1
EXHIBIT 99.1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO THE STOCKHOLDERS OF
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES:
We have audited the accompanying consolidated balance sheets of SmarTel
Communications, Inc. (a Delaware corporation) and subsidiaries as of December
31, 1996 and 1995, and the related consolidated statements of operations,
redeemable preferred stock and stockholders' equity (deficit) and cash flows for
each of the three years in the period ended December 31, 1996. 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 generally accepted auditing
standards. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SmarTel
Communications, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1996, in conformity with generally accepted accounting
principles.
As explained in Note 1(c) to the financial statements, the Company has
given retroactive effect to a change in its revenue recognition methodology
relating to promotional cards.
/s/ ARTHUR ANDERSEN LLP
Boston, Massachusetts
April 4, 1997 (except with respect
to the matter discussed in Notes 1,
3(a), 4(d), 5 and 9, as to which the
date is May 24, 1997 and to the matter
discussed in Note 1(c), as to which
the date is November 24, 1997)
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SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS -- DECEMBER 31, 1996 AND 1995
ASSETS
1996 1995
(AS (AS
RESTATED) RESTATED)
Current Assets:
Cash and cash equivalents....................................... $ 1,763,473 $ 1,869,656
Accounts receivable, net of allowance for doubtful accounts..... 785,146 565,576
Inventories..................................................... 26,798 30,238
Other current assets............................................ 439,213 499,015
----------- -----------
Total current assets.................................... 3,014,630 2,964,485
----------- -----------
Property and Equipment:
Computer and office equipment................................... 189,523 159,926
Printing equipment.............................................. 29,788 23,717
Leasehold improvements.......................................... 63,153 63,153
Furniture and fixtures.......................................... 13,046 --
----------- -----------
295,510 246,796
Less -- Accumulated depreciation and amortization............... 101,511 42,244
----------- -----------
193,999 204,552
----------- -----------
Other Assets:
Note receivable from stockholder................................ 79,180 --
Intangible assets, net of accumulated amortization of $15,206
and $0 at December 31, 1996 and 1995, respectively........... 46,524 61,730
Organization costs, net of accumulated amortization of $29,015
and $14,911 at December 31, 1996 and 1995, respectively...... 40,162 54,267
Other assets.................................................... 50,677 50,639
----------- -----------
$ 3,425,172 $ 3,335,673
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Subordinated notes payable to stockholders, current portion..... $ 157,500 $ --
Capital lease obligation, current portion....................... 12,459 13,500
Equipment line of credit, current portion....................... 16,798 11,199
Unsecured note payable.......................................... -- 15,000
Accounts payable................................................ 1,764,543 435,255
Accrued expenses................................................ 282,068 139,806
Deferred revenue................................................ 3,742,622 2,530,993
----------- -----------
Total current liabilities............................... 5,975,990 3,145,753
----------- -----------
Equipment Line of Credit, net of current portion.................. 33,597 44,795
----------- -----------
Subordinated Notes Payable to Stockholders........................ -- 157,500
----------- -----------
Minority Interest -- Preferred Stock.............................. 30,000 30,000
----------- -----------
Commitments and Contingencies (Notes 3, 4, 6 and 7)
Redeemable Preferred Stock:
Authorized -- 4,002 shares
Issued and outstanding -- 3,909 shares (liquidation preference
of $4,161,019 and $4,040,989 at December 31, 1996 and 1995,
respectively)................................................ 3,796,190 2,718,686
Stockholders' Equity (Deficit):
Common stock, $.001 par --
Authorized -- 10,000,000 shares
Issued and outstanding -- 2,434,035 shares................... 2,434 2,434
Additional paid-in capital...................................... 1,507,004 1,507,004
Accumulated deficit............................................. (7,920,043) (4,270,499)
----------- -----------
Total stockholders' equity (deficit).................... (6,410,605) (2,761,061)
----------- -----------
$ 3,425,172 $ 3,335,673
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
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3
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
1996 1995 1994
(AS (AS (AS
RESTATED) RESTATED) RESTATED)
Revenues............................................ $ 5,034,192 $ 1,377,035 $ 77,857
Cost of Revenues.................................... 4,100,955 1,201,163 113,680
----------- ----------- ---------
Gross profit.............................. 933,237 175,872 (35,823)
Selling, General and Administrative Expenses........ 3,524,677 2,043,007 741,714
Loss on Discontinuance of Long Distance Service
Businesses, net (Note 1).......................... -- 310,613 58,230
----------- ----------- ---------
Loss from operations...................... (2,591,440) (2,177,748) (835,767)
Interest Income (Expense), net...................... 7,241 (211) --
Other Income, net................................... 12,159 -- --
----------- ----------- ---------
Net loss.................................. (2,572,040) (2,177,959) (835,767)
Accretion of Redeemable Preferred Stock Dividends
and Discount...................................... (1,074,744) (223,905) --
----------- ----------- ---------
Net Loss Attributable to Common Stockholders........ $(3,646,784) $(2,401,864) $ (835,767)
=========== =========== =========
Net Loss per Common Share........................... $ (1.50) $ (1.27) $ (0.52)
=========== =========== =========
Weighted Average Number of Common Shares
Outstanding....................................... 2,434,035 1,895,495 1,612,511
=========== =========== =========
The accompanying notes are an integral part of these consolidated financial
statements.
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SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY
(DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
STOCKHOLDERS' EQUITY (DEFICIT)
REDEEMABLE -----------------------------------------------------------------------------
PREFERRED STOCK COMMON STOCK
------------------------ ----------------------- ADDITIONAL
NUMBER REDEMPTION NUMBER $.001 PAID-IN TOTAL
OF SHARES VALUE OF SHARES PAR VALUE CAPITAL ACCUMULATED STOCKHOLDERS'
DEFICIT EQUITY
(AS RESTATED) (DEFICIT)
(AS RESTATED)
Balance, December 31,
1993 (Unaudited)... -- $ -- 1,539,000 $ 1,539 -- $ 5,823 $ 7,362
Sale of common
stock............ -- -- 130,183 130 199,831 -- 199,961
Net loss........... -- -- -- -- -- (835,767) (835,767)
----- --------- --------- ------ --------- ----------- -----------
Balance, December 31,
1994............... -- -- 1,669,183 1,669 199,831 829,944 (628,444)
Issuance of
redeemable
preferred stock
and warrants, net
of issuance costs
of $191,097...... 3,002 1,494,996 -- -- 1,507,004 (191,097) 1,315,907
Accretion of
preferred stock
dividends........ -- 33,989 -- -- -- (33,989) (33,989)
Accretion of
preferred stock
discount......... -- 190,491 -- -- -- (190,491) (190,491)
Preferred stock
dividend on
common stock..... 908 1,000,000 -- -- (199,831) (800,169) (1,000,000)
Exercise of common
stock warrants in
exchange for
redemption of
preferred stock.. (1) (790) 789,888 790 -- -- 790
Repurchase and
retirement of
common stock..... -- -- (25,036) (25) -- (46,850) (46,875)
Net loss........... -- -- -- -- -- (2,177,959) (2,177,959)
----- --------- --------- ------ --------- ----------- -----------
Balance, December 31,
1995............... 3,909 2,718,686 2,434,035 2,434 1,507,004 (4,270,499) (2,761,061)
Accretion of
preferred stock
dividends........ -- 120,030 -- -- -- (120,030) (120,030)
Accretion of
preferred stock
discount......... -- 957,474 -- -- -- (957,474) (957,474)
Net loss........... -- -- -- -- -- (2,572,040) (2,572,040)
----- ---------- --------- ------ --------- ----------- -----------
Balance, December 31,
1996............... 3,909 $3,796,190 2,434,035 $ 2,434 $ 1,507,004 $(7,920,043) $(6,410,605)
===== ========== ========= ====== ========= =========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
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SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
1996 1995 1994
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Cash Flows from Operating Activities:
Net loss.......................................................... $(2,572,040) $(2,177,959) $(835,767)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization................................... 88,576 50,161 6,993
Changes in assets and liabilities:
Accounts receivable........................................... (219,570) (327,617) (191,940)
Inventories................................................... 3,440 (21,688) (8,550)
Other current assets.......................................... 59,802 (207,806) (281,108)
Accounts payable.............................................. 1,329,288 329,895 65,218
Accrued expenses.............................................. 142,262 (65,003) 126,214
Deferred revenue.............................................. 1,211,629 1,676,424 854,569
----------- ----------- ---------
Net cash provided by (used in) operating activities........ 43,387 (743,593) (264,371)
----------- ----------- ---------
Cash Flows from Investing Activities:
Note receivable from stockholder.................................. (79,180) -- --
Purchases of property and equipment............................... (86,156) (184,996) (31,496)
Proceeds from sale of property and equipment...................... 48,489 -- --
Increase in other assets.......................................... (38) (40,039) (10,600)
Organization costs................................................ -- (53,032) (16,145)
----------- ----------- ---------
Net cash used in investing activities...................... (116,885) (278,067) (58,241)
----------- ----------- ---------
Cash Flows from Financing Activities:
Proceeds from sale of common stock................................ -- -- 199,961
Proceeds from sale of minority interest -- preferred stock........ -- -- 30,000
Proceeds from sale of preferred stock and warrants, net of
issuance costs.................................................. -- 2,810,903 --
Repurchase and retirement of common stock......................... -- (46,875) --
(Payments on) proceeds from subordinated notes payable to
stockholders.................................................... -- (37,500) 195,000
(Payments on) proceeds from advances from stockholders............ -- (62,500) 2,000
Payments on unsecured note payable................................ (15,000) -- --
Payments on capital lease obligation.............................. (12,086) (8,532) (5,328)
(Payments on) proceeds from borrowings on equipment line of
credit.......................................................... (5,599) 55,994 --
----------- ----------- ---------
Net cash (used in) provided by financing activities........ (32,685) 2,711,490 421,633
----------- ----------- ---------
Net (Decrease) Increase in Cash and Cash Equivalents................ (106,183) 1,689,830 99,021
Cash and Cash Equivalents, beginning of year........................ 1,869,656 179,826 80,805
----------- ----------- ---------
Cash and Cash Equivalents, end of year.............................. $ 1,763,473 $ 1,869,656 $ 179,826
=========== =========== =========
Supplemental Disclosure of Noncash Information:
Cash paid for interest............................................ $ 7,145 $ 20,685 $ 3,955
=========== =========== =========
Supplemental Disclosure of Noncash
Investing and Financing Activities:
Exercise of common stock warrants in exchange for redemption of
preferred stock................................................. $ -- $ 790 $ --
=========== =========== =========
Accretion of preferred stock dividends............................ $ 117,270 $ 33,414 $ --
=========== =========== =========
Accretion of preferred stock discount............................. $ 957,474 $ 190,491 $ --
=========== =========== =========
Purchase of Global Media Networks --
Fair value of assets purchased.................................. $ -- $ 82,673 $ --
Issuance of note payable........................................ -- (15,000) --
Liabilities assumed............................................. -- (67,673) --
=========== =========== =========
$ -- $ -- $ --
=========== =========== =========
Equipment acquired under capital lease obligation................... $ 11,045 $ -- $ --
=========== =========== =========
The accompanying notes are an integral part of these consolidated financial
statements.
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6
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
SmarTel Communications, Inc. (the Company) (formerly Z-Axis Communications)
is engaged in the business of providing marketing and telecommunications
services through the sale of prepaid telephone cards. The Company was
incorporated in 1985 as a Massachusetts corporation. On January 20, 1995, the
Company reorganized in Delaware. In connection with this reorganization, the
Delaware corporation issued 1,500 shares of common stock for each existing share
of common stock in the Massachusetts corporation. All share amounts in the
accompanying consolidated financial statements have been retroactively restated
for this reorganization.
Prior to 1994, the Company was also engaged in the business of selling long
distance services principally to other businesses. The Company discontinued its
operation in this business in June 1994 and, as a result, recorded a loss of
approximately $58,000, net of $98,500 of revenue, in the accompanying
consolidated statement of operations for the year ended December 31, 1994.
In addition, during 1994, the Company began developing technology in an
attempt to enter the international call arbitrage business. The Company
abandoned this attempt in June 1995 and, as a result, recorded a loss of
approximately $311,000 in the accompanying statement of operations for the year
ended December 31, 1995. Through December 31, 1994, approximately $30,000 was
charged to selling, general and administrative expenses relating to the
development of this abandoned product line.
On December 21, 1995, the Company acquired certain assets and liabilities
of Global Media Network (see Note 8).
The Company continues to be subject to certain risks common to companies in
similar stages of development. Principal among these risks are dependence on key
individuals; successful marketing of current products and services, combined
with the need to successfully develop and introduce new products and services;
dependence on independent commission agents whose compensation is based on the
profitability of prepaid telephone card programs; the ability to raise
additional capital to fund operations; and the ability to achieve profitable
future operations. On May 24, 1997, the Company merged with SmarTalk
Teleservices, Inc. (see Note 9).
The accompanying consolidated financial statements reflect the application
of the following significant accounting policies:
(a) Principles of Consolidation
The accompanying consolidated financial statements include the
accounts of the Company and its subsidiaries, SmarTel, Inc. (90%-owned),
SmarTel Communications of Virginia, Inc. (100%-owned) and SmarTel
International, Inc. (100%-owned). All significant intercompany transactions
and balances have been eliminated in consolidation.
(b) Management's Use of Estimates
The preparation of these consolidated financial statements in
conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
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7
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(c) Revenue Recognition
The Company has restated its financial statements to give retroactive
effect to a change in its revenue recognition relating to promotional
cards. From inception, the Company's management has estimated, based on the
usage patterns of customers, the portion of calling time which would not be
used by the customer ("breakage") and recognized this as additional revenue
for its promotional card programs. In November 1997 in consultation with
the Securities and Exchange Commission staff, the Company modified its
revenue recognition policy such that revenue is recognized as described
herein.
As a result, the Company has restated its financial statements and the
impact on the Company's previously issued financial results for each of the
three years ended December 31, 1996, 1995 and 1994 as summarized below:
1996 1995 1994
------------------------- ------------------------- -------------------------
AS REPORTED AS RESTATED AS REPORTED AS RESTATED AS REPORTED AS RESTATED
----------- ----------- ----------- ----------- ----------- -----------
Revenues................... $ 5,496,640 $ 5,034,192 $ 2,546,246 $ 1,377,035 $ 861,270 $ 77,857
Net Loss................... (2,065,902) (2,572,040) (1,116,834) (2,177,959) (294,426) (835,767)
Net Loss attributable to
Common Stockholder....... (3,140,646) (3,646,784) (1,340,739) (2,401,864) (294,426) (835,767)
Net Loss per Common Share... (1.29) (1.50) (.71) (1.27) (.18) (.52)
The Company sells its product into two distinct markets, retail and
promotional. Retail card sales are ultimately funded by the end user, while
promotional card sales are funded by third parties who have promotional
information attached to the card. Promotional cards are then given to the
end user to promote the buyer's product or service.
The Company accounts for revenue from these sales as follows:
- For retail markets, the Company records deferred retail revenue when
it sells the card and recognizes revenues as the ultimate customer
utilizes the calling time or as the card expires. Retail card revenue
for the years ended December 31, 1996 and 1995 was approximately
$512,000 and $142,000, respectively. The Company did not have any
retail card revenue for the year ended December 31, 1994.
- For promotional markets, the Company defers 100% of the revenue when
it sells the card and recognizes the revenue as the ultimate customer
utilizes the calling time or the card expires.
- Revenue from third-party prepaid phone cards for which the Company
acts solely as a reseller is recognized upon delivery.
- The Company's primary costs of its prepaid telephone cards include the
cost of design and manufacturing of the cards, long-distance carrier
fees for processing the calls generated by use of the prepaid
telephone cards and switch administration fees. For retail and
promotional telephone cards, these costs are expensed as the
associated revenues are earned.
Substantially all prepaid telephone cards sold by the Company have
expiration dates 12 months from the date of delivery to the customer and
provide that payments for cards are nonrefundable.
The Company utilizes several service bureaus to process calls and
provide administrative support for calls generated by the use of prepaid
telephone cards. These services are concentrated with one service provider.
The Company could be adversely affected if this service bureau were unable
or unwilling to
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8
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
continue this relationship. Management believes that there are alternative
service bureaus it could use to minimize any adverse impact on the loss of
the existing service bureau.
(d) Cash and Cash Equivalents
The Company considers all highly liquid investments with original
maturities of less than three months to be cash equivalents. These
investments are reported at cost, which approximates market value.
(e) Inventories
Inventories are recorded at the lower of cost (first-in, first-out) or
market. At December 31, 1996, inventories consisted primarily of printing
materials and supplies used in the production of the telephone cards.
(f) Depreciation and Amortization
The Company provides for depreciation and amortization using the
straight-line method by charges to operations in amounts that allocate the
cost of the property and equipment over their estimated useful lives, as
follows:
ESTIMATED
ASSET CLASSIFICATION USEFUL LIFE
Computer and office equipment.......... 4-7 years
Printing equipment..................... 5 years
Leasehold improvements................. Life of lease
Furniture and fixtures................. 7 years
(g) Note Receivable from Stockholder
On January 10, 1996, the Company entered into a $75,000 note
receivable agreement (the Note) with a stockholder. The Note accrues
interest at a rate of 5.73% compounded annually, totaling $4,180 at
December 31, 1996. Principal and accrued interest, then outstanding, is due
on January 10, 2005. The Note is secured by the stockholder's stock in the
Company.
(h) Organization Costs
Organization costs include legal fees and costs associated with
registering the Company as a public utility in jurisdictions where the
Company provides telephone services. These costs are being amortized on a
straight-line basis over five years.
(i) Minority Interest
The Company's 90%-owned subsidiary, SmarTel, Inc., has 50,000
authorized shares of preferred stock, of which 1,000 shares were issued at
$30 per share in 1994 to a third party and were outstanding as of December
31, 1996. These 1,000 shares were convertible into a 10% interest in the
subsidiary and had a $30,000 liquidation preference. Accordingly, this
minority interest reflected its priority claim on the underlying equity in
the subsidiary at December 31, 1996. This preferred stock was returned to
the Company and retired on May 24, 1997 (see Note 5).
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9
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(j) Postretirement Benefits
The Company has no obligations for postretirement benefits.
(k) Financial Instruments
The estimated fair value of the Company's financial instruments, which
include trade accounts receivable, note receivable from stockholder and
long-term debt, approximates their carrying value.
(l) Concentration of Credit Risk
Statement of Financial Accounting Standards (SFAS) No.105, Disclosure
of Information About Financial Instruments with Off-Balance-Sheet Risk and
Financial Instruments with Concentrations of Credit Risk, requires
disclosure of any significant off-balance-sheet and credit risk
concentrations. Financial instruments that subject the Company to credit
risk consists primarily of trade accounts receivable. The Company had one
customer who accounted for approximately 24% of consolidated revenue for
the year ended December 31, 1996. The Company had no significant customers
in the years ended December 31, 1995 and 1994.
(m) Net Loss per Common and Common Equivalent Share
Net loss per common share was computed based on the weighted average
number of common shares outstanding. The Company's net loss was increased
by $1,074,744 and $223,905 for the years ended December 31, 1996 and 1995,
respectively, for accretion of dividends and discount on redeemable
preferred stock to determine the loss applicable to common stock. Common
equivalent shares are not included in the per share calculations as the
effect of their inclusion would be antidilutive.
On March 3, 1997, the Financial Accounting Standards Board (FASB)
issued SFAS No. 128, Earnings per Share. SFAS No. 128 establishes standards
for computing and presenting earnings per share and applies to entities
with publicly held common stock or potential common stock. This statement
is effective for fiscal years ending after December 15, 1997, and early
adoption is not permitted. When adopted, the statement will require
restatement of prior years' earnings per share. The Company believes that
the adoption of SFAS No. 128 will not have a material effect on its
financial statements.
2. INCOME TAXES
The Company provides for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes. Under SFAS No. 109, deferred tax assets and
liabilities are recognized based on temporary differences between the
financial statement and tax bases of assets and liabilities using currently
enacted statutory rates. The Company's gross deferred tax asset of
$1,360,000 consists principally of the net operating loss carryforwards of
approximately $3,200,000. Due to the uncertainty related to the realization
of future tax return benefits of the gross deferred tax asset, a full
valuation allowance has been provided.
The United States Tax Reform Act of 1986 contains provisions that may
limit the Company's net operating loss and credit carryforwards available
to be used in any given year in the event of significant changes in the
ownership interests of significant stockholders. The Company has completed
several financings since its inception and may have incurred ownership
changes, as defined in the Tax Reform Act of 1986. The Company believes
that the ownership changes will not significantly impact its ability to
utilize its net operating loss and credit carryforwards.
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10
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
3. DEBT
(a) Subordinated Notes Payable to Stockholders
During 1994, the Company issued $195,000 of subordinated promissory notes
payable to certain stockholders. The notes were issued in conjunction with the
Company's 1994 private placement offering of its common stock and bear interest
at 10% per year, payable semiannually. During 1995, the Company repurchased
25,036 shares of common stock and a $37,500 subordinated note payable held by a
stockholder for $87,500, including accrued interest. These notes are unsecured
and subordinate to all present and future senior debt issuances. The outstanding
principal of $157,500 was due on February 28, 1997. These amounts and accrued
interest of $184,721 were repaid on May 24, 1997, the closing date on sale of
the Company (see Note 9). Accordingly, these amounts have been classified as a
current liability as of December 31, 1996, in the accompanying consolidated
financial statements.
(b) Lines of Credit
On September 8, 1995, the Company entered into a credit facility (the
facility) with a bank, which provided for a $250,000 working capital line of
credit. This line of credit expired on September 8, 1996. Advances under this
line of credit bore interest at prime plus 1%. In addition, the facility
provides for a $500,000 equipment line of credit. Advances under this line of
credit bear interest at prime (8.25% at December 31, 1996) plus 2%. Principal
payments are due in monthly installments on the first business day of each
calendar month commencing August 5, 1996, with the final installment due on
December 1, 1999. The Company was required to comply with certain operational
and financial covenants under this credit facility. The financial covenants
required certain minimum levels of profitability, tangible net worth and
liquidity. At December 31, 1996, the Company was in default of certain of these
covenants.
On January 31, 1997, the facility was amended eliminating the existing
financial covenants and providing for one liquidity covenant. This liquidity
covenant provides that the Company shall maintain, as of the last calendar day
of each month, at least $600,000 of cash or cash equivalents. The Company was in
compliance with this covenant on January 31, 1997.
4. STOCKHOLDERS' EQUITY (DEFICIT)
(a) Common Stock
In connection with the Company's private placement offering of its common
stock and subordinated notes payable, the Company had committed to certain
levels of annual internal rate of return on each combined debt and equity unit
within three years from the completion of the offering in December 1994. In
connection with the September 15, 1995 preferred stock offering, the holders
have terminated their rights with respect to the Company's commitment to
achieving these levels.
(b) Stock Option Plan
In December 1994, the Board of Directors approved the SmarTel
Communications, Inc. 1994 Stock Incentive Plan (the Plan) pursuant to which
options to purchase up to 82,500 shares of common stock may be granted to
directors, officers and other employees of the Company. Incentive stock options
may be granted under the Plan at a price not less than the fair market value on
the date of grant. Options vest over a two-year period and expire 10 years from
the date of grant. In connection with the September 15, 1995 preferred stock
offering, the Plan was amended to provide that no additional options be granted
thereunder.
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11
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
4. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
The following table summarizes option activity under the Plan:
WEIGHTED
AVERAGE
NUMBER OF EXERCISE PRICE EXERCISE
OPTIONS PER SHARE PRICE
Granted and Outstanding, December 31, 1994.......... 24,500 $0.50-$2.00 $ 1.69
Granted........................................... 5,000 2.00 2.00
Canceled.......................................... (1,000) 2.00 2.00
------- ----------- ------
Outstanding, December 31, 1995...................... 28,500 0.50-2.00 1.73
Granted........................................... -- -- --
Canceled.......................................... (10,000) 0.50-2.00 1.25
------- ----------- ------
Outstanding, December 31, 1996...................... 18,500 $ 2.00 $ 2.00
======= =========== ======
Exercisable, December 31, 1996...................... 18,000 $ 2.00 $ 2.00
======= =========== ======
The weighted average fair value of options granted during the year ended
December 31, 1995 was $.51. There were no options granted during 1996.
In October 1995, the Financial Accounting Standards Board issued SFAS No.
123, Accounting for Stock-Based Compensation, which requires the measurement of
the fair value of stock options or warrants to be included in the statement of
operations or disclosed in the notes to the financial statements. The Company
has determined that it will continue to account for stock-based compensation for
employees under Accounting Principles Board Opinion No. 25 and elect the
disclosure-only alternative under SFAS No. 123 for options granted in 1995 and
1996 using the Black-Scholes option pricing model prescribed by SFAS No. 123.
The total value of options granted during the years ended December 31, 1996 and
1995 was not significant.
(c) Common Stock Warrants
In connection with the September 15, 1995 preferred stock offering, the
Company granted warrants to purchase up to 1,507,968 shares of common stock to
stockholders holding 3,002 shares of preferred stock. The warrants are
exercisable at $.001 per share and expire on September 15, 2002. During 1995
warrants to purchase 789,888 shares of common stock were exercised. No warrants
were exercised in 1996. Warrants to purchase up to 718,080 shares of common
stock are outstanding at December 31, 1996. At any time on or after the date of
the sale of the Company, liquidation of the Company or September 15, 2002,
whichever occurs first, the warrant holders may put back the outstanding
warrants and common shares to the Company at the then current fair market value
of the common stock. However, if the Company redeems the warrant holder's
preferred stock in cash prior to September 15, 2002 a portion of the warrants
become unexercisable, as defined. The Company assigned the fair value,
calculated using the Black-Scholes option pricing model, of $1,507,004 to the
warrants as a component of additional paid-in capital in the accompanying
financial statements.
(d) Preferred Stock Dividend on Common Stock
In conjunction with the issuance of redeemable preferred stock, the
Company's Board of Directors authorized the issuance of up to 1,000 shares and
declared a dividend on the Company's outstanding common stock for an aggregate
of 1,000 shares of redeemable preferred stock, which were allocated to common
stockholders based on each common stockholder's ownership percentage. In 1995,
908 of these shares were issued, and the 92 remaining shares were issued on May
24, 1997.
11
12
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
5. RELATED PARTY TRANSACTIONS
During 1994, the Company received advances of $62,500 from parties related
to corporate officers. These advances were repaid in 1995.
The Company has a business relationship with an independent distributor who
was also a stockholder in one of the Company's subsidiaries (see Note 1(i)).
During the years ended December 31, 1996 and 1995, the Company entered into
arrangements for promotional cards totaling approximately $903,000 and
$1,542,000, respectively, with this distributor. In connection with these
arrangements, the Company paid approximately $118,000 and $296,000 of
commissions to this independent distributor. As of December 31, 1995 and 1996,
the Company believes it has amounts due of $390,000 and $150,000, respectively,
from this distributor. This relationship was terminated in June 1996 and the
Company has commenced legal action against this distributor to collect these
amounts. Therefore, the Company has provided a full reserve for these amounts in
the accompanying financial statements as of December 31, 1995 and 1996,
respectively.
On May 24, 1997, the Company reached a settlement agreement with this
distributor/stockholder. Under the terms of the settlement, the Company forgave
its claim on all amounts due from the distributor/stockholder in exchange for
the return of the distributor/stockholder's preferred stock to the Company.
6. REDEEMABLE PREFERRED STOCK
During 1995, the Company authorized the issuance of up to 4,002 shares of
redeemable preferred stock, $.001 par value, and issued 3,002 shares of
preferred stock for $1,000 per share and issued 908 shares of preferred stock as
a stock dividend to the common stockholders. At December 31 1996, 92 shares of
preferred stock remain issuable. The rights and preferences of the redeemable
preferred stock are as follows.
(a) Voting
Redeemable preferred stockholders are not entitled to vote, except for
matters required by law, including, but not limited to, matters involving
alterations of rights and preferences of capital stock; merger or sale of
the Company; issuance of capital stock or rights to capital stock, which
are senior to preferred stockholders; purchase or redemption of capital
stock, other than certain preferred stock or capital stock, as defined; or
alteration of the Company's bylaws or Certificate of Incorporation.
(b) Dividends
Preferred stockholders are entitled to receive cumulative annual
dividends, when, as and if declared by the Board of Directors, at the
annual rate of 3% of the base amount of each share of redeemable preferred
stock. The base amount of preferred stock as of a particular date shall be
an amount equal to the sum of $1,000 plus any unpaid dividends on such
share added to the base amount of such share and not thereafter paid. The
Company recorded $120,030 and $33,989 of dividend accretion on the
outstanding shares of preferred stock for the years ended December 31, 1996
and 1995, respectively.
(c) Liquidation Rights
In certain events, including liquidation, dissolution or winding up of
the Company, the holders of preferred stock shall be entitled, before any
distribution or payment is made upon any shares of common stock, to be paid
in cash an amount equal to the base amount of such share on such date, plus
all unpaid dividends accrued on such share and not previously added to the
base amount. If the assets of the Company shall be insufficient to permit
payment in full to the holders of the preferred stock, then the entire
assets of the Company that are available for distributions shall be
distributed ratably among the preferred stockholders.
12
13
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
6. REDEEMABLE PREFERRED STOCK (CONTINUED)
(d) Redemption
The preferred stock is redeemable at the option of the Company, or at
the option of the redeemable preferred stockholders, in three equal annual
installments, beginning on August 31, 2000, unless redeemed earlier in
connection with a liquidity event, as defined. The redemption price will
equal $1,000 per share plus all accrued and unpaid dividends as of the
redemption date. The proceeds from the issuance of the 3,002 shares of
preferred stock for $1,000 per share have been allocated, based on the
relative fair value, to the preferred stock and the warrants to purchase
common stock issued to these preferred stockholders. The value attributable
to the warrants issued to purchase common stock resulted in a $1,507,004
discount to the preferred stock. The Company has accreted this discount to
the preferred stock over the redemption period (see Note 9). The Company
recorded $957,474 and $190,491 of accretion on the discount of the 3,002
shares of preferred stock for the years ended December 31, 1996 and 1995,
respectively.
If for any reason the Company shall fail to redeem for cash all
preferred shares requested to be redeemed by the holders thereof within 30
days of notice, each preferred stockholder shall have the right to require
the Company to purchase some or all of the preferred shares at a price
equal to the redemption price on such date. To the extent the Company does
not have cash available or is not legally permitted to make such payments,
the preferred stockholders will loan to the Company and its subsidiaries
additional amounts necessary to fund the repurchase. The resulting
preferred notes shall be secured by all assets of the Company and its
subsidiaries and will bear interest at prime plus 2%. The notes will be
repaid quarterly based on available cash.
7. COMMITMENTS
(a) Lease Commitments
The Company leases its facility and certain equipment under operating lease
agreements expiring through fiscal 2000. Future minimum rental payments due
under these agreements are approximately as follows:
YEAR AMOUNT
1997...................................... $142,000
1998...................................... 136,000
1999...................................... 110,000
2000...................................... 65,000
--------
$453,000
========
Total rental expense included in the accompanying consolidated statements
of operations amounted to approximately $125,000 and $31,000 for the years ended
December 31, 1996 and 1995, respectively. During 1994, the Company leased its
facilities and certain office equipment from an entity controlled by a related
party to the officers and directors of the corporation. During 1994, the Company
incurred approximately $75,000 in rental charges to this entity.
(b) Litigation
In the ordinary course of business, the Company is party to various types
of litigation. The Company believes it has meritorious defense to all claims,
and, in its opinion, all litigation currently pending or threatened will not
have a material effect on the Company's financial position on results of
operations.
13
14
SMARTEL COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
8. ACQUISITION OF GLOBAL MEDIA NETWORK
On December 21, 1995, the Company acquired certain assets of Global Media
Network (GMN), previously its west coast distributor, in exchange for a $15,000
note payable and the assumption of certain GMN liabilities totaling $67,673.
This transaction was accounted for as a purchase and, accordingly, the
results of GMN since December 21, 1995 have been included in the accompanying
consolidated financial statements. The aggregate purchase price has allocated
based on the fair value of the tangible and intangible assets as follows:
Current assets............................. $16,269
Property and equipment..................... 4,674
Purchased intangible assets................ 61,730
-------
$82,673
=======
Included in purchased intangible assets are amounts related to trade names
and customer lists. These intangibles will be amortized on a straight-line basis
over their estimated useful life of three years. The 1995 results of GMN
operations were not material to the financial statements taken as a whole.
During 1995, the Company entered into arrangements for promotional cards
totaling approximately $479,000 with GMN prior to December 21, 1995. In
connection with these arrangements, the Company paid approximately $142,000 in
commissions to GMN.
9. SALE OF COMPANY TO SMARTALK TELESERVICES, INC.
On May 24, 1997, the Company entered into a merger agreement (the "Merger")
with SmarTalk TeleServices, Inc. (SmarTalk) in which SmarTalk acquired all
outstanding common and preferred stock of the Company in a tax-free,
stock-for-stock merger transaction. Under the terms of the Merger, SmarTel
common and preferred stockholders received 714,286 shares of SmarTalk common
stock, which, using a SmarTalk per share value of $14, had an approximate value
of approximately $10,000,000. In addition, certain officers/stockholders of
SmarTel received contingent value rights which would entitle them to receive
additional shares of SmarTalk common stock based on SmarTel's future sales and
profitability.
14