As filed with the Securities and Exchange Commission on February 27, 2006
Registration No. 333-____
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM SB-2
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
ELECTRONIC CONTROL SECURITY INC.
(Name of small business issuer in its charter)
New Jersey 7381 22-2138196
(State or other jurisdiction of (Primary Standard Industrial (IRS. Employer
incorporation or organization) Classification Code Number) Identification Number)
790 Bloomfield Avenue, Building C, Suite 1
Clifton, New Jersey 07012
(973) 574-8555
(Address and telephone number of principal executive offices)
Arthur Barchenko, President and
Chief Executive Officer
Electronic Control Security Inc.
790 Bloomfield Avenue
Building C, Suite 1
Clifton, New Jersey 07012
Telephone: (973) 574-8555
Telecopier: (973) 574-8562
(Name, address and telephone number of agent for service)
Copies of communications to:
Spencer G. Feldman, Esq.
Constantine S. Potamianos, Esq.
Greenberg Traurig, LLP
200 Park Avenue - 15th Floor
New York, New York 10166
Telephone No. (212) 801-9200
Telecopier No. (212) 801-6400
Approximate date of proposed sale to the public: As soon as practicable
after the effective date of this Registration Statement.
If any of the securities being registered on this Form are to be offered
on a delayed or continuous basis pursuant to Rule 415 under the Securities Act
of 1933, check the following box. [X]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. [ ]
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CALCULATION OF REGISTRATION FEE
Amount to Proposed Proposed
Title of Each be Maximum Maximum Amount of
Class of Securities Registered Offering Price Aggregate Registration
to be Registered (1) per Unit Offering Price Fee
- ----------------------------------------- ------------------- ----------------------- ---------------------- -------------------
Common Stock, $.001 par value 441,862 $ .98 (2) $ 433,025 $ 46.34
Common Stock, $.001 par value (3) 869,566 $ 1.15 (15) $ 999,990 $ 107.00
Common Stock, $.001 par value (4) 217,392 $ .98 (2) $ 213,045 $ 22.80
Common Stock, $.001 par value (5) 260,871 $ .98 (2) $ 255,654 $ 27.36
Common Stock, $.001 par value (6) 434,783 $ 2.00 (15) $ 1,086,958 $ 116.31
Common Stock, $.001 par value (7) 108,696 $ .98 (2) $ 106,523 $ 11.40
Common Stock, $.001 par value (8) 100,000 $ 1.50 (15) $ 150,000 $ 16.05
Common Stock, $.001 par value (9) 21,739 $ 1.15 (15) $ 25,000 $ 2.68
Common Stock, $.001 par value (10) 300,000 $ 2.25 (15) $ 675,000 $ 72.23
Common Stock, $.001 par value (11) 500,000 $ 1.50 (15) $ 750,000 $ 80.25
Common Stock, $.001 par value (12) 120,000 $ 1.00 (15) $ 120,000 $ 12.84
Common Stock, $.001 par value (13) 281,250 $ .98 (2) $ 275,625 $ 29.50
Common Stock, $.001 par value (14) 466,696 $ .98 (2) $ 457,363 $ 48.94
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Total Registration Fee 4,122,855 $ 593.70
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(1) Pursuant to Rule 416 of the Securities Act of 1933, the shares of our
common stock offered hereby also include an indeterminate number of
additional shares of our common stock as may from time to time become
issuable by reason of stock splits, stock dividends, recapitalizations or
other similar transactions.
(2) Estimated solely for the purpose of computing the amount of the
registration fee pursuant to Rule 457(c) under the Securities Act of 1933,
as amended, based on the average of the bid and asked prices of the
registrant's common stock reported on the OTC Bulletin Board on February
24, 2006.
(3) Represents shares of common stock issuable upon the assumed conversion of
an aggregate of $1,000,000 of our senior secured convertible debentures
issued in connection with our private financing in January 2006 based on a
conversion price of $1.15 per share.
(4) Represents additional shares of common stock issuable upon the conversion
of an aggregate of $1,000,000 of our senior secured convertible debentures
issued in connection with our private financing in January 2006 as a
result of possible adjustments to the conversion price and other potential
adjustments.
(5) Represents shares of common stock issuable in connection with the payment
of interest on an aggregate of $1,000,000 of our senior secured
convertible debentures issued in connection with our private financing in
January 2006, if such interest is not otherwise paid in cash.
(6) Represents shares of common stock issuable upon the exercise of warrants
issued in connection with our private financing in January 2006.
(7) Represents additional shares of common stock issuable upon the exercise of
warrants issued in connection with our private financing in January 2006
as a result of adjustments to the exercise price and other potential
adjustments.
(8) Represents shares of common stock issuable upon the exercise of warrants,
at an exercise price of $1.50 per share, received by Dunwoody Asset
Management, LLC and Resource Horizons Group, LLC for acting together as
one of two placement agents in connection with our private financing in
January 2006.
(9) Represents shares of common stock issuable upon the exercise of warrants,
at an exercise price of $1.15 per share, received by H.C. Wainright & Co.,
Inc. for acting as one of two placement agents in connection with our
private financing in January 2006.
(10) Represents shares of common stock issuable upon the exercise of warrants
at an exercise price of $2.25 per share.
(11) Represents shares of common stock issuable upon the exercise of warrants
at an exercise price of $1.50 per share.
(12) Represents shares of common stock issuable upon the exercise of warrants
at an exercise price of $1.00 per share.
(13) Represents shares of common stock issuable in connection with the payment
of dividends payable on outstanding shares of series A convertible
preferred stock, if such dividends are not otherwise paid in cash.
(14) Represents shares of common stock issuable in connection with the payment
of dividends payable on outstanding shares of 10% series B convertible
preferred stock, if such dividends are not otherwise paid in cash.
(15) Calculated pursuant to Rule 457(g).
-----------------------
The registrant hereby amends this registration statement on such date
or dates as may be necessary to delay its effective date until the registrant
shall file a further amendment which specifically states that this registration
statement shall thereafter become effective in accordance with Section 8(a) of
the Securities Act of 1933 or until the registration statement shall become
effective on such date as the Commission, acting pursuant to said Section 8(a),
may determine.
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The information in this prospectus is not complete and may be changed. Our
selling stockholders may not sell these securities until the registration
statement filed with the Securities and Exchange Commission is effective. This
prospectus is not an offer to sell these securities and is not soliciting an
offer to buy these securities in any state where the offer or sale is not
permitted.
PRELIMINARY PROSPECTUS Subject to Completion, dated February 27, 2006
ELECTRONIC CONTROL SECURITY INC.
4,122,855 Shares of Common Stock
This prospectus relates to the public offering, which is not being
underwritten, of up to 3,374,909 shares of our common stock by the selling
stockholders listed in this prospectus. The shares offered by this prospectus
include 441,862 presently outstanding shares of our common stock, 1,347,829
shares of our common stock issuable upon conversion of our senior secured
convertible debentures (including shares issuable in connection with the payment
of interest on the debentures if interest is not otherwise paid in cash and
additional shares issuable in the event of possible adjustments to the
conversion price and other potential adjustments), 1,585,218 shares of our
common stock issuable upon exercise of warrants to purchase shares of our common
stock (including additional shares issuable upon exercise of the warrants issued
in connection with our private financing in January 2006 in the event of
adjustments to the exercise price and other potential adjustments), 281,250
shares of our common stock issuable in connection with the payment of dividends
payable on outstanding shares of our series A convertible preferred stock, if
such dividends are not otherwise paid in cash, and 466,696 shares of our common
stock issuable in connection with the payment of dividends payable on
outstanding shares of our 10% series B convertible preferred stock, if such
dividends are not otherwise paid in cash. These shares may be sold by the
selling stockholders from time to time in the over-the-counter market or other
national securities exchange or automated interdealer quotation system on which
our common stock is then listed or quoted, through negotiated transactions at
negotiated prices or otherwise at market prices prevailing at the time of sale.
Pursuant to registration rights granted by us to the selling stockholders,
we are obligated to register the shares held or to be acquired by these selling
stockholders. The distribution of the shares by the selling stockholders is not
subject to any underwriting agreement. We will receive none of the proceeds from
the sale of the shares by the selling stockholders, except the cash exercise
price upon exercise of the warrants. We will bear all expenses of registration
incurred in connection with this offering, but all selling and other expenses
incurred by the selling stockholders will be borne by them.
Our common stock is quoted on the OTC Bulletin Board under the symbol
EKCS.OB. The high and low bid prices for shares of our common stock on February
24, 2006, were $1.00 and $0.97 per share, respectively, based upon bids that
represent prices quoted by broker-dealers on the OTC Bulletin Board. These
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commissions, and may not represent actual transactions.
The selling stockholders and any broker-dealer executing sell orders on
behalf of the selling stockholders may be deemed to be "underwriters" within the
meaning of the Securities Act of 1933. Commissions received by any broker-dealer
may be deemed to be underwriting commissions under the Securities Act of 1933.
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An investment in these securities involves a high degree of risk.
Please carefully review the section titled "Risk Factors" beginning on page 6.
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NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
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The date of this prospectus is _______ __, 2006
We have not authorized anyone to provide you with information different
from that contained in this prospectus. This prospectus is not an offer to sell,
or a solicitation of an offer to buy, shares of common stock in any jurisdiction
where offers and sales would be unlawful. The information contained in this
prospectus is complete and accurate only as of the date on the front cover of
this prospectus, regardless of the time of delivery of this prospectus or of any
sale of the shares of common stock. When considering the acquisition of the
common stock described in this prospectus, you should rely only on the
information contained in this prospectus.
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TABLE OF CONTENTS
Page
Prospectus Summary...........................................................1
The Offering.................................................................4
Risk Factors.................................................................6
Special Note Regarding Forward-Looking Statements...........................14
Use of Proceeds.............................................................15
Market for our Common Stock and Related Stockholder Matters.................16
Management's Discussion and Analysis or Plan of Operation...................18
Business....................................................................26
Management..................................................................36
Principal Stockholders......................................................43
Certain Relationships and Related Transactions..............................45
Selling Stockholders........................................................46
Plan of Distribution........................................................55
Description of Securities...................................................57
Shares Eligible for Future Sale.............................................61
Legal Matters...............................................................62
Experts.....................................................................62
Where You Can Find More Information.........................................62
Index to Financial Statements..............................................F-1
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We obtained statistical data, market data and other industry data and
forecasts used throughout this prospectus from market research, publicly
available information and industry publications. Industry publications generally
state that they obtain their information from sources that they believe to be
reliable, but they do not guarantee the accuracy and completeness of the
information. Similarly, while we believe that the statistical data, industry
data and forecasts and market research are reliable, we have not independently
verified the data and we do not make any representation as to the accuracy of
that information.
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PROSPECTUS SUMMARY
This summary highlights information contained elsewhere in this
prospectus. It is not complete and does not contain all of the information that
you should consider before investing in our common stock. Before making a
decision to purchase our shares, you should read this entire prospectus,
including the financial statements and related notes and risk factors. "We,"
"our," "us" and similar phrases refer to Electronic Control Security Inc., a New
Jersey corporation, together with its subsidiaries.
Our Company
We design, develop, manufacture and market technology-based integrated
security systems. We also provide consulting services consisting of risk
assessment and vulnerability studies to ascertain a customer's security
requirements in developing a comprehensive risk management and mitigation
program, as well as product design and engineering services.
We market our products domestically and internationally to:
o national and local government entities, including the U.S.
Department of Defense (DoD) and the U.S. Department of Energy (DoE),
o large chemical and petrochemical facilities, and major office
complexes,
o energy facilities, including nuclear power stations, power utilities
and pipelines, and
o commercial transportation centers, such as airports and seaports,
and
o water and agricultural resources including reservoirs, dams, fish
hatcheries and rivers.
We believe that we are one of a few comprehensive security solution
providers in the industry. We analyze security risks and develop security
solutions specifically tailored to mitigate those risks, including designing,
engineering and manufacturing individual components of a system as may be
necessary to deliver a fully integrated security system customized to a
customer's requirements. We are frequently engaged by security system
integrators, security system dealers/installers, and commercial architects and
engineers because we are able to deliver an integrated platform for a fully
integrated security solution to support our customers' requirements for the
completion of a given project.
We believe that we have developed a superior reputation as a provider of
integrated security systems since our inception in 1976 because we:
o offer a complete range of solutions-driven responses to accommodate
our customers' needs,
o offer technologically superior products,
o are able to design, engineer and manufacture systems customized to
our customers' specific requirements,
o deliver systems that are easy to operate and maintain while
providing superior life cycle cost performance compared to systems
offered by our competitors,
o have established solid credentials in protecting high value targets,
and
o offer our customers what we believe may be the best warranty in the
industry.
1
Recent Developments
During fiscal year 2006, we, to date, have:
o received approximately $8,000,000 in new orders under the Integrated
Base Defense Security/Tactical Automated Sensor Systems (IBDSS/TASS)
contract that we expect to ship in the latter half of fiscal year
2006,
o entered into agreements with Hudson Marine Management
Services/HudsonTrident to undertake projects in Morocco and Lebanon,
o received notice of the DoD's increase in the amount to be spent to
secure Tinker Air Force Base by $400,000, bringing the total to
approximately $5.2 million,
o acquired the assets of Clarion Sensing Systems, a provider of
proprietary nuclear, bio-chemical and radiological remote monitoring
sensor systems for air and water applications, for a purchase price
of approximately $1.4 million, including the issuance of 394,682
shares of common stock and the assumption of $655,587 of specific
liabilities of Clarion (of which we already have paid approximately
$413,144), which provided us with remote environmental monitoring
sensor system products that enhance our existing product line,
o received a significant commitment from the Israeli Ministry of
Defense (MOD) to supply our security technologies for their
high-threat facilities for which we will deliver our Perimeter
Intrusion Detection Systems (PIDS) designed to prevent unauthorized
entry or access to high threat complexes through June 2006 and
possibly 2007,
o entered into a joint manufacturing and marketing agreement with GM
Cope, Inc., a subsidiary of GM Merc A/S, for its Aerial Warning
System, and they in turn will market our products in Europe, and
o augmented our management team by hiring Richard Deyulio, with 36
years experience in various positions in the federal government, the
U.S. Army and the Air National Guard focusing on "commercial
off-the-shelf" security and tactical systems, as Senior Project
Manager and hiring Bernard Boucek, with over 35 years of experience
in disciplines and/or projects directly related to physical security
systems, as Program Manager, and
o strengthened our advisory board comprised of representatives from
government, academia and industry by adding Col. Edward Badolato,
U.S. Marines (Ret.), Juda Engelmayer, Chief Communications Officer,
American Jewish Congress, and Charles Gargano, Chairman and CEO of
Empire State Development Corporation and Vice-Chairman of the Port
Authority of New York and New Jersey.
About this Offering
This prospectus relates to the public offering, which is not being
underwritten, of up to 4,122,855 shares of our common stock by the selling
stockholders listed in this prospectus. The shares offered by this prospectus
include 441,862 presently outstanding shares of our common stock, 1,347,829
shares of our common stock issuable upon conversion of our senior secured
convertible debentures (including shares issuable in connection with the payment
of interest on the debentures if interest is not otherwise paid in cash and
additional shares issuable in the event of possible adjustments to the
conversion price and other potential adjustments), 1,585,218 shares of our
common stock issuable upon exercise of warrants to purchase our common stock
(including additional shares issuable upon exercise of the warrants issued in
connection with our private financing in January 2006 in the event of possible
adjustments to the exercise price and other potential adjustments), 281,250
shares of our common stock issuable in connection with the payment of dividends
payable on outstanding shares of our series A convertible preferred stock, if
such dividends are not otherwise paid in cash, and 466,696 shares of our common
stock issuable in connection with the payment of dividends on outstanding shares
of our 10% series B convertible preferred stock, if such dividends are not
otherwise paid in cash. These shares may be sold by the selling stockholders
from time to time in the over-the-counter market or other national securities
exchange or automated interdealer quotation system on which our common stock is
then listed or quoted, through negotiated transactions or otherwise at market
prices prevailing at the time of sale or at negotiated prices. We will receive
none of the proceeds from the sale of the shares by the selling stockholders,
except upon exercise of the warrants. We will bear all expenses of registration
incurred in connection with this offering, but all selling and other expenses
incurred by the selling stockholders will be borne by them.
2
2,013,047 shares of common stock being offered by this prospectus relate
to a private financing we completed in January 2006. On January 11, 2006, we
entered into an agreement for the sale of our senior secured convertible
debentures in aggregate principal amount of $1,000,000. The debentures have a
term of three years and come fully due on January 11, 2009. The debentures are
convertible at the option of the holder at any time and from time to time into
shares of our common stock at a conversion price of $1.15 per share of common
stock, or initially 869,566 shares of common stock, subject to certain
adjustments. We also issued common stock purchase warrants to the purchasers to
purchase up to 434,783 shares of our common stock at an exercise price of $2.00
per share. We are obligated to register an additional number of shares of our
common stock (25% of the amount the debentures and the warrants are initially
convertible or exercisable, respectively, into) to cover possible adjustments.
We are also registering 260,871 shares of our common stock issuable in
connection with the payment of interest on the debentures, if such interest is
not otherwise paid in cash. In connection with completing the financing, we paid
fees to our placement agents of $72,500 and issued warrants to our placement
agents to purchase up to 121,739 shares of our common stock on substantially
similar terms as the purchasers' warrants. For a more detailed discussion
regarding the January 2006 transaction, see the discussion under the heading
"Selling Stockholders - Description of the January 2006 Private Placement."
137,292 shares of common stock being offered by this prospectus are shares
of common stock issued in connection with dividends on our 10% series B
convertible preferred stock issued in June 2004. These shares are additional
conversion shares that were issuable as a consequence of an addition to the
stated value of our 10% series B convertible preferred stock resulting from the
dividend declaration and a corresponding adjustment in the beneficial conversion
price. We are also registering 466,696 shares of our common stock issuable in
connection with the payment of dividends on outstanding shares of our 10% series
B convertible preferred stock, if such dividends are not otherwise paid in cash.
99,378 shares of common stock being offered by this prospectus are shares of
common stock issued as dividends on shares of our series A convertible preferred
stock issued from January to March 2002. We are also registering 281,250 shares
of our common stock issuable in connection with the payment of dividends on
outstanding shares of our series A convertible preferred stock, if such
dividends are not otherwise paid in cash. Of the remaining shares of common
stock being offered by this prospectus, 205,192 shares of our common stock are
shares that were issued to our employees or consultants on account of services
rendered and 920,000 shares of our common stock are issuable upon exercise of
warrants to purchase common stock.
The number of shares being offered by this prospectus represents
approximately 47% of our outstanding shares of common stock as of February 24,
2006.
Corporate Information
Our corporate headquarters are located at 790 Bloomfield Avenue, Building
C, Suite 1, Clifton, New Jersey 07012, and our telephone number is (973)
574-8555. We maintain manufacturing and administrative facilities in Madison,
Alabama. Our web address is www.anti-terrorism.com. Information on our website
is not part of this prospectus.
3
THE OFFERING
Common stock offered by the selling stockholders:
Presently outstanding number of
shares being offered by this prospectus....441,862 shares
Number of shares that may be
issued upon conversion of
outstanding senior secured
convertible debentures
(including shares issuable in
connection with the payment of
interest on the debentures if
interest is not otherwise paid
in cash and additional shares
issuable in the event of
possible adjustments to the
conversion price and other
potential adjustments......................1,347,829 shares
Number of shares that may be
issued in connection with the
payment of dividends payable on
outstanding shares of our series
A convertible preferred stock
and our 10% series B convertible
preferred stock, if such
dividends are not otherwise paid
in cash....................................747,946 shares
Number of shares that may be
issued upon exercise of
outstanding warrants to purchase
common stock (including
additional shares issuable upon
exercise of warrants issued in
connection with our private
financing in January 2006 in the
event of possible adjustments to
the exercise price and other
potential adjustments).....................1,585,218 shares
----------------
Total shares offered.......................4,122,855
=========
Common stock outstanding.........................8,772,559 shares (1)
Use of proceeds..................................We will receive none of the
proceeds from the sale of the
shares by the selling
stockholders, except cash for
the warrant exercise price upon
exercise of the warrants, which
would be used for working
capital purposes.
OTC Bulletin Board symbol........................EKCS.OB
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(1) As of February 27, 2006. Does not include:
o 369,318 shares of our common stock that may be issued upon
conversion of outstanding shares of series A convertible preferred
stock,
o 934,918 shares of our common stock that may be issued upon
conversion of outstanding shares of 10% series convertible B
preferred stock,
o 1,446,875 shares of our common stock that are reserved for issuance
pursuant to outstanding warrants to purchase common stock,
4
o 869,566 shares of our common stock that may be issued upon
conversion of outstanding senior secured convertible debentures,
o 1,444,500 shares of our common stock that are reserved for issuance
pursuant to outstanding stock options to purchase common stock under
our Incentive Stock Option Plan,
o 555,500 shares of our common stock available for future issuance
under our Incentive Stock Option Plan,
o 80,000 shares of our common stock that are reserved for issuance
pursuant to outstanding stock options to purchase common stock under
our Non-Statutory Stock Option Plan, and
o 170,000 shares of our common stock available for future issuance
under our Non-Statutory Stock Option Plan.
5
RISK FACTORS
An investment in our common stock involves a high degree of risk. You
should carefully consider the following material risks, together with the other
information contained in this prospectus, before you decide to buy our common
stock. If any of the following risks actually occur, our business, results of
operations and financial condition would likely suffer. In these circumstances,
the market price of our common stock could decline, and you may lose all or part
of your investment.
Risks Related to Our Business
We depend on government contracts for a large part of our total sales, and
therefore our business is vulnerable to fluctuations in government spending.
Because many of our contracts are with governmental entities, our business
is subject to risks that are out of our control, including global economic
developments, wars, political instability, changes in the tax and regulatory
environments, foreign exchange rate volatility and fluctuations in government
spending. For example, the 2005 Homeland Security Appropriations Act provided
$28.9 billion in discretionary spending for the Department of Homeland Security,
$1.8 billion more than the 2004 level of funding, which may result in increased
business opportunities for us. However, because many customers are governmental
entities with variable and uncertain budgets, the amount of business that we
might receive from them may vary from year to year, regardless of the perceived
quality of our business.
Some of our orders and contracts may be cancelled at any time on short notice
with little or no penalty, or may not be funded fully or at all.
Some of our contracts are subject to cancellation by customers upon short
notice with little or no penalty, so we cannot be certain that our backlog will
be filled. The contracts we enter into with government entities are often
awarded prior to legislative funding appropriations to support those contracts.
Consequently, the entire amount of orders and contracts received from these
entities may never be funded. If a substantial portion of our backlog orders is
cancelled, our business, operating results and financial condition could be
materially and adversely affected. In addition, the cancellation of a
substantial portion of booked orders would negatively impact other areas of our
business. For example, if we have booked orders from a large customer and the
customer cancels its order, it would greatly affect our operating results for
the period during which we would have recognized revenues from that customer.
This could cause our stock price to fluctuate and make it difficult to evaluate
our company. Moreover, cancellation of a booked order after we have ordered
components and materials to manufacture systems could result in our having
excess inventory with no corresponding income.
Because a small number of customers account for a substantial portion of our
revenues, a substantial decrease in orders from these customers could have an
adverse effect on our business unless we were able to identify other customers,
and because our sales tend to be concentrated among a small number of customers
during any period, our operating results may be subject to substantial
fluctuations.
For our fiscal year ended June 30, 2005, two customers accounted for 76%
and 20%, respectively, of our net revenues. Given the nature of our customers
and products, we receive relatively large orders for products and services from
a relatively small number of customers. Consequently, a single order from one
customer may represent a substantial portion of our sales in any one period and
significant orders by any customer during one period may not be followed by
further orders from the same customer in subsequent periods. This concentration
of customers can cause our revenues and earnings to fluctuate from
quarter-to-quarter, based on the requirements of our customers and the timing of
delivery of products and services. Although the particular customers are likely
to change from period to period, we believe that large engagements by a limited
number of customers will continue to account for a substantial portion of our
revenues in any fiscal period. In any period, the unexpected loss of or decline
in engagements from a major customer, or the failure to generate significant
revenues from other customers, could have a material adverse effect on our
financial results. Also, our sales and operating results are subject to very
substantial periodic variations. Since quarterly performance is likely to vary
significantly, our results of operations for any quarter are not necessarily
indicative of the results that we might achieve for any subsequent period.
Accordingly, quarter-to-quarter comparisons of our operating results may not be
meaningful.
6
If we were to have an event of default or breach a covenant under our senior
secured convertible debentures issued in our January 2006 private financing, the
outstanding principal amount of the debentures plus all accrued and unpaid
interest would become immediately due and payable to the holders of the
debentures, and we currently do not have the cash resources to pay these
obligations, which are secured by all of our assets including our intellectual
property and would therefore be subject to seizure by the holders of the
debentures in the event of a default or covenant breach.
Our senior secured convertible debentures contain numerous events of
default and covenants. Events of default under the debentures include:
o failure to pay principal or any premium on any debenture when due,
o failure to pay any interest, late fees or liquidated damages on any
debenture after a period of three trading days,
o failure to perform other covenants under the debenture that is not
cured by the earlier of seven trading days after notice by holder or
15 trading days after we are aware of such default,
o default under the other financing documents that is not cured by the
earlier of five trading days after notice or ten trading days after
we aware of such default,
o any representation or warranty under the financing documents that is
untrue or incorrect in any material respect,
o certain events of bankruptcy or insolvency of us or any of our
subsidiaries,
o any default by us or our subsidiaries under any instrument in excess
of $150,000 that results in such obligation becoming due and payable
prior to maturity,
o our becoming party to a change of control transaction, or disposing
of greater than 40% of our assets or redeeming more than a de
minimus number of outstanding equity securities,
o failure by us to have this registration statement registering the
resale of the common stock issuable upon the conversion of the
debentures and exercise of the accompanying common stock purchase
warrants declared effective by the SEC on or before July 10, 2006,
o if, during the effectiveness period of this registration statement,
the effectiveness of the registration statement lapses for any
reason or the holder shall not be permitted to resell registrable
securities under the registration statement, in either case, for
more than 30 consecutive trading days or 60 non-consecutive trading
days during any 12-month period, subject to certain limited
exceptions, and
o failure to deliver common stock certificates to a holder prior to
the fifth trading day after a debenture conversion date.
Upon an event of default, the outstanding principal of the debentures plus
all accrued and unpaid interest shall become immediately due and payable to the
holders of the debentures.
The debentures contain various covenants that limit our ability to:
o incur additional debt, other than permitted debt as defined in the
debenture,
o incur specified liens, other than permitted liens as defined in the
debenture,
7
o amend our certificate of incorporation or by-laws in a material
adverse manner to the holder, or
o repay or repurchase more than a de minimus number of shares of
common stock.
As part of the financing, we have agreed to be bound by the following
covenants:
o not to issue shares of common stock or other securities convertible
or exercisable into common stock until 90 days after the effective
date of this registration statement,
o not to assume any corporate debt which is senior to the debentures,
o not to repay or repurchase more than a de minimus number of shares
of common stock,
o not to incur specified liens, other than certain specified permitted
liens,
o not to amend our current certificate of incorporation, and
o not to pay cash dividends or distributions on our equity securities.
We currently do not have the cash resources to pay these obligations,
which are secured by all of our assets including our personal and intellectual
property, and such assets would therefore be subject to seizure by the holders
of the debentures in the event of a default or covenant breach. We cannot assure
you that we will not have an event of default under the debentures or experience
a covenant breach that would trigger such an event of default.
We rely on rolling forecasts when ordering components and materials for the
manufacture of our products and we could overestimate or underestimate our
actual requirements, which could result in an increase in our costs or prevent
us from meeting customer demand.
We use rolling forecasts based on anticipated orders to determine
component requirements. Lead times for materials and components vary
significantly and depend on factors such as specific supplier requirements,
contract terms and current market demand for such components. As a result, our
component requirement forecasts may not be accurate. If our management
overestimates our component requirements, we may have excess inventory, which
would increase our costs. If our management underestimates component
requirements, we may have inadequate inventory, which could interrupt
manufacturing and delay delivery of product to customers.
Our product offerings involve a lengthy sales cycle and our management may not
anticipate sales levels appropriately, which could impair our profitability.
Our products and services are designed for medium to large commercial,
industrial and government facilities, such as military installations, office
buildings, nuclear power stations and other energy facilities, airports,
correctional institutions and high technology companies desiring to protect
valuable assets and/or prevent intrusion into high security facilities. Given
the nature of our products and customers, sales cycles can be lengthy since
customers conduct intensive investigations of specific competing technologies
and providers. Moreover, orders received from governments may be subject to
funding appropriations which may not be approved. For these and other reasons,
the sales cycle associated with our products is typically lengthy and subject to
a number of significant risks over which we have little or no control. If sales
in any period fall significantly below anticipated levels, our revenues could
suffer. In addition, our operating expenses are based on anticipated sales
levels, and a high percentage of our expenses are generally fixed in the short
term. As a result of these factors, a small fluctuation in timing of sales can
cause our operating results, which are tied to the marketing and sale of our
products, to fluctuate widely.
8
A portion of our business involves projects and sales outside the United States,
and we are therefore influenced by factors and regulations in other countries.
During our fiscal years ended June 30, 2005 and 2004, we generated
approximately 5% and 11%, respectively, of our business from projects outside
the United States. The occurrence of any of the following risks could have a
materially adverse effect on both the market for our products and services or
our ability to provide them, and, as a result, these risks could materially
adversely affect the operations and value of any of our overseas projects:
o changes in, and difficulty in complying with, laws and regulations
of the different countries including authority to trade our products
or perform our services,
o nullification, modification and renegotiation of contracts,
o reversal of current policies, including favorable tax policies,
encouraging foreign investment of foreign trade, or relating to the
use of local agents,
o restrictive actions by local governments including tariffs and
limitations on imports and exports, and
o difficulty in collecting accounts receivable and longer collection
times.
We depend on relationships with strategic partners as a source of business and
our business could suffer if these relationships are terminated.
We have entered into strategic partnerships or teaming arrangements with
several large multinational corporations that promote our products and services
and incorporate our products into their projects. In the event that we are
unable to maintain these strategic relationships for any reason, our business,
operating results and financial condition could be adversely affected.
We compete against entities that have significantly greater name recognition and
financial resources than we have, enabling them to respond more quickly to
changes in customer requirements and to allocate greater resources to marketing
efforts in this competitive industry.
The security industry is highly competitive and continues to become
increasingly so as security issues and concerns have become a primary
consideration at both government and private facilities worldwide. Competition
is intense among a wide ranging and fragmented group of product and service
providers, including security equipment manufacturers, providers of integrated
security systems, systems integrators, consulting firms, engineering and design
firms and others that provide individual elements of a system, some of which are
larger than us and possess significantly greater name recognition, assets,
personnel, sales and financial resources. These entities may be able to respond
more quickly to changing market conditions by developing new products that meet
customer requirements or are otherwise superior to our products and may be able
to more effectively market their products than we can because of the financial
and personnel resources. We cannot assure you that we will be able to
distinguish ourselves in a competitive market.
We rely on suppliers for principal components used in our products, and
prolonged disruptions in supply or significant increases in component costs
could materially harm our business.
We rely on suppliers for several key components utilized in the
manufacture of our products. Our reliance on suppliers involves certain risks,
including a potential inability to obtain an adequate supply of required
components, price increases, timely delivery and component quality. To date,
although we have not experienced any disruption in supplies of components, we
cannot assure you that there will not be a disruption of our supplies in the
future. Disruption or termination of the supply of components could delay
shipments of products and could have a material adverse affect on our business,
operating results and financial condition.
9
If our subcontractors fail to perform their contractual obligations, our prime
contract performance and our ability to obtain future business may be seriously
harmed.
Many of our contracts involve subcontracts with other companies upon which
we rely to perform a portion of the services that we must provide to our
customers. There is a risk that we may have disputes with our subcontractors,
including disputes regarding the quality and timeliness of work performed by the
subcontractor. A failure by one or more of our subcontractors to satisfactorily
perform the agreed-upon services may materially and adversely impact our ability
to perform our obligations as the prime contractor. Subcontractor performance
deficiencies could result in a customer terminating our contract for default. A
default termination could expose us to liability and have a material adverse
effect on our ability to compete for future contracts and orders.
Our products, services and reputation, and ultimately our results of operations,
may be adversely affected by product defects or inadequate performance for
customers.
In the event our products do not perform to specifications or are
defective in any way, our reputation may be adversely affected and we may suffer
a loss of business and a corresponding loss in revenues.
If we are unable to retain key executives, who we need to succeed, or hire new
qualified personnel, who are difficult to attract, our business will be
adversely affected.
Our success greatly depends on our ability to retain existing management
and attract key technical, sales, marketing, information systems, and financial
and executive personnel. We are especially dependent on the continued services
of our senior management team, particularly Arthur Barchenko, our President and
Chief Executive Officer, and our key marketing personnel. The loss of any of
these people could have a materially detrimental effect on our business. We have
not entered into employment agreements with any of these people. We do not
maintain key person life insurance on any of our personnel. In addition, we are
seeking to engage senior sales staff and if we fail to attract, hire or retain
the necessary personnel, or if we lose the services of any member of our senior
management team, our business could be adversely affected.
Risks Related to Our Common Stock
Our common stock price has fluctuated considerably and may not appreciate in
value.
Prices for our common stock has in the past, and could continue to,
fluctuate significantly and will be influenced by many factors, including the
depth and liquidity of the market for the common stock, investor perception of
the industry in which we operate and our products, and general economic and
market conditions. Factors which could cause fluctuation in the price of our
common stock include:
o conditions or trends in the industry,
o failure to keep pace with changing technology,
o costs associated with developing new products and services,
o cost associated with marketing products and services may increase
significantly,
o the timing of sales and the recognition of revenues from them,
o government regulations may be enacted which affect how we do
business and the products which may be used at government
facilities,
o downward pressure on prices due to increased competition,
o changes in our operating expenses,
o sales of common stock,
10
o actual or anticipated variations in quarterly results, and
o changes in financial estimates by securities analysts.
The stock market in general has experienced extreme price and volume
fluctuations. The market prices of shares of security-related companies have
experienced fluctuations that often have been unrelated or disproportionate to
the operating results of these companies. Continued market fluctuations could
result in extreme volatility in the price of our common stock, which could cause
a decline in the value of our common stock. Price volatility might be worse if
the trading volume of our common stock is low.
Our common stock may be considered a "penny stock" and may be difficult to
trade.
The SEC has adopted regulations which generally define "penny stock" as an
equity security with a market or exercise price of less than $5.00 per share,
subject to specific exemptions. The market price of our common stock is less
than $5.00 per share, and therefore may be designated as a "penny stock"
according to SEC rules. Under these rules, broker-dealers who recommend such
securities to persons other than institutional accredited investors must:
o make a special written suitability determination for the purchaser,
o receive the purchaser's written agreement to a transaction prior to
sale,
o provide the purchaser with risk disclosure documents which identify
certain risks associated with investing in "penny stocks" and which
describe the market for these "penny stocks" as well as a
purchaser's legal remedies, and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the required
risk disclosure document before a transaction in a "penny stock" can
be completed.
Under these rules, broker-dealers may find it difficult to effectuate
customer transactions and trading activity in our securities may be adversely
affected. As a result, the market price of our securities may be depressed, and
you may find it more difficult to sell our securities. In addition, you may find
it difficult to obtain accurate quotations of our common stock and may
experience a lack of buyers to purchase such stock or a lack of market makers to
support the stock price.
Our common stock is traded over the counter, which may result in higher price
volatility and less market liquidity for our common stock.
Our common stock is quoted on the OTC Bulletin Board. As such, our common
stock may have fewer market makers, lower trading volumes and larger spreads
between bid and asked prices than securities listed on an exchange such as the
New York Stock Exchange, the American Stock Exchange or the Nasdaq Stock Market.
These factors may result in higher price volatility and less market liquidity
for our common stock.
Compliance with changing regulation of corporate governance and public
disclosure may result in additional expenses.
Keeping abreast of, and in compliance with, changing laws, regulations and
standards relating to corporate governance and public disclosure, including the
Sarbanes-Oxley Act of 2002, new SEC regulations and, in the event we are
approved for listing on a registered exchange at some point, stock exchange
rules, will require an increased amount of management attention and external
resources. We intend to continue to invest all reasonably necessary resources to
comply with evolving standards, which may result in increased general and
administrative expenses and a diversion of management time and attention from
revenue-generating activities to compliance activities.
11
Our principal stockholders have significant voting power and may take actions
that may not be in the best interest of other stockholders.
Our executive officers, directors and principal stockholders control
approximately 33% of our currently outstanding shares of common stock. If these
stockholders act together, they may be able to exert significant control over
our management and affairs requiring stockholder approval, including approval of
significant corporate transactions. This concentration of ownership may have the
effect of delaying or preventing a change in control and might adversely affect
the market price of our common stock. This concentration of ownership may not be
in the best interests of all our stockholders.
We do not anticipate paying cash dividends on our common stock in the near
future, and the lack of dividends may have a negative effect on our stock price.
We have never declared or paid any cash dividends or distributions on our
capital stock. We currently intend to retain our future earnings to support
operations and to finance expansion and therefore we do not anticipate paying
any cash dividends on our common stock in the near future.
Investors in our securities will suffer dilution.
The issuance of shares of our common stock, or shares of our common stock
underlying warrants, options, preferred stock or convertible debentures, will
dilute the equity interest of existing stockholders who do not have
anti-dilution rights and could have a significant adverse effect on the market
price of our common stock. The sale of our common stock acquired, or converted
or exercised into, at a discount could have a negative impact on the market
price of our common stock and could increase the volatility in the market price
of our common stock. In addition, we may seek additional financing which may
result in the issuance of additional shares of our common stock and/or rights to
acquire additional shares of our common stock. The issuance of our common stock
in connection with such financing may result in substantial dilution to the
existing holders of our common stock who do not have anti-dilution rights. The
sale of our common stock, or securities convertible or exercisable into shares
of our common stock, could trigger the anti-dilution rights of our outstanding
securities that have such rights, specifically our preferred stock, convertible
debentures and some of our warrants, which could result in further dilution to
the existing holders of our common stock who do not have anti-dilution rights.
With respect to the senior secured convertible debentures and warrants that we
issued in our January 2006 private financing, in the event that we issue common
stock in an equity financing at a price less than the then conversion price and
exercise price for the debentures and the warrants, respectively, (i) the
conversion price of the debentures shall be immediately adjusted to the price at
which such common stock was issued, subject to specified exempt issuances, and
(ii) the exercise price of the warrants shall be reduced to the price at which
such common stock was issued and the share amount shall be increased such that
the aggregate exercise price payable, after taking into account the decrease in
the exercise price, shall be equal to the aggregate exercise price prior to such
adjustment. Those additional issuances of our common stock and potential
triggering of existing anti-dilution rights would result in a reduction of an
existing holder's percentage interest in our company.
A significant number of our shares will be eligible for sale, and their sale
could depress the market price of our common stock.
Sales of a significant number of shares of our common stock in the public
market could harm the market price of our common stock. We are registering an
aggregate of 3,374,909 shares of our common stock for resale in the public
market pursuant to this registration statement. As such shares of our common
stock are resold in the public market, the supply of our common stock will
increase, which could decrease its price. In addition, there is an aggregate of
[8,772,559] shares of our common stock which are not being registered pursuant
to this registration statement. Some or all of these shares of our common stock
may also be offered from time to time in the open market pursuant to Rule 144,
and these sales may have a depressive effect on the market for our shares of
common stock. In general, a person who has held restricted shares for a period
of one year may, upon filing with the SEC a notification on Form 144, sell into
the market shares of our common stock in an amount equal to the greater of 1% of
the outstanding shares or the average weekly number of shares sold in the last
four weeks prior to such sale. Such sales may be repeated once each three
months, and any of the restricted shares may be sold by a non-affiliate after
they have been held for two years.
12
We could issue "blank check" preferred stock without stockholder approval with
the effect of diluting then current stockholder interests and impairing their
voting rights.
Our certificate of incorporation authorizes the issuance of up to an
additional 3,898,000 shares of "blank check" preferred stock with designations,
rights and preferences as may be determined from time to time by our board of
directors. Accordingly, our board of directors is empowered, without stockholder
approval, to issue a series of preferred stock with dividend, liquidation,
conversion, voting or other rights which could dilute the interest of, or impair
the voting power of, our common stockholders. The issuance of a series of
preferred stock could be used as a method of discouraging, delaying or
preventing a change in control. For example, it would be possible for our board
of directors to issue preferred stock with voting or other rights or preferences
that could impede the success of any attempt to change control of our company.
The liability of our directors is limited under State of New Jersey corporate
law.
As permitted by the corporate laws of the State of New Jersey, our
certificate of incorporation includes a provision which eliminates the personal
liability of our directors for monetary damages for breach or alleged breach of
their fiduciary duties as directors, subject to certain exceptions. In addition,
our by-laws provide that we are required to indemnify our officers and directors
under certain circumstances, including those circumstances in which
indemnification would otherwise be discretionary, and we are required to advance
expenses to our officers and directors as incurred in connection with
proceedings against them for which they may be indemnified.
13
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Included in this prospectus are "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, as well as historical information. Although we
believe that the expectations reflected in these forward-looking statements are
reasonable, we cannot assure you that the expectations reflected in these
forward-looking statements will prove to be correct. Our actual results could
differ materially from those anticipated in forward-looking statements as a
result of certain factors, including matters described in the section titled
"Risk Factors." Forward-looking statements include those that use
forward-looking terminology, such as the words "anticipate," "believe,"
"estimate," "expect," "intend," "may," "project," "plan," "will," "shall,"
"should," and similar expressions, including when used in the negative. Although
we believe that the expectations reflected in these forward-looking statements
are reasonable and achievable, these statements involve risks and uncertainties
and we cannot assure you that actual results will be consistent with these
forward-looking statements. Important factors that could cause our actual
results, performance or achievements to differ from these forward-looking
statements include the following:
o the fact that all orders and contracts placed by government entities
may be cancelled, so there is a risk that our backlog may not be
fulfilled,
o because our sales tend to be concentrated among a small number of
customers in any period, our operating results may be subject to
substantial fluctuations,
o we rely on rolling forecasts when ordering components and materials
from which we manufacture products, which could cause us to
overestimate or underestimate our actual requirements and which
could cause an increase in our costs or prevent us from meeting
customer demand,
o our product offerings involve a lengthy sales cycle and management
may not anticipate sales levels appropriately, which could impair
profitability, and
o we are subject to the risks of doing business in foreign countries.
All forward-looking statements attributable to us are expressly qualified
in their entirety by these and other factors. We undertake no obligation to
update or revise these forward-looking statements, whether to reflect events or
circumstances after the date initially filed or published, to reflect the
occurrence of unanticipated events or otherwise.
14
USE OF PROCEEDS
This prospectus relates to shares of our common stock that may be offered
and sold from time to time by the selling stockholders. We will not receive any
proceeds from the sale of shares of common stock in this offering. However, we
could receive up to $2,567,566 from the cash exercise price upon exercise of
warrants held by the selling stockholders. We expect to use the proceeds
received from the exercise of the warrants, if any, for working capital and
general corporate purposes. We will bear all expenses of registration incurred
in connection with this offering, but all selling and other expenses incurred by
the selling stockholders will be borne by them. We estimate that our expenses in
connection with the filing of this registration statement will be approximately
$35,000.
15
MARKET FOR OUR COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Based on information furnished by our transfer agent, as of February 27,
2006, there were approximately 200 holders of record of our common stock and
there were 8,772,559 shares of our common stock outstanding. This number of
holders of record does not include beneficial owners our common stock whose
shares are held in the names of various security holders, dealers and clearing
agencies.
Quotation of our common stock on the OTC Bulletin Board commenced in June
2001 and it is quoted on the OTC Bulletin Board under the trading symbol
EKCS.OB. The following table sets forth, for the periods indicated, quotations
for the high and low bid prices for our common stock for each quarter within the
last two fiscal years, as reported by the OTC Bulletin Board. These quotations
reflect inter-dealer prices, without retail mark-up, markdown, or commission and
may not represent actual transactions.
Closing Bid
High Low
-------- ---------
Fiscal Year 2004 (July 1, 2003 - June 30, 2004)
- -----------------------------------------------
First Quarter $ 1.75 $ .26
Second Quarter 1.80 1.00
Third Quarter 1.30 .59
Fourth Quarter 2.24 .60
Fiscal Year 2005 (July 1, 2004 - June 30, 2005)
- -----------------------------------------------
First Quarter $ 2.25 $ 1.10
Second Quarter 3.20 1.90
Third Quarter 2.50 1.30
Fourth Quarter 1.70 1.08
Fiscal Year 2006 (July 1, 2005 - June 30, 2006)
- -----------------------------------------------
First Quarter $ 1.85 $ 1.15
Second Quarter 1.50 .85
Third Quarter (January 1, 2006 - February 24, 2006) 1.14 .95
Dividend Policy
We have never declared or paid any cash dividends on our common stock. We
anticipate that any earnings will be retained for development and expansion of
our business and do not anticipate paying any cash dividends in the near future.
Our Board of Directors has sole discretion to pay cash dividends based on our
financial condition, results of operation, capital requirements, contractual
obligations and other relevant factors.
Equity Compensation Plan Information
Incentive Stock Option Plan. In 1986, we adopted our Incentive Stock
Option Plan, which we renewed in 1996 for a second ten-year term. We initially
had reserved 1,000,000 shares of common stock for issuance under the Incentive
Stock Option Plan, which was increased to 2,000,000 shares upon the approval of
the stockholders at our 2005 annual meeting. Our board of directors administers
the Incentive Stock Option Plan but may delegate such administration to a
committee of three persons, one of whom must be a member of the board. The board
or the committee has the authority to determine the number of stock options to
be granted, when the stock options may be exercised and the exercise price of
the stock options, provided that the exercise price may never be less than the
fair market value of the shares of the common stock on the date the stock option
is granted (110% in the case of any employee who owns more than 10% of the
combined voting power or value of all classes of stock). Stock options may be
granted for terms not exceeding ten years from the date of the grant, except for
stock options granted to any person holding in excess of 5% of our common stock,
in which case the stock options may not be granted for a term not to exceed five
years from the date of the grant.
16
Non-Statutory Stock Option Plan. We also adopted a Non-Statutory Stock
Option Plan and have reserved 250,000 shares of common stock for issuance to
directors, employees and non-employees. Stock options granted pursuant to this
plan will be non-transferable and expire, if not exercised within five years
from the date of the grant. Stock options will be granted in such amounts and at
such exercise prices as our board of directors may determine.
The following table sets forth additional information as of February 27,
2006, concerning shares of our common stock that may be issued upon the exercise
of stock options and other rights under our existing equity compensation plans
and arrangements, divided between plans approved by our stockholders and plans
or arrangements not submitted to our stockholders for approval. The information
includes the number of shares covered by and the weighted average exercise price
of, outstanding stock options and other rights and the number of shares
remaining available for future grants excluding the shares to be issued upon
exercise of outstanding stock options, warrants and other rights.
Equity Compensation Plan Information
- -----------------------------------------------------------------------------------------------------------------------------------
Number of securities
remaining available
for future issuance
under equity
Number of securities to be compensation plans
issued upon exercise of Weighted-average exercise (excluding securities
outstanding options, warrants price of outstanding reflected in the second
Plan Category and rights options, warrants and rights column)
- ----------------------------------------- ------------------------------- ------------------------------ -----------------------
Equity compensation plans approved by 1,524,500(2) $1.30 725,500
security holders (1)
Equity compensation plans not approved -- -- --
by security holders
Total 1,524,500 $1.30 725,500
- -----------------------------------------
(1) Includes our Incentive Stock Option Plan and our Non-Statutory Stock
Option Plan.
(2) Consists of stock options to purchase 1,524,500 shares of common stock
17
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
The following discussion of our financial condition and results of
operations should be read in conjunction with our financial statements and the
related notes included in this prospectus beginning on page F-1. This discussion
includes forward-looking statements that involve risks and uncertainties. As a
result of many factors, such as those set forth under "Risk Factors" and
elsewhere in this prospectus, our actual results may differ materially from
those anticipated in these forward-looking statements.
Overview
We design, develop, manufacture and market technology-based integrated
security systems. We also provide consulting services consisting of risk
assessment and vulnerability studies to ascertain a customer's security
requirements in developing a comprehensive risk management and mitigation
program, as well as product design and engineering services.
We market our products domestically and internationally to:
o national and local government entities, including DoD and DoE,
o large chemical and petrochemical facilities, and major office
complexes,
o energy facilities, including nuclear power stations, power utilities
and pipelines, and
o commercial transportation centers, such as airports and seaports,
and
o water and agricultural resources including reservoirs, dams, fish
hatcheries and rivers.
We believe that we are one of a few comprehensive security solution
providers in the industry. We analyze security risks and develop security
solutions specifically tailored to mitigate those risks, including designing,
engineering and manufacturing individual components of a system as may be
necessary to deliver a fully integrated security system customized to a
customer's requirements. We are frequently engaged by security system
integrators, security system dealers/installers, and commercial architects and
engineers because we are able to deliver an integrated platform for a fully
integrated security solution to support our customers' requirements for the
completion of a given project.
Critical Accounting Policies
Our significant accounting policies, including the assumptions and
judgments underlying them, are more fully described in our "Notes to
Consolidated Financial Statements" included with financial statements in this
prospectus. Some of our accounting policies require the application of
significant judgment by our management in the preparation of the consolidated
financial statements, and as a result, they are subject to a greater degree of
uncertainty. In applying these policies, our management uses its judgment to
determine the appropriate assumptions to be used in calculating estimates that
affect the reported amounts of assets, liabilities, revenues and expenses. Our
management bases its estimates and assumptions on historical experience and on
various other factors that are believed to be reasonable under the
circumstances. We have identified certain of our accounting policies as the ones
that are most important to the portrayal of our consolidated financial condition
and results of operations and which require our management to make its most
difficult and subjective judgments, often as a result of the need to make
estimates of matters that are inherently uncertain. Our critical accounting
policies include the following:
Inventory Valuation
Inventories are valued at lower of cost or market. We routinely evaluate
the composition of our inventory to identify obsolete or otherwise impaired
inventories. Inventories identified as impaired are evaluated to determine if
reserves are required. We do not currently have any reserves against inventory.
18
Allowance for Doubtful Accounts
The allowance for doubtful accounts is comprised of two parts, a specific
account analysis and a general reserve. Accounts where specific information
indicates a potential loss may exist are reviewed and a specific reserve against
amounts due is recorded. As additional information becomes available such
specific account reserves are updated. Additionally, a general reserve is
applied to the aging categories based on historical collection and write-off
experience.
Accounting for Income Taxes
We record a valuation allowance to our deferred tax assets to the amount
that is more likely than not to be realized. While we consider historical levels
of income, expectations and risks associated with estimates of future taxable
income and ongoing prudent and feasible tax planning strategies in assessing the
need for the valuation allowance, in the event that we determine that we would
be able to realize deferred tax assets in the future in excess of the net amount
recorded, an adjustment to the deferred tax asset would increase income in the
period such determination has been made. Likewise, should we determine that we
would not be able to realize all or part of the net deferred tax asset in the
future, an adjustment to the deferred tax asset would be charged against income
in the period such determination was made. A valuation allowance in the amount
of $515,553 has been recorded against our deferred tax asset at June 30, 2005.
Results of Operations
Six Months Ended December 31, 2005 (the 2005 period) Compared to Six
Months Ended December 31, 2004 (the 2004 period)
Revenues. We had net revenues of $4,059,565 for the 2005 period as
compared to net revenues of $1,957,592 for the 2004 period, an increase of
approximately 107%. The increase in revenues in the 2005 period is primarily
attributable to the IBDSS contract award on the Tinker Air Force Base project
and nuclear facility security upgrades. Of the revenues reported in the 2005
period, approximately 98% are attributable to domestic projects and 2% are
attributable to international projects.
Gross Margins. Gross margins for the 2005 period were 22.23% of revenue as
compared to 37.76% of revenue for the 2004 period. The decrease in gross margins
for the 2005 period as compared to the 2004 period is primarily attributable to
an increase in the utilization of sub-contractors related to the Tinker Air
Force Base project during the 2005 period as well as an increase in the order
mix for lower gross margin products during the 2005 period. In the corresponding
period in 2004, we performed a greater percentage of higher gross profit
generating activities such as design and engineering services.
Research and Development. Research and development expenses consist
primarily of expenses incurred in designing and developing upgrades to existing
products and systems as well as new product development work on the Sentinal(TM)
water technologies. Research and development expenses for the 2005 period were
$109,102 as compared to $161,829 for the 2004 period, a decrease of
approximately 33%. The decrease in research and development expenses during the
2005 period as compared to the 2004 period is primarily attributable to the
completion or termination of certain research and development programs.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the 2005 period were $1,136,699 as compared to
$806,299 for the 2004 period, an increase of approximately 41%. The increase is
primarily attributable to the recruitment of new financial management personnel,
as well as marketing and sales support personnel. The increase is also partially
attributable to the general and administrative costs incurred by our new
wholly-owned subsidiary, Clarion Systems, Inc., which approximated $157,000 for
the 2005 period.
Stock-Based Compensation. In the 2005 period, we issued immediately-vested
stock to various consultants valued at $61,087 at the time of issuance. In the
2004 period, we issued immediately-vested stock to various consultants and to
the directors that were valued at $120,000 at the time of issuance. Stock-based
compensation is non-cash and, therefore, has no impact on cash flow or
liquidity.
19
Interest Expense. Interest expense in the 2005 period was $57,809 as
compared to $56,885 in the 2004 period, an increase of approximately 2%. The
increase in the 2005 period is attributable to the higher average amount of
outstanding debt balances.
Minority Interest in Subsidiary Loss. The minority interest in the loss
attributable to the foreign subsidiary was $27,340 for the 2005 period as
compared to the $27,166 for the 2004 period.
Net Loss. Net loss before deemed dividends is $(432,376) for the 2005
period and as compared to $(364,098) for the 2004 period.
Year Ended June 30, 2005 (the fiscal 2005 period) Compared to Year Ended
June 30, 2004 (the fiscal 2004 period)
Revenues. We had net revenues of $5,967,469 for the fiscal 2005 period as
compared to revenues of $2,061,412 for the fiscal 2004 period, an increase of
190%. Of the revenues reported in the fiscal 2005 period, approximately 95% was
domestic and 5% was related to international projects. The increase in sales in
the fiscal 2005 period is primarily attributable to the award of Tinker Air
Force Base by the DoD and release of other certain projects that were awaiting
funding and/or the approval of 26 submittal drawings. The funding and/or
submitted drawings are related to domestic projects. Foreign governments as well
as private industrial concerns overseas have slowed the release of other
anticipated projects.
Gross Margins. Gross margins for the fiscal 2005 period were 40.82% of
revenue as compared to 54.95% of revenue for the fiscal 2004 period. The
decrease in the fiscal 2005 period is primarily due to an increase in the order
mix for lower gross margin subcontractor services related to the Tinker Air
Force Base contract, as compared to the fiscal 2004 period, where the
fulfillment of orders mostly entailed the shipment of higher gross margin
products and services.
Research and Development. Research and development expenses decreased in
the fiscal 2005 period to $285,916 from $322,912 in the fiscal 2004 period, a
decrease of approximately 12%. Research and development expenses in the fiscal
2005 period were for upgrades to existing products and systems and for new
product development work on the Fiber Optic Intrusion Detection System
(FOIDS(R)).
Selling, General and Administrative. Selling, general and administrative
expenses increased in the fiscal 2005 period to $2,101,435 from $1,782,534 in
the fiscal 2004 period, an increase of approximately 18%. The increase in fiscal
2005 is primarily the result of our management's action to increase certain
fixed overhead and payroll costs commencing January 1, 2005 to support higher
revenues. The increase was also partially due to the write-off of certain
accounts receivable totaling $200,025 due to the projects not being funded.
Stock-Based Compensation. In the fiscal 2005 period, we issued immediately
vested stock to a consultant valued at $120,000. In the fiscal 2004 period, we
issued immediately vested stock and stock options to various employees,
consultants and to the directors valued at $117,200. Stock-based compensation is
non-cash and, therefore, has no impact on our net worth, cash flow or liquidity.
Interest Expense. Interest expense in the fiscal 2005 period was $118,029
as compared to $105,916 for the fiscal 2004 period, an increase of 11.4%. The
increase was attributable to the higher average amount of outstanding debt
balances.
Interest Income. Interest income in the fiscal 2005 period was $15,498 as
compared to $3,128 in the fiscal 2004 period, an increase of 395%. The increase
was due to certain investments and certificate of deposit.
Minority Interest in Subsidiary Loss. The minority interest in the loss
from the foreign subsidiaries was $48,899 for the fiscal 2005 period as compared
to $42,633 for the fiscal 2004 period, an increase of 14.7%. The first foreign
subsidiary was formed in January 2002 and commenced operations in May 2002. In
January 2003, it ceased to exist as an operating subsidiary and the assets were
transferred to a newly created foreign subsidiary. We established the new
foreign operating subsidiary, in which we own a 70% interest, to conduct our
business in the Middle East.
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Income Tax Benefit. In the fiscal 2005 period, we did not recognize any
tax benefits from current year net operating loss. In the fiscal 2004 period, we
recognized $31,300 of tax benefits from the current year net operating loss,
which will be used to offset taxable income in a future.
Net Loss. Net loss before dividends for the fiscal 2005 period was
$(122,196) as compared to a loss of $(1,118,656) for the same period in fiscal
2004, a decrease of 89.1%.
Dividends Related to Preferred Stock
In July 2005, we declared and paid dividends equal to $153,042 on our
series A convertible preferred stock for the years ended March 31, 2004 and
2005. The dividend was paid via the issuance of 99,378 shares of our common
stock.
In the 2005 period, we recorded dividends totaling $81,902 on our 10%
series B convertible preferred stock as compared to $100,000 in the 2004 period.
In the fiscal 2005 period, we recorded dividends totaling $199,306 on our 10%
series B convertible preferred stock. In lieu of a cash payment we have elected
under the terms of the agreement by which we sold these securities to add this
amount to the stated value of the 10% series B convertible preferred stock.
These dividends are non-cash and, therefore, have no impact on our net
worth, cash flow or liquidity.
In addition, we recorded a deemed dividend totaling $1,044,147 in the
fiscal 2004 period to reflect the beneficial conversion price of our 10% series
B convertible preferred stock as compared to the prevailing market price of the
common stock on the date of commitment. This adjustment has no impact on our net
equity since the offset to the deemed dividend is an offsetting increase in
additional paid-in capital.
Liquidity and Capital Resources
At December 31, 2005, we had working capital of approximately $2.6 million
compared to approximately $3.2 million at June 30, 2005. Net cash used by
operating activities for the six months ended December 31, 2005 was $199,727 as
compared to net cash used by operating activities of $364,721 for the six months
ended December 31, 2004.
Inventory has decreased by $159,914 during the six months ended December
31, 2005, but has remained relatively high in anticipation of shipments for
committed projects.
Accounts receivables as a percentage of sales has increased. Days sales
outstanding (DSO) were 233 days at December 31, 2005 as compared to 86 days at
June 30, 2005. This is due to certain payments and retainage on the Tinker Air
Force Base work being held until final completion of projects expected to occur
in the third quarter of fiscal year 2006.
Accounts payable and accrued expenses have increased by $982,733, to
$2,168,156, for the six months ended December 31, 2005 as payments to vendors
have been delayed to match the corresponding delay in collection of accounts
receivables.
Investing activities for the 2005 period included the purchase of
equipment and software required to upgrade two major product lines at a cost of
$92,235. We do not have any material commitments for capital expenditures going
forward.
Financing activities in the 2005 period included a short-term loan in the
amount $500,000, of which $325,000 was repaid in the period and fully repaid in
January 2006 from the proceeds of the private placement discussed below.
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In January 2006, we raised net proceeds of $927,500 in a private placement
to four institutional accredited investors of $1,000,000 in principal amount of
our senior secured convertible debentures. Our obligations with respect to the
debentures are secured by a lien on all of our assets, including our
intellectual property. The debentures have a term of three years and are
convertible at the option of the holder at any time into shares of our common
stock at a conversion price of $1.15 per share, subject to certain adjustments.
Interest is payable at a rate equal to the greater of 8% per annum or the prime
rate for the applicable interest period (the current prime rate is 7.5%) plus
2.5%. Quarterly interest payments on the debentures are scheduled to begin on
April 1, 2006. At our option, interest payments are payable either in cash or in
registered shares of our common stock, subject to certain conditions. Investors
in the private placement received three-year warrants to purchase up to 434,783
shares of our common stock at a per share exercise price of $2.00. The warrants
may be exercised on a cashless basis following the first anniversary of issuance
if a registration statement covering the common stock issuable upon exercise of
such warrants is not in effect at the time of exercise. The debentures restrict
our ability to incur additional debt, except for specified exempt issuances.
A portion of the net proceeds from the private placement of the debentures
was used to repay in full outstanding loans in the aggregate amount of $658,339
owed to a commercial bank. In connection with the repayment of these loans, the
bank released our certificate of deposit in the amount of $255,721 that it held
as collateral to secure repayment of those loan obligations. Remaining long-term
bank debt in the aggregate amount of $70,675 at December 31, 2005 is payable in
monthly installments of $2,750 plus interest at the rate of prime plus 0.5% per
annum.
We also realized net proceeds of $54,400 from the exercise of outstanding
stock options and warrants in the 2005 period and $644,950 in the 2004 period.
We expect that cash on hand together with cash generated from operations
will be sufficient to provide for our working capital needs for the next 12
months. We remain committed to pursuing acquisitions that may add to our
revenues and enhance both our product line and, ultimately, our ability to
compete in our industry. It is likely that we will require additional financing
or other sources of capital to complete any acquisitions, as well as take
advantage of any major business opportunities that arise. We may not be
successful in our efforts to raise additional funds. Even if we are able to
raise additional funds through the issuance of debt or other means, our cash
needs could be heavier than anticipated in which case we could be forced to
raise additional capital. At the present time, we have no commitments for any
additional financing, and there can be no assurance that, if needed, additional
capital will be available to us on commercially acceptable terms or at all.
Discussion of Results, Business Outlook and Identifiable Industry Trends
Spending in the security industry has increased over the last several
months as the U.S. Congress has continued to allocate money to fund homeland
security initiatives. We expect this trend will continue for the foreseeable
future. As a result, the level of new proposals continues and our committed
backlog, including the IBDSS awards from the U.S. Air Force, is the largest
backlog in our history. We cannot, however, assure you that we will complete any
or all of the orders comprising our backlog within the anticipated time frame.
Our experience has taught us that all of these anticipated releases and new
contracts are subject to cancellation or delay, thus we cannot be certain as to
the total realized revenue amount of our backlog and do not even reference the
total dollar amount of our present backlog or submitted proposals.
Our sales dependency has shifted from our President and Chief Executive
Officer, Arthur Barchenko, to seven marketing and sales managers to meet our
revenue objectives. During the last year, we have sought to mitigate the
concentration of sales efforts by (i) retaining new personnel and engaging
independent contractors to market our products and generate sales opportunities
and (ii) expanding sales efforts in geographic regions on which we have not
focused our resources in years past such as the Caribbean, Latin America, Egypt
and the Middle East, and Africa, where we are developing projects that
management believes will result in ongoing revenue.
We submitted bids on 11 new projects for work to be performed at our
Clifton, New Jersey, Indianapolis, Indiana and Madison, Alabama facilities. We
cannot be certain that we will be successful in winning any of the bids
tendered. Even if we do receive orders, contracts are subject to cancellation by
customers upon short notice with little or no penalty, as is typical in our
industry.
22
We believe these steps and others we expect to implement over the course
of fiscal year 2006 will help us to achieve revenue stability and consistent and
steady growth in the years ahead.
We are committed to offering our customers comprehensive, integrated
security systems that employ the latest technologies and address the most
critical security requirements. The security industry continues to evolve
rapidly as new technologies are developed specifically to meet security
challenges and existing technologies are being adapted for new uses. In
addition, the public and private sectors continue to analyze and distinguish new
security risks and industry participants seek to develop technologies and
products to fill these newly discerned requirements. We remain committed to
pursuing acquisitions that may add to our revenues and enhance both our product
line and, ultimately, our ability to compete in our industry.
During the first quarter of fiscal year 2006, we entered into a letter of
intent to acquire Phone-Or Ltd., an Israeli company that provides proprietary
acoustic monitoring sensor systems designed for detection sensing applications.
We currently are completing a due diligence investigation of Phone-Or. Phone-Or
is an innovative technology leader in acoustic communications and monitoring
systems that has made limited sales in Canada, Russia, China, Malaysia, Japan,
Thailand, Taiwan, Singapore, India, Australia, Italy, the United Kingdom,
Scandinavia and Romania. If we decide to move forward with the acquisition, we
intend to introduce our technologies through Phone-Or's channel of distribution.
Business Outlook
As global economic prospects began to change during 2005, orders and
commitments increased. Currently, purchase order commitments continue to grow.
However, our historical results have taught us that the release of funds that
support contracts and orders may never be forthcoming. Furthermore, as is
customary in the security industry, our contracts are subject to cancellation or
delay at any time with little notice or penalty. Government based orders which
are subject to legislative appropriations are particularly sensitive to economic
and political conditions. Thus we cannot be certain as to the total realized
value and revenue which we will generate from committed orders. We expect to
receive releases and task orders for a significant portion of our contract
commitments sometime within the next 8 to 12 months, although we cannot be
certain that we will complete any or all of such orders within the anticipated
time frame.
The security industry as a whole has not changed. The security market
historically has been a product-oriented opportunity for manufacturers, both
within the United States and internationally. The difficulty the industry
traditionally has faced has been the ability to develop a standard security
platform that would permit systems integrators to design a seamless interface
between the multiple products and subsystems required to address threats in
high-security environments. A number of companies are attempting to develop
platforms that address seamless integration of multiple technologies. We expect
this trend continuing for the foreseeable future, since the demand for
integrated platforms will continue.
We recognized this trend early in our existence and to that end, we have
developed, marketed and installed integrated platforms which encompass multiple
technologies. We continue to seek to improve our integrated systems and have
retained a highly-competent system oriented software programmer and two
computer-oriented electronic engineers to further develop and enhance the
integrated platform for current and future projects.
Business Approach
Over the last several years we have sought to develop the contacts and
relationships enjoyed by our directors by obtaining introductions to potential
strategic partners. The strategic relationship framework provides a
comprehensive and thorough mechanism for developing and implementing corporate
strategy. Our board of directors determined early in our existence that given
our size and the criticality of our business situation that the strategic
relationship framework would provide us with a non-resource-exhaustive and more
expedient and efficient means of entering new markets. This approach has met
with considerable success and we continue to seek strategic alliances.
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We believe we are well positioned for better economic results during
fiscal year 2006. A number of factors contribute to this outlook.
o Our selection by the U.S. Air Force, Force Protection Office, as one
of four companies, among two multinational and two small businesses
organizations, entitling us to submit proposals to obtain contracts
to supply and install security system upgrades for 34 military
facilities worldwide over a five year period with a total value in
excess of $540 million.
o Our estimate that orders recently received, including nuclear power
station security upgrades, Hanscom Air Force Base tactical equipment
purchases, Israeli Defense Forces - MOD purchase orders and
IBDSS/TASS task orders, will amount to $8,500,000.
o The conclusion of agreements with new strategic partners that we
anticipate will be a source for material orders in the years ahead.
Off-Balance Sheet Arrangements
We have not entered into any transactions with unconsolidated entities in
which we have financial guarantees, subordinated retained interests, derivative
instruments or other contingent arrangements that expose us to material
continuing risks, contingent liabilities or any other obligations under a
variable interest in an unconsolidated entity that provides us with financing,
liquidity, market risk or credit risk support.
Recently Issued Accounting Pronouncements
In November 2004, the FASB issued SFAS 151, "Inventory Costs." SFAS 151
amends the accounting for abnormal amounts of idle facility expense, freight,
handling costs, and wasted material (spoilage) under the guidance in ARB 43,
Chapter 4, "Inventory Pricing." Paragraph 5 of ARB 43, Chapter 4, previously
stated that "...under some circumstances, items such as idle facility expense,
excessive spoilage, double freight, and rehandling costs may be so abnormal as
to require treatment as current period charges...." This Statement requires that
those items be recognized as current-period charges regardless of whether they
meet the criterion of "so abnormal." In addition, this Statement requires that
allocation of fixed production overheads to the costs of conversion be based on
the normal capacity of the production facilities. This statement is effective
for inventory costs incurred during fiscal years beginning after June 15, 2005.
Our management does not expect adoption of SFAS 151 to have a material impact on
our financial statements.
In December 2004, the FASB issued SFAS 123(R), "Share-Based Payment." SFAS
123(R) amends SFAS 123, "Accounting for Stock-Based Compensation," and APB
Opinion 25, "Accounting for Stock Issued to Employees." SFAS 123(R) requires
that the cost of share-based payment transactions (including those with
employees and non-employees) be recognized in the financial statements. SFAS
123(R) applies to all share-based payment transactions in which an entity
acquires goods or services by issuing (or offering to issue) its shares, share
options, or other equity instruments (except for those held by an ESOP) or by
incurring liabilities (1) in amounts based (even in part) on the price of the
entity's shares or other equity instruments, or (2) that require (or may
require) settlement by the issuance of an entity's shares or other equity
instruments. This statement is effective for public companies qualifying as SEC
small business issuers, as of the first interim period or fiscal year beginning
after December 15, 2005.
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As permitted by SFAS No. 123, we currently account for share-based
payments to employees using APB No. 25's intrinsic value method and, as such,
generally recognize no compensation expenses for employee stock options.
Accordingly, the adoption of SFAS 123(R)'s, fair value method will have a
significant impact on our results of operations, although it will have no impact
on our overall financial position. The impact of adoption of SFAS No. 123(R)
cannot be predicted at this time because it will depend on levels of share-based
payments granted in the future, however, had we adopted SFAS 123(R) in prior
periods, the impact of the standard would have approximated the impact of SFAS
No. 123 as described in the disclosure of pro forma net income (loss) and net
income (loss) per share in Note 2 to the consolidated financial statements. SFAS
No. 123(R) also requires the benefits of tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow, rather than as an
operating cash flow as required under current literature. While we cannot
estimate what those amounts will be in the future (because they depend on, among
other things, when employees exercise stock options), there were no operating
cash flows recognized in the years ended June 30, 2005 and 2004 for such excess
tax deductions.
25
BUSINESS
Overview
We design, develop, manufacture and market technology-based integrated
security systems. We also provide consulting services consisting of risk
assessment and vulnerability studies to ascertain a customer's security
requirements in developing a comprehensive risk management and mitigation
program, as well as product design and engineering services.
We market our products domestically and internationally to:
o national and local government entities, including the U.S.
Department of Defense (DoD) and the U.S. Department of Energy (DoE),
o large chemical and petrochemical facilities, and major office
complexes,
o energy facilities, including nuclear power stations, power utilities
and pipelines, and
o commercial transportation centers, such as airports and seaports,
and
o water and agricultural resources including reservoirs, dams, fish
hatcheries and rivers.
We believe that we are one of a few comprehensive security solution
providers in the industry. We analyze security risks and develop security
solutions specifically tailored to mitigate those risks, including designing,
engineering and manufacturing individual components of a system as may be
necessary to deliver a fully integrated security system customized to a
customer's requirements. We are frequently engaged by security system
integrators, security system dealers/installers, and commercial architects and
engineers because we are able to deliver an integrated platform for a fully
integrated security solution to support our customers' requirements for the
completion of a given project.
We believe that we have developed a superior reputation as a provider of
integrated security systems since our inception in 1976 because we:
o offer a complete range of solutions-driven responses to accommodate
our customers' needs,
o offer technologically superior products,
o are able to design, engineer and manufacture systems customized to
our customers' specific requirements,
o deliver systems that are easy to operate and maintain while
providing superior life cycle cost performance compared to systems
offered by our competitors,
o have established solid credentials in protecting high value targets,
and
o offer our customers what we believe may be the best warranty in the
industry.
We are ISO 9001:2000 registered and will seek to maintain our ISO status.
Security Industry Overview
The Security Institute of America estimates that the worldwide market for
security products and services in 2006 will exceed $130 billion. The industry
encompasses a wide ranging, highly fragmented group of product and service
providers which includes entities that market comprehensive security systems and
offer security consulting services, dealers/installers, small single product
companies, equipment manufacturers, consultants and systems integrators.
26
We believe that the security industry has experienced significant growth
over the last decade, both as to the total dollar amount generated from sales
and the number of entrants offering security related products, and continues to
grow rapidly because:
o Western nations have been the target of high profile terrorist
attacks over the last several years that have squarely focused
attention on security issues and threat mitigation,
o perimeter security for airports, maritime, chemical, transportation,
energy and pharmaceutical facilities has been mandated by homeland
security concerns,
o newer, more effective and efficient security equipment incorporating
advancements in security technology is replacing obsolete equipment,
o the proliferation of computers and advanced communications systems
has created a new and growing need for information technology
security to prevent the misuse of proprietary information and other
intellectual property, and
o private industry is operating in more remote geographic locations
and higher-risk environments.
Products, Systems and Technologies
The services and technologies required to create a secure environment must
address the entire range of security concerns that challenge government and
commercial institutions, including the protection of:
o life,
o tangible assets, such as buildings, vessels and personal
possessions,
o intangible assets, such as intellectual property, sensitive research
and other confidential information, and
o electronic data and information technology.
Integrated security systems are comprised of one or more subsystems and
components that perform a variety of security functions for a facility or group
of facilities under the direction of a single command center and communications
network. We offer both integrated, turnkey security solutions that incorporate
many of our systems and stand-alone systems that comprise an individual
technology of a security program.
The integrated security systems and stand-alone products we market
include:
o Computer Based Command, Control and Communications Networks. The
command network consists of a central processor, a common database
and software that links various subsystems and components, allowing
them to communicate with each other, and integrates the subsystems
and components into a single system.
o Intrusion Detection Systems. Fixed location and rapid deployable
infrared and fiber optic perimeter intrusion detection systems
consist of sensors which detect an intruder passing through the
system's sensors.
o Video Motion Detection and Assessment Systems. As an adjunct to our
perimeter intrusion detection systems, we offer video surveillance
equipment using closed circuit television cameras, digital
processing and fiber optic links to monitor and assess the nature of
an annunciated threat at the control center.
27
o Electronic Surveillance System. This system creates a detection and
verification band outside and parallel to a secured perimeter and is
geared toward high-level security demands such as border control,
military bases, power stations, oil and gas storage facilities,
nuclear power plants, industrial sites, prisons and airports.
o Ordnance Flash Detection System. Our VIPER ordnance flash detection
system is a muzzle flash detection system that detects and locates
the discharge of firearms and provides counter fire response.
o Aerial Warning System (AWS). The Aerial Warning System is designed
to improve security through an intrusion detection system for
restricted air space and flight restricted areas.
o Environmental Monitoring Systems. Our Sentinal(TM) system remotely
monitors drinking water quality throughout the drinking water
distribution system to detect and instantly report the evidence of
chemical, biological or radiological contamination.
o Facial Recognition System. This system is based on biometric
technology that identifies individuals by their unique facial
characteristics. This technology can be utilized for virtually any
application that requires real-time identification or verification
of an individual.
o Architectural Security Lighting Systems. As a complement to our
security systems, we offer interior and exterior lighting systems
that can enhance a facility's security by illuminating areas which
otherwise may be subject to infiltration because of darkness or a
location remote from a facility's main security center.
o Computer Intrusion Detection Equipment. An information technology
security system designed to protect computer local area networks
(LANs) from illegal access via the Internet or by persons seeking to
splice into a LAN's hard wiring.
o Access Control Systems. Access control systems are designed to
exclude unauthorized personnel from specified areas and provide
access control that is typically card-activated.
In order to provide customers with the highest quality and most advanced
systems, we incorporate technologies and products developed and manufactured by
us or which have been licensed from other entities. Frequently, we enter into
technology transfer agreements covering the technologies or products to be used
so that we may design and execute the best possible security solutions for a
customer within the confines of their security budget. Products incorporate
state of the art components that can be configured to develop flexible systems
tailored specifically to meet the needs of risk mitigation in high threat
environments.
We believe that our products are qualitatively comparable to, or more
effective than, those offered by our competitors because our products:
o provide low nuisance and false alarm rates,
o are reliable in virtually any environmental condition,
o in many cases can be user-specified and adapted to their
environment, and
o are subject to low installation and maintenance costs.
We believe that we have built a solid reputation as a provider of
leading-edge, high technology security solutions and services. Our view is
shared and supported by the many international governmental sector and
commercial customers that engage our services and products on a continuing
basis.
Consulting Services
The consulting services we provide are an integral part of the security
solutions offered to our customers. Effective and efficient use of technology
can be achieved only if used intelligently. Toward that end, we:
28
o conduct risk assessment, vulnerability and criticality studies to
ascertain a customer's security requirements and develop a
comprehensive risk management and mitigation program, and
o provide security system design services.
Our consulting and advisory services generally represent the first steps
in the development of a security solution. The risk assessment, threat,
vulnerability and criticality analyses we utilize allow us to undertake a
detailed risk management investigation of our customers' operations to determine
realistic threats, develop effective responses and programs necessary to address
and mitigate the range of threats, and to implement the appropriate solutions.
We utilize "adversary perspective" penetration analysis, U.S. Department of
Energy and military-developed threat modeling systems, and interactive,
integrated systems performance testing of total protection strategies to
formulate a comprehensive security system. The testing involves not only systems
but the human operators who must assess intrusions and generate instant
responses and the security forces that must successfully interrupt adversary
actions to prevent injury, theft or sabotage.
Our customers benefit from an integrated, interactive process by which our
vulnerability/threat/penetration analysts examine existing and/or candidate
systems to determine levels of risk. The analysts consult with our systems
design staff to determine systems configurations and human operation
requirements that will provide the most cost-effective options for mitigating
risk. Our security advisors are technically accomplished and fully familiar with
the latest trends in planning, programming, and designing systems utilizing
standard peripheral components, mini/micro architecture, and "user friendly"
software/firmware applications. Many of our security advisors have the federal
government's highest security clearances.
We also provide security system design services involving the evaluation,
design and specifications of security systems and components that meet a
customer's operating and budgetary requirements. Typically, these services are
provided within the context of a comprehensive security evaluation and
implementation program in conjunction with risk management analysis.
Occasionally, we may be asked to evaluate and design a single component of a
security system.
We work closely with the customer and facility owner, architect, engineer,
system integrator and/or construction manager to develop and design security
monitoring and control systems that afford a normal but secure environment for
management, staff and visitors. Our design personnel are expert in their
knowledge of the various technologies (mature and emerging) as they apply to
security challenges, both in the United States and abroad, because they continue
to be intimately involved in developing security systems for government
facilities around the world.
Product Design
We design and develop new products based upon market requirements, and as
deemed necessary to meet the customers' specific needs. We research and assess
threat and vulnerability issues and design and engineer our products in-house,
with outside consultants as necessary, and in conjunction with joint venture
partners to meet the needs of customers based upon the results of such research.
We investigate new and emerging technologies that have application in the
security industry and seek to license these technologies which we then
incorporate into our product line.
Markets for Our Products
We have identified a number of markets for our products and have developed
programs to gain access to those target markets. Generally, private industry and
government facilities which possess sensitive information, valuable assets or by
virtue of the nature of their business may be subject to terrorist threats,
recognize the need to implement security measures to protect personnel and
property. In many instances, laws have been enacted and mandates decreed for
compliance with some minimum-security standards. Airport security is a prime
example. We target these entities as well as entities where we can demonstrate
the need for security measures.
Primary markets which we target include:
29
o the U.S. government, its agencies and departments, including the
U.S. Department of Defense and the U.S. Department of Energy,
o large industrial facilities, including pharmaceutical companies and
major office complexes,
o energy facilities, including nuclear power plants, utilities, and
chemical and petrochemical pipelines,
o commercial aviation and maritime facilities,
o rail and bus transportation, and
o foreign/export opportunities in all of the above-mentioned areas.
The U.S. government along with many of its agencies and departments
represent a significant market for our products. We actively market our products
to the following U.S. government agencies, all of which have purchased our
products in the past and continue to be among our top customers:
o The U.S. Department of Defense and a number of its subdivisions have
been using our products for force and asset protection at numerous
military bases and U.S. Air Force installations around the world.
Certain of our products have been certified and included as part of
the government's tested and approved technologies.
o The U.S. Department of Energy, in connection with the clean-up and
operation of military bases and government-owned nuclear processing
facilities, offers an expansive and varied market. We are involved
with the supply and support services at nine sites on an ongoing
basis.
o The U.S. Department of Transportation includes airports, trucking
and distribution centers and marine terminals. Our products and
systems directly apply to the security needs of this multi-billion
dollar market opportunity.
Our open-ended contract with the General Services Administration (GSA),
which has been extended through July 31, 2009, authorizes the U.S. government
and a network of eligible sources to purchase materials and services from us
without having to undergo a full competition. In September 2003, we announced
the finalization of a 5-year indefinite delivery/indefinite quantity contract
for the Integrated Base Defense Security System (IBDSS) with the U.S. Air Force
to secure highly strategic military facilities throughout the world. During
fiscal year 2005, we were awarded an additional modification to the IBDSS
contract for Tactical Automated Sensor Systems (TASS).
We also target state and local governments, and governmental authorities
and agencies fulfilling the roles described above.
Large Industrial Facilities and Major Office Complexes. These types of
facilities, such as pharmaceutical companies, frequently house sensitive data
where research and product development occur and are likely to acquire
integrated security packages to create a "smart building." The technologies
required to create a smart building in today's environment must address life,
safety, power, lighting, information technology protection and other security
systems to create a normal yet secure environment for employees, visitors and
service personnel.
Energy Facilities, Including Nuclear Power Plants, Utilities and
Petrochemical Pipelines. Nuclear power stations and utilities that house
sensitive information and dangerous materials represent a large and lucrative
market for our products. Petrochemical, natural gas and pipeline companies, many
of which operate in high risk environments and remote geographic locations,
invest huge sums in the assets necessary to operate those businesses and adopt
appropriate measures to protect their investments through the acquisition of
security equipment and systems.
Commercial Aviation, Maritime, Rail and Bus Line Transportation.
Infrastructure security has been at the forefront of security consciousness for
many years. The federal government has appropriated significant funds for the
acquisition and installation of new, high-technology security systems at these
facilities. There are approximately 1,200 facilities in the United States which
the Federal Aviation Agency has identified and mandated for security systems
upgrade to be completed over the next several years. We will bid to provide
products and services to many of these sites.
30
Foreign/Export Opportunities. Government operations and private industries
in foreign countries are all subject to the same security issues that challenge
similar entities in the United States. We, along with our strategic teaming
partners and international sales representatives, continue to seek to penetrate
of these markets. Although, during fiscal years 2005 and 2004, we generated
approximately 5% and 11%, respectively, of our revenues from projects completed
outside the United States, we believe the export opportunities may be
significant in fiscal year 2006 and beyond.
Sales and Marketing
We have developed a multi-tiered marketing plan, allowing us to
effectively market products to each of the separate government and industry
segments identified as target markets both in the United States and
internationally. Our marketing strategy highlights product strengths as they
apply to each particular industry.
The primary goals of our marketing strategy are to:
o broaden the base of potential customers, and
o demonstrate the efficacy of our products.
To that end, we have entered into strategic partnerships, teaming,
representative and joint venture relationships with major multinational
corporations in each of the industries which comprise our target markets. These
companies generally enjoy a strong market presence in their respective
industries and we believe that our association with these entities affords us
and our products added credibility. These entities frequently subcontract our
services and purchase our products in connection with larger projects. During
fiscal year 2005, we entered into teaming agreements with Lockheed Martin
Transportation and Security Solutions, SIGCOM, and Hudson Marine Management
Services/HudsonTrident.
Members of our management team have many years of experience in the
security industry. Each member is assigned an industry area and makes direct
contact with, and sales proposals to, government and commercial organizations in
that area. We attempt to cultivate and maintain relationships and contacts with
employees of the major government agencies encompassing our target markets.
We generate a significant portion of our international business through a
network of independent sales representatives. Agreements are in place with
various entities that allow us to maintain a presence in 25 countries worldwide.
These agreements generally extend for a period of two years and provide the
dealer/installer with price discounts from current price schedules as an
incentive to market our products in their geographic area. We rely on our
dealer/installer base to represent our product line throughout the world and to
apprise us of potential projects where the products can be incorporated. In
addition, we rely on our dealers/installers to introduce our company and
products to key government and private enterprise personnel in their respective
geographic regions.
We also market directly to providers of integrated security systems,
security systems dealers/installers, systems engineers and other entities that
may be contracted for a security system on behalf of a customer.
We maintain a presence at the major trade conferences that address our
target markets and advertise in the relevant conference publications.
We employ a variety of pricing strategies for our services. Proposals for
consulting services are based on an estimate of hours multiplied by standard
rates. Systems integration projects are based on the estimated cost of the
components including subcontractors and equipment, plus a profit margin. Pricing
for engineering and maintenance services vary widely depending on the scope of
the specific project and the length of engagement.
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Business Growth Strategy
In order to achieve a sustainable and continuous growth rate, we believe
that we must devote additional resources to marketing and product development.
Specifically, we have or intend to:
o Increase sales and marketing personnel. This year, we added a sales
representative who has extensive sales and marketing experience in
the Mid-Atlantic states. We believe this individual will allow us to
access wider markets and focus sales efforts required to develop
business in our target markets. We will seek to add further sales
and marketing personnel as necessary.
o Expand our base of dealers/installers/integrators worldwide. We
believe this is an effective and cost-efficient means of increasing
sales. These entities serve as our local agents to market products
and provide customer support. Furthermore, these entities are
familiar with local laws and frequently have local contacts in
government and business at decision-making levels.
o Expand our global presence. We formed a subsidiary in the Middle
East to represent and support product sales. We have entered into
sales agreements with a number of multi-national companies to
represent and support their products as well. We believe the
Mid-East operation will provide access to potential projects in
Africa, India and Eastern Europe.
o Design and develop new systems. We will continue to develop new
security systems to expand our portfolio of proprietary products. We
believe this will allow us to open up new markets and retain our
position as a leading-edge provider of technology-based security
equipment.
o License new and emerging technologies. We will continue to identify,
analyze and potentially acquire new and emerging technologies for
application in the security industry. We will seek to acquire
technologies that will enhance our existing systems and develop new
products.
o Upgrade existing products. We have and will continue to upgrade
existing products to take advantage of technological advancements to
ensure they remain state-of-the-art.
o Purchase laboratory and testing equipment. We will seek to purchase
certain laboratory and testing equipment which will allow us to
enhance and maintain product quality standards and support our
extended warranty program.
o Strengthen our management team. We have added a Vice President &
General Manager of Operations to support the projected increase in
manufacturing, production engineering and purchasing required to
meet our delivery requirements.
o Improve our telecommunications infrastructure. We expect to install
a T1 telecommunications line for network connectivity between our
geographically-dispersed U.S. facilities. This will permit an
integrated method of communication between and among our management
and key employees.
Customers
We provide products and services to customers through direct sales to
end-users and through subcontracting agreements. During the past five years we
have provided products to approximately 50 customers covering more than 220
projects. Given the nature of our customers and products, we receive relatively
large orders for products and services from a relatively small number of
customers. For the fiscal year ended June 30, 2005, customers that accounted for
10% or more of our net revenues were the U.S. Air Force and Duke Energy
Corporation, accounting for 76% and 20%, respectively, of our net revenues. In
fiscal year 2004, customers that accounted for 10% or more of our net revenues
were the U.S. Air Force, DoE and Duke Energy Corporation, accounting for 11%,
11% and 10%, respectively, of our net revenues.
Manufacturing
We maintain manufacturing operations at our facilities in Clifton, New
Jersey and Madison, Alabama. These activities include the procurement of
materials, product assembly and component integration, product assurance,
quality control and final testing. We are planning to open a logistical
engineering and sales support facility in Virginia to support our U.S. Air Force
contract and expand our government base to cover the expected market for our
products which may result from the Homeland Security Act.
32
Compliance with environmental laws has no impact on our manufacturing or
other operations.
We purchase the individual components that comprise our products or
subcontract the manufacture of specific subsystems to third parties. We are not
dependent on any one supplier for the components of our products and, in the
event of any disruption in supply or discontinuation of production by any of our
present suppliers, we believe that the components used in our products are
available from numerous sources at competitive prices. Various aspects of the
software programming required in connection with our computer products are
designed and written by in-house personnel or are subcontracted to third
parties.
We have not entered into any long-term contracts for the purchase of
components but rather rely on rolling forecasts to determine the number of units
we will sell and the components required. We maintain an inventory of certain
long-term lead items required in the manufacture of our products, as reflected
in our balance sheet. To date, we have been able to obtain supplies of these
components and we believe that adequate quantities are available to meet our
needs.
Intellectual Property and Other Proprietary Rights
Proprietary protection for our technological know-how, products and
product candidates are important to our business. Currently, we rely upon trade
secrets, know-how and continuing technological innovation to develop and
maintain our competitive position. We also rely on a combination of trade secret
protection and non-disclosure agreements to establish and protect our
proprietary rights.
Our success is dependent to a great extent on our proprietary knowledge,
innovative skills, technical expertise and marketing ability. Our intention is
not to rely primarily on patents or other intellectual property rights to
protect or establish our market position.
We have obtained trademarks in the United States, South Korea, United
Kingdom and Saudi Arabia for FOIDS(R) (our Fiber Optic Intelligent Detection
System), IPID(R) (our Infrared Perimeter Intrusion Detection technology),
RDIDS(R) (our Rapid Deployment Intrusion Detection System) and IDMS(R) (our
Intrusion Detection and Monitoring System). We have also filed for trademarks on
these marks in other countries.
We require all employees, consultants and contractors to execute
non-disclosure agreements as a condition of employment with or engagement by us.
We cannot be certain, however, that we can limit unauthorized or wrongful
disclosures of unpatented trade secret information.
Although we continue to implement protective measures and intend to defend
our proprietary rights, policing unauthorized use of our technology or products
is difficult and we cannot be certain that these measures will be effective or
successful.
Research and Development
The forces that drive the design and development of our new products
include the need to meet new security threats, incorporate newly developed
technologies or to satisfy a customer's unique security requirements. We
research and assess threat and vulnerability issues at selected facilities
within our target markets, and design and engineer products in-house with
outside consultants as necessary and in conjunction with joint venture partners
to meet the needs of customers based upon the results of such research. We
investigate new and emerging technologies in the security industry and seek to
license certain technologies which we then incorporate into our products.
33
Product Warranty
IPID sensors and FOIDS processors are warranted for ten years, under
normal use, against defects in workmanship and material from date of
installation of the system on the customer's premises. All other components are
warranted for one year from date of purchase.
Technology Licensing Arrangements
As we endeavor to design and manufacture the most effective and efficient
technology based security solutions, we review and investigate new and emerging
technologies that have application in the security industry. Frequently, we seek
to incorporate these technologies into our systems. We are party to agreements
to use certain technologies including licenses with Lucent Technologies, Visage,
Inc. and Hyperdyne, Inc.
Competition
As the public and private sectors become increasingly concerned with
security issues, we expect that the security and anti-terrorism industry will
experience continuing growth. Competition is intense among a fragmented and wide
ranging group of product and service providers, including security equipment
manufacturers, providers of integrated security systems, systems integrators,
consulting, engineering and design firms and others that provide individual
elements of a system. Many of our current and potential competitors possess
greater name recognition and financial, technical and marketing resources than
we do. As a result, they may be able to respond more quickly to new or emerging
technologies and changes in customer requirements, or to devote greater
resources to the development, promotion, sale and support of their products than
we can. Because of growth in the marketplace, we anticipate increased
competition from other sources, ranging from emerging to established companies.
We believe that the principal factors affecting competition in the industry
include applied technology, product performance, price and customer service. We
cannot be certain that we will be able to compete successfully in the future
against existing or potential competitors.
We believe that we are able to sustain our competitive position in the
industry because:
o our principal officers, security analysts, design personnel and
sales persons have an aggregate of over 200 years of combined
experience in the security industry,
o we have the ability to analyze security risks, design, engineer and
manufacture products customized to a customer's requirements,
o our products address a wide range of security requirements,
o our products are among the most technologically advanced and the
highest quality available,
o our products are flexible in that many of them can be configured and
customized to meet a customer's specific needs and can be integrated
with each other in new or existing security systems,
o our products are reliable, and relatively easy and inexpensive to
install and maintain, and
o we have been successful in teaming with large multinational
companies to market and incorporate our products into their product
offerings, thereby contributing to the credibility and efficacy of
our products.
Government Regulation
Employees
As of February 27, 2006, we employed 28 individuals on a full-time basis
including six design and engineering staff, eight manufacturing and assembly
employees, five marketing employees, two project managers and seven
administrative employees. A number of the employees serve in multiple
capacities. Our manufacturing staff may oversee site installation of the
products.
34
We have relationships with 12 independent sales representative
organizations covering specific regions in the United States, Central America,
South America, the United Kingdom, India, the Middle East and Southeast Asia.
None of our employees are covered by a collective bargaining agreement or
are represented by a labor union. We consider our relationship with our
employees to be satisfactory.
Properties
Our corporate headquarters are located at 790 Bloomfield Avenue, Clifton,
New Jersey, where we lease approximately 12,200 square feet of space divided
among administrative space (2,600 square feet) and manufacturing space (9,600
square feet) space. Our lease on this space runs through April 30, 2008 at a
rent of $5,256 per month, increasing to $5,361 per month by the end the lease
term. We also lease approximately 2,500 square feet of manufacturing space at
102 Commerce Circle, Madison, Alabama. Our lease on this space runs through
February 2007 at a rent of $2,000 per month. Our foreign subsidiary in the
Middle East leases approximately 2,000 square feet of office space through
December 2006 at a rent of $1,170 per month. Our subsidiary, Clarion Sensing
Systems, Inc., leases 1,000 square feet of office and laboratory space at 3901
W. 30th Street, Indianapolis, Indiana through December 2006 at a rent of $1,520
per month.
Legal Proceedings
We are not involved in any pending or threatened litigation or other legal
proceedings.
35
MANAGEMENT
Executive Officers, Directors and Key Employees
The names, ages and positions of our executive officers, directors and key
employees are as follows:
Name Age Position
- ------------------- -------- -----------------------------------------------
Arthur Barchenko 72 President, Chief Executive Officer and Director
Mark Barchenko 49 Vice President-Marketing
Natalie Barchenko 71 Treasurer, Secretary and Director
Gene Rabois 60 Director
Edward Snow 66 Director
Robert F. Reiter 55 Director
Stephen Rossetti 54 Director
Thomas F. Donahue 55 Director
Eldon Moberg 55 Vice President
Thomas Isdanavich 57 Vice President-Product Management
Richard Stern 55 Vice President-Manufacturing
Joseph McAndrew 51 Vice President-Operations
Martin Harmless 61 President-Clarion Sensing Systems Inc.
The principal occupations for the past five years (and, in some instances,
for prior years) of each of our executive officers, directors and key employees
are as follows:
Arthur Barchenko has been our President and Chief Executive Officer since
December 1976. Mr. Barchencko also participates in the management of our
subsidiaries. Prior to founding our company, Mr. Barchenko co-founded and
directed the operations of Bajer Industries, a lighting manufacturing company
that was subsequently sold to the Charter Group. From June 1952 to May 1972, he
held various sales and marketing positions at Lightolier, Inc., a company
engaged in the manufacturing and marketing of lighting fixtures. During his
tenure at Lightolier, Inc., Mr. Barchenko served as the vice president of sales
and was responsible for directing a sales force of approximately 150 persons and
a support staff of approximately 50 persons. Mr. Barchenko also served as a
member of the board of directors and on the executive committee Lightolier, Inc.
Mr. Barchenko is active with the National Defense Industrial Association and the
American Society for Industrial Security. He served on the Radio Technical
Commission for Aeronautics Committee 183 for upgrade of FAR 107.14(a) and (b) as
a member of the special access control security task force for the Federal
Aviation Administration. Federal Aviation Regulation 107.14 (FAR 107.14a and b)
is the document produced by RTCA committee 183 for the security upgrade of the
access control system and universal access control system requirements for
civilian commercial and shared civilian/military airports under U.S.
jurisdiction.
36
Mark Barchenko joined us in 1993 and has been our Vice President-Marketing
since February 2004. He has focused his marketing and business development
efforts on Southeast Asian government projects and U.S. airports and maritime
facilities. Mr. Barchenko spearheaded the IS0 9001:2000 quality program based on
the international standard of operation, from inception through registration
during 2000. Mr. Barchenko is active with the National Defense Industrial
Association and the American Society for Industrial Security. He served on the
Radio Technical Commission for Aeronautics Committee 183 for upgrade of FAR
107.14(a) and (b) as a member of the special access control security task force
for the Federal Aviation Administration. Federal Aviation Regulation 107.14 (FAR
107.14a and b) is the document produced by RTCA committee 183 for the security
upgrade of the access control system and universal access control system
requirements for civilian commercial and shared civilian/military airports under
U.S. jurisdiction. Mr. Barchenko holds a U.S. patent titled "Jet Propulsion
Engine Assembly for Aircraft."
Natalie Barchenko has been our Treasurer and Secretary, and a member of
our board of directors, since 2001. Over the last ten years, she has been
actively involved with our day-to-day operations in the areas of human
resources, accounting, advertising and sales functions.
Gene Rabois has been a member of our board of directors since October
1989. Previously he was employed as our Chief Financial Officer. Mr. Rabois has
more than 30 years' experience in accounting and finance, SEC financial
reporting, installation and management of computer systems, and control and
administration of corporate financial affairs. He served as controller for SJT
Imaging, Inc., a printing concern, for more than the past five years to May
2004, and, since June 2004, has served as controller at e.comm Technologies,
Inc.
Edward Snow has been a member of our board of directors since June 2000.
From October 1999 to October 2000, he has served as the Assistant to the
President of Space America Corp. From October 1996 to October 1999, he was the
co-owner and operated Phoenix Fiber Optics Inc., a manufacturer and marketer of
fiber optic products. Since 1996, he has acted as a private consultant to the
government and industry.
Robert F. Reiter has been a member of our board of directors since
November 2001. Since January 2002, he has been the President of HAZ-X Holdings,
Ltd., a company which engages in non-intrusive inspection engineering and
operations. Since November 1997, he has served as the President of R.F. Reiter &
Associates, an engineering consulting firm. From 1977 through 1997, he was the
Vice President of Analytical Systems Engineering Corp. an engineering consulting
company.
Stephen Rossetti has been a member of our board of directors since October
2004. Mr. Rossetti is a former senior staff member of the House Armed Services
Committee, where he had an established reputation as a strident government
reform advocate. As director of the Readiness Subcommittee staff, he was
responsible for the oversight of the vast Department of Defense infrastructure
and combat readiness, directing a subcommittee with nearly $90 billion in annual
spending. Over the years, he has served in various capacities with the
Department of Defense and received several honors for his services from
Congress, the President and the Secretary of Defense. Mr. Rossetti currently
serves as President of each of Zegato Solutions, Inc. and Markquest, Inc. since
August 2003 and January 2001, respectively.
Thomas F. Donahue has been a member of our board of directors since
November 2004. Since October 2005, Mr. Donahue has served as the President of
Mobility Products Unlimited, LLC, a national distributor of medical equipment.
He is also the President of Donahue Consulting, a corporate finance and
management firm. In 2002 and 2003, we engaged him to provide financial analysis
and guidance with respect to corporate operations and potential acquisitions.
Tom has 30 years of experience in finance beginning with his first job in 1976
as the Business Administrator for Morris Catholic High School in New Jersey. In
1979 he became Assistant Controller at Thomas G. Ferguson Associates where he
spent the next four years. He achieved the position of Vice President - Finance
where he managed all financial aspects of the pharmaceutical advertising agency
including financial payment negotiations with clients including Wallace
Laboratories, C. R. Bard, Squibb, Ortho, Serono, USV Revlon, Warner-Lambert,
Barnes-Hind and Pfizer. In May 1983, Tom joined AT&T just before the divestiture
of the former Bell System operating companies. Initially, he served as the
Manager of Treasury Operations charged with automating and upgrading a highly
manual and decentralized department. Tom ultimately joined a newly formed AT&T
venture in the world of financial services in 1990 - Universal Card Services -
and rose to the rank of Vice President & Treasurer. From September 1999 to
January, 2002, Tom held the position of Corporate Vice President & Treasurer
with Sensormatic Electronics, a global provider of anti-theft technology and
software. He was responsible for capital markets activities, including, raising
capital, investor relations, risk management and mergers and acquisitions
analytics. Following the sale of Sensormatic to Tyco International in November
2001, Tom opened his own consulting firm.
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Key Employees
Eldon Moberg joined us in 1996 as Vice President of our FOIDS product
division and, subsequently, has been our Vice President since July 1999. Mr.
Moberg is responsible for establishing the FOIDS manufacturing and test facility
in Madison, Alabama. His duties include planning and coordinating manufacturing
schedules and resources and the provision of technical data for security system
design and project cost analysis. Prior to joining us, Mr. Moberg was the
Production Supervisor for Mason & Hanger National, Inc., a company engaged in
the manufacture and marketing of our FOIDS product line, where he initially was
a production support technician and performed optical/electronic fabrication and
testing of a fiber optic-based security system and components. Thereafter, as
Production Supervisor, he was responsible for planning and scheduling personnel,
materials and equipment to support product manufacture. Other duties included
procurement, product acceptance testing, quality assurance and quality control,
inventory control and MRP system operation. Before entering private industry,
Mr. Moberg served for twenty years in the U.S. Army where he gained experience
as senior radar repair technician for several Army air defense systems, team
leader for missile system direct support maintenance and training developer for
newly acquired Army missile systems.
Thomas Isdanavich has been our Vice President-Product Management since
July 1997. He determines installation and service support requirements for
in-house and field applications. His responsibilities include field labor
analysis and the planning and coordination of all administrative phases of sales
and customer support services. Mr. Isdanavich was employed by Beall
Technologies, Inc., a manufacturer of matrix switching equipment for IBM
compatible mainframe computers, from 1973 to 1997. Prior to entering private
industry, Mr. Isdanovich served in the U.S. Navy for four years.
Richard Stern has been our Vice President-Manufacturing since December
1997. He is responsible for the overall management of our manufacturing
department, which includes supervising all manufacturing, maintenance and test
personnel; manufacturing engineering, including the review and evaluation of new
and existing product design in a manufacturing environment; oversight of
maintenance of plant equipment and facilities; mechanical package design of new
product development; quality control, including the development of test
equipment and procedures; production scheduling; shipping and receiving and
inventory of all materials and finished products, purchasing and expediting of
materials and supplies, and oversight of manufacturing personnel, labor reports.
Prior to joining us, Mr. Stern spent 25 years in the data communication and
temperature processing fields. He has held managerial positions in
manufacturing, engineering, quality control, service, as well as been involved
in the design and development of product lines within these fields.
Joseph McAndrew has been our Vice President-Operations since May 2003.
Prior to that, Mr. McAndrew spent 20 years as an innovative, hands-on
manufacturing operations executive with experience in controlling all of the
elements inherent in producing superior products at the lowest possible costs.
From April 1984 until October 2002, he served as manufacturing engineering
manager, director of operations and VP/GM for a manufacturer of microwave
communications components.. He has headed global manufacturing operations for
multi-layer radio frequency signal processing components used in the military,
satellite and commercial markets with annual sales of $25 million. Mr. McAndrew
has developed new and unique process techniques, allowing entry into the
commercial market and resulting in the issuance of four U.S. patents. His
experience is multi-national with important technology operation transfers in
Canada and production build-outs in Central America. Mr. McAndrew has a master's
degree in Engineering Management from the New Jersey Institute of Technology.
Martin Harmless is the President of our subsidiary, Clarion Sensing
Systems, Inc., and has been president since founding the company in September,
1999 (in March 2005 we acquired the assets of Clarion). He is an environmental
engineer with over 30 years of experience consulting to municipalities, military
installations, and governmental agencies on water and air quality issues. His
experience in this area includes engineering management of the design and
construction of drinking water distribution and treatment plants, and wastewater
collection system and waste treatment plant upgrades. Mr. Harmless has supplied
remote online water quality systems to the Limited Objective Experiment (LOE)
being conducted at Ft. Leonard Wood, Missouri. He has also supplied critical
building environmental monitoring systems to the Naval Surface Warfare Center
(NSWC), Crane. Mr. Harmless envisioned these applications and was instrumental
in the basic design. Recently, he performed research on the elimination of
chlorine as a disinfectant in water and wastewater treatment in order to reduce
the amount of this hazardous substance in populated areas. He has expertise in
integration of nuclear, biological, chemical and radiological technologies
through online remote monitoring.
38
All directors hold office until the next annual meeting of stockholders
and the election and qualification of their successors. Officers are elected
annually by the board of directors and serve at the discretion of the board.
Arthur Barchenko and Natalie Barchenko are married. Mark Barchenko is
their son. Otherwise, there are no family relationships among our directors and
executive officers. No director or executive officer has been a director or
executive officer of any business which has filed a bankruptcy petition or had a
bankruptcy petition filed against it. No director or executive officer has been
convicted of a criminal offense or is the subject of a pending criminal
proceeding. No director or executive officer has been the subject of any order,
judgment or decree of any court permanently or temporarily enjoining, barring,
suspending or otherwise limiting his involvement in any type of business,
securities or banking activities. No director or officer has been found by a
court to have violated a federal or state securities or commodities law.
None of our directors or executive officers or their respective immediate
family members or affiliates is indebted to us. As of the date of this
prospectus, there is no material proceeding to which any of our directors,
executive officers or affiliates is a party or has a material interest adverse
to us.
Advisory Board
During fiscal year 2005, we established an advisory board to provide
expert analysis and information to us regarding security issues and technologies
applicable to the industry. Our advisory board is comprised of representatives
from government, academia and industry. Our advisory board is composed of the
following persons:
Dr. Norris Krone, President and CEO of the University Research Foundation
(URF) and its co-founder, directs all aspects of the Maryland Advanced
Development Lab. Dr. Krone is a highly decorated Vietnam War veteran. He is a
recognized leader in the field of aeronautical sciences and pioneered the
development of the technical principles of the forward swept wing aircraft
concept, a breakthrough in the field. His has also served on NASA's Aerospace
Technology Advisory Committee and Aerospace Safety and Advisory Panel.
Dr. John H. Estes, Principal Research Engineer/Director for San Antonio,
Ops, Georgia Tech Research Institute, has over 20 years of leadership in
fast-paced engineering organizations including facilities/project engineering,
management and force protection, among others. He has extensive experience in
strategic planning, marketing and execution of major engineering and
environmental programs. He is often selected to present briefings to civic
leaders, the Secretary of Defense and Congressional leaders.
Brad Billet, Deputy Commissioner, United Nations, has a long and
distinguished record of emergency and response operations service to his native
New York City. As a responder to the September 11th disaster, he was called upon
by Mayor Rudolph Giuliani to provide essential services in the rescue and
recovery process. In 1997, Mr. Billet was appointed to his present position and
is the agency's Chief Operating and Administrative Officer.
Ambassador (Ret.) Patrick Nickolas Theros has served as the U.S.
Ambassador to Qatar. Prior to this, he served as deputy coordinator for
counterterrorism where he was responsible for the coordination of all U.S.
government counterterrorism activities outside the United States. He also served
in various diplomatic positions in other nations as well as in the State
Department. He currently heads his own company, Theros & Theros LLP, which
represents firms transacting business in the Middle East and Europe.
Rafi Ron, President and CEO of New Age Security Solutions, is a former
director of security at Ben-Gurion International Airport and the Israeli Airport
Authority. He is a leading expert on aviation, maritime and law enforcement in
Israel and world-wide. He also served as a chief security officer in Israeli
embassies around the world, where he was instrumental in establishing security
systems. Mr. Ron's company conducts security-related training and consultation
in the United States and other countries.
39
Col. Edward Badolato (Ret.) is the Executive Vice President for Homeland
Security for The Shaw Group, a Fortune 500 corporation. He has a unique
background in security, transportation, energy and risk management spanning 30
years and has been involved in numerous high profile programs dealing with
security, protection of energy infrastructure and counterterrorism operations.
Under Presidents Reagan and Bush, he served as a Deputy Assistant Secretary at
the Department of Energy (1985-1989) where he was the principal director of
security, energy contingency planning and international energy security
activities. He was responsible for coordinating nuclear emergency response and
planning activities and played a leading role in many DOE agencies. He is well
experienced in the security of transportation systems, offshore and land based
energy facilities, and maritime assets. In 1989, he founded Contingency
Management Services, Inc., an international energy security consulting firm. In
November 2002, CMS was acquired by the Shaw Group., and he became Executive Vice
President for Homeland Security.
Committees of Board of Directors
Our board of directors does not have a nominations and governance
committee or a compensation committee as yet, but we will establish such
committees if we move to list our company on the American Stock Exchange or the
Nasdaq Stock Market in the future. The selection of nominees for the board of
directors is made by the entire board of directors. Compensation of our
management is determined by the entire board of directors.
Audit Committee. In 2002, we established an audit committee of the board
of directors, which consists of Mr. Rabois, who is chairman of the committee,
and Messrs. Snow and Donahue, all three of whom are independent directors. The
audit committee meets at least quarterly with our management and our independent
registered public accounting firm to review and help ensure the adequacy of our
internal controls and to review the results and scope of the auditors'
engagement and other financial reporting and control matters. Messrs. Rabois,
Snow and Donahue are financially literate, and Mr. Rabois is a financial expert,
as such term is defined under the Sarbanes-Oxley Act of 2002.
Our audit committee has adopted a formal written charter specifying: (i)
the scope of the audit committee's responsibilities and how it is to carry out
those responsibilities, including structure, processes and membership
requirements; (ii) the audit committee's responsibility for ensuring its receipt
from the outside auditor of a formal written statement delineating all
relationships between the auditor and the company, consistent with Independence
Standards Board Standard 1, adopted in January 1999 by the Independence
Standards Board (the private sector standard-setting body governing the
independence of auditors from their public company clients) and the committee's
responsibility for actively engaging in communications with the auditor with
respect to any relationships or services that may impact the objectivity and
independence of the auditor and for taking, or recommending that the entire
board of directors take, appropriate action to oversee the independence of the
outside auditor; and (iii) the outside auditor's ultimate accountability to the
board of directors and the audit committee, as representatives of our company's
stockholders, and these stockholder representatives' ultimate authority and
responsibility to select, evaluate and, where appropriate, replace the outside
auditor (or to nominate the outside auditor for stockholder approval). Our audit
committee will review and reassess the adequacy of our written charter on an
annual basis.
Our audit committee has adopted guidelines and procedures: (i) making it
directly responsible for the appointment, compensation and oversight of the work
of any public accounting firm engaged by it (including resolution of any
disagreements between management and the firm regarding financial reporting) for
the purpose of preparing or issuing an audit report or related work, and each
such public accounting firm will report directly to the audit committee; (ii)
providing for the (a) receipt, retention and treatment of complaints received by
our company regarding accounting, internal accounting controls or auditing
matters and (b) confidential, anonymous submission by our employees of concerns
regarding questionable accounting or auditing matters; (iii) affording it the
authority to engage independent counsel and other advisers, as it may determine
to be necessary to carry out its duties; and (iv) providing for appropriate
funding for payment of: (a) the public accounting firm engaged by us for the
purpose of rendering or issuing an audit report and (b) any advisers engaged by
the audit committee as described under clause (iii) above.
40
Sarbanes-Oxley 404 Committee
In December 2004, we organized a committee, the 404 committee, to evaluate
and update our internal control structure and procedures for financial reporting
as required by Section 404 of the Sarbanes-Oxley Act of 2002. Our 404 committee
is comprised of members of our audit committee and personnel drawn from our
finance, operations and marketing departments. The 404 committee is responsible
for preparing an internal control report that attests to the effectiveness of
our internal control structure and procedures for financial reporting, and to
the extent applicable, describes any material weakness in internal control over
financial reporting identified by the 404 committee. The 404 committee's report
is to be filed with our Annual Report on Form 10-KSB along with a report of our
registered public accounting firm which includes the auditor's opinions on
whether our management's assessment of internal control over financial reporting
is fairly stated and whether we maintained effective internal control over
financial reporting. The 404 committee is working toward meeting our June 30,
2007 internal control over financial reporting requirements.
As constituted, our 404 committee consists of the following persons who
also serve us in the capacities set forth opposite their names:
o Mark Barchenko, Vice President-Marketing,
o Joseph McAndrew, Vice President-Operations,
o Natalie Barchenko, Director, Treasurer,
o Gene Rabois, Director, Audit Committee Chairman,
o Edward Snow, Director, Audit Committee Member, and
o Thomas Donahue, Director, Audit Committee Member.
Code of Conduct and Ethics
We have adopted a code of conduct and ethics that applies to our
directors, officers and all employees. The code of conduct and ethics will be
posted on our website at www.anti-terrorism.com in the near future. Until that
time, the code of business conduct and ethics may be obtained free of charge by
writing to Electronic Control Security Inc., Attn: Arthur Barchenko, 790
Bloomfield Avenue, Building C, Suite 1, Clifton, New Jersey 07012.
Director Compensation
In addition to reimbursing non-employee directors for travel and related
expenses for attending meetings of the board or committees of the board, we pay
our directors a fee of $1,000 for each board meeting attended in person and $500
for each board meeting attended telephonically. During the year ended June 30,
2005, we did not grant any stock options to our directors; however, under our
Incentive Stock Option Plan, non-employee directors are entitled to receive
stock options.
Executive Compensation
The table below summarizes the compensation earned for services rendered
to us in all capacities for the year ended June 30, 2005, by Arthur Barchenko,
our chief executive officer. No other individuals employed by us received a
salary and bonus in excess of $100,000 during fiscal year 2005.
41
Summary Compensation Table
Annual Compensation Long-Term Compensation
---------------------------------- ------------------------------------------------
Awards Payouts
----------------------- -----------------------
Securities
Restricted Underlying
Other Annual Stock Options/ LTIP All Other
Name and Principal Fiscal Salary Bonus Compensation Award(s) SARs Payouts Compensation
Position Year ($) ($) ($) (1) ($) (#) ($) ($)
- ------------------------ --------- ------- ------- -------------- ---------- ----------- -------- -------------
Arthur Barchenko 2005 130,000 - - - 250,000 - -
President and Chief
Executive Officer 2004 96,000 - - - 50,000 - -
2003 101,700 - - - - - -
- ------------------
(1) The aggregate amount of benefits in each of the years indicated did not
exceed the lesser of $50,000 or 10% of the compensation of any named
officer.
Option Grants in the Last Fiscal Year
The following table presents certain information concerning stock options
granted to Arthur Barchenko, the executive named above, under our various stock
option plans during the 2005 fiscal year.
Option/SAR Grants in Last Fiscal Year
(Individual Grants)
- ----------------------------------------------------------------------------------------------------------------------
Number of Securities % of Total Options/SARs Exercise or Base
Underlying Granted to Employees in Price
Name Option/SARs Granted Fiscal Year ($ /sh) Expiration Date
- --------------------- ----------------------- ----------------------------- -------------------- -----------------
Arthur Barchenko 250,000 22.73% 2.40 (1)
- -----------------------
(1) Of the 250,000 stock options granted to Mr. Barchenko during fiscal year
2005, options to purchase 50,000 shares of common stock vest in each of
the next five years.
Aggregated Option Exercises in the Last Fiscal Year and Year-End Option Values
The following table sets forth information concerning unexercised options
held by Arthur Barchenko, the executive named above, as of June 30, 2005. No
options were exercised by the named executive officer during fiscal year 2005 or
2006 through the date of this prospectus.
Aggregate Option/ SAR Exercises in Last Fiscal Year and FY-End Option/ SAR Value
Value of
Unexercised
In-the-Money
Number of Securities Options/
Underlying Unexercised SARs at FY-End ($)
Shares Acquired on Options/ SARs at FY-End (#) Exercisable/
Name Exercise (#) Value Realized ($) Exercisable/ Unexercisable Unexercisable
- ---------------------- -------------------- ------------------ ------------------------------ --------------------
Arthur Barchenko -0- -0- 150,000/250,000 $0/$0
Employment Agreements
We have not entered into any employment agreements with any of our
officers or employees.
42
Stock Option Plans
Incentive Stock Option Plan. In 1986, we adopted an Incentive Stock Option
Plan, which we renewed in 1996 for a second ten-year term. We initially had
reserved 1,000,000 shares of common stock for issuance under the Incentive Stock
Option Plan, which was increased to 2,000,000 shares upon the approval of the
stockholders at our 2005 annual meeting. Our board of directors administers the
Incentive Stock Option Plan but may delegate such administration to a committee
of three persons, one of whom must be a member of the board. The board or the
committee has the authority to determine the number of stock options to be
granted, when the stock options may be exercised and the exercise price of the
stock options, provided that the exercise price may never be less than the fair
market value of the shares of the common stock on the date the stock option is
granted (110% in the case of any employee who owns more than 10% of the combined
voting power or value of all classes of stock). Stock options may be granted for
terms not exceeding ten years from the date of the grant, except for stock
options granted to any person holding in excess of 5% of our common stock, in
which case the stock options may not be granted for a term not to exceed five
years from the date of the grant.
Non-statutory Stock Option Plan. We also adopted a Non-Statutory Stock
Option Plan and have reserved 250,000 shares of common stock for issuance to
directors, employees and non-employees. Stock options granted pursuant to this
plan will be non-transferable and expire, if not exercised within five years
from the date of the grant. Stock options will be granted in such amounts and at
such exercise prices as our board of directors may determine.
PRINCIPAL STOCKHOLDERS
Security Ownership of Certain Beneficial Owners and Management
The table and accompanying footnotes set forth information as of February
27, 2006 with respect to the ownership of our common stock by:
o each person or group who beneficially owns more than 5% of our
common stock,
o each of our executive officers and directors, and
o all of our executive officers and directors as a group.
Applicable percentage of ownership for each holder is based on 8,772,559
shares of common stock outstanding on February 27, 2006.
A person is deemed to be the beneficial owner of securities that can be
acquired within 60 days from the exercise of stock options and warrants or the
conversion of convertible securities. Accordingly, common stock issuable upon
exercise of stock options and warrants that are currently exercisable or
exercisable within 60 days after the date of this prospectus, and common stock
issuable upon conversion of convertible preferred stock or senior secured
convertible debentures, have been included in the table with respect to the
beneficial ownership of the person owning the stock options, warrants,
convertible preferred stock or senior secured convertible debentures, but not
with respect to any other persons.
Unless otherwise indicated, we believe that all persons named in the table
above have sole voting and investment power with respect to all shares of common
stock beneficially owned by them.
43
Number of
Name and Address of Beneficial Owner (1) Shares Beneficially Owned Percentage of Common Stock (2)
- ---------------------------------------- ------------------------- ------------------------------
Arthur Barchenko (3) ......................... 1,186,643 13.2%
Mark Barchenko .............................. 12,000 *
Natalie Barchenko (4) ........................ 1,609,079 18.2%
Gene Rabois (5) .............................. 100,203 1.1%
Edward Snow (6) .............................. 35,000 *
Robert F. Reiter (7) ........................ 30,000 *
Stephen Rossetti (8) ......................... 5,000 *
Thomas Donahue (9) ........................... 45,000 *
All directors and executive officers as a
group (8 persons) (10) ....................... 3,022,925 32.7%
Bluegrass Growth Fund, L.P. (11).............. 652,174 6.9%
- ------------------
* Less than 1%.
(1) Except as otherwise set forth, the address of each of the persons listed
is c/o Electronic Control Security Inc., 790 Bloomfield Avenue, Clifton,
New Jersey, 07012.
(2) Applicable percentage of ownership for each holder is based on 8,772,559
shares of common stock outstanding on February 27, 2006.
(3) Includes 155,536 shares of common stock not registered in Mr. Barchenko's
name, but over which he has depository power and control, and stock
options to purchase 200,000 shares of common stock.
(4) Includes stock options to purchase 180,000 shares of common stock.
(5) Includes stock options to purchase 5,000 shares of common stock.
(6) Includes stock options to purchase 30,000 shares of common stock.
(7) Includes stock options to purchase 25,000 shares of common stock.
(8) Consists of stock options to purchase 5,000 shares of common stock.
(9) Includes stock options to purchase 25,000 shares of common stock.
(10) Includes options to purchase an aggregate of up to 470,000 shares of
common stock which are held by all directors and executive officers.
(11) Consists of 434,783 shares of common stock issuable upon the conversion of
senior secured convertible debentures and 217,391 shares of common stock
issuable upon the exercise of warrants.
44
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In March 2004, we issued 735,294 shares of common stock to Natalie
Barchenko, our Treasurer and a director, and the wife of Arthur Barchenko, our
President and Chief Executive Officer and a director, upon the conversion of
loans made by Ms. Barchenko to us in the aggregate amount of $250,000. The
offering price of the shares was based upon a then outstanding offer by a third
party to purchase shares of common stock at such price.
Until we achieved profitability, we relied on loans from officers,
directors, shareholders and their affiliates to assist in the funding of our
operations. At June 30, 2005 and 2004, related party debt consisted of $431,617
and $387,050, respectively. The loans are repayable with interest at rates
varying from no interest through 12% interest per annum. All interest for fiscal
years 2005 and 2004 has been paid. We are restricted from repaying the principal
amount of the loans except as permitted under the Purchase Agreement, dated June
30, 2004, under which we sold the shares of series B convertible preferred stock
which provides that (i) repayment shall be later than December 31, 2005, (ii)
for the six month period ended June 30, 2005 (x) our reported revenues shall not
be less than $11 million and (y) the reported earnings per share of common stock
shall be not less than $0.23 based upon 7,250,000 shares of common stock
outstanding, and (iii) both at December 31, 2005 and at the time of any such
repayment, the purchasers are entitled to sell their shares under an effective
registration statement.
45
SELLING STOCKHOLDERS
Description of January 2006 Private Placement
On January 11, 2006, we entered into a Securities Purchase Agreement for
the sale of our senior secured convertible debentures in the aggregate principal
amount of $1,000,000. The transaction closed on January 13, 2006. We also
entered into a Security Agreement, dated as of January 11, 2006, pursuant to
which the debentures are secured by all of our assets, including our
intellectual property. Interest is payable on the debentures at a rate equal to
the greater of 8% per annum or the prime rate for the applicable interest period
(the current prime rate is 10%) plus 2.5%. Quarterly principal and interest
payments on the debentures begin on April 1, 2006. At our option, interest
payments on the debentures are payable either in cash or in registered shares of
common stock, subject to certain conditions as specified in the debentures.
The debentures have a term of three years and come fully due on January
11, 2009. The debentures are convertible at the option of the holder at any time
and from time to time into shares of our common stock at a conversion price of
$1.15 per share of common stock, or initially 869,566 shares of common stock,
subject to certain adjustments. In the event that we issue common stock in an
equity financing at a price less than the then conversion price, the conversion
price shall be immediately adjusted to the price at which such common stock was
issued, subject to specified exempt issuances.
Events of default under the debentures include:
o failure to pay principal or any premium on any debenture when due,
o failure to pay any interest, late fees or liquidated damages on any
debenture after a period of three trading days,
o failure to perform other covenants under the debenture that is not
cured by the earlier of seven trading days after notice by holder or
15 trading days after we are aware of such default,
o default under the other financing documents that is not cured by the
earlier of five trading days after notice or ten trading days after
we aware of such default,
o any representation or warranty under the financing documents that is
untrue or incorrect in any material respect,
o certain events of bankruptcy or insolvency of us or any of our
subsidiaries,
o any default by us or our subsidiaries under any instrument in excess
of $150,000 that results in such obligation becoming due and payable
prior to maturity,
o our becoming party to a change of control transaction, or disposing
of greater than 40% of our assets or redeeming more than a de
minimus number of outstanding equity securities,
o failure by us to have this registration statement registering the
resale of the common stock issuable upon the conversion of the
debentures and exercise of the accompanying common stock purchase
warrants declared effective by the SEC on or before July 10, 2006,
o if, during the effectiveness period of this registration statement,
the effectiveness of the registration statement lapses for any
reason or the holder shall not be permitted to resell registrable
securities under the registration statement, in either case, for
more than 30 consecutive trading days or 60 non-consecutive trading
days during any 12-month period, subject to certain limited
exceptions, and
o failure to deliver common stock certificates to a holder prior to
the fifth trading day after a debenture conversion date.
46
Upon an event of default, the outstanding principal of the debentures plus
all accrued and unpaid interest shall become immediately due and payable to the
holders of the debentures.
The debentures contain various covenants that limit our ability to:
o incur additional debt, other than permitted debt as defined in the
debenture,
o incur specified liens, other than permitted liens as defined in the
debenture,
o amend our certificate of incorporation or by-laws in a material
adverse manner to the holder, or
o repay or repurchase more than a de minimus number of shares of
common stock.
As part of the financing, we have agreed to be bound by the following
covenants:
o not to issue shares of common stock or other securities convertible
or exercisable into common stock until 90 days after the effective
date of this registration statement,
o not to assume any corporate debt which is senior to the debentures,
o not to repay or repurchase more than a de minimus number of shares
of common stock,
o not to incur specified liens, other than certain specified permitted
liens,
o not to amend our current certificate of incorporation, and
o not to pay cash dividends or distributions on our equity securities.
In addition, so long as any debentures remain outstanding, we have agreed
to maintain (i) a consolidated cash, cash equivalents and accounts receivable
balance equal to at least 125% of the aggregate outstanding principal balance of
the debentures and (ii) consolidated inventory as set forth in our balance sheet
included in our most recent periodic report of at least 80% of the aggregate
outstanding principal balance of the debentures.
Pursuant to the Securities Purchase Agreement, we also issued common stock
purchase warrants to the purchasers. The warrants are exercisable until January
11, 2009 to purchase initially up to 434,783 shares of our common stock at an
exercise price of $2.00 per share. The warrants contain provisions to adjust the
exercise price and the share amount in the event that we issue common stock in
an equity financing at a price less than the then applicable exercise price, in
which case (i) the exercise price shall be reduced to the price at which such
common stock was issued and (ii) the share amount shall be increased such that
the aggregate exercise price payable, after taking into account the decrease in
the exercise price, shall be equal to the aggregate exercise price prior to such
adjustment. The warrants also may be exercised on a cashless basis following the
first anniversary of issuance if a registration statement covering the common
stock issuable upon exercise of such warrants is not in effect at the time of
exercise.
The financing was completed through a private placement to four accredited
investors and was exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933, as amended. Pursuant to the Registration Rights
Agreement with the purchasers, dated as of January 11, 2006, we agreed to file a
registration statement covering the resale of the shares issuable to the
purchasers upon the conversion of the debentures and exercise of the warrants.
Those shares are included in the shares of common stock being offered by this
prospectus. In addition, for one year following the effectiveness of the
registration statement, the holders of the debentures have the right to
participate in our future equity or equity-linked financings, subject to
specified exempt issuances.
47
In connection with consummating the financing pursuant to the Securities
Purchase Agreement, we paid fees to our placement agents of $72,500 and issued
warrants to our placement agents to purchase up to 121,739 shares of our common
stock on substantially similar terms as the purchasers' warrants.
The net proceeds of the financing are being used by us to repay in full
our outstanding term loans in the amount of $658,339 and for working capital and
general corporate purposes.
2,013,047 shares of common stock being offered by this prospectus relate
to the January 2006 private financing. Of these, 869,566 shares of common stock
are shares into which the debentures are initially convertible and 434,783
shares of our common stock are shares into which the warrants are initially
exercisable. We are obligated to register an additional 326,088 shares of our
common stock (25% of the amount the debentures and the warrants are initially
convertible or exercisable, respectively, into) to cover potential adjustments.
We are also registering 260,871 shares of our common stock issuable in
connection with the payment of interest on the debentures, if such interest is
not otherwise paid in cash, as well as 121,739 shares of our common stock
issuable upon exercise of warrants issued to our placement agents.
Issuance to 10% Series B Convertible Preferred Stock Holders
On June 30, 2004, we issued 2,000 shares of our 10% series B convertible
preferred stock and warrants to purchase 2,000,000 shares of our common stock to
eight institutional and other accredited investors. The sale of the 10% series B
convertible preferred stock and warrants resulted in $2,000,000 in gross
proceeds to us, prior to the exercise of the warrants. The 10% series B
convertible preferred stock provides for a dividend at the rate of 10% per
annum, payable quarterly, in cash or by adding the dollar amount of such
dividends to the stated value for conversion purposes, on a cumulative basis.
The shares of 10% series B convertible preferred stock were initially
convertible into an aggregate of 2,000,000 shares of our common stock. We
previously filed a registration statement in respect of the common stock
issuable upon conversion of the 10% series B convertible preferred stock and the
shares of common stock issuable upon exercise of the warrants.
On November 15, 2005, we issued an aggregate of 360,248 shares of our
common stock in connection with the conversion of 314 shares of our 10% series B
convertible preferred stock. These shares are additional conversion shares that
were issuable as a consequence of an addition to the stated value of our 10%
series B convertible preferred stock resulting from a dividend declaration and a
corresponding adjustment in the beneficial conversion price. These shares are
included in the shares of common stock being offered by this prospectus. We are
also registering 466,696 shares of our common stock issuable in connection with
the payment of dividends on outstanding shares of our 10% series B convertible
preferred stock, if such dividends are not paid in cash.
Issuance to Series A Convertible Preferred Stock Holders
From January to March 2002, we issued 25,000 shares of our series A
convertible preferred stock and warrants to purchase 12,500 shares of our common
stock to accredited investors. The sale of the series A convertible preferred
stock and warrants resulted in $2,000,000 in gross proceeds to us, prior to the
exercise of the warrants. The series A convertible preferred stock provides for
an annual dividend of $.20 per share, payable quarterly, in cash or shares of
our common stock valued at $2.00 per share, when, as and if declared by our
board of directors. Each share of series A convertible preferred stock was
initially convertible at the option of the holder into one share of common
stock. The conversion ratio is subject to certain adjustments, and has since
been adjusted. All of the warrants issued in connection with this offering have
since expired unexercised.
Our board of directors declared cumulative dividends, totaling $153,042,
on outstanding shares of our series A convertible preferred stock on July 8,
2005. The dividends were paid by the issuance of 99,378 additional shares of our
common stock to holders of shares of our series A convertible preferred stock.
These shares are included in the shares of common stock being offered through
this prospectus. We are also registering 281,250 shares of our common stock
issuable in connection with the payment of dividends payable on outstanding
shares of our series A convertible preferred stock, if such dividends are not
paid in cash.
48
Other Issuances
Of the remaining shares of common stock being offered by this prospectus,
205,192 shares are shares of our common stock that were issued to our employees
or consultants on account of services rendered, and 920,000 shares are shares of
our common stock issuable to consultants upon exercise of outstanding warrants
at exercise prices ranging from $1.00 per share to $2.25 per share.
Selling Stockholder Table
The following table sets forth the shares beneficially owned, as of the
date of this prospectus, by the selling stockholders prior to the offering
contemplated by this prospectus, the number of shares each selling stockholder
is offering by this prospectus and the number of shares which each selling
stockholder would own beneficially if all such offered shares are sold. None of
the selling stockholders is known to us to be a registered broker-dealer or an
affiliate of a registered broker-dealer, or a member of the National Association
of Securities Dealers, Inc., except for Dunwoody Asset Management, LLC, Resource
Horizons Group, LLC and H.C. Wainwright & Co., Inc., all of which acquired
warrants to purchase shares of our common stock as compensation for investment
banking services. Each of the selling stockholders has acquired his, her or its
shares solely for investment and not with a view to or for resale or
distribution of such securities. We are not aware of any agreements or
understandings among the selling stockholders to distribute the securities.
Beneficial ownership is determined under the rules of the SEC. The number
of shares beneficially owned by a person includes shares of common stock
underlying warrants, stock options and other derivative securities to acquire
our common stock held by that person that are currently exercisable or
convertible within 60 days after February 24, 2006. The shares issuable under
these securities are treated as outstanding for computing the percentage
ownership of the person holding these securities, but are not treated as
outstanding for the purposes of computing the percentage ownership of any other
person.
No selling stockholder is an affiliate of ours or is controlled by our
affiliates, or is now a director or officer, except Edward Snow, who is a member
of our board of directors. Yaser Hassan, Thomas Isdanavich, Eldon Moberg,
Richard Stern and Kathleen Zomack are employees of our company. No selling
stockholders has or had a material relationship with us or any of our affiliates
for the past three years, not described elsewhere in this section of the
prospectus.
Beneficial Ownership
After this Offering (2)
----------------------------
Beneficial
Ownership Shares
Prior to Registered Number Percent
Name this Offering (1) in this Offering of Shares (3)
- ------------------------------------------- ------------------ ----------------- ------------ ------------
ABS SOS-Plus Partners Ltd. 163,044 236,414(4) -- *
Altitude Group, LLC 1,563 1,563(5) -- *
Beradino Investment Group 1,563 1,563(6) -- *
Carol Beradino, Robert Baumeister and 1,563 1,563 -- *
Linda Ravella, Ten. in Com
Carol Beradino IRA Account 1,563 1,563(7) -- *
Bluegrass Growth Fund, L.P. 652,174 945,653(8) -- *
Corsair Capital Investors Ltd. 76,190 38,870(9) 37,320 *
Corsair Capital Partners, LP 580,358 260,961(10) 319,397 3.6%
Corsair Capital Partners 100 LP 26,899 12,339(11) 14,560 *
Corsair Long Short International, Ltd. 40,114 12,374(12) 27,740 *
Corsair Select LP 366,521 105,732(13) 260,789 3.0%
49
Beneficial Ownership
After this Offering (2)
----------------------------
Beneficial
Ownership Shares
Prior to Registered Number Percent
Name this Offering (1) in this Offering of Shares (3)
- ------------------------------------------- ------------------ ----------------- ------------ ------------
Dunwoody Asset Management, LLC 80,000 80,000(14) -- *
Endeavor Asset Management L.P. 307,541 147,502(15) 160,039 1.8%
Mitchell Finesod 625 625 -- *
Fred Franks 28,125 625 27,500 *
Charles Gargano 65,000 48,793(16) 16,207 *
John A. Gentile 32,500 24,397(17) 8,103 *
Mark Goodman, M.D 938 938 -- *
Yaser Hassan 10,000 10,000 -- *
H.C. Wainwright & Co., Inc. 21,739 21,739(18) -- *
InteSec Group LLC 82,192 82,192(19) -- *
Iroquois Master Fund Ltd. 326,087 472,827(20) -- *
Thomas Isdanavich 30,000 20,000 10,000 *
JCM Capital Corp. 1,563 1,563(21) -- *
Arthur H. and Barbara Lerner 5,000 24,397(22) -- *
Lipman Capital Group, Inc. 120,000 120,000(23) -- *
Richard Lippe 60,000 43,793(24) 16,207 *
Marlin Financial Group, Inc. 820,000 820,000(25) -- *
Eldon Moberg 65,000 20,000 45,000 *
John Pappajohn 20,968 20,968 -- *
Mary Pappajohn 5,242 5,242 -- *
Joseph D. Posillico, Jr 65,000 48,793(26) 16,207 *
Protect-A-Life Inc. 18,000 18,000(27) -- *
Benjamin Rabinovici 1,875 1,875 -- *
Regency Resources, Inc. 32,500 24,397(28) 8,103 *
Regenmacher Holdings, Ltd. 163,044 236,414(29) -- *
Resource Horizons Group, LLC 20,000 20,000(30) -- *
Edward Rotter 5,000 5,000 -- *
Barry Seidman 16,875 9,375 7,500 *
George Shenewolf 3,750 2,500 1,250 *
Edward Snow 42,500 5,000 37,500 *
Richard Stern 30,000 25,000 5,000 *
Pasquale Tullo 3,125 3,125 -- *
View Far Management Limited 178,750 134,180(31) 44,750 *
Kathleen Zomack 10,000 5,000 5,000 *
---------
Selling Stockholders as a Group 4,122,855
---------
50
- ---------------
* Represents less than 1% of outstanding shares.
(1) Beneficial ownership as of February 27, 2006 for the selling stockholders
based upon information provided by the selling stockholders or known to
us.
(2) Assumes the sale of all shares of common stock registered pursuant to this
prospectus, although the selling stockholders are under no obligation
known to us to sell any shares of common stock at this time.
(3) Based on 8,772,559 shares of common stock outstanding on February 27,
2006. The shares issuable under stock options and warrants and other
derivative securities to acquire our common stock that are currently
exercisable or convertible within 60 days after February 27, 2006, are
treated as if outstanding for computing the percentage ownership of the
person holding these securities, but are not treated as outstanding for
purposes of computing the percentage ownership of any other person. Unless
otherwise indicated, also includes shares owned by a spouse, minor
children, by relatives sharing the same home, and entities owned or
controlled by the named person.
(4) Consists of 108,696 shares of common stock issuable upon the conversion of
senior secured convertible debentures, 54,348 shares of common stock
issuable upon the exercise of warrants, 40,761 shares of common stock
issuable to cover potential adjustments to the conversion and exercise
price of the debentures and warrants, respectively, and 32,609 shares of
common stock issuable in connection with the payment of interest payable
on the debentures, if such interest is not paid in cash. Jonathan Knight
is the President of ABS SOS-Plus Partners Ltd., which is the registered
holder of the shares of common stock. Mr. Knight, as the President of ABS
SOS-Plus Partners Ltd., has voting and disposition power of the shares
owned by ABS SOS-Plus Partners Ltd. offered under this prospectus.
(5) Michael Kreizman is the Managing Member of Altitude Group, LLC, which is
the registered holder of the shares of common stock. Michael Kreizman, as
the Managing Member of Altitude Group, LLC, has voting and disposition
power of the shares owned by Altitude Group, LLC offered under this
prospectus.
(6) Joseph Beradino is the control person of Beradino Investment Group, which
is the registered holder of the shares of common stock. Joseph Beradino,
as the control person of Beradino Investment Group, has voting and
disposition power of the shares owned by Beradino Investment Group offered
under this prospectus.
(7) Carol Beradino has voting and disposition power over the shares offered in
this prospectus.
51
(8) Consists of 434,783 shares of common stock issuable upon the conversion of
senior secured convertible debentures, 217,391 shares of common stock
issuable upon the exercise of warrants, 163,044 shares of common stock
issuable to cover potential adjustments to the conversion and exercise
price of the debentures and warrants, respectively, and 130,435 shares of
common stock issuable in connection with the payment of interest payable
on the debentures, if such interest is not paid in cash. Brian Shatz is
the Managing Member of Bluegrass Growth Fund, LLC, the general partner of
Bluegrass Growth Fund, L.P., which is the registered holder of the shares
of common stock. Brian Shatz, as the Managing Member of the general
partner of Bluegrass Growth Fund, L.P., has voting and disposition power
of the shares owned by Bluegrass Growth Fund, L.P. offered under this
prospectus.
(9) Consists of 8,190 shares of common stock and 30,680 shares of common stock
issuable in connection with the payment of dividends payable on the 10%
series B preferred convertible stock, if such dividends are not paid in
cash. Thomas Hess is the Controller of Corsair Capital Investors Ltd.,
which is the registered holder of the shares of common stock. Thomas Hess,
as the Controller of Corsair Capital Investors Ltd., has voting and
disposition power of the shares owned by Corsair Capital Investors Ltd.
offered under this prospectus.
(10) Consists of 60,358 shares of common stock and 200,603 shares of common
stock issuable in connection with the payment of dividends payable on the
10% series B preferred convertible stock, if such dividends are not paid
in cash. Thomas Hess is the Controller of Corsair Capital Partners, LP,
which is the registered holder of the shares of common stock. Thomas Hess,
as the Controller of Corsair Capital Partners, LP, has voting and
disposition power of the shares owned by Corsair Capital Partners, LP
offered under this prospectus.
(11) Consists of 2,899 shares of common stock and 9,440 shares of common stock
issuable in connection with the payment of dividends payable on the 10%
series B preferred convertible stock, if such dividends are not paid in
cash. Thomas Hess is the Controller of Corsair Capital Partners 100 LP,
which is the registered holder of the shares of common stock. Thomas Hess,
as the Controller of Corsair Capital Partners 100 LP, has voting and
disposition power of the shares owned by Corsair Capital Partners 100 LP
offered under this prospectus.
(12) Consists of 4,114 shares of common stock and 8,260 shares of common stock
issuable in connection with the payment of dividends payable on the 10%
series B preferred convertible stock, if such dividends are not paid in
cash. Thomas Hess is the Controller of Corsair Long Short International,
Ltd., which is the registered holder of the shares of common stock. Thomas
Hess, as the Controller of Corsair Long Short International, Ltd., has
voting and disposition power of the shares owned by Corsair Long Short
International, Ltd. offered under this prospectus.
(13) Consists of 35,521 shares of common stock and 70,211 shares of common
stock issuable in connection with the payment of dividends payable on the
10% series B preferred convertible stock, if such dividends are not paid
in cash. Thomas Hess is the Controller of Corsair Select LP, which is the
registered holder of the shares of common stock. Thomas Hess, as the
Controller of Corsair Select LP, has voting and disposition power of the
shares owned by Corsair Select LP offered under this prospectus.
(14) Consists of shares of common stock issuable upon the exercise of warrants.
David Jenkins and Christopher K. Norman are the Managing Members of
Dunwoody Asset Management, LLC, which is the registered holder of the
shares of common stock. David Jenkins and Christopher K. Norman, as the
Managing Members of Dunwoody Asset Management, LLC, have voting and
disposition power of the shares owned by Dunwoody Asset Management, LLC
offered under this prospectus.
(15) Consists of 147,502 shares of common stock issuable in connection with the
payment of dividends payable on the series A preferred convertible stock,
if such dividends are not paid in cash. Patrick Tully, Mark Fain and Chad
Comiteau have voting and disposition power of the shares owned by Endeavor
Asset Management L.P. offered under this prospectus.
(16) Consists of 10,000 shares of common stock and 38,793 shares of common
stock issuable in connection with the payment of dividends payable on the
series A preferred convertible stock, if such dividends are not paid in
cash.
52
(17) Consists of 5,000 shares of common stock and 19,397 shares of common stock
issuable in connection with the payment of dividends payable on the series
A preferred convertible stock, if such dividends are not paid in cash.
(18) Consists of shares of common stock issuable upon the exercise of warrants.
John Clarke is the President of H.C. Wainwright & Co., Inc., which is the
registered holder of the shares of common stock. Mr. Clarke, as the
President of H.C. Wainwright & Co., Inc., has voting and disposition power
of the shares owned by H.C. Wainwright & Co., Inc. offered under this
prospectus. H.C. Wainwright & Co., Inc. is a member of the National
Association of Securities Dealers, Inc.
(19) John Kaufman is the control person of InteSec Group, which is the
registered holder of the shares of common stock. Mr. Kaufman, as the
control person of InteSec Group, has voting and disposition power of the
shares owned by InteSec Group offered under this prospectus.
(20) Consists of 217,391 shares of common stock issuable upon the conversion of
senior secured convertible debentures, 108,696 shares of common stock
issuable upon the exercise of warrants, 81,522 shares of common stock
issuable to cover potential adjustments to the conversion and exercise
price of the debentures and warrants, respectively, and 65,218 shares of
common stock issuable in connection with the payment of interest payable
on the debentures, if such interest is not paid in cash. Joshua Silverman
is the Managing Member of Iroquois Master Fund Ltd., which is the
registered holder of the shares of common stock. Joshua Silverman, as the
Managing Member of Iroquois Master Fund Ltd., has voting and disposition
power of the shares owned by Iroquois Master Fund Ltd. offered under this
prospectus.
(21) Joseph Beradino is the President of JCM Capital Corp., which is the
registered holder of the shares of common stock. Joseph Beradino, as the
President of JCM Capital Corp., has voting and disposition power of the
shares owned by JCM Capital Corp. offered under this prospectus.
(22) Consists of 5,000 shares of common stock and 19,397 shares of common stock
issuable in connection with the payment of dividends payable on the series
A preferred convertible stock, if such dividends are not paid in cash.
(23) Consists of shares of common stock issuable upon the exercise of warrants.
John Lipman is the President of Lipman Capital Group, Inc., which is the
registered holder of the shares of common stock. Mr. Lipman, as the
President of Lipman Capital Group, Inc., has voting and disposition power
of the shares owned by Lipman Capital Group, Inc. offered under this
prospectus.
(24) Consists of 5,000 shares of common stock and 38,793 shares of common stock
issuable in connection with the payment of dividends payable on the series
A preferred convertible stock, if such dividends are not paid in cash.
(25) Consists of 20,000 shares of common stock and 800,000 shares of common
stock issuable upon the exercise of warrants. Mark Levin is the President
of Marlin Financial Group, Inc., which is the registered holder of the
shares of common stock. Mr. Levin, as the President of Marlin Financial
Group, Inc., has voting and disposition power of the shares owned by
Marlin Financial Group, Inc. offered under this prospectus.
53
(26) Consists of 10,000 shares of common stock and 38,793 shares of common
stock issuable in connection with the payment of dividends payable on the
series A preferred convertible stock, if such dividends are not paid in
cash.
(27) J. Paul is the President of Protect-A-Life Inc., which is the registered
holder of the shares of common stock. J. Paul, as the President of
Protect-A-Life Inc., has voting and disposition power of the shares owned
by Protect-A-Life Inc. offered under this prospectus.
(28) Consists of 5,000 shares of common stock and 19,397 shares of common stock
issuable in connection with the payment of dividends payable on the series
A preferred convertible stock, if such dividends are not paid in cash.
Jeffrey Furman is the President of Regency Resources, Inc., which is the
registered holder of the shares of common stock. Jeffrey Furman, as the
President of Regency Resources, Inc., has voting and disposition power of
the shares owned by Regency Resources, Inc. offered under this prospectus.
(29) Consists of 108,696 shares of common stock issuable upon the conversion of
senior secured convertible debentures, 54,348 shares of common stock
issuable upon the exercise of warrants, 40,761 shares of common stock
issuable to cover potential adjustments to the conversion and exercise
price of the debentures and warrants, respectively, and 32,609 shares of
common stock issuable in connection with the payment of interest payable
on the debentures, if such interest is not paid in cash. Jonathan Knight
is the President of Siam Capital Management, the investment manager of
Regenmacher Holdings, Ltd., which is the registered holder of the shares
of common stock. Mr. Knight, as the President of the investment manager of
Regenmacher Holdings, Ltd., has voting and disposition power of the shares
owned by Regenmacher Holdings, Ltd. offered under this prospectus.
(30) Consists of shares of common stock issuable upon the exercise of warrants.
David K. Miller is the Managing Member of Resource Horizons Group, LLC,
which is the registered holder of the shares of common stock. David K.
Miller, as the Managing Member of Resource Horizons Group, LLC, has voting
and disposition power of the shares owned by Resource Horizons Group, LLC
offered under this prospectus.
(31) Consists of 27,500 shares of common stock and 106,680 shares of common
stock issuable in connection with the payment of dividends payable on the
series A preferred convertible stock, if such dividends are not paid in
cash. K.L. Wong is the control person of View Far Management Limited,
which is the registered holder of the shares of common stock. K.L. Wong,
as the control person of View Far Management Limited, has voting and
disposition power of the shares owned by View Far Management Limited
offered under this prospectus.
54
PLAN OF DISTRIBUTION
We are registering an aggregate of 4,122,855 shares of our common stock
covered by this prospectus on behalf of the selling stockholders. Each selling
stockholder of our common stock, and any of their pledgees, assignees and
successors-in-interest may, from time to time, sell any or all of their shares
of common stock on any stock exchange, market or trading facility on which the
shares are traded or in private transactions. These sales may be at fixed or
negotiated prices. A selling stockholder may use any one or more of the
following methods when selling shares:
o ordinary brokerage transactions and transactions in which the
broker-dealer solicits purchasers,
o block trades in which the broker-dealer will attempt to sell the
shares as agent but may position and resell a portion of the block
as principal to facilitate the transaction,
o purchases by a broker-dealer as principal and resale by the
broker-dealer for its account,
o an exchange distribution in accordance with the rules of the
applicable exchange,
o privately negotiated transactions,
o settlement of short sales entered into after the effective date of
the registration statement of which this prospectus is a part,
o broker-dealers may agree with the selling stockholders to sell a
specified number of such shares at a stipulated price per share,
o a combination of any such methods of sale,
o through the writing or settlement of options or other hedging
transactions, whether through an options exchange or otherwise, or
o any other method permitted pursuant to applicable law.
The selling stockholders may also sell shares under Rule 144 under the
Securities Act of 1933, if available, rather than under this prospectus.
Broker-dealers engaged by the selling stockholders may arrange for other
brokers-dealers to participate in sales. Broker-dealers may receive commissions
or discounts from the selling stockholders (or, if any broker-dealer acts as
agent for the purchaser of shares, from the purchaser) in amounts to be
negotiated, but, except as set forth in a supplement to this prospectus, in the
case of an agency transaction not in excess of a customary brokerage commission
in compliance with NASDR Rule 2440; and in the case of a principal transaction a
markup or markdown in compliance with NASDR IM-2440.
In connection with the sale of our common stock or interests therein, the
selling stockholders may enter into hedging transactions with broker-dealers or
other financial institutions, which may in turn engage in short sales of our
common stock in the course of hedging the positions they assume. The selling
stockholders may also sell shares of our common stock short and deliver these
securities to close out their short positions, or loan or pledge our common
stock to broker-dealers that in turn may sell these securities. The selling
stockholders may also enter into option or other transactions with
broker-dealers or other financial institutions or the creation of one or more
derivative securities which require the delivery to such broker-dealer or other
financial institution of shares offered by this prospectus, which shares such
broker-dealer or other financial institution may resell pursuant to this
prospectus (as supplemented or amended to reflect such transaction).
The selling stockholders and any broker-dealers or agents that are
involved in selling the shares may be deemed to be "underwriters" within the
meaning of the Securities Act in connection with such sales. In such event, any
commissions received by such broker-dealers or agents and any profit on the
resale of the shares purchased by them may be deemed to be underwriting
commissions or discounts under the Securities Act. Each selling stockholder has
informed us that he, she or it does not have any written or oral agreement or
understanding, directly or indirectly, with any person to distribute our common
stock. In no event shall any broker-dealer receive fees, commissions and markups
which, in the aggregate, would exceed eight percent.
55
We are required to pay certain fees and expenses incurred by us incident
to the registration of the shares of our common stock. We have agreed to
indemnify the selling stockholders against certain losses, claims, damages and
liabilities, including liabilities under the Securities Act.
Because selling stockholders may be deemed to be "underwriters" within the
meaning of the Securities Act, they will be subject to the prospectus delivery
requirements of the Securities Act. In addition, any securities covered by this
prospectus which qualify for sale pursuant to Rule 144 under the Securities Act
may be sold under Rule 144 rather than under this prospectus. Each selling
stockholder has advised us that they have not entered into any written or oral
agreements, understandings or arrangements with any underwriter or broker-dealer
regarding the sale of the resale shares. There is no underwriter or coordinating
broker acting in connection with the proposed sale of the resale shares by the
selling stockholders.
We agreed to keep this prospectus effective until the earlier of (i) the
date on which the shares may be resold by the selling stockholders without
registration and without regard to any volume limitations by reason of Rule
144(e) under the Securities Act or any other rule of similar effect or (ii) all
of the shares have been sold pursuant to the prospectus or Rule 144 under the
Securities Act or any other rule of similar effect. The resale shares will be
sold only through registered or licensed brokers or dealers if required under
applicable state securities laws. In addition, in certain states, the resale
shares may not be sold unless they have been registered or qualified for sale in
the applicable state or an exemption from the registration or qualification
requirement is available and is complied with.
Under applicable rules and regulations under the Securities Exchange Act
of 1934, any person engaged in the distribution of the resale shares may not
simultaneously engage in market making activities with respect to our common
stock for the applicable restricted period, as defined in Regulation M, prior to
the commencement of the distribution. In addition, the selling stockholders will
be subject to applicable provisions of the Exchange Act and the rules and
regulations thereunder, including Regulation M, which may limit the timing of
purchases and sales of shares of our common stock by the selling stockholders or
any other person. We will make copies of this prospectus available to the
selling stockholders and have informed them of the need to deliver a copy of
this prospectus to each purchaser at or prior to the time of the sale.
56
DESCRIPTION OF SECURITIES
General
Our authorized capital consists of 15,000,000 shares of common stock, par
value $0.001 per share, and 5,000,000 shares of preferred stock, par value $0.01
per share, of which 1,100,000 shares are designated as series A convertible
preferred stock and 2,000 shares are designated as 10% series B convertible
preferred stock. The balance of the authorized but unissued preferred stock has
not been designated at the date hereof. At February 27, 2006, we had the
following securities outstanding:
Common Stock: 8,772,559 shares.
Series A Preferred Stock: 325,000 shares convertible into 369,318 shares of
common stock.
Series B Preferred Stock: 741 shares convertible into 934,918 shares of
common stock.
Warrants: 1,446,875 exercisable for a like number of shares
of common stock.
Stock Options: 1,524,500 exercisable for a like number of shares
of common stock.
Other Securities: $1,000,000 of senior secured convertible
debentures initially convertible into 869,566
shares of common stock.
Common Stock
Each outstanding share of common stock has one vote on all matters
requiring a vote of the stockholders. There is no right to cumulative voting;
thus, the holders of fifty percent or more of the shares outstanding (including
the shares of Series A Preferred Stock voting with the common stock on an as
converted basis) can, if they choose to do so, elect all of the directors. In
the event of a voluntary or involuntary liquidation, all stockholders are
entitled to a pro rata distribution after payment of liabilities and after
provision has been made for each class of stock, if any, having preference over
the common stock. The holders of the common stock have no preemptive rights with
respect to offerings of our securities. Holders of common stock are entitled to
dividends if, as and when declared by our board of directors out of the funds
legally available therefore, subject to the rights of holders of the preferred
stock and the senior secured convertible debentures. It is our present intention
to retain earnings, if any, for use in our business. Cash dividends are,
therefore, unlikely in the foreseeable future.
Series A Convertible Preferred Stock
Dividends. We pay a cumulative dividend on the Series A Preferred Stock,
prior and in preference to any declaration or payment of any cash dividend on
the common stock, at the rate of $.20 per share per annum payable quarterly
(payable in cash or shares of common stock valued at a price of $2.00 per
share), when, as and if declared by our board of directors.
Unless we pay the full amount of dividends on the Series A Preferred Stock
for the then current dividend period, we shall not (A) pay any cash dividend on
any common stock, or (B) purchase, redeem, or acquire any shares of common
stock, nor shall we pay into or set aside or make available any funds for a
sinking fund for the purchase, redemption, or acquisition of the common stock.
Conversion. Holders of Series A Preferred Stock are entitled to convert
each share into shares of common stock at any time at the option of the holder.
Each share of Series A Preferred Stock is convertible into one share of common
stock, subject to certain adjustments as the result of the payment of dividends
(and other distributions) in common stock on the outstanding shares of common
stock and subdivisions, combinations and reclassifications of common stock.
Voting Rights. Except as provided by law, the holders of the Series A
Preferred Stock will vote on an as-if converted basis with the holders of common
stock (and any other class or series which may be similarly entitled to vote
with the common stock) as one class on all corporate matters requiring
stockholder approval. The holders of the Series A Preferred Stock will be
entitled to vote as a separate class with respect to matters directly affecting
the Series A Preferred Stock.
57
Liquidation Payment. In the event of any liquidation, dissolution or
winding up of our company, or in the event of a consolidation or merger of our
company with or into any other corporation, or a sale, conveyance or disposition
of all or substantially all of our assets or the effectuation by us of a
transaction or series of related transactions in which more than 50% of the
voting power of our company is disposed of, the holders of Series A Preferred
Stock shall be entitled to receive, prior and in preference to any distribution
of any of our assets to the holders of common stock, (x) an amount per share
equal to $2.00 and (y) an amount equal to declared but unpaid dividends on each
such share. In addition, (1) in the case of a dissolution or winding up of our
company, our remaining assets available for distribution to stockholders shall
be distributed among the holders of the Series A Preferred Stock and the common
stock pro rata based on the number of shares of common stock held by each
(assuming conversion of all shares of Series A Preferred Stock), or (2) in the
case of a merger or sale of our company, the remaining consideration to be paid
by the acquiring corporation in such transaction shall be distributed among the
holders of the Series A Preferred Stock and the common stock pro rata based on
the number of shares of common stock held by each (assuming conversion of all
shares of Series A Preferred Stock).
Redemption Rights. We have the right to redeem the Series A Preferred
Stock at any time provided that the average closing bid price per share of our
common stock for the 20 trading days prior to the redemption notice is $4.00.
Protective Provisions. During such time as shares of Series A Preferred
Stock are outstanding, we will not, without first obtaining the approval of the
holders of at least a majority of the then outstanding shares of Series A
Preferred Stock, voting separately, undertake certain acts that would directly
affect the Series A Preferred Stock, such as, (a) selling or otherwise disposing
of or encumbering all or substantially all of our property or business, except
in connection with liens granted to any lender providing us with a revolving
line of credit; (b) altering or changing the rights, preferences or privileges
of the shares of Series A Preferred Stock so as to adversely effect the shares;
(c) increasing the authorized number of shares of Series A Preferred Stock; or
(d) undertaking any proposed capital reorganization or reclassification with
respect to equity securities (or securities convertible into other securities)
into equity securities ranking senior to the Preferred Stock with respect to
dividends, distributions or rights upon liquidation.
10% Series B Convertible Preferred Stock.
Dividends. We pay a cumulative dividend on the Series B Preferred Stock,
prior and in preference to any declaration or payment of any cash dividend on
the Series A Preferred Stock and the common stock, at the rate of 10% per share
per annum payable quarterly (payable in cash or shares of common stock, at our
option), when, as and if declared by our board of directors. To the extent we
elect to pay the dividend on this class of shares in common stock, the dollar
amount of the dividend is added to the stated value of each share of 10% series
convertible B preferred stock and such shares are issued upon conversion of the
10% series convertible B preferred stock into shares of common stock.
Unless we pay the full amount of dividends on the 10% series convertible B
preferred stock for the then current dividend period, we shall not (A) pay any
cash dividend on any common stock or Series A Preferred Stock, or (B) purchase,
redeem, or acquire any shares of common stock or Series A Preferred Stock nor
shall we pay into or set aside or make available any funds for a sinking fund
for the purchase, redemption, or acquisition of the common stock.
Voting Rights. Except as provided by law, the holders of the 10% series
convertible B preferred stock are not entitled to vote their shares. The holders
of the 10% series convertible B preferred stock will be entitled to vote as a
separate class with respect to matters directly affecting the 10% series
convertible B preferred stock.
Liquidation. Upon any liquidation of our company, holders of 10% series
convertible B preferred stock shall be entitled to receive out of our assets,
for each share of 10% series convertible B preferred stock an amount equal to
the stated value per share (calculated by adding the purchase price per share of
$1,000 plus the amount of any dividends added thereto) before any distribution
or payment shall be made to the holders of any securities ranking below the 10%
series convertible B preferred stock, and if our assets shall be insufficient to
pay in full such amounts to all holders of 10% series convertible B preferred
stock, then the entire assets to be distributed to the holders of such shares
shall be distributed among these holders ratably in accordance with the
respective stated values represented by the 10% series convertible B preferred
stock then held by them.
58
Conversion at Option of a Holder. Each share of 10% series convertible B
preferred stock initially is convertible into 1,000 shares of common stock, at
the option of the applicable holder, at any time.
Conversion at Our Option. We may require the conversion of all (but not
less than all) of the then outstanding shares of 10% series convertible B
preferred stock, if at any time: (i) the volume weighted average trading price
per share of common stock for each of 20 consecutive trading days prior to a
conversion notice is greater than $2.50 (subject to adjustment), (ii) the daily
trading volume of the common stock is at least 100,000 shares for each of the 20
trading days prior to a conversion notice (subject to equitable adjustment in
the event of stock splits and reverse splits), and (iii) all shares of common
stock underlying the 10% series convertible B preferred stock are the subject of
an effective registration statement. We are restricted from converting any
shares of 10% series convertible B preferred stock that would cause a holder to
own, upon any conversion, (i) when added to shares of common stock already owned
by such holder a number of shares of common stock that does not exceed 4.999% of
the total number of issued and outstanding shares of common stock (including for
such purpose the shares of common stock issuable upon such conversion) or (ii)
when added to shares of common stock already owned by such holder and its
affiliates and any other persons whose beneficial ownership of common stock
would be aggregated with the holder's as provided under the Securities Exchange
Act of 1934, would exceed 9.999% of the total number of issued and outstanding
shares of common stock (including for such purpose the shares of common stock
issuable upon such conversion).
The number of shares issuable upon conversion of 10% series convertible B
preferred stock is subject to adjustment in certain cases including, if at any
time prior to July 1, 2007, at any time while shares of 10% series convertible B
preferred stock are outstanding, we issue any common stock or any common stock
equivalents entitling any person to acquire shares of common stock at a price
per share less than the $1 per share (or as otherwise adjusted) then the
conversion price shall be automatically adjusted to the lowest conversion,
exchange or purchase price for such common stock or common stock equivalents at
issue.
Protective Provisions. While any shares of 10% series convertible B
preferred stock are outstanding, we have agreed, without first obtaining the
affirmative vote of the holders of at least a majority of the shares of 10%
series convertible B preferred stock then outstanding:
o alter or change the powers, preferences or rights given to the 10%
series convertible B preferred stock,
o increase or decrease the number of shares of 10% series convertible
B preferred stock or increase or decrease the number of authorized
shares of common stock,
o authorize or create (by reclassification or otherwise) any class of
equity security ranking as to dividends or distribution of assets
upon a liquidation senior to or on a par with the 10% series
convertible B preferred stock,
o redeem, purchase or otherwise acquire directly or indirectly any of
our other securities,
o directly or indirectly pay or declare any dividend or make any
distribution (other than dividends due and paid in the ordinary
course on outstanding preferred stock at such times when we are in
compliance with our payment obligations to the 10% series
convertible B preferred stock) upon, nor shall any distribution be
made in respect of, any junior securities, nor shall any monies be
set aside for or applied to the purchase or redemption (through a
sinking fund or otherwise) of any junior securities or securities on
a par with the 10% series convertible B preferred stock,
o enter into any agreement with respect to a change of control
transaction unless on the date of such agreement certain conditions,
including the effectiveness of a registration statement covering the
common stock underlying the 10% series convertible B preferred stock
and the associated warrants, are satisfied,
59
o amend or waive any provision in our certificate of incorporation in
a manner adverse to the 10% series convertible B preferred stock, or
o enter into any agreement with respect to the foregoing clauses.
Options and Warrants
As of February 24, 2006, options and warrants for 2,971,375 shares of our
common stock were outstanding. Holders of options and warrants do not have any
of the rights or privileges of our stockholders, including voting rights, prior
to exercise of the options and warrants. We have reserved sufficient shares of
authorized common stock to cover the issuance of common stock subject to the
options and warrants.
In connection with the sale of our senior secured convertible debentures
in aggregate principal amount of $1,000,000 in January 2006, we issued common
stock purchase warrants to the purchasers. The warrants are exercisable until
January 11, 2009 to purchase initially up to 434,783 shares of our common stock
at an exercise price of $2.00 per share. The warrants contain provisions to
adjust the exercise price and the share amount in the event that we issue common
stock in an equity financing at a price less than the then applicable exercise
price, in which case (i) the exercise price shall be reduced to the price at
which such common stock was issued and (ii) the share amount shall be increased
such that the aggregate exercise price payable, after taking into account the
decrease in the exercise price, shall be equal to the aggregate exercise price
prior to such adjustment. The warrants also may be exercised on a cashless
basis. See also "Selling Stockholders - Description of the January 2006 Private
Placement."
Transfer Agent and Registrar
The transfer agent and registrar for our common stock is Continental Stock
Transfer & Trust Company, 17 Battery Place, New York, New York 10004.
Commission Position on Indemnification for Securities Act Liabilities
As permitted by Section 14A:3-5 of the New Jersey Business Corporation
Act, our certificate of incorporation provides for the indemnification by us of
each of our directors and officers to the fullest extent permitted by New Jersey
Law.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to our directors, officers or controlling persons, we have
been informed that in the opinion of the SEC such indemnification is against
public policy as expressed in the Securities Act and is therefore unenforceable.
60
SHARES ELIGIBLE FOR FUTURE SALE
As of February 27, 2006, we had outstanding an aggregate of 8,772,559
shares of our common stock, assuming no exercises of our outstanding stock
warrants or stock options or conversion of our outstanding convertible preferred
stock or senior secured convertible debentures. All shares sold in this offering
will be freely tradable without restriction or further registration under the
Securities Act, unless they are purchased by our "affiliates," as that term is
defined in Rule 144 promulgated under the Securities Act.
As of February 27, 2006, the remaining outstanding shares of our common
stock not included in this prospectus consist of 6,723,641 shares that are in
the public float and 1,607,056 shares that are restricted.
Public Float
Our 6,723,641 of public float shares are freely tradable without
restriction or further registration under the Securities Act, unless they are
purchased by our "affiliates," as that term is defined in Rule 144 promulgated
under the Securities Act.
Rule 144
In general, under Rule 144, as currently in effect, a person who has
beneficially owned shares of our common stock for at least one year, including
the holding period of prior owners other than affiliates, is entitled to sell
within any three-month period a number of shares that does not exceed the
greater of:
o 1% of the number of shares of our common stock then outstanding,
which equaled 87,725 shares as of February 27, 2006, or
o the average weekly trading volume of our common stock on the OTC
Bulletin Board during the four calendar weeks preceding the filing
of a notice on Form 144 with respect to that sale.
Sales under Rule 144 are also subject to manner-of-sale provisions, notice
requirements and the availability of current public information about us. In
order to effect a Rule 144 sale of our common stock, our transfer agent will
require an opinion from legal counsel. We may charge a fee to persons requesting
sales under Rule 144 to obtain the necessary legal opinions.
61
LEGAL MATTERS
The validity of the shares of common stock offered by this prospectus will
be passed upon by our counsel, Greenberg Traurig, LLP, New York, New York.
EXPERTS
The financial statements for the years ended June 30, 2005 and 2004
included in this prospectus have been audited by Demetrius & Company, L.L.C.
independent registered public accounting firm, as set forth in their report
contained herein. These financial statements have been included in reliance upon
the report of Demetrius & Company, L.L.C., given upon the authority of such firm
as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed a registration statement on Form SB-2 with the SEC for the
securities we are offering by this prospectus. This prospectus does not contain
all of the information set forth in the registration statement and the exhibits
and schedules to that registration statement. A copy of the registration
statement may be inspected by anyone without charge at the SEC's principal
office in Washington, D.C., and copies of all or any part of the registration
statement may be obtained from the SEC's Public Reference Room at 100 F Street,
N.E., Washington, D.C. 20549, upon payment of certain fees prescribed by the
SEC. Please call the SEC at 1-800-SEC-0330 for further information on the
operation of the public reference rooms. Our filings with the SEC are also
available to the public through the SEC's Internet site at http://www.sec.gov.
You may also request a copy of our filings at no cost, by writing or
telephoning us at:
Electronic Control Security Inc.
790 Bloomfield Avenue
Building C, Suite 1
Clifton, New Jersey 07012
Attention: Arthur Barchenko, President and Chief Executive Officer
Telephone: (973) 574-8555
We are subject to the information reporting requirements of the Securities
Exchange Act of 1934, as amended and, in accordance therewith, we file annual,
quarterly and current reports, proxy statements and other information with the
SEC. We intend to furnish to our stockholders annual reports containing audited
financial statements and may furnish interim reports as we deem appropriate. You
will be able to inspect and copy these reports, proxy statements and other
information at the address set forth above.
You should rely only on the information provided in this prospectus, any
prospectus supplement or as part of the registration statement filed on Form
SB-2 of which this prospectus is a part, as such registration statement is
amended and in effect with the SEC. We have not authorized anyone else to
provide you with different information. We are not making an offer of these
securities in any state where the offer is not permitted. You should not assume
that the information in this prospectus, any prospectus supplement or any
document incorporated by reference is accurate as of any date other than the
date of those documents.
62
ELECTRONIC CONTROL SECURITY INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm ....................F-2
Consolidated Balance Sheets as of June 30, 2005 and 2004....................F-3
Consolidated Statements of Operations for the years ended June 30, 2005
and 2004....................................................................F-4
Consolidated Statements of Changes in Shareholders' Equity..................F-5
Consolidated Statements of Cash Flows for the years ended Jun 30, 2005
and 2004....................................................................F-7
Notes to the Audited Consolidated Financial Statements......................F-8
Consolidated Balance Sheets as of December 31, 2005 (unaudited) and June
30, 2005....................................................................F-20
Consolidated Statements of Operations for the six months ended December
31, 2005 (unaudited) and December 31, 2004 (unaudited) and the three
months ended December 31, 2005 (unaudited) and December 31, 2004
(unaudited).................................................................F-21
Consolidated Statements of Cash Flows for the six months ended December
31, 2005 (unaudited) and December 31, 2004 (unaudited)......................F-22
Notes to the Unaudited Consolidated Financial Statements....................F-23
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Electronic Control Security Inc.
and Subsidiaries
We have audited the accompanying consolidated balance sheets of Electronic
Control Security, Inc. and Subsidiaries as of June 30, 2005 and 2004, and the
related consolidated statements of operations, changes in shareholders' equity,
and cash flows for the years then ended. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
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 consolidated financial position of
Electronic Control Security, Inc. and its subsidiaries as of June 30, 2005 and
2004, and the consolidated results of their operations and cash flows for the
years then ended in conformity with accounting principles generally accepted in
the United States of America.
DEMETRIUS & COMPANY, L.L.C.
Wayne, New Jersey
September 12, 2005
F-2
Electronic Control Security Inc.
Consolidated Balance Sheets
June 30,
2005 2004
------------ -----------
ASSETS
Current assets
Cash and cash equivalents $ 221,293 $ 1,552,575
Certificate of deposit -- 101,723
Accounts receivable, net of allowance of $100,000 2,088,546 729,070
Inventories 1,965,501 1,635,305
Other current assets 363,868 318,795
------------ -----------
Total current assets 4,639,208 4,337,468
Property, equipment and software development costs - net 502,644 549,727
Intangible assets - net 1,438,999 40,733
Certificate of deposit, pledged 253,084 --
Goodwill 50,000 50,000
Deferred income taxes 456,300 441,800
Other assets 59,827 84,709
------------ -----------
$ 7,400,062 $ 5,504,437
============ ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable and accrued expenses $ 1,185,423 $ 465,078
Bank line of credit -- 500,000
Short-term loan -- 250,000
Current maturities of long-term debt 232,992 99,996
Obligations under capital leases -- 4,396
Payroll taxes payable 16,234 3,012
Income taxes payable -- 2,500
------------ -----------
Total current liabilities 1,434,649 1,324,982
Noncurrent liabilities
Long-term debt 437,565 141,671
Due to officers and shareholders 431,617 387,050
Deferred income taxes 62,500 48,000
------------ -----------
Total liabilities 2,366,331 1,901,703
COMMITMENTS AND CONTINGENCIES - see notes
Shareholders' equity
Series A Convertible Preferred stock, cumulative, $.01 par value; $2.00
liquidation preference; 5,000,000 shares authorized,
325,000 and 587,500 shares issued and outstanding, respectively 3,250 5,875
Series B 10% Convertible Preferred stock, cumulative, $.001 par value;
$1,000 per share liquidation preference; 2,000 shares authorized,
1,900 and 2,000 shares issued and outstanding, respectively 2 2
Common Stock, $.001 par value; 30,000,000 shares authorized;
7,384,935 and 5,555,707 shares issued; 7,284,935 and 5,455,707
shares outstanding, respectively 7,385 5,556
Additional paid-in capital 10,344,782 8,577,764
Accumulated deficit (5,311,807) (4,990,305)
Accumulated other comprehensive income 119 13,842
Treasury stock, at cost, 100,000 shares (10,000) (10,000)
------------ -----------
Total shareholders' equity 5,033,731 3,602,734
------------ -----------
$ 7,400,062 $ 5,504,437
============ ===========
See Notes to Consolidated Financial Statements.
F-3
Electronic Control Security Inc.
Consolidated Statements of Operations
Year
Ended
June 30,
2005 2004
----------- -----------
Revenues $ 5,967,469 $ 2,061,412
Cost of revenues 3,531,312 928,567
----------- -----------
Gross profit 2,436,157 1,132,845
----------- -----------
Research and development 285,916 322,912
Selling, general and administrative expenses 2,101,435 1,782,534
Stock based compensation 120,000 117,200
----------- -----------
Loss from operations (71,194) (1,089,801)
Other (income) expense
Interest expense 118,029 105,916
Interest income (15,498) (3,128)
Minority interest in subsidiary loss (48,899) (42,633)
Gain on sale of marketable securities (2,630) --
----------- -----------
Total other (income) expense 51,002 60,155
----------- -----------
Loss before tax benefit (122,196) (1,149,956)
Income tax benefit -- (31,300)
----------- -----------
Net loss before dividends (122,196) (1,118,656)
Dividends related to convertible preferred stock 199,306 1,167,147
----------- -----------
Net loss attributable to common shareholders $ (321,502) $(2,285,803)
=========== ===========
Net loss per share:
Basic $ (0.05) $ (0.49)
=========== ===========
Diluted $ (0.05) $ (0.49)
=========== ===========
Weighted average number of common shares and equivalents:
Basic 6,450,739 4,705,027
=========== ===========
Diluted 6,450,739 4,705,027
=========== ===========
See Notes to Consolidated Financial Statements.
F-4
Electronic Control Security Inc.
Consolidated Statements of Changes in Shareholders Equity
Series A Convertible Series B 10% Convertible
Preferred Stock Preferred Stock
Shares Amount Shares Amount
----------- ----------- ----------- -----------
Balances at July 1, 2003 637,500 6,375 -- --
Conversion of preferred stock (50,000) (500)
Common stock dividend on preferred stock
Issuance of Common Stock for services
Issuance of Common Stock Options for services
Private placement of convertible preferred stock
and common stock warrants, net of
offering costs of $56,307 2,000 2
Beneficial conversion feature of prefered stock
Conversion of stockholder loan
Exercise of stock option
Foreign currency translation adjustments
Net loss
----------- ----------- ----------- -----------
Balances at June 30, 2004 587,500 5,875 2,000 2
Conversion of preferred stock (262,500) (2,625) (100) (0)
Common stock dividend on preferred stock
Issuance of Common Stock for services
Issuance of Common Stock for Clarion Aquisition
Exercise of stock options
Exercise of warrants
Foreign currency translation adjustments
Net loss
----------- ----------- ----------- -----------
Balances at June 30, 2005 325,000 $ 3,250 1,900 $ 2
=========== =========== =========== ===========
Accumulated
Additional Other
Common Stock Paid-in Accumulated Comprehensive
Shares Amount Capital Deficit Income
----------- ----------- ----------- ----------- -------------
Balances at July 1, 2003 4,494,753 4,495 5,098,787 (2,704,502) 653
Conversion of preferred stock 50,000 50 450
Common stock dividend on preferred stock 61,500 62 122,939 (123,000)
Issuance of Common Stock for services 85,000 85 96,815
Issuance of Common Stock Options for services 20,300
Private placement of convertible preferred stock
and common stock warrants, net of
offering costs of $56,307 1,943,691
Beneficial conversion feature of prefered stock 1,044,147 (1,044,147)
Conversion of stockholder loan 735,294 735 249,265
Exercise of stock option 129,160 129 1,371
Foreign currency translation adjustments 13,189
Net loss (1,118,656)
----------- ----------- ----------- ----------- -----------
Balances at June 30, 2004 5,555,707 5,556 8,577,764 (4,990,305) 13,842
Conversion of preferred stock 399,994 400 2,225
Common stock dividend on preferred stock 199,306 (199,306)
Issuance of Common Stock for services 82,192 82 119,918
Issuance of Common Stock for Clarion Aquisition 394,682 395 662,671
Exercise of stock options 88,088 88 4,862
Exercise of warrants 864,272 864 778,036
Foreign currency translation adjustments (13,723)
Net loss (122,196)
----------- ----------- ----------- ----------- -----------
Balances at June 30, 2005 7,384,935 $ 7,385 $10,344,782 $(5,311,807) $ 119
=========== =========== =========== =========== ===========
Treasury
Stock Total
----------- -----------
Balances at July 1, 2003 (10,000) 2,395,808
Conversion of preferred stock --
Common stock dividend on preferred stock --
Issuance of Common Stock for services 96,900
Issuance of Common Stock Options for services 20,300
Private placement of convertible preferred stock
and common stock warrants, net of
offering costs of $56,307 1,943,693
Beneficial conversion feature of prefered stock --
Conversion of stockholder loan 250,000
Exercise of stock option 1,500
Foreign currency translation adjustments 13,189
Net loss (1,118,656)
----------- -----------
Balances at June 30, 2004 (10,000) 3,602,734
Conversion of preferred stock --
Common stock dividend on preferred stock --
Issuance of Common Stock for services 120,000
Issuance of Common Stock for Clarion Aquisition 663,066
Exercise of stock options 4,950
Exercise of warrants 778,900
Foreign currency translation adjustments (13,723)
Net loss (122,196)
----------- -----------
Balances at June 30, 2005 $ (10,000) $ 5,033,731
=========== ===========
See Notes to Consolidated Financial Statements.
F-5
Electronic Control Security Inc.
Consolidated Statements of Cash Flows
Year
Ended
June 30,
2005 2004
----------- -----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Cash flows from operating activities:
Net loss before deemed dividends $ (122,196) $(1,118,656)
Adjustments to reconcile loss
to net cash used by operating activities:
Depreciation and amortization 222,336 163,888
Increase in allowance for bad debts -- 50,000
Stock based compensation 120,000 117,200
Minority interest in subsidiary loss (48,899) (42,633)
Gain on sales marketable securities (2,630) --
Deferred income taxes -- (33,800)
Foreign currency translation adjustments (13,723) 13,189
Increase (decrease) in cash attributable
to changes in assets and liabilities
Accounts receivable (1,359,478) (77,054)
Inventory (330,196) (264,186)
Other current assets 3,826 49,037
Other assets 24,882 (57,795)
Accounts payable and accrued expenses 571,403 (197,702)
Income taxes payable (2,500) (3,500)
Payroll taxes payable 13,222 (9,847)
----------- -----------
Net cash used by operating activities (923,953) (1,411,859)
Cash flows from investing activities:
Investment in marketable securities 2,630 --
Investment in Clarion (572,327) --
Acquisition of property, equipment and software development (95,683) (132,745)
----------- -----------
Net cash used in investing activities (665,380) (132,745)
Cash flows from financing activities:
Proceeds from issuance of preferred stock -- 1,943,693
Proceeds from exercise of stock options and warrants 783,850 1,500
Proceeds (payments) on bank loan and line of credit -- (60,000)
Repayment of short-term borrowing (250,000) 250,000
Certificate of deposit (purchased) redeemed (151,361) 298,277
Payments on long-term debt (164,609) (100,000)
Payments on lease obligations (4,396) (11,416)
Loan officers and shareholders - net 44,567 700,044
----------- -----------
Net cash provided by financing activities 258,051 3,022,098
----------- -----------
Net increae (decrease) in cash and cash equivalents (1,331,282) 1,477,494
Cash and cash equivalents at beginning of period 1,552,575 75,081
----------- -----------
Cash and cash equivalents at end of period $ 221,293 $ 1,552,575
=========== ===========
See Notes 3 for a summary of noncash investing activities
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest $ 118,029 $ 68,179
=========== ===========
Taxes $ 4,510 $ 1,000
=========== ===========
See Notes to Consolidated Financial Statements.
F-6
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Nature of Operations
Electronic Control Security, Inc. (The "Company") is engaged in the
design, manufacture and marketing of electronic security and lighting
systems for high threat environments. The Company also performs consulting
services, which consists principally of designing security system
solutions in support of their technologies to system integrators, for
medium to large government and commercial facilities worldwide.
In March 2005, the Company, through its wholly owned subsidiary, Clarion
Sensing Systems Acquisition Corp, acquired all of the assets and assumed
certain of the liabilities of Clarion Sensing Systems, Inc., an Indiana
corporation ("Clarion"). Clarion is a provider of proprietary nuclear,
biological, chemical and radiological (NBCR) remote monitoring sensor
systems designed for air and water contamination detection sensing
applications.
Note 2 - Summary of Significant Accounting Policies
Principles of Consolidation
The financial statements include the accounts of the Company, its wholly
owned subsidiaries, and its majority owned subsidiary. All significant
intercompany accounts and transactions have been eliminated.
Reclassifications
Certain prior year balances have been reclassified to conform to the
current year presentation.
Accounts Receivable
Trade accounts receivable is recorded net of an allowance for expected
losses. The allowance is estimated from historical performance and
projections of trends.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or
market.
Property and Equipment and Depreciation
Depreciation is provided for by straight-line and accelerated methods over
the estimated useful lives of the assets, which vary from three to ten
years. Cost of repairs and maintenance are charged to operations in the
period incurred.
Software Development Costs
Software development costs are expensed as incurred until technological
feasibility is established. Software development costs incurred subsequent
to establishing technological feasibility are capitalized and amortized.
Amortization is provided based on the greater of the ratios that current
gross revenues for a product bear to the total of current and anticipated
future gross revenues for that product, or the straight-line method over
the estimated useful life of the product. The estimated useful life for
the straight-line method is determined to be 5 years. Approximately
$57,000 and $93,000 of software development costs have been capitalized
for the years ended June 30, 2005 and 2004, respectively.
Earnings per Share
In determining basic or diluted earnings per share (EPS), the effects of
dividends related to the Company's convertible preferred stock is added to
the net loss.
F-7
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Basic EPS is computed by dividing net income or net loss by the weighted
average number of common shares outstanding for the period. Diluted EPS
reflects the potential dilution from the exercise or conversion of other
securities into common stock, but only if dilutive. The following
securities have been excluded from the dilutive per share computation as
they are antidilutive.
2005 2004
---- ----
Stock options 1,110,000 590,000
Warrants 1,496,875 3,096,875
Convertible Preferred Stock 2,269,318 2,667,614
Foreign Currency Translation
The functional currency of the Company's foreign subsidiaries is the local
currency. Accordingly, the Company translates all assets and liabilities
into U.S. dollars at current rates. Revenues, costs, and expenses are
translated at average rates during each reporting period. Gains and losses
resulting from the translation of the consolidated financial statements
are excluded from results of operations and are reflected as a translation
adjustment and a separate component of stockholders' deficit.
Gains and losses resulting from foreign currency transactions are
recognized in the consolidated statement of operations in the period they
occur.
Cash and Cash Equivalents
The Company considers all short-term deposits with a maturity of three
months or less to be cash equivalents.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.
Long-lived assets
The Company records impairment losses on long-lived assets used in
operations when events and circumstances indicate that the assets might be
impaired and the undiscounted cash flows estimated to be generated by
those assets are less than the carrying amounts of those assets
Revenue Recognition
The Company recognizes product revenue at the time of shipment. Revenues
from consulting and design services are recognized at the time the
services are rendered.
The Company also provides professional and technical services under a
specific contract, based on a time and material plus fixed profit basis.
Revenue on this contract is recognized to the extent of costs incurred
plus a proportionate amount of profit earned. Contract costs including
indirect costs are subject to audit by agencies of the United States
Government. Management believes future adjustments, if any, from
government cost audits will not have a material effect on the financial
statements.
F-8
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Research and Development
Research and development expenditures are expensed as incurred. Research
an development costs for the years ended June 30, 2005 and 2004 amounted
to $285,916 and $322,912, respectively.
Income Taxes
The Company uses the liability method to determine its income tax expense
as required under Statement of Financial Accounting Standards No. 109
(SFAS 109). Under SFAS 109, deferred tax assets and liabilities are
computed based on differences between financial reporting and tax basis of
assets and liabilities, and are measured using the enacted tax rates and
laws that will be in effect when the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax
assets, if it is more likely than not that all or a portion of it will not
be realized.
Intangible Assets
The cost of licenses, patents, and trademarks are being amortized on the
straight-line method over their useful lives, ranging from 5 to 20 years.
Amortization expense charged to operations was $31,570 and $5,734 for the
years ended June 30, 2005 and 2004, respectively.
Advertising Costs
Advertising costs are reported in selling, general and administrative
expenses, and include advertising, marketing and promotional programs.
These costs are charged to expense in the year in which they are incurred.
Advertising costs for the years ended June 30, 2005 and 2004 were
approximately $23,000 and $49,000, respectively.
Stock Based Compensation
The Company accounts for stock-based employee and outside directors
compensation under Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees", and related interpretations.
The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure", which was released in December
2002 as an amendment of SFAS No. 123. Stock options and warrants granted
to non-employees are recorded at their fair value, as determined in
accordance with SFAS No. 123 and Emerging Issues Task Force Consensus No.
96-18, and recognized over the related service period.
The following table illustrates the effect on net income and earnings per
share if the fair value based method had been applied to all awards
Year Ended June 30
2005 2004
---- ----
Net loss, as reported $ (321,502) $(2,285,803)
Add: Stock based compensation
expense, as reported, net of related tax effects -- 20,300
Deduct: Total stock-based compensation
expense determined under the fair value based
method for all awards, net of related tax effects (107,571) (206,501)
----------- -----------
$ (429,073) $(2,472,004)
=========== ===========
Basic and diluted loss per share, as reported $ (.05) $ (.49)
Basic and diluted loss per share, pro forma $ (.07) $ (.53)
F-9
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The weighted average per share fair value of options granted during fiscal
2005 and 2004 was $2.28 and $.93, respectively. The fair value of each
option granted was estimated using the Black-Scholes option-pricing model
with the following weighted average assumptions:
2005 2004
---- ----
Expected volatility 151.12% 156.88%
Risk free rate 3.65% 3.79%
Expected life of option 6.5 8
Dividend yield 0% 0%
Fair Value of Financial Instruments
The carrying values of cash, accounts receivable, accounts payable,
accrued expenses and other current liabilities are representative of their
fair value due to the short-term maturity of these instruments. The
carrying value of the Company's long-term debt is considered to
approximate its fair value, based on current market rates and conditions.
Recent Pronouncements
In November 2004, the FASB issued SFAS 151, "Inventory Costs." SFAS 151
amends the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) under the guidance
in ARB 43, Chapter 4, "Inventory Pricing." Paragraph 5 of ARB 43, Chapter
4, previously stated that "...under some circumstances, items such as idle
facility expense, excessive spoilage, double freight, and rehandling costs
may be so abnormal as to require treatment as current period charges...."
This Statement requires that those items be recognized as current-period
charges regardless of whether they meet the criterion of "so abnormal." In
addition, this Statement requires that allocation of fixed production
overheads to the costs of conversion be based on the normal capacity of
the production facilities. This statement is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. Management
does not expect adoption of SFAS 151 to have a material impact on the
Company's financial statements.
In December 2004, the FASB issued SFAS 123(R), "Share-Based Payment." SFAS
123(R) amends SFAS 123, "Accounting for Stock-Based Compensation," and APB
Opinion 25, "Accounting for Stock Issued to Employees." SFAS 123(R)
requires that the cost of share-based payment transactions (including
those with employees and non-employees) be recognized in the financial
statements. SFAS 123(R) applies to all share-based payment transactions in
which an entity acquires goods or services by issuing (or offering to
issue) its shares, share options, or other equity instruments (except for
those held by an ESOP) or by incurring liabilities (1) in amounts based
(even in part) on the price of the entity's shares or other equity
instruments, or (2) that require (or may require) settlement by the
issuance of an entity's shares or other equity instruments. This statement
is effective for public companies qualifying as SEC small business
issuers, as of the first interim period or fiscal year beginning after
December 15, 2005
As permitted by SFAS No. 123, the Company currently accounts for
share-based payments to employees using APB No. 25's intrinsic value
method and, as such, generally recognizes no compensation expenses for
employee stock options. Accordingly, the adoption of SFAS 123(R)'s, fair
value method will have a significant impact on our results of operations,
although it will have no impact on our overall financial position. The
impact of adoption of SFAS No. 123(R) cannot be predicted at this time
because it will depend on levels of share-based payments granted in the
future, however, had the Company adopted SFAS 123(R) in prior periods, the
impact of the standard would have approximated the impact of SFAS No. 123
as described in the disclosure of pro forma net
F-10
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
income (loss) and net income (loss) per share in Note 2 to the
consolidated financial statements. SFAS No. 123(R) also requires the
benefits of tax deductions in excess of recognized compensation cost to be
reported as a financing cash flow, rather than as an operating cash flow
as required under current literature. This requirement will reduce net
operating cash flows and increase net financing cash flows in periods
after adoption. While the Company cannot estimate what those amounts will
be in the future (because they depend on, among other things, when
employees exercise stock options), there were no operating cash flows
recognized in the years ended June 30, 2005 and 2004 for such excess tax
deductions.
Note 3 - Non-cash Investing and Financing Activities
Non-cash investing and financing activities are excluded from the
consolidated statement of cash flows. For the year ended June 31, 2005,
non-cash activities included the following items:
Asset Acquisition of Clarion Sensing Systems, Inc., ("Clarion") (See Note
4).
Fair value of assets acquired $1,477,835
==========
Cash advanced to sellers $ 413,144
Liabilities assumed 242,442
Stock issued 663,066
Transaction costs 159,183
----------
Total purchase price $1,477,835
==========
Note 4 - Acquisition
On March 4, 2005, the Company, through its wholly owned subsidiary,
Clarion Sensing Systems Acquisition Corp.(the "Subsidiary"), entered into
a series of agreements with Clarion Sensing Systems, Inc., an Indiana
corporation ("Clarion"), and its stockholders (the "Clarion Stockholders")
to acquire all of Clarion's assets (the "Clarion Assets") and assume
certain of its liabilities. Clarion is a provider of proprietary nuclear,
biological, chemical and radiological (NBCR) remote monitoring sensor
systems designed for air and water contamination detection sensing
applications.
The purchase price was approximately $1.45 million consisting of (i) the
issuance of 394,682 shares of common stock of ECSI ("Shares") and (ii) the
assumption of $655,586 of certain liabilities of Clarion, of which ECSI
already had paid approximately $413,144 as of the date hereof and (iii)
transaction fees of $159,183. Based on an independent valuation, the
reported purchase price includes approximately $48,000 of furniture and
equipment and $1.4 million of identifiable intangibles. The identifiable
intangibles acquired from Clarion consist of trademarks, patents pending
and proposed patents, and internet domain names. These assets will be
amortized on a straight-line basis over estimated useful lives of from
five to twenty years.
In addition to the initial cost of the acquisition, the Company agreed to
assume $438,959 of certain liabilities of Clarion on a contingent basis .
The Subsidiary will be obligated to pay the Contingent Liabilities, if at
all, only if the Subsidiary achieves (A) sales in excess of $3,000,000
("$3,000,000 in Sales") and/or (B) net earnings before taxes in excess of
$600,000 ("$600,000 in Net Earnings") in one of its fiscal years beginning
within three (3) years of March 4, 2005. In the event $3,000,000 in Sales
are achieved but $600,000 in Net Earnings are not achieved, then 10% of
the Subsidiary's net earnings before taxes earned during such fiscal year
shall be utilized to pay the Contingent Liabilities. In the event $600,000
in Net Earnings are achieved (whether or not $3,000,000 in Sales are
achieved), then (I) all net earnings before taxes in excess of $600,000
earned during such fiscal year plus (II) 10% of the Subsidiary's net
earnings before taxes earned during such fiscal year, shall be utilized to
pay the Contingent Liabilities. If the Contingent Liabilities are not paid
in full and $3,000,000 in sales or $600,000 in net earnings occurs in one
or more subsequent fiscal years, then
F-11
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
net earnings before taxes with respect to such fiscal years shall be
utilized to pay the Contingent Liabilities in the manner set forth in the
preceding two sentences until such time, if ever, the Contingent
Liabilities are paid in full. Any amounts shall be payable in cash or
shares of common stock (valued as of the closing ask price on the date of
issuance) as the recipient shall direct.
The Company anticipates the contingent payments made, if any, will be
treated as additional purchase price and included as an addition to the
identifiable intangible assets. As of June 30, 2005, the Company is not
liable for any contingent payments and, therefore, has not accrued any at
this time. The Company will continue to asses its liability under the
contingent payment arrangement in each successive quarter, and will record
additional purchase price through an increase to intangible assets, if and
when a liability is realized.
The following table presents unaudited pro forma revenue, net loss and
loss per share giving the effect of the Clarion acquisition as if it had
been completed at the beginning of each period presented:
Year ended June 30,
2005 2004
---- ----
Revenue $ 5,975,914 $ 2,186,717
============ ============
Net loss $ (664,263) $ (2,537,834)
============ ============
Net loss per share, basic and diluted $ (0.10) $ (0.50)
Note 5 - Inventories
Inventories at June 30, 2005 and 2004 consist of the following:
2005 2004
---- ----
Raw materials $ 322,958 $ 203,765
Work-in-process 402,045 240,093
Finished goods 1,240,498 1,191,447
------------ ------------
$ 1,965,501 $ 1,635,305
============ ============
Note 6 - Property, Equipment and Software Development Costs
Property, equipment and software development costs consist of the
following:
2005 2004
---- ----
Furniture and fixtures $ 93,087 $ 37,074
Machinery and equipment 579,561 549,140
Improvements 9,296 9,296
Software 96,761 96,512
Software development costs 489,228 432,228
------------ ------------
1,267,933 1,124,250
Less: accumulated depreciation and amortization 765,289 574,523
------------ ------------
$ 502,644 $ 549,727
============ ============
Equipment under capital leases included in
property, equipment and purchased software are as follows:
Machinery and equipment $ -- $ 25,694
Less: accumulated depreciation -- 22,696
------------ ------------
$ -- $ 2,998
============ ============
F-12
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Depreciation expense was $190,766 and $158,154 for the years ended June
30, 2005 and 2004, respectively.
Note 7 - Short-Term Borrowing
On April 1, 2004, the company entered into a strategic investment
relationship with the Fairchild Corporation. The investment relationship
began with a six-month revolving line of credit in the amount of $250,000
at 7% interest per annum. This loan was repaid in July 2004.
Note 8 - Long-Term Debt
In November 2004, the Company's existing $500,000 revolving line of credit
was converted into a term loan to be repaid over five years in monthly
installments of $8,333 plus interest at the rate of 8% per annum. In
connection with conversion the Company pledged a certificate of deposit in
the amount of $250,000 as additional collateral. At June 30, 2005, the
Company received a waiver for non-compliance of one of the required
financial covenants under this agreement.
In November 2001, an existing $500,000 revolving line of credit was
converted into a term loan to be repaid over five years in monthly
installments of $8,333 plus interest at the rate of 7.5% per annum
In connection with the Clarion acquisition the Company assumed an existing
loan in the amount of $95,300. The loan is payable in 34 monthly
installments of $2,750 plus interest at the rate of prime plus 1/2% per
annum.
The annual maturities of long-term debt as of June 30, 2005 are as
follows:
2005 $ 232,999
2006 174,667
2007 121,224
2008 99,999
2009 41,668
------------
$ 670,557
============
Note 9 - Due to Officers and Shareholders
These amounts represent interest bearing advances and are due on demand.
The Company is restricted from repaying the principal amount of the loans
except as permitted under the Purchase Agreement, in connection with the
sale of shares of Series B Preferred Stock. The agreement provides that
the repayment shall not be before December 31, 2005, and for the six month
period ended June 30, 2005 the reported revenues of the Company shall not
be less than $11 million and the reported earnings per share of Common
Stock shall be not less than $0.23 based upon 7,250,000 shares of Common
Stock outstanding. In addition, both at December 31, 2005 and at the time
of any such repayment, the Selling Stockholders are entitled to sell their
shares under an effective registration statement
In March 2004, in order to be in compliance with bank loan covenants by
the year ended June 30, 2004, Company's Board of Directors voted to
convert $250,000 principal amount of Officer/shareholder loans into
735,294 shares of Common Stock.
F-13
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10 - Income Taxes
The provision for taxes for the year ended June 30, 2005 and 2004 includes
the following components:
2005 2004
---- ----
Current
Federal $ -- $ --
State -- 2,500
Foreign -- --
----------- -----------
-- 2,500
Deferred
Federal -- (31,300)
State -- (2,500)
Foreign -- --
----------- -----------
-- (33,800)
----------- -----------
$ -- $ (31,300)
=========== ===========
The components of the deferred tax accounts as of June 30, 2005 and 2004
are as follows:
2005 2004
---- ----
Deferred tax assets
Net operating loss carryforward $ 919,353 $ 751,939
Stock based compensation 31,140 240,283
Other 21,448 80,669
----------- -----------
971,941 1,072,891
Deferred tax liabilities
Depreciation and amortization 62,588 47,123
----------- -----------
Subtotal 909,353 1,025,768
Valuation allowance (515,553) (631,968)
----------- -----------
Net deferred tax assets $ 393,800 $ 393,800
=========== ===========
The valuation allowance at June 30, 2003 was $216,817.
The reconciliation of estimated income taxes attributed to operations at
the statutory tax rates to the reported income tax benefit is as follows:
2005 2004
---- ----
Expected federal tax at statutory rate $ (125,936) $ (781,026)
State taxes, net of federal tax effect (12,444) (129,302)
Foreign rate differential (9,780) (8,527)
Non deductible expenses 86,873 475,682
Change in valuation allowance 51,126 415,151
Other 10,161 (3,278)
----------- -----------
$ -- $ (31,300)
=========== ===========
F-14
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
At June 30, 2005 the Company had net operating loss carryforwards for
federal and state income tax purposes of $1,748,000 and $1,485,000
respectively, expiring through 2025. The Company has foreign net operating
loss carryforwards of $433,928 with no expiration date.
Note 11- Shareholders' Equity
Series A Convertible Preferred Stock
In January to March 2002, the Company realized gross proceeds of
$2,000,000 from the private placement of 40 Units, each Unit consisting of
25,000 shares of Series A Convertible Preferred Stock ("Series A
Preferred") and 12,500 common stock purchase Warrants. The Series A
Preferred provides for an annual dividend of $.20 per share, payable
quarterly, (payable in cash or shares of common stock valued at $2.00 per
share), when, as and if declared by the Board of Directors. Dividends will
be paid on a cumulative basis. Each Series A Preferred share was initially
convertible at the option of the holder into one common share, commencing
120 days after closing. The conversion ratio is subject to certain
adjustments, as defined and has since been adjusted to .88 Series A
Preferred shares for one common share. The Series A Preferred shares have
a liquidation preference in the amount of $2.00 per share and the Company
may redeem them commencing one year from date of issuance if the common
shares have traded at or above $4.00 for a period of twenty consecutive
trading days. All of the Warrants issued in connection with this offering
have since expired unexercised.
As of June 30, 2005, 675,000 shares of Series A Preferred were converted
into a like amount of common stock.
On April 26, 2004, the Company's board of Directors declared dividends on
the Series A Convertible Preferred Stock. The dividend was paid by the
issuance of 61,500 additional shares of the Company's common stock,
respectively. Cumulative but undeclared dividends at June 30, 2005 totaled
approximately $155,000 This dividend was declared by Company's board of
Directors on July 28, 2005 and the Company paid the dividend by issuing an
additional 100,628 shares of it's Common Stock
Series B Convertible Preferred Stock
On June 30, 2004, the Company completed a private placement of 2,000
shares of its 10% Series B Convertible Preferred Stock ("Series B
Preferred") and warrants to purchase up to 2,000,000 shares of common
stock for an aggregate purchase price of $2,000,000. The Preferred Stock
provides for a dividend at the rate of 10% per annum, payable quarterly,
(payable in cash or by adding the dollar amount of such dividends to the
Stated Value), dividends will be paid on a cumulative basis. The preferred
shares have a liquidation preference in the amount of $1,000 per share and
has preference to any payments to the Preferred A shareholders. Each
preferred share is convertible at the option of the holder into 1,000
shares of common stock. The conversion price is subject to anti-dilution
adjustments, including, among other things, in the event that the Company
sells common stock during the next three years for a price of less than
one dollar per share. The Company may require the conversion of all (but
not less than all) of the then outstanding shares of Series B Preferred
Stock, if at any time the volume weighted average trading price per share
of common stock for each of 20 consecutive trading days prior to a
conversion notice is greater than $2.50 (subject to adjustment), and the
daily trading volume of the common stock is at least 100,000 shares. In
addition all shares of common stock underlying the Series B Preferred
Stock must be covered by an effective registration statement.
The Warrants are exercisable for a period of four years from the date of
issuance at an exercise price per share of $1.00 per share and have
similar anti-dilution privileges as the Series B Preferred Stock. The
Company may call the Warrants if the volume weighted average trading price
per share of
F-15
common stock for each of 20 consecutive trading days is greater than 200%
of the exercise price, and the daily trading volume of the common stock is
at least 100,000 shares. In addition all shares of common stock underlying
Warrants must be covered by an effective registration. The Company has
valued the warrants issued at $955,853 using the Black-Scholes pricing
model.
In connection with the private placement, the Company issued 200,000
warrants with identical terms to a placement agent.
The Company has recorded a deemed dividend and an offsetting increase in
additional paid-in capital totaling $1,044,147 to reflect the beneficial
conversion price of the preferred stock as compared to the prevailing
market price of the common stock.
Stock Option Plans
Incentive Stock Option Plan
During September 1986, the Company adopted an incentive stock option plan
for which 750,000 shares of common stock have been reserved. The plan has
since been extended until September 2006.
Under the plan, incentive stock options were granted to certain employees
of the Company. The exercise price may not be less than 100% of the fair
market value of the stock at the date of the grant (110% in the case of
any employee who owns more than 10% of the combined voting power or value
of all classes of stock). Options may be granted for terms not exceeding
ten years from the date of the grant, except for options granted to person
holding in excess of 5% of the common stock, in which case the options may
not be granted for a term not to exceed five years from the date of the
grant.
Non-statutory Stock Option Plan
The Company also has adopted a non-statutory stock option plan and has
reserved 250,000 shares of common stock for issuance to Directors,
employees and non-employees. Options granted pursuant to this plan will be
non-transferable and expire, if not exercised within five years from the
date of the grant.
Other Option Grants
In addition to the options granted under the Stock Option Plans, the
Company has issued options outside of the plans, pursuant to various
consulting agreements.
F-16
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Option activity for 2004 and 2005 is summarized as follows:
Weighted
Average
Options Exercise
Plan Nonplan Total Price
---- ------- ----- -----
Options outstanding, July 1, 2003 575,000 45,000 620,000 $ 1.45
Granted 220,000 -- 220,000 .87
Exercised (180,000) -- (180,000) .20
Forfeited (25,000) (45,000) (70,000) 2.00
---------- ---------- ---------- ----------
Options outstanding, June 30, 2004 590,000 -- 590,000 $ 1.53
Granted 565,000 -- 565,000 $ 2.40
Exercised (45,000) -- (45,000) .07
Forfeited -- -- -- --
---------- ---------- ---------- ----------
Options outstanding, June 30, 2005 1,110,000 -- 1,110,000 $ 2.03
========== ========== ========== ==========
Shares of common stock available
for future grant under the plans 945,000
==========
The following table summarizes information about stock options outstanding
at June 30, 2005.
Options Exercisable
Weighted Average Weighted
Remaining Average
Number Contractual Exercise Number Exercise
Ranges of price Outstanding Life Price Exercisable Price
- --------------- ----------- ---- ----- ----------- -----
$.25-.39 60,000 5.98 $0.31 60,000 $0.31
$.50-.88 110,000 4.49 $0.66 110,000 $0.66
$1.00-1.10 155,000 8.51 $1.01 155,000 $1.01
$2.40 565,000 9.56 $2.40 113,000 $2.40
$2.70-2.97 220,000 1.62 $2.95 220,000 $2.95
------- ---- ----- ------- -----
$.05-$2.97 1,110,000 7.14 $2.03 658,000 $1.77
========= ==== ===== ======= =====
Note 12 - Concentrations and Economic Dependency
The Company had two customers that accounted for 76% and 20%, respectively
of net revenues for year ended June 30, 2005 and three customers that
accounted for 11%, 11% and 10%, of net revenues for year ended June 30,
2004. Three customers accounted for 94% of the accounts receivables as of
June 30, 2005. At June 30, 2005 approximately 14% of accounts receivable
were from foreign customers. The Company performs ongoing credit
evaluations of its customers' financial condition and generally requires
no collateral from its customers.
F-17
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During the year and at year end, the Company had cash deposits in a bank
in excess of FDIC limits. The Company periodically reviews the financial
condition of the bank to minimize its exposure
Note 13 - Commitments and Contingencies
Lease Agreements
Future minimum annual rental payments required under non-cancelable
operating leases for years after June 30, 2005 are as follows:
2006 $ 103,900
2007 90,700
2008 54,700
------------
$ 249,300
============
Rent expense under all operating leases was $125,309 and $84,249 for the
years ended June 30, 2005 and 2004.
License Agreement
The Company has acquired intellectual property, equipment and a tooling
license from Mason & Hanger National, Inc. and a patent license from
Lucent Technologies, Inc. for the Fiber Optic Intelligence Detection
Systems (FOIDS(R)). In conjunction with these two license agreements
whereby royalties totaling 5.4% are due on revenues from the Fiber Optic
Intelligence Detection System (FOIDS(R)).
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the
ordinary course of business, are recorded as liabilities when the
likelihood of loss is probable and an amount or range of loss can be
reasonably estimated. Management does not believe there now are such
matters that will have a material effect on the financial statements
Note 14 - Geographic Data
The Company currently operates in the United States and the Middle East.
The following is a summary of local operations by geographic area:
U.S. % of total Middle East % of total
---- ---------- ----------- ----------
For the year ended
June 30, 2005
Revenue $ 5,898,503 98.84% $ 68,966 1.16%
Operating income (loss) 89,516 -125.74% (160,710) 225.74%
Identifiable assets 7,046,418 95.41% 339,144 4.59%
For the year ended
June 30, 2004
Revenue $ 2,009,856 97.50% $ 51,556 2.50%
Operating loss (949,840) 87.16% (139,961) 12.84%
Identifiable assets 5,212,101 94.71% 290,836 5.29%
F-18
ELECTRONIC CONTROL SECURITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 15 - Related Party Transactions
In fiscal 2004, the Company earned revenues totaling $234,225 from a
Company in which one of the Company's Directors is the president and CEO.
The Company made non-interest bearing advances that are due on demand to a
former officer and director of the Company. The balances outstanding at
June 30, 2005 and 2004 were $73,030 and $62,655, respectively.
F-19
Electronic Control Security Inc.
Consolidated Balance Sheets
December 31 June 30,
2005 2005
ASSETS (Unaudited)
Current assets
Cash and cash equivalents $ 10,775 $ 221,293
Accounts receivable, net of allowance of $100,000 3,095,967 2,088,546
Inventories 1,805,587 1,965,501
Other current assets 321,060 363,868
--------------- --------------
Total current assets 5,233,389 4,639,208
Property, equipment and software development costs - net 483,383 502,644
Intangible assets - net 1,415,478 1,438,999
Certificate of deposit, pledged 255,721 253,084
Goodwill 50,000 50,000
Deferred income taxes 456,300 456,300
Other assets 208,551 59,827
--------------- --------------
$ 8,102,822 $ 7,400,062
=============== ==============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable and accrued expenses $ 2,168,156 $ 1,185,423
Short-term loan 175,000 -
Current maturities of long-term debt 232,992 232,992
Payroll taxes payable 20,194 16,234
--------------- --------------
Total current liabilities 2,596,342 1,434,649
Noncurrent liabilities
Long-term debt 321,017 437,565
Due to officers and shareholders 402,846 431,617
Deferred income taxes 62,500 62,500
--------------- --------------
Total liabilities 3,382,705 2,366,331
Shareholders' equity
Series A Convertible Preferred stock, cumulative, $.01 par value;
$2.00 liquidation preference; 5,000,000 shares authorized,
325,000 shares issued and outstanding, respectively 3,250 3,250
Series B 10% Convertible Preferred stock, cumulative, $.001 par value;
$1,182 per share liquidation preference; 2,000 shares authorized,
791 and 2,000 shares issued and outstanding, respectively 1 2
Common Stock, $.001 par value; 30,000,000 shares authorized;
8,785,601 and 7,384,935 shares issued; 8,685,601 and 7,284,935
shares outstanding, respectively 8,785 7,385
Additional paid-in capital 10,693,814 10,344,782
Accumulated deficit (5,979,127) (5,311,807)
Accumulated other comprehensive income 3,394 119
Treasury stock, at cost, 100,000 shares (10,000) (10,000)
--------------- --------------
Total shareholders' equity 4,720,117 5,033,731
--------------- --------------
$ 8,102,822 $ 7,400,062
=============== ==============
See Notes to Consolidated Financial Statements.
F-20
Electronic Control Security Inc.
Consolidated Statements of Operations
Six Months Three Months
Ended Ended
December 31, December 31,
2005 2004 2005 2004
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
Revenues $ 4,059,565 $ 1,957,592 $ 2,536,251 $ 1,002,127
Cost of revenues 3,157,222 1,218,469 1,905,319 624,759
----------- ----------- ----------- -----------
Gross profit 902,343 739,123 630,932 377,368
----------- ----------- ----------- -----------
Research and development 109,102 161,829 51,750 88,881
Selling, general and administrative expenses 1,136,699 806,299 574,881 457,421
Stock based compensation 61,087 120,000 61,087 -
----------- ----------- ----------- -----------
Loss from operations (404,545) (349,005) (56,786) (168,934)
Other (income) expense
Interest expense 57,809 56,885 30,006 30,298
Interest income (2,638) (7,107) (2,638) (5,027)
Minority interest in subsidiary loss (27,340) (27,166) (13,600) (15,466)
Gain on sale of marketable securities - (7,519) - (7,519)
----------- ----------- ----------- -----------
Total other (income) expense 27,831 15,093 13,768 2,286
----------- ----------- ----------- -----------
Loss before tax benefit (432,376) (364,098) (70,554) (171,220)
Income tax (benefit) - - - -
----------- ----------- ----------- -----------
Net loss before dividends (432,376) (364,098) (70,554) (171,220)
Dividends related to convertible preferred stock 234,944 100,000 27,414 50,000
----------- ----------- ----------- -----------
Net loss attributable to common shareholders $ (667,320) $ (464,098) $ (97,968) $ (221,220)
=========== =========== =========== ===========
Net loss per share:
Basic $ (0.08) $ (0.08) $ (0.01) $ (0.04)
=========== =========== =========== ===========
Diluted $ (0.08) $ (0.08) $ (0.01) $ (0.04)
=========== =========== =========== ===========
Weighted average number of
common shares and equivalents:
Basic 8,059,022 5,952,320 8,505,477 6,222,646
=========== =========== =========== ===========
Diluted 8,059,022 5,952,320 8,505,477 6,222,646
=========== =========== =========== ===========
See Notes to Consolidated Financial Statements.
F-21
Electronic Control Security Inc.
Consolidated Statements of Cash Flows
Six Months
Ended
December 31,
2005 2004
(Unaudited) (Unaudited)
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Cash flows from operating activities:
Net loss before deemed dividends $ (432,376) $ (364,098)
Adjustments to reconcile loss
to net cash used by operating activities:
Depreciation and amortization 135,017 84,167
Stock based compensation 61,087 120,000
Minority interest in subsidiary loss (27,340) (27,166)
Gain on sales marketable securities - (7,519)
Foreign currency translation adjustments 3,275 6,564
Increase (decrease) in cash attributable
to changes in assets and liabilities
Accounts receivable (1,007,421) (333,460)
Inventory 159,914 60,994
Other current assets (75,138) (93,010)
Other assets (3,438) 5,884
Accounts payable and accrued expenses 982,733 177,607
Income taxes payable - (2,500)
Payroll taxes payable 3,960 7,816
------------ ------------
Net cash used in operating activities (199,727) (364,721)
Cash flows from investing activities:
Investment in marketable securities - (745,804)
Acquisition of property, equipment and software development (92,235) (34,475)
------------ ------------
Net cash used in investing activities (92,235) (780,279)
Cash flows from financing activities:
Proceeds from exercise of stock options and warrants 54,400 644,950
Proceeds from short-term borrowings 500,000 -
Repayment of short-term borrowing (325,000) (545,485)
Certificate of deposit purchased (2,637) (250,460)
Payments on long-term debt (116,548) (58,333)
Payments on lease obligations - (3,094)
Loan officers and shareholders - net (28,771) (32,255)
------------ ------------
Net cash provided by (used in) financing activities 81,444 (244,677)
------------ ------------
Net decrease in cash and cash equivalents (210,518) (1,389,677)
Cash and cash equivalents at beginning of period 221,293 1,552,575
------------ ------------
Cash and cash equivalents at end of period $ 10,775 $ 162,898
============ ============
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest $ 57,809 $ 56,885
============ ============
Taxes $ 2,786 $ -
============ ============
See Notes to Consolidated Financial Statements.
F-22
Electronic Control Security Inc.
Notes to the Consolidated Financial Statements
Note 1 - Basis of Presentation
- ------------------------------
The accompanying unaudited consolidated financial statements of
Electronic Control Security Inc. and its subsidiaries (collectively the
"Company") have been prepared in accordance with generally accepted
accounting principles for interim financial information and with Item
310(b) of Regulation SB. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included.
Operating results for the six months ended December 31, 2005 are not
necessarily indicative of the results that may be expected for the year
ending June 30, 2006. These unaudited consolidated financial statements
should be read in conjunction with the audited consolidated financial
statements and footnotes thereto included in the Company's Form 10-KSB
for the fiscal year ended June 30, 2005, as filed with the Securities
and Exchange Commission.
Note 2 - Earnings Per Share
- ---------------------------
In determining basic or diluted earnings per share (EPS), the effects
of dividends related to the Company's Series A convertible preferred
stock is added to the net loss.
Basic EPS is computed by dividing net income or net loss by the
weighted average number of common shares outstanding for the period.
Diluted EPS reflects the potential dilution from the exercise or
conversion of other securities into common stock, but only if dilutive.
The following securities have been excluded from the dilutive per share
computation, as they are anti-dilutive.
2005 2004
---- ----
Stock options 1,524,500 545,000
Warrants 1,446,875 2,456,875
Convertible Preferred Stock 1,304,236 2,441,932
Note 3 - Inventories
Inventories consist of the following:
December June
2005 2005
---- ----
Raw materials $ 322,438 $ 322,958
Work-in-process 203,564 402,045
Finished goods 1,279,585 1,240,498
------------ ------------
$ 1,805,587 $ 1,965,501
============ ============
F-23
Electronic Control Security Inc.
Notes to the Consolidated Financial Statements
Note 4 - Stock Based Compensation Plans
- ---------------------------------------
The Company accounts for stock-based employee and outside directors
compensation under Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees", and related
interpretations. The Company has adopted the disclosure-only provisions
of Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation" and SFAS No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure", which was
released in December 2002 as an amendment of SFAS No. 123. Stock
options and warrants granted to non-employees are recorded at their
fair value, as determined in accordance with SFAS No. 123 and Emerging
Issues Task Force Consensus No. 96-18, and recognized over the related
service period.
The following table illustrates the effect on net income and earnings
per share if the fair value based method had been applied to all
awards.
Six Months Three months
Ended December 31,
2005 2004 2005 2004
------------- -------------- -------------- ------------
Net loss, as reported $(667,320) $(464,098) $(97,678) $(221,220)
Add: Employee stock based compensation
expense, as reported, net of related tax effects -- -- -- --
Deduct: Total stock-based compensation
expense determined under the fair value based
method for all awards, net of related tax effects (1,199,069) (--) (1,133,750) (--)
------------- -------------- -------------- ------------
Pro forma net loss $(1,866,389) $(464,098) $(1,231,718) $(221,220)
============= ============== ============== ============
Basic and diluted loss per share, as reported $(.08) $(.08) $(.01) $(.04)
Basic and diluted loss per share, pro forma $(.23) $(.08) $(.14) $(.04)
The weighted average per share fair value of options granted during the
six months ended December 31, 2005 was $1.02. The fair value of each
option granted was estimated using the Black-Scholes option-pricing
model and the following weighted average assumptions; volatility of
140.60%, expected life of options of 5 years, risk free interest rate
of approximately 4.39% and a dividend yield of 0%. No options were
granted in the six months ended December 31, 2004.
On December 9, 2005, the Board of Directors voted to exchange 565,000
options issued in January 2005 at an exercise price of $2.40 for
282,000 options with an exercise price of $1.20. The Board also voted
to accelerated the vesting on these options to become immediately
exercisable. The acceleration and repricing of the options had no
effect on the Company's financial position. The accelerated
amortization expense and incremental value recognized due to the
changes are included in the disclosure above.
F-24
Electronic Control Security Inc.
Notes to the Consolidated Financial Statements
Note 5 - Series A Convertible Preferred Stock Dividend
- ------------------------------------------------------
Cumulative dividends for the years ended March 31, 2004 and 2005
totaling $153,042 were declared on July 8, 2005 by the Company's Board
of Directors. The dividend was paid by the issuance of 99,378
additional shares of the Company's common stock.
Note 6 - Subsequent Events
- --------------------------
Private Placement
- -----------------
In January 2006, the Company raised net proceeds of $927,500 in a
private placement of $1million in principal amount of its Senior
Secured Convertible Debentures (the "Debentures"). The Company's
obligations with respect to the Debentures are secured by a lien on all
of the assets of the Company, including its intellectual property. The
Debentures have a term of three years and are convertible at the option
of the holder at any time into shares of the Company's common stock,
par value $0.001 per share (the "Common Stock") at a conversion price
of $1.15 per share, subject to certain adjustments. Interest is payable
at a rate equal to the greater of 8% per annum or the prime rate for
the applicable interest period plus 2.5%. Quarterly interest payments
on the Debentures are scheduled to begin on April 1, 2006. At the
option of the Company, interest payments are payable either in cash or
in registered shares of Common Stock, subject to certain conditions.
Investors in the private placement also received three-year warrants to
purchase up to 434,783 shares of the Company's Common Stock at a per
share exercise price of $2.00 (the "Warrants"). The Warrants also may
be exercised on a cashless basis following the first anniversary of
issuance if a registration statement covering the Common Stock issuable
upon exercise of the Warrants is not in effect at the time of exercise.
In connection with the financing the Company paid a cash fee in the
amount of $72,500 to placements agents and also issued to such persons
four and five year warrants to purchase a total 121,739 shares of
Common Stock. The warrants issuable to the placement agents are
exercisable on substantially the same terms and conditions as the
Warrants, including without limitation, potential adjustments and
cashless exercise rights as provided above.
Repayment of Debt
- -----------------
A portion of the net proceeds of the financing were used to repay in
full the Company's term loans in the outstanding amount of $658,339.
F-25
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
Item 24. Indemnification of Directors and Officers.
Under the New Jersey Business Corporations Act ("NJBCA"), any corporation
in the State of New Jersey has the power to indemnify a corporate agent,
including an officer and director, against his expenses and liabilities in
connection with any proceeding involving the corporate agent if; (a) such
corporate agent acted in good faith and in manner reasonably believed to be in
the best interests of the corporation, and (b) with respect to any criminal
proceeding, such corporate agent had no reasonable cause to believe his conduct
was unlawful. The termination of any proceeding by judgment, order, settlement,
conviction or plea of nolo contendre or its equivalent, shall not itself create
a presumption that such corporate agent did not meet the applicable standards of
conduct.
Our Certificate of Incorporation provides that none of our directors or
officers shall be personally liable to the company or any stockholder to the
full extent permitted under the corporate laws of the State of New Jersey.
Additionally, our By-Laws provide for the indemnification of any of our
directors, officers and employees by reason of their serving in such capacity
against expenses and liabilities in connection with any proceeding involving
him/her by reason of his/her being or having been a corporate agent, other than
a proceeding by or in the right of the corporation, if (a) such person acted in
good faith and in a manner he/she reasonably believed to be or not opposed to
the best interest of the corporation, or (b) in a criminal proceeding, if such
person had no reasonable cause to believe that his/her conduct was unlawful. In
addition, the company may indemnify a corporate agent against expenses and
liabilities in connection with any proceeding by or in right of the corporation
if he acted in good faith and in a manner he/she reasonably believed to be in or
not opposed to the best interest of the corporation. Such indemnification is not
deemed to be exclusive of any other rights to which those indemnified may be
entitled, under any by-law, agreement, vote of stockholders or otherwise. The
foregoing provisions of our Certificate of Incorporation may reduce the
likelihood of derivative litigation against our directors and officers for
breach of their fiduciary duties, even though such action, if successful, might
otherwise benefit us and our stockholders.
Item 25. Other Expenses of Issuance and Distribution.
The following table sets forth our expenses in connection with this
registration statement. All of such expenses are estimates, other than the
registration fee payable to the SEC.
SEC registration fee.................................. $ 593.70
Accounting fees and expenses.......................... $ 5,000.00
Legal fees and expenses............................... $ 25,000.00
Blue sky fees......................................... $ 2,500.00
Printing and engraving expenses....................... $ 2,000.00
Miscellaneous expenses................................ $ 1,906.30
------------
Total $ 35,000.00
------------
Item 26. Recent Sales of Unregistered Securities.
The following is a summary of transactions within the last three years
involving sales of our securities that were not registered under the Securities
Act:
II-1
2006
On January 11, 2006, we entered into the Securities Purchase Agreement for
the sale of our senior secured convertible debentures in aggregate principal
amount of $1,000,000. The transaction closed on January 13, 2006. We also
entered into a Security Agreement, dated as of January 11, 2006, pursuant to
which the debentures are secured by all of our assets, including our
intellectual property. Interest is payable on the debentures at a rate equal to
the greater of 8% per annum or the prime rate for the applicable interest period
plus 2.5%. Quarterly principal and interest payments on the debentures begin on
April 1, 2006. At our option, interest payments on the debentures are payable
either in cash or in registered shares of common stock, subject to certain
conditions as specified in the debentures.
The debentures have a term of three years and come fully due on January
11, 2009. The debentures are convertible at the option of the holder at any time
and from time to time into shares of our common stock at a conversion price of
$1.15 per share of common stock, or initially 869,566 shares of common stock,
subject to certain adjustments. Pursuant to the Securities Purchase Agreement,
we also issued common stock purchase warrants to the purchasers. The warrants
are exercisable until January 11, 2009 to purchase initially up to 434,783
shares of our common stock at an exercise price of $2.00 per share.
The financing was completed through a private placement to four accredited
investors and is exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933, as amended. Pursuant to the Registration Rights
Agreement with the purchasers, dated as of January 11, 2006, we have agreed to
file this registration statement covering the resale of the shares issuable to
the investors upon the conversion of the debentures and exercise of the warrants
on or before February 27, 2006.
In connection with consummating the financing pursuant to the Securities
Purchase Agreement, we paid aggregate fees to Dunwoody Asset Management, LLC and
H.C. Wainwright & Co., Inc., a broker dealers registered with the Securities and
Exchange Commission and the National Association of Securities Dealers, and our
placement agents in this private financing, of $72,500 and issued warrants to
our placement agents to purchase up to 121,739 shares of our common stock on
substantially similar terms as the warrants.
For a more complete description of the private financing, see our Current
Report on Form 8-K, filed January 18, 2006.
2004
On June 30, 2004, we consummated the issuance of (i) 2,000 shares
("Preferred Shares") of 10% Series B Convertible Preferred Stock, and (ii)
Warrants to purchase 2,000,000 shares of our common stock to eight institutional
and other accredited investors. In addition, we issued to certain persons who
identified the investors in the Preferred Shares Finders' Warrants to purchase
200,000 shares of our common stock. The sale of the Preferred Shares and
Warrants resulted in $2,000,000 in gross proceeds to us prior to the exercise of
the Warrants. The Preferred Shares are initially convertible into an aggregate
of 2 million shares of common stock. We agreed to file a registration statement
in respect of the common stock issuable upon conversion of the Preferred Shares
and the shares of common stock underlying the Warrants. The effective price in
the private placement was $1,000 for each unit. Each unit consists of one
Preferred Share and a Warrant to purchase 1,000 shares of common stock. The unit
purchase price was determined based on negotiation between the company and the
purchasers of the units. The Warrants have an exercise period of five years and
an exercise price of $1.00 per share. The Warrants are exercisable in cash, and,
under certain circumstances, allow for cashless exercise, representing a
potential $2,000,000 in additional proceeds. We could realize and additional
$200,000 in proceeds from the exercise of the Finders' Warrants.
2002
On March 14, 2002, we completed a private placement of 40 units of our
securities, each unit consisting of 25,000 shares of Series A Convertible
Preferred Stock and Redeemable Warrants entitling the holders to purchase 12,500
shares of common stock at an exercise price of $3.00 per share until March 14,
2005. The offering was made and sold to 25 accredited investors. We received
gross proceeds of $2,000,000 from the sale of the units. We paid aggregate cash
commissions of $187,500 in connection with the placement of the units, including
$50,000 to DC Capital Corp., a broker dealer registered with the Securities and
Exchange Commission and the National Association of Securities Dealers, and
$137,500 to certain finders where the payment of such commissions was
permissible under local law. In addition, we issued to the finders warrants to
purchase up to an aggregate of four units identical to those offered in the
offering, the underlying shares of common stock of which were registered in a
previous registration statement.
II-2
The above sales were made in reliance upon the private offering exemptions
contained in Rule 506 of Regulation D of the Securities Act of 1933. Each
investor represented that he/she/it was acquiring the securities for investment
purposes only and not with a view to distribute. Each investor further
represented that he/she/it (a) had such knowledge and experience in financial
and business matters and was capable of evaluating the merits and risks of the
investment, (b) was able to bear the complete loss of the investment, and (c)
had the opportunity to ask questions of, and receive answers from, us and our
management concerning the terms and conditions of the offering and to obtain
additional information. Each investor further represented to us that he/she/it
was an "accredited investor" as such term is defined in Rule 501 of the
Securities Act of 1933.
The above transactions did not involve any underwriters, underwriting
discounts or commissions, or any public offering, and the registrant believes
the transactions were exempt from the Securities Act of 1933 in reliance on
Section 4(2) thereof, as transactions by an issuer not involving public
offerings. The recipients of securities in the transactions represented their
intention to acquire the securities for investment only and not with a view to
or for sale in connection with any distribution thereof, and appropriate legends
were affixed to the share certificates and instruments issued in such
transactions. All recipients either received adequate information about the
registrant or had access, through their relationships with the registrant, to
such information.
Item 27. Exhibits.
The exhibits listed in the following Exhibit Index are filed as part of
this Registration Statement.
Exhibit No. Description
- --------------- --------------------------------------------------------------
3.1 Certificate of Incorporation of Electronic Control Security
Inc.(1)
3.2 Certificate of Amendment to Certificate of Incorporation of
Electronic Control Security Inc.(2)
3.3 Certificate of Amendment to Certificate of Incorporation. (3)
3.4 By-Laws of Electronic Control Security Inc.(1)
3.5 Certificate of Incorporation of SEM Consultants III, Inc.(1)
3.6 By-Laws of SEM Consultants III, Inc.(1)
3.7 Certificate of Incorporation of ECSI International, Inc.(1)
3.8 By-Laws of ECSI International, Inc.(1)
3.9 Certificate of Incorporation of ECSI FOIDS, Inc.(1)
3.10 By-Laws of ECSI FOIDS, Inc.(1)
3.11 Certificate of Incorporation of ECSI-DSA, Inc.(1)
3.12 By-Laws of ECSI-DSA, Inc.(1)
3.13 Memorandum of Association of ECSI Security Communications,
Inc., an Israeli corporation. (2)
3.14 Articles of Association of ECSI Security Communications, Inc.,
an Israeli corporation.(2)
4.1 Form of Senior Secured Convertible Debenture due January 11,
2009.(3)
4.2 Form of Common Stock Purchase Warrant.(4)
4.3 Registration Rights Agreement, dated as of January 11, 2006,
by and among Electronic Control Security Inc. and the
Purchasers named in the Securities Purchase Agreement, dated
as of January 11, 2006.(4)
II-3
Exhibit No. Description
- --------------- --------------------------------------------------------------
5.1 Opinion of Greenberg Traurig, LLP.*
10.1 Securities Purchase Agreement, dated as of January 11, 2006,
by and among Electronic Control Security Inc. and the
Purchasers named therein.(4)
10.2 Security Agreement, dated as of January 11, 2006, by and among
Electronic Control Security Inc. and the Purchasers named in
the Securities Purchase Agreement, dated as of January 11,
2006.(4)
14.1 Code of Ethics and Business Conduct.(3)
23.1 Consent of Demetrius & Company, L.L.C.*
23.2 Consent of Greenberg Traurig, LLP (included in its opinion
filed as Exhibit 5.1 hereto).
- --------------
(1) Incorporated herein by reference to Registration Statement on
Form 10-SB of Electronic Control Security Inc., filed February
16, 2001.
(2) Incorporated herein by reference to Registration Statement on
Form SB-2 of Electronic Control Security Inc., filed June 6,
2002.
(3) Incorporated herein by reference to Registration Statement on
Form SB-2 of Electronic Control Security Inc., filed August 9,
2004.
(4) Incorporated herein by reference to Current Report on Form
8-K, filed January 18, 2006.
* Filed herewith.
Item 28. Undertakings.
(a) The undersigned registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being made,
a post-effective amendment to this registration statement:
i. To include any prospectus required by Section 10(a)(3) of the
Securities Act of 1933;
ii. To reflect in the prospectus any facts or events arising after
the effective date of the registration statement (or the most
recent post-effective amendment thereof) which, individually
or in the aggregate, represent a fundamental change in the
information set forth in the registration statement.
Notwithstanding the foregoing, any increase or decrease in
volume of securities offered (if the total dollar value of
securities offered would not exceed that which was registered)
and any deviation from the low or high end of the estimated
maximum offering range may be reflected in the form of
prospectus filed with the Commission pursuant to Rule 424(b)
if, in the aggregate, the changes in volume and price
represent no more than 20 percent change in the maximum
aggregate offering price set forth in the "Calculation of
Registration Fee" table in the effective registration
statement.
iii. To include any material information with respect to the plan
of distribution not previously disclosed in the registration
statement or any material change to such information in the
registration statement.
II-4
(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall be
deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time
shall be deemed to be the initial bona fide offering thereof.
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
(b) Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors, officers and controlling
persons of the registrant pursuant to the foregoing provisions, or
otherwise, the registrant has been advised that in the opinion of the
Securities and Exchange Commission such indemnification is against public
policy as expressed in the Act and is, therefore, unenforceable. In the
event that a claim for indemnification against such liabilities (other
than the payment by the registrant of expenses incurred or paid by a
director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities
being registered, the registrant will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a
court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the Act and
will be governed by the final adjudication of such issue.
(c) That, for the purpose of determining any liability under the Securities
Act of 1933 to any purchaser, each prospectus filed pursuant to Rule
424(b) as part of a registration statement relating to an offering, other
than registration statements relying on Rule 430B or other than
prospectuses filed in reliance on Rule 430A, shall be deemed to be part of
and included in the registration statement as of the date it is first used
after effectiveness. Provided, however, that no statement made in a
registration statement or prospectus that is part of the registration
statement or made in a document incorporated or deemed incorporated by
reference into the registration statement or prospectus that is part of
the registration statement will, as to a purchaser with a time of contract
of sale prior to such first use, supersede or modify any statement that
was made in the registration statement or prospectus that was part of the
registration statement or made in any such document immediately prior to
such date of first use.
II-5
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Clifton, New Jersey, on
the 27th day of February 2006.
ELECTRONIC CONTROL SECURITY INC.
By: /s/ Arthur Barchenko
-------------------------------------
Arthur Barchenko, President,
Chief Executive Officer, and
principal accounting and financial
officer
POWER OF ATTORNEY
We, the undersigned officers and directors of Electronic Control Security
Inc., hereby severally constitute and appoint Arthur Barchenko (with full power
to act alone), our true and lawful attorney-in-fact and agent, with full power
of substitution, for us and in our stead, in any and all capacities, to sign any
and all amendments (including pre-effective and post-effective amendments) to
this Registration Statement and all documents relating thereto, and to file the
same, with all exhibits thereto, and other documents in connection therewith,
with the U.S. Securities and Exchange Commission, granting to said
attorney-in-fact and agent, full power and authority to do and perform each and
every act and thing necessary or advisable to be done in and about the premises,
as full to all intents and purposes as he might or could do in person, hereby
ratifying and confirming the said attorney-in-fact and agent, or his substitute
or substitutes may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities and on the dates indicated.
SIGNATURE TITLE DATE
- ----------------------------------------------- -------------------------------------------- -------------------
/s/ Arthur Barchenko President, Chief Executive Officer, February 27, 2006
- -------------------------------------------- principal accounting and financial officer,
Arthur Barchenko and Director
/s/ Natalie Barchenko Treasurer and Director February 27, 2006
- --------------------------------------------
Natalie Barchenko
/s/ Gene Rabois Director February 27, 2006
- --------------------------------------------
Gene Rabois
/s/ Edward Snow Director February 27, 2006
- --------------------------------------------
Edward Snow
/s/ Robert F. Reiter Director February 27, 2006
- --------------------------------------------
Robert F. Reiter
/s/ Stephen Rossetti Director February 27, 2006
- --------------------------------------------
Stephen Rossetti
/s/ Thomas F. Donahue Director February 27, 2006
- --------------------------------------------
Thomas F. Donahue
II-6