STARTRAK SYSTEMS, LLC AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
AND
INDEPENDENT AUDITORS' REPORT
DECEMBER 31, 2005 AND 2004
CONTENTS
Independent Auditors' Report 1
Consolidated Financial Statements
Consolidated balance sheets 2
Consolidated statements of operations and members' deficit 3
Consolidated statements of cash flows 4-5
Notes to consolidated financial statements 6-15
Supplementary Information
Consolidated schedules of selling, general and
administrative expenses 16
Consolidated supplementary financial data 17
INDEPENDENT AUDITORS' REPORT
To the Members of
StarTrak Systems, LLC
We have audited the accompanying consolidated balance sheets of StarTrak
Systems, LLC and Subsidiaries (the "Company") as of December 31, 2005 and 2004,
and the related consolidated statements of operations, members' deficit and cash
flows for the years then ended. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company's internal control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of StarTrak Systems,
LLC and Subsidiaries as of December 31, 2005 and 2004, and the results of their
operations and their cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of America.
Our audits were conducted for the purpose of expressing an opinion on the basic
financial statements taken as a whole. The supplementary information listed in
the accompanying table of contents is presented for purposes of additional
analysis and is not a required part of the basic financial statements. Such
information has been subjected to the auditing procedures applied in the audits
of the basic financial statements and in our opinion, is fairly stated in all
material respects in relation to the basic financial statements taken as a
whole.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 2, the
Company has a significant accumulated deficit and working capital deficit, and
has incurred a significant net loss from operations. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans in regard to these matters are also described in Note 2. The
accompanying consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
/s/ Rothstein, Kass & Company, P.C.
Roseland, New Jersey
March 16, 2006
1
CONSOLIDATED BALANCE SHEETS
December 31, 2005 2004
- --------------------------------------------------------------------------------
ASSETS
Current assets
Cash and cash equivalents $ 79,562 $ 203,557
Accounts receivable, less allowance for doubtful
accounts of approximately $30,000 and $184,000
in 2005 and 2004, respectively 935,640 659,949
Inventories 731,583 725,888
Prepaid expenses and other current assets 50,326 87,817
--------------------------
Total current assets 1,797,111 1,677,211
Computer equipment, net of accumulated depreciation
of approximately $43,000 and $14,000 in 2005 and
2004, respectively 44,505 27,147
Security deposits 6,408 6,408
--------------------------
$ 1,848,024 $ 1,710,766
==========================
LIABILITIES AND MEMBERS' DEFICIT
Current liabilities
Notes payable, current portion $ 534,588 $ 801,088
Customer advances 1,255,270
Accounts payable 1,620,184 1,299,112
Accrued expenses 450,000 118,000
Accrued warranty 515,001 191,872
Other current liabilities 19,372 188,077
--------------------------
Total current liabilities 4,394,415 2,598,149
--------------------------
Long-term liabilities
Notes payable, net of current portion 5,000,000 4,250,000
Accrued interest payable 437,815 114,568
Due to members 569,666 113,000
--------------------------
6,007,481 4,477,568
--------------------------
Members' deficit (8,553,872) (5,364,951)
--------------------------
Total liabilities and members' deficit $ 1,848,024 $ 1,710,766
==========================
See accompanying notes to consolidated financial statement
2
CONSOLIDATED STATEMENTS OF OPERATIONS AND MEMBERS' DEFICIT
Years Ended December 31, 2005 2004
- --------------------------------------------------------------------------------
Net sales $ 6,327,980 $ 4,819,420
Cost of sales 4,037,413 3,811,696
--------------------------
Gross profit 2,290,567 1,007,724
--------------------------
Expenses
Selling, general and administrative expenses 5,315,858 3,800,159
Depreciation expense 29,039 13,573
--------------------------
5,344,897 3,813,732
--------------------------
Loss from operations (3,054,330) (2,806,008)
--------------------------
Other income (expense)
Interest expense (344,576) (148,018)
Forgiveness of debt income 200,000
Interest income 9,985
--------------------------
(134,591) (148,018)
--------------------------
Net loss (3,188,921) (2,954,026)
Members' deficit, beginning of year (5,364,951) (2,322,503)
Excess of purchase price over departing member's
equity (88,422)
--------------------------
Members' deficit, end of year $(8,553,872) $(5,364,951)
==========================
See accompanying notes to consolidated financial statement
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2005 2004
- --------------------------------------------------------------------------------
Cash flows from operating activities
Net loss $(3,188,921) $(2,954,026)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation 29,039 13,573
Provision for doubtful accounts 58,998 120,313
Provision for accrued warranty 714,139 395,000
Forgiveness of debt income (255,000)
Changes in operating assets and liabilities
Accounts receivable (334,689) (489,482)
Inventories (5,695) (526,211)
Prepaid expenses and other current assets 37,491 (94,225)
Accrued interest payable 328,218 130,196
Customer advances 1,255,270
Members' salary accrual 126,666 130,000
Accounts payable 506,072 629,523
Accrued expenses 332,000 (480,370)
Accrued warranty (391,010) (248,190)
Other current liabilities (168,705) 188,077
--------------------------
Net cash used in operating activities (956,127) (3,185,822)
--------------------------
Net cash flows used in investing activities
Purchases of computer equipment (46,397) (40,720)
--------------------------
Cash flows from financing activities
Proceeds from issuance of promissory notes
(see Note 9) 750,000 3,900,000
Principal payments on notes payable (271,471) (434,962)
Advances from (repayments to) members 400,000 (185,000)
--------------------------
Net cash provided by financing activities 878,529 3,280,038
--------------------------
Net increase (decrease) in cash and cash
equivalents (123,995) 53,496
Cash and cash equivalents, beginning of year 203,557 150,061
--------------------------
Cash and cash equivalents, end of year $ 79,562 $ 203,557
==========================
See accompanying notes to consolidated financial statement
4
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
Years Ended December 31, 2005 2004
- --------------------------------------------------------------------------------
Supplementary disclosure of cash flow information,
cash paid during the year for interest $ 16,358 $ 33,462
==========================
Supplementary disclosure of non-cash investing and
financing activities
Promissory note issued as consideration for equity
repurchase agreement (see Note 9) $ - $ 388,422
==========================
Debt to members paid by third party in accordance
with the September 30, 2004 post closing
agreement (see Note 9) $ 130,000 $ -
=========================
See accompanying notes to consolidated financial statement
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of operations
StarTrak Systems, LLC (the "Company"), a Delaware Limited Liability Company, was
formed on March 26, 2001. The Company also conducts business under the name
"StarTrak LLC".
The Company provides wireless subscription information services ("Subscription
Services") and tracking and monitoring devices ("Monitoring Devices") to freight
operators of refrigerated tractor trailers and rail cars and original equipment
manufacturers ("OEM's") of refrigerated transport systems. The Monitoring
Devices collect and transmit to the Company critical information, via satellite,
cellular or radio frequency, regarding a tractor trailer's or rail car's
location, operational status, and the status of other sensors such as fuel, door
openings, and weight loads. The Company's Subscription Services process this
information, combine it with the known freight shipment and logistical data, and
delivers it to the client via several information technology applications
allowing the client to monitor and track shipments, control temperature
sensitive freight environments, remotely send commands to refrigeration systems,
and troubleshoot problems.
The Company's Subscription Services are marketed as ReeferTrak(R) Commander,
ReeferTrak(R) Sentry, ReeferTrak(R) Scout and GenTrak(TM) while the Monitoring
Devices, which enable the Subscription Services are known as ReeferTrak(R) RT
3000, ReeferTrak(R) RT 2000, ReeferTrak(R) RT 4000, GenTrak(TM) RT 4000 and
GenTrak(TM) RT 2000.
2. Going concern
At December 31, 2005, the Company had a members' deficit of approximately $8.6
million and a working capital deficit of approximately $2.6 million For the
years ended December 31, 2005 and 2004, the Company incurred net losses of
approximately $3.2 million and $3.0 million, respectively, and net cash used in
operations of $1.0 million and $3.2 million respectively. These conditions raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans primarily consist of (i) obtaining additional financing
and/or capital and (ii) attaining profitable operations. The consolidated
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
3. Summary of significant accounting policies
Principles of Consolidation
In December 2003, the Financial Accounting Standards Board ("FASB") issued
revised FASB Interpretation 46, "Consolidation of Variable Interest Entities"
("FIN 46"). FIN 46 requires certain variable interest entities ("VIE") to be
consolidated by the primary beneficiary of the entity if the equity investors in
the entity do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
The Company is the primary beneficiary of StarTrak Wireless Technologies Private
Limited ("StarTrak India") under FIN 46. StarTrak India is a private company
registered on September 21, 2005 in the State of Tamil Nadu, India. StarTrak
India was formed primarily to allow the Company to outsource certain programming
functions. The Company consolidated the results of StarTrak India's operations,
consisting of approximately $45,000 in operational expenses and no revenues.
StarTrak India's assets and liabilities were not significant to the consolidated
financial statements.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Summary of significant accounting policies (continued)
Principles of Consolidation (continued)
The consolidated financial statements include the accounts of the Company, a
wholly-owned inactive subsidiary and StarTrak India. All intercompany
transactions and balances have been eliminated in consolidation.
Cash Equivalents
The Company considers highly-liquid financial instruments purchased with a
maturity of three months or less as cash equivalents.
Accounts Receivable
The Company carries its accounts receivable at cost less an allowance for
doubtful accounts. On a periodic basis, the Company evaluates its accounts
receivable and establishes an allowance for doubtful accounts, based on a
history of past write-offs and collections and current credit conditions.
Accounts are written off as uncollectible at the discretion of management.
Fair Value of Financial Instruments
The fair values of the Company's assets and liabilities, which qualify as
financial instruments under Statement of Financial Accounting Standards ("SFAS")
No. 107, "Disclosures About Fair Value of Financial Instruments", approximate
the carrying amounts presented in the accompanying consolidated balance sheets.
Inventories
Inventories are stated at the lower of cost, determined by the First-In,
First-Out ("FIFO") method, or market. Finished Goods consist of Monitoring
Devices that are completed and parts available for shipment to customers. Parts
consist of items that are necessary to construct Monitoring Devices and parts
available for warranty purposes. The Company accounts for all unbilled work-in
process as parts inventory.
Computer Equipment
Computer equipment is stated at cost less accumulated depreciation. The Company
provides for depreciation using the straight-line method over the estimated
useful lives of the assets of three years.
Revenue Recognition
In November 2002, the Emerging Issues Task Force ("EITF") issued EITF 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables". This issue
addresses the determination of whether an arrangement involving more than one
deliverable contains more than one unit of accounting and how arrangement
consideration should be measured and allocated to the separate units of
accounting. EITF 00-21 does not require the deferral of revenue when all
material deliverables are considered separate units of accounting.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Summary of significant accounting policies (continued)
Revenue Recognition (continued)
All of the material deliverables in the Company's sales arrangements meet the
criteria for separate units of accounting as set forth in EITF 00-21.
Accordingly, revenues for Monitoring Devices are recognized upon delivery to
customers. Subscription Service revenues are recognized for "activated"
Monitoring Devices, as delivered, on a monthly basis. Advances from customers
are recognized as liabilities until the required products are delivered and
services are performed as specified in individual customer contracts. Cost of
sales includes all direct materials and other indirect costs related to the
production of Monitoring devices and the delivery of the Subscription Service.
Selling, general and administrative costs are charged to expense as incurred.
Product and Subscription Service Warranties
The Company sells Monitoring Devices and Subscription Services to customers with
certain warranties including performance, repair, replacement and limited labor
costs. Warranty accruals are based upon the Company's historical experience.
Use of Estimates
The preparation of the 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 disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates.
4. Risks and uncertainties
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of
credit risk consist of cash and cash equivalent accounts in financial
institutions, which exceed Federal depository insurance coverage $100,000
limits. The Company has not experienced losses on these accounts and management
believes the Company is not exposed to significant risks on such accounts.
Major Customers
For the year ended December 31, 2005, net sales to four customers equaled
approximately $4,420,000 or 70% of total revenues. Accounts receivable from
these customers was approximately $686,000 at December 31, 2005.
For the year ended December 31, 2004, net sales to two customers equaled
approximately $2,208,000 or 46% of total revenues. Accounts receivable from
these customers was approximately $383,000 at December 31, 2004.
Major Vendors
The Company relies upon three major suppliers to manufacture and provide
critical parts for its Monitoring Devices. In addition, the Company relies on
one major vendor to deliver its Subscription Services. The Company does not have
long-term contracts with any of these vendors.
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. Inventories
Inventories consist of the following at December 31:
2005 2004
Finished goods $ 249,851 $ 95,250
Parts 481,732 630,638
------------------------
$ 731,583 $ 725,888
=========================
6. Accrued warranty
The Company sells a majority of its products to customers together with repair
and replacement warranties ranging from one year to five years. The accompanying
consolidated financial statements include an accrual for estimated warranty
claims, based on the Company's experience of the amount of such claims actually
paid. The following is a reconciliation of the aggregate warranty liability as
of December 31, 2005 and 2004:
2005 2004
Beginning balance $ 191,872 $ 45,062
Claims paid during the year (391,010) (248,190)
Additional warranty reserve 714,139 395,000
-------------------------
Ending balance $ 515,001 $ 191,872
=========================
7. Customer advances
On August 24, 2005, a customer entered into a GPS Software License and Hardware
Purchase Agreement ("Purchase Agreement") under which the customer placed an
order of 4,700 of the Company's GenTrak(TM) II units and also agreed to
subscribe to web-based monitoring services for these units. Pursuant to the
Purchase Agreement, the customer paid the Company an advance of approximately
$1,162,000 related to a certain percentage of the sales price of the initial
hardware order of 4,700 GenTrak(TM) II units plus advances on certain
non-recurring engineering costs. The Company began shipping GenTrak(TM) II units
under this Purchase Agreement in February 2006.
8. Other current liabilities
As of December 31, 2004, other current liabilities primarily consisted of
approximately $169,000 in overdue payables owed to a former vendor. In
accordance with a settlement agreement signed in September 2005, the balance was
reduced to $155,000 and the Company agreed to make a payment of $100,000, with
the remainder to be paid on or before January 31, 2006. However, the vendor was
unable to make delivery of certain parts in January 2006 and agreed to release
the Company from payment of the $55,000, which was written off as of December
31, 2005.
9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Long-term debt
Long-term debt consists of the following at December 31:
2005 2004
Notes payable-Tenix Holdings $ 5,000,000 $ 4,250,000
Accrued interest payable 437,815 114,568
Due to TransCore 361,167 536,167
Note payable-former member 173,421 264,921
-------------------------
5,972,403 5,165,656
Less:current maturities (534,588) (801,088)
--------------------------
$ 5,437,815 $ 4,364,568
==========================
Aggregate future required principal and interest payments are as follows:
Amount
2006 $ 534,588
2007 5,437,815
-----------
$ 5,972,403
===========
Notes Payable-Tenix Holdings
Senior Promissory Notes
On September 30, 2004, the Company and its founders, Timothy Slifkin and Thomas
Robinson (collectively, the "Founders") entered into a Securities Purchase
Agreement (the "SPA") for senior promissory notes ("Senior Promissory Notes")
and Class A Member Units with Tenix Holdings, Inc ("THI").
Under the terms of the SPA, THI exchanged a senior promissory note for a series
of prior secured promissory notes issued between December 22, 2003 and September
30, 2004 in the amount of $3,182,288, including unpaid accrued interest of
$72,288 (the "Initial Note"). The second promissory note (the "Second Note") was
exchanged for the remaining secured promissory notes issued or to be issued. As
of March 5, 2005, the Second Note was exchanged for prior promissory notes
issued from October 14, 2004 to March 5, 2005, in the cumulative amount of
$1,890,000 plus unpaid accrued interest. THI's total promissory note exchange
commitment was $5 million which they fulfilled by March 2005.
In addition, as consideration for the obligation to exchange its senior secured
notes for the Senior Promissory Notes, THI was granted 510,000 Class A
Membership Units (the "THI Units") or 51% of the total outstanding membership
units of the Company. The amount of THI Units outstanding is subject to
reduction per terms of the Deed of Release, described below. The fair value of
the THI Units was estimated to be zero based on the book value of the Company at
September 30, 2004.
10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Long-term debt (continued)
As of December 31, 2005 and 2004, the balance of the Senior Promissory Notes is
as follows:
Initial Second Accrued Total
Note Note Interest
Balance at January 1, 2004 $ 350,000 $ - $ - $ 350,000
Secured promissory notes issued
between February 13, 2004 and
September 30, 2004 2,760,000 $2,760,000
Secured promissory notes issued
between October 14, 2004 and
December 13, 2004 1,140,000 1,140,000
Accrued interest 114,568 114,568
-----------------------------------------------
Balances at December 31, 2004 3,110,000 1,140,000 114,568 4,364,568
Secured promissory notes issued
between January 21, 2005 and
March 5, 2005 750,000 750,000
Accrued interest 323,247 323,247
-----------------------------------------------
Balances at December 31, 2005 $3,110,000 $1,890,000 $ 437,815 $5,437,815
===============================================
The Senior Promissory Notes carry interest rates of 6.75% per annum and are
collateralized by all assets of the Company. On an event of default, including
among other things, failure to pay any principal or accrued interest as due, an
additional 7.5% interest rate per annum will be charged from the date of the
default until the default is cured.
The Senior Promissory Notes plus accrued interest are automatically payable in
full on the earlier of (i) December 31, 2007, (ii) upon a liquidation event,
(iii) upon a firm commitment of an initial public offering in excess of $20
million, or (iv) at the discretion of THI upon the termination of the Founders
full time employment by the Company prior to December 31, 2007.
However, at its own option, THI can defer the automatic payment events defined
above and can instead seek partial or total repayment through market value
calculations, as defined in the SPA, to be conducted as of December 31, 2006 and
December 31, 2008. If partial repayment is made under the market value
calculations then all remaining balances are to become due and payable six
months after year end. The Company can prepay the Senior Promissory Notes at any
time without prepayment penalty.
The Company, under terms of the SPA, was to comply with certain positive and
negative covenants including, among other things, certain restrictions on the
amount of purchase and sale of assets that it may make in one year.
Also on September 30, 2004, the Company and THI entered into a Post Closing
Agreement in which THI acknowledged and agreed to pay certain debt owed by the
Company to a Founder along with certain expenses incurred by the Founder for a
total of $130,000. In addition, THI permitted the Company to adopt an Employee
Phantom Equity Plan, however such a plan was never adopted.
11
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Long-term debt (continued)
Deed of Release
On March 30, 2005, THI and the Company entered into a Deed of Release (the
"Deed") in which both THI and the Company agreed to release each other from the
terms and obligations of the SPA and also agreed to modify the terms of the
Senior Promissory Notes in the event of an outside investor taking a significant
equity position in the Company.
Per the terms of the Deed, THI agreed that in the event of an outside investor
taking a significant equity position in the Company, the Senior Promissory Notes
will be reduced to a single amount of $2 million with $1.5 million due and
payable on December 31, 2007 and the remainder due on December 31, 2008, and
THI's percentage ownership of the Company will be reduced from 51% to 15%. Upon
such an occurrence, THI will retain one non-voting board of directors seat. THI
will also receive a put option to sell 75% of its ownership of the Company at
90% of market value as determined by an independent valuation and 25% of its
membership units under the same terms but with an execution date of December 31,
2008. In addition, the Company will have a call option to purchase all THI
membership units at a price of $3.5 million.
In addition, under the Deed, THI and the Founders agreed to advance $200,000
each to the Company for working capital purposes for a total of $400,000. THI
also agreed to use its best efforts to cooperate on a proposed financing
transaction.
Due to TransCore
TransCore Link Logistics Corporation ("TransCore") is a vendor to the Company.
In June 2004, the Company and Transcore entered into a Settlement Agreement
("Settlement Agreement") for past due accounts payable. The Settlement Agreement
provided for the Company to adhere to a certain payment schedule and to purchase
$1,805,000 of product from Transcore at a certain fixed price within 12 months
from the date of the settlement agreement. The Settlement Agreement also
provided for the forgiveness of $182,000 of indebtedness if payments are made
pursuant to the Settlement Agreement.
The Company made certain payments under the Settlement Agreement and ceased
making payments in July 2005. In April 2005, TransCore demanded immediate
payment of all amounts due under the Settlement Agreement, including the
$182,000.
On February 3, 2006, the Company entered into a credit agreement ("Credit
Agreement") and a security agreement ("Security Agreement") with TransCore. The
Credit Agreement provides for scheduled monthly repayment of all amounts due to
TransCore through September 30, 2006 plus interest on the outstanding balance at
a rate of 1% per month, compounded monthly. The Credit Agreement also provides
an open credit amount for future purchases of approximately $142,000. In order
to evidence its indebtedness, TransCore required the Company to sign a
promissory note agreement in the principal amount of $1 million.
Any prepayments of the amounts due to TransCore are applied first against any
accrued but unpaid interest and then against the remaining scheduled payments
due in inverse order of maturity. If the Company obtains additional capital from
an investor, the Company will be required to prepay the amounts due by $300,000.
12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Long-term debt (continued)
Upon full payment of the amount due, the contingent liability of $182,000 due to
TransCore will be forgiven.
The Security Agreement grants to TransCore a security interest in all the assets
of the Company and the Credit Agreement requires the Company to use its best
efforts to obtain from THI a subordination of its lien on the Company's assets
in favor of TransCore. To date, THI has not signed the subordination agreement.
At December 31, 2005 and 2004, the balances due to TransCore under the Credit
Agreement and Settlement Agreement are as follows:
Balances included in Accounts
Payable
Current maturities - unpaid $ 605,630 $ -
amount from Settlement
Agreement 179,167 354,167
Current maturities -
contingently payable 182,000 182,000
------------------------
$ 966,797 $ 536,167
========================
Note Payable-Former Member
In May 2004, the Company, pursuant to a promissory note and an equity repurchase
agreement, agreed to pay $388,422 to a departing member in exchange for his
5.66% interest in the Company. The $388,422 represented payment of the departing
member's original principal and $88,422 of other consideration, which was
guaranteed personally by the Company Founders and by THI. The promissory note
was payable in monthly installments of principal and interest of $17,391 through
May 2006. However, the Company ceased making payments in July 2005. Accordingly,
the unpaid balance due of $173,421 and $264,921 as of December 31, 2005 and
2004, respectively, has been classified as a current liability.
10. Master factoring agreement
In June 2005, the Company entered into a master factoring agreement ("Factoring
Agreement") with an accounts receivable financing company (the "Factor"). The
Factoring Agreement provides for the factoring of up to $2 million of accounts
receivable. The receivables are factored with full recourse and are advanced up
to 85% of the face value of factored receivables. The Factor charges a servicing
fee of 0.75% of the face amount of the receivable for each 30 days, or portion
thereof, from the date of the advance to the time the receivable is settled. The
Factor also charges a daily discount fee of .022% of the face amount of each
receivable factored. The daily discount fee is defined as a certain published
prime rate plus 2% per annum divided by 360.
The Factoring Agreement is secured by substantially all the assets of the
Company. THI has signed an inter-creditor agreement with the Factor in which it
took a subordinate position to the Factor in relation to its security interest
in the assets of the Company.
No accounts receivable were financed through the Factoring Agreement during
2005. The Company began factoring certain accounts receivable in February 2006.
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. Members' equity and LLC operating agreements
From January 1, 2004 to September 30, 2004, the Company was operating under the
amended and restated operating agreement, effective November 24, 2003 (the "2003
Operating Agreement"). Since September 30, 2004 the Company operates under the
second amended and restated Limited Liability Company Agreement (the "2004
Operating Agreement").
Pursuant to the 2003 Operating Agreement, the Company has authorized and issued
1,060 Class A member units. In addition, the Company authorized an additional
200 Class B non-voting membership units to be issued under an employee option
plan. The exercise price of the options was to be fair market value at date of
option grant. The options were to vest in 25% increments on the first and each
subsequent anniversary of the date of grant of the options. No employee option
plan was established and no Class B membership units or options were issued.
The 2003 Operating Agreement generally provided for allocation of profits and
losses to members in proportion to their respective capital accounts.
Simultaneous with the signing of the SPA with THI, the Company members adopted
the 2004 Operating Agreement which authorized the issuance of 510,000 Class A
membership units to THI, 490,000 Class B membership units to the Founders, and
200,000 Class C membership units. The Class A members are entitled to three
board seats and the Class B members are entitled to two board seats. Only Class
C membership units are non-voting. A supermajority of the board of directors is
required to authorize, among other things, a capital transaction. A
supermajority is defined as a majority of Class A board members and all of the
Class B board members. Class C membership units are reserved for an employee
incentive bonus plan. No such plan was established and no Class C membership
units were issued.
In accordance with the 2004 Operating Agreement, profits and losses are
generally allocated in proportion to the members' respective capital accounts.
The 2004 Operating Agreement also has mandatory transfer provisions,
discretionary transfer provisions and final transfer provisions. These
provisions provide for the potential sale of all Class B membership units to
Class A members dependent upon, among other things, the market value of the
Company as of December 31, 2006, December 31, 2008, and September 30, 2012.
12. Commitments and contingencies
Founders Employment Agreements
On September 30, 2004, each Founder signed an employment agreement ("Employment
Agreement") with the Company simultaneous with the signing of the SPA with THI.
Each Employment Agreement provides for a minimum base salary of $160,000 per
year and bonuses up to 20% of the base salary. The bonuses are to be paid based
upon meeting certain financial and non financial targets. To date, no bonuses
have been paid.
The Employment Agreements end on the later of June 30, 2009 or at such time the
Founders individual equity interests have been purchased by THI pursuant to the
2004 Operating Agreement (see Note 11). The Employment Agreements can be
extended for one additional year.
14
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. Commitments and contingencies (continued)
If the Employment Agreements are terminated by the Company prior to June 30,
2007, the Founders are entitled to 48 months of base pay, less pay for the
amount of months that expired under the term of the Employment Agreement. After
June 30, 2007, termination without cause or for good reason results in a
severance payment of twelve months of base pay. However, any termination within
six months prior to or twelve months after a change in control, as defined, will
result in an additional twelve months of severance.
During the years ended December 31, 2005 and 2004, the Founders have not been
paid their full base salaries under the Employment Agreement. The accrual for
the unpaid salary is included in Due to Members.
Lease Commitments
The Company leases office space through September 30, 2007. Future minimum
rental payments under the lease are approximately as follows:
Year Ending December 31,
2006 $ 57,000
2007 43,000
------------
$ 100,000
============
Rent expense, including common occupancy charges, was approximately $77,000 and
71,000 for the years ended December 31, 2005 and 2004, respectively.
Legal Proceedings
The Company is subject to various legal proceedings and claims that arise in the
ordinary course of business. In the opinion of management, the amount of any
ultimate liability with respect to these actions will not materially affect the
Company's consolidated financial statements.
13. Employee benefit plan
The Company maintains a prototype qualified profit-sharing plan under Internal
Revenue Code Section 401(k) ("401(k) Plan") for all eligible employees. The
401(k) Plan provides for a discretionary matching contribution by the Company.
For the years ended December 31, 2005 and 2004, the Company elected to not make
any matching contributions.
14. Subsequent event
In February 2006, both Founders loaned a combined $200,000 to the Company in
exchange for two Subordinated Promissory Notes (the "Notes"). The Notes are
unsecured, mature on December 31, 2008, and provide for interest payments from
time to time at an interest rate of 6.75% per annum.
15
CONSOLIDATED SCHEDULES OF SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Years Ended December 31, 2005 2004
- --------------------------------------------------------------------------------
Compensation
Members' compensation $ 320,000 $ 257,812
Staff salaries 1,693,529 1,534,921
Payroll taxes and employee benefits 536,953 372,127
Commission expense 110,081
Employee performance bonuses 350,000
--------------------------
Total compensation costs 2,900,482 2,274,941
--------------------------
Other significant expenses
Warranty expense 714,139 395,000
Engineering supplies 277,700 133,715
Legal fees 15,000 128,387
Shipping charges 89,387 20,289
Bad debt expense 58,998 120,313
--------------------------
Total other significant expenses 1,155,224 797,704
--------------------------
Expenses by department
Sales, marketing and customer service 344,871 191,541
Information technology 197,203 75,967
Engineering 171,591 197,517
Facilities management 138,015 92,942
Administrative and other 408,472 169,547
--------------------------
Total other significant expenses 1,260,152 727,514
--------------------------
Total selling, general and administrative expenses $ 5,315,858 $ 3,800,159
--------------------------
See accompanying notes to consolidated financial statement
16
CONSOLIDATED SUPPLEMENTARY FINANCIAL DATA
$ Increase
Years Ended December 31, 2005 2004 (decrease) %
- -----------------------------------------------------------------------------
Net sales $ 6,327,980 $ 4,819,420 $ 1,508,560 31%
Cost of sales 4,037,413 3,811,696 225,717 6%
-----------------------------------------
Gross profit 2,290,567 1,007,724 1,282,843 127%
-----------------------------------------
Selling, general and
administrative expenses 5,315,858 3,800,159 1,515,699 40%
Depreciation expense 29,039 13,573 15,466 114%
-----------------------------------------
Total operating expenses 5,344,897 3,813,732 1,531,165 40%
-----------------------------------------
Loss from operations (3,054,330) 2,806,008) (248,322) 9%
Interest expense, net [1] (334,591) (148,018) (186,573) 126%
Forgiveness of debt income 200,000 200,000
-----------------------------------------
Net loss $ (3,188,921) $ (2,954,026) $ (234,895) 8%
=================================================
See accompanying notes to consolidated financial statement
[1] Pursuant to the Deed of Release dated March 30, 2005, upon the occurence of
an investor taking a significant equity position in the Company, the THI
Senior Secured Promissory Notes payable will be convered into a single $2
million Unsecured Note. At that time, all accrued interest on the Senior
Secured Promissory Notes will also be reversed. For the years ended December
31, 2005 and 2004, there was $323,247 and $114,568, respectively, of accrued
THI interest included in interest expense.