses;

ability to generate revenues from patent licensing and enforcement activity through our arrangement with Fortress;

future adjustments to the conversion price of our convertible preferred stock and to the exercise price of the warrants issued in our March 2013 private placement;

ability to anticipate market needs or develop new or enhanced products to meet those needs;

ability to expand into other sectors of the storage market, beyond protection storage;

expectations regarding market acceptance of our products;

ability to compete in our industry and innovation by our competitors;

ability to protect our confidential information and intellectual property rights;

ability to successfully identify and manage any potential acquisitions;

ability to manage expansion into international markets;

ability to remediate any material weakness in our internal controls identified by our independent registered public accounting firm;

ability to maintain or broaden our business relationships and develop new relationships with strategic alliances, suppliers, customers, distributors or otherwise;

ability to recruit and retain qualified sales, technical and other key personnel;

ability to obtain additional financing; and

ability to manage growth.

All forward-looking statements involve risks, assumptions and uncertainties. The occurrence of the events described, and the achievement of the expected results depends on many events, some or all of which are not predictable or within our control. Actual results may differ materially from expected results. These risks, assumptions and uncertainties are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors also could harm our results. In light of these risks, uncertainties and assumptions, the forward-looking events might not occur.

Readers are cautioned not to place undue reliance on forward-looking statements, as there can be no assurance that the plans, intentions or expectations upon which they are based will occur. By their nature, forward-looking statements involve numerous assumptions, known and unknown risks and uncertainties, both general and specific, that contribute to the possibility that the predictions, forecasts, projections and other things contemplated by the forward-looking statements will not occur. Forward-looking statements in this quarterly report are based on management’s beliefs and opinions at the time the statements are made. The forward-looking statements contained in this quarterly report are expressly qualified in their entirety by this cautionary statement. The forward-looking statements included in this quarterly report are made as of the date of this quarterly report and we undertake no obligation to publicly update or revise any forward-looking statements to reflect new information, future events or otherwise, except as required by applicable securities laws.

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Overview

The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q.

Crossroads Systems, Inc. (“Crossroads” “the Company,” “we” or “us”) is a global provider of data protection solutions. A 17-year old company based in Austin, Texas, Crossroads develops products that address specific IT challenges, such as cost-effectively storing and protecting business-critical data. Crossroads’ commitment to innovation is evident through our 100+ patent awards and numerous industry recognitions for excellence in data storage and protection. Our products are sold worldwide to Fortune 2000 companies. Additionally, technology leaders such as IBM, Hewlett Packard (HP), Hitachi Data Systems (HDS) and Fujifilm are among our original equipment manufacturer (OEM) and strategic partners.

Our strategic focus is on long-term data preservation in markets experiencing high data growth. We currently ship the following products: StrongBox®, Read Verify Appliance® (“RVA”), SPHiNX™, and storage bridges and routers. All of our solutions solve data management problems involving storage, protection, and archiving. Our approach emphasizes long-term investment protection for our customers by reducing the complexities and ongoing costs associated with data protection and storage management. Moreover, our products are designed with a scalable architecture, which enables companies to purchase additional storage as needed and make it available instantly without operation-halting downtime. We sell these products through a network of OEM and strategic partners for our United States and European operations.

IP Licensing Campaign Focus

We continue to realize revenue from existing intellectual property, or IP, licensees with go-forward royalties derived from the ‘972 patent family, which accounts for eight of our existing 117 granted patents and 5 pending patents as of January 31, 2014. We maintain an active licensing program related to the ‘972 family, which has been licensed to over 40 of the leading storage industry providers. We pursue licensing fees for past shipments and recurring licensing fees related to ongoing shipments. In some cases we are required to litigate where we believe other companies are infringing our patents. Historically, these cases have generally been settled quickly as we engage in business discussions with the opposing parties; however, one or more of the litigants may pursue their defense to greater lengths, which would require higher expenses to continue the lawsuit.

In July 2013, we entered into a loan transaction with Fortress Credit Co LLC, an affiliate of Fortress Investment Group LLC (we refer to those affiliates collectively as Fortress), which included the formation of a partnership controlled by Fortress (the “Partnership”) to which we assigned all of our existing and issued patents and applications other than our patents in the ’972 family. The Partnership may seek to generate revenues through patent licensing and enforcement activity with respect to these patents, but we are unable to predict at this time when or if such efforts may commence or, if they do, whether they will be profitable. We also have the right, in connection with the repayment of the amounts due under the credit agreement and upon the payment of a pre-determined premium of $2.0 million (20% of the amount Fortress loaned to the Company), to buy out Fortress’s interest in the Partnership and return all of the rights to the assigned non-’972 patent rights to ourselves. We intend to periodically monitor and assess the viability and the value to us of such a buyout.

We continue to look for different ways to extract value from our patents outside the ‘972 family, which may include commercial, financial and strategic initiatives. We believe our IP has value beyond its quantifiable monetary value. For example, we believe that the proprietary nature of our products is appealing to both end-users and strategic partners who view our products as not being easily replaceable. Additionally, IP may be a significant barrier to entry for potential competitors. Therefore, we will continue to assess the value of our current portfolio and attempt to expand and take advantage of our IP portfolio.

Key Financial Definitions

Revenue. Revenue consists of sales of hardware, software and services, as well as royalties we earn for products and the license of certain intellectual property. Our “product revenue” is composed of sales of our hardware products and software products sold to our network of strategic partners, including value added resellers, and original equipment manufacturers, as well as directly to end users. Our “IP license, royalty and other revenue” is derived from the licensing of intellectual property, royalty payments, and sales of service contracts.

Cost of Revenue. Cost of revenue is composed of cost of product revenue and IP license, royalty and other revenue. “Cost of product revenue” consists primarily of the cost charged by our previous contract manufacturer to manufacture our products, shipping charges and warranty obligations. “Cost of IP license, royalty and other revenue” consists of professional fees and services, overhead allocations, and obsolete inventory adjustments.

Operating Expenses. Operating expenses consist of sales and marketing, research and development, general and administrative expenses and amortization of intangible assets. Personnel-related costs, which include stock-based compensation expense, are the most significant component of each of these expense categories. We had 139 employees as of October 31, 2012 and 45 employees as of January 31, 2014. In any particular period, the timing of additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue.

	18

Sales and MarketingExpenses. Sales and marketing expenses include personnel costs, employee sales commissions and marketing programs. We have sales and marketing personnel throughout the United States and in our sales office in Germany.

Research and DevelopmentExpenses. Research and development expenses primarily include personnel costs, depreciation on lab equipment, costs of prototype equipment, other related costs of quality assurance and overhead allocations. We expense research and development costs as incurred. Though we incur software development costs, the costs of software development that we incur after a product has reached marketability are considered immaterial, and to date, we have not capitalized any such costs.

General and AdministrativeExpenses. General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resource, information technology and legal organizations, and fees for professional services. Professional services, excluding those for IP (which are included in cost of revenue), consists of outside legal, tax and audit costs.

Interest Expense. Interest expense consists of amounts charged by lenders related to interest on our line of credit and term loans, as well as the effective interest amortization of debt, which includes the amortization of financing costs, and the fair value of the Fortress warrants.

Critical Accounting Policies and Estimates

Contracts to Modify or Customize Products

We have entered into contracts with certain customers to significantly modify or customize products. In accounting for such arrangements, we first look to the guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 985-605,Software - Revenue Recognition (“ASC 985-605”), and then ASC Subtopic 605-25,Revenue Recognition – Multiple-Element Arrangements, to determine the appropriate accounting elements in the arrangement. We then consider the appropriate recognition model for each accounting element based on the nature of the element and apply the guidance in ASC Subtopic 605-35,Revenue Recognition – Construction-Type and Production-Type Contracts, ASC Subtopic 985-60, ASC Subtopic 605-15,Revenue Recognition – Products, or ASC Subtopic 605-20,Revenue Recognition – Services, as applicable. Amounts allocated to the modification/customization service element are evaluated for classification in the consolidated statement of operations as either revenue or reduction of research and development expense based on the following considerations: whether and in what circumstances the consideration received is refundable, ownership of the final product and intellectual property rights to develop the product, and exclusivity of the final product.

On March 4, 2013, the FASB issued ASU 2013-05,Foreign Currency Matters (Topic 830) Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (“ASU 2013-05”). ASU 2013-05 updates accounting guidance related to the application of consolidation guidance and foreign currency matters. This guidance resolves the diversity in practice about what guidance applies to the release of the cumulative translation adjustment into net income. This guidance is effective for interim and annual periods beginning after December 15, 2013. We anticipate adopting ASU 2013-05 beginning November 1, 2014. We do not anticipate that these changes will have a material impact on our consolidated financial statements or disclosures.

There have been no other material updates to our critical accounting policies and estimates set forth in “Part II—Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” in our 2013 Form 10-K.

Results of Operations

Three Months Ended January 31, 2014 Compared to the Three Months Ended January 31, 2013

Revenue. Total revenue increased $0.6 million, or 16.2%, to $4.1 million for the three months ended January 31, 2014 from $3.6 million for the three months ended January 31, 2013.

Product revenues for the three months ended January 31, 2014 decreased $0.7 million, or 35.9%, to $1.2 million compared with $1.9 million for the three months ended January 31, 2013 primarily due to a large sale of multiple petabyte licenses to FujiFilm during the fiscal first quarter of 2013, and reduced shipments of the OEM Sphinx product by HP during the fiscal first quarter 2014.

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IP license, royalty and other revenue consists of the following for the three months ended January 31, 2013 and 2014:

	Three months ended January 31,
	2013		2014
	(in thousands)
IP license revenue		118		1,078
HP royalty and post contract service revenue		860		972
Post contract service and other service revenue (non-HP)		655		845
IP license, royalty and other revenue		1,633		2,895

IP license, royalty and other revenues for the three months ended January 31, 2014 increased $1.3 million, or 77.3%, to $2.9 million compared with $1.6 million for the three months ended January 31, 2013.

IP license revenue increased $1.0 million for the three months ended January 31, 2014, primarily as a result of the increased royalties received from IBM, due to their acquisition of Texas Memory Systems (“TMS”). TMS holds a license to utilize our ‘972 patents that was transferred to IBM upon the acquisition of TMS. HP royalty and post contract service revenue increased $0.1 million for the three months ended January 31, 2014, due to increasing support payment on our OEM Sphinx product shipped by HP. Post contract services and other service revenue (non-HP) increased $0.2 million due to increased revenue recognized from the Iron Mountain research and development services agreement.

Cost of Revenue. Cost of revenue decreased $0.3 million, or 34.7%, to $0.6 million, for the three months ended January 31, 2014 from $0.9 million for the three months ended January 31, 2013. Product costs for the three months ended January 31, 2013 and 2014 remained consistent at $0.2 million. IP license, royalty and other costs decreased $0.4 million for the three months ended January 31, 2014 to $0.4 million from $0.8 million for the three months ended January 31, 2013, due to a reduction in cost of sales related to the Iron Mountain research and development agreement being finalized.

Sales and Marketing. Sales and marketing expenses decreased approximately $1.0 million, or 47.3%, to $1.0 million for the three months ended January 31, 2014 from $2.0 million for the three months ended January 31, 2013. This decrease was due to decreased payroll, benefits, and stock based compensation of approximately $0.6 million, a decrease in evaluation units shipped of approximately $0.1 million, reduced expenses related to our German office of $0.1 million, and a general reduction in other sales and marketing overhead of $0.2 million due to a reduction in force that occurred in October of 2013. Headcount for Sales and Marketing departments has decreased from 44 to 17, or 61% from the fiscal first quarter ended January 31, 2013.

Research and Development. Research and development expenses decreased approximately $1.4 million, or 46.4%, to $1.5 million for the three months ended January 31, 2014 from $2.9 million for the three months ended January 31, 2013. This decrease was due to decreases in payroll, benefits, and stock based compensation, due to a reduction in force which occurred in October of 2013. Headcount for Research and Development departments has decreased from 76 to 23, or 70% from the fiscal first quarter ended January 31, 2013.

General and Administrative. General and administrative expenses increased $0.4 million, or 52.7%, to $1.3 million for the three months ended January 31, 2014 from $0.9 million for the three months ended January 31, 2013. The increase was due to increases in professional fees of $0.2 million, payroll, benefits and stock based compensation of $0.1 million, and insurance expenses of $0.1 million. We expect the absolute amount of general and administrative expenses going forward to be consistent.

Gain on settlement. Gain on settlement increased $1.1 million, or 100.0%, for the three months ended January 31, 2014 from $0.0 million for the three months ended January 31, 2013. The increase was due to the bifurcation of the final payment received from IRM, between amounts received for work performed on the development of the product, and a gain from settlement. We recorded the amounts attributable to development in IP license and other revenue.

Interest expense. Interest expense increased $0.5 million, or 987.0%, to $0.6 million for the three months ended January 31, 2014 from $0.1 million for the three months ended January 31, 2013. The increase was due to the Fortress credit arrangement entered into during fiscal year 2013.

Change in value of derivative liability. The change in value of derivative liability increased to $3.4 million for the three months ended January 31, 2014 from $0 for the three months ended January 31, 2013. The change is the periodic revaluation of the warrants issued in connection with the Series F preferred shares sold during fiscal year 2013. At January 31, 2014, the Company engaged a third party firm to value the outstanding warrants. During the three months ended January 31, 2014, there were 152,979 warrants exercised leaving 2,129,775 warrants outstanding valued at approximately $3,957,000. This is an increase of approximately $3.4 million in warrant liability from the previous measurement date of October 31, 2013. Upon the expiration of the full ratchet anti-dilution provisions on the one-year anniversary of the March 2013 private placement or the shareholder approval of the expiration on March 14, 2014, the Company expects the preferred stock and warrants to be reclassified back to permanent stockholders' equity. At this time, the derivative liability associated with the warrants will be removed and recorded as a positive change in derivative liability in the statement of operations.

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Liquidity and Capital Resources

Cash Flows

Our principal liquidity requirements are to meet our lease obligations, our working capital needs as well as the repayment of our $10 million line of credit with Fortress. Subject to our operating performance, which, if significantly adversely affected, would adversely affect the availability of funds, we expect to finance our operations through cash and cash equivalents provided by operations (including IP licensing) and customer reimbursed expenses, proceeds from the sale of our common stock or preferred stock and exercises of options or warrants. Expected revenue from our StrongBox product has been slower to materialize than expected, as the selling cycle for StrongBox is longer than our other products. We may require additional capital from equity or debt financings to fund our operations or respond to competitive pressures or strategic opportunities. We are currently evaluating various alternatives to monetize our intellectual property or other financing arrangements. We may not be able to secure timely additional financing on favorable terms, or at all.

The following table summarizes our primary sources and uses of cash in the periods presented:

	Three Month Ended January 31,
	2013		2014
	(in thousands)

Net cash used in operating activities	$	(2,606)	$	(65)
Net cash used in investing activities		(119)		(9)
Net cash (used in) provided by financing activities		(1,718)		280
Net (decrease) increase in cash and cash equivalents		(4,439)		203
Cash, cash equivalents, end of period		2,456		7,998

Net cash used in operating activities decreased from approximately $2.6 million in the three months ended January 31, 2013 to approximately $0.1 million in the three months ended January 31, 2014. Net loss for the three months ended January 31, 2014 was $3.3 million, a 5.9% increase in the net loss of $3.1 million during the three months ended January 31, 2013, although included in 2014 net loss were non-cash adjustments for the loss on change in fair value of derivative liability of $3.4 million, and amortization of debt discount of $0.3 million, reducing cash used in operating activities. These non-cash adjustments were offset partially by an increase in accounts receivable during the three months ended January 31, 2014.

Cash flows from investing activities primarily relate to capital expenditures to support our employees, our capital needs in our research and development efforts. Net cash used by investing activities was approximately $9,000 in the three months ended January 31, 2014 compared to $0.1 million in cash used by investing activities during the three months ended January 31, 2013. In the three months ended January 31, 2014, the entire use of cash related to the purchase of property and equipment, while in the three months ended January 31, 2013 are purchases of property and equipment of $0.1 million.

Cash flows provided by financing activities in the three months ended January 31, 2014 was $0.3 million. Proceeds from the sale of common stock, and exercise of options amounted to approximately $0.5 million, offset by the repayment of debt of $0.2 million. Cash used in financing activities in the three months ended January 31, 2013 was $1.7 million, primarily from the repayment of debt.

Financing Arrangements

Fortress Loan Transaction and Related Warrants . Effective July 22, 2013, we entered into a Credit Agreement (the “Credit Agreement”) with Fortress Credit Co LLC, an affiliate of Fortress Investment Group LLC (such affiliates collectively, “Fortress”) that provides for aggregate term loan commitments of up to $10 million, consisting of a term loan A (“Term Loan A”) in the principal amount of $5 million and a term loan B (“Term Loan B” and, together with Term Loan A, the “Term Loans”) in the principal amount of $5 million. We drew down the full $10 million of both Term Loans on July 24, 2013. The obligations of the Company under the Credit Agreement are secured by, among other things, substantially all of the assets of the Company. In connection with our entry into this loan transaction with Fortress, we transferred 109 pending or granted non-’972 patents, which constitute substantially all of our patents other than those relating to the Company’s ’972 patent family, to a limited partnership of which we are a limited partner and of which an affiliate of Fortress is the general partner. The limited partnership concurrently provided the Company a non-exclusive license to the assigned non-’972 patent rights for the life of such patents, subject to earlier termination if we undergo an insolvency event.

Term Loan A will mature on July 22, 2016 and Term Loan B will mature on February 1, 2016. The outstanding principal balance of the Term Loans will bear interest at 10.0% per annum. Term Loan A requires payments of interest only until August 1, 2014, with the principal to be repaid in 24 equal monthly payments beginning on that date together with accrued interest. Term Loan B requires payments of interest only for six months after it is initially drawn, with the principal to be repaid in 24 equal monthly payments beginning on the first day of the month that is seven months after the date Term Loan B is initially drawn, together with accrued interest. The Company may prepay all or any part of the Term Loans at any time.

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Under the Credit Agreement, we are subject to certain customary affirmative covenants, including, but not limited to, the obligations of the Company to deliver financial statements to Fortress, provide certain information and notices to Fortress, discharge all taxes, maintain good standing and governmental authorizations, maintain its properties and maintain insurance. The Company, Crossroads Systems (Texas), Inc., a wholly owned subsidiary of the Company (“Crossroads Texas”), and the limited partnership described above are also subject to certain customary negative covenants, including, but not limited to, limitations on dispositions, changes in the nature of business, mergers or acquisitions, distributions, investments and transactions with affiliates.

The Credit Agreement also contains certain covenants that generally protect the collateral granted to Fortress and the patents and patent rights of the Company, Crossroads Texas and the limited partnership. The Company is also subject to certain financial covenants, including (i) a requirement to maintain a minimum of $1,500,000 of unrestricted cash at each month end; (ii) a prohibition on making any cash dividend payments or distributions to any of its equity security holders other than dividends payable with respect to the Company’s presently issued and outstanding 5% Series F Convertible Preferred Stock (described below) and any additional shares of preferred stock issued pursuant to the transaction documents currently in effect pursuant to which the presently issued and outstanding shares of 5% Series F Convertible Preferred Stock were issued; and (iii) a prohibition on incurring other indebtedness without Fortress’s prior written consent or as provided in the Credit Agreement.

Events of Default are defined under the Credit Agreement to include, but are not limited to, actions by any of the Company, Crossroads Texas or the limited partnership that result in a payment default, breach of representations and warranties, failure to comply with specific covenants, other defaults under or invalidity of any loan documents, insolvency proceedings, inability to pay debts, change of control and certain events relating to the intellectual property of the Company.

The Credit Agreement also contains customary representations and warranties by the Company to Fortress and customary indemnification provisions.

As a condition to and in connection with the Credit Agreement, the Company issued to Fortress the Fortress Warrant, pursuant to which Fortress is entitled to purchase 1,454,545 shares of our common stock. The Fortress Warrant is exercisable on or after October 22, 2013 and will expire on the seventh anniversary of the effective date of the Fortress transactions. If the Fortress Warrant is exercisable and there is no effective Registration Statement registering, or no current prospectus available for, the resale of, the shares of common stock issuable upon exercise of the Fortress Warrant, then the Fortress Warrant may also be exercised at such time by means of a “cashless exercise,” determined according to the terms of the Fortress Warrant.

The Fortress Warrant previously contained what is commonly referred to as “full-ratchet” anti-dilution protection pursuant to which, if the Company issued or was deemed to have issued additional shares of Common Stock without consideration or for a consideration per share less than the applicable exercise price, which is initially $2.0625 per share, then the exercise price of the Fortress Warrant would be reduced, concurrently with such issue, to the consideration per share received by the Company for such issue or deemed issue of the additional shares of common stock.

On January 23, 2014, the warrantholder and Crossroads entered into an amendment to remove the “full-ratchet” anti-dilution provision. This “full-ratchet” anti-dilution provision would have expired no later than July 22, 2014 under the original terms of the Warrant.

Private Placements. On March 22, 2013, we entered into a Securities Purchase Agreement with certain accredited investors for the issuance and sale in a private placement of 4,231,154 units at a purchase price of $2.0625 per unit, valued at $8.6 million, for net proceeds of approximately $7.9 million after related expenses.

Each unit consists of one share of 5.0% Series F convertible preferred stock, par value $0.001 per share and a warrant to purchase one-half of a share of common stock per share of convertible preferred stock purchased, at an exercise price of $2.00 per whole share, subject to certain adjustments, resulting in the issuance of warrants to purchase an additional 2,282,754 shares of common stock with an exercise price of $2.00 per share. The warrants were valued using the Black-Scholes pricing model at approximately $2,284,000. This resulted in a beneficial conversion feature on the convertible preferred stock of approximately $1,090,000. This amount was recorded as a deemed dividend.

The convertible preferred stock has the rights, qualifications, limitations and restrictions set forth in the Certificate of Designation (the “Certificate of Designation”) filed with the Secretary of State of the State of Delaware on March 28, 2013. The Certificate of Designation authorizes for issuance up to 4,500,000 shares of convertible preferred stock, with 3,750,000 shares designated as “Sub-Series F-1” and 750,000 shares designated as “Sub-Series F-2.” The right of holders of convertible preferred stock to convert the convertible preferred stock is subject to a 9.99% beneficial ownership limitation for holders of Sub-Series F-1 and a 4.99% beneficial ownership limitation for holders of Sub-Series F-2. Such beneficial ownership limitations may be increased or decreased by a holder of Sub-Series F-1 to any percentage not in excess of 19.99% after providing notice of such increase or decrease to the Company. For as long as at least 90% of the aggregate number of shares of Sub-Series F-1 issued on the Original Issue Date are outstanding, the holders of such Sub-Series F-1, voting as a single class, will be entitled to elect two directors of the Company. If less than 90%, but at least 20%, of such shares of Sub-Series F-1 are outstanding, such holders, voting as a single class, will be entitled to elect one director of the Company. The holders of Sub-Series F-2 will not be entitled to vote on the directors elected by the holders of Sub-Series F-1. As of the date hereof, less than 90% of the aggregate number of shares of Sub-Series F-1 are outstanding, as the remainder have been voluntarily converted into common stock at the option of the holders. Therefore, the holders of Sub-Series F-1 shares are entitled to elect one director to our board of directors. The holders of shares of the convertible preferred stock are entitled to a liquidation preference equal to the original issuance price plus accrued and unpaid dividends.

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The Certificate of Designation contains customary anti-dilution protection for proportional adjustments (e.g. stock splits). In addition, prior to the earlier to occur of (A) twelve months following the original issue date of March 28, 2013 and (B) the date on which the Company indicates a positive earnings per share in its public disclosures, if the Company issues or is deemed to have issued additional shares of Common Stock without consideration or for a consideration per share less than the applicable conversion price, which is initially $2.0625 per share, then the conversion price of the convertible preferred stock will be reduced, concurrently with such issue, to the consideration per share received by the Company for such issue or deemed issue of the additional shares of Common Stock. We have previously announced our intention to hold an annual stockholders’ meeting on March 14, 2014, and intend to submit to our stockholders a proposal to amend the terms of the convertible preferred stock such that the “full-ratchet” anti-dilution provision would expire on March 14, 2014. Holders of a majority of our outstanding convertible preferred stock have executed non-binding indications of their intent to support this stockholder proposal. The warrants issued in March 2013 also contain customary anti-dilution protection for proportional adjustments (e.g. stock splits). In addition, prior to the earlier to occur of (1) twelve months following the date of the warrants and (2) the date on which the Company indicates a positive earnings per share in its public disclosures, if the Company issues or is deemed to have issued additional shares of Common Stock without consideration or for a consideration per share less than the applicable exercise price, which is initially $2.00 per share, then the exercise price of the warrants will be reduced, concurrently with such issue, to the consideration per share received by the Company for such issue or deemed issue of the additional shares of Common Stock. In accordance with ASC 815-40-25 and ASC 815-10-15 Derivatives and Hedging and ASC 480-10-25 Liabilities-Distinguishing Liabilities from Equity, the convertible preferred shares are accounted for net, outside of stockholder’s equity and warrants may be accounted for as liabilities at their fair value during periods where the full ratchet anti-dilution provision is in effect, which could have a significant impact on the Company’s financial statements.

The Series F warrants are accounted for as a liability at their fair value of approximately $4.0 million as of January 31, 2014. The value of the derivative warrant liability will be re-measured at each reporting period with changes in fair value recorded as earnings. Crossroads engaged an independent company to value its derivative liability and perform re-measurements. To derive an estimate of the fair value of these warrants, a dynamic Black Scholes Merton formula is utilized that computes the impact of share dilution upon the exercise of the warrant shares. This process relies upon inputs such as shares outstanding, estimated stock prices, strike price, and volatility assumptions to dynamically adjust the payoff of the warrants in the presence of the dilution effect. In the event the convertible preferred shares are redeemed, any redemption price in excess of the carrying amount of the convertible preferred stock would be treated as a dividend.

The warrants became exercisable on June 21, 2013, and expire March 22, 2018.

Dividends on the Series F convertible preferred stock will accrue at an annual rate of 5.0% of the original issue price and will be payable on a semi-annual basis. The convertible preferred ranks senior to the common stock and each other class or series of the Company’s capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. Pursuant to a registration rights agreement entered into with the purchasers of the Series F convertible preferred stock, in the event that a registration statement for the resale of the common stock underlying the convertible preferred stock and March 2013 warrants is not declared effective prior to July 26, 2013 (120 days from the closing of the March 2013 private placement), then the rate at which dividends accrue on our convertible preferred stock will be increased to an annual rate of 12.0% from that date until such time as a registration statement is declared effective, at which time the dividend rate will revert to an annual rate of 5.0%. Our registration statement was not declared effective by July 26, 2013, and as a result the dividend rate on the convertible preferred stock at present increased to an annual rate of 12.0% until September 19, 2013, when that registration statement was declared effective. We may elect to satisfy our obligation to pay semi-annual dividends in cash, by distribution of common stock or a combination thereof, in our discretion.

On February 28, 2013, we issued promissory notes to two investors for an aggregate principal amount of $550,000. Pursuant to the terms of the notes, both note holders had the right to convert the outstanding amounts under their notes into units at a discount of 15% to the issue price of the units. Each note holder exercised this right and received 188,235 units resulting from converting $330,000 of promissory notes and interest, and 156,863 units resulting from converting $275,000 of promissory notes and interest.

Nasdaq Listing Compliance . Nasdaq Listing Rule 5550(b)(1) requires companies listing on the Nasdaq Capital Market to maintain stockholders’ equity of at least $2.5 million, or to meet alternative requirements of market value of listed securities or net income from continuing operations. On September 18, 2013, we received a letter from the Nasdaq Listing Qualifications Department indicating that we no longer complied with the minimum stockholders’ equity requirement for continued listing on the Nasdaq Capital Market as a result of our stockholders’ equity of $(6.2) million as of July 31, 2013. Because we did not meet the alternatives of market value of listed securities or net income from continuing operations, we were not in compliance with the Nasdaq listing rules.

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As of January 31, 2014, the end of our most recently completed fiscal quarter, we were not in compliance with these requirements and had a stockholders’ deficit of $(9.3) million.

We are currently evaluating various alternative courses of action to regain compliance. If we fail to comply with the listing requirements of the Nasdaq Capital Market and our common stock is delisted, our ability to raise equity financing, and therefore our ability to meet our liquidity needs, could be materially and adversely impacted.

Recent Accounting Pronouncements

On March 4, 2013, the FASB issued ASU 2013-05,Foreign Currency Matters (Topic 830) Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (“ASU 2013-05”). ASU 2013-05 updates accounting guidance related to the application of consolidation guidance and foreign currency matters. This guidance resolves the diversity in practice about what guidance applies to the release of the cumulative translation adjustment into net income. This guidance is effective for interim and annual periods beginning after December 15, 2013. We anticipate adopting ASU 2013-05 beginning November 1, 2014. We do not anticipate that these changes will have a material impact on our consolidated financial statements or disclosures.

ITEM 3.

QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 4.

CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, our management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective (i) to ensure that information required to be disclosed by us in 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 rules and forms; and (ii) to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

Changes in Internal Controls

During the last fiscal quarter, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

Intellectual Property Litigation

Legal Proceedings

We filed a lawsuit on September 11, 2013 against Dot Hill Systems Corp. ("Dot Hill") styled Crossroads Systems, Inc. v. Dot Hill Systems Corp., Civil Action No. 1:13-CV-800-SS alleging patent infringement and breach of the Amended Settlement and License Agreement dated June 27, 2006 between Crossroads and Dot Hill. Dot Hill filed a motion to dismiss and the Court denied Dot Hill’s motion. The action is proceeding in the Western District of Texas.

We filed a lawsuit on October 7, 2013 against Oracle Corporation alleging infringement by Oracle Corporation of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc., v. Oracle Corporation; Civil Action No. 1:13-CV-895-SS (W.D. Tex., Austin Division)). Oracle has answered the complaint. The action is pending.

We filed a lawsuit on November 26, 2013 against Tandberg Data Corporation alleging infringement by Tandberg Data Corporation of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Tandberg Data Corporation; Civil Action No. 1:13-cv-01026-SS (W.D. Tex., Austin Division)). Tandberg Data answered the complaint and the action is pending.

We filed a lawsuit on November 26, 2013 against Huawei Technologies Co. Ltd., Huawei Enterprise USA, Inc. & Huawei Technologies USA, Inc. alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Huawei Technologies Co., Ltd. et al; Civil Action No. 1:13-cv-01025-SS (W.D. Tex., Austin Division)). Huawei has answered the complaint and the action is pending.

We filed a lawsuit on November 26, 2013 against Dell Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Dell Inc.; Civil Action No. 1:13-cv-01023-SS (W.D. Tex., Austin Division)). Dell answered the complaint and the action is pending.

We filed a lawsuit on February 18, 2014 against Cisco Systems, Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Cisco Systems, Inc.; Civil Action No. 1:14-cv-00148-SS (W.D. Tex., Austin Division)). Cisco has not yet answered the complaint. The action is pending.

We filed a lawsuit on February 18, 2014 against NetApp, Inc. alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. NetApp, Inc.; Civil Action No. 1:14-cv-00149-SS (W.D. Tex., Austin Division)). NetApp has not yet answered the complaint. The action is pending.

We filed a lawsuit on February 18, 2014 against Quantum Corporation alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Quantum Corporation; Civil Action No. 1:14-cv-00150-SS (W.D. Tex., Austin Division)). Quantum has not yet answered the complaint. The action is pending.

The above lawsuits seek monetary damages and injunctive relief for the alleged infringement of our intellectual property.

In addition to the above lawsuits, from time to time, we may become involved in legal proceedings arising in the ordinary course of our business. We are not presently involved in any legal proceeding in which the outcome, if determined adversely to us, would be expected to have a material adverse effect on our business, operating results or financial condition.

ITEM 1A.

RISK FACTORS

Not applicable.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

In January 2014, the company issued an aggregate of 150,703 shares of common stock as a dividend to the holders of its Series F convertible preferred stock.

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The issuance of these securities was exempt from the registration requirements of the Securities Act of 1933, as amended (the Securities Act), as under applicable Securities and Exchange Commission guidance, the issuance did not constitute a “sale” within the meaning of Section 2(a)(3) of the Securities Act.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.

OTHER INFORMATION.

None.

ITEM 6.

EXHIBITS.

Exhibit No.		Description
31.1		Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended

31.2		Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended

32.1		Certification of Principal Executive Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350.

32.2		Certification of Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350

101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Schema Linkbase Document
101.CAL		XBRL Taxonomy Calculation Linkbase Document
101.DEF		XBRL Taxonomy Definition Linkbase Document
101.LAB		XBRL Taxonomy Labels Linkbase Document
101.PRE		XBRL Taxonomy Presentation Linkbase Document

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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.

	CROSSROADS SYSTEMS, INC.

March 7, 2014	/s/ Richard K. Coleman, Jr.
(Date)	Richard K. Coleman, Jr.
	President and Chief Executive Officer
	(Principal Executive Officer)

March 7, 2014	/s/ Jennifer Crane
(Date)	Jennifer Crane
	Chief Financial Officer
	(Principal Accounting Officer)

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Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Avg

Crossroads Systems Inactive 10-Q2014 Q1 Quarterly report

Content analysis