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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2005
Commission File Number: 0-21683
----------------------
GraphOn Corporation
(Exact name of Registrant as specified in its charter)
----------------------
Delaware 13-3899021
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
5400 Soquel Avenue, Suite A2
Santa Cruz, CA 95062
(Address of principal executive offices)
Registrant's telephone number: (800) 472-7466
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an
accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [ ] No [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of November 14, 2005, there were issued and outstanding 46,167,047
shares of the Registrant's Common Stock, par value $0.0001.
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GRAPHON CORPORATION
FORM 10-Q
Table of Contents
Page
PART I.FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2005
(unaudited) and December 31, 2004 2
Unaudited Condensed Consolidated Statements of Operations and
Comprehensive Income (Loss) for the three months ended
September 30, 2005 and 2004 and for the nine months ended
September 30, 2005 and 2004 3
Unaudited Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 2005 and 2004 4
Notes to Unaudited Condensed Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk 24
Item 4. Controls and Procedures 25
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 25
Item 6.Exhibits 25
Signatures 26
PART I--FINANCIAL INFORMATION
ITEM 1 Financial Statements
GRAPHON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2005 2004
ASSETS ------------- ------------
------------ (Unaudited)
Current Assets:
Cash and cash equivalents ..................... $ 3,125,900 $ 675,300
Accounts receivable, net of allowance for
doubtful accounts of $62,000 and $46,800 ..... 459,200 518,900
Prepaid expenses and other current assets ..... 10,300 24,100
------------ ------------
Total Current Assets .......................... 3,595,400 1,218,300
------------ ------------
Property and equipment, net ...................... 93,500 75,400
Capitalized software, net ........................ 128,500 273,700
Patents, net ..................................... 4,827,400 --
Deferred acquisition costs ....................... -- 269,700
Note receivable - related party .................. -- 350,000
Other assets ..................................... 9,400 37,300
------------ ------------
TOTAL ASSETS ................................ $ 8,654,200 $ 2,224,400
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current Liabilities:
Accounts payable .............................. $ 122,900 $ 250,200
Accrued expenses .............................. 231,100 231,400
Accrued wages ................................. 327,400 260,100
Deferred revenue .............................. 818,800 689,800
------------ ------------
Total Current Liabilities ..................... 1,500,200 1,431,500
Deferred revenue .............................. 567,400 426,600
------------ ------------
TOTAL LIABILITIES ........................... 2,067,600 1,858,100
------------ ------------
Commitments and contingencies
Stockholders' Equity:
Preferred stock, $0.01 par value, 5,000,000 shares
authorized, no shares issued and outstanding .... -- --
Common stock, $0.0001 par value, 195,000,000
shares authorized, 46,167,047 and 21,716,765
shares issued and outstanding ................... 4,600 2,200
Additional paid in capital ....................... 58,397,500 46,930,700
Deferred Compensation ............................ (6,900) --
Notes receivable - directors ..................... -- (50,300)
Note receivable - shareholder .................... (347,400) --
Accumulated other comprehensive loss ............. -- (400)
Accumulated deficit .............................. (51,461,200) (46,515,900)
------------ ------------
TOTAL STOCKHOLDERS' EQUITY .................. 6,586,600 366,300
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .. $ 8,654,200 $ 2,224,400
============ ============
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
2
GRAPHON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
Revenue:
Product licenses .............................. $ 829,700 $ 568,800 $ 2,666,900 $ 1,645,800
Service fees .................................. 338,000 257,700 939,400 751,700
Other ......................................... 8,700 105,000 26,300 114,300
------------ ------------ ------------ ------------
Total Revenue .............................. 1,176,400 931,500 3,632,600 2,511,800
------------ ------------ ------------ ------------
Cost of Revenue:
Product costs ................................. 53,000 60,000 156,800 517,100
Service costs ................................. 62,300 87,100 210,200 244,800
------------ ------------ ------------ ------------
Total Cost of Revenue ...................... 115,300 147,100 367,000 761,900
------------ ------------ ------------ ------------
Gross Profit ............................... 1,061,100 784,400 3,265,600 1,749,900
------------ ------------ ------------ ------------
Operating Expenses:
Selling and marketing ......................... 337,100 356,700 1,014,000 1,119,500
General and administrative .................... 756,900 357,000 2,252,000 869,700
Research and development ...................... 333,200 366,800 969,900 1,226,400
------------ ------------ ------------ ------------
Total Operating Expenses ...................... 1,427,200 1,080,500 4,235,900 3,215,600
------------ ------------ ------------ ------------
Loss From Operations .......................... (366,100) (296,100) (970,300) (1,465,700)
------------ ------------ ------------ ------------
Other Income (Expense):
Interest and other income .................. 10,200 2,500 30,000 9,000
Interest and other expense ................. (3,500) -- (5,000) --
------------ ------------ ------------ ------------
Total Other Income ......................... 6,700 2,500 25,000 9,000
------------ ------------ ------------ ------------
Net Loss ...................................... (359,400) (293,600) (945,300) (1,456,700)
Other Comprehensive Income (Loss), net of tax:
Foreign currency translation gain (loss) ... -- (100) -- 400
------------ ------------ ------------ ------------
Comprehensive Loss ............................ (359,400) (293,700) (945,300) (1,456,300)
Deemed dividends on preferred stock ........... -- -- (4,000,000) --
------------ ------------ ------------ ------------
Loss Attributable to Common Shareholders ...... $ (359,400) $ (293,700) $ (4,945,300) $ (1,456,300)
============ ============ ============ ============
Basic and Diluted Loss per Common Share ....... $ (0.01) $ (0.01) $ (0.12) $ (0.07)
============ ============ ============ ============
Weighted Average Common Shares Outstanding .... 46,158,786 21,679,723 40,373,157 21,218,971
============ ============ ============ ============
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
3
GRAPHON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30,
2005 2004
------------ ------------
(Unaudited) (Unaudited)
Cash Flows From Operating Activities:
Net loss .............................................. $ (945,300) $ (1,456,700)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization ...................... 777,300 596,000
Amortization of deferred compensation .............. 2,000 --
Provision for doubtful accounts .................... 15,200 --
Proceeds from notes receivable - directors .......... 50,300 --
Proceeds from note receivable - shareholder ......... 2,600 --
Interest accrued on notes receivable - directors ... (300) (1,400)
Interest accrued on note receivable - shareholder .. (9,600) --
Proceeds from interest accrued on notes receivable -
directors ........................................ 4,300 --
Proceeds from interest accrued on note receivable -
Shareholder ...................................... 1,200 --
Changes in operating assets and liabilities:
Accounts receivable ................................ 44,500 (17,200)
Prepaid expenses and other current assets .......... 13,800 6,000
Accounts payable ................................... 12,100 33,400
Accrued expenses ................................... (38,600) (144,300)
Accrued wages ...................................... 67,300 63,500
Deferred revenue ................................... 269,800 56,600
------------ ------------
Net Cash Provided By (Used In) Operating Activities ... 266,600 (864,100)
------------ ------------
Cash Flows From Investing Activities:
Cash paid for NES acquisition ......................... (697,500) --
Capital expenditures .................................. (55,500) (33,400)
Other assets .......................................... (4,600) 5,200
------------ ------------
Net Cash Used In Investing Activities .............. (757,600) (28,200)
------------ ------------
Cash Flows From Financing Activities:
Proceeds from private placement
of preferred stock and warrants ...................... 3,335,000 1,150,000
Costs of private placement of preferred stock
and warrants ......................................... (402,000) (215,200)
Proceeds from sale of common stock under
employee stock purchase plan ......................... 10,000 9,000
Proceeds from exercise of warrants .................... -- 6,900
------------ ------------
Net Cash Provided By Financing Activities .......... 2,943,000 950,700
------------ ------------
Effect of exchange rate fluctuations on cash and
cash equivalents ................................... (1,400) 400
------------ ------------
Net Increase in Cash and Cash Equivalents ............. 2,450,600 58,800
Cash and Cash Equivalents, beginning of period ........ 675,300 1,025,500
------------ ------------
Cash and Cash Equivalents, end of period .............. $ 3,125,900 $ 1,084,300
============ ============
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
4
GRAPHON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The unaudited condensed consolidated financial statements of GraphOn
Corporation (the Company) and its subsidiaries included herein have been
prepared in accordance with the instructions for Form 10-Q and, therefore, do
not include all information and footnotes necessary for a complete presentation
of the Company's results of operations, financial position and cash flows.
The unaudited condensed consolidated financial statements included herein
reflect all adjustments (which include only normal, recurring adjustments in the
three and nine-month periods ended September 30, 2005 and 2004) that are, in the
opinion of management, necessary to state fairly the results for the periods
presented. This Quarterly Report on Form 10-Q should be read in conjunction with
the Company's audited financial statements contained in the Company's Annual
Report on Form 10-K for the year ended December 31, 2004, which was filed with
the Securities and Exchange Commission (the Commission) on April 15, 2005. The
interim results presented herein are not necessarily indicative of the results
of operations that may be expected for the full fiscal year ending December 31,
2005, or any future period.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. These estimates include the allowance for
doubtful accounts, the estimated lives of intangible assets, depreciation of
fixed assets and accrued liabilities, among others. Actual results could differ
materially from those estimates.
Significant intercompany accounts and transactions are eliminated upon
consolidation.
2. Patents (Network Engineering Software Acquisition).
On January 31, 2005, the Company acquired all of the outstanding common stock
of Network Engineering Software ("NES") in exchange for 9,599,993 shares of the
Company's common stock, valued at $3,916,800, and approximately $897,800 in cash
payments to settle various claims against NES prior to the acquisition.
Approximately $665,000 of the $897,800 cash payments was made in December
2004 by AIGH Investment Partners, LLC ("AIGH"), an affiliate of a principal
stockholder (Orin Hirschman), to settle, on the Company's behalf, certain third
party litigation against NES. The Company reimbursed this amount through a
partial credit against the price of our securities acquired by AIGH in the 2005
private placement (See Note 3).
The Company incurred $563,500 of transaction costs, resulting in a purchase
price of $5,378,100. The acquisition was accounted for as a business
combination. Accordingly, the assets acquired (primarily consisting of patents,
patent applications, and in-process patent applications) have been recorded at
their estimated fair value.
In connection with the acquisition, the Company recorded a deferred tax
liability of $2,151,200, resulting from a difference between the tax basis and
5
financial statement basis of the assets acquired. Furthermore, the Company has
recorded a corresponding $2,151,200 reduction in its valuation allowance on its
deferred tax assets as of March 31, 2005 to reflect management's estimate that
it is more likely than not that the Company will realize the tax benefits from
utilization of certain of its tax net operating loss carryforwards from future
reversals of the taxable temporary differences arising from the NES acquisition.
These amounts have been netted together on the Company's condensed balance
sheet.
The estimated cost of the patent related assets is being amortized over a
6-year period using the straight-line method. For the three and nine-month
periods ended September 30, 2005, approximately $224,200 and $594,700 of
amortization was charged against the cost of the patent related assets. No such
amortization was charged in the corresponding periods of the prior year. The
estimated cost of these assets and their estimated useful lives may change as a
result of the completion of a valuation study and as all direct acquisition
costs are finalized. The final adjustments to the estimated costs of these
assets are not expected to be material.
As of December 31, 2004, prior to the consummation of the acquisition, the
Company had deferred approximately $269,700 of the acquisition costs. These
deferred acquisition costs are included in the transaction costs above.
The following unaudited pro forma information presents the consolidated
results of the Company as if the NES acquisition had occurred at the beginning
of the respective periods. The pro forma information is not necessarily
indicative of what would have occurred had the acquisition been made as of such
period, nor is it indicative of future results of operations. The pro forma
amounts give effect to appropriate adjustments for the fair value of the
patents, amortization and income taxes.
Nine Months Ended September 30,
2005 2004
-------------- --------------
Revenue $ 3,632,600 $ 2,511,800
Net loss (1,051,400) (2,668,800)
Net loss attributable to
common shareholders (5,051,400) (6,668,800)
Loss per share - basic and
diluted (0.11) (0.14)
3. Stockholders' Equity
During the first quarter of 2005, the Company issued 15,489 shares of common
stock to employees under provisions of the Employee Stock Purchase Plan (the
ESPP), resulting in cash proceeds of approximately $4,600.
During the first quarter of 2005, the Company completed a private placement
(the "2005 Private Placement"), which, after the Company's stockholders approved
an amendment to the Company's Certificate of Incorporation, resulted in the
issuance of 14,814,800 shares of common stock and gross cash proceeds of
approximately $3,335,000, net of the $665,000 credit issued to AIGH (See Note 2
and Note 9)).
Also during the first quarter of 2005, the Company issued 9,599,993 shares of
common stock, with a value of $3,916,800, to consummate its acquisition of NES
(See Note 2).
During the first quarter of 2005, the Company reclassified note receivable -
third party from the long-term assets section of its balance sheet to the equity
section under the title note receivable - shareholder to reflect the replacement
of the NES stock that had been collateralizing the note, as of December 31,
2004, with Company stock, upon the consummation of the acquisition of NES (See
Note 2) on January 31, 2005.
During the first quarter of 2005, the Company received an aggregate of
approximately $54,600 as payment in full of the principal and accrued interest
due from the notes receivable - directors.
During the third quarter of 2005, the Company issued 20,000 shares of common
6
stock to employees under provisions of the ESPP, resulting in cash proceeds of
approximately $5,400.
4. Litigation
The Company is currently not involved in any litigation that it believes
would have a materially adverse affect upon its financial results or financial
position.
5. Stock-Based Incentive Programs
The Company accounts for stock-based compensation under the intrinsic value
method of accounting for stock awards, in accordance with Accounting Principles
Board Opinion number 25, "Accounting for Stock Issued to Employees" (APB 25) as
permitted by Statement of Financial Accounting Standards number 123,
"Stock-Based Compensation" (SFAS 123). The Company has not changed to the fair
value method of accounting for stock-based employee compensation. Had the
Company applied the fair value recognition provisions of SFAS 123 to stock-based
compensation, the Company's net loss and basic and diluted loss per share would
have been changed from the "as reported" amounts to the "pro forma" amounts as
follows for each of the respective periods:
Three months ended
September 30,
---------- ----------
2005 2004
Net loss:
As reported: $ (359,400) $ (293,600)
Add: stock-based compensation expense
included in net loss, net of related
tax effects 500 -
Deduct: total stock-based compensation
expense determined under fair-value
method for all awards, net of related
tax effects (122,600) (51,000)
---------- ----------
Pro forma net loss attributable
to common shareholders: $ (481,500) $ (344,600)
========== ==========
Basic and diluted loss per share:
As reported $ (0.01) $ (0.01)
Pro forma $ (0.01) $ (0.02)
Nine months ended
September 30,
2005 2004
------------ ------------
Net loss:
As reported: $ (945,300) $ (1,456,700)
Less: Deemed dividends on
preferred stock (4,000,000) -
7
Add: stock-based compensation expense
included in net loss, net of related
tax effects 2,000 -
Deduct: total stock-based compensation
expense determined under fair-value
method for all awards, net of related
tax effects (316,900) (232,600)
------------ ------------
Pro forma net loss attributable
to common shareholders: $ (5,260,200) $ (1,689,300)
============ ============
Basic and diluted loss per share:
As reported $ (0.11) $ (0.07)
Pro forma $ (0.11) $ (0.08)
6. Commitments and Contingencies
In October 2004, the Company renewed its operating lease for an approximate
3,300 square foot facility in New Hampshire. This lease is cancelable by the
landlord or the Company upon 30-days written notice. Monthly rental payments for
this facility are approximately $5,300.
The Company currently occupies approximately 1,900 square feet of office
space in Santa Cruz, California. The office space is rented pursuant to a
three-year operating lease, which became effective August 1, 2005. Rent on this
facility will approximate $2,900 per month over the course of the lease. The
Company has an option to extend the lease term for one additional three-year
period.
The Company has been occupying leased facilities in Rolling Hills Estates,
California, on a month-to-month basis since October 2002. Rent on this facility
is approximately $1,000 per month.
The Company has also been renting an office in Berkshire, England, United
Kingdom since December 2002. This operating lease runs through December 2005.
Rent on this office, which can fluctuate depending on exchange rates, is
approximately $400 per month.
As a condition of a private placement that occurred during January 2004 (the
"2004 private placement"), the Company entered into an Investment Advisory
Agreement with Orin Hirschman, a significant stockholder of the Company,
pursuant to which it was agreed that in the event the Company completes a
transaction with a third party introduced by Mr. Hirschman, the Company shall
pay to Mr. Hirschman 5% of the value of that transaction. The agreement, as
amended, expires on January 29, 2008.
7. Supplemental Disclosure of Cash Flow Information
The Company disbursed no cash for the payment of income taxes during either
the three or nine-month periods ended September 30, 2005 or 2004. The Company
disbursed approximately $2,600 for the payment of interest expense during the
three and nine-month period ended September 30, 2005. The Company disbursed no
cash for the payment of interest during the three or nine-month periods ended
September 30, 2004.
In conjunction with its acquisition of NES (See Note 2), the Company issued
9,599,993 shares of its common stock, with a value of $3,916,800.
As of December 31, 2004, the Company had capitalized approximately $179,500
and $31,000 of deferred acquisition costs, related to the NES acquisition, that
8
were included in accounts payable and accrued expenses, respectively.
Additionally, the Company accrued approximately $32,500 of deferred financing
costs, related to the 2005 private placement, as other assets, as of December
31, 2004.
As of September 30, 2005, the Company had capitalized approximately $0 and
$81,800 of costs, related to the NES acquisition, that were included in accounts
payable and accrued expenses, respectively. Additionally, as of September 30,
2005, the Company included approximately $20,000 and $40,100 of costs, related
to the 2005 private placement, in accrued expenses and accounts payable,
respectively.
8. Loss Per Share
Potentially dilutive securities have been excluded from the computation of
diluted loss per common share, as their effect is antidilutive. For the quarters
ended September 30, 2005 and 2004, 19,022,157 and 6,043,951 shares,
respectively, of common stock equivalents were excluded from the computation of
diluted loss per share since their effect would be antidilutive.
9. Deemed Dividends on Preferred Stock
On February 2, 2005, the Company completed the 2005 Private Placement, which
raised a total of $4,000,000 (inclusive of the $665,000 credit issued to AIGH,
see Note 2) through the sale of 148,148 shares of Series A preferred stock and
five-year warrants to purchase 74,070 shares of Series B preferred stock.
The deemed fair value of the Series A preferred stock was estimated based on
the market price and underlying number of common shares they would have
converted into had the conversion occurred immediately upon their issuance. The
market price for the Company's common stock on on the commitment date of the
2005 private placement was $0.46 and the Series A preferred stock would have
converted into 14,814,800 common shares, thus deriving an estimated fair value
of approximately $6,814,800 at that date.
The fair value of the warrants was estimated to be $1,877,700 and was
calculated using the Black-Scholes option pricing model with the following
weighted average assumptions: a risk free interest rate of 1.5%, a volatility
factor of 60%, a dividend yield of 0% and a five year contractual life.
Based on the relative fair values of the Preferred Shares and the warrants at
the time of their issuance, the Company allocated $3,136,000 of the $4,000,000
proceeds of the 2005 Private Placement to the Preferred Shares and $864,000 to
the warrants.
The Preferred Shares issued by the Company contained a non-detachable
conversion feature (the "Beneficial Conversion Feature") that was in-the-money
upon completion of the 2005 Private Placement, in that the deemed fair value of
Common Stock into which the Preferred Shares could be converted exceeded the
allocated value of $3,136,000 by $3,678,800 (using the intrinsic value method).
This discount resulting from recording the Beneficial Conversion Feature was
limited to the allocated proceeds of $3,136,000 and has been recognized as if
this amount had been declared a non-cash dividend to the preferred shareholders
during the quarter ended March 31, 2005.
Additionally, the approximate $864,000 discount resulting from the allocation
of the proceeds of the 2005 Private Placement on a relative fair value basis to
the Series A preferred shares and the warrants issued in the 2005 Private
Placement has also been recognized as if this amount had been declared a
9
non-cash dividend to the preferred shareholders during the quarter ended March
31, 2005.
10. New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS
No. 123R, "Share-Based Payment," which requires companies to expense the value
of employee stock options and similar awards. As of the effective date, the
Company will be required to expense all awards granted, modified, cancelled or
repurchased as well as the portion of prior awards for which the requisite
service has not yet been rendered, based on the grant-date fair value of those
awards as calculated for pro forma disclosures under SFAS No. 123. The Company
will apply SFAS No. 123R using a modified version of prospective application.
Under this method, compensation cost is recognized on or after the required
effective date for the portion of outstanding awards for which the requisite
service has not yet been rendered, based on the grant-date fair value of those
awards calculated under SFAS No. 123 for either recognition or pro forma
disclosures. The Company expects to adopt Statement 123(R) on January 1, 2006.
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Forward-Looking Statements
The following discussion of our financial condition and results of operations
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Actual results and the timing of certain events could differ materially from
those anticipated in these forward-looking statements as a result of certain
factors. Such factors, including:
o our history of operating losses, and expectation that those losses will
continue;
o the uncertainty as to whether or not we will realize the anticipated
benefits of acquiring NES;
o that a significant portion of our revenue has been and continues to be
earned from a very limited number of significant customers;
o that our stock price has been volatile and you could lose your investment;
and
o other factors set forth under "Risk Factors" in our Annual Report on
Form 10-K for the year ended December 31, 2004 and in other documents we
filed with the Securities and Exchange Commission, could have a material
adverse effect upon our business, results of operations and financial
condition.
Overview
We are developers of business connectivity software, including Unix, Linux
and Windows server-based software, with an immediate focus on web-enabling
applications for use by independent software vendors (ISVs), application service
providers (ASPs), corporate enterprises, governmental and educational
institutions, and others.
Server-based computing, sometimes referred to as thin-client computing, is a
computing model where traditional desktop software applications are relocated to
run entirely on a server, or host computer. This centralized deployment and
10
management of applications reduces the complexity and total costs associated
with enterprise computing. Our software architecture provides application
developers with the ability to relocate applications traditionally run on the
desktop to a server, or host computer, where they can be run over a variety of
connections from remote locations to a variety of display devices. With our
server-based software, applications can be web enabled, without any modification
to the original application software required, allowing the applications to be
run from browsers or portals. Our server-based technology can web-enable a
variety of Unix, Linux or Windows applications.
On January 31, 2005, we acquired NES, which is engaged in the development and
patenting of proprietary technologies relating to the submission, storage,
retrieval and security of information remotely accessed by computers, typically
through computer networks or the Internet. In a contemporaneous transaction, we
issued, in the 2005 private placement Series A Preferred Stock and warrants to
purchase Series B Preferred Stock.
These transactions are described in our Current Report on Form 8-K, filed
with the Securities and Exchange Commission (SEC) on February 4, 2005.
In order to ensure that we will be able to realize our assets and settle our
liabilities within the normal course of our business operations, we must
consider several aggressive strategic initiatives aimed at increasing revenue or
securing additional alternative sources of financing. If we were unsuccessful in
increasing revenues or finding additional alternative sources of financing, we
would face a severe constraint on our ability to sustain operations in a manner
that would create future growth and viability, and we may need to cease
operations entirely.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States of America
requires us to make judgments, assumptions and estimates that affect the amounts
reported in the Condensed Financial Statements and accompanying notes. Estimates
are used for, but not limited to, the accounting for the allowance for doubtful
accounts, revenue recognition, the impairment of intangible assets,
contingencies and other special charges and taxes. Actual results could differ
materially from these estimates. The following critical accounting policies are
impacted significantly by judgments, assumptions and estimates used in the
preparation of the Condensed Consolidated Financial Statements.
Revenue Recognition
Generally, software license revenues are recognized when a non-cancelable
license agreement has been signed and the customer acknowledges an unconditional
obligation to pay, the software product has been delivered, there are no
uncertainties surrounding product acceptance, the fees are fixed or determinable
and collection is considered probable. Delivery is considered to have occurred
when title and risk of loss have been transferred to the customer, which occurs
when the customer is given access to the licensed programs. If collectibility is
not considered probable, revenue is recognized when the fee is collected.
Revenue earned on software arrangements involving multiple elements is
allocated to each element arrangement based on the relative fair values of the
elements. If there is no evidence of the fair value for all the elements in a
11
multiple element arrangement, all revenue from the arrangement is deferred until
such evidence exists or until all elements are delivered. We recognize revenue
from the sale of software licenses when all the following conditions are met:
o Persuasive evidence of an arrangement exists;
o Delivery has occurred or services have been rendered;
o Our price to the customer is fixed or determinable; and
o Collectibility is reasonably assured.
Revenues recognized from multiple-element software arrangements are allocated
to each element of the arrangement based on the fair values of the elements,
such as licenses for software products, maintenance or customer training. The
determination of fair value is based on objective evidence. We limit our
assessment of objective evidence for each element to either the price charged
when the same element is sold separately or the price established by management
having the relevant authority to do so, for an element not yet sold separately.
If evidence of fair value of all undelivered elements exists but evidence does
not exist for one or more delivered elements, then revenue is recognized using
the residual method. Under the residual method, the fair value of the
undelivered elements is deferred and the remaining portion of the arrangement
fee is recognized as revenue.
Certain of our Independent Software Vendors ("ISVs"), Value-Added Resellers
("VARs") or Application Service Provider ("ASPs") customers (who we refer to as
"resellers") prepay for licenses they intend to resell. Upon receipt of the
prepayment, if all other revenue recognition criteria outlined above have been
met, we recognize licensing revenue when the reseller is given access to the
licensed programs. The resellers provide monthly sell-through reports that
detail, for the respective month, the number of licenses purchased from us, the
number they have sold to other parties, the ending balance of licenses they hold
as inventory available for future sale and in some cases certain information
pertaining to their customers such as customer name, licenses purchased,
purchase date and contact information. We monitor and reconcile the resellers'
inventory records to our records via the monthly sell-through reports.
Other resellers will only purchase licenses from us when they have already
closed a deal to sell the product(s) to another party. These resellers will
typically submit a purchase order in order to receive product that they can
deliver to their customer. In these cases, assuming all other revenue
recognition criteria, as set forth above, have been satisfied, we recognize
licensing revenue when the reseller has been given access to the licensed
programs. There are no rights of return granted to resellers or other purchasers
of our software programs.
We recognize revenue from service contracts ratably over the related contract
period, which generally ranges from 1-5 years.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is based on our assessment of the
collectibility of specific customer accounts and the aging of the accounts
receivable. If there is a deterioration of a major customer's credit worthiness
or actual defaults are higher than our historical experience, our estimates of
the recoverability of amounts due us could be adversely affected.
12
Capitalized Software Development Costs
Software development costs incurred in the research and development of new
products are expensed as incurred until technological feasibility, in the form
of a working model, has been established, at which time such costs are typically
capitalized until the product is available for general release to customers.
Capitalized costs are amortized based on either estimated current and future
revenue for the product or straight-line amortization over the shorter of three
years or the remaining estimated life of the product, whichever produces the
higher expense for the period.
Patents
The estimated cost of the patents and patent-related assets acquired in the
NES acquisition is being amortized over a 6-year period using the straight-line
method. The estimated cost of these assets and their estimated useful lives may
change as a result of the completion of a valuation study and as all direct
acquisition costs are finalized. The final adjustments to the estimated costs of
these assets are not expected to be material.
Impairment of Intangible Assets
We perform impairment tests on our intangible assets on an annual basis or
when circumstances indicate that a potential impairment may have occurred. In
response to changes in industry and market conditions, we may strategically
realign our resources and consider restructuring, disposing of, or otherwise
exiting businesses, which could result in an impairment of intangible assets.
Loss Contingencies
We are subject to the possibility of various loss contingencies arising in
the ordinary course of business. We consider the likelihood of the loss or
impairment of an asset or the incurrence of a liability as well as our ability
to reasonably estimate the amount of loss in determining loss contingencies. An
estimated loss contingency is accrued when it is probable that a liability has
been incurred or an asset has been impaired and the amount of the loss can be
reasonably estimated. We regularly evaluate current information available to us
to determine whether such accruals should be adjusted.
Stock Compensation
We apply Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock Issued to Employees" and related interpretations thereof (hereinafter
collectively referred to as APB 25) when accounting for our employee and
directors stock options and employee stock purchase plans. In accordance with
APB 25, we apply the intrinsic value method in accounting for employee stock
options. Accordingly, we generally recognize no compensation expense with
respect to stock-based awards to employees.
We have determined pro forma information regarding net income and earnings
per share as if we had accounted for employee stock options under the fair value
method as required by Statement of Financial Accounting Standards (SFAS) No.
123, "Accounting for Stock-Based Compensation" as amended by SFAS 148
(hereinafter collectively referred to as SFAS 123). The fair value of these
stock-based awards to employees was estimated using the Black-Scholes
13
option-pricing model. Had compensation cost for our stock option plans and
employee stock purchase plan been determined consistent with SFAS 123, our
reported net loss and net loss common per share would have been changed to the
amounts discussed elsewhere in this Form 10-Q.
Loss Per Share of Common Stock
Basic loss per share includes no dilution and is computed by dividing loss
attributable to common shareholders by the weighted-average number of common
shares outstanding for the period. Diluted loss per share reflects the potential
dilution of securities by adding other common stock equivalents, including
common stock options, warrants and redeemable convertible preferred stock, in
the weighted average number of common shares outstanding for a period, if
dilutive. Potentially dilutive securities have been excluded from the
computation, as their effect is antidilutive. For the quarters ended September
30, 2005 and 2004, 19,022,157 and 6,043,951 shares, respectively, of common
stock equivalents were excluded from the computation of diluted loss per share
since their effect would be antidilutive.
Results of Operations for the Three and Nine-Month Periods Ended September 30,
2005 Versus the Three and Nine-Month Periods Ended September 30, 2004.
Revenue
Product line revenue for the three-month periods ended September 30, 2005 and
2004, was as follows:
Change in
Product licenses 2005 2004 Dollars Percent
---------------- ----------- ----------- ------------ ---------
Windows $ 580,100 $ 284,900 $ 295,200 103.6%
Unix 249,600 283,900 (34,300) (12.1)
----------- ----------- ------------
829,700 568,800 260,900 45.9
----------- ----------- ------------
Service fees
Windows 174,100 126,900 47,200 37.2
Unix 163,900 130,800 33,100 25.3
----------- ----------- ------------
338,000 257,700 80,300 31.2
----------- ----------- ------------
Other (1) 8,700 105,000 (96,300) (91.7)
----------- ----------- ------------
Total Revenue $ 1,176,400 $ 931,500 $ 244,900 26.3%
=========== =========== ============
(1) Amortization of private labeling and other fees. Private labeling fees
are derived when we contractually agree to allow a customer to brand our
product with their name. We defer these fees upon contract signing and
recognize the revenue ratably over the initial term of the contract,
typically, three years. 2004 includes $100,000 from the sale of a software
developer's kit ("SDK"). SDKs allow customers to add value by integrating
additional software layers with our products.
Product line revenue for the nine-month periods ended September 30, 2005 and
2004, was as follows:
Change in
Product licenses 2005 2004 Dollars Percent
---------------- ------------ ------------ ------------ ---------
Windows $ 1,721,200 $ 893,800 $ 827,400 92.6%
Unix 945,700 752,000 193,700 25.8
------------ ------------ ------------
2,666,900 1,645,800 1,021,100 62.0
------------ ------------ ------------
Service fees
Windows 478,400 380,100 98,300 25.9
Unix 461,000 371,600 89,400 24.1
------------ ------------ ------------
939,400 751,700 187,700 25.0
------------ ------------ ------------
Other (1) 26,300 114,300 (88,000) (77.0)
------------ ------------ ------------
Total Revenue $ 3,632,600 $ 2,511,800 $ 1,120,800 44.6%
============ ============ ============
14
(1) Amortization of private labeling and other fees and the sale of a
software developer's kit.
The changes in both Windows and Unix-based product licenses revenue for the
three and nine-month periods ended September 30, 2005, as compared with the same
periods in 2004, were reflective of how such revenue varies because a
significant portion of this revenue has been, and continues to be earned from a
limited number of significant customers, most of whom are VARs. Consequently, if
any of these significant customers change their order level or fail to order
during the reporting period, our revenue could be materially adversely impacted.
We expect this situation to continue throughout 2005.
During the three-month period ended September 30, 2005, three of our
significant Windows customers purchased approximately an aggregate $208,100 more
product licenses than they did during the same period of 2004. Also during the
three-month period ended September 30, 2005, one of our large Unix enterprise
customers made no Unix product purchases, as compared with approximately $68,000
in the same period of 2004. This decrease was partially offset by an increase of
approximately $47,800 in Unix product purchases during the three-month period
ended September 30, 2005 from one of our large Unix VARs, as compared with the
same period of 2004.
The remainder of the changes in third quarter 2005 Windows and Unix-based
product revenue, as compared with the third quarter of 2004, was due to a
combination of the demand by and composition of our various smaller customers.
During the nine-month period ended September 30, 2005, six of our significant
Windows customers purchased approximately an aggregate $734,700 more product
licenses than they did during the same period in 2004. Included in this increase
were purchases of $72,000 and $25,000 received from new Windows customers during
the nine-month period ended September 30, 2005. Partially offsetting this
increase was an aggregate decrease of approximately $103,000 resulting from
reduced product purchases from three significant Windows customers.
During the nine-month period ended September 30, 2005, three of our
significant Unix customers increased their aggregate product purchases by
approximately $282,700 as compared with the similar period in 2004. Partially
offsetting this increase was a decrease in aggregate product purchases of
approximately $137,500 received from three significant Unix customers during the
nine-month period ended September 30, 2005 as compared with the same period in
2004.
The remainder of the changes in Windows and Unix-based product revenue for
the first nine months of 2005, as compared with the same period of 2004, was due
to a combination of the demand by and composition of our various smaller
customers.
Our customers typically purchase a maintenance contract at the time they
license our product. Our Windows-based maintenance contracts are primarily for a
one-year time period and generally are renewed upon expiration. Our Unix-based
maintenance contracts vary in term from one to five years and generally are
renewed upon expiration. Service fees associated with maintenance contracts are
deferred and recognized as revenue ratably over the underlying service period of
the maintenance contract.
The increase in both Windows and Unix-based service fees for the three and
nine-month periods ended September 30, 2005, as compared with the same periods
15
of the prior year was primarily due to higher levels of maintenance contract
purchases that began approximately during the third quarter of 2004 and have
continued throughout 2005.
The decrease in other revenue for both the three and nine-month periods ended
September 30, 2005, as compared with the respective periods of the prior year,
was due to the sale of an SDK during the three-month period ended September 30,
2004. No SDK was sold during either the three or nine-month periods ended
September 30, 2005.
Cost of Revenue
Cost of revenue consists primarily of the amortization of capitalized
technology developed in-house and customer service costs. Shipping and packaging
materials are immaterial as virtually all of our deliveries are made via
electronic means over the Internet. Under accounting principles generally
accepted in the United States, research and development costs for new product
development, after technological feasibility is established, are recorded as
"capitalized software" on our balance sheet. Such capitalized costs are
subsequently amortized as cost of revenue over the shorter of three years or the
remaining estimated life of the products.
Cost of revenue decreased by $31,800, or 21.6%, to $115,300 for the third
quarter of 2005, from $147,100 for the third quarter of 2004. Product costs
decreased by $7,000, or 11.7%, to $53,000 for the third quarter of 2005, from
$60,000 for the third quarter of 2004. Service costs decreased by $24,800, or
28.5%, to $62,300 for the third quarter of 2005, from $87,100 for the third
quarter of 2004.
Cost of revenue decreased by $394,900, or 51.8%, to $367,000 for the nine
months ended September 30, 2005, from $761,900 for the same period of 2004.
Product costs decreased by $360,300, or 69.7%, to $156,800 for the nine months
ended September 30, 2005, from $517,100 for the same period of 2004. Service
costs decreased by $34,600, or 14.1%, to $210,200 for the nine months ended
September 30, 2005, from $244,800 for the same period of 2004.
The decrease in product costs for both the three and nine-month periods ended
September 30, 2005, as compared with the same periods in 2004 was because our
purchased technology became fully amortized as of June 30, 2004. Product costs
incurred during both the three and nine-month periods ended September 30, 2005
primarily consisted of the amortization of capitalized software development
costs. We expect these costs to remain consistent throughout 2005.
The decrease in service costs for the three and nine-month periods ended
September 30, 2005, as compared with the same periods in 2004, resulted from
certain engineers spending more time in other engineering-related tasks than
customer service in 2005, as compared with 2004. The amount of time our
engineers spend in customer service is a function of the number of customer
service inquiries received, and their complexity. Whenever the resolution of
customers' inquiries permit, engineers whose first priority is customer service
will assist with other engineering-related tasks.
We expect costs of revenue to remain fairly constant over the next few
reporting periods. Cost of revenue was approximately 9.8% and 15.8% of revenue
for the third quarter of 2005 and 2004, respectively, and 10.1% and 30.3% of
revenue for the nine-month periods ended September 30, 2005 and 2004,
respectively.
16
Selling and Marketing Expenses
Selling and marketing expenses primarily consist of employee costs,
consulting services and travel and entertainment. Selling and marketing expenses
for the third quarter of 2005 decreased by $19,600, or 5.5%, to $337,100 from
$356,700 for the third quarter of 2004. Selling and marketing expenses for the
first nine months of 2005 decreased by $105,500, or 9.4%, to $1,014,000 from
$1,119,500 for the first nine months of 2005.
Expense categories that were primary contributors to the net decrease in the
third quarter of 2005 as compared with the third quarter of 2004 are summarized
as follows:
Increase
(Decrease)
Expense From 2004
------- ---------
Employees costs $ (49,800)
Commissions and bonuses 52,300
Consulting services (16,200)
Other items (5,900)
---------
$ (19,600)
=========
Expense categories that were primary contributors to the net decrease in the
first nine months of 2005 as compared with the same period of 2004 are
summarized as follows:
Increase
(Decrease)
Expense From 2004
------- ----------
Employees costs $ (106,800)
Commissions and bonuses 159,800
Consulting services (95,200)
Recruitment (17,000)
Travel & entertainment (19,900)
Other items (26,400)
----------
$ (105,500)
==========
The decrease in employee costs for the three and nine-month periods ended
September 30, 2005, as compared with the same periods in 2004, resulted
primarily from having two fewer sales representatives during these periods of
2005 as compared with 2004.
The increase in commissions and bonuses for the three and nine-month periods
ended September 30, 2005, as compared with the same periods in 2004, resulted
from an increase in new orders during these periods in 2005, as compared with
2004, and the attainment of certain performance objectives during each of these
periods in 2005, respectively.
Consulting services were decreased during both the three and nine-month
periods ended September 30, 2005, as compared with the same periods in 2004, as
we began deferring certain planned selling and marketing activities towards the
end of the fourth quarter of 2004 and have continued doing so in 2005 as we
strive to determine the most cost effective use of our marketing expenditures.
Recruitment expenses were lower during the three and nine-month periods ended
September 30, 2005, as compared with the same periods in 2004, as we did not
fill either of the two positions of the terminated sales representatives,
discussed above.
17
Cumulative travel and entertainment expense for the first nine months of 2005
is lower than that for the same period in 2004 primarily as a result of having
two fewer sales representatives, as discussed above.
We anticipate that selling and marketing expenses for 2005 will approximate
2004 levels. Selling and marketing expenses were 28.7% and 38.3% of revenue for
the third quarter of 2005 and 2004, respectively, and 27.9% and 44.6% of revenue
for the first nine months of 2005 and 2004, respectively.
General and Administrative Expenses
General and administrative expenses primarily consist of employee costs,
legal, professional and other outside services, amortization and depreciation,
travel and entertainment, certain costs associated with being a publicly held
corporation, and bad debts expense. Additionally included in general and
administrative costs are the costs associated with deriving economic benefits
from the patent-related assets acquired from NES. General and administrative
expenses for the third quarter of 2005 increased by $399,900, or 112.0%, to
$756,900 from $357,000 for the third quarter of 2004, and by $1,382,300, or
158.9%, to $2,252,000 for the first nine months of 2005, as compared with
$869,700 for the same period of 2004.
Expense categories that were primary contributors to the net increase in
general and administrative expense for the third quarter 2005 as compared with
2004 are summarized as follows:
Increase
(Decrease)
Expense From 2004
------- ----------
Employee costs $ 188,400
Professional services (35,400)
Depreciation and amortization 225,200
Other items 21,700
----------
$ 399,900
==========
Expense categories that were primary contributors to the net increase in
general and administrative expense for the first nine months of 2005 as compared
with the same period in 2004 are summarized as follows:
Increase
(Decrease)
Expense From 2004
------- -----------
Employee costs $ 410,200
Professional services 270,600
Depreciation and amortization 588,600
Bad debts expense 15,200
Other items 97,700
-----------
$ 1,382,300
===========
The increase in employee costs in the three and nine-month periods ended
September 30, 2005, as compared with the same periods in 2004, was primarily due
to having five more employees. Two of these employees, hired during the first
quarter of 2005, have been tasked with developing revenue opportunities for the
patents and patent applications we acquired in conjunction with the NES
acquisition as well as developing additional patent applications. Two employees
were hired into the accounting department during 2005, one of whom replaced an
outside consultant.
18
Professional services decreased during the third quarter of 2005 as compared
with the third quarter of 2004 primarily as a result of the due diligence and
other general services provided by our attorneys during the third quarter of
2004 related to our evaluation of NES as a potential acquisition target prior to
our acquisition of NES. No such comparable services were performed during the
third quarter of 2005.
The primary reason for the increase in professional services for the
nine-month period ended September 30, 2005, as compared with the same period in
2004, was legal fees related to the administration of the patent portfolio,
which we began incurring upon the consummation of the NES acquisition in January
2005.
Depreciation and amortization expense increased in both the three and
nine-month periods ended September 30, 2005, as compared with the same periods
in 2004, primarily due to the commencement of amortization of the patent-related
assets acquired from NES in January 2005. We expect depreciation and
amortization to be significantly higher for the remainder of 2005, as compared
with the comparable periods in 2004, due to the amortization of the
patent-related assets.
As a result of the increased volume of new business and related
uncertainties, we increased our allowance for doubtful accounts during the
nine-month period ended September 30, 2005.
We anticipate that aggregate general and administrative expenses for 2005
will be substantially higher than 2004, primarily due to the additional
personnel, the amortization of the patent-related assets and the professional
costs associated with the process of realizing the anticipated benefits of the
NES acquisition. General and administrative expenses were approximately 64.3%
and 38.3% of revenues for the third quarter of 2005 and 2004, respectively, and
approximately 62.0% and 34.6% of revenue for the nine-month periods ended
September 30, 2005 and 2004, respectively.
Research and Development Expenses
Research and development expenses consist primarily of employee costs,
payments to contract programmers, rent, depreciation and computer related
supplies. Research and development expenses for the third quarter of 2005
decreased by $33,600, or 9.2%, to $333,200 from $366,800 for the third quarter
of 2004, and by $256,500, or 20.9%, to $969,900 for the first nine months of
2005, as compared with $1,226,400 for the same period in 2004.
Under accounting principles generally accepted in the United States, all
costs of product development incurred once technological feasibility has been
established, but prior to general release of the product, are typically
capitalized and amortized to expense over the estimated life of the underlying
product, rather than being charged to expense in the period incurred. No product
development costs were capitalized during either the three or nine-month periods
ended September 30, 2005 or 2004.
Expense categories that were primary contributors to the net decrease in
third quarter 2005 as compared with 2004 are summarized as follows:
Increase
(Decrease)
Expense From 2004
------- ---------
Employee costs $ (34,700)
Contract programmers 15,500
Depreciation (9,500)
19
Other items (4,900)
---------
$ (33,600)
=========
Expense categories that were primary contributors to the net decrease in the
first nine months of 2005 as compared with the period in 2004 are summarized as
follows:
Increase
(Decrease)
Expense From 2004
------- ----------
Employee costs $ (159,700)
Contract programmers (27,500)
Depreciation (41,100)
Other items (28,200)
----------
$ (256,500)
==========
The decrease in employee costs for the three and nine-month periods ended
September 30, 2005, as compared with the same periods of 2004, was primarily due
to having two fewer engineers.
The increase in contract programmers for the third quarter of 2005, as
compared with the third quarter of 2004, was due to the timing of work we
contracted the programmers to perform. Conversely, the decrease in contract
programmers for the nine-month periods ended September 30, 2005, as compared
with the same period of 2004, was due to the non-renewal of certain contracts
upon their expiration. Once certain elements of the work being performed for us
was completed, the underlying programmers' contracts were not renewed as their
services were not immediately required. We believe that we will be able to enter
into new contracts with these engineers, or ones with similar talents, without
difficulty in the future, should we need their services again. We chose not to
immediately renew their contracts in effort to reduce our cash expenditures in
order use our research and development dollars most efficiently.
Depreciation expense was lower in the both the three and nine-month periods
ended September 30, 2005, as compared with the same periods of 2004, because
during 2003 and 2004, we purchased virtually no new capitalizable assets in
support of our research and development efforts. Since the beginning of 2003,
various assets have become fully depreciated more quickly than we have replaced
them and hence, depreciation expense has steadily declined. We expect to make
more fixed asset purchases in 2005 than we did in 2004, however, we do not
expect to replace all the assets that have, or will, become fully depreciated.
Consequently, we expect depreciation expense for 2005 to remain lower than 2004
levels.
We anticipate that research and development expenses for 2005 will be lower
than those incurred during 2004, primarily due to the lower number of engineers
and lower depreciation, as outlined above. Research and development expenses
were approximately 28.3% and 39.4% of revenues for the third quarter of 2005 and
2004, respectively, and approximately 26.7% and 48.8% of revenue for the
nine-month periods ended September 30, 2005 and 2004, respectively.
Interest and other income
During the three and nine-month periods ended September 30, 2005, interest
and other income consisted primarily of interest income on excess cash and note
receivable - shareholder. During the three and nine-month periods ended
September 30, 2004, interest and other income consisted primarily of interest
income on excess cash. Also included in interest and other income for the
nine-month period ended September 30, 2004 was interest income on notes
receivable - directors.
20
Interest and other income for the third quarter of 2005 increased by $7,700,
or 308.0%, to $10,200 from $2,500 for the third quarter of 2004. Interest and
other income for the first nine months of 2005 increased by $21,000, or 233.3%,
to $30,000 from $9,000 for the same period of 2004.
Interest income on excess cash for both the three and nine-month periods
ended September 30, 2005, approximately $10,200 and $30,000, respectively, as
compared with the same periods of 2004, approximately $2,500 and $9,000,
respectively, was higher, primarily due to higher average cash balances and
rates of interest being earned on those balances in 2005 as compared with 2004.
The increase in the average cash balances in 2005, as compared with 2004, was
primarily due to the net proceeds of the 2005 private placement, approximately
$2,933,000, as compared with the net proceeds of the 2004 private placement,
approximately $934,800. Our excess cash is held in interest bearing money market
accounts.
Interest income on the note receivable - shareholder was approximately $3,200
and $9,600 for the three and nine-month periods ended September 30, 2005. No
such note receivable was outstanding during the same three and nine-month
periods of 2004.
We anticipate that interest income for the remainder of 2005 will be higher
than comparable periods from 2004 as we expect that we will continue to have
higher average cash balances for the remainder of the year, as compared with the
prior year.
Net Loss
As a result of the foregoing items, net loss for the third quarter of 2005
was $359,400, an increase of $65,700, or 22.4%, from a net loss of $293,700 for
the third quarter of 2004. Net loss for the first nine months of 2005 was
$945,300, a decrease of $511,000, or 35.1%, from a net loss of $1,456,300 for
the same period of 2004. As a result of our continued operating loss we intend
to continue to pursue revenue growth opportunities through all available means.
Net loss attributable to common shareholders for the third quarter of 2005
was $359,400, an increase of $65,800, or 22.4%, from a net loss attributable to
common shareholders of $293,700 for the third quarter of 2004. Net loss
attributable to common shareholders for the first nine months of 2005 was
$4,945,300, an increase of $3,489,000, or 239.6%, from a net loss attributable
to common shareholders of $1,456,300 for the same period in 2004. The increase
in net loss attributable to common shareholders for the first nine months of
2005 was due to the deemed dividends on preferred stock, as discussed below.
Deemed Dividends on Preferred Stock
On February 2, 2005, we completed the 2005 private placement, which raised a
total of $4,000,000 through the sale of 148,148 shares of Series A preferred
stock and five-year warrants to purchase 74,070 shares of Series B preferred
stock.
The deemed fair value of the Series A preferred stock was estimated based on
the market price and underlying number of common shares they would have
converted into had the conversion occurred immediately upon their issuance. The
market price for our common stock on February 2, 2005 was $0.46 and the Series A
preferred stock would have converted into 14,814,800 common shares, thus
deriving an estimated fair value of approximately $6,814,800 at that date.
21
The fair value of the warrants was estimated to be $1,877,700 and was
calculated using the Black-Scholes option pricing model with the following
weighted average assumptions: a risk free interest rate of 1.5%, a volatility
factor of 60%, a dividend yield of 0% and a five year contractual life.
Based on the relative fair values of the Preferred Shares and the warrants at
the time of their issuance, we allocated $3,136,000 of the $4,000,000 proceeds
of the 2005 Private Placement to the Preferred Shares and $864,000 to the
warrants.
The Preferred Shares we issued contained a non-detachable conversion feature
(the "Beneficial Conversion Feature") that was in-the-money upon completion of
the 2005 Private Placement, in that the deemed fair value of Common Stock into
which the Preferred Shares could be converted exceeded the allocated value of
$3,136,000 by $3,678,800 (using the intrinsic value method). This discount
resulting from recording the Beneficial Conversion Feature was limited to the
allocated proceeds of $3,136,000 and has been recognized as if this amount had
been declared a non-cash dividend to the preferred shareholders during the
quarter ended March 31, 2005.
Additionally, the approximate $864,000 discount resulting from the allocation
of the proceeds of the 2005 Private Placement on a relative fair value basis to
the Series A preferred shares and the warrants issued in the 2005 Private
Placement has also been recognized as if this amount had been declared a
non-cash dividend to the preferred shareholders during the quarter ended March
31, 2005.
Liquidity and Capital Resources
We continue to manage our operations to bring our cash expenditures in line
with our revenues in order to determine the most cost effective use of our cash
on hand. We are simultaneously looking at ways to improve our revenue stream.
Additionally, we continue to review potential merger opportunities as they
present themselves to us and at such time as a merger might make financial sense
and add value for our shareholders, we will pursue that merger opportunity. We
believe that improving or maintaining our current revenue stream, coupled with
our cash on hand, including the cash raised in the 2005 private placement will
sufficiently support our operations during 2005.
On January 31, 2005, we acquired NES for 9,599,993 shares of common stock,
the assumption of approximately $232,800 of NES' indebtedness and the
reimbursement to AIGH Investment Partners, LLC ("AIGH"), an affiliate of a
principal stockholder (Orin Hirschman), of $665,000 for its advance on our
behalf of a like sum in December 2004 to settle certain third party litigation
against NES. We reimbursed the advance through a partial credit against the
price of our securities acquired by AIGH in the 2005 private placement.
The 2005 private placement, which was consummated on February 2, 2005, raised
a total of $4,000,000, inclusive of the $665,000 credit issued to AIGH. As of
September 30, 2005 we had consumed approximately $402,000 and $730,000 of the
cash raised paying for expenses related to the 2005 private placement and the
NES acquisition, respectively. We estimate that we will disburse an additional
$60,100 and $81,800 of cash paying for expenses related to the 2005 private
placement and the NES acquisition, respectively, however, there can be no
guarantees that these amounts will be final.
We anticipate incurring further costs associated with the development of the
patents and patent-related assets acquired from NES for the next several
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reporting periods. We expect to fund these development costs through working
capital.
Until the revenues we derive from either the sale of software products or the
licensing of patents are sufficient enough to generate positive cash flows from
operations, we will continue to experience operating losses. Although we believe
that we will be able to attain sufficient sales levels to meet our operational
needs, there can be no certainty that we will be able to do so. Should the cash
flows generated from sales and working capital be insufficient to satisfy short
term operating needs, or should we be unsuccessful in securing alternative
sources of financing, we may have to significantly curtail the current nature of
our operations.
As of September 30, 2005, cash and cash equivalents totaled $3,125,900, an
increase of $2,450,600, or 362.9%, from $675,300 as of December 31, 2004. The
increase in cash and cash equivalents was primarily attributable to the
$2,933,000 net cash infusion from the 2005 private placement, which comprises
the majority of the cash provided by our financing activities for the first nine
months of 2005. The balance of the cash provided by our financing activities was
derived from the sale of stock to employees through our employee stock purchase
program.
Our net loss for the first nine months of 2005 was $945,300. Included in the
net loss were non-cash charges, comprised of depreciation and amortization,
which aggregated approximately $779,300. Our operating assets and liabilities
provided approximately $368,900 of cash for our operations during the first nine
months of 2005, primarily resulting from a $269,800 increase in aggregate
deferred revenue.
Accounts Receivable
The decrease in accounts receivable was primarily due to the timing and
collection of various sales transactions. The decrease in accounts receivable
also included an increase in our allowance for doubtful accounts, which resulted
from the increased volume of new business and related uncertainties.
Deferred Revenue
The increase in total deferred revenue, aggregate short and long-term,
generated $269,800 of cash flow during the first nine months of 2005. Included
in deferred revenue as of September 30, 2005, were deferred private labeling and
other fees, aggregating approximately $43,800, which we expect to recognize as
revenue, generally, over the underlying term of the respective private labeling
agreement. These agreements typically are for a three-year period and the
revenue is recognized on a straight-line basis over such period.
Also included in deferred revenue at September 30, 2005 was approximately
$14,100 of deferred licensing sales. Generally, product sales that do not
satisfy all criteria for revenue recognition at the time of the transaction are
deferred until all such criteria are met. We anticipate recognizing this revenue
during the next twelve months.
Accounts Payable
Accounts payable as of September 30, 2005 decreased by $127,300, or 50.9%, to
$122,900 from $250,200 as of December 31, 2004. Accounts payable as of September
30, 2005 were primarily comprised of various operating expenses. Accounts
payable as of December 31, 2004 were comprised of operating expenses and
significant costs associated with the NES acquisition and the 2005 private
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placement. The amounts related to the NES acquisition and the 2005 private
placement were paid during the first quarter of 2004 and their payment was the
primary reason for the decrease in accounts payable.
Accrued Expenses
Accrued expenses as of September 30, 2005 approximated those as of December
31, 2004. Accrued expenses are charges for services rendered for which an
invoice has not yet been received and typically include legal, accounting and
outside consultant fees, utilities and other items.
Accrued Wages
Accrued wages as of September 30, 2005 increased by $67,300, or 25.9%, to
$327,400 from $260,100 as of December 31, 2004. The increase was primarily due
to hiring five new general and administrative employees during the first nine
months of 2005, an increase in commissions and bonuses, based on third quarter
2005 sales, as well as an increase in the costs of employee benefits.
Deferred Compensation
During the first nine months of 2005, we deferred, and amortized,
compensation totaling approximately $8,900 and $2,000, respectively, related to
stock options granted to our interim Chief Executive Officer, Robert Dilworth.
We are amortizing this amount monthly on the straight-line method, to
compensation expense over a three-year period ending in January 2008.
Notes Receivable - Directors
During the first quarter of 2005, we received payment in full of our notes
receivable - directors, generating operating cash of $50,300. Also during the
first quarter of 2005, we received a $2,600 principal repayment of the note
receivable - shareholder.
Working Capital
As of September 30, 2005, we had current assets of $3,595,400 and current
liabilities of $1,500,200, which netted to working capital of $2,095,200.
Included in current liabilities was the current portion of deferred revenue of
$818,800.
We have been successful in significantly reducing operating costs through a
series of strategic restructurings and work force reductions that began in
September of 2001. Based on our current operating revenues and reduced operating
cost structure, and the cash raised in the 2005 private placement, we believe
that we will be able to support our operational needs with currently available
resources for at least the next twelve months. However, due to inherent
uncertainties associated with predicting future operations, there can be no
assurances that these resources will be sufficient to fund our anticipated
expenses during the next twelve months.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
We are currently not exposed to any significant financial market risks from
changes in foreign currency exchange rates or changes in interest rates and do
not use derivative financial instruments. A substantial majority of our revenue
and capital spending is transacted in U.S. dollars. However, in the future, we
may enter into transactions in other currencies. An adverse change in exchange
rates would result in a decline in income before taxes, assuming that each
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exchange rate would change in the same direction relative to the U.S. dollar. In
addition to the direct effects of changes in exchange rates, such changes
typically affect the volume of sales or foreign currency sales price as
competitors' products become more or less attractive.
ITEM 4. Controls and Procedures
Our management carried out an evaluation, with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of our
disclosure controls and procedures as of September 30, 2005. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures were effective to ensure that
information required to be disclosed by us in reports that we file or submit
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported, within the time periods specified in the rules and forms of the
Securities and Exchange Commission.
There has not been any change in our internal control over financial
reporting in connection with the evaluation required by Rule 13a-15(d) under the
Exchange Act that occurred during the quarter ended September 30, 2005 that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
PART II--OTHER INFORMATION
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the three-month period ended September 30, 2005, we granted the
following stock options:
o stock options to purchase an aggregate 85,000 shares of common stock, at
exercise prices ranging from $0.35 to $0.40 per share, were granted to
two non-executive employees;
The grant of such stock options to the above-listed persons was not
registered under the Securities Act of 1933, because the stock options either
did not involve an offer or sale for purposes of Section 2(a)(3) of the
Securities Act, in reliance on the fact that the stock options were granted for
no consideration, or were offered and sold in transactions not involving a
public offering, exempt from registration under the Securities Act pursuant to
Section 4(2).
ITEM 6. Exhibits
Exhibit 31 - Rule 13a-14(a)/15d-14(a) Certifications
Exhibit 32 - Section 1350 Certifications
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
GraphOn Corporation
(Registrant)
Date: November 21, 2005
By: /s/ Robert Dilworth
---------------------------------
Robert Dilworth,
Chief Executive Officer (Interim) and
Chairman of the Board
(Principal Executive Officer)
Date: November 21, 2005
By: /s/ William Swain
---------------------------------
William Swain,
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
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