UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period endedSeptember 30, 2008.
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission File Number:000-51936
FORTIFIED HOLDINGS CORP.
(Exact name of issuer as specified in its charter)
| Nevada | 98-0420577 |
| (State or other jurisdiction of incorporation or | (IRS Employer Identification No.) |
| organization) |
125 Elm Street, New Canaan, Connecticut 06840
(Address of principal executive offices)
(203)594-1686
(Issuer’s telephone number)
Indicate by check mark whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange
Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a
smaller reporting company. See 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 (Do not check if a smaller reporting company)
Smaller reporting company [X]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
As of November 19, 2008, the registrant had outstanding 173,395,738 shares of common stock, par value $0.001 per share,
of which there is only a single class.
TABLE OF CONTENTS
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FORTIFIED HOLDINGS CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
| September 30, | December 31, | |||||
| 2008 | 2007 | |||||
| Assets | (Unaudited) | (Audited) | ||||
| Current assets: | ||||||
| Cash | $ | 8,793 | $ | 1,835,509 | ||
| Accounts receivable | 54,777 | 107,447 | ||||
| Inventories, net | 151,332 | 190,408 | ||||
| Notes receivable, net | 204,536 | 1,343,415 | ||||
| Prepaid expenses and other current assets | 31,394 | 25,316 | ||||
| Total current assets | 450,832 | 3,502,095 | ||||
| Property and equipment, net | 53,561 | 92,016 | ||||
| Other assets | - | 340,500 | ||||
| Total assets | $ | 504,393 | $ | 3,934,611 | ||
| Liabilities and Stockholders' Deficit | ||||||
| Current liabilities | ||||||
| Accounts payable and accrued expenses | $ | 335,366 | $ | 889,171 | ||
| Demand notes payable | 549,014 | 1,541,618 | ||||
| Convertible notes payable | 830,899 | 814,225 | ||||
| Term notes payable | 3,875,071 | 4,416,687 | ||||
| Other current liabilities | 30,099 | 92,616 | ||||
| Total current liabilities | 5,620,449 | 7,754,317 | ||||
| Other liabilities | - | 3,405,000 | ||||
| Total liabilities | 5,620,449 | 11,159,317 | ||||
| Commitments and contingencies (Note 11) | ||||||
| Stockholders' Deficit | ||||||
| Common stock, par value $.001 per share; | ||||||
| 200,000,000 shares authorized | ||||||
| 103,069,105 shares issued and outstanding at | ||||||
| September 30, 2008; 60,707,605 issued and | ||||||
| outstanding at December 31, 2007 | 103,070 | 60,708 | ||||
| Additional paid-in capital | 8,133,642 | 3,043,428 | ||||
| Accumulated deficit | (13,352,768 | ) | (10,328,842 | ) | ||
| Total stockholders' deficit | (5,116,056 | ) | (7,224,706 | ) | ||
| Total liabilities and stockholders' deficit | $ | 504,393 | $ | 3,934,611 |
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
| For the three months ended | For the nine months ended | |||||||||||
| September 30, | September 30, | |||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||
| Net sales | $ | 88,451 | $ | 25,054 | $ | 348,486 | $ | 84,249 | ||||
| Cost of sales | 37,576 | 208,330 | 201,304 | 242,922 | ||||||||
| Gross profit | 50,875 | (183,276 | ) | 147,182 | (158,673 | ) | ||||||
| Operating expenses: | ||||||||||||
| Research and development | 172,610 | 133,977 | 526,066 | 331,652 | ||||||||
| Selling, general and administrative | 544,920 | 932,222 | 1,896,509 | 1,611,920 | ||||||||
| Professional and consulting fees | 118,403 | 468,723 | 472,069 | 521,099 | ||||||||
| Total operating expenses | 835,933 | 1,534,922 | 2,894,644 | 2,464,671 | ||||||||
| Loss from operations | (785,058 | ) | (1,718,198 | ) | (2,747,462 | ) | (2,623,344 | ) | ||||
| Other income and expenses: | ||||||||||||
| Interest income | 3,153 | 11,502 | 72,335 | 14,569 | ||||||||
| Interest expense | (83,838 | ) | (91,062 | ) | (348,799 | ) | (103,992 | ) | ||||
| Loss before provision for income taxes | (865,743 | ) | (1,797,758 | ) | (3,023,926 | ) | (2,712,767 | ) | ||||
| Provision for income taxes | - | - | - | - | ||||||||
| Net loss | $ | (865,743 | ) | $ | (1,797,758 | ) | $ | (3,023,926 | ) | $ | (2,712,767 | ) |
| Basic and diluted net loss per share | $ | (0.01 | ) | $ | (0.12 | ) | $ | (0.03 | ) | $ | (0.33 | ) |
| Basic and diluted weighted average | ||||||||||||
| number of shares outstanding | 103,069,105 | 14,452,747 | 91,100,266 | 8,162,500 | ||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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FORTIFIED HOLDINGS CORP.
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN
STOCKHOLDERS’ DEFICIT
(Unaudited)
| Additional | |||||||||||||||
| Common Stock | Paid-In | Accumulated | |||||||||||||
| Shares | Amount | Capital | Deficit | Total | |||||||||||
| Balance, January 1, 2008 | 60,707,605 | $ | 60,708 | $ | 3,043,428 | $ | (10,328,842 | ) | $ | (7,224,706 | ) | ||||
| Additional shares issued in | |||||||||||||||
| connection with reverse merger | 10,000,000 | 10,000 | (10,000 | ) | - | ||||||||||
| Issuance of stock for cash, net | 29,575,000 | 29,575 | 4,854,925 | 4,884,500 | |||||||||||
| Employee stock based compensation | 196,043 | 196,043 | |||||||||||||
| Non employee stock based | |||||||||||||||
| compensation | 52,033 | 52,033 | |||||||||||||
| Fee paid in stock | 2,786,500 | 2,787 | (2,787 | ) | - | ||||||||||
| Net loss | (3,023,926 | ) | (3,023,926 | ) | |||||||||||
| Balance, September 30, 2008 | 103,069,105 | $ | 103,070 | $ | 8,133,642 | $ | (13,352,768 | ) | $ | (5,116,056 | ) | ||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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FORTIFIED HOLDINGS CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
| Nine Months Ended | Nine Months Ended | |||||
| September 30, 2008 | September 30, 2007 | |||||
| Cash flows from operating activities: | ||||||
| Net loss | $ | (3,023,926 | ) | $ | (2,712,767 | ) |
| Adjustments to reconcile net loss to | ||||||
| net cash used in operating activities: | ||||||
| Depreciation and amortization | 40,696 | 16,576 | ||||
| Stock based compensation | 248,076 | 816,908 | ||||
| Non-cash interest expense | 340,927 | 86,614 | ||||
| Non-cash interest income | (72,335 | ) | (16,900 | ) | ||
| Loss on disposal of assets | - | 36,672 | ||||
| Provision for loss on transfer of assets | - | 44,409 | ||||
| Provision for obsolete inventory | - | 57,500 | ||||
| Provision for warranty costs | - | 15,000 | ||||
| Write-off of note receivable and accrued interest | 17,356 | - | ||||
| Provision for loss on notes receivable | 2,756 | - | ||||
| Changes in assets and liabilities: | ||||||
| Accounts receivable | 52,670 | 199,708 | ||||
| Inventories | 39,076 | (204,029 | ) | |||
| Prepaid expenses and other current assets | (6,078 | ) | (6,406 | ) | ||
| Accounts payable and accrued expenses | (506,620 | ) | 507,498 | |||
| Other current liabilities | (62,517 | ) | 70,245 | |||
| Net cash used in operating activities | (2,929,919 | ) | (1,088,972 | ) | ||
| Cash flows from investing activities: | ||||||
| Notes receivable | (29,000 | ) | (43,568 | ) | ||
| Purchase of software for resale | - | (31,845 | ) | |||
| Acquisition of fixed assets | (2,241 | ) | (106,500 | ) | ||
| Net cash used in investing activities | (31,241 | ) | (181,913 | ) | ||
| Cash flows from financing activities: | ||||||
| Proceeds from issuance of stock, net | 1,820,000 | - | ||||
| Proceeds related to recapitalization | - | 1,271,649 | ||||
| Proceeds from notes payable | 114,444 | - | ||||
| Repayment of notes | (800,000 | ) | - | |||
| Net cash provided by financing activities | 1,134,444 | 1,271,649 | ||||
| Net change in cash | (1,826,716 | ) | 764 | |||
| Cash, beginning of period | 1,835,509 | 159,136 | ||||
| Cash, end of period | $ | 8,793 | $ | 159,900 |
The accompanying notes are an integral part of these condensed consolidated financial statements.
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FORTIFIED HOLDINGS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Organization and Basis of Presentation
Fortified Holdings Corp. was incorporated in the State of Nevada, on February 5, 2004 under the name Major Creations Incorporated (“Major”). On December 5, 2006, Major changed its name to Aegis Industries, Inc. (“Aegis”). At that time, Major, a reseller of vintage style tractors, had decided to pursue other business objectives including the acquisition of Aegis Industries, Inc., a Delaware corporation that was in the business of designing, developing and manufacturing intermediate force products for military, law enforcement and security forces. A definitive acquisition agreement was never finalized, however, and the parties ceased discussions (see Note 11). On June 5, 2007, Aegis formed a wholly-owned subsidiary, Fortified Holdings Corp. in the State of Colorado, and on June 6, 2007, the Company merged with Fortified Holdings Corp. and changed its name to Fortified Holdings Corp. (the “Company” or “Fortified”). On September 13, 2007, Fortified completed the acquisition of Z5 Technologies LLC (“Z5”). The acquisition of Z5 was effected through the merger of Z5 with and into a subsidiary of Fortified (the “Merger”) formed for the purpose of the Merger, pursuant to an Agreement and Plan of Merger (the “Merger Agreement”).
Prior to the Merger, Fortified (then a development stage enterprise), the legal acquirer, had no business operations and no working capital and Z5 was a non-reporting privately held company. For accounting purposes, the Merger has been treated as a recapitalization of Z5 using accounting principles applicable to reverse acquisitions, with Z5 being treated as the accounting parent (acquirer). Accordingly, all equity and options of Z5 prior to the Merger have been converted into shares and options of the Company. The acquirer is considered to have issued shares of its Common Stock to shareholders of Fortified in exchange for the net assets of Fortified. The net assets consisted of $1,164,000 of notes receivable and $1,314,000 of other current and non-current assets and $3,087,000 of notes payable and other current liabilities. Results of operations for the periods prior to the Merger reflect the operations of Z5. Historical equity of Z5 prior to the Merger has been retroactively restated to reflect the number of shares outstanding immediately post-Merger. Per share information for periods prior to the Merger has been restated to reflect the number of equivalent shares received by Z5’s members. Pro forma information giving effect to the acquisition of Z5 has not been provided since the combination is not considered a business combination under Statement of Financial Accounting Standards No. 141, “Business Combinations”. The Company is quoted on the Over-the-Counter Bulletin Board under the symbol FFDH.
Prior to the Merger, Z5 was in the business of developing and selling a line of man-portable Command and Control, Communications and Computer (C4) solutions for field based incident management and emergency operations support. Z5’s products (and now our products) are marketed under the NOMADTM brand, principally for use by the military, first responders, relief workers and high risk industries. To effect the Merger, Z5 merged with a new, wholly-owned subsidiary of Fortified, which has been renamed Fortified Data Communications, Inc. or “Fortified DataCom” and which now conducts the former Z5 business.
As consideration for the Merger, Fortified issued an aggregate of 15,000,000 shares of the Company’s common stock and a promissory note in the amount of $5,000,000 to Thomas Keenan Ventures LLC, the owner of all Z5’s equity outstanding at the time of the Merger (respectively, “TKV” and the “TKV Note”). Of the foregoing shares issued to TKV, pursuant to the terms of the Merger Agreement 5,000,000 shares were issued at the closing of the Merger, 5,000,000 shares were issued on January 7, 2008 upon raising new capital and the final 5,000,000 shares were issued on February 15, 2008.
Prior to the Merger, Z5 borrowed $900,000 from Fortified under various notes payable. These borrowings, in conjunction with $371,649 of cash held by Fortified at the time of the Merger, provided $1,271,649 of proceeds related to the recapitalization. In connection with the Merger, the Company entered into a Standby Financing Agreement with a third party, Clarus Capital Limited and one of its affiliates (collectively, “Clarus”), under which Clarus committed to make direct or indirect investments in the Company up to an aggregate of $2.7 million if equity investments were not obtained from third parties. Of this amount, $500,000 was funded prior to the Merger and $200,000 was funded subsequent to the Merger; this agreement expired with no further funding from Clarus when the required investments were obtained from third parties.
The shares issued to TKV in the Merger are subject to a Registration Rights Agreement, under which the Company undertook to register the shares for resale as promptly as practicable, but no later than six months after any registration of shares that the Company sells in a private placement financing after the closing of the Merger, or one year after the closing of the Merger, if earlier. The Agreement does not, however, stipulate specific penalties if the foregoing deadlines are not met. As of the filing of this report, no registration statement covering the shares had yet been filed with the U.S. Securities and Exchange Commission and TKV has made no demand that such a registration statement be filed.
The accompanying unaudited condensed consolidated financial statements as of September 30, 2008 and for the three and nine months ended September 30, 2008 and 2007 reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. All such adjustments are of a normal nature, except as otherwise disclosed in the
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accompanying notes to the unaudited condensed consolidated financial statements. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for the interim financial information and with the instructions to Form 10-Q and Article 10 of the Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Consolidated Financial Statements as filed on Form 10-KSB for the year ended December 31, 2007. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period.
The financial statements have been prepared on a going-concern basis, which assumes realization of all assets and settlement or payment of all liabilities in the ordinary course of business. The Company has limited capital resources and has generated net operating losses and negative cash flows from operations since inception. Based on government purchasing programs in which it was selected as a participant, initial responses to sales proposals and other sales activity, the Company believed until recently that it would have begun generating significant revenues from product sales by this time, and that within the next one to two calendar quarters its sales would be sufficient to enable the Company to begin covering its ongoing operating expenses. However, the Company’s sales have not developed at the pace that was previously expected. As a consequence, there is now substantial doubt regarding the Company’s ability to continue to operate as a going concern. The Company is therefore exploring various alternatives, including seeking additional financing (either equity or debt), continuing our business in its current form as an independent company, a sale of a limited portion of our operations (such as intellectual property for our software), a sale of our operations as a whole, or a merger of the Company with another business having greater financial resources. However, any such additional financing (if available at all) is likely to be significantly dilutive to existing stockholders. Furthermore, in the event of a sale of some or all of the Company’s operations, the Company’s creditors would be legally entitled to payment before any consideration would become available for distribution to stockholders. Those liabilities totaled $5,620,449 at September 30, 2008, of which $3,500,000 is secured by the assets of the Company’s operating subsidiary. There can be no assurance that the Company will be able to obtain either financing or a buyer (whether for limited operations or for the Company as a whole) prior to the time that it exhausts its limited remaining resources, raising substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Note 2- Use of Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenue and expenses during the period reported. The Company’s most significant estimates include assessing the collectability of accounts receivable and notes receivable, the use and recoverability of inventory, determining the fair value of stock-based awards, useful lives of depreciation and amortization periods of tangible and intangible assets, and long-lived asset impairments, among others.
The markets for the Company’s products are characterized by intense competition, rapid technological developments, evolving standards, short product life cycles and price competition, all of which could impact the future realizable value of the Company’s assets. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the period that they are determined to be necessary. Actual results could differ from those estimates.
Note 3 - Earnings Per Share
Earnings per share is presented in accordance with the provisions of SFAS No. 128,Earnings Per Share (EPS). Basic earnings per share is calculated by dividing net income or loss by the weighted average number of outstanding common shares during the period. Diluted earnings per share is calculated by adjusting net income or loss and outstanding shares for all dilutive potential common shares outstanding. Diluted net loss per common share is equal to basic net loss per common share since all potential common shares are anti-dilutive. Potential common shares excluded from diluted net loss per share consist of stock options, convertible debt instruments and warrants. The number of potential common shares, calculated using the treasury stock method, for the three and nine months ended September 30, 2008, is 0 and 126,627, respectively.
Note 4 - Recent Accounting Developments
In December 2007, the FASB issued SFAS No. 141R,Business Combinations. This Statement replaces FASB SFAS No. 141. SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company believes the adoption of this pronouncement will not have a material impact on the Company’s financial statements.
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In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51. This Statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128,Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company believes the adoption of this pronouncement will not have a material impact on the Company’s financial statements.
In March 2008, the FASB issued SFAS Statement No. 161 Disclosures about Derivative Instruments and Hedging Activities (“SFAS No. 161”). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The new standard also improves transparency about the location and amounts of derivative instruments in an entity’s financial statements; how derivative instruments and related hedged items are accounted for under SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”); and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows. The Company does not expect the adoption of SFAS No. 161 to have a material impact on its financial statements.
Note 5 - Reclassifications
Certain amounts in the 2007 financial statements have been reclassified to conform to the 2008 presentation with no impact or change to previously reported net income or stockholders’ deficit.
Note 6 - Notes Receivable
Notes receivable consist of the following demand notesfrom Aegis Industries Inc. (“AI”), from three employees and from an unrelated third party supplier:
| September 30, | December 31, | |||||
| 2008 | 2007 | |||||
| (a) AI, accrues interest at 10%-12% per annum | $ | - | $ | 1,095,283 | ||
| (b) Note receivable from employee | 128,750 | 128,750 | ||||
| (c) Note receivable from FastNet | 30,000 | 45,000 | ||||
| (d) Note receivable from employee | 15,000 | - | ||||
| (e) Note receivable from employee | 14,000 | - | ||||
| Total principal | $ | 187,750 | $ | 1,269,033 | ||
| Accrued interest | 16,786 | 120,185 | ||||
| Reserve | - | (45,803 | ) | |||
| Notes receivable, net | $ | 204,536 | $ | 1,343,415 |
(a) On various dates between December 1, 2006, and March 26, 2007, the Company loaned an aggregate of $1,095,283 to AI. These loans were unsecured and due on demand, and bore interest at a non-default rates between 10% and 12% per annum. In connection with the resolution of the litigation described below under Note 11, effective June 30, 2008 the Company assigned all of these notes receivable, totaling approximately $1,269,000 with accrued interest, to a third party that had loaned the Company an aggregate of $1,000,000 under several notes payable, in full satisfaction of those notes payable, totaling approximately $1,173,000 with accrued interest. As part of the assignment, the latter party also assumed approximately $47,000 in accounts payable due from the Company to AI. The difference between the aggregate principal and interest on the assigned notes receivable after offset for the assumed accounts payable, and the aggregate principal and interest on the satisfied notes payable ($49,000) was reserved in anticipation of the assignment. Accrued interest of $110,786 is included in notes receivable at December 31, 2007.
(b) Note receivable from employee (who is not an executive officer) is due on demand and accrues interest at 5% per annum; subsequent to demand for payment, principal and interest in arrears accrue interest at 9% per annum. Accrued interest of $13,796 and $8,896 is included in notes receivable at September 30, 2008 and December 31, 2007, respectively.
(c) On November 27, 2007, the Company loaned $45,000 to FastNet, Inc. (“FastNet”), a supplier to the Company. The loan accrues interest at 12% per annum. The loan is collateralized by assets of FastNet, and guaranteed by the majority shareholder of
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FastNet, and was due on January 31, 2008. In May 2008, the Company hired FastNet’s majority shareholder as its Vice President of Engineering. Contemporaneously with his hiring, the Company and the majority shareholder of FastNet entered an agreement for forgiveness of the note over time provided that he does not terminate his employment with the Company (and is not terminated by the Company for cause) during that period. Beginning June 1, 2008, 1/12 of the balance of principal and accrued interest as of May 1, 2008 will be forgiven monthly (i.e., $3,941 per month) until the note has been satisfied in full. The forgiveness of the note receivable is recorded as a charge to selling, general and administrative expense in the statement of operations. In addition, the interest accrued in the prior month will be forgiven. Principal and interest in arrears bear interest at 18% per annum. Accrued interest of $1,825 and $503 is included in notes receivable at September 30, 2008 and December 31, 2007, respectively.
(d) Note receivable from employee (who is not an executive officer) is due on demand and accrues interest at 8% per annum; subsequent to demand for payment, principal and interest in arrears accrue interest at 12% per annum. Accrued interest of $813 is included in notes receivable at September 30, 2008.
(e) Note receivable from employee (who is not an executive officer) is due on demand and accrues interest at 5% per annum; subsequent to demand for payment, principal and interest in arrears accrue interest at 9% per annum. Accrued interest of $352 is included in notes receivable at September 30, 2008.
Note 7 - Notes Payable (including Notes Payable to Shareholder)
Notes payable consists of the following:
| September 30, | December 31, | |||||
| 2008 | 2007 | |||||
| (A) Demand notes | $ | - | $ | 1,000,000 | ||
| (B) Demand notes | 400,000 | 400,000 | ||||
| (C) Demand note | 84,444 | - | ||||
| Accrued interest | 64,570 | 141,618 | ||||
| $ | 549,014 | $ | 1,541,618 | |||
| (D) Promissory note payable to TKV | $ | 3,500,000 | $ | 4,250,000 | ||
| (E) Promissory notes to shareholder | 105,130 | 75,130 | ||||
| Accrued interest | 269,941 | 91,557 | ||||
| $ | 3,875,071 | $ | 4,416,687 |
(A) On various dates between November 28, 2006 and March 15, 2007, the Company received loan proceeds in the aggregate amount of $1,000,000. These loans were unsecured and due on demand, and bore interest at a non-default rate of 12% per annum. In connection with the settlement of litigation described in Note 11, effective June 30, 2008 the Company assigned certain notes receivable that the Company held (as described in Note 6 above), having an aggregate principal balance of $1,095,283, to the holder of these notes payable in full satisfaction of the notes payable (including accrued interest). As part of that assignment, the holder of the notes payable also assumed approximately $47,000 in accounts payable due from the Company to AI. Interest of $113,081 is included in notes payable at December 31, 2007; all interest on the notes was satisfied in the foregoing assignment as of September 30, 2008.
(B) During the period May 4, 2007 through August 24, 2007, the Company received loan proceeds totaling $400,000. The notes are unsecured and accrue interest at the rate of 12% per annum. Any payment of principal and interest in arrears bears interest at 30% per annum. Accrued interest of $64,570 and $28,537 is included in loans payable at September 30, 2008 and December 31, 2007, respectively.
(C) During September 2008 the Company entered into an agreement with a shareholder and officer of the Company. This loan was secured by sales orders of the Company totaling $84,444 and bears an interest rate of 10%.
(D) Secured note, as amended, payable to TKV in conjunction with the acquisition of Z5 on September 13, 2007, bearing interest at 5% per annum. The note is guaranteed by Fortified DataCom and collateralized by Fortified DataCom’s assets. TKV and the Company have entered into three Note Modification Agreements to revise the payment schedule thereunder, the most recent of which was entered into as of May 14, 2008. Pursuant to the first and second Note Modification Agreements, which were entered into at times that there were past-due payments outstanding under the note, TKV also waived the Company’s failure to make all past-due payments on a timely basis (although no acceleration notice had previously been given by TKV). No other terms of the note were amended.
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Pursuant to the note as currently modified, which is explained in greater detail in the Subsequent Events section below, the remaining principal balance of the Note and interest accrued under the Note are due on the following schedule:
In addition to the foregoing scheduled payments, if the Company receives equity or equity-linked financing in excess of $2,000,000 between April 1, 2008 and the payment of the note in full, then a portion of the note will become due equal to 25% of amount by which the gross financing proceeds exceed $2,000,000.
Accrued interest of $245,087 and $73,472 is included in promissory notes payable at September 30, 2008 and December 31, 2007, respectively.
(E) During 2006, the Company received loan proceeds from an officer and shareholder of the Company totaling $170,130. The amount was due under an unsecured promissory note payable to an officer of the Company on December 31, 2007 or upon an equity raise of $1 million, if earlier. The principal amount bears interest at 12% per annum. $95,000 of principal was repaid during 2007. In September of 2008 the Company received an additional $30,000 in loan proceeds under a demand promissory note from the same officer and shareholder of the Company. The note is due on demand any time on or after December 15, 2008 and bears interest at 12% per annum. This results in the total principal outstanding to the officer and shareholder to $105,130 at September 30, 2008. Accrued interest of $24,854 and $18,085 is included in promissory notes payable at September 30, 2008 and December 31, 2007, respectively.
Note 8 - Convertible Notes Payable
During the period April 26, 2007 through May 18, 2007, the Company issued a series of convertible notes upon receiving cash proceeds aggregating $750,000. The notes are unsecured and initially were due upon the occurrence of either (i) the consummation of one or more related transactions pursuant to which no less than $15,000,000 of equity securities of the Company were sold for cash, or (ii) October 31, 2007. In late 2007, the Company reached an informal understanding with the holders that payment would be deferred at that date, and principal and interest are now due on demand.
The principal amount bears interest at 12% per annum. At any time that the principal and accrued interest remains outstanding, the lender of each note has the right to convert such principal and accrued interest into shares of the Company’s common stock at a rate of $0.50 per share, which was less than the fair value of the Company’s common stock on the date of issue. Accrued interest of $114,427 and $64,225 is included in convertible notes payable at September 30, 2008 and December 31, 2007, respectively.
The convertible notes payable had a beneficial conversion discount because the conversion prices of the notes were less than the fair value of the Company’s common stock at the date of issuance. A discount of $750,000 was recorded with the offset to additional paid in capital for the fair market value of the beneficial conversion feature (the “BCF”). The resulting discount (BCF) was amortized into income as interest expense over the term of the debt. As of December 31, 2007, the BCF was fully amortized.
Note 9 - Capital Stock
At September 30, 2008, the Company had 200,000,000 shares authorized, at a par value of $.001 per share, of which 103,069,105 shares were issued and outstanding.
2007 Private Placement Offering.Effective November 16, 2007, the Company conducted the initial closing of a sale of Units under a private placement (the “2007 Offering”). Each Unit in the 2007 Offering was sold at a price of $0.40 per Unit. Prior to the 2008 Private Placement Offering described below, each Unit (a “2007 Unit) consisted of (i) one (1) share of common stock, par value $.001 per share (“Common Stock”), and (ii) one (1) warrant (a “Warrant”) to purchase one (1) share of Common Stock at an exercise price of $0.65. Warrants are exercisable at any time through November 30, 2010. Also prior to the 2008 Private Placement Offering described below, if at any time after November 30, 2008 the closing price of the Common Stock exceeded $2.00 per share for 15 consecutive trading days and the average trading volume of the Common Stock exceeded 500,000 shares per trading day over the same period, the Company had the right to redeem the Warrants 60 days after notice to the Warrant holders, and Warrants not exercised within that 60 day period will be redeemed at a redemption price of $0.001 per Warrant share. In that event, a Warrant holder desiring to exercise its Warrant will have the opportunity to do so within that 60 day period. The warrants have been accounted for at fair value using the Black-Scholes option pricing model. The relative fair value assigned to the warrants issued was approximately $333,000, which is reported as a component of additional paid-in-capital within stockholders’ deficit.
In the initial closing of the 2007 Offering in November 2007, the Company issued 4,852,605 of the 2007 Units in exchange for a combination of $918,000 in cash, net of $102,000 of associated cash fees, and conversion of certain convertible notes totaling
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$921,000 in related principal and interest. The convertible notes exchanged were issued in July, September and October 2007 for gross proceeds of $900,000.
In the second and third closings of the 2007 Offering, both conducted in January 2008, the Company issued an aggregate of 10,312,500 of the 2007 Units in exchange for $4,125,000 in cash, net of $412,500 of associated cash fees. Of the total amount invested in the second and third closings, $3,405,000 had been received by the Company prior to December 31, 2007, and was recorded as “other liabilities” on the balance sheet at that date and the associated fees of $340,500 were paid prior to December 31, 2007 and recorded as prepaid expenses at that date and included in “other assets”; both such amounts were transferred to paid-in capital within stockholders’ deficit upon the second closing.
In addition to cash placement fees, designees of Falcon Capital, the Company’s placement agent, were issued an aggregate of 1,250,750 shares of Common Stock in connection with the sales of Units in the 2007 Offering.
The 2007 Units were offered and sold only to “accredited investors” (as such term is defined in Rule 501 promulgated under the Securities Act) in reliance on the exemption provided by Section 4(2) of the Securities Act and Rule 506 promulgated thereunder. Each investor executed a subscription agreement confirming its “accredited investor” status.
Subsequent to the 2007 Offering, each investor in the 2007 offering was issued an additional share of common stock for each share of common stock that was purchased under the 2007 Offering and the exercise price of the warrants issued under the 2007 Offering was reduced from $0.65 to $0.40. See 2008 Private Placement Offering described below.
Issuances for Z5 Merger.Effective January 7, 2008, the Company issued an additional 5,000,000 shares of its Common Stock to designees of Thomas Keenan Ventures LLC pursuant to the terms of the Agreement and Plan of Merger between the Company, Z5 and certain other parties, dated May 31, 2007, as modified by a Letter Agreement dated September 12, 2007. Pursuant to that Agreement and Plan of Merger and Letter Agreement, such shares were due to be issued to Thomas Keenan Ventures LLC at such time as the Company raised not less than $2,600,000 through the sale of equity or equity-linked securities.
In addition, effective February 15, 2008, the Company issued the final installment of 5,000,000 shares of its Common Stock to designees of Thomas Keenan Ventures LLC pursuant to the terms of an Agreement and Plan of Merger of the Company, dated May 31, 2007, as modified by a Letter Agreement dated September 12, 2007. Pursuant to that Agreement and Plan of Merger and Letter Agreement, such shares were due to be issued to Thomas Keenan Ventures LLC at the earlier of February 15, 2008 or at such time as the Company raised not less than $6,000,000 through the sale of equity or equity-linked securities. Through February 15, 2008, the Company raised a total of $5,145,000, including the November 2007 and January 2008 closings under the 2007 Offering.
2008 Private Placement Offering.Effective May 14, 2008, the Company closed on the sale of 3,150,000 Units in an initial closing under a private placement (the “2008 Offering”), in exchange for an aggregate of $1,152,000 in cash (net of $108,000 in associated cash placement fees). Effective June 10, 2008 the Company completed the sale of a final 50,000 Units in the 2008 Offering in exchange for $20,000 in cash. Each Unit in the 2008 Offering (a “2008 Unit) was sold at a price of $0.40 per Unit and consisted of (i) two (2) shares of Common Stock, and (ii) one (1) warrant (a “Warrant”) to purchase one (1) share of Common Stock at an exercise price of $0.40 (i.e., an aggregate of 6,400,000 shares of Common Stock and 3,200,000 Warrants). Warrants are exercisable at any time through April 30, 2011. At any time after April 30, 2009, if the closing price of the Common Stock exceeds $1.20 per share for 15 consecutive trading days and the average trading volume of the Common Stock has exceeded 500,000 shares per trading day over the same period, the Company may redeem the Warrants 60 days after notice to the Warrant holders, and Warrants not exercised within that 60 day period will be redeemed at a redemption price of $0.001 per Warrant share. In that event, a Warrant holder desiring to exercise its Warrant will have the opportunity to do so within that 60 day period. The Warrants have been accounted for at fair value using the Black-Scholes option pricing model. The relative fair value of the warrants issued was approximately $292,000, which is reported as a component of additional-paid-in-capital within stockholders equity. In addition to cash placement fees, designees of Falcon Capital, the Company’s placement agent, were issued an aggregate of 540,000 shares of Common Stock in connection with the sales of Units in the 2008 Offering.
The principal investors in the initial closing under the 2008 Offering, representing $1,080,000 of the gross amount invested, were also investors in the 2007 Offering. As a condition to the Company’s obtaining their investment in the 2008 Offering, the Company agreed to issue additional shares to each investor in the 2007 Offering that invested through the efforts of Falcon Capital Ltd. as placement agent, and to amend those investors’ Warrants issued in the 2007 Offering so as to effectively amend the economic terms of the 2007 Offering to be the same as those of the 2008 Offering. Specifically, the Company agreed to issue one (1) additional share of Common Stock for each share of Common Stock that each such investor purchased in the 2007 Offering, and to reduce the exercise price of the Warrants issued to each such investor in the 2007 Offering from $.65 to $.40. The Company revalued all warrants issued under the 2007 Private Placement Offering which resulted in a relative fair value of approximately $1,274,000, which is reported as a component of additional-paid-in-capital within stockholders equity. The Company also agreed to adjust the number of shares issued to Falcon Capital as placement agent to maintain the agreed-upon proportion of investor shares and placement fees paid in shares. As a consequence of this adjustment, contemporaneously with the initial closing of the 2008 Offering, the Company issued an additional
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12,862,500 shares of Common Stock to investors with respect to the 2007 Offering, and an additional 1,250,750 shares of Common Stock to Falcon Capital with respect to the 2007 Offering.
Of the Units sold in the 2008 Offering, 500,000 Units (i.e., 1,000,000 shares of Common Stock plus 500,000 Warrants) were purchased by Brendan Reilly, the Company’s Chief Executive Officer, in exchange for $200,000 in cash. The 2008 Units purchased by Mr. Reilly were sold on the terms identical to the 2008 Units sold to other investors (although the Company did not pay any placement agent fees with respect to the investment by Mr. Reilly). Neither Mr. Reilly nor any of the Company’s other officers or directors were investors in the 2007 Offering; as a consequence, neither Mr. Reilly nor any other officer or director received any additional shares of Common Stock as a result of the adjustment of the 2007 Offering described in the preceding paragraph.
Note 10 - Stock Based Compensation
The Company’s stock option plan, adopted on September 13, 2007, allows the board of directors to grant incentives to employees, directors and consultants in the form of incentive stock options (ISOs); nonqualified stock options; stock appreciation rights (SARs); and restricted and unrestricted stock awards. Stock awards under the Company’s plan are granted at prices which are no less than the fair market price of the stock on the date of grant. ISO grants and SAR’s granted to ten percent shareholders, however, are issued at 110% of fair market value. Options granted under this plan can be time based or performance based options and vesting varies accordingly. Options under this plan expire ten years from the date of grant. Compensation expense recognized in the Statement of Operations during the three and nine months ended September 30, 2008 amounted to $(6,239) and $248,076, respectively. The reduction in compensation expense for the three months ended September 30, 2008 resulted from forfeitures of unvested options by employees who left the Company.
The fair value of each option award granted is estimated on the date of grant, subject to remeasurement for non-employees, using the Black-Scholes option valuation model and assumptions as noted in the following table:
| For the Nine Months | |
| Ended September 30, 2008 | |
| Expected life | 2.5 – 3.5 years |
| Expected volatility | 82.53%-121.21% |
| Risk-free interest rate | 2.51%-2.90% |
| Dividend yield | 0% |
The expected life of options was estimated using the simplified method described in SAB 107, which is based on the vesting period and contractual term for each grant, or for each vesting-tranche for awards with graded vesting. Groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected volatility pre-Merger was based on an index, and post-Merger is based on volatility of the Company’s stock. The risk-free interest rate is based on the continuous rates provided by the U.S. Treasury with a term equal to the expected life of the options. The expected dividend yield is zero as the Company has never paid dividends and does not currently anticipate paying any in the foreseeable future. The status of the Company’s stock option plan at September 30, 2008 is summarized as follows:
| Weighted | |||
| Number of | Weighted | Average | |
| Shares | Average | Remaining | |
| Under Option | Exercise Price | Contractual | |
| (000’s) | per Share | Term in Years | |
| Outstanding, January 1, 2008 | 10,605 | $.52 | 4.54 |
| Granted | 1,520 | $.21 | 4.58 |
| Exercised | - | - | - |
| Canceled or Forfeited | 2,018 | $.54 | - |
| Outstanding September 30, 2008 | 10,107 | $.47 | 3.91 |
On March 28, 2008, 520,000 stock options were granted. The weighted average fair value of each option granted, estimated as of the grant date using the Black-Scholes option valuation model, was $.13 per share. The options were immediately vested upon grant. On May 15, 2008, 1,000,000 stock options were issued. The weighted average fair value of each option granted, estimated as of the grant date using the Black-Scholes option valuation model, was $.14 per share. The options vest ratably over a three year period. The aggregate intrinsic value of options outstanding and exercisable at September 30, 2008 is $0. The aggregate intrinsic value represents the total pretax intrinsic value, based on options with an exercise price less than the Company’s closing stock price of $.02 per share at September 30, 2008, which would have been received from the option holders had those option holders exercised their options as of that date.
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The following table summarizes information about stock options outstanding at September 30, 2008:
| Weighted Average | |||
| Number | Remaining | Number | |
| Outstanding | Contractual Life | Exercisable | |
| Exercise Prices | (000’s) | (Years) | (000’s) |
| $.28 | 2,179 | 3.3 | 2,179 |
| $.41 | 2,053 | 3.9 | 2,053 |
| $.76 | 2,000 | 4.0 | - |
| $.77 | 1,105 | 4.0 | - |
| $.45 | 1,500 | 4.1 | - |
| $.26 | 270 | 4.5 | 270 |
| $.18 | 1,000 | 4.6 | - |
As of September 30, 2008, there was approximately $425,000 of total unrecognized compensation cost that remains to be amortized over the remaining vesting period.
Note 11 - Commitments and Contingencies
The Company presently leases approximately 150 square feet of office space in Norwalk, Connecticut for the Company’s headquarters under a lease that expires in April 2009. In addition, the Company leases 1,000 square feet in Alexandria, Virginia through January, 2009.
Rent expense charged to operations amounted to $54,900 and $157,500 for the three and nine months ended September 30, 2008 and $21,000 for both the three and nine months ended September 30, 2007. Future minimum lease payments as of September 30, 2008 are approximately $32,000.
On or about June 8, 2007, Aegis Industries, Inc., (a privately held Delaware Corporation) (“AI”) filed an action against Fortified, two of its directors and several other additional parties in the Second Judicial District Court, County of Washoe, State of Nevada (the “Court”), in which the plaintiffs alleged claims for (among other claims) breach of contract related to a non-binding letter of intent entered into by AI and Fortified in November 2006. By stipulation of the parties, the Court entered orders of dismissal, dismissing Fortified and each of its directors from the litigation as of July 18, 2008 and July 25, 2008 respectively. The dismissals did not include a legal release of the plaintiffs’ claims and were without prejudice to the right of the plaintiffs to re-assert the same claims in the future, but the Company has been given no reason to believe the plaintiffs intend to re-assert those or any other claims. Please refer to Note 6(a).
In addition, the Company is involved in various claims in the ordinary course of business. The Company’s management believes that the amounts of such claims are not material and as such, no amounts have been accrued for legal matters in the accompanying financial statements as of September 30, 2008 and December 31, 2007.
Note 12 - Related Party Transactions
Management Fees.During the three and nine months ended September 30, 2007, the Company paid management fees totaling $14,000 and $64,000, respectively, to a company controlled by a director and former officer of the Company. There were no such payments made in the three and nine months ended September 30, 2008.
The Company has entered into numerous related party transactions that are fully disclosed in Notes 1,6,7 and 9.
Note 13 – Fair Value Measurements
On January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157,Fair Value Measurements(“SFAS No. 157”).SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances. The FASB has partially delayed the effective date for one year for certain fair value measurements when those measurements are used for financial statement items that are not measured at fair value on a recurring basis.
SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a
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basis for considering market participant assumptions in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. There was no impact from the adoption of this standard on the Company’s financial position or results from operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS No. 159, a company may elect to use fair value to measure eligible items at specified election dates and to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are not limited to, accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, issued debt and firm commitments. If elected, SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We have not elected to apply the fair value option to any of our financial instruments.
Note 14 - Subsequent Events
On October 2, 2008, the Company entered into a non-binding letter of intent with Grand Investigative Services Corporation. The completion of the transactions contemplated by this letter of intent are subject to the negotiation and execution of definitive agreements, as well as due diligence by both parties. There can be no assurance that negotiations will lead to the execution of definitive agreements or that the transactions will be completed following the execution of the agreements.
The letter of intent provides that the parties will commence negotiations of an acquisition by the Company (via a merger with a Company subsidiary) of all of the existing capital stock of Grand ISS in consideration of the issuance of 75,000,000 shares of Company common stock and the issuance of a convertible promissory note in principal amount of $12,500,000 which will be later converted to shares of the Company common stock.
The proposed transaction will require that the following steps will have been accomplished prior to the closing: (a) the conversion by TKV of $1,300,000 of the Company’s outstanding indebtedness to common stock of the Company, (b) the sale by the Company of its wholly-owned subsidiary, Fortified Data Communications, Inc., to Fortified Acquisition Corp. (“FAC”) in consideration of the assumption of all of the Company’s remaining debt to TKV ($2,200,000), the assumption of approximately $250,000 of current trade-debt, $50,000 in cash and a $150,000 promissory note and (c) the relinquishing by certain shareholders of a total of approximately 88,630,800 shares of Company common stock.
On November 10, 2008, Brendan T. Reilly submitted his resignation from his positions as Chairman and Chief Executive Officer of Fortified Holdings Corp. (the “Company”) effective November 10, 2008.
On November 10, 2008, Dennis Mee submitted his resignation as a Director of the Company effective November 10, 2008.
On November, 13, the Company’s Board of Directors voted to approve the appointment of Steven Cooper as interim Chief Executive Officer of the Company. Mr. Cooper currently serves as President and a Director of the Company.
On November 10, 2008, the Company failed to make a timely payment of One Million Dollars ($1,000,000) in principal due under that certain Term Loan Note dated September 13, 2007, as amended (the “Note”) payable to Thomas Keenan Ventures, LLC (“TKV”), with a remaining balance due of Three Million Five Hundred Thousand Dollars ($3,500,000). The failure to timely make such payment is an event of default under the Note. TKV is controlled by Brendan T. Reilly, who, prior to his resignation effective November 10, 2008, was the Chairman of the Board of Directors and Chief Executive Officer of the Company.
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On November 14, 2008, the Company and TKV entered into the Fourth Note Modification Agreement pursuant to which TKV agreed to extend the due date for such One Million Dollar ($1,000,000) principal payment under the Note until December 15, 2008. In consideration therefore, the Company agreed to issue to TKV shares of its common stock with a value equal to Fifty Thousand Dollars ($50,000) based on the closing price of the Company’s shares on the date of the default ($0.01) . Therefore, the Company will issue Five Million (5,000,000) shares of its common stock to TKV.
In addition, on November 14, 2008, pursuant to an authorization approved by the Board of Directors on October 2, 2008, the Company and TKV entered into a Note Conversion and Modification Agreement whereby TKV converted One Million Three Hundred Thousand Dollars ($1,300,000) of principal amount of the Note into shares of common stock at the closing price on October 2, 2008. Based on a closing price of $0.0199, the Company will issue Sixty Five Million Three Hundred Twenty Six Thousand Six Hundred Thirty Three (65,326,633) shares of its common stock to TKV. As a result of such conversion, the remaining principal amount due under the Note has been reduced from Three Million Five Hundred Thousand Dollars ($3,500,000) to Two Million Two Hundred Thousand Dollars ($2,200,000).
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ITEM 2. MANAGEMENT DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
Cautionary Note Regarding Forward-Looking Statements
This report on Form 10-Q as well as press releases and other information provided periodically in writing or verbally by our officers or our agents contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. In many but not all cases you can identify forward-looking statements by words such as “expect”, “anticipate”, “believe”, “intend”, “plan”, “estimate”, “may”, “would”, “could”, variations of those words, and similar expressions. These forward-looking statements, which are based on information available to us at this time, include statements regarding our expectations, beliefs, or intentions about the future with respect to, among other things: (i) our liquidity and capital resources; (ii) our financing opportunities and plans; (iii) our ability to generate revenues; (iv) market and other trends affecting our future financial condition or plan of operation; and (v) our growth and operating strategy.
Investors and prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance, that they involve various risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The factors that might cause such differences include, among others, those set forth in Part I, Item 2 of this report on Form 10-Q entitled “Management’s Discussion and Analysis or Plan of Operation” or in Part II, Item 6 of our annual report on Form 10-K under the heading “Investment Considerations”. We urge you to review and consider those factors, and those identified from time to time in our reports and filings with the SEC, for information about risks and uncertainties that may affect our future results. Our reports and filings are available from the SEC’s website (www.sec.gov) or from the investor page of our website (www.fortifiedholdings.com/investors). We undertake no obligation to update any forward-looking statement after the date when made, and specifically decline any obligation to update or correct any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
Our financial statements, which have been prepared in accordance with United States generally accepted accounting principles (“GAAP”), contemplate that we will continue as a going concern. They do not contain any adjustments that might result if we were unable to continue as a going concern.
Overview
Fortified Holdings Corp. (“we”, “Fortified” or the “Company”) has been working to establish itself as a leading provider of a variety of deployable products used for field-based Emergency Management and Critical Incident Response by law enforcement, first responders, the military, the private security industry, humanitarian relief organizations and others who respond to “critical incidents”. Within this market, we have focused to date especially (but not exclusively) on so-called Command, Control, Communications and Compute, Intelligence, Surveillance and Reconnaissance (“C4ISR”) products.
We currently produce and sell a line of man-portable Command, Control, Communications and Compute (C4) solutions for field-based incident management and emergency operations support under the NOMADTM brand. Originally developed by our predecessor Z5Technologies LLC (“Z5”), our NOMADTM products are a line of Incident Command units and related deployable communications and tactical power solutions, which are used by the military, first responders, relief workers and high risk industries. We have also developed, and have recently released, a suite of software applications for the Geospatial Information Services market.
Our ability to conduct acquisitions, and to a lesser extent our ability to engage in internal product development, is dependent on our raising additional capital through one or more private placements of our common stock, as described below under “Liquidity and Capital Resources”. During the nine months ended September 30, 2008, we raised gross proceeds of $1.28 million in one such private placement (of which $200,000 was invested by one of our executive officers).
Prior to our acquisition of Z5 in September 2007, we had minimal operations, and consequently the acquisition of Z5 has been accounted for as a recapitalization of Z5. In this Report, unless the context indicates to the contrary, the term “we” includes the business operations of Z5 prior to its acquisition by Fortified.
Results of Operations for the Three and Nine Month Periods Ended September 30, 2008
Compared to Results of Operations for the Three and Nine Month Periods Ended September 30, 2007
Since inception, we have operated at a loss. In early 2006, we were primarily engaged in organizational activity including product development, negotiating vendor contracts, engaging and developing our initial customer base, and recruiting and managing staff. Our first products shipped in the third calendar quarter of 2006, to the City of New Orleans Police Department, and sales of military products began during the fourth calendar quarter of 2006. Total sales for 2006 were
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approximately $671,000. During 2007 we returned our focus to the development and release of next generation products to correct performance and reliability issues. Those efforts were further delayed during 2007 while we worked to complete Fortified’s acquisition of Z5 and obtain funding necessary for our operations. Consequently, sales during 2007 were limited, totaling approximately $156,000 for the year. We resumed our sales efforts near the end of 2007. Recognized revenues remain low during the first nine months of 2008 due to the current stage of our business. As a corollary, the relationships between revenue, cost of revenue and operating expenses reflected in the financial information included herein are not reflective of the relationships between those figures that we expect in the future once we achieve a higher volume of sales.
Sales.Our sales during the quarter ended September 30, 2008 were approximately $88,000, and our sales during the nine months ended September 30, 2008 were approximately $348,000. Portions of the revenue in both periods – particularly in the first three months of 2008 – consisted of revenue that was deferred in 2007 and subsequently recognized in the current period, and correspondingly revenue was reduced by amounts required to be deferred and recognized only in subsequent periods. On a pro forma basis excluding recognition of those previously-deferred amounts and excluding the effect of those revenue deferrals, revenue during the quarter ended March 31, 2008 would have been $96,000, revenue during the quarter ended June 30, 2008 would have been $137,000, and revenue during the quarter ended September 30, 2008 would have been $58,000. In contrast, we recorded $59,000, zero, and $25,000 in sales during the three month periods ended March 31, June 30, and September 30, 2007, respectively.
As noted above, sales during 2007 were constrained due to product redesign efforts, which caused shipments to be halted during the first quarter of the year and which were not resumed until late in the year. We believe that we have corrected all identified technical problems, including transitioning to new suppliers where necessary, and that we are currently positioned to ship product in commercial quantities to address demand from customers as orders are received. We do not believe inflation was a material factor in the increase in our sales between the 2007 and 2008 periods.
Gross Profit and Margin.Our cost of goods sold consists primarily of direct costs of the manufactured units. Gross profit for the quarter ended September 30, 2008 was approximately $51,000, representing a gross margin of 58%. Gross profit for the nine month period ended September 30, 2008 was approximately $147,000, representing a gross margin of 42%. The higher gross margin rates of the current quarter are largely due to the mix of higher-margin products that were sold. Currently, while our sales volumes remain low, our percentage margin may be subject to wide fluctuations depending on product mix and other factors; we believe that once our volumes reach higher levels the percentage margin will be less susceptible to change based on individual sales transactions and will stabilize modestly above the levels recorded in the first nine months of 2008.
Comparing the corresponding quarter of 2007, sales were approximately $25,000, while gross margins were negative. For the nine months ended September 30, 2007, we recorded sales of approximately $84,000, while gross margins were negative. Negative margins for those periods were driven by an upgrade program that has not been billed, combined with additional warranty and obsolescence reserves stemming from the rollout of the new NOMAD C4 design.
Gross profit for the nine month period of this year constitutes an increase of approximately $306,000 over the negative gross profit recorded in the first nine months of 2007. The substantial increase in gross profit is a consequence of the increase in total sales volume during the period.
Operating Expense.We recorded total operating expense of approximately $836,000 for the quarter ended September 30, 2008. The operating expense for the current-year quarter represents a decrease of approximately $699,000 or 46% less than the levels recorded in the corresponding three-month period of 2007. Selling, General & Administrative costs decreased from approximately $932,000 to $545,000 in gross dollar terms from the year-earlier period. In addition, Professional and Consulting fees also dropped from the corresponding three-month period of 2007, from approximately $469,000 to $118,000.
In the second quarter, we took significant steps to reduce our operating expenses and conserve cash while we work to build our sales to a sustainable level. These steps included elimination of a number of personnel positions, temporary reductions in the compensation paid to certain other employees (including our CEO, who is currently not receiving any salary, and certain other senior officers), and significant curtailment of research and development efforts. Those reductions continued to be in effect for the current quarter.
For the nine months ended September 30, 2008, total operating expense was approximately $2,895,000. This figure represents an increase of approximately $430,000 over the operating expense recorded in the corresponding period of 2007. The majority of that increase occurred in the first quarter of this year, prior to our significant steps to reduce operating expenses as described above.
The Company issues stock options to employees and non-employees. Fair value of the options for non-employees is remeasured at each reporting date and compensation expense being amortized is adjusted accordingly. The aggregate non-cash compensation expense to be recognized in the future for awards issued to employees is approximately $425,000, which
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will be recognized through 2011. We expect to continue issuing stock options as an important component of incentive compensation. Stock-based compensation charges can fluctuate substantially from period to period based on the fair market value of our stock and the number of options granted during each period.
Interest Expense. During the quarter ended September 30, 2008, interest expense (net) increased to approximately $81,000 from $79,000 in the corresponding period of 2007, and for or the nine month period ended September 30, 2008, interest expense (net) increased to approximately $276,000 from $89,000 in the corresponding period of 2007. These increases reflects a significant increase in borrowing over the course of 2007, as we conducted multiple bridge note borrowings in order to fund operations prior to the closing of the acquisition of Z5 and thereafter until we received proceeds from the equity offerings conducted in the fourth quarter of 2007 and in 2008. A portion of those borrowings remain outstanding currently. In addition, we issued a $5.0 million promissory note in September 2007 as part of the consideration paid for our acquisition of Z5. A principal balance of $3.5 million remained outstanding on that Note as of September 30, 2008. Although no interest has been paid in cash on that Note, interest expense has been accrued.
Liquidity and Capital Resources
Cash. At September 30, 2008, we had approximately $9,000 in cash and cash equivalents. This figure represents a net reduction in cash of approximately $704,000 during the quarter and a reduction of approximately $1,827,000 during the first nine months of 2008, down from approximately $713,000 at June 30, 2008, approximately $993,000 at March 31, 2008 and approximately $1,836,000 at December 31, 2007. In comparison, at September 30, 2007, cash and cash equivalents were approximately $160,000.
For the nine months ended September 30, 2008, our operating activities used approximately $2,930,000 of cash, compared to approximately $1,089,000 of cash used in operating activities during the corresponding period of 2007. Primary uses of cash during the 2008 period included cash costs associated with cash based operating expenses outlined above and with reductions of accounts payable, accrued expenses and other current liabilities totaling $569,000. The net loss was offset in part by non-cash expense associated with stock-based compensation and interest expense that was accrued but not paid in cash during the period. During the nine month 2007 period, operating cash flows reflected a net loss of approximately $2,713,000 plus an increase in inventory of $204,000, which were largely offset by non-cash expense associated with stock-based compensation of $817,000, a significant net increase in accounts payable, accrued expenses and other current liabilities of $578,000 and net decrease (through collections) of accounts receivable of $200,000.
Cash used in investing activities during the nine months ended September 30, 2008 was $31,000 verses $182,000 for the corresponding period of 2007. The decrease was primarily due to a reduction in the purchase of fixed assets.
Cash flows from financing activities provided a net of $1,134,000 during the nine month period ended September 30, 2008, reflecting net proceeds of a private placements of our common stock during the period yielding an aggregate $1,820,000 and additional proceeds from notes payable of $114,000, offset by $800,000 in repayment of notes payable. During the corresponding period of 2007, financing activities yielded $1,272,000 proceeds from the recapitalization of the Company.
Notes Payable and Notes Receivable.Upon the Merger with Z5 in September 2007, the Company issued a promissory note for $5,000,000 to TKV, as the sole member of Z5 (the “TKV Note”). The TKV Note is guaranteed by our operating subsidiary, Fortified DataCom, and is secured by substantially all of Fortified DataCom’s assets. Under the TKV Note’s original terms, principal was payable in several installments, with the final installment due March 31, 2008. Due to our inability to pay all of the installments when due, the TKV Note has been amended four times to extend the payment dates. Under the latest amendment, entered into on November 10, 2008, the balance of $3,500,000 remaining outstanding at the date of balance sheet in this report will come due on various dates between December 15, 2008 and July 1, 2009, as follows:
In addition to the foregoing scheduled payments, if the Company receives equity or equity-linked financing in excess of $2,000,000 between April 1, 2008 and the payment of the TKV Note in full, then a portion of the TKV Note will become due in an amount equal to 25% of amount by which the gross financing proceeds exceed $2,000,000.
We made the payment due on July 1, 2008 with our existing cash resources, and had $588,000 in cash remaining after that payment. We were unable to make the payments due on November 1, 2008. Subsequently, we entered into an agreement with TKV to extend the deadline to make the November 1 payment until December 15, 2008. In consideration of that extension, we issued 5,000,000 shares of common stock to TKV as explained above the subsequent events section.
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Our ability to make the payments due on December 15, 2008 and thereafter remain dependent on how rapidly we are able to execute on our sales efforts and, potentially, on our ability to raise additional outside funding. If we are unable to generate sufficient cash through a combination of our sales and outside funding prior to each of those due dates, we anticipate that we would be required to negotiate with TKV to amend the Note again to extend the due date for some or all of the remaining principal and for the accrued interest. However, TKV is under no obligation to agree to such an extension; moreover, it is possible that (unlike the previous four amendments) TKV could impose additional requirements as a condition to such an extension, such as but not limited to an increase in the interest rate or payment of some separate consideration. As noted above, the TKV Note is guaranteed by our operating subsidiary, Fortified Data Communications, Inc., and is secured by substantially all of the assets of Fortified Data Communications. If TKV were to foreclose on that security interest, we would likely be forced to seek bankruptcy protection or cease operations.
During 2006, the Company issued a $170,130 note payable to an affiliate, due December 31, 2007, in consideration of funds loaned to the Company. $95,000 of that note was repaid during 2007 and $30,000 additional funds were loaned to the Company during September of 2008. The principal balance outstanding at September 30, 2008 is $105,130.
Liquidity.As noted above, as of September 30, 2008, we had approximately $9,000 in cash and cash equivalents. We generated a net loss (including non-cash items) of approximately $866,000 during the quarter ended September 30, 2008. The net loss of the current quarter is slightly lower than our net loss in the quarter ended June 30, 2008 of approximately $913,000. The lowering of the loss during the current period reflects cost cutting measures described above taken in the past six months to conserve cash. While the net loss of the current quarter is smaller than the net loss of the previous two quarters, the loss during the current period remains substantial.
The foregoing reductions between the second quarter and the third quarter of 2008 in both our net loss and our cash loss reflect numerous and material cost reductions that we have made from late in the first quarter through the present time in an effort to reduce our cost structure and thereby preserve our remaining cash resources. We undertook those steps in the expectation that our sales were developing within a timeframe that would enable us to generate material revenues and cashflow from operations by the third calendar quarter of 2008, and to begin generating sufficient cashflow from operations to cover our operating costs (as reduced by those cost-cutting actions) by the fourth calendar quarter of 2008. As discussed in the following paragraphs, we no longer believe that our sales will grow sufficiently to enable us to cover our operating costs, even with those reductions, prior to the time we exhaust our existing cash resources. As a consequence, there is now substantial doubt regarding our ability to continue to operate as a going concern.
Since December 31, 2007, we have received contracts and orders in excess of $2,500,000. As expected, the larger contracts included in that figure were scheduled to result in product deliveries over an extended period. Nonetheless, it had been management’s belief that the delivery schedule under these contracts and additional sales contracts anticipated in the near future would enable the Company to generate revenue from operations adequate to cover ongoing expenses prior to the time that we exhaust our existing cash resources. However, there have subsequently occurred a variety of factors that have caused further, unanticipated delays in product deliveries (such as delays in subcontracts being issued by prime contractors, and third-party protests of government contracts awarded to us). As a consequence of the continued delay in product deliveries beyond the timeframe previously anticipated, and the resultant delay in anticipated collections from customers, there is now substantial doubt regarding our ability to continue to operate using only our existing capital resources.
We are now pursuing a variety of alternatives, including seeking to raise additional capital (either equity, debt or a hybrid), a sale of some or all of our existing operations to raise cash, continuing our business in its current form as an independent company, a sale of the Company as a whole, or a merger of the Company with another business having greater financial resources. As described elsewhere in this report, we raised approximately $1.28 million (net of cash fees) from a private placement of our equity in May 2008. (Our former CEO participated in this private placement, investing $200,000 of the total.) The equity sold in that placement was priced at $.20 per share (if no value is ascribed to the warrants included in the placement). Since that time, however, the market price of our stock has fluctuated dramatically; from a high during the quarter on July 25, 2008, when our shares closed at $0.14 in Over-the-Counter trading, subsequently reaching a low on September 30, 2008, of $0.02. Our ability to raise additional capital through sales of equity or equity-linked securities such as convertible debt is likely to be limited while our stock price remains in its current range, and in all events any sale of equity or equity-linked securities with the stock price in its current range would be significantly dilutive to existing holders.
In addition to efforts to raise additional capital, we are simultaneously pursuing strategic alternatives to continuing our business in its current form as an independent company. Such alternatives could include a sale of a limited portion of our operations (such as the intellectual property for our software), a sale of our operations as a whole, or a merger of the Company with another business having greater financial resources.
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On October 2, 2008, the Company entered into a non-binding letter of intent with Grand Investigative Services Corporation. The completion of the transactions contemplated by this letter of intent are subject to the negotiation and execution of definitive agreements, as well as due diligence by both parties. There can be no assurance that negotiations will lead to the execution of definitive agreements or that the transactions will be completed following the execution of the agreements.
The letter of intent provides that the parties will commence negotiations of an acquisition by the Company (via a merger with a Company subsidiary) of all of the existing capital stock of Grand ISS in consideration of the issuance of 75,000,000 shares of Company common stock and the issuance of a convertible promissory note in principal amount of $12,500,000 which will be later converted to shares of the Company common stock.
The proposed transaction will require that the following steps will have been accomplished prior to the closing: (a) the conversion by TKV of $1,300,000 of the Company’s outstanding indebtedness to common stock of the Company, (b) the sale by the Company of its wholly-owned subsidiary, Fortified Data Communications, Inc., to Fortified Acquisition Corp. (“FAC”) in consideration of the assumption of all of the Company’s remaining debt to TKV ($2,200,000), the assumption of approximately $250,000 of current trade-debt, $50,000 in cash and a $150,000 promissory note and (c) the relinquishing by certain shareholders of a total of approximately 88,630,800 shares of Company common stock.
It should be noted that, in the event of any such sale, it is likely we would be obligated to satisfy our existing liabilities before any consideration became available for distribution to our stockholders. At September 30, 2008, we had $5,620,000 in total liabilities, principally in the form of notes payable. Moreover, the largest of those notes payable, the TKV Note, is secured by substantially all of the assets of our operating subsidiary, which provides the lender under the TKV Note a claim to those assets or their proceeds ahead of the claims of other creditors and ahead of the rights of the company’s stockholders.
While, as stated above, the Company is undertaking significant efforts either to obtain sufficient capital to continue its operations or to engage in a strategic transaction with a third party, there can be no assurance that we will succeed in achieving either of these objectives. For this reason, there is a substantial risk that we will be forced to cease operations in the near future.
Capital Expenditures
There were capital expenditures in the amount of $2,000 in the nine months ended September 30, 2008. Capital expenditures in the corresponding period of 2007 totaled $107,000. We anticipate keeping capital expenditure costs to a minimum until the Company turns cash flow positive.
Seasonality
Historically, we have not experienced significant seasonality in our business, although our revenue may be subject to fluctuation due to government and commercial purchasing cycles. In particular, the U.S. Government’s fiscal year ends on September 30 of each year. Any orders expected to be received around that timeframe may experience delays. In addition, the U.S Government reacts slowly to new procurements during the quarter following the September 30 fiscal year-end. Certain of our current sales contracts and orders with anticipated delivery dates in the next 90 days are with U.S. Government entities, and delivery may experience delays.
Off-Balance Sheet Arrangements
We do not maintain any off-balance sheet arrangements that have, or that are reasonably likely to have, a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
Our critical accounting policies, including the assumptions and judgments underlying those policies, are more fully described in the notes to our audited financial statements contained in our Annual Report on Form 10-KSB. We have not adopted any material changes to our critical accounting policies from those discussed in our Annual Report. We have consistently applied these policies in all material respects except as specifically identified herein. Investors are cautioned, however, that these policies are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially. Set forth below are the accounting policies that we believe most critical to an understanding of our financial condition and liquidity.
Below is a brief description of key accounting principles which we have adopted in determining our recognition of revenues and expenses:
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Convertible Instruments.When the Company issues convertible debt securities with a non-detachable conversion feature that provides for an effective rate of conversion that is below market value on the commitment date, it is known as a beneficial conversion feature (“BCF”). Pursuant to EITF Issue No. 98-5 “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios” and EITF Issue No. 00-27, the conversion feature of the security that has characteristics of an equity instrument is measured at its intrinsic value at the commitment date and is recorded as additional paid in capital. A portion of the proceeds of the security issued is allocated to the conversion feature equal to its intrinsic value to a maximum of the amount allocated to the convertible instrument. The resulting discount of the debt instrument is amortized into income as interest expense over the conversion feature’s vesting period.
Revenue Recognition.We recognize revenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Under these guidelines, revenue is recognized when persuasive evidence of an arrangement exists, shipment has occurred or services rendered, the price is fixed or determinable and payment is reasonably assured. Under these requirements, when the terms of sale include customer acceptance provisions, and compliance with those provisions has not been previously demonstrated, revenues are deferred and recognized upon acceptance. Revenue will be deferred and recognized once acceptance has occurred.
Stock Based Compensation.Awards under our stock option plans are accounted for in accordance with Statement of Financial Accounting Standards (SFAS) No. 123R (SFAS 123R) Share Based Payment, EITF 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees For Acquiring, Or In Conjunction With Selling, Goods or Services” and SAB No. 107, Share-Based Payment. Compensation is measured on the grant date of an award and recognized over the service period for which the award was granted, generally the vesting period. For awards with graded vesting, compensation is recorded using the straight line method over the vesting period, but in no event shall total compensation recognized under the awards be less than the aggregate fair value of shares vested under such awards. Stock option related compensation is equal to the fair value of the award which we determine using a binomial option-pricing model.
Income Taxes.We account for income taxes using the asset and liability method, as provided by SFAS 109, Accounting for Income Taxes (SFAS 109) which requires the recognition of different tax assets and liabilities for the future tax consequences of temporary differences between the financial statement and tax basis carrying amounts of assets and liabilities. No income taxes were provided because we have incurred losses from our inception. Due to the Company’s limited operating history and, therefore, uncertainty of future taxable income, no future tax benefits have been recognized.
Recent Accounting Pronouncements.In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods of those fiscal years. In February 2008, the FASB released a FASB Staff Position (FSP FAS 157-2—Effective Date of FASB Statement No. 157) which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. There was no impact from adoption of this standard on our financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS No. 159, a company may elect to use fair value to measure eligible items at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are not limited to, accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, issued debt and firm commitments. If elected, SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We have not elected to apply the fair value option to any of our financial instruments.
Use of Estimates.The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenue and expenses during the period reported. The Company’s most significant estimates include assessing the collectability of accounts receivable and notes receivable, the use and recoverability of inventory, determining the fair value of stock-based awards, useful lives of depreciation and amortization periods of tangible and intangible assets, and long-lived asset impairments, among others.
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The markets for the Company’s products are characterized by intense competition, rapid technological developments, evolving standards, short product life cycles and price competition, all of which could impact the future realizable value of the Company’s assets. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the period that they are determined to be necessary. Actual results could differ from those estimates.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
Based on an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) required by paragraph (b) of Rule 13a-15 or Rule 15d-15, as of September 30, 2008, our Chief Executive Officer and Principal Financial Officer have concluded that our disclosure controls and procedures were not effective due to the fact that we lack sufficient internal accounting personnel and segregation of duties necessary to ensure that an adequate review of the financial statements and notes thereto is performed and 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 our management, including our Chief Executive Officer and Principal Financial Officer, all in a manner that allows timely decisions regarding required disclosure. We are undertaking planning and actions to provide effective disclosure controls and procedures in the future.
In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the relationship between the benefit of desired controls and procedures and the cost of implementing new controls and procedures.
In connection with the preparation and filing of this Quarterly Report, we completed an evaluation of the effectiveness of our disclosure controls and procedures under the supervision and with the participation of our chief executive officer and chief financial officer. This evaluation was conducted pursuant to the Securities Exchange Act of 1934, as amended. Based on the evaluation, management concluded that it did not have effective disclosure controls and procedures as of September 30, 2008, due to the effect of the material weaknesses described below (as similarly incorporated in our Form 10-KSB/A for the period ended December 31, 2007).
Management’s Report on Internal Control Over Financial Reporting
Management assessed the effectiveness of our internal control over financial reporting as of September 30, 2008. In making this assessment, management used the framework set forth in the report Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. The COSO framework summarizes each of the components of a company’s internal control system, including (i) the control environment, (ii) risk assessment, (iii) control activities, (iv) information and communication, and (v) monitoring.
Based on the evaluation, management concluded that it did not have effective internal control over financial reporting. The Company has identified the material weaknesses noted below. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected on a timely basis by employees in the normal course of their work.
As evidenced by the material weaknesses described below, we determined that entity-level controls related to the control environment and control activities did not operate effectively resulting in material weaknesses in each of these respective COSO components. The deficiency in each of these individual COSO components represents a separate material weakness. These material weaknesses contributed to an environment where there is a more than a remote likelihood that a material misstatement of the interim and annual financial statements could occur and not be prevented or detected.
The Company is a non-accelerated filer. Accordingly, while this quarterly report does not require an attestation report by the registered public accounting firm regarding internal control over financial reporting, management is required to assess and report on its evaluation of the effectiveness of internal controls over financial reporting as of September 30, 2008. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to the temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this quarterly report. The Company was a shell company until September, 2007. Subsequently, management began to design and implement internal controls as required under the Sarbanes-Oxley Act of 2002.
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Control Environment
Our accounting support staff lacked sufficient training or experience. Because the accounting department was understaffed we did not have sufficient review capabilities and could not adequately segregate duties.
Risk Assessment
The Company did not perform an entity level risk assessment to evaluate the implication of relevant risks on financial reporting, including the impact of potential fraud-related risks and the risks related to non-routine transactions, if any, on its internal control over financial reporting. Lack of an entity-level risk assessment constituted an internal control design deficiency which resulted in more than a remote likelihood that a material error would not have been prevented or detected, and constituted a material weakness.
Control Activities
The internal controls were not adequately designed or operating in a manner to effectively support the requirements of the financial reporting and period-end close process. This material weakness is the result of aggregate deficiencies in internal control activities. The material weakness includes failures in the operating effectiveness of controls which would ensure (i) independent review and approval of key balance sheet account analyses and reconciliations, (ii) journal entries and their supporting worksheets are consistently reviewed and approved, (iii) appropriate review for the accuracy of classification within the income statement, (iv) accuracy and completeness of the financial statement disclosures and presentation in accordance with GAAP. Due to the significance of the financial closing and reporting process to the preparation of reliable financial statements and the potential impact of the deficiencies to significant account balances and disclosures, there is more than a remote likelihood that a material misstatement of the interim and annual financial statements would not be prevented or detected. In addition, due to the misinterpretation of certain accounting literature, material adjustments to and restatement of our April 30 and July 31, 2007 interim consolidated financial statements were required (as incorporated in our Form 10-QSB for the period ended September 30, 2007).
Entity Level Controls
In addition to the material weaknesses noted above, management also concluded that there is a material weakness in our entity level controls. This was evidenced by the lack of a code of conduct, asset protection programs, and comprehensive accounting and human resources policies and procedures manuals. Formalized audit, compensation, governance and other Board of Directors committees have not been established. These items were, in the aggregate, considered a material weakness in the entity level internal controls over financial reporting.
Because of the material weaknesses described above, management believes that, as ofSeptember 30, 2008, we did not maintain effective internal control over financial reporting based on the COSO criteria. Nevertheless, management believes that the consolidated financial statements in this Annual Report on Form 10-Q/Afairly present, in all material respects, our financial position, results of operations and cash flows as of the dates, and for the periods presented, in conformity with generally accepted accounting principles in the United States of America.
Plan for Remediation of Material Weakness
Management acknowledges its responsibility for internal controls over financial reporting and seeks to continually improve those controls. In order to achieve compliance with Section 404 of the Act, we are currently performing the system and process documentation and evaluation needed to comply with the Act. We believe our process for documenting, evaluating and monitoring our internal control over financial reporting is consistent with the objectives of the Act.
In addition, in order to remediate the material weakness described above, management plans to (1) conduct additional training, (2) hire additional resources, (3) complete a risk assessment, (4) design and implement new policies, procedures and controls, and (5) create subcommittees for the Board of Directors.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
On or about June 8, 2007, Aegis Industries, Inc., (a privately held Delaware Corporation) (“AI”) filed an action against Fortified, two of its directors and several other additional parties in the Second Judicial District Court, County of Washoe, State of Nevada. Plaintiffs alleged claims for, among other claims, breach of contract related to a non-binding letter of intent entered into by AI and Fortified in November 2006.
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By stipulation of the parties, the Court entered an order dismissing Fortified from the litigation as of July 18, 2008, and a separate Order dismissing its two directors from the litigation as of July 25, 2008. The dismissals did not include a legal release of the plaintiffs’ claims and were without prejudice to the right of the plaintiffs to re-assert the same claims in the future, but we have not been given any reason to believe the plaintiffs intend to re-assert those or any other claims. Additional details about this event are described above in Note 11, Accounts Payable.
On or about October 22, 2008, Rajant Corporation, a privately held Deleware Corporation (Rajant) filed an action against Fortified and Z5 Technologies in the Court of Common Pleas, Chester County, State of Pennsylvania. Plaintiffs alleged claims for, among other claims, breach of contract related to a Strategic Alliance and Reseller Agreement dated as of November 16, 2006 between it and Z5 Technologies (a predecessor of Fortified. The Company believes that the suit is without merit and is preparing the appropriate pleadings in answer of the complaint. Further, the Company believes that any liability that may result will not have any material effect on the Company.
Except as otherwise disclosed above, there are no pending material legal proceedings to which we are a party and we are not aware that any are contemplated. There can be no assurance, however, that we will not be made a party to litigation in the future. Any finding of liability imposed against us is likely to have an adverse effect on our business, our financial condition, including liquidity and profitability, and our plan of operation.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
As disclosed (as a subsequent event) in our Form 10-Q for the period ended March 31, 2008, we conducted a private placement of Units (as defined below) under which an initial closing occurred on May 14, 2008. The transaction was referred to in that filing as the “2008 Offering”. Effective June 10, 2008 we completed the sale of a final 50,000 Units in the 2008 Offering. The Units were sold at a price of $.40 per Unit. Each Unit consisted of two (2) shares of our Common Stock together with a warrant to purchase one (1) additional share of Common Stock at an exercise price of $.40 (i.e., 100,000 shares of Common Stock and 50,000 Warrants in the final closing, and a total of 6,400,000 shares of Common Stock and 3,200,000 Warrants in the initial closing and the final closing taken together). Warrants are exercisable at any time through April 30, 2011. At any time after April 30, 2009, if the closing price of the Common Stock exceeds $1.20 per share for 15 consecutive trading days and the average trading volume of the Common Stock has exceeded 500,000 shares per trading day over the same period, the Company may redeem the Warrants 60 days after notice to the Warrant holders, and Warrants not exercised within that 60 day period will be redeemed at a redemption price of $0.001 per Warrant share. In that event, a Warrant holder desiring to exercise its Warrant will have the opportunity to do so within that 60 day period. The Units were offered and sold only to “accredited investors” (as such term is defined in Rule 501 promulgated under the Securities Act) in reliance on the exemption provided by Section 4(2) of the Securities Act and Rule 506 promulgated thereunder. Each investor executed a subscription agreement confirming its “accredited investor” status.
Designees of Falcon Capital, the Company’s placement agent, were issued an additional 10,000 shares of Common Stock in connection with the foregoing final closing. Additionally, as discussed in our Form 10-Q for the period ended March 31, 2008, as a condition to the Company’s obtaining the investors’ subscriptions in the 2008 Offering the Company agreed to issue additional shares to all of the investors in its 2007 Offering who invested through Falcon Capital and to make certain amendments to the Warrants issued to those investors in the 2007 Offering. Our engagement agreement with Falcon Capital provided for it (or its designees) to be issued a number of shares of Common Stock as equity placement fees based on the number of shares of Common Stock issued to investors in the 2007 Offering. In connection with the foregoing adjustment of the shares issued to the investors, we also issued an additional 1,250,750 shares of Common Stock to designees of Falcon Capital as an adjustment to its equity placement fees.
ITEM 3. DEFAULT UPON SENIOR SECURITIES.
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There were no reportable events under this Item 3 during the quarterly period ended September 30, 2008.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of our stockholders, through the solicitation of proxies or otherwise, during the quarterly period ended September 30, 2008.
ITEM 5. OTHER INFORMATION.
There have been no changes made during the quarter ended September 30, 2008 to the method by which shareholders may recommend nominees to the Company’s Board of Directors.
ITEM 6. EXHIBITS.
| No. | Description of Exhibit |
| 2.1 | Articles of Merger, filed with the Secretary of State of Nevada, incorporated by reference from Exhibit 3.1 to the Form 8-K filed April 10, 2006. |
| 2.2 | Articles of Merger, filed with the Secretary of State of Nevada, incorporated by reference from Exhibit 3.1 to the Form 8-K filed July 3, 2007. |
| 2.3 | Letter Agreement, incorporated by reference to Exhibit 2.2 on Form 8-K filed September 19, 2007. |
| 3.1 | Articles of Incorporation, incorporated by reference to the Exhibits filed with our Registration Statement on Form SB-2 filed on February 17, 2005, SEC File Number 333-122870. |
| 3.2 | By-laws, incorporated by reference to the Exhibits filed with our Registration Statement on Form SB-2 filed on February 17, 2005, SEC File Number 333-122870. |
| 31.1 | |
| 31.2 | |
| 32.1 | |
| 32.2 |
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Signatures
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: November 19, 2008
| FORTIFIED HOLDINGS CORP. | ||
| By: | /s/ Steven Cooper | |
| Steven Cooper | ||
| Interim Chief Executive Officer | ||
| By: | /s/ Kirk Hanson | |
| Kirk Hanson | ||
| Chief Financial Officer |
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