UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
S
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2008
OR
£
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from ________ to ________
Commission File No.0-13316
BROADCAST INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
|
|
|
Utah |
| 87-0395567 |
(State or other jurisdiction of |
| (IRS Employer |
incorporation or organization) |
| Identification No.) |
7050 Union Park Ave. #600, Salt Lake City, Utah 84047
(Address of principal executive offices and zip code)
(801) 562-2252
(Registrant’s telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes S 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 S Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes £ No S
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:
Class | Outstanding as of May 5, 2008 |
Common Stock, $.05 par value | 38,565,696 shares |
1
Broadcast International, Inc.
Form 10-Q
Table of Contents
Part I - Financial Information
Page
Item 1. Financial Statements
3
Item 2. Management’s Discussion and Analysis of Financial Condition
and Results of Operations
21
Item 3. Quantitative and Qualitative Disclosures about Market Risk
27
Item 4T Controls and Procedures
27
Part II -Other Information
Item 1. Legal Proceedings
28
Item 1A. Risk Factors
28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
28
Item 3. Defaults Upon Senior Securities
29
Item 4. Submission of Matters to a Vote of Security Holders
29
Item 5. Other Information
29
Item 6. Exhibits
30
Signatures
33
2
Item 1. Financial Information
BROADCAST INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
|
| December 31, |
| March 31, |
|
| 2007 |
| 2008 |
|
|
|
| (Unaudited) |
ASSETS: |
|
|
|
|
Current assets |
|
|
|
|
Cash and cash equivalents | $ | 16,598,300 | $ | 3,302,725 |
Available-for-sale securities (note 7) |
| -- |
| 4,075,000 |
Trade accounts receivable, net |
| 220,834 |
| 428,259 |
Inventory |
| 57,218 |
| 51,342 |
Prepaid expenses |
| 2,449,236 |
| 2,275,903 |
|
|
|
|
|
Total current assets |
| 19,325,588 |
| 10,133,229 |
|
|
|
|
|
Property and equipment, net |
| 641,314 |
| 1,259,561 |
|
|
|
|
|
Other assets |
|
|
|
|
Debt offering Costs |
| 1,367,583 |
| 1,250,775 |
Patents, net |
| 197,346 |
| 196,411 |
Available-for-sale securities (note 7) |
| -- |
| 6,964,813 |
Deposits and other assets |
| 8,795 |
| 9,058 |
|
|
|
|
|
Total other assets |
| 1,573,724 |
| 8,421,057 |
|
|
|
|
|
Total assets | $ | 21,540,626 | $ | 19,813,847 |
|
|
|
|
|
See accompanying notes to consolidated financial statements.
3
BROADCAST INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)
|
| December 31, |
| March 31, |
|
| 2007 |
| 2008 |
LIABILITIES: |
|
|
| (Unaudited) |
|
|
|
|
|
Current liabilities |
|
|
|
|
Accounts payable | $ | 640,292 | $ | 491,230 |
Payroll and related expenses |
| 460,236 |
| 351,406 |
Other accrued expenses |
| 55,356 |
| 394,198 |
Unearned revenue |
| 169,359 |
| 107,437 |
Current debt obligations |
| 47,692 |
| -- |
Derivative valuation |
| 14,267,600 |
| 6,958,200 |
|
|
|
|
|
Total current liabilities |
| 15,640,535 |
| 8,302,471 |
|
|
|
|
|
Long-term liabilities |
|
|
|
|
Convertible debt (net of $13,068,755 and $11,937,596 |
|
|
|
|
discount, respectively) |
| 2,931,245 |
| 4,062,404 |
|
|
|
|
|
Total liabilities |
| 18,571,780 |
| 12,364,875 |
|
|
|
|
|
Commitments and contingencies (Note 6) |
|
|
|
|
|
|
|
|
|
STOCKHOLDERS’ EQUITY: |
|
|
|
|
Preferred stock, no par value, 20,000,000 shares |
|
|
|
|
authorized; none issued |
| - |
| - |
Common stock, $.05 par value, 180,000,000 shares |
|
|
|
|
authorized; 37,775,034 and 38,501,296 shares issued as |
|
|
|
|
of December 31, 2007 and March 31, 2008, respectively |
| 1,888,752 |
| 1,925,065 |
Additional paid-in capital |
| 65,289,354 |
| 67,920,900 |
Unexercised stock options and warrants |
| 3,789,095 |
| 3,977,566 |
Accumulated other comprehensive loss |
| - |
| (560,187) |
Subscriptions receivable |
| (25,000) |
| - |
Accumulated deficit |
| (67,973,355) |
| (65,814,372) |
|
|
|
|
|
Total stockholders’ equity |
| 2,968,846 |
| 7,448,972 |
|
|
|
|
|
Total liabilities and stockholders’ equity | $ | 21,540,626 | $ | 19,813,847 |
See accompanying notes to consolidated financial statements.
4
BROADCAST INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
|
| For the three months ended March 31, | ||
|
| 2007 |
| 2008 |
|
|
|
|
|
|
|
|
|
|
Net sales | $ | 1,599,066 | $ | 1,187,392 |
|
|
|
|
|
Cost of sales |
| 1,594,775 |
| 1,136,446 |
|
|
|
|
|
Gross profit |
| 4,291 |
| 50,946 |
|
|
|
|
|
Operating expenses: |
|
|
|
|
Administrative and general |
| 1,574,684 |
| 1,534,181 |
Selling and marketing |
| 142,621 |
| 246,192 |
Research and development |
| 185,063 |
| 776,633 |
|
|
|
|
|
Total operating expenses |
| 1,902,368 |
| 2,557,006 |
|
|
|
|
|
Total operating loss |
| (1,898,077) |
| (2,506,060) |
|
|
|
|
|
Other income (expense): |
|
|
|
|
Interest income |
| 9,035 |
| 162,619 |
Interest expense |
| (773,831) |
| (1,501,792) |
Derivative valuation gain (loss) |
| (1,654,390) |
| 6,009,063 |
Other income (expense) |
| 2,666 |
| (4,847) |
|
|
|
|
|
Total other income (expense) |
| (2,416,520) |
| 4,665,043 |
|
|
|
|
|
Income (loss) before income taxes |
| (4,314,597) |
| 2,158,983 |
|
|
|
|
|
Provision for income taxes |
| -- |
| -- |
|
|
|
|
|
Net Income (loss) | $ | (4,314,597) | $ | 2,158,983 |
|
|
|
|
|
Net income (loss) per share – basic | $ | (0.15) | $ | 0.06 |
|
|
|
|
|
Net income (loss) per share – diluted | $ | (0.15) | $ | 0.05 |
|
|
|
|
|
Weighted average shares – basic |
| 27,854,000 |
| 38,139,100 |
|
|
|
|
|
Weighted average shares – diluted |
| 27,854,000 |
| 43,762,197 |
See accompanying notes to consolidated financial statements.
5
BROADCAST INTERNATIONAL, INC.
CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS
(Unaudited)
|
| Three Months Ended | ||
|
| March 31, | ||
|
| 2007 |
| 2008 |
Cash flows from operating activities: |
|
|
|
|
|
|
|
|
|
Net income (loss) | $ | (4,314,597) | $ | 2,158,983 |
|
|
|
|
|
Adjustments to reconcile net income (loss) to net cash used in operating activities: |
|
|
|
|
Depreciation and amortization |
| 60,603 |
| 83,441 |
Common stock issued for services |
| -- |
| 54,600 |
Common stock issued for in process research and development |
| -- |
| 19,667 |
Accretion of discount on convertible notes payable |
| 291,669 |
| 1,131,916 |
Unexercised options and warrant expense |
| 611,993 |
| 188,471 |
Gain on sale of assets |
| (5,100) |
| -- |
Derivative liability valuation |
| 1,654,390 |
| (6,009,063) |
Extinguishment of debt |
| 281,249 |
| 6,056 |
Allowance for doubtful accounts |
| 19,150 |
| 56,232 |
Changes in assets and liabilities: |
|
|
|
|
Accounts receivable |
| 611,179 |
| (263,657) |
Inventories |
| 11,185 |
| 5,876 |
Debt offering costs |
| 147,951 |
| 116,808 |
Prepaid and other assets |
| 836,617 |
| 661,070 |
Accounts payable and accrued expenses |
| (275,054) |
| (26,958) |
Deferred revenues |
| (465,622) |
| (61,922) |
|
|
|
|
|
Net cash used in operating activities |
| (534,387) |
| (1,878,480) |
|
|
|
|
|
Cash flows from investing activities: |
|
|
|
|
|
|
|
|
|
Purchase of equipment |
| (18,867) |
| (592,845) |
Purchase of available-for-sale securities |
| -- |
| (11,600,000) |
Proceeds from sale of assets |
| 5,100 |
| -- |
|
|
|
|
|
Net cash used in investing activities |
| (13,767) |
| (12,192,845) |
|
|
|
|
|
Cash flows from financing activities: |
|
|
|
|
|
|
|
|
|
Proceeds from the exercise of warrants |
| -- |
| 750,000 |
Principal payments on debt |
| (536,460) |
| -- |
Proceeds from subscription receivable |
| -- |
| 25,000 |
Proceeds from the exercise of options |
| -- |
| 750 |
Proceeds for the sale of stock |
| 348,020 |
| -- |
Loan proceeds |
| 249,974 |
| -- |
|
|
|
|
|
Net cash provided by financing activities |
| 61,534 |
| 775,750 |
|
|
|
|
|
Net decrease in cash and cash equivalents |
| (486,620) |
| (13,295,575) |
|
|
|
|
|
Cash and cash equivalents, beginning of period |
| 807,741 |
| 16,598,300 |
|
|
|
|
|
Cash and cash equivalents, end of period | $ | 321,121 | $ | 3,302,725 |
See accompanying notes to consolidated financial statements.
6
BROADCAST INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
March 31, 2008
NOTE 1 - BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited condensed consolidated financial statements of Broadcast International, Inc. (“we” or the “Company”) contain the adjustments, all of which are of a normal recurring nature, necessary to present fairly our financial position at December 31, 2007 and March 31, 2008 and the results of operations for the three months ended March 31, 2007 and 2008, respectively, with the cash flows for each of the three month periods ended March 31, 2007 and 2008, in conformity with U.S. generally accepted accounting principles.
These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2007. Operating results for the three months ended March 31, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.
NOTE 2 - RECLASSIFICATIONS
Certain 2007 financial statement amounts have been reclassified to conform to 2008 presentations.
NOTE 3 - WEIGHTED AVERAGE SHARES
The computation of basic earnings (loss) per common share is based on the weighted average number of shares outstanding during each period.
The computation of diluted earnings per common share is based on the weighted average number of common shares outstanding during the period, plus the common stock equivalents that would arise from the exercise of stock options and warrants outstanding, using the treasury stock method and the average market price per share during the period, plus the effect of assuming conversion of the convertible debt. The computation of diluted earnings per share does not assume conversion or exercise of securities that would have an anti-dilutive effect on earnings.
Outstanding stock options and warrants were not included in the calculation of diluted earnings per share for the period ended March 31, 2007 as their inclusion would be anti-dilutive, thereby reducing the net loss per common share.
The following table sets forth the computation of basic and diluted net income per share for March 31, 2007 and 2008:
|
|
|
| Three Months Ended March 31, | ||
|
| 2007 |
| 2008 | ||
|
|
|
|
| ||
Net income |
| $ (4,314,597) |
| $ 2,158,983 | ||
|
|
|
|
|
|
|
Basic weighted average shares outstanding |
| 27,854,000 |
| 38,139,100 | ||
Effect of dilutive securities: |
|
|
|
| ||
| Stock options and warrants |
| - |
| 5,623,097 | |
|
|
|
|
| ||
Dilutive weighted average shares outstanding |
| 27,854,000 |
| 43,762,197 | ||
|
|
|
|
|
|
|
Net income per share |
|
|
|
| ||
| Basic |
| $ (0.15) |
| $ 0.06 | |
| Diluted |
| $ (0.15) |
| $ 0.05 | |
|
|
|
|
|
|
|
7
Options and warrants to purchase 3,080,600 and 15,014,643 shares of common stock at prices ranging from $.02 to $45.90 per share were outstanding at March 31, 2008 and 2007, respectively, but were excluded from the calculation of diluted earnings per share because the effect of the stock options and warrants was anti-dilutive. Furthermore, the Company had convertible debt that was convertible into 3,418,961 shares of common stock at March 31, 2008, that was excluded from the calculation of diluted earnings per share because the effect was anti-dilutive.
NOTE 4 - STOCK COMPENSATION
Beginning on January 1, 2006, we began accounting for stock-based compensation under the provisions of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS 123R), which requires the recognition of the fair value of stock-based compensation. We have used the modified prospective application. Under the fair value recognition provisions for FAS 123R, stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense ratably over the requisite service period of the award. We have used the Black-Scholes valuation model to estimate fair value of our stock-based awards, which requires various judgmental assumptions including estimated stock price volatility, forfeiture rates, and expected life. Our computation of expected volatility is based on a combination of historical and market-based implied volatility.
We calculated the fair market value of each option and warrant awarded on the date of grant using the Black-Scholes option-pricing model. The following assumptions were used for the grants awarded for the three months ended March 31, 2008.
Risk-free interest rate | 3.45% - 3.70% |
Expected lives in years | 10.0 |
Dividend yield | 0 |
Expected volatility | 76.73% - 77.43% |
Net income (loss) for the three months ended March 31, 2008 and 2007 includes $188,471 and $611,993, respectively, of non-cash stock-based compensation expense. Options issued to directors vest immediately and all other options and warrants are subject to applicable vesting schedules. Expense is recognized proportionally as each grant vests.
Included in the $188,471 for the three months March 31, 2008 is (i) $22,145 for the vested portion of 286,500 options granted to eight employees, (ii) $182,215 resulting from the vesting of unexpired options and warrants issued prior to January 1, 2008, (iii) ($15,889) credit for recovery of previously recorded expense of vested options forfeited during the period.
Included in the $611,993 for the three months March 31, 2007 is $405,000 resulting from 500,000 options granted to two directors, $125,941 resulting from the vesting of unexpired options issued prior to January 1, 2007, $57,330 resulting from 1,300,000 warrants issued to 5 consultants, $13,362 resulting from the issuance of 366,500 options issued to non-executive management employees and $10,360 for repriced options previously granted to executive management. Warrants to acquire 231,999 shares of our common stock were also granted to certain equity investors.
The impact on our results of operations for recording stock-based compensation under FAS 123R for the three months ended March 31, 2008 and 2007 are as follows:
| 2008 |
| 2007 |
|
|
|
|
General and administration | $ 103,581 |
| $ 599,188 |
Research and development in process | 84,890 |
| 52,805 |
|
|
|
|
Total | $ 188,471 |
| $ 611,993 |
8
Due to unexercised options outstanding at March 31, 2008, we will recognize a total of $1,547,656 of compensation expense over the next four years for employees and consultants as a result of the adoption of FAS 123R based upon option and warrant award vesting parameters as shown below:
|
|
2008 | $ 672,200 |
2009 | 473,583 |
2010 | 360,942 |
2011 | 40,931 |
|
|
Total | $ 1,547,656 |
The following unaudited tables summarize option and warrant activity during the three months ended March 31, 2008.
| Options and Warrants Outstanding |
| Options or Warrants Price Per Share | ||
|
|
|
|
|
|
Outstanding at December 31, 2007 | 16,034,019 |
| $ 0.02 | – | $ 45.90 |
Options granted | 286,500 |
| 2.60 | – | 3.45 |
Warrants issued | -- |
| -- | – | -- |
Expired | -- |
| -- | – | -- |
Forfeited | (37,796) |
| 0.55 | – | 4.00 |
Exercised | (502,258) |
| 0.33 | – | 1.50 |
|
|
|
|
|
|
Outstanding at March 31, 2008 | 15,780,465 |
| $ 0.02 | – | $ 45.90 |
The following table summarizes information about stock options and warrants outstanding at March 31, 2008.
|
| Outstanding | Exercisable | |||||
|
|
| Weighted |
| Weighted Average |
|
| Weighted Average |
| Range of Exercise Prices | Number Outstanding | Contractual Life (years) |
| Exercise Price | Number Exercisable |
| Exercise Price |
$ | 0.02-0.04 | 1,264,495 | 2.07 | $ | 0.03 | 1,264,495 | $ | 0.03 |
| 0.33-0.95 | 1,676,822 | 6.58 |
| 0.72 | 1,510,155 |
| 0.70 |
| 1.06-6.25 | 12,835,548 | 3.37 |
| 2.52 | 12,238,714 |
| 2.51 |
| 9.50-11.50 | 2,000 | 3.27 |
| 10.65 | 2,000 |
| 10.65 |
| 36.25-45.90 | 1,600 | 2.42 |
| 41.08 | 1,600 |
| 41.08 |
$ | 0.02-45.90 | 15,780,465 | 3.61 | $ | 2.14 | 15,016,965 | $ | 2.12 |
NOTE 5- SIGNIFICANT ACCOUNTING POLICIES
Management Estimates
The preparation of financial statements 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 and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
9
Cash and Cash Equivalents
We consider all cash on hand and in banks, and highly liquid investments with maturities of three months or less, to be cash equivalents. At March 31, 2008 and 2007, we had bank balances in the excess of amounts insured by the Federal Deposit Insurance Corporation. We have not experienced any losses in such accounts, and believe we are not exposed to any significant credit risk on cash and cash equivalents.
Current financial market conditions have had the effect of restricting liquidity of cash management investments and have increased the risk of even the most liquid investments and the viability of some financial institutions. We do not believe, however, that these conditions will materially affect our business or our ability to meet our obligations or pursue our business plans.
Account Receivables
Included in our $428,259 and$220,834 net accounts receivable for the three months ending March 31, 2008 and year ending December 31, 2007, respectively, were, (i) $96,214 and $35,106 of unbilled trade receivables and (ii) $19 and $5,421 for employee travel advances and other receivables, respectively. Trade account receivables are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by identifying troubled accounts and by using historical experience applied to an aging of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.
A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more than 90 days. After the receivable becomes past due, it is on non-accrual status and accrual of interest is suspended.
Inventories
Inventories consisting of electrical and computer parts are stated at the lower of cost or market determined using the first-in, first-out method.
Property and Equipment
Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the property, generally from three to five years. Repairs and maintenance costs are expensed as incurred except when such repairs significantly add to the useful life or productive capacity of the asset, in which case the repairs are capitalized.
Patents
Patents represent initial legal costs incurred to apply for United States and international patents on the CodecSys technology, and are amortized on a straight-line basis over their useful life of approximately 20 years. We have filed several patents in the United States and foreign countries. As of March 31, 2008, the United States Patent and Trademark Office had approved 2 patents. Additionally, five foreign countries had approved patent rights. While we are unsure whether we can develop the technology in order to obtain the full benefits, the patents themselves hold value and could be sold to companies with more resources to complete the development. On-going legal expenses incurred for patent follow-up have been expensed from July 2005 forward.
Amortization expense recognized on all patents totaled $935 and $737 for the three months ended March 31, 2008 and 2007, respectively.
Estimated amortization expense, if all patents were issued at the beginning of 2008, for each of the next five years is as follows:
10
Year ending December 31: |
|
2008 | $10,652 |
2009 | 10,652 |
2010 | 10,652 |
2011 | 10,652 |
2012 | 10,652 |
Long-Lived Assets
We review our long-lived assets, including patents, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to future un-discounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, then the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. Fair value is determined by using cash flow analyses and other market valuations.
Income Taxes
We account for income taxes in accordance with the asset and liability method of accounting for income taxes prescribed by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to the taxable income in the years in which those temporary differences are expected to be recovered or settled.
Revenue Recognition
We recognize revenue when evidence exists that there is an arrangement between us and our customers, delivery of equipment sold or service has occurred, the selling price to our customers is fixed and determinable with required documentation, and collectability is reasonably assured. We recognize as deferred revenue, payments made in advance by customers for services not yet provided.
When we enter into a multi-year contract with a customer to provide installation, network management, satellite transponder and help desk, or combination of these services, we recognize this revenue as services are performed and as equipment is sold. These agreements typically provide for additional fees, as needed, to be charged if on-site visits are required by the customer in order to ensure that each customer location is able to receive network communication. As these on-site visits are performed the associated revenue and cost are recognized in the period the work is completed. If we install, for an additional fee, new or replacement equipment to an immaterial number of new customer locations, and the equipment immediately becomes the property of the customer, the associated revenue and cost are recorded in the period in which the work is completed.
Research and Development
Research and development costs are expensed when incurred. We expensed $776,633, and $185,063 of research and development costs for the three months ended March 31, 2008 and 2007, respectively.
Concentration of Credit Risk
Financial instruments, which potentially subject us to concentration of credit risk, consist primarily of trade accounts receivable. In the normal course of business, we provide credit terms to our customers. Accordingly, we perform ongoing credit evaluations of our customers and maintain allowances for possible losses which, when realized, have been within the range of management’s expectations.
For the three months ended March 31, 2008, we had 3 customers that individually constituted greater than 10% of our total revenues, which represented 22%, 19% and 19% of our revenues, respectively. For the three months ended March 31, 2007, we had 3 customers that individually constituted greater than 10% of our total revenues, which represented 42%, 16% and 14% of our revenues, respectively. One of the three customers in 2008 was not the same customer as in 2007
11
Fair Value of Financial Instruments
Our financial instruments consist of cash, receivables, notes receivables, payables, and notes payable. The carrying amount of cash, receivables and payables approximates fair value because of the short-term nature of these items. The aggregate carrying amount of the notes receivable and notes payable approximates fair value as the individual notes bear interest at market interest rates.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
NOTE 6 - LONG TERM OBLIGATIONS
Senior Secured 6.25% Convertible Note
On December 24, 2007, we entered into a securities purchase agreement in which we raised $15,000,000 (less $937,000 of prepaid interest). We intend to use the proceeds from this financing to support our CodecSys commercialization and development and for general working capital purposes. Pursuant to the financing, we issued a senior secured convertible note in the principal amount of $15,000,000 which is due December 21, 2010 and bears interest at 6.25% per annum. Interest for the first year was prepaid at closing. Interest-only payments thereafter in the amount of $234,375 are due quarterly and commence in April 2009. Interest payments may be made through issuance of common stock in certain circumstances. The note is convertible into 2,752,294 shares of our common stock, at a conversion price of $5.45 per share, convertible any time during the term of the note. We have granted a first priority security interest in all of our property and assets and of our subsidiaries to secure our obligations under the note and related transaction agreements.
In connection with the financing, the senior secured convertible note holder received warrants to acquire 1,875,000 shares of our common stock exercisable at $5.00 per share. The warrants are exercisable any time for a five-year period beginning on the date of grant. We also issued to the convertible note holder 1,000,000 shares of our common stock valued at $3,750,000 and incurred an additional $1,377,000 for commissions, finders fees and other transaction expenses, including the grant of a three-year warrant to purchase 112,500 shares of our common stock to a third party at an exercise price of $3.75 per share, valued at $252,000. A total of $1,377,000 was included in debt offering costs and is being amortized over the term of the note. The warrants and the embedded conversion feature and prepayment provision of the senior secured convertible notes have been accounted for as derivatives pursuant to EITF 00-19 and SFAS No. 133.
The $5.45 conversion price of the senior secured convertible note and the $5.00 exercise price of the warrants are subject to adjustment pursuant to standard anti-dilution rights. These rights include (i) equitable adjustments in the event we effect a stock split, dividend, combination, reclassification or similar transaction; (ii) “weighted average” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than the then current market price of our common stock; and (iii) “full ratchet” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than $5.45 per share.
The conversion feature and the prepayment provision of the notes were accounted for as embedded derivatives and valued on the transaction date using a Black-Scholes pricing model. The warrants were accounted for as derivatives and were valued on the transaction date using a Black-Scholes pricing model as well. At the end of each quarterly reporting date, the values of the derivatives are calculated using a Black-Scholes pricing model and adjusted to current fair value. The note conversion feature and the warrants may be exercised at any time and, therefore, have been reported as current liabilities.
The senior secured convertible note contains a prepayment provision allowing us to prepay, in certain limited circumstances, all or a portion of the note. The portion of the note subject to prepayment must be purchased at a price equal to the greater of (i) 135% of the amount to be purchased and (ii) the company option redemption price, as defined in the note. Even if we elect to prepay the note, the note holder may still convert any portion of the note being prepaid pursuant to the conversion feature thereof.
We also entered into a registration rights agreement with the holder of the senior secured convertible note pursuant to which we agreed to provide certain registration rights with respect to the shares of common stock, the
12
shares of common stock issuable upon conversion of the note, the shares of common stock issuable as interest shares under the note and shares of common stock issuable upon exercise of the warrant under the Securities Act of 1933, as amended. The holder is entitled to demand registration of the above-mentioned shares of common stock after six months from the closing of the securities purchase agreement in certain circumstances.
The securities purchase agreement under which the senior secured convertible note and related securities were issued contains, among other things, covenants that may restrict our ability to obtain additional capital, to declare or pay a dividend or to engage in other business activities. A breach of any of these covenants could result in a default under our senior secured convertible note, in which event the holder of the note could elect to declare all amounts outstanding to be immediately due and payable, which would require us to secure additional debt or equity financing to repay the indebtedness or to seek bankruptcy protection or liquidation. The securities purchase agreement provides that we cannot do any of the following without the prior written consent of the holder:
·
directly or indirectly, redeem, or declare or pay any cash dividend or distribution on, our common stock;
·
issue any additional notes or issue any other securities that would cause a breach or default under the senior secured convertible note;
·
issue or sell any rights, warrants or options to subscribe for or purchase common stock or directly or indirectly convertible into or exchangeable or exercisable for common stock at a price which varies or may vary with the market price of the common stock, including by way of one or more reset(s) to any fixed price unless the conversion, exchange or exercise price of any such security cannot be less than the then applicable conversion price with respect to the common stock into which any note is convertible or the then applicable exercise price with respect to the common stock into which any warrant is exercisable;
·
enter into or affect any dilutive issuance (as defined in the note) if the effect of such dilutive issuance is to cause us to be required to issue upon conversion of any note or exercise of any warrant any shares of common stock in excess of that number of shares of common stock which we may issue upon conversion of the note and exercise of the warrants without breaching our obligations under the rules or regulations of the principal market or any applicable eligible market;
·
liquidate, wind up or dissolve (or suffer any liquidation or dissolution);
·
convey, sell, lease, license, assign, transfer or otherwise dispose of all or any substantial portion of our properties or assets, other than transactions in the ordinary course of business consistent with past practices, and transactions by non-material subsidiaries, if any;
·
cause, permit or suffer, directly or indirectly, any change in control transaction as defined in the senior secured convertible note.
As of March 31, 2008, we recorded an aggregate derivative liability of $4,710,800, and a derivative valuation gain of $3,909,300 to reflect the change in value of the aggregate derivate liability since December 31, 2007. The aggregate derivative liability of $4,710,800 included $2,367,000 for the conversion feature and $2,343,800 for the warrants. These values were calculated using the Black-Scholes pricing model with the following assumptions: (i) risk-free interest rate between 1.79% and 2.46%, (ii) expected life (in years) of 2.7 for the conversion feature and 4.7 for the warrants; (iii) expected volatility of 82.08% for the conversion feature and 76.73% for the warrants; (iv) expected dividend yield of 0.00%; and (v) stock trading price of $2.60.
The principal value of $15,000,000 of the 6.25% senior secured convertible note is being accreted over the term of the obligation, for which $1,047,825 was included in interest expense for the three months ended March 31, 2008. The note bears a 6.25% annual interest rate payable quarterly, and for the three months ended March 31, 2008, $234,375 was included in interest expense. On December 21, 2007, we paid $937,500 as interest for the first year of the note and at March 31, 2008 have recorded $679,687 as prepaid interest.
Unsecured Convertible Note
On September 29, 2006, we entered into a letter of understanding with Triage Capital Management, or Triage, dated September 25, 2006. The letter of understanding provided that Triage loan $1,000,000 to us in exchange for us entering into, on or prior to October 30, 2006, a convertible note securities agreement. It was intended that the
13
funding provided by Triage be replaced by a convertible note and accompanying warrants, as described below. Effective November 2, 2006, we entered into securities purchase agreement, a 5% convertible note, a registration rights agreement, and four classes of warrants to purchase our common stock, all of which were with an individual note holder, the controlling owner of Triage, who caused our agreement with Triage to be assigned to him, which satisfied our agreement with Triage.
Pursuant to the securities purchase agreement, (i) we sold to the convertible note holder a three-year convertible note in the principal amount of $1,000,000 representing the funding received by us on September 29, 2006; (ii) the convertible note bears an annual interest rate of 5%, payable semi-annually in cash or shares of our common stock; (iii) the convertible note is convertible into shares of our common stock at a conversion price of $1.50 per share; and (iv) we issued to the convertible note holder four classes of warrants (A Warrants, B Warrants, C Warrants and D Warrants), which give the convertible note holder the right to purchase a total of 5,500,000 shares of our common stock as described below. The A and B Warrants originally expired one year after the effective date of a registration statement filed under the Securities Act of 1933, as amended (the “Securities Act”), to register the subsequent sale of shares received from exercise of the A and B Warrants. The C Warrants and D Warrants originally expired eighteen months and twenty four months, respectively, after the effective date of a registration statement to be filed under the Securities Act. The A Warrants grant the convertible note holder the right to purchase up to 750,000 shares of common stock at an exercise price of $1.60 per share, the B Warrants grant the convertible note holder the right to purchase up to 750,000 shares of common stock at an exercise price of $1.75 per share, the C Warrants grant the convertible note holder the right to purchase up to 2,000,000 shares of common stock at an exercise price of $2.10 per share, and the D Warrants grant the convertible note holder the right to purchase up to 2,000,000 shares of common stock at an exercise price of $3.00 per share.
During the fourth quarter of the year ended December 31, 2007, the convertible note holder exercised 454,000 A Warrants at an exercise price of $1.60 per share providing $726,400 in funding to us. Additionally, we entered into an exchange agreement dated October 31, 2007 in which the convertible note holder received 650,000 shares of our common stock in exchange for cancellation of the C and the D Warrants. The expiration date of the A Warrants and the B Warrants was extended from January 11, 2008 to December 3, 2008.
As of March 31, 2008 and 2007, we recorded an aggregate derivative liability of $2,194,400 and $4,237,200, and derivative valuation gain of $1,954,300 and derivative valuation loss $1,056,400, respectively, to reflect the change in value of the aggregate derivate liability since December 31, 2007 and 2006, respectively. The aggregate derivative liability of $2,194,400 included $1,006,700 for the conversion feature and $1,187,700 for the warrants. These values were calculated using the Black-Scholes pricing model with the following assumptions: (i) risk-free interest rate between 1.15% and 1.59%, (ii) expected life (in years) of 1.50 for the conversion feature and 0.70 for the warrants; (iii) expected volatility of 89.65% for the conversion feature and 82.16% for the warrants; (iv) expected dividend yield of 0.00%; and (v) stock trading price of $2.60.
The principal value of $1,000,000 of the unsecured convertible note is being accreted over the term of the obligation, for which $83,334 was included in interest expense for both three month periods ended March 31, 2008 and 2007. The note bears a 5% annual interest rate payable semi-annually, and for both the three-month periods ended March 31, 2008 and 2007, $12,501 was included in interest expense.
Senior Secured 6% Convertible Notes
On May 16, 2005, we consummated a private placement of $3,000,000 principal amount of 6% senior secured convertible notes and related securities, including common stock warrants and additional investment rights, to four institutional funds. The senior secured convertible notes were originally due May 16, 2008 and were originally convertible into 1,200,000 shares of our common stock at a conversion price of $2.50 per share. On March 16, 2006, we entered into a waiver and amendment agreement (discussed below), which adjusted the conversion rate to $1.50 per share. The warrants and the embedded conversion feature of the senior secured convertible notes have been accounted for as derivatives pursuant to EITF 00-19 and SFAS No. 133.
We issued to the note holders a total of 600,000 A warrants and 600,000 B warrants to purchase common stock with an exercise price of $2.50 and $4.00, respectively. The $2.50 conversion price of the senior secured convertible notes and the $2.50 and $4.00 exercise price of the A Warrants and the B Warrants, respectively, are subject to adjustment pursuant to standard anti-dilution rights. On March 16, 2006, we entered into a waiver and amendment agreement (discussed below), which adjusted the exercise price of both the A and B warrants to $2.00 per share. These anti-dilution rights include (i) equitable adjustments in the event we effect a stock split, dividend,
14
combination, reclassification or similar transaction; (ii) “weighted average” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than the then current market price of the common stock; and (iii) “full ratchet” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than $1.50 per share. In no event, however, will the conversion price or exercise price be adjusted below $0.50 per share for the reset provision.
The conversion feature and the prepayment provision of the notes were accounted for as embedded derivatives and valued on the transaction date using a Black-Scholes pricing model. The warrants were accounted for as derivatives and were valued on the transaction date using a Black-Scholes pricing model as well. At the end of each quarterly reporting date, the values of the derivatives are evaluated and adjusted to current fair value. The note conversion feature and the warrants may be exercised at any time and, therefore, have been reported as current liabilities. The prepayment provision was not exercisable by us until May 16, 2007, and then only in certain limited circumstances. For all periods since the issuance of the senior secured convertible notes, the derivative value of the prepayment provision has been nominal and has not had any offsetting effect on the valuation of the conversion feature of the notes.
The senior secured convertible notes required that we secure an effective registration statement with the Securities and Exchange Commission within 120 days from May 16, 2005 (September 13, 2005). Section 4(a) of the senior secured convertible notes enumerated circumstances that are considered an event of default. The remedies for default provide that if an event of default occurs and is continuing, the holders may declare all of the then outstanding principal amount of the notes and any accrued and unpaid interest thereon to be immediately due and payable in cash. In the event of an acceleration, the amount due and owing to the holders is 125% of the outstanding principal amount of the notes and interest on such amount is calculated using the default rate of 18% per annum if the full amount is not paid within one business day after acceleration. We were in default under Section 4(a)(viii), related to the effective date of our registration statement, beginning October 13, 2005 until February 3, 2006, at which time the event of default was cured and is no longer continuing. For the years ended December 31, 2006 and 2005, we recorded $66,000 and $218,000, respectively, as additional interest expense for this default.
On March 16, 2006, we entered into a waiver and amendment agreement with the four institutional funds regarding our default discussed above. Under the terms of the waiver, the institutional funds terminated a forbearance agreement and waived any and all defaults under the senior secured convertible notes and related transaction agreements. In consideration of the waiver, we and the funds agreed to amend the transaction agreements as follows: (i) Section 3.12 of the securities purchase agreement was deleted, which provision gave the funds a preemptive right to acquire any new securities issued by us; (ii) Section 3.15(c) of the securities purchase agreement was deleted, which provision prohibited us from completing a private equity or equity-linked financing; (iii) the conversion price, at which the notes are convertible into shares of our common stock, was amended to be $1.50 instead of $2.50; (iv) the exercise price, at which all warrants (A warrants and B warrants) held by the funds are exercisable, was changed to $2.00 (which exercise price was subsequently reduced to $1.50 due to applicable antidilution provisions); and (v) the notes were amended by adding a new event of default, which is that if we fail to raise and receive at least $3,000,000 in cash net proceeds through one or more private or public placements of its securities by September 30, 2006, we would have been in default under the notes.
On April 21, 2006, two of the institutional funds converted an aggregate of $500,000 of their convertible notes into 333,334 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $3,000,000 to $2,500,000.
On March 18, 2007, two of the institutional funds converted an aggregate of $750,000 of their convertible notes into 500,000 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $2,500,000 to $1,750,000.
On April 4, 2007, one of the institutional funds converted an aggregate of $100,000 of its convertible notes into 66,667 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $1,750,000 to $1,650,000.
On September 13, 2007, one of the institutional funds assigned $54,505 of its convertible note and certain associated warrants to a third party.
15
On September 25, 2007, two of the institutional funds converted an aggregate of $225,000 of their convertible notes into 150,000 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $1,650,000 to $1,425,000.
During October 2007, four of the institutional funds converted an aggregate of $1,091,944 of their convertible notes into 727,963 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $1,425,000 to $333,056.
During November 2007, one of the institutional funds converted an aggregate of $278,551 of its convertible notes into 185,701 shares of our common stock. Upon completion of this conversion, the principal amount of the senior secured convertible notes was reduced from $333,056 to $54,505.
During the fourth quarter of the year ended December 31, 2007, four of the institutional funds exercised an aggregate of 667,298 of their A and B warrants at an exercise price of $1.50 providing $1,000,947 in funding to us. As of December 31, 2007, there were 532,702 remaining warrants outstanding.
During the three months ended March 31, 2008, three of the institutional funds exercised an aggregate of 500,000 of their A and B warrants at an exercise price of $1.50 providing $750,000 in funding to us. As of March 31, 2008, there were 32,702 remaining warrants outstanding.
As of March 31, 2008 and 2007, we recorded an aggregate derivative liability of $53,000 and $1,543,700 and a derivative valuation gain of $145,463 and a valuation loss of $597,990 to reflect the change in value of the aggregate derivate liability since December 31, 2007 and 2006, respectively. The aggregate derivative liability of $53,000 was for the 32,702 remaining warrants. The value was calculated using the Black-Scholes pricing model with the following assumptions: (i) risk-free interest rate of 1.62%; (ii) expected life (in years) of 2.1; (iii) expected volatility of 87.51; (iv) expected dividend yield of 0.00%; and (v) stock trading price of $2.60.
The remaining $54,505 principal value of the senior secured convertible notes was converted during the three months ended March 31, 2008. Prior to conversion the outstanding principle value was being accreted over the term of the obligations, for which $757 and $208,335 was included in interest expense for the three months ended March 31, 2008 and 2007, respectively. The notes bore a 6% annual interest rate payable semi annually, and for the three months ended March 31, 2008 and 2007, $136 and $36,125, respectively, was included in interest expense.
IDI Bankruptcy Settlement
On May 18, 2004, the debtor-in-possession’s plan of reorganization for IDI was confirmed by the United States Bankruptcy Court. As a result of this confirmation, we issued to the creditors of IDI approximately 111,842 shares of our common stock, valued at approximately $682,222, and assumed cash liabilities of approximately $312,768 to be paid over a 4-year period in exchange for approximately 50,127,218 shares of the common stock of IDI representing approximately 86% of the equity of IDI.
During the year ended December 31, 2007, we satisfied our obligation to the creditors of IDI. For the three months ended March 31, 2007, we paid approximately $17,547 of the $312,768 original obligation. The balance remaining as of March 31, 2007 was approximately $87,733 of which $70,187 and had been recorded as the current portion (for that year) with $17,547 as long-term debt.
NOTE 7 – FAIR VALUE MEASUREMENTS
The Company adopted SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”) as of January 1, 2008 for financial instruments measured at fair value on a recurring basis. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States and expands disclosures about fair value measurements.
SFAS 157 establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). These tiers include:
16
·
Level 1, defined as observable inputs such as quoted prices in active markets;
·
Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and
·
Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
We measure certain financial instruments at fair value on a recurring basis. Assets and liabilities measured at fair value on a recurring basis are as follows at March 31, 2008:
|
|
|
|
|
| Quoted Prices in |
| Significant Other |
| Significant |
|
|
|
|
|
| Active Markets for |
| Observable |
| Unobservable |
|
|
|
|
|
| Identical Assets |
| Inputs |
| Inputs |
|
|
|
| Total |
| (Level 1) |
| (Level 2) |
| (Level 3) |
Assets |
|
|
|
|
|
|
|
|
| |
| Money market funds |
|
| $ 2,809,554 |
| $ 2,809,554 |
| $ - |
| $ - |
| Treasury cash reserve securities |
| 525,000 |
| 525,000 |
| $ - |
| $ - | |
| Auction rate preferred securities |
| 11,039,813 |
| - |
| - |
| 11,039,813 | |
Total assets measured at fair value |
| $ 14,374,367 |
| $ 3,334,554 |
| $ - |
| $ 11,039,813 | ||
|
|
|
|
|
|
|
|
|
|
|
Liabilities |
|
|
|
|
|
|
|
|
| |
| Derivative valuation (1) |
|
| $ 6,958,200 |
| $ - |
| $ - |
| $ 6,958,200 |
Total liabilities measured at fair value | $ 6,958,200 |
| $ - |
| $ - |
| $ 6,958,200 | |||
|
|
|
|
|
|
|
|
|
|
|
| (1) See Note 6 of the Company's Condensed Consolidated Financial Statements for additional discussion. |
The table below presents the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in SFAS 157 at March 31, 2008. The Company classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model.
|
|
| Derivative |
| Auction Rate |
|
|
|
|
| Valuation Liability |
| Preferred Securities |
| Total |
Balance at December 31, 2007 |
| $ (14,267,600) |
| $ - |
| $ (14,267,600) | |
Total gains or losses (realized and unrealized) |
|
|
|
|
| ||
| Included in net income |
| 6,009,063 |
| - |
| 6,009,063 |
| Included in other comprehensive income | - |
| (560,187) |
| (560,187) | |
Purchases, issuances, and settlements, net | 1,300,337 |
| 11,600,000 |
| 12,900,337 | ||
Transfers to Level 3 |
| - |
| - |
| - | |
Balance at March 31, 2008 |
| $ (6,958,200) |
| $ 11,039,813 |
| $ 4,081,613 | |
|
|
|
|
|
|
|
|
Money Market Funds and Treasury Securities
The money market funds and treasury cash reserve securities balances are classified as cash and cash equivalents on the Company’s Condensed Consolidated Balance Sheet.
Auction Rate Preferred Securities
As of March 31, 2008, the Company had investments in auction rate preferred securities (“ARPS”), which are classified as available-for-sale securities on the Company’s Condensed Consolidated Balance Sheet and reflected at fair value. Due to recent events in credit markets, the auction events for these instruments held by the
17
Company failed during first quarter 2008. Therefore, the fair values of these securities were estimated utilizing a discounted cash flow analysis as of March 31, 2008. This analysis considers, among other items, the collateralization of the underlying security investments, the creditworthiness of the counterparty, the timing of expected future cash flows and the expectation of the next time the security is expected to have a successful auction or the security has been called by the issuer.
As a result of the temporary decline in fair value for the Company’s ARPS, which it attributes to liquidity issues rather than credit issues, the Company has recorded an unrealized loss of $560,187 to Accumulated other comprehensive loss. The ARPS held by the Company at March 31, 2008, totaling $11,039,813, were in AAA rated funds. Due to the Company’s belief that the market for a portion of these instruments may take in excess of twelve months to fully recover, the Company has classified $6,964,813 of these investments as noncurrent. $4,075,000 of the ARPS have been classified as current since there is a specific plan for redemption by the investments’ issuers within the next four months for a portion of ARPS held by the Company. As of March 31, 2008, the Company continues to earn interest on its ARPS under the default interest rate features of the ARPS. Any future fluctuation in fair value related to these instruments that the Company deems to be temporary, including any recoveries of previous write-downs, would be recorded to Accumulated other comprehensive loss. If the Company determines that any future valuation adjustment is other than temporary, it would record a charge to earnings as appropriate.
NOTE 8 – COMPREHENSIVE INCOME
Comprehensive loss equaled net loss of $4,314,597 for the three months ended March 31, 2007. Comprehensive income totaled $1,628,631 for the three months ended March 31, 2008 and included unrealized losses on auction rate preferred securities. The difference between net loss and comprehensive loss for the three months ended March 31, 2008 was as follows:
|
|
|
| Three Months Ended |
|
|
|
| March 31, 2008 |
| Net income |
| $ 2,158,983 | |
| Unrealized loss on available-for-sale securities |
| (560,187) | |
| Comprehensive income |
| $ 1,598,796 |
Accumulated other comprehensive loss per the Company’s Condensed Consolidated Balance Sheet consists of the Company’s unrealized loss of $560,187 on its available-for-sale securities.
NOTE 9 - SUPPLEMENTAL CASH FLOW INFORMATION
During the three months ended March 31, 2008, we issued 160,000 shares of our common stock to a corporation, to provide investor relations services for the Company. The value of these shares of $488,000 was recorded as a prepaid expense and will be recognized over the service periods as follows:
2008 | $ 427,003 |
2009 | 60,997 |
| $ 488,000 |
During the three months ended March 31, 2008, we issued 21,000 shares of our common stock pursuant to an existing consulting agreement to a corporation, to provide investor relations services for the Company. The value of these shares of $54,600 was recorded in general and administrative expense.
On March 18, 2007, one of the institutional funds converted an aggregate of $54,505 of their convertible notes into 36,337 shares of our common stock resulting in an extinguishment of debt non-cash expense of $6,056 included as interest expense for the three months ended March 31, 2008. See Note 6.
For the three months ended March 31, 2008 and 2007, an aggregate non-cash expense of $1,131,916 and 291,669 was recorded for the accretion of i) the senior 6% convertible notes of $757 and 208,335, respectively, ii) the unsecured convertible note of $83,334 in each of the periods and (iii) $1,047,825 for the senior secured 6.25% Convertible note in 2008, as interest expense. See Note 6.
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During the three months ended March 31, 2007, we received $348,020 from the sale of 232,012 shares of common stock pursuant to a Private Placement Offering at a price of $1.50 per share. Additionally, the holders of 231,999 of these shares received a warrant to acquire one share of our common stock. The warrants have a three-year exercise period and are exercisable at a $2.00 exercise price.
During the three months ended March 31, 2007, we issued 2,160,000 shares of our common stock to three corporations, which provide investor relations services for the Company. The value of these shares of $2,124,000 was recorded as a prepaid expense and will be recognized over the service periods as follows:
2007 | $ 996,997 |
2008 | 968,655 |
2009 | 158,348 |
| $ 2,124,000 |
On March 18, 2007, two of the institutional funds converted an aggregate of $750,000 of their convertible notes into 500,000 shares of our common stock resulting in an extinguishment of debt, a non-cash expense included as interest expense for the three months ended March 31, 2007. See Note 6.
On February 28 and March 30, 2007, we entered into two unsecured promissory 6% notes with a Utah corporation, in the aggregate of $249,974 included at March 31, 2007 as current debt obligations. Payment of principal and interest were due on December 31, 2007, but were paid before maturity.
The Company paid no cash for income taxes during the quarters ended March 31, 2008 and 2007.
The Company paid $1,108 and $3,586 for interest expense during the three months ended March 31, 2008 and March 31, 2007, respectively.
NOTE 10 - RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which establishes specific criteria for the fair value measurements of financial and nonfinancial assets and liabilities that are already subject to fair value under current accounting rules. SFAS 157 also requires expanded disclosures related to fair value measurements. In February 2008, the FASB approved FASB Staff Position (FSP) FAS 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2) which allows companies to elect a one-year delay in applying SFAS 157 to certain fair value measurements of non-financial instruments, except for those recognized or disclosed at fair value on at least an annual basis. We elected the delayed adoption date for the portions of SFAS 157 impacted by FSP 157-2 and, as a result, we partially adopted SFAS 157 on January 1, 2008. The partial adoption of SFAS 157 was prospective and did not have a significant effect on our Condensed Consolidated Financial Statements. See Note 7 for information about fair value measurements. We are currently evaluating the impact of applying the deferred portion of SFAS 157 to the nonrecurring fair value measurements of our nonfinancial assets and nonfinancial liabilities. In accordance with FSP 157-2, the fair value measurements for these items will be adopted effective January 1, 2009.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of SFAS 115” (“SFAS 159”). SFAS 159 permits a company to voluntarily elect to use fair value, instead of historic or original cost, to account for certain financial assets and liabilities. The fair value option is designated on an item-by-item basis, is irrevocable and requires that changes in fair value in subsequent periods be recognized in earnings in the period of change. We adopted SFAS 159 on January 1, 2008. The adoption had no impact on our Condensed Consolidated Financial Statements as we did not make a fair value election for any of our existing financial assets and liabilities. Any election to use the fair value method for future eligible transactions will be made on a case-by-case and instrument-by-instrument basis.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). Under SFAS 141R, an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and
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amortized over its estimated useful life. The adoption of SFAS 141R will change our accounting treatment for business combinations on a prospective basis beginning in the first quarter of fiscal year 2009.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”), which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We do not expect that the adoption of SFAS 160 will have a significant impact on our Condensed Consolidated Financial Statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“SFAS 161”), which requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. SFAS 161 is effective for fiscal years beginning after November 15, 2008. We are currently evaluating the impact of SFAS 161 on our Condensed Consolidated Financial Statements.
The Company has reviewed all other recently issued, but not yet adopted, accounting standards in order to determine their effects, if any, on its condensed consolidated financial statements. Based on that review, the Company believes that none of these pronouncements will have a significant effect on its current or future consolidated financial statements.
NOTE 11 - SUBSEQUENT EVENTS
During the April 2008, the unsecured convertible note holder exercised 64,400 A Warrants at an exercise price of $1.60 per share providing $103,040 in funding to us.
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Note Regarding Forward-Looking Statements
This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risk and uncertainties. Any statements about our expectations, beliefs, plans, objectives, strategies or future events or performance constitute forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend” and similar words or phrases. Accordingly, these statements involve estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed or implied therein. All forward-looking statements are qualified in their entirety by reference to the factors discussed in this report, including, among others, the following risk factors discussed more fully in Item 1A hereof:
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dependence on commercialization of our CodecSys technology;
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our need and ability to raise sufficient additional capital;
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our continued losses;
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restrictions contained in our outstanding convertible notes;
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general economic and market conditions;
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ineffective internal operational and financial control systems;
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rapid technological change;
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intense competitive factors;
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our ability to hire and retain specialized and key personnel;
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dependence on the sales efforts of others;
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dependence on significant customers;
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uncertainty of intellectual property protection;
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potential infringement on the intellectual property rights of others;
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factors affecting our common stock as a “penny stock;”
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extreme price fluctuations in our common stock;
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price decreases due to future sales of our common stock;
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future shareholder dilution; and
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absence of dividends.
Because the risk factors referred to above could cause actual results or outcomes to differ materially from those expressed or implied in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any forward-looking statement. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of future events or developments. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
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Critical Accounting Policies
The preparation of financial statements in conformity with U.S. GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to recognition of revenue, valuation of investments, valuation of inventory, valuation of intangible assets, valuation of derivatives, measurement of stock-based compensation expense and litigation. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss our critical accounting policies in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2007. Except for the critical accounting policy set forth below entitled “Valuation of Investments,” there have been no other significant changes in our critical accounting policies or estimates since those reported in our Annual Report.
Valuation of Investments
As discussed in Note 6 to the unaudited condensed consolidated financial statements, we adopted the provisions of Statement 157 effective January 1, 2008. In valuing our investments we predominantly use market data or data derived from market sources. When market data is not available, such as when the investment is illiquid, we utilize a discounted cash flow analysis to arrive at the recorded fair value. This process involves incorporating our assumption about the anticipated term and the yield that a market participant would require to purchase the security in the marketplace. We utilized unobservable (Level 3) inputs in determining the fair value of our auction rate preferred securities, which totaled $11,039,813 at March 31, 2008.
Our auction rate preferred securities are classified as available-for-sale securities and reflected at fair value. In prior periods, due to the auction process which took place every 7-30 days for most securities, quoted market prices were readily available, which would qualify as Level 1 under Statement 157. However, due to events in credit markets during first quarter 2008, the auction events for most of these instruments failed, and, therefore, we have determined the estimated fair values of these securities utilizing a discounted cash flow analysis as of March 31, 2008. This analysis considers, among other items, the collateralization of the underlying securities, the expected future cash flows and the expectation of the next time the security is expected to have a successful auction. These securities were also compared, when possible, to other observable market data with similar characteristics to the securities held by us. Due to these events, we reclassified these instruments as Level 3 during first quarter 2008 and recorded a temporary unrealized decline in fair value of $560,187, with an offsetting entry to Accumulated other comprehensive loss. We currently believe that this temporary decline in fair value is due entirely to liquidity issues and not credit issues, because they are in AAA closed-end bond mutual funds that are over-collateralized by at least 200% and are backed by the underlying marketable securities. We believe we have sufficient cash and cash equivalents available at March 31, 2008 to allow us sufficient time for the securities to return to full value. We will re-evaluate each of these factors as market conditions change in subsequent periods.
Executive Overview
In March 2007, we commenced a private placement offering of our securities by selling shares of our common stock at a price of $1.50 per share. In the offering, the purchaser of each share received a warrant to acquire one share of common stock. The warrants have a three-year exercise period and are exercisable at an exercise price of $2.00 per share. In the fourth quarter of 2007, we completed the offering pursuant to which we raised $5,975,317 from the sale of 3,983,557 shares of our common stock.
On October 31, 2007, we entered into an exchange agreement with the holder of our unsecured convertible note in the principal amount of $1.0 million and related warrants. Pursuant to the exchange agreement, we cancelled the holder’s warrants to acquire up to 2,000,000 shares of our common stock at $2.10 per share and other warrants to acquire up to 2,000,000 additional shares of our common stock at $3.00 per share in exchange for the issuance of 650,000 shares of our common stock to the holder.
In the fourth quarter of 2007, the institutional fund holders of our outstanding senior secured convertible notes issued in 2005 completed conversion of substantially all of their convertible notes into shares of our common stock.
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At December 31, 2007, only an immaterial amount of the senior secured convertible notes remained outstanding, and has since been converted.
On November 15, 2007, we entered into a two-year license agreement with IBM pursuant to which we will license our patented CodecSys technology for use by IBM in video encoders that IBM intends to manufacture and sell. The IBM video encoder is not completed in a commercially deployable form. The IBM agreement is our first significant license of the CodecSys technology for use in a commercial application. We believe this agreement may hold substantial revenue opportunities for our business. Although IBM has commenced marketing and sales activities with respect to products incorporating our CodecSys technology, no sales of products have been made, and we have not derived any material revenue from our CodecSys technology to date.
On December 24, 2007, we completed a $15.0 million private placement of securities with an institutional investor. Pursuant to the financing, we entered into various agreements with the investor, including (i) a securities purchase agreement pursuant to which we, in exchange for $15.0 million, issued and sold to the investor (A) 1,000,000 shares of our common stock, (B) a 6.25% senior secured convertible promissory note in the principal amount of $15.0 million which is convertible into shares of our common stock at a conversion price of $5.45 per share, and (C) a five-year warrant that is exercisable to purchase up to 1,875,000 shares of common stock at an exercise price of $5.00 per share; (ii) a registration rights agreement pursuant to which we agreed to provide certain registration rights with respect to the shares of common stock, the shares of common stock issuable upon conversion of the note, the shares of common stock issuable as interest shares under the note and shares of common stock issuable upon exercise of the warrant; and (iii) a security agreement granting a first priority security interest in all of our property and assets to secure the note.
Our revenues declined for the quarter ended March 31, 2008 compared to the quarter ended March 31, 2007, and the net cash used for operations similarly increased in 2008 compared to 2007 although not by the same percentages. Until cash from operations are sufficient to cover all corporate expenses, we will continue to deplete our available cash and increase our need for future equity and debt financing.
The conversion feature and the prepayment provision of the $15.0 million senior secured convertible note and the $1.0 million unsecured convertible note have been accounted for as embedded derivatives and valued on the respective transaction dates using a Black-Scholes pricing model. The warrants related to the convertible notes have been accounted for as derivatives and were valued on the respective transaction dates using a Black-Scholes pricing model as well. At the end of each quarterly reporting date, the values of the embedded derivatives and the warrants are evaluated and adjusted to current market value. The conversion features of the convertible notes and the warrants may be exercised at any time and, therefore, have been reported as current liabilities. Prepayment provisions contained in the convertible notes limit our ability to prepay the notes in certain circumstances. For all periods since the issuance of the senior secured convertible note and the unsecured convertible note, the derivative values of the respective prepayment provisions have been nominal and have not had any offsetting effect on the valuation of the conversion features of the notes. For a description of the accounting treatment of the senior secured convertible note financing, see Note 5 of our notes to consolidated financial statements included elsewhere herein.
Results of Operations for the Three Months ended March 31, 2008 and March 31, 2007
Revenues
The Company generated $ 1,187,392 in revenue during the three months ended March 31, 2008. During the same three-month period in 2007, the Company generated revenue of $1,599,066. The decrease in revenue of $411,674 or approximately 35% was due primarily to the Company performing significantly less installation work in the three months ended March 31, 2008, for two customers than it did for those customers in the first quarter of 2007. The Company realized $791,507 less revenue from services performed for these two customers in the quarter ended March 31, 2008, than in the first quarter of 2007. We do not expect to perform any services for these customers in the remainder of 2008. The decrease in revenues from these two customers was partially offset by the addition of two new customers.
The Company's three largest customers’ sales revenues accounted for approximately 59% and 71% of total revenues for the quarters ended March 31, 2008 and 2007, respectively. Any material reduction in revenues generated from any one of its largest customers could harm the Company’s results of operations, financial condition and liquidity.
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Cost of Revenues
Costs of Revenues decreased by approximately $458,329 to $1,136,446 for the three months ended March 31, 2008, from $1,594,775 for the three months ended March 31, 2007. The decrease was due primarily to decreased activity in installation of equipment, which resulted in a decrease in the costs related to such installation services for all the Company’s customers of $399,813. There was not a decrease in the cost of equipment relative to the sales price of the equipment, but the general operations department costs decreased by approximately $93,859 due to the decrease in installation activity. The cost decreases were partially offset by an increase of approximately $10,654 in satellite distribution costs and a $24,690 increase in depreciation and amortization, which was the result of purchases of network and development equipment.
Expenses
General and Administrative expenses for the three months ended March 31, 2008 were $1,534,181 compared to $1,574,684 for the three months ended March 31, 2007. The decrease of approximately $40,503 resulted primarily from an increase in expenses incurred for outside consultants of $215,852 offset by a decrease in expenses of $465,228 for options and warrants granted. Research and development in process increased by $591,570 for the three months ended March 31, 2008 to $776,633 from $185,063 for the three months ended March 31, 2007. This increase resulted primarily from increased development staff and related expenses of increasing the development activity.
Interest Expense
For the three months ended March 31, 2008, the Company incurred interest expense of $1,501,792 compared to interest expense for the three months ended March 31, 2007 of $773,831. The increase of $727,961 resulted primarily from the Company recording interest expense of $1,047,825 related to note accretion of our 6.25% senior secured convertible note, which was not outstanding during the first quarter of 2007. The interest expense recorded primarily consisted of interest of $1,131,916 recorded to account for the accretion of note liability on our balance sheet, interest payable on all notes of $247,012 and amortization of debt offering costs of $114,750.
Net Loss
The Company realized net income for the three months ending March 31, 2008 of $2,158,983 compared with a net loss for the three months ended March 31, 2007 of $4,314,597. The increase in net income of $6,473,580 was primarily the result of an increase in derivative valuation gain of $7,663,453, which resulted primarily from valuation of our 6.25% senior secured convertible note, which was issued in December of 2007. Even though revenues decreased as described above, gross margin from work performed actually increased by $46,655, which also contributed slightly to the increased net income. The gain in derivative valuation was partially offset by an increase in research and development in process of $591,570 and an increase in interest expense of $727,961, all as explained above.
Liquidity and Capital Resources
At March 31, 2008, we had cash of $3,302,725, total current assets of $10,133,229, and total current liabilities of $8,302,471 and total stockholders' equity of $7,448,972. Included in current liabilities is $6,958,200 which relates to the value of the embedded derivatives for the 6.25% senior secured convertible note and related warrants and the unsecured convertible note and warrants. Our current liabilities, without considering the derivative liability are $1,344,271.
As of March 31, 2008, we held approximately $11,039,816 of auction rate preferred securities, of which $4,075,000 was classified as current assets and $6,964,813 was classified as non-current assets. Beginning in February 2008, many of these auction rate preferred securities became illiquid because their scheduled auctions failed to settle. As a result, we may have limited or no opportunities to liquidate a portion of these investments and fully recover their stated value in the near term. An auction failure occurs when the parties wishing to sell securities at auction cannot. When an auction fails the affected securities begin to pay interest under their default interest rate terms. As a result of this illiquidity caused by the lack of an active market, $6,964,813 of these investments were classified as non-current. However, some of the issuers of the auction rate preferred securities held by us have announced a definitive plan for redemption of these securities in the near term. As a result, $4,075,000 of these investments
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were classified as current. A temporary unrealized loss of $560,187 was recorded in the first quarter of 2008. We utilized a discounted cash flow analysis in determining the fair value of these securities, which used significant unobservable inputs at March 31, 2008.
We believe the impairment of these securities is temporary because they are backed by more than 200% collateral. Substantially all of our auction rate preferred securities are currently rated AAA, the highest rating by a rating agency. We believe we will ultimately be able to liquidate these investments without significant loss through successful auctions or redemptions of securities by the issuers. However, it could take a long period of time to realize the investments’ full value for a portion of the investments. Based on our expected operating cash flows, and our other sources of cash, we do not anticipate that the current illiquidity of $6,964,813 of these investments will adversely affect our operations.
We experienced negative cash flow used in operations during the three months ending March 31, 2008 of $1,878,480 compared to negative cash flow used in operations for the three months ended March 31, 2007 of $534,387. The negative cash flow was met by cash reserves. We expect to continue to experience negative operating cash flow as long as we continue our technology development program or until we begin to receive licensing revenue from licenses of our CodecSys technology or increase our sales by adding new customers.
On December 24, 2007, we entered into a securities purchase agreement described above in which we raised $15,000,000 (less $937,000 of prepaid interest). We intend to use the proceeds from this financing to support our CodecSys commercialization and development and for general working capital purposes. The senior secured convertible note is due December 21, 2010 and bears interest at 6.25% per annum. Interest for the first year was prepaid at closing. Interest-only payments thereafter in the amount of $234,375 are due quarterly and commence in April 2009. Interest payments may be made through issuance of common stock in certain circumstances. The note is convertible into 2,752,294 shares of our common stock at a conversion price of $5.45 per share, convertible any time during the term of the note. We have granted a first priority security interest in all of our property and assets and of our subsidiaries to secure our obligations under the note and related transaction agreements.
In connection with the financing, the senior secured convertible note holder received warrants to acquire 1,875,000 shares of our common stock exercisable at $5.00 per share. The warrants are exercisable any time for a five-year period beginning on the date of grant. We also issued to the convertible note holder 1,000,000 shares of our common stock valued at $3,750,000 and incurred an additional $1,377,000 for commissions, finders fees and other transaction expenses, including the grant of a three-year warrant to purchase 112,500 shares of our common stock to a third party at an exercise price of $3.75 per share, valued at $252,000. A total of $1,377,000 was included in debt offering costs and is being amortized over the term of the note.
The $5.45 conversion price of the senior secured convertible note and the $5.00 exercise price of the warrants are subject to adjustment pursuant to standard anti-dilution rights. These rights include (i) equitable adjustments in the event we effect a stock split, dividend, combination, reclassification or similar transaction; (ii) “weighted average” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than the then current market price of our common stock; and (iii) “full ratchet” price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than $5.45 per share.
The senior secured convertible note contains a prepayment provision allowing us to prepay, in certain limited circumstances, all or a portion of the note. The portion of the note subject to prepayment must be purchased at a price equal to the greater of (i) 135% of the amount to be purchased and (ii) the company option redemption price, as defined in the note. Even if we elect to prepay the note, the note holder may still convert any portion of the note being prepaid pursuant to the conversion feature thereof.
We also entered into a registration rights agreement with the holder of the senior secured convertible note pursuant to which we agreed to provide certain registration rights with respect to the shares of common stock, the shares of common stock issuable upon conversion of the note, the shares of common stock issuable as interest shares under the note and shares of common stock issuable upon exercise of the warrant under the Securities Act of 1933, as amended. The holder is entitled to demand registration of the above-mentioned shares of common stock after six months from the closing of the securities purchase agreement in certain circumstances.
The securities purchase agreement under which the senior secured convertible note and related securities were issued contains, among other things, covenants that may restrict our ability to obtain additional capital, to declare
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or pay a dividend or to engage in other business activities. A breach of any of these covenants could result in a default under our senior secured convertible note, in which event the holder of the note could elect to declare all amounts outstanding to be immediately due and payable, which would require us to secure additional debt or equity financing to repay the indebtedness or to seek bankruptcy protection or liquidation. The securities purchase agreement provides that we cannot do any of the following without the prior written consent of the holder:
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directly or indirectly, redeem, or declare or pay any cash dividend or distribution on, our common stock;
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issue any additional notes or issue any other securities that would cause a breach or default under the senior secured convertible note;
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issue or sell any rights, warrants or options to subscribe for or purchase common stock or directly or indirectly convertible into or exchangeable or exercisable for common stock at a price which varies or may vary with the market price of the common stock, including by way of one or more reset(s) to any fixed price unless the conversion, exchange or exercise price of any such security cannot be less than the then applicable conversion price with respect to the common stock into which any note is convertible or the then applicable exercise price with respect to the common stock into which any warrant is exercisable;
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enter into or affect any dilutive issuance (as defined in the note) if the effect of such dilutive issuance is to cause us to be required to issue upon conversion of any note or exercise of any warrant any shares of common stock in excess of that number of shares of common stock which we may issue upon conversion of the note and exercise of the warrants without breaching our obligations under the rules or regulations of the principal market or any applicable eligible market;
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liquidate, wind up or dissolve (or suffer any liquidation or dissolution);
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convey, sell, lease, license, assign, transfer or otherwise dispose of all or any substantial portion of our properties or assets, other than transactions in the ordinary course of business consistent with past practices, and transactions by non-material subsidiaries, if any;
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cause, permit or suffer, directly or indirectly, any change in control transaction as defined in the senior secured convertible note.
On November 2, 2006, we closed on a convertible note securities agreement dated October 28, 2006 with an individual that provided we issue to the convertible note holder (i) an unsecured convertible note in the principal amount of $1,000,000 representing the funding received by us from an affiliate of the convertible note holder on September 29, 2006, and (ii) four classes of warrants (A warrants, B warrants, C warrants and D warrants) which gave the convertible note holder the right to purchase a total of 5,500,000 shares of our common stock as described below. The unsecured convertible note is due October 16, 2009 and bears an annual interest rate of 5%, payable semi-annually in cash or in shares of our common stock if certain conditions are satisfied. The unsecured convertible note is convertible into shares of our common stock at a conversion price of $1.50 per share, convertible any time during the term of the note, and is subject to standard anti-dilution rights.
The A warrants and B warrants expire December 3, 2008. The original expiration date was to be one year after the effective date of a registration statement filed under the Securities Act registering the subsequent sale of shares received from exercise of the A warrants and B warrants, but was extended in connection with the exchange agreement described below. The A warrants grant the convertible note holder the right to purchase up to 750,000 shares of common stock at an exercise price of $1.60 per share and the B warrants grant the convertible note holder the right to purchase up to 750,000 shares of common stock at an exercise price of $1.75 per share. The convertible note holder also received C warrants to purchase 2,000,000 shares of common stock and D warrants to purchase 2,000,000 shares of common stock, all of which have been cancelled as discussed below. The A warrants and B warrants are exercisable at any time until their expiration date and are subject to adjustment pursuant to standard anti-dilution rights. As of March 15, 2008, the convertible note holder had exercised 475,000 A warrants and no B warrants.
In October 2007, we entered into an exchange agreement with the convertible note holder. Pursuant to the exchange agreement, we cancelled the C warrant holder’s right to acquire up to 2,000,000 shares of our common stock at $2.10 per share and the D warrant holder’s right to acquire up to 2,000,000 shares of our common stock at $3.00 per share in exchange for the issuance of 650,000 shares of our common stock.
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In 2005, we secured a new customer contract, which resulted in revenues of approximately $1,400,000 for 2005 and $8,775,000 for 2006 and was our largest customer in 2007. We realized revenues of only $668,771 from this customer in 2007. We have, however, recently secured an additional customer that could partially replace the revenues lost from our largest customer in 2006, but we do not yet know the extent of the work or services that we will be providing for this customer. We anticipate that our negative cash flow will diminish as our new customers make projects and equipment available and as we are able to perform under their respective contracts.
Our monthly operating expenses currently exceed our monthly net sales by approximately $500,000 per month. This amount could increase significantly. We expect our operating expenses will continue to outpace our net sales until we are able to generate additional revenue. Our business model contemplates that sources of additional revenue include (i) sales from our private communication network services, (ii) sales resulting from new customer contracts, and (iii) sales, licensing fees and/or royalties related to commercial applications of our CodecSys technology, including from our IBM license agreement.
Our long-term liquidity is dependent upon execution of our business model and the realization of additional revenue and working capital as described above, and upon capital needed for continued commercialization and development of the CodecSys technology. Commercialization and future applications of the CodecSys technology are expected to require additional capital estimated to be approximately $2.0 million annually for the foreseeable future. This estimate will increase or decrease depending on specific opportunities and available funding.
To date, we have met our working capital needs primarily through funds received from sales of our common stock and from convertible debt financings. Until our operations become profitable, we must continue to rely on external funding.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. We do not issue financial instruments for trading purposes or have any derivative financial instruments. As discussed above, however, the embedded conversion feature and prepayment option of our senior secured convertible notes and our related warrants are deemed to be derivatives and are subject to quarterly “mark-to-market” valuations.
We have investments in auction rate preferred securities, which are classified as available-for-sale securities and reflected at fair value. Due primarily to instability in credit markets, we have classified $6,964,813 of these investments as non current assets in the unaudited Condensed Consolidated Balance Sheet as of March 31, 2008. The remaining investment in auction rate preferred securities totaling $4,075,000 are classified as current assets since the issuers of these securities have announced definitive plans for redemption, which will happen in the near future. For a complete discussion on auction rate preferred securities, including our methodology for estimating their fair value, see Note 7 to the unaudited condensed consolidated financial statements.
Our cash and cash equivalents are also exposed to market risk. However, because of the short-term maturities of our cash and cash equivalents, we do not believe that an increase in market rates would have any significant impact on the realized value of our cash and cash equivalent investments. We currently do not hedge interest rate exposure and are not exposed to the impact of foreign currency fluctuations.
Item 4T. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
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As required by Rule 13a-15(b) of the Exchange Act, we conducted an evaluation, under the supervision of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2008. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 31, 2008 in alerting them in a timely manner to material information required to be included in our reports filed under the Exchange Act.
Our evaluation identified a deficiency that existed in the design or operation of our disclosure controls and procedures related to the identification and reporting of certain transactions required to be included in current reports on Form 8-K filed with the SEC. Our management has disclosed the deficiency to our audit committee and board of directors. Additional effort is needed to fully remedy the deficiency and we are continuing efforts to improve and strengthen our system of disclosure controls and procedures.
Important Considerations
The effectiveness of our disclosure controls and procedures and our internal control over financial reporting is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of our systems, the possibility of human error, and the risk of fraud. Moreover, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and the risk that the degree of compliance with policies or procedures may deteriorate over time. Because of these limitations, there can be no assurance that any system of disclosure controls and procedures or internal control over financial reporting will be successful in preventing all errors or fraud or in making all material information known in a timely manner to the appropriate levels of management.
Changes in Internal Control over Financial Reporting
During the most recent fiscal quarter covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Part II – Other Information
Item 1.
Legal Proceedings
None.
Item 1A. Risk Factors
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There have been no material changes in risk factors from those described in our Annual Report of Form 10-K for the year ended December 31, 2007.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
In January, 2008, we issued 41,000 shares of our common stock in consideration of services performed in 2007 by two consultants for the Company, both of whom are accredited investors. No underwriting discounts or commissions were paid. In the transactions, we relied on the exemptions from registration under the Securities Act set forth in Section 4(2) and Section 4(6) thereof.
In March, 2008, we issued 160,000 shares of our common stock in consideration of services performed by a consultant for the Company who is an accredited investor. No underwriting discounts or commissions were paid. In the transaction, we relied on the exemptions from registration under the Securities Act set forth in Section 4(2) and Section 4(6) thereof.
In April, 2008, we issued 21,000 shares of our common stock to a consultant for services performed for the Company who is an accredited investor. No underwriting discounts or commissions were paid. In the transaction, we relied on the exemption from registration under the Securities Act set forth in Section 4(2) and Section 4(6) thereof.
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At various times during the three months ending March 31, 2008, we granted options to eight employees pursuant to our Long Term Incentive Plan to acquire up to 286,500 shares of our common stock at various prices, but not less than the fair market value on the date of grant. In the transaction, we relied on the exemption from registration under the Securities Act set forth in Section 4(2) and Section 4(6) thereof.
In February, 2008, we issued 6,667 shares of our common stock to a shareholder of IDI in exchange for 100,000 shares of common stock of IDI. The shareholder is an accredited investor and in the transaction, we relied on the exemption from registration under the Securities Act set forth in Section 4(2).
In February, 2008, we issued 2,258 shares of our common stock to one employee who exercised his option granted pursuant to our Long Term Incentive Plan in consideration of the payment of $750, the option exercise price. The employee was fully informed regarding his exercise transaction. We relied on the exemption from registration under the Securities Act set forth in Section 4(2).
Item 3. Defaults Upon Senior Securities
None.
Item 4.
Submission of Matters to Vote of Security Holders.
None.
Item 5.
Other Information
(a) None.
(b) None.
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Item 6.
Exhibits
Exhibit | Description of Document |
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3.1 | Amended and Restated Articles of Incorporation of Broadcast International. (Incorporated by reference to Exhibit No. 3.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2006 filed with the SEC on November 14, 2006.) |
3.2 | Amended and Restated Bylaws of Broadcast International. (Incorporated by reference to Exhibit No. 3.2 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2006 filed with the SEC on November 14, 2006.) |
4.1 | Specimen Stock Certificate of Common Stock of Broadcast International. (Incorporated by reference to Exhibit No. 4.1 of the Company's Registration Statement on Form SB-2, filed under cover of Form S-3, pre-effective Amendment No. 3 filed with the SEC on October 11, 2005.) |
4.2 | Form of A Warrant issued by Broadcast International to each of Gryphon Master Fund, L.P., GSSF Master Fund, LP, Bushido Capital Master Fund, LP and Gamma Opportunity Capital Partners, LP (the “Institutional Funds”). (Incorporated by reference to Exhibit No. 4.3 of the Company's Registration Statement on Form SB-2, filed under cover of Form S-3, pre-effective Amendment No. 3 filed with the SEC on October 11, 2005.) |
4.3 | Form of B Warrant issued by Broadcast International to each of the Institutional Funds. (Incorporated by reference to Exhibit No. 4.4 of the Company’s Registration Statement on Form SB-2, filed under cover of Form S-3, pre-effective Amendment No. 3 filed with the SEC on October 11, 2005.) |
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10.1* | Employment Agreement of Rodney M. Tiede dated April 28, 2004. (Incorporated by reference to Exhibit No. 10.1 of the Company's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2004 filed with the SEC on May 12, 2004.) |
10.2* | Employment Agreement of Reed L. Benson dated April 28, 2004. (Incorporated by reference to Exhibit No. 10.3 of the Company's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2004 filed with the SEC on May 12, 2004.) |
10.3* | Broadcast International Long-Term Incentive Plan. (Incorporated by reference to Exhibit No. 10.4 of the Company's Annual Report on Form 10-KSB for the year ended December 31, 2003 filed with the SEC on March 30, 2004.) |
10.4* | Registration Rights Agreement dated May 16, 2005 among Broadcast International and the Institutional Funds. (Incorporated by reference to Exhibit No. 10.7 of the Company's Registration Statement on Form SB-2, filed under cover of Form S-3, pre-effective Amendment No. 3 filed with the SEC on October 11, 2005.) |
10.5 | Stock Purchase and Option Grant Agreement dated February 6, 2004 among Broadcast International and certain principals and shareholders of Streamware Solutions AB. (Incorporated by reference to Exhibit No. 10.9 of the Company's Registration Statement on Form SB-2, filed under cover of Form S-3, pre-effective Amendment No. 3 filed with the SEC on October 11, 2005.) |
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10.6 | Technology License Agreement – e-publishing technology – dated August 15, 2006 between Broadcast International and Yang Lan Studio Ltd. (Incorporated by reference to Exhibit 10.9 of the Company’s Current Report on Form 8-K filed with the SEC on August 22, 2006.) |
10.7 | Termination and Release Agreement dated January 17, 2007 among Broadcast International, Yang Lan Studio Ltd., Broadvision Global, Ltd. and Sun Media Investment Holdings, Ltd. (Incorporated by reference to Exhibit No. 10.1 of the Company’s Current Report on Form 8-K filed with the SEC on January 25, 2007.) |
10.8 | Securities Purchase Agreement dated October 28, 2006 between Broadcast International and Leon Frenkel. (Incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed with the SEC on November 6, 2006.) |
10.9 | 5% Convertible Note dated October 16, 2006 issued by Broadcast International to Leon Frenkel. (Incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed with the SEC on November 6, 2006.) |
10.10 | Registration Rights Agreement dated October 28, 2006 between Broadcast International and Leon Frenkel. (Incorporated by reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed with the SEC on November 6, 2006.) |
10.11 | Form of A Warrant dated October 28, 2006 issued by Broadcast International to Leon Frenkel. (Incorporated by reference to Exhibit 10.4 of the Company’s Current Report on Form 8-K filed with the SEC on November 6, 2006.) |
10.12 | Form of B Warrant dated October 28, 2006 issued by Broadcast International to Leon Frenkel. (Incorporated by reference to Exhibit 10.5 of the Company’s Current Report on Form 8-K filed with the SEC on November 6, 2006.) |
10.13 | Exchange Agreement dated October 31, 2007 between Broadcast International and Leon Frenkel. (Incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed with the SEC on November 7, 2007.) |
10.14 | Securities Purchase Agreement dated as of December 21, 2007, by and among Broadcast International and the investors listed on the Schedule of Buyers attached thereto. (Incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed with the SEC on December 26, 2007.) |
10.15 | Registration Rights Agreement dated as of December 21, 2007, by and among Broadcast International and the buyers listed therein. (Incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed with the SEC on December 26, 2007.) |
10.16 | 6.25% Senior Secured Convertible Promissory Note dated December 21, 2007 issued to the holder listed therein. (Incorporated by reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed with the SEC on December 26, 2007.) |
10.17 | Warrant to Purchase Common Stock dated December 21, 2007 issued to the holder listed therein. (Incorporated by reference to Exhibit 10.4 of the Company’s Current Report on Form 8-K filed with the SEC on December 26, 2007.) |
10.18 | Security Agreement dated as of December 21, 2007, made by each of the parties set forth on the signatures pages thereto, in favor of the collateral agent listed therein. (Incorporated by reference to Exhibit 10.5 of the Company’s Current Report on Form 8-K filed with the SEC on December 26, 2007.) |
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14.1 | Code of Ethics. (Incorporated by reference to Exhibit No. 14 of the Company’s Annual Report on Form 10-KSB filed with the SEC on March 30, 2004.) |
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21.1 | Subsidiaries. (Incorporated by reference to Exhibit No. 21.1 of the Company’s Annual Report on Form 10-KSB filed with the SEC on April 1, 2005.) |
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| * Management contract or compensatory plan or arrangement |
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SIGNATURES
Pursuant to the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Broadcast International, Inc.
Date: May 15, 2008
/s/ Rodney M. Tiede
By: Rodney M. Tiede
Its: President and Chief Executive Officer (Principal Executive Officer)
Date: May 15, 2008
/s/ Reed L. Benson
By: Reed Benson
Its: Chief Financial Officer (Principal Financial and Accounting Officer)
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