EXHIBIT 99.1
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Financial Statements
December 31, 1999, 2000, and 2001
(With Independent Auditors' Report Thereon)
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Encore Software, Inc.:
We have audited the accompanying balance sheets of Encore Software, Inc.
(Debtor-in-Possession) as of December 31, 2000 and 2001 and the related
statements of operations, stockholders' equity (deficit), and cash flows for
each of the years in the three-year period ended December 31, 2001. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these 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 audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes 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 financial statements referred to above present fairly, in
all material respects, the financial position of Encore Software, Inc.
(Debtor-in-Possession) as of December 31, 2000 and 2001, and the results of its
operations and its cash flows for each of the years in the three-year period
ended December 31, 2001 in conformity with accounting principles generally
accepted in the United States.
The accompanying financial statements have been prepared assuming the Company
will continue as a going concern. As discussed in note 1 to the financial
statements, the Company's significant loss from operations in fiscal 2001 and
its working capital and stockholders' deficiencies at December 31, 2001, and
subsequent bankruptcy filing raise substantial doubt about its ability to
continue as a going concern. Management's plans in regard to these matters are
also described in note 1. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
As discussed in note 10, the accompanying 2000 financial statements have been
restated.
November 14, 2002
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Balance Sheets
December 31, 2000 and 2001
ASSETS 2000 2001
----------- ------------
RESTATED
(NOTE 10)
Current assets:
Cash $ 6,006 --
Trade accounts receivable, less allowances
of $2,099,254 in 2000 and $6,908,485 in 2001 7,219,266 7,782,867
Inventories 3,552,083 2,420,062
Prepaid royalties 619,809 196,320
Software development costs, net 1,082,506 590,648
Prepaid expenses 726,397 429,996
----------- ------------
Total current assets 13,206,067 11,419,893
Property and equipment, net 968,154 1,399,284
Intangible asset, net 471,643 40,106
Other assets 110,314 107,911
----------- ------------
$ 14,756,178 12,967,194
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Current portion of capital lease obligations $ 4,822 195,291
Bank line of credit 1,884,207 8,154,519
Accounts payable and accrued expenses 3,480,422 5,963,084
Royalties payable 1,491,325 2,165,556
----------- ------------
Total current liabilities 6,860,776 16,478,450
----------- ------------
Stock appreciation rights plan obligation 257,509 254,757
Capital lease obligations, excluding current portion 13,362 379,470
Redeemable convertible preferred stock, $0.01 par value. Authorized
75,000 shares; issued and outstanding 75,000 shares in 2000
and 2001, stated at liquidation value, net of issuance costs 7,181,543 8,769,112
Stockholders' equity (deficit):
Common stock Class A, $0.01 par value. Authorized 15,000,000
shares; issued and outstanding 2,715,900 shares in 2000
and 2,735,900 shares in 2001 27,159 27,359
Additional paid-in capital 815,302 852,502
Unearned compensation (494,673) (260,446)
Retained earnings (deficit) 95,200 (13,534,010)
----------- ------------
Total stockholders' equity (deficit) 442,988 (12,914,595)
Commitments and contingencies (note 5)
----------- ------------
$ 14,756,178 12,967,194
=========== ============
See accompanying notes to the financial statements
2
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Statements of Operations
Years ended December 31, 1999, 2000, and 2001
1999 2000 2001
------------ ---------- ----------
RESTATED
(NOTE 10)
Net product sales $ 22,520,103 32,823,641 32,047,658
Cost of product sales 10,140,452 16,684,541 22,390,281
------------ ---------- ----------
Gross profit 12,379,651 16,139,100 9,657,377
Selling, general, and administrative expenses 10,663,729 16,040,329 21,181,245
------------ ---------- ----------
Operating income (loss) 1,715,922 98,771 (11,523,868)
Other income (expense):
Gain on fire insurance settlement -- 301,996 --
Other 24,050 -- (45,680)
Interest expense (158,021) (276,126) (389,980)
------------ ---------- ----------
Income (loss) before income taxes 1,581,951 124,641 (11,959,528)
Income tax expense 27,999 33,662 --
------------ ---------- ----------
Net income (loss) 1,553,952 90,979 (11,959,528)
Accretion on redeemable preferred stock -- (269,421) (1,617,682)
------------ ---------- ----------
Net income (loss) attributable to common stockholders $ 1,553,952 (178,442) (13,577,210)
============ ========== ==========
See accompanying notes to the financial statements.
3
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Statements of Stockholders' Equity (Deficit)
Years ended December 31, 1999, 2000, and 2001
RETAINED
COMMON STOCK ADDITIONAL EARNINGS NET
----------------------- PAID-IN UNEARNED (ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT CAPITAL COMPENSATION DEFICIT) EQUITY (DEFICIT)
--------- ----------- ----------- ------------- ----------- ----------------
Balance, December 31, 1998 2,633,800 $ 26,338 23,812 -- 3,033,550 3,083,700
Exercise of stock options 28,000 280 -- -- -- 280
Net income -- -- -- -- 1,553,952 1,553,952
Distribution to stockholders -- -- -- -- (1,798,338) (1,798,338)
--------- ----------- ----------- -------- ----------- -----------
Balance, December 31, 1999 2,661,800 26,618 23,812 -- 2,789,164 2,839,594
Exercise of stock options 54,100 541 -- -- -- 541
Stock-based compensation
to employees -- -- 791,490 (494,673) -- 296,817
Net income, as restated -- -- -- -- 90,979 90,979
Accretion on redeemable
convertible preferred stock -- -- -- -- (269,421) (269,421)
Distribution to stockholders -- -- -- -- (2,515,522) (2,515,522)
--------- ----------- ----------- -------- ----------- -----------
Balance, December 31, 2000, as restated 2,715,900 27,159 815,302 (494,673) 95,200 442,988
Exercise of stock options 20,000 200 37,200 -- -- 37,400
Stock-based compensation
to employees -- -- -- 234,227 -- 234,227
Accretion on redeemable
convertible preferred stock -- -- -- -- (1,617,682) (1,617,682)
Net loss -- -- -- -- (11,959,528) (11,959,528)
Distribution to stockholders -- -- -- -- (52,000) (52,000)
--------- ----------- ----------- -------- ----------- -----------
Balance, December 31, 2001 2,735,900 $ 27,359 852,502 (260,446) (13,534,010) (12,914,595)
--------- ----------- ----------- -------- ----------- -----------
See accompanying notes to the financial statements.
4
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Statements of Cash Flows
Years ended December 31, 1999, 2000, and 2001
1999 2000 2001
--------- ---------- ---------
RESTATED
(NOTE 10)
Cash flows from operating activities:
Net income (loss) $ 1,553,952 90,979 (11,959,528)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 208,826 212,949 1,764,456
Impairment charges -- -- 1,707,898
Gain on fire insurance settlement -- (301,996) --
Increase in accounts receivable allowances 74,007 1,380,855 4,809,231
Stock-based compensation -- 296,817 234,227
Changes in operating assets and liabilities:
Trade accounts receivable (599,322) (4,227,487) (5,372,832)
Inventories (507,715) (1,405,772) 1,132,021
Software development and prepaid royalties (569,908) (1,043,946) (1,760,057)
Prepaid expenses (338,827) (369,221) 296,401
Other assets (46,250) (47,608) 2,403
Accounts payable and accrued expenses 513,105 2,138,737 2,520,062
Royalties payable (75,406) 684,622 674,231
Stock appreciation rights obligation 189,793 (113,479) (2,752)
--------- ---------- ---------
Net cash provided by (used in) operating activities 402,255 (2,704,550) (5,954,239)
--------- ---------- ---------
Cash flows from investing activities:
Purchase of property and equipment (252,579) (347,020) (231,976)
Purchase of intangibles (596,417) (59,798) --
--------- ---------- ---------
Net cash used in investing activities (848,996) (406,818) (231,976)
--------- ---------- ---------
Cash flows from financing activities:
Net borrowings (repayments) under bank line of credit 1,900,000 (1,015,793) 6,270,312
Proceeds from issuance of note payable to bank 376,028 -- --
Repayments of note payable to bank (108,278) (267,750) --
Repayments of capital lease obligation (17,303) (4,382) (7,990)
Stockholder distributions (1,798,338) (2,515,522) (52,000)
Proceeds from exercise of stock options 280 541 --
Cash received from sale of preferred stock -- 7,500,000 --
Issuance costs from sale of preferred stock -- (587,878) (30,113)
--------- ---------- ---------
Net cash provided by financing activities 352,389 3,109,216 6,180,209
--------- ---------- ---------
Net decrease in cash (94,352) (2,152) (6,006)
Cash at beginning of year 102,510 8,158 6,006
--------- ---------- ---------
Cash at end of year $ 8,158 6,006 --
========= ========== =========
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest $ 42,001 286,749 --
Income taxes 77,967 230,000 --
Supplemental disclosure of noncash investing and financing activities:
During 2001, the Company purchased property and equipment, financed through
capital lease obligations, totaling $564,567.
See accompanying notes to the financial statements.
5
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) THE COMPANY
Encore Software, Inc. (the Company), is a publisher and
distributor of educational, entertainment and reference software
for the Personal Computer (PC) platform which sells to the
wholesale and retail markets. Effective October 31, 2000,
Math.com, LLC, an entity wholly owned by certain stockholders of
Encore Software, Inc., was merged with and into Encore Software,
Inc. Math.com, LLC, was developing a website focused on building
an online mathematics-focused community for teachers and students.
This transaction was treated as a combination of entities under
common control. Accordingly, the assets and liabilities of
Math.com, LLC have been transferred to Encore Software, Inc. at
historical cost. The accounts of Math.com, LLC are included in the
accompanying financial statements since 1999 in a manner similar
to a pooling of interests. All intercompany transactions and
balances for the periods presented have been eliminated.
In conjunction with the merger, the Company elected to change its
tax status for federal and state income tax purposes. Accordingly,
effective November 1, 2000, the Company changed from an S
Corporation to a C Corporation for tax purposes. As a result, the
Company terminated its ability to qualify as a nontaxable entity
(note 6).
GOING CONCERN AND COMPANY BANKRUPTCY
The accompanying financial statements have been prepared assuming
the Company will continue as a going concern. The Company has
incurred significant losses from operations in fiscal 2001 and has
working capital and stockholders' deficiencies at December 31,
2001. In March 2002, the Company filed for a voluntary petition
for relief under Chapter 11 of Title 11 of the United States
Bankruptcy Code in the United States Bankruptcy Court for the
Central District of California (Bankruptcy Court) and is operating
as Debtor-in-Possession. These matters raise substantial doubt
about the Company's ability to continue as a going concern.
Management's plans include generating cash from operations and the
sale of the Company's assets.
If the Company were unable to obtain additional cash as described
above, such inability would have an adverse effect on the
financial position, results of operations, cash flows, and
prospects of continuing as a going concern. The financial
statements do not give effect to any adjustments that might be
necessary if the Company were unable to meet its obligations or
continue operations, and do not reflect any adjustments to assets
or liabilities that may result from its bankruptcy filing.
Effective August 1, 2002, upon approval by the Bankruptcy Court,
the Company sold substantially all of its assets and transferred
certain specified liabilities and obligations to Navarre
Corporation. See note 11 - Subsequent Events.
(B) REVENUE RECOGNITION
The Company distributes the majority of its products through
several third-party distributors and directly to national and
regional retailers. The distribution of these products is governed
by distribution agreements, direct sale agreements or purchase
orders, which generally provide for a product return privilege.
The Company grants its customers sales incentives in the form of
price protection on unsold customer inventory, advertising
allowances, and volume based distribution fees.
6 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
Revenue is recognized net of an allowance for sales returns and
price protections. The Company records an allowance for returns
and price protections as a reduction in gross product sales and
for advertising and distributor fees as an operating expense. The
allowances are estimated based primarily on historical experience,
customer inventory levels and sales incentive programs.
The Company recognizes revenue from product sales when the
following are met: the selling price is fixed, the buyer is
obligated to pay the Company, title of the product transfers to
the buyer, the buyer has economic substance apart from the
Company, the Company does not have further obligations to assist
the buyer in the resale of the product, and the returns can be
reasonably estimated.
(C) INVENTORIES
Inventories consist primarily of product packaging material and
finished goods and are stated at the lower-of-average cost or
market.
(D) PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. Maintenance and
repairs are charged to expense as incurred. Depreciation is
computed on the straight-line method based on the estimated useful
lives of the assets, which range from five to seven years.
Leasehold improvements are amortized on the straight-line method
over the shorter of the lease term or the estimated useful life.
The Company accounts for website development costs under Statement
of Position 98-1 (SOP 98-1), Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use, and Emerging
Issues Task Force Issue No. 00-2, Accounting for Website
Development Costs. SOP 98-1 requires the capitalization of direct
costs incurred in connection with developing or obtaining software
for internal use, including external direct costs of materials and
services and payroll and payroll-related costs for employees who
are directly associated with and devote time to an internal-use
software development project. Such capitalized costs are amortized
on a straight-line basis over the software's economic useful life,
which is the shorter of five years or the license period. Website
developments costs are included in property and equipment (note
3).
(E) PREPAID ROYALTIES AND ROYALTIES PAYABLE
Prepaid royalties represent fees advanced under license agreements
for the right to certain intellectual property, such as
trademarks, copyrights, and characters. Minimum guaranteed royalty
payments made pursuant to licensing agreements are recorded as an
asset (prepaid royalties) upon payment. Once the related product
is available for release, prepaid royalties are expensed at the
contractual royalty rate as cost of product sales based on actual
net product sales. Management evaluates the future realization of
prepaid royalties, and charges to cost of product sales any
amounts that management deems unlikely to be amortized at the
contractual royalty rate through product sales. Prepaid royalties
are classified as current assets based on estimated product sales
within the next 12 months. During 2001, the Company determined
that prepaid royalties related to certain products were impaired
based on the Company's estimate of future product sales.
Accordingly, the Company recognized an impairment charge of
$449,141 to write off these prepaid royalties.
Royalties payable represent amounts due under licensing
agreements. Royalties are calculated at the contractual royalty
rate as cost of product sales based on actual net product sales
and are typically remitted on a quarterly basis.
7 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
(F) INTANGIBLE ASSETS
Intangible assets include acquired software content and website
domain names. Assets are stated at cost and amortized on the
straight-line method based on the estimated useful life ranging
from three to five years.
The Company assesses the recoverability of these intangible assets
by determining whether the amortization of the balances over their
remaining life can be recovered through undiscounted future
operating cash flows. The amount of impairment, if any, is
measured based on projected discounted future operating cash flows
using a discount rate reflecting the Company's average cost of
funds. During 2001, the Company determined that certain intangible
assets were impaired. Accordingly, the Company recognized a charge
of $309,122 to write down these intangible assets to net
realizable value.
Intangible assets were $656,216 and $66,106 and related
accumulated amortization was $184,571 and $20,000, respectively,
as of December 31, 2000 and 2001.
(G) INCOME TAXES
During 1999, the Company had elected to be treated as an S
Corporation under Subchapter S of the Internal Revenue Code. As a
result of this election, the stockholders of the corporation are
taxed on the Company's income on their individual tax return.
Therefore, no provision or liability for federal income taxes has
been included in the 1999 financial statements. However,
California imposes a corporate level tax on S Corporations.
The Company accounts for income taxes in accordance with SFAS No.
109, Accounting for Income Taxes. SFAS No. 109 specifies an asset
and liability approach, which requires the recognition of deferred
tax assets and liabilities for the expected future tax
consequences of events that have been recognized in the Company's
financial statements. Effective November 1, 2000, the Company
elected to change its tax status from an S Corporation to a C
Corporation for tax purposes.
(H) STOCK-BASED COMPENSATION
The Company has a Stock Appreciation Rights Plan (SAR) to grant
incentive units to key employees. Employees are selected to
participate in the SAR Plan, as determined at management's
discretion. The Company is authorized to grant 20,000 incentive
units, of which 8,967 have been granted at December 31, 2001. All
awards vest according to the terms set forth in each participant's
written award agreement, subject to the SAR Plan's ten-year term.
The Company accounts for the SAR Plan using the variable plan
accounting prescribed by Accounting Principles Board (APB) Opinion
No. 25 and FASB Interpretation No. 28, Accounting for Stock
Appreciation Rights and Other Variable Stock Option or Award
plans. Under APB No. 25, compensation cost is recognized for the
increase in fair value of the incentive units over the employees'
basis in those units proportionately over the employees' vesting
period, which is generally five years. As of December 31, 2001,
the total amount of accrued compensation expense for the Company's
SAR plan was $254,757.
8 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
In 1999, the Company implemented the 1999 Executive Stock Option
Plan, which provides for the grant of incentive stock options.
SFAS No. 123 Accounting for Stock-Based Compensation encourages,
but does not require, companies to record compensation cost for
stock-based employee compensation plans at fair value. SFAS No.
123 allows entities to continue to apply the provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, and provide pro forma net income
disclosure for employee stock option grants as if the
fair-value-based method defined in SFAS No. 123 had been applied.
The Company has elected to apply the provisions of APB Opinion No.
25 and Interpretation No. 44, Accounting for Certain Transactions
Involving Stock Compensation, and provide the pro forma disclosure
provisions of SFAS No. 123.
The Company accounts for stock options and stock warrants issued
to nonemployees in accordance with the provisions of SFAS No. 123
and Emerging Issues Task Force Issue No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services. The
Company uses the Black-Scholes option pricing model to value
options and warrants granted to nonemployees. The related expense
is recorded over the period in which the related services are
received.
(I) CONCENTRATION OF CREDIT RISK
Certain financial instruments potentially subject the Company to
credit risk. These financial instruments consist primarily of
trade accounts receivable. The Company sells principally to
distributors and major retailers. As of December 31, 2001, the
Company had accounts receivable from one customer which
approximate 29% of total accounts receivable. Revenues earned from
this customer was 47% of net product sales for the year ended
December 31, 2001.
As of December 31, 2000, the Company had accounts receivable from
two customers which approximate 18% and 40%, respectively, of
total accounts receivable. Revenues for these customers were 18%
and 53%, respectively, of net product sales for the year ended
December 31, 2000.
For the year ended December 31, 1999, revenues to three customers
were 53%, 17% and 10%, respectively, of net product sales.
(J) SOFTWARE DEVELOPMENT COSTS
Software development costs represent payments made to third party
software developers for the development of the Company's software
products and are expensed as incurred except for certain software
development costs capitalized under Statement of Financial
Accounting Standards No. 86, Accounting for the Cost of Computer
Software to be Sold, Leased, or Otherwise Marketed. Software
development costs are capitalized once technological feasibility
of a product is established and such costs are determined to be
recoverable. Technological feasibility for educational,
entertainment and reference software has been established when a
proven game engine technology exists evidenced by a working model.
Technological feasibility is evaluated on a product-by-product
basis.
Software development costs are capitalized and then amortized on a
straight-line basis over the estimated product life, or on the
ratio of current revenues to total projected product revenues,
whichever is greater, commencing with the availability of each
product, generally for a period of six
9 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
months to twenty-four months. The Company evaluates the
recoverability of software development costs and charges to
expense any amounts that management deems unlikely to be recovered
by future revenues.
During 2001, the Company determined that capitalized software
development costs related to certain products were impaired.
Accordingly, the Company recognized a charge of $949,635 to write
down capitalized software development costs in the accompanying
2001 financial statements. After consideration of the impairment
charge in 2001, capitalized software development costs were
$1,787,404 and $594,648 and the related accumulated amortization
was $704,898 and $4,000, respectively, as of December 31, 2000 and
2001.
(K) USE OF ESTIMATES
Management of the Company has made a number of estimates and
assumptions relating to the reporting of assets and liabilities at
the date of the financial statements and the reported amounts of
revenue and expenses during the reporting period and the
disclosure of contingent assets and liabilities to prepare these
financial statements in conformity with accounting principles
generally accepted in the United States of America. Actual results
could differ from those estimates.
(L) COMPREHENSIVE INCOME (LOSS)
The Company does not have any components of comprehensive income
or loss, and accordingly, the Company's comprehensive income or
loss is the same as its net income or loss for the years ended
December 31, 1999, 2000 and 2001.
(N) RECLASSIFICATIONS
Certain reclassifications have been made to the December 31, 1999
and 2000 balances to conform to the December 31, 2001
presentation.
(2) INVENTORIES
Inventories consist of the following at December 31, 2000 and 2001:
2000 2001
------------- -------------
Packaging materials and components $ 1,531,902 1,460,935
Finished goods 2,020,181 959,127
------------- -------------
$ 3,552,083 2,420,062
============= =============
10 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
(3) PROPERTY AND EQUIPMENT
A summary of property and equipment at December 31, 2000 and 2001 is as
follows:
2000 2001
------------ ---------
Computer equipment $ 395,383 467,702
Computer software 113,936 703,150
Furniture and fixtures 81,705 109,719
Equipment 79,003 143,026
Website development costs 181,229 228,212
Leasehold improvements 392,614 388,604
------------ ---------
1,243,870 2,040,413
Less accumulated depreciation and amortization (275,716) (641,129)
------------ ---------
$ 968,154 1,399,284
============ =========
(4) BANK LINE OF CREDIT
The Company has a revolving line of credit agreement with a bank. The
agreement provides for borrowings of up to $10,000,000, subject to
eligible accounts receivable and inventory, for working capital and bears
interest at the prime rate. The line of credit is guaranteed by all of
the Company's assets. As of December 31, 2001, the Company had $8,154,519
of outstanding borrowings under the line of credit. The line of credit
agreement contains certain financial covenants related to financial
ratios, profitability and minimum levels of working capital and tangible
net worth. At December 31, 2001, the Company was not in compliance with
certain covenants, accordingly, the debt is classified as current. The
line of credit agreement expires on April 20, 2003.
(5) COMMITMENTS AND CONTINGENCIES
The Company leases its operating and warehouse facilities under
noncancelable operating leases extending through 2005. Total rent expense
amounted to $202,000, $540,536, and $660,550 for the years ended December
31, 1999, 2000, and 2001 respectively.
Future commitments for the year ended December 31, 2001 under these
operating leases are as follows:
2002 $ 720,390
2003 658,891
2004 658,891
2005 219,056
-------------
$ 2,257,228
=============
11 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
The Company is obligated under three capital lease agreements for
computer software and equipment that expire on various dates through
April 2006. At December 31, 2001, the gross amount of computer software
and equipment is $590,197 and the related accumulated amortization is
$35,674. Future minimum capital lease payments as of December 31, 2001
are:
Year ending December 31:
2002 $ 227,926
2003 227,926
2004 187,541
2005 9,324
2006 3,108
-------------
Total minimum lease payments 655,825
Less amounts representing interest 81,064
-------------
Present value of net minimum capital lease payments 574,761
Less current installments of obligations under capital leases 195,291
-------------
Obligations under capital leases, excluding current installments $ 379,470
=============
In April 2000, the Company entered into an agreement to obtain licensing
and distribution rights to educational software. The agreement provides
for minimum guaranteed royalty payments to be made by the Company over
the term of the agreement. The agreement expires on December 31, 2005.
The following schedule represents the future minimum payments:
Year ending December 31:
2002 $ 1,600,000
2003 1,530,000
2004 900,000
2005 270,000
--------------
$ 4,300,000
==============
For the year ended December 31, 2001, the Company paid and recorded as a
charge to cost of product sales approximately $1,100,000 in minimum
guaranteed payments under the software license and distribution
agreement.
CONTINGENCIES
The Company is a party to various legal actions and claims arising in the
normal course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not have a material
adverse affect on the Company's financial position or results of
operations.
(6) INCOME TAXES
Effective November 1, 2000, the Company changed its tax status from an S
Corporation to C Corporation. Accordingly, the Company recognized
deferred tax assets and liabilities related to the tax effects of
differences between the carrying amounts of existing assets and
liabilities and their respective tax bases as of the date of the change
in status. Prior to the current year, income tax expense consisted of
state income taxes only.
12 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
Income taxes for 1999 and 2000 were comprised of state franchise taxes as
an S Corporation. Due to the losses incurred by the Company as a C
Corporation during 2001, the Company has no federal and state income
taxes except for minimum state franchise taxes.
Income taxes differs from the amount computed by applying the federal
statutory tax rate of 34% to income before income taxes as shown below:
1999 2000 2001
---------- ---------- ----------
Computed expected income tax expense (benefit) $ 537,863 42,378 (4,066,240)
State income taxes, net of federal income tax 27,999 (42,486) (550,833)
benefit
Tax effect of S Corporation earnings (704,499) (188,789) --
Tax effect of Math.com LLC losses 166,636 77,593 --
Deferred tax assets recognized on change of -- (308,012) --
tax status
Other -- (228) --
Valuation allowance -- 453,206 4,617,073
---------- ---------- ----------
Income taxes $ 27,999 33,662 --
========== ========== ==========
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at
December 31, 2001 are presented below:
2000 2001
------------- -------------
Deferred tax assets:
Inventories $ 18,722 775,847
Accounts receivable and sales returns and allowances 232,826 2,180,816
State income taxes 11,445 --
Net operating loss carry-forwards -- 1,923,403
Other 190,213 190,213
------------- -------------
Total gross deferred tax assets 453,206 5,070,279
Less valuation allowance (453,206) (5,070,279)
------------- -------------
Net deferred tax assets $ -- --
============= =============
The Company has federal net operating loss carryforwards aggregating
approximately $5,089,000 which expire in 2021. The net operating loss
carryforwards may be subject to Section 382 of the Internal Revenue Code,
which imposes annual limitations on their utilization. A valuation
allowance has been recognized in 2001 to fully offset the tax benefit
from these net operating loss carryforwards.
13 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
In assessing the realizability of deferred tax assets, management
considers whether it is more likely than not that some portion or all of
the deferred tax assets will not be realized. The ultimate realization of
deferred tax assets is dependent upon the generation of future taxable
income during the periods in which those temporary differences become
deductible. Management considers projected future taxable income and tax
planning strategies in making this assessment. Based on the uncertainty
surrounding the Company's ability to generate future taxable income over
the periods in which the level of deferred tax assets are deductible,
management has provided a full valuation allowance against net deferred
tax assets.
(7) STOCK OPTION PLAN
Under the Company's 2000 Executive Stock Option Plan (the Plan), options
can be granted from time to time for an aggregate of no more than
1,500,000 shares of common stock as determined by the board of directors.
The Company grants options at an exercise price at the date of grant
equal to or greater than the fair value of the Company's common stock as
determined by the board of directors. The options vest over a period
ranging from two to four years and are exercisable up to ten years from
the date of grant.
A summary of the activity of the Plan is as follows:
WEIGHTED-
AVERAGE
SHARES EXERCISE PRICE
-------------- --------------
Options outstanding at December 31, 1998 82,000 $ 0.01
Grants 265,000 1.87
Exercised 28,000 0.01
-------------- --------------
Options outstanding at December 31, 1999 319,000 1.56
Grants 407,600 1.99
Exercised 54,100 0.01
Canceled 115,000 1.73
-------------- --------------
Options outstanding at December 31, 2000 557,500 1.95
Grants 498,321 4.40
Exercised 20,000 1.87
Canceled 60,000 1.87
-------------- --------------
Options outstanding as of December 31, 2001 975,821 $ 3.21
============== ==============
14 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
The following table summarizes information regarding options outstanding
and options exercisable at December 31, 2001:
WEIGHTED-
AVERAGE OPTIONS
OUTSTANDING AT REMAINING EXERCISABLE AT
DECEMBER 31, CONTRACTUAL LIFE DECEMBER 31,
EXERCISE PRICE 2001 (YEARS) 2001
-------------- ------------- ----------------- --------------
$ 1.87 100,000 7.8 100,000
1.95 102,500 8.0 25,625
2.00 275,000 8.6 68,750
4.40 498,321 9.7 --
In connection with stock option grants in 2000, the Company determined
that the fair value of its common stock exceeded the exercise price at
the date of grant. Accordingly, the Company recorded unearned
compensation of approximately $791,000. Unearned compensation is being
amortized for financial reporting purposes over the vesting period of the
options. The amount recognized as expense for the year ended December 31,
2000 and 2001 amounted to $296,817 and $234,227, respectively.
Pro forma information regarding net income (loss) is required by SFAS No.
123 which also require that the information be determined as if the
Company has accounted for its stock options under the fair value method
of the statement. Had the Company determined compensation cost based on
the fair value at the grant date for its stock options under SFAS No.
123, the Company's net income (loss) would have been changed to the pro
forma amounts indicated below:
YEAR ENDED DECEMBER 31
-------------------------------------------------------------
1999 2000 2001
---------------- ---------------- ----------------
Net income (loss) attributable to common
stockholders:
As reported $ 1,553,952 (178,442) (13,577,210)
Pro forma 1,458,000 (354,000) (13,888,000)
The following assumptions were used to calculate the fair value of the
stock option grants under the minimum-value method: risk-free interest
rate of 5.3% in 1999, 6.1% in 2000, and 3.8% in 2001; no dividend yield;
and an expected life of an option of four years.
The weighted-average fair value of options granted to employees for the
years ended December 31, 1999, 2000, and 2001 were $0.36, $0.43, and
$0.62, respectively.
(8) REDEEMABLE CONVERTIBLE PREFERRED STOCK
In October 2000, the Company issued 75,000 shares of Redeemable
Convertible Preferred Stock (Preferred Stock) for $7,500,000. Issuance
costs associated with the Preferred Stock were $587,878 in 2000 and
$30,113 in 2001. The Preferred Stock is convertible into Common Stock on
or after November 1, 2002.
15 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
The number of shares of Common Stock into which the Preferred Stock is
convertible is equal to the original issue price of the Preferred Stock
divided by the conversion price of $3.44 per share. The conversion of the
Preferred Stock is at the option of the holder, however becomes
mandatorily redeemable upon the closing of qualified initial public
offering or sale transaction, as defined. The holders of Preferred Stock
and Common Stock vote together as if they were one class.
The holders of Preferred Stock are entitled to dividends or other
distributions when and if declared by the board of directors in the same
amount and manner as they would have been entitled to receive if the
Preferred Stock were converted into Common Stock.
The holders of Preferred Stock have a redemption option upon election by
holders possessing at least 75% of the outstanding Preferred Stock under
which the Company shall redeem the Preferred Stock for 200% of the
original issue price. The Company recorded $269,421 in 2000 and
$1,617,682 in 2001 related to the pro rata accretion of the preferred
stock value to the redeemable amount. The redemption option shall become
exercisable on October 30, 2005.
In the event of a liquidation of the Company, the holders of Preferred
Stock have liquidation preferences over common stockholders at 200% of
the original issue price per share. If assets available for distribution
are insufficient to pay the foregoing amounts in full, then the amounts
payable to the holders of the preferred stock shall be calculated, pro
rata, on the basis of each such holder's liquidation preference.
(9) INSURANCE SETTLEMENT
On February 28, 2000, the Company's leased warehouse in El Segundo,
California was destroyed in a fire. There were $1,536,523 of assets on
hand at the time of the fire. The Company's settlement from the insurance
company was $1,838,519, of which $95,206 was a receivable at December 31,
2000. The Company recorded a gain of $301,996 as a result of the
insurance settlement in 2000.
(10) RESTATEMENT OF FISCAL 2000
Subsequent to the issuance of the Company's 2000 financial statements,
the Company's management determined that its financial statements as of
December 31, 2000 and for the year then ended should be restated to
address the matters discussed below.
The Company concluded, based upon receipt of delayed reporting from its
distributors and retailers, that its method of estimating product returns
was inaccurate as of December 31, 2000. The revenues, product costs,
distributor fees and royalty costs relating to product shipments to these
customers have been restated in the accompanying financial statements to
reflect an increase in estimated product returns. As a result, the 2000
financial statements have been restated from the amounts previously
reported to reduce net sales by $407,360 and reduce related cost of sales
by $112,450.
The Company also determined that sales to one of its distributors were on
a consignment basis and accordingly, the associated net sales to this
distributor have been restated in the accompanying 2000 financial
statements to reflect product sales only upon sell-through of the
Company's product to the distributor's customer. As a result, the 2000
financial statements have been restated from the amounts previously
reported to reduce net sales by $675,000, reduce related costs of sales
by $344,250, and increase distribution fees by $112,000.
16 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
The Company also determined that certain sales to another distributor
were recognized prior to the point when title to the associated product
passed to the distributor. As a result, the 2000 financial statements
have been restated from amounts previously reported to reduce net sales
by $234,000 and reduce related costs of sales by $139,000.
The Company also determined that certain lease payments totaling $83,653
inadvertently capitalized within fixed assets as construction-in-progress
should have been expensed as a charge to 2000 results of operations. As a
result, the 2000 financial statements have been restated from the amounts
previously reported to increase overhead costs by $83,653.
The Company reevaluated the future realization of its net deferred tax
assets in light of the restated pre-tax results of operations for 2000
and the Company determined that a full valuation allowance should have
been recorded against the net deferred tax assets of $502,157 as of
December 31, 2000. Accordingly, the 2000 financial statements have been
restated from the amounts previously reported to increase income tax
expense by $502,157.
The Company determined that a pro rata accretion of the Preferred Stock
value to the redemption value of $269,421 was not recorded in 2000. As a
result, the 2000 financial statements have been restated from the amounts
previously reported for the Preferred Stock accretion.
A summary of the effects of the restatement is as follows:
FOR THE YEAR ENDED
DECEMBER 31, 2000
--------------------------------------
AS PREVIOUSLY
REPORTED AS RESTATED
--------------- --------------
At December 31, 2000:
Trade accounts receivable, net $ 8,647,626 7,219,266
Inventories 2,956,383 3,552,083
Property and equipment, net 1,051,807 968,154
Redeemable preferred stock 6,912,122 7,181,543
Retained earnings 1,783,901 95,200
For the year ended December 31, 2000:
Net revenues $ 34,252,001 32,823,641
Cost of sales 17,280,241 16,684,541
Selling, general and administrative expenses 15,726,860 16,040,329
Income before income taxes 1,041,000 124,641
Income tax expense (benefit) (468,495) 33,662
Net income 1,509,449 90,979
Net income (loss) attributable to common stockholders 1,240,028 (178,442)
17 (Continued)
ENCORE SOFTWARE, INC.
(Debtor-in-Possession)
Notes to Financial Statements
December 31, 1999, 2000, and 2001
(11) SUBSEQUENT EVENTS
In March 2002, the Company filed a voluntary petition for relief under
Chapter 11 of Title 11 of the United States Bankruptcy Code in the United
States Bankruptcy Court for the Central District of California
(Bankruptcy Court). Under Chapter 11, certain claims against the Company
in existence prior to the filing of the petitions for relief under the
federal bankruptcy laws are stayed while the Company continues business
operations as Debtor-in-possession.
The redemption provisions contained in the terms of the Preferred Stock
were triggered and as a result, the preferred stockholders submitted
their claim to redeem the stated liquidation value of the redeemable
preferred stock with the Bankruptcy Court.
Effective August 1, 2002, upon approval by the Bankruptcy Court, the
Company closed on a transaction with Navarre Corporation (Navarre)
pursuant to an Amended and Restated Asset Purchase Agreement between the
Company and Navarre as of July 10, 2002, as amended by amendment No. 1 to
the agreement as of July 31, 2002 (Sale Transaction). Navarre paid $6.7
million in cash and agreed to pay or assumed $2.1 million in debt which
includes the Company's bank debt. Substantially all of the assets of the
Company were sold including, certain fixed assets, intellectual property,
inventory, receivables, and contract rights related to the Company's
business. Navarre also assumed only certain specified liabilities from
the Company.
In connection with the Sale Transaction, the Company transferred certain
of its lease obligations under leases related to its facilities and
computer software and equipment and transferred its agreements to certain
licensing and distribution rights to Navarre.
The Bankruptcy Court will determine the ultimate distribution of cash
remaining in the bankruptcy estate upon settlement between Navarre and
the unsecured creditors of remaining amounts to be paid by Navarre. As of
November 14, 2002, the Company is awaiting determination of the remaining
cash and final settlement of all claims in the bankruptcy estate by the
Bankruptcy Court.
18