MobileSmith, Inc. - Quarter Report: 2009 September (Form 10-Q)
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
(Mark
One)
x
Quarterly
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
For
the quarterly period ended September 30, 2009
OR
o
Transition
report pursuant to Section 13 of 15(d) of the Securities Exchange Act of
1934
Commission
File Number: 001-32634
SMART
ONLINE, INC.
(Exact
name of registrant as specified in its charter)
|
Delaware
|
95-4439334
|
|
(State
or other jurisdiction of
|
(I.R.S.
Employer
|
|
incorporation
or organization)
|
Identification
No.)
|
|
4505
Emperor Blvd., Ste. 320
Durham,
North Carolina
|
27703
|
|
(Address
of principal executive offices)
|
(Zip
Code)
|
(919)
765-5000
(Registrant’s
telephone number, including area code)
Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days: Yes x No o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
|
Large accelerated filer
|
o
|
Accelerated filer
|
o
|
|
Non-accelerated filer
|
o
(Do not check if a smaller reporting company)
|
Smaller reporting company
|
x
|
Indicate by check mark whether the registrant is a shell
company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of
November 11, 2009, there were 18,332,542 shares of the registrant’s common
stock, par value $0.001 per share, outstanding.
SMART
ONLINE, INC.
FORM
10-Q
For the
Quarterly Period Ended September 30, 2009
TABLE
OF CONTENTS
|
Page No.
|
||||
|
PART
I – FINANCIAL INFORMATION
|
||||
|
Item
1.
|
Financial
Statements
|
|||
|
Consolidated
Balance Sheets as of September 30, 2009 (unaudited) and December 31,
2008
|
3
|
|||
|
Consolidated
Statements of Operations (unaudited) for the three and nine months ended
September 30, 2009 and 2008
|
4
|
|||
|
Consolidated
Statements of Cash Flows (unaudited) for the nine months ended September
30, 2009 and 2008
|
5
|
|||
|
Notes
to Consolidated Financial Statements (unaudited)
|
6
|
|||
|
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
18
|
||
|
Item
3.
|
Quantitative
and Qualitative Disclosures About Market Risk
|
29
|
||
|
Item
4.
|
Controls
and Procedures
|
29
|
||
|
Item
4T.
|
Controls
and Procedures
|
29
|
||
|
PART
II – OTHER INFORMATION
|
||||
|
Item
1.
|
Legal
Proceedings
|
30
|
||
|
Item
1A.
|
Risk
Factors
|
31
|
||
|
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
36
|
||
|
Item
6.
|
Exhibits
|
36
|
||
|
Signatures
|
37
|
|||
Page 2 of 37
PART
I – FINANCIAL INFORMATION
Item 1. Financial
Statements
SMART
ONLINE, INC.
CONSOLIDATED
BALANCE SHEETS
|
September
30,
|
December 31,
|
|||||||
|
2009
|
2008
|
|||||||
|
(unaudited)
|
||||||||
|
ASSETS
|
||||||||
|
Current
Assets:
|
|
|
||||||
|
Cash
and Cash Equivalents
|
$ | 18,749 | $ | 18,602 | ||||
|
Accounts
Receivable, Net
|
10,510 | 184,930 | ||||||
|
Note
Receivable
|
- | 60,000 | ||||||
|
Prepaid
Expenses
|
274,069 | 289,372 | ||||||
|
Total
current assets
|
303,328 | 552,904 | ||||||
|
Property
and equipment, net
|
267,716 | 365,993 | ||||||
|
Capitalized
software, net
|
468,056 | 261,221 | ||||||
|
Note
Receivable, non-current
|
- | 372,317 | ||||||
|
Prepaid
expenses, non-current
|
147,600 | 258,301 | ||||||
|
Intangible
assets, net
|
599,309 | 1,410,245 | ||||||
|
Other
assets
|
2,087 | 1,736 | ||||||
|
TOTAL
ASSETS
|
$ | 1,788,096 | $ | 3,222,717 | ||||
|
LIABILITIES
AND STOCKHOLDERS' EQUITY (DEFICIT)
|
||||||||
|
Current
liabilities
|
||||||||
|
Accounts
payable
|
$ | 752,337 | $ | 398,237 | ||||
|
Notes
payable (See Note 3)
|
2,504,850 | 2,341,177 | ||||||
|
Deferred
revenue (See Note 2)
|
166,142 | 323,976 | ||||||
|
Accrued
liabilities (See Note 2)
|
2,107,751 | 478,917 | ||||||
|
Total
current liabilities
|
5,531,080 | 3,542,307 | ||||||
|
Long-term
liabilities:
|
||||||||
|
Long-term
portion of notes payable (See Note 3)
|
8,042,838 | 5,327,211 | ||||||
|
Deferred
revenue (See Note 2)
|
37,018 | 67,353 | ||||||
|
Total
long-term liabilities
|
8,079,856 | 5,394,564 | ||||||
|
Total
liabilities
|
13,610,936 | 8,936,871 | ||||||
|
Commitments
and contingencies (See Note 4)
|
||||||||
|
Stockholders'
equity (deficit):
|
||||||||
|
Preferred
stock, 0.001 par value, 5,000,000 shares authorized, no
shares
|
||||||||
|
issued
and outstanding at September 30, 2009 and December 31,
2008
|
||||||||
|
Common
Stock, $.001 par value, 45,000,000 shares authorized,
|
||||||||
|
18,332,542
and 18,333,601 shares Issued and Outstanding at
|
||||||||
|
September
30, 2009 and December 31, 2008 respectively.
|
18,333 | 18,334 | ||||||
|
Additional
paid-in capital
|
67,032,729 | 66,945,588 | ||||||
|
Accumulated
deficit
|
(78,873,902 | ) | (72,678,076 | ) | ||||
|
Total
Stockholders’ Deficit
|
(11,822,840 | ) | (5,714,154 | ) | ||||
|
TOTAL
LIABILITIES AND STOCKHOLDERS’ DEFICIT
|
$ | 1,788,096 | $ | 3,222,717 | ||||
The
accompanying notes are an integral part of these financial
statements.
Page 3 of 37
SMART ONLINE,
INC.
CONSOLIDATED
STATEMENTS OF OPERATIONS
(Unaudited)
|
Three
Months Ended
|
Nine
Months Ended
|
|||||||||||||||
|
September 30,
2009
|
September 30,
2008
|
September 30,
2009
|
September 30,
2008
|
|||||||||||||
|
REVENUES:
|
||||||||||||||||
|
Subscription
fees
|
$ | 908,007 | $ | 642,880 | $ | 2,049,930 | $ | 2,132,787 | ||||||||
|
Professional
service fees
|
63,200 | 574,970 | 261,699 | 2,011,497 | ||||||||||||
|
License
fees
|
11,250 | 291,250 | 33,750 | 395,000 | ||||||||||||
|
Hosting
fees
|
33,751 | 70,856 | 139,005 | 166,534 | ||||||||||||
|
Other
revenue
|
26,300 | 31,501 | 100,777 | 108,432 | ||||||||||||
|
Total
revenues
|
1,042,508 | 1,611,457 | 2,585,161 | 4,814,250 | ||||||||||||
|
COST
OF REVENUES
|
430,967 | 409,414 | 1,125,901 | 1,768,609 | ||||||||||||
|
GROSS
PROFIT
|
611,541 | 1,202,043 | 1,459,260 | 3,045,641 | ||||||||||||
|
OPERATING
EXPENSES:
|
||||||||||||||||
|
General
and administrative
|
2,355,353 | 1,115,398 | 4,112,993 | 3,456,054 | ||||||||||||
|
Sales
and marketing
|
929,617 | 733,369 | 2,136,256 | 2,200,857 | ||||||||||||
|
Research
and development
|
36,406 | 887,657 | 540,232 | 1,798,190 | ||||||||||||
|
Loss
on Impairment
|
- | - | 438,286 | |||||||||||||
|
(Gain)
loss on disposal of assets, net
|
(12,307 | ) | - | (22,574 | - | |||||||||||
|
Total
operating expenses
|
3,309,069 | 2,736,424 | 7,205,135 | 7,455,101 | ||||||||||||
|
LOSS
FROM OPERATIONS
|
(2,697,528 | ) | (1,534,381 | ) | (5,745,875 | ) | (4,409,460 | ) | ||||||||
|
OTHER
INCOME (EXPENSE):
|
||||||||||||||||
|
Interest
expense, net
|
(169,609 | ) | (150,510 | ) | (455,951 | ) | (519,746 | ) | ||||||||
|
Gain
on legal settlements, net
|
- | 291,407 | 6,000 | 386,710 | ||||||||||||
|
Other
Income
|
- | 1,064 | - | 17,133 | ||||||||||||
|
Total
other expense
|
(169,609 | ) | 141,961 | (449,951 | ) | (115,903 | ) | |||||||||
|
NET
LOSS
|
$ | (2,867,137 | ) | $ | (1,392,420 | ) | $ | (6,195,826 | ) | $ | (4,525,363 | ) | ||||
|
NET
LOSS PER COMMON SHARE:
|
||||||||||||||||
|
Basic
and fully diluted
|
$ | (0.16 | ) | $ | (0.08 | ) | $ | (0.34 | ) | $ | (0.25 | ) | ||||
|
WEIGHTED-AVERAGE
NUMBER OF SHARES USED IN COMPUTING NET LOSS PER COMMON
SHARE
|
||||||||||||||||
|
Basic
and fully diluted
|
18,332,542 | 18,378,940 | 18,332,653 | 18,282,180 | ||||||||||||
The
accompanying notes are an integral part of these financial
statements.
Page 4 of 37
SMART ONLINE,
INC.
CONSOLIDATED
STATEMENTS OF CASH FLOWS
(Unaudited)
|
Nine
Months
|
Nine
Months
|
|||||||
|
Ended
|
Ended
|
|||||||
|
September
30, 2009
|
September
30, 2008
|
|||||||
|
CASH
FLOWS FROM OPERATING ACTIVITIES:
|
|
|||||||
|
Net
Loss
|
$ | (6,195,826 | ) | $ | (4,525,363 | ) | ||
|
Adjustments
to reconcile let loss to net cash used in operating
activities:
|
||||||||
|
Depreciation
and amortization
|
462,761 | 638,930 | ||||||
|
Amortization
of deferred financing costs
|
- | 301,249 | ||||||
|
Bad
debt expense
|
2,207,685 | 266,875 | ||||||
|
Stock-based
compensation expense
|
88,235 | 341,722 | ||||||
|
Loss
on impairment of intangible assets
|
438,228 | - | ||||||
|
Gain
on disposal of assets
|
(22,574 | ) | (3,729 | ) | ||||
|
Changes
in assets and liabilities:
|
||||||||
|
Accounts
receivable
|
213,010 | (120,108 | ) | |||||
|
Notes
receivable
|
(3,228,038 | ) | (148,236 | ) | ||||
|
Costs
in excess of billings
|
- | - | ||||||
|
Prepaid
expenses
|
126,004 | (544,297 | ) | |||||
|
Other
assets
|
(352 | ) | 36,660 | |||||
|
Deferred
revenue
|
(188,170 | ) | (330,686 | ) | ||||
|
Accounts
payable
|
1,768,181 | 10,836 | ||||||
|
Accrued
and other expenses
|
1,627,739 | 96,189 | ||||||
|
Net
cash used in operating activities
|
(2,703,117 | ) | (3,979,958 | ) | ||||
|
CASH
FLOWS FROM INVESTING ACTIVITIES:
|
||||||||
|
Purchases
of furniture and equipment
|
(14,565 | ) | (293,656 | ) | ||||
|
Capitalized
software
|
(206,835 | ) | (120,191 | ) | ||||
|
Proceeds
from sale of furniture and equipment
|
45,362 | 13,564 | ||||||
|
Net
Cash used in Investing Activities
|
(176,038 | ) | (400,283 | ) | ||||
|
CASH
FLOWS FROM FINANCING ACTIVITIES:
|
||||||||
|
Repayments
on notes payable
|
(5,068,063 | ) | (5,022,392 | ) | ||||
|
Debt
borrowings
|
7,947,365 | 5,861,924 | ||||||
|
Issuance
of common Stock
|
- | 97,500 | ||||||
|
Net
cash provided by financing activities
|
2,879,302 | 937,032 | ||||||
|
NET
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
|
147 | (3,443,209 | ) | |||||
|
CASH
AND CASH EQUIVALENTS,
|
||||||||
|
BEGINNING
OF PERIOD
|
18,602 | 3,473,959 | ||||||
|
CASH
AND CASH EQUIVALENTS, END OF PERIOD
|
$ | 18,749 | $ | 30,750 | ||||
|
Supplemental
disclosures of cash flow information:
|
||||||||
|
Cash
paid during the period for:
|
||||||||
|
Interest
|
$ | 461,360 | $ | 243,168 | ||||
|
Taxes
|
$ | 10 | $ | 38,905 | ||||
|
Supplemental
schedule of non-cash financing activities:
|
||||||||
|
Conversion
of debt to equity
|
$ | - | $ | 228,546 | ||||
|
The
accompanying notes are an integral part of these financial
statements.
|
||||||||
Page 5 of 37
SMART
ONLINE, INC.
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. SUMMARY OF BUSINESS AND SIGNIFICANT
ACCOUNTING POLICIES
Description of
Business - Smart Online, Inc. (the “Company”) was incorporated in the
State of Delaware in 1993. The Company develops and markets software products
and services (One Biz™) targeted to small businesses that are delivered via a
Software-as-a-Service (“SaaS”) model. The Company sells its SaaS products and
services primarily through private-label marketing partners. In addition, the
Company provides sophisticated and complex website consulting and development
services, primarily in the e-commerce retail and direct-selling organization
industries. The Company maintains a website that offers additional information
about these capabilities as well as certain corporate information at
www.smartonline.com.
Basis of
Presentation - The financial statements as of and for the three and nine
months ended September 30, 2009 and 2008 included in this Quarterly Report
on Form 10-Q are unaudited. The balance sheet as of December 31, 2008 is
obtained from the audited financial statements as of that date. The accompanying
statements should be read in conjunction with the audited financial statements
and related notes, together with management’s discussion and analysis of
financial condition and results of operations, contained in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2008 filed with the
Securities and Exchange Commission (the “SEC”) on March 30, 2009 (the “2008
Annual Report”).
The
financial statements have been prepared in accordance with United State
Generally Accepted Accounting Principles (“US GAAP”). In the opinion of the
Company’s management, the unaudited statements in this Quarterly Report on Form
10-Q include all normal and recurring adjustments necessary for the fair
presentation of the Company’s statement of financial position as of September
30, 2009, and its results of operations and cash flows for the three and nine
months ended September 30, 2009 and 2008. The results for the three and nine
months ended September 30, 2009 are not necessarily indicative of the results to
be expected for the fiscal year ending December 31, 2009.
The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. During the three and nine months ended
September 30, 2009 and 2008, the Company incurred net losses as well as negative
cash flows, is involved in a class action lawsuit (See Note 4, “Commitments and
Contingencies,” in the 2008 Annual Report), and the repayment of the
legal fees advanced on behalf of former officers and employees who were
convicted in Federal Court and had deficiencies in working capital. These
factors indicate that the Company may be unable to continue as a going
concern.
The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts or
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. At November 6, 2009, the Company does
have a commitment from its convertible secured subordinated noteholders to
purchase up to an additional $6.25 million in convertible notes upon approval
and call by the Company’s Board of Directors. There can be no assurance that, if
the noteholders do not purchase the $6.25 million in convertible notes, the
Company will be able to obtain alternative funding. There can be no assurance
that the Company’s efforts to raise capital or increase revenue will be
successful. If these efforts are unsuccessful, the Company may have to cease
operations and liquidate the business. The Company’s future plans include the
introduction of its new One Biz™ platform, the development of additional new
products and applications, and further enhancement of its existing
small-business applications and tools. The Company’s continuation as a
going concern depends upon its capability to generate sufficient cash flows to
meet its obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations and positive cash
flows.
Significant
Accounting Policies - In the opinion of the Company’s management, the
significant accounting policies used for the three and nine months ended
September 30, 2009 are consistent with those used for the years ended December
31, 2008 and 2007. Accordingly, please refer to the 2008 Annual Report for the
Company’s significant accounting policies.
Use of Estimates
- The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions in the Company’s financial
statements and notes thereto. Significant estimates and assumptions made by
management include the determination of the provision for income taxes, the fair
market value of stock awards issued, and the period over which revenue is
generated. Actual results could differ materially from those
estimates.
Page 6 of
37
Fair Value of
Financial Instruments - US GAAP requires disclosures of fair value
information about financial instruments, whether or not recognized in the
balance sheet, for which it is practical to estimate that value. Due to the
short period of time to maturity, the carrying amounts of cash equivalents,
accounts receivable, accounts payable, accrued liabilities, and notes payable
reported in the financial statements approximate the fair value.
Reclassifications
- Certain prior year and comparative period amounts have been reclassified to
conform to current year presentation. These reclassifications had no effect on
previously reported net income or stockholders’ equity.
Principles of
Consolidation - The accompanying financial statements for the three and
nine months ended September 30, 2008 include the accounts of the Company and its
former wholly owned subsidiaries, Smart CRM, Inc. (“Smart CRM”) and Smart
Commerce, Inc. (“Smart Commerce”). All significant intercompany accounts and
transactions have been eliminated. Subsidiary accounts are included only from
the date of acquisition forward. On December 31, 2008, each of Smart CRM and
Smart Commerce were merged into the Company.
Segments -
Segmentation is based on an entity’s internal organization and reporting of
revenue and operating income based upon internal accounting methods commonly
referred to as the “management approach.” Operating segments are defined as
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision maker in
deciding how to allocate resources and in assessing performance. The Company’s
chief operating decision maker is its Interim Chief Executive Officer, who
reviews financial information presented on a consolidated basis. Accordingly,
the Company has determined that it has a single reporting segment and operating
unit structure.
Concentration of
Credit Risk - Financial instruments that potentially subject the Company
to concentrations of credit risk consist primarily of cash and accounts
receivable. At times, cash balances may exceed the Federal Deposit Insurance
Corporation (“FDIC”) insurable limits. See Note 6, “Major Customers and
Concentration of Credit Risk,” for further discussion of risk within accounts
receivable.
Allowance for
Doubtful Accounts - The Company maintains an allowance for doubtful
accounts for estimated losses resulting from the inability, failure, or refusal
of its customers to make required payments. The need for an allowance for
doubtful accounts is evaluated based on specifically identified amounts that
management believes to be potentially uncollectible. If actual collections
experience changes, revisions to the allowance may be required.
Additionally,
from time to time the Company, as part of its negotiated contracts, has granted
extended payment terms to its strategic partners. As payments become due under
the terms of the contract, they are invoiced and reclassified as accounts
receivable. During the second quarter of 2008, the Company entered into a web
services agreement with a direct-selling organization customer that provided for
extended payment terms related to both professional services and the grant of a
software license. During the third quarter of 2008, this customer began
experiencing cash flow difficulties and has since significantly slowed its
payments to the Company. In addition, the Company entered into a web services
agreement with a real estate services customer in the third quarter of 2007 that
called for contractual payments against a note receivable upon delivery and
acceptance of a custom application. The Company and the customer are currently
in discussions with respect to whether the application was delivered as per the
specifications, and the customer has not commenced payment subject to the
outcome of these discussions.
Based on
these criteria, management determined that at September 30, 2009, an allowance
for doubtful accounts of $2,193,776 was required, comprising the full
outstanding balance of the direct-selling organization customer’s account and
contract receivable and the entire amount of the real estate services customer’s
note receivable. The total allowance for doubtful accounts includes
the additional reserve for bad debt of $1,804,207 for the possibility that it
will not be able to collect the amount of these legal expenses that the Company
will be required to advance on behalf of Michael Nouri and Eric Reza Nouri, both
of whom were convicted on criminal charges brought by the US Department of
Justice. The total identified to date equals
$1,804,207. The amount could exceed $2,400,000.
Intangible
Assets - Intangible assets consist primarily of assets obtained
through the acquisitions of iMart Incorporated (“iMart”) in 2005 and include
customer bases, acquired technology non-compete agreements, trademarks, and
trade names. The Company also owns several copyrights and trademarks related to
products, names, and logos used throughout its non-acquired product
lines. All assets are amortized on a straight-line basis over their
estimated useful lives with the exception of the iMart trade name, which is
deemed by management to have an indefinite life and is not amortized. During the
nine month period ending September 30, 2009, we impaired the value of a portion
of the customer base intangible asset due to the fact that the Company is no
longer doing business with the customer.
Revenue
Recognition - The Company derives revenue primarily from subscription
fees charged to customers accessing its SaaS applications; the perpetual or term
licensing of software platforms or applications; and professional services,
consisting of consulting, development, hosting, and maintenance services. These
arrangements may include delivery in multiple-element arrangements if the
customer purchases a combination of products and/or services. Because the
Company licenses, sells, leases, or otherwise markets computer software, it uses
the residual method pursuant to the US GAAP, as amended. This method allows the
Company to recognize revenue for a delivered element when such element has
vendor specific objective evidence (“VSOE”) of the fair value of the delivered
element. If VSOE cannot be determined or maintained for an element, it could
impact revenues as all or a portion of the revenue from the multiple-element
arrangement may need to be deferred.
Page 7 of 37
If
multiple-element arrangements involve significant development, modification, or
customization or if it is determined that certain elements are essential to the
functionality of other elements within the arrangement, revenue is deferred
until all elements necessary to the functionality are provided by the Company to
a customer. The determination of whether the arrangement involves significant
development, modification, or customization could be complex and require the use
of judgment by management.
US GAAP
provide the arrangement does not require significant development, modification,
or customization, revenue is recognized when all of the following criteria have
been met:
1.
persuasive evidence of an arrangement exists
2.
delivery has occurred
3.
the fee is fixed or determinable
4.
collectability is probable
If at the
inception of an arrangement the fee is not fixed or determinable, revenue is
deferred until the arrangement fee becomes due and payable. If collectability is
deemed not probable, revenue is deferred until payment is received or collection
becomes probable, whichever is earlier. The determination of whether fees are
collectible requires judgment of management, and the amount and timing of
revenue recognition may change if different assessments are made.
Under the
provisions of US GAAP, consulting, website design fees, and application
development services are accounted for separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed-price or long-term contracts. The majority of the
Company’s consulting service contracts are on a time and material basis and are
typically billed monthly based upon standard professional service
rates.
Application
development services are typically fixed price and of a longer term. As such,
they are accounted for as long-term construction contracts that require revenue
recognition to be based on estimates involving total costs to complete and the
stage of completion. The assumptions and estimates made to determine the total
costs and stage of completion may affect the timing of revenue recognition, with
changes in estimates of progress to completion and costs to complete accounted
for as cumulative catch-up adjustments. If the criteria for revenue recognition
on construction-type contracts are not met, the associated costs of such
projects are capitalized and included in costs in excess of billings on the
balance sheet until such time that revenue recognition is
permitted.
Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user or the aggregating entity. Any payments received in advance of the
subscription period are accrued as deferred revenue and amortized over the
subscription period.
Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as the services are provided in accordance with US
GAAP that includes
the right to use software stored on another entity’s hardware.
Deferred
Revenue - Deferred revenue consists of billings or payments
received in advance of revenue recognition, and it is recognized as the revenue
recognition criteria are met. Deferred revenue also includes certain
professional service fees and license fees where all the criteria of US GAAP
were not met. Deferred revenue that will be recognized over the succeeding
12-month period is recorded as current and the remaining portion is recorded as
non-current.
Cost of
Revenues - Cost of revenues primarily is composed of costs related
to third-party hosting services, salaries and associated costs of customer
support and professional services personnel, credit card processing,
depreciation of computer hardware and software used in revenue-producing
activities, domain name and e-mail registrations, and allocated development
expenses and general and administrative overhead.
Page 8 of 37
The
Company allocates development expenses to cost of revenues based on time spent
by development personnel on revenue-producing customer projects and support
activities. The Company allocates general and administrative overhead such as
rent and occupancy expenses, depreciation, general office expenses, and
insurance to all departments based on headcount. As such, general and
administrative overhead expenses are reflected in cost of revenues and each
operating expense category.
Software
Development Costs - Current US GAAP requires capitalization of certain
software development costs subsequent to the establishment of technological
feasibility, with costs incurred prior to this time expensed as research and
development. Technological feasibility is established when all planning,
designing, coding, and testing activities that are necessary to establish that
the product can be produced to meet its design specifications have been
completed. Historically, the Company had not developed detailed design plans for
its SaaS applications, and the costs incurred between the completion of a
working model of these applications and the point at which the products were
ready for general release had been insignificant. These factors, combined with
the historically low revenue generated by the sale of the applications that do
not support the net realizable value of any capitalized costs, resulted in the
continued expensing of underlying costs as research and
development.
Beginning
in May 2008, the Company determined that it was strategically desirable to
develop an industry standard platform and enhance the current SaaS applications.
A detailed design plan indicated that the product was technologically feasible,
and in July 2008, development commenced. All related costs from that point in
time are being capitalized in accordance with current US GAAP. The
first release of the revised product took place in July
2009. At that time additional development costs were no longer
capitalized and the costs capitalized to that point are now being
amortized.
Advertising
Costs - The Company expenses all advertising costs as they are incurred.
The amounts charged to sales and marketing expense during the third quarter of
2009 and 2008 were $3,000 and $7,795, respectively. During the first nine months
of 2009 and 2008, these amounts were $4,032 and $20,205,
respectively.
Net Loss Per
Share - Basic net loss per share is computed using the weighted-average
number of common shares outstanding during the relevant periods. Diluted net
loss per share is computed using the weighted-average number of common and
dilutive common equivalent shares outstanding during the relevant periods.
Common equivalent shares consist of convertible notes, stock options, and
warrants that are computed using the treasury stock method.
Stock-Based
Compensation - The Company adopted US
GAAP provisions related to share based payments which requires companies to
expense the value of employee stock options, restricted stock, and similar
awards and applies to all such securities outstanding and vested.
In
computing the impact of stock-based compensation expense, the fair value of each
award is estimated on the date of grant based on the Black-Scholes
option-pricing model utilizing certain assumptions for a risk-free interest
rate, volatility, and expected remaining lives of the awards. The assumptions
used in calculating the fair value of share-based payment awards represent
management’s best estimates, but these estimates involve inherent uncertainties
and the application of management’s judgment. As a result, if factors change and
the Company uses different assumptions, the Company’s stock-based compensation
expense could be materially different in the future. In addition, the Company is
required to estimate the expected forfeiture rate and only recognize expense for
those shares expected to vest. In estimating the Company’s forfeiture rate, the
Company analyzed its historical forfeiture rate, the remaining lives of unvested
options, and the amount of vested options as a percentage of total options
outstanding. If the Company’s actual forfeiture rate is materially different
from its estimate, or if the Company reevaluates the forfeiture rate in the
future, the stock-based compensation expense could be significantly different
from what the Company has recorded in the current period.
The
following is a summary of the Company’s stock-based compensation expense for the
periods indicated:
|
Three
Months Ended
|
Nine
Months Ended
|
|||||||||||||||
|
September 30,
2009
|
September 30,
2008
|
September 30,
2009
|
September 30,
2008
|
|||||||||||||
|
Compensation
expense included in G&A expense related to stock
options
|
$ | 5,191 | $ | 30,995 | $ | 40,155 | $ | 106,199 | ||||||||
|
Compensation
expense included in G&A expense related to restricted stock
awards
|
560 | 50,583 | 48,080 | 235,523 | ||||||||||||
|
Total
expense
|
$ | 5,751 | $ | 81,578 | $ | 88,235 | $ | 341,722 | ||||||||
Page 9 of
37
The fair
value of option grants under the Company’s equity compensation plan and other
stock option issuances during the three months and nine months ended September
30, 2009 and 2008 were estimated using the Black-Scholes option-pricing model
with the following weighted-average assumptions:
|
Three Months Ended
|
Nine Months Ended
|
|||||||||
|
September 30,
2009
|
September 30,
2008
|
September 30,
2009
|
September 30,
2008
|
|||||||
|
Dividend
yield
|
0.0
|
%
|
0.0
|
%
|
0.0
|
%
|
0.0
|
%
|
||
|
Expected
volatility
|
70
|
%
|
40
|
%
|
69
|
%
|
46
|
%
|
||
|
Risk-free
interest rate
|
2.37
|
%
|
4.39
|
%
|
2.30
|
%
|
4.43
|
%
|
||
|
Expected
lives (years)
|
4.0
|
4.3
|
4.0
|
4.4
|
||||||
The
expected lives of the options represent the estimated period of time until
exercise or forfeiture and are based on historical experience of similar awards.
Expected volatility is partially based on the historical volatility of the
Company’s common stock since the end of the prior fiscal year as well as
management’s expectations for future volatility. The risk-free interest rate is
based on the published yield available on U.S. treasury issues with an
equivalent term remaining equal to the expected life of the option.
The
following is a summary of the stock option activity for the nine months ended
September 30, 2009:
|
Shares
|
Weighted
Average
Exercise
Price
|
|||||
|
BALANCE,
December 31, 2008
|
271,250
|
$
|
5.89
|
|||
|
Granted
|
40,000
|
1.10
|
||||
|
Forfeited
|
(173,750
|
) |
5.81
|
|||
|
Exercised
|
0
|
-
|
||||
|
BALANCE,
September 30, 2009
|
137,500
|
$
|
4.32
|
|||
Recently Issued
Accounting Pronouncements -. The current US GAAP concerning the life of
intangible assets require, entities to consider their own historical experience
in renewing or extending similar arrangements when developing assumptions
regarding the useful lives of intangible assets and also mandates certain
related disclosure requirements.
All other
new and recently issued, but not yet effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.
2. ASSETS &
LIABILITIES
Prepaid
Expenses
In July
2008, the Company entered into a 36-month sublease agreement with Advantis Real
Estate Services Company for approximately 9,837 square feet of office space in
Durham, North Carolina, into which the Company relocated its headquarters in
September 2008. The agreement included the conveyance of certain furniture to
the Company without a stated value and required a lump-sum, upfront payment of
$500,000 that was made in September 2008. Management has assessed the fair
market value of the furniture to be approximately $50,000, and this amount was
capitalized and is subject to depreciation in accordance with the Company’s
fixed asset policies. The remainder of the payment was recorded as prepaid
expense; with the portion relating to rent for periods beyond the next twelve
months classified as non-current, and is being amortized to rent expense over
the term of the lease. The Company’s prepaid sublease with Advantis
Real Estate Services Company includes an expiration date of September 2011. On
November 3, 2009, the Company received notice from the prime landlord of the
office space that the Company’s sub-landlord, Advantis Real Estate Services
Company, had defaulted on the prime lease, thereby giving the prime landlord the
right to terminate the Company’s sublease, and that the prime landlord was
seeking to renegotiate the occupancy terms for the Company’s office space. The
Company is currently engaged in discussions with the prime landlord to lease the
office space from the prime landlord on a prime lease basis.
Page 10 of 37
Intangible
Assets
The
following table summarizes information about intangible assets at September 30,
2009:
|
Asset Category
|
Value
Assigned
|
Residual
Value
|
Weighted
Average
Amortization
Period
(in Years)
|
Accumulated
Amortization
|
Carrying
Value
|
|||||||||||||||
|
Customer base
|
$
|
1,012,421
|
$
|
-
|
6.2
|
$
|
801,464
|
$
|
210,957
|
|||||||||||
|
Acquired
technology
|
501,264
|
-
|
3.0
|
501,264
|
-
|
|||||||||||||||
|
Non-compete
agreements
|
801,785
|
-
|
4.0
|
793,433
|
8,352
|
|||||||||||||||
|
Trademarks
and copyrights
|
52,372
|
-
|
9.7
|
52,372
|
-
|
|||||||||||||||
|
Trade
name
|
380,000
|
N/A
|
N/A
|
N/A
|
380,000
|
|||||||||||||||
|
Totals
|
$
|
2,747,842
|
$
|
-
|
$
|
2,148,533
|
$
|
599,309
|
||||||||||||
Accrued
Liabilities
At
September 30, 2009, the Company had accrued liabilities totaling $2,107,751.
This amount consisted primarily of $117,102 of liability accrued related to the
development of the Company’s custom accounting application; $1,804,207 related
to legal expenses associated with the Company’s former officers and
employees (see Note 4, “Commitments and Contingencies”); $24,518 for
tax-related liabilities associated with the vesting of restricted stock; $10,043
of loss estimated on a long-term customer contract; $25,685 of accrued payroll;
$87,688 of convertible note interest payable and other liabilities of
$36,617.
At
December 31, 2008, accrued liabilities totaled $478,917. This amount consisted
primarily of $117,102 of liability related to the above-noted development of the
Company’s custom accounting application; $137,500 related to legal reserves (see
Note 4, “Commitments and Contingencies”); $30,198 for tax-related liabilities
associated with the vesting of restricted stock; $30,903 of loss estimated on a
long-term customer contract; $79,300 of cash collected through the Company’s
merchant account on behalf of a customer; $54,467 of convertible note interest
payable and other liabilities of $29,447.
Deferred
Revenue
Deferred
revenue comprises the following items:
|
·
|
Subscription
Fees - short-term and long-term portions of cash received related to one-
or two-year subscriptions for domain names and/or email
accounts
|
|
·
|
License
Fees - licensing revenue where customers did not meet all the criteria of
US GAAP. Such deferred revenue will be recognized as cash is delivered or
collectability becomes probable.
|
The
components of deferred revenue for the periods indicated were as
follows:
|
September 30,
2009
|
December 31,
2008
|
|||||||
|
Subscription
fees
|
$
|
56,010
|
$
|
89,852
|
||||
|
License
fees
|
75,000
|
108,750
|
||||||
|
Professional
service fees
|
72,150
|
192,727
|
||||||
|
Totals
|
$
|
203,160
|
$
|
391,329
|
||||
|
Current
portion
|
$
|
166,142
|
$
|
323,976
|
||||
|
Non-current
portion
|
37,018
|
67,353
|
||||||
|
Totals
|
$
|
203,160
|
$
|
391,329
|
||||
Page 11 of 37
3. NOTES PAYABLE
Convertible
Notes
As of
September 30, 2009, the Company had $7.85 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2010 (the “notes”)
outstanding, after the $200,000 reduction of such current outstanding debt on
account of the sale-leaseback described in item 4, Commitments and
Contingencies, below. On November 14, 2007, in an initial closing, the
Company sold $3.3 million aggregate principal amount of notes (the “Initial
Notes”). In addition, the noteholders committed to purchase on a pro rata basis
up to $5.2 million aggregate principal amount of notes in future closings upon
approval and call by the Company’s Board of Directors. On August 12, 2008, the
Company exercised its option to sell $1.5 million aggregate principal amount of
notes with substantially the same terms and conditions as the Initial Notes (the
“Additional Notes”). In connection with the sale of the Additional Notes, the
noteholders holding a majority of the aggregate principal amount of the notes
then outstanding agreed to increase the aggregate principal amount of notes that
they are committed to purchase from $8.5 million to $15.3 million.
On
November 21, 2008, the Company sold $500,000 aggregate principal amount of notes
(the “New Notes”) to two new investors with substantially the same terms and
conditions as the previously outstanding notes.
On each
of January 6, 2009, February 24, 2009, April 3, 2009, and June 2, 2009 the
Company sold a note in the principal amount of $500,000 (total $2,000,000)
to a current noteholder with substantially the same terms and conditions as the
previously outstanding notes.
On each
of July 16, 2009, August 26, 2009, September 8, 2009, October 5, 2009 and
October 9, 2009 the Company sold a note in the principal amount of $250,000
(total $1,250,000) to a current noteholder with substantially the same terms and
conditions as the previously outstanding notes. On November 6, 2009
the Company sold a note in the principal amount of $500,000 to a current
noteholder with substantially the same terms and conditions.
Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that the Company may sell up to $6
million aggregate principal amount of notes to new investors or existing
noteholders at any time on or before December 31, 2009 with a maturity date of
November 14, 2010 or later. In addition, the maturity date definition for each
of the notes was changed from November 14, 2010 to the date upon which the note
is due and payable, which is the earlier of (1) November 14, 2010, (2) a change
of control, or (3) if an event of default occurs, the date upon which
noteholders accelerate the indebtedness evidenced by the notes.
The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.
The
Company is obligated to pay interest on the notes at an annualized rate of 8%
payable in quarterly installments commencing three months after the purchase
date of the notes. The Company is not permitted to prepay the notes without
approval of the holders of at least a majority of the principal amount of the
notes then outstanding.
On the
earlier of November 14, 2010 or a merger or acquisition or other transaction
pursuant to which existing stockholders of the Company hold less than 50% of the
surviving entity, or the sale of all or substantially all of the Company’s
assets, or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
|
·
|
convert
the principal then outstanding on its notes into shares of the Company’s
common stock, or
|
|
·
|
receive
immediate repayment in cash of the notes, including any accrued and unpaid
interest.
|
If a
noteholder elects to convert its notes under these circumstances, the conversion
price will be the lowest “applicable conversion price” determined for each note.
The “applicable conversion price” for each note shall be calculated by
multiplying 120% by the lowest of:
|
·
|
the
average of the high and low prices of the Company's common stock on the
OTC Bulletin Board averaged over the five trading days prior to the
closing date of the issuance of such
note,
|
|
·
|
if
the Company's common stock is not traded on the Over-The-Counter market,
the closing price of the common stock reported on the Nasdaq National
Market or the principal exchange on which the common stock is listed,
averaged over the five trading days prior to the closing date of the
issuance of such note, or
|
Page 12 of 37
|
·
|
the
closing price of the Company's common stock on the OTC Bulletin Board, the
Nasdaq National Market or the principal exchange on which the common stock
is listed, as applicable, on the trading day immediately preceding the
date such note is converted,
|
in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.
Payment
of the notes will be automatically accelerated if the Company enters voluntary
or involuntary bankruptcy or insolvency proceedings.
The notes
and the common stock into which they may be converted have not been registered
under the Securities Act of 1933, as amended (the “Securities Act”), or the
securities laws of any other jurisdiction. As a result, offers and sales of the
notes were made pursuant to Regulation D of the Securities Act and only made to
accredited investors. The investors in the Initial Notes include (i) The
Blueline Fund, which originally recommended Philippe Pouponnot, a former
director of the Company, for appointment to the Company’s Board of Directors;
(ii) Atlas Capital SA (“Atlas”), an affiliate of the Company that originally
recommended Shlomo Elia, one of the Company’s current directors, for appointment
to the Board of Directors; (iii) Crystal Management Ltd. (“Crystal”), which is
owned by Doron Roethler, who subsequently served as Chairman of the Company’s
Board of Directors from December 2007 until December 9, 2008 and Chairman and
Interim President and Chief Executive Officer from December 9, 2008
until May 19, 2009, and serves as the noteholders’ bond
representative; and (iv) William Furr, who is the father of Thomas Furr, who, at
the time, was one of the Company’s directors and executive officers. The
investors in the Additional Notes are Atlas and Crystal. The investors in the
New Notes are not affiliated with the Company. . Atlas purchased $6,800,000 and
Union Bancaire Privee purchased $500,000 of the $9,050,000 aggregate principal
amount of notes issued through November 11, 2009.
If the
Company proposes to file a registration statement to register any of its common
stock under the Securities Act in connection with the public offering of such
securities solely for cash, subject to certain limitations, the Company shall
give each noteholder who has converted its notes into common stock the
opportunity to include such shares of converted common stock in the
registration. The Company has agreed to bear the expenses for any of these
registrations, exclusive of any stock transfer taxes, underwriting discounts,
and commissions.
Line
of Credit
On
November 14, 2006, the Company entered into a revolving credit arrangement with
Wachovia Bank, NA (“Wachovia”) for $1.3 million to be used for general working
capital. Any advances made on the line of credit were to be paid off no later
than August 1, 2007, with monthly payments of accrued interest on any
outstanding balance commencing on December 1, 2006. The interest accrued on the
unpaid principal balance at the LIBOR Market Index Rate plus 0.9%. The line of
credit was secured by the Company’s deposit account at Wachovia and an
irrevocable standby letter of credit in the amount of $1.3 million issued by
HSBC Private Bank (Suisse) SA (“HSBC”) with Atlas, a current stockholder, as
account party.
On
January 24, 2007, the Company entered into an amendment to its line of credit
with Wachovia to increase the available principal from $1.3 million to $2.5
million and to extend the maturity date from August 1, 2007 to August 1, 2008.
The amended line of credit was secured by the Company’s deposit account at
Wachovia and a modified irrevocable standby letter of credit in the amount of
$2.5 million issued by HSBC with Atlas as account party. On February 15, 2008,
the Company repaid the full outstanding principal balance of $2,052,000 and
accrued interest of $2,890.
On
February 20, 2008, the Company entered into a revolving credit arrangement with
Paragon Commercial Bank (“Paragon”) that is renewable on an annual basis subject
to mutual approval. The line of credit advanced by Paragon is $2.47 million and
can be used for general working capital. Any advances made on the line of credit
were to be paid off no later than February 19, 2009, subject to extension due to
renewal, with monthly payments being applied first to accrued interest and then
to principal. The interest accrued on the unpaid principal balance at the Wall
Street Journal’s published Prime Rate minus one half percent. The line of
credit is secured by an irrevocable standby letter of credit in the amount of
$2.5 million issued by HSBC with Atlas as account party that expires on February
18, 2010. The Company also has agreed with Atlas that in the event of a default
by the Company in the repayment of the line of credit that results in the letter
of credit being drawn, the Company shall reimburse Atlas any sums that Atlas is
required to pay under such letter of credit. At the sole discretion
of the Company, these payments may be made in cash or by issuing shares of the
Company’s common stock at a set per-share price of $2.50.
On
February 19, 2009, the Company renewed its revolving credit arrangement with
Paragon. Any advances made on the line of credit must be paid off no later than
February 19, 2010. Interest shall accrue on the unpaid principal balance at the
Wall Street Journal's published Prime Rate, but at no time shall the interest
rate be less than 5.5%. As of November 10, 2009, the Company had an outstanding
balance of $2.05 million under the line of credit. As of September
30, 2009, the Company had notes payable totaling $10,547,688. The detail of
these notes is as follows:
Page 13 of 37
|
Note Description
|
Short-Term
Portion
|
Long-Term
Portion
|
TOTAL
|
Maturity
|
Rate
|
||||||||||||
|
Paragon
Commercial Bank credit line
|
$ | 2,401,124 | $ | - | $ | 2,401,124 |
Feb
‘10
|
5.5 | % | ||||||||
|
Various
capital leases
|
40,205 | 192,838 | 233,043 |
Various
|
8-19 | % | |||||||||||
|
Insurance
premium note
|
63,521 | - | 63,521 |
Jul
‘10
|
5.4 | % | |||||||||||
|
Convertible
notes
|
- | 7,850,000 | 7,850,000 |
Nov
‘10
|
8.0 | % | |||||||||||
|
TOTAL
|
$ | 2,504,850 | $ | 8,042,838 | $ | 10,547,688 | |||||||||||
4. COMMITMENTS
AND CONTINGENCIES
Lease
Commitments
The
Company leases computer and office equipment under capital lease agreements that
expire through August 2019. Total amounts financed under these capital leases
were $233,043and $53,517 at September 30, 2009 and December 31, 2008,
respectively, net of accumulated amortization of $39,121 and $18,647,
respectively. The current and non-current portions of the capital leases have
been recorded in current and long-term portions of notes payable on the balance
sheets as of September 30, 2009 and December 31, 2008. See also Note 3, “Notes
Payable.”
In 2008,
the Company entered into a non-cancelable sublease with a remaining term of 36
months to relocate its headquarters to another facility near Research Triangle
Park, North Carolina. As described in Note 2, “Assets and Liabilities,” the
Company prepaid the lease and purchased existing furniture and fixtures for a
lump-sum payment of $500,000, of which $450,080 was allocated to rent and is
being amortized monthly over the remaining term of the lease. The Company also
had a lease through October 2009 for an apartment near its headquarters that was
utilized by its out of town executives and members of its Board of Directors.
The lease was terminated as of August 4, 2009.
On
September 4, 2009, the Company entered into a sale-leaseback agreement with the
current bondholders. The bondholders paid a market rate cost of
$200,000 through the reduction of current outstanding debt in exchange for all
of the Company’s office furniture, equipment and computers. The
bondholders then leased all furniture, equipment and computers back to the
company over a ten (10) year period. The monthly lease payment under
the agreement is $2,427.
Rent
expense for the nine months ended September 30, 2009 and 2008 was $129,572 and
$243,218 respectively.
Development
Agreement
In August
2005, the Company entered into a software assignment and development agreement
with the developer of a customized accounting software application. In
connection with this agreement, the developer would be paid up to $512,500 and
issued up to 32,395 shares of the Company’s common stock based upon the
developer attaining certain milestones. This agreement was modified on
March 26, 2008 to adjust the total number of shares issuable under the agreement
to 29,014. As of September 30, 2009, the Company had paid $470,834 and issued
3,473 shares of common stock related to this obligation.
Legal
Proceedings
On May
29, 2009, Dennis Michael Nouri and Reza Eric Nouri (together, the “Nouris”), a
former officer and employee of the Company, respectively, filed a complaint (the
“Nouri Complaint”) to bring a summary proceeding against the Company in the
Court of Chancery of the State of Delaware. The Nouri Complaint
sought to compel the Company to advance legal fees and costs in the amount of
$826,798 incurred by the Nouris in their defense of criminal proceedings brought
against them by the United States, and in their defense of civil proceedings
brought against them by the Securities and Exchange Commission and the Company’s
stockholders, together with future verified expenses that will be incurred by
the Nouris in defending the actions against them and the expenses incurred by
the Nouris in prosecuting the advancement action against the
Company.
On July
2, 2009, the Nouris were convicted of nine counts of criminal activity in a
federal criminal action brought against them in the United States District Court
for the Southern District of New York, and are presently awaiting
sentence.
Page 14 of 37
On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris. By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009. The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $2.4 million. Though the
Nouris have entered into an undertaking that requires them to repay to the
Company any amounts advanced by it in the event the Nouris are ultimately
determined not to be entitled to indemnification for the expenses incurred, it
is uncertain at this time that the Company will be able to recover such amounts
advanced without considerable expense to the Company, or whether the Company
will be able to recover any of the amounts advanced at all.
On
September 24, 2009, the Nouris filed a Motion for Rule to Show Cause and the
Appointment of a Receiver in the Court of Chancery of the State of Delaware
against the Company (the “Motion”). The Motion, among other things,
seeks the appointment of a receiver for the Company under Section 322 of the
Delaware General Corporation Law on account of the Company’s failure to pay the
monetary judgment in the amount of $826,798 entered against it by order of the
Court of Chancery on August 6, 2009 for the advancement of legal expenses
incurred by the Nouris in their defense of the foregoing criminal
proceedings. The Company intends to vigorously contest the
Motion.
Please refer to Part I, Item 3 of our annual report on Form 10-K for
the fiscal year ending December 31, 2008 for a further description of material
legal proceedings.
5. STOCKHOLDERS’ EQUITY
Preferred
Stock
The Board
of Directors is authorized, without further stockholder approval, subject to the
approval of the Noteholders, to issue up to 5,000,000 shares of $0.001 par value
preferred stock in one or more series and to fix the rights, preferences,
privileges, and restrictions applicable to such shares, including dividend
rights, conversion rights, terms of redemption, and liquidation preferences, and
to fix the number of shares constituting any series and the designations of such
series. There were no shares of preferred stock outstanding at September 30,
2009.
Common
Stock
The
Company is authorized to issue 45,000,000 shares of common stock, $0.001 par
value per share. As of September 30, 2009, it had 18,332,543 shares of common
stock outstanding. Holders of common stock are entitled to one vote for each
share held.
In
January 2008, the Company issued 28,230 shares of common stock to a consulting
firm as full payment of the outstanding obligation related to fees accrued for
services rendered in conjunction with the 2005 acquisitions of iMart and
Computility.
Warrants
As
incentive to modify a letter of credit relating to the Wachovia line of credit
(see Note 3, “Notes Payable”), the Company entered into a Stock Purchase Warrant
and Agreement (the “Warrant Agreement”) with Atlas on January 15, 2007. Under
the terms of the Warrant Agreement, Atlas received a warrant containing a
provision for cashless exercise to purchase up to 444,444 shares of the
Company’s common stock at $2.70 per share at the termination of the line of
credit or if the Company is in default under the terms of the line of credit
with Wachovia. The fair value of the warrant was $734,303 as measured using the
Black-Scholes option pricing model at the time the warrant was issued. This
amount was recorded as deferred financing costs and was amortized to interest
expense in the amount of $37,657 per month over the remaining period of the
modified line of credit, which expired on August 2008. As of December 31,
2007, the deferred financing costs to be amortized to interest expense over the
remaining eight months, or $301,249, were classified as current assets. In
consideration for Atlas providing the Paragon line of credit (see Note 3, “Notes
Payable”), the Company agreed to amend the Warrant Agreement to provide that the
warrant is exercisable within 30 business days of the termination of the Paragon
line of credit or if the Company is in default under the terms of the line of
credit. If the warrant is exercised in full for cash, it will result in gross
proceeds to the Company of approximately $1.2 million.
Under a
Securities Purchase Agreement with two investors entered in connection with a
2007 private placement of the Company’s common stock, the investors were issued
warrants for the purchase of an aggregate of 1,176,471 shares of common stock at
an exercise price of $3.00 per share. These warrants contain a provision for
cashless exercise and must be exercised by February 21, 2010.
As part
of the commission paid to Canaccord Adams, Inc. (“CA”), the Company’s placement
agent in the 2007 private placement transaction, CA was issued a warrant to
purchase 35,000 shares of the Company’s common stock at an exercise price of
$2.55 per share. This warrant contains a provision for cashless exercise and
must be exercised by February 21, 2012.
As of
September 30, 2009, warrants to purchase up to 1,655,915 shares were
outstanding.
Page 15 of
37
Equity
Compensation Plans
The
Company adopted its 2004 Equity Compensation Plan (the “2004 Plan”) as of March
31, 2004. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, and other direct stock awards to
employees (including officers) and directors of the Company as well as to
certain consultants and advisors. In June 2007, the Company temporarily limited
the issuance of shares of its common stock reserved under the 2004 Plan to
awards of restricted or unrestricted stock and in June 2008 again made options
available for grant under the 2004 Plan. The total number of shares of common
stock reserved for issuance under the 2004 plan is 5,000,000 shares, subject to
adjustment in the event of a stock split, stock dividend, recapitalization, or
similar capital change.
Restricted Stock – During the
first, second and third quarters of 2009, no shares of restricted stock were
issued. A total of 1,059 shares of restricted stock were canceled during the
first three quarters of 2009 due to terminations and payment of employee
tax obligations resulting from share vesting. At September 30, 2009, there was
no unvested expense yet to be recorded related to all restricted stock
outstanding.
Stock Options – The exercise
price for incentive stock options granted under the 2004 Plan is required to be
no less than the fair market value of the common stock on the date the option is
granted, except for options granted to 10% stockholders, which are required to
have an exercise price of not less than 110% of the fair market value of the
common stock on the date the option is granted. Incentive stock options
typically have a maximum term of ten years, except for option grants to 10%
stockholders, which are subject to a maximum term of five years. Non-statutory
stock options have a term determined by either the Board of Directors or the
Compensation Committee. Options granted under the 2004 Plan are not
transferable, except by will and the laws of descent and
distribution.
The
following is a summary of the stock option activity for the six months ended
September 30, 2009:
|
Shares
|
Weighted
Average
Exercise
Price
|
|||||||
|
BALANCE, December
31, 2008
|
271,250
|
$
|
5.89
|
|||||
|
Granted
|
40,000
|
1.10
|
||||||
|
Exercised
|
-
|
-
|
||||||
|
Canceled
|
(173,750
|
)
|
5.81
|
|||||
|
BALANCE,
September 30, 2009
|
137,500
|
$
|
4.32
|
|||||
The
following table summarizes information about stock options outstanding at
September 30, 2009:
|
Currently Exercisable
|
||||||||||||||||||||
|
Exercise Price
|
Number of
Options
Outstanding
|
Average
Remaining
Contractual
Life (Years)
|
Weighted
Average
Exercise
Price
|
Number of
Shares
|
Weighted
Average
Exercise
Price
|
|||||||||||||||
|
From
$2.50 to $3.50
|
85,000
|
6.3
|
$
|
3.15
|
85,000
|
$
|
3.14
|
|||||||||||||
|
$5.00
|
25,000
|
6.0
|
$
|
5.00
|
25,000
|
$
|
5.00
|
|||||||||||||
|
From
$8.61 to $9.00
|
27,500
|
6.5
|
$
|
8.73
|
27,500
|
$
|
8.73
|
|||||||||||||
|
Totals
|
137,500
|
3.6
|
$
|
6.10
|
137,500
|
$
|
6.10
|
|||||||||||||
At
September 30, 2009, there remains $19,469 of unvested expense yet to be recorded
related to all options outstanding.
Dividends
The
Company has not paid any cash dividends through September 30, 2009.
6. MAJOR CUSTOMERS AND CONCENTRATION OF
CREDIT RISK
The
Company derives a significant portion of its revenues from certain customer
relationships. The following is a summary of customers that represent greater
than ten percent of total revenues for their respective time
periods:
Page 16 of
37
|
|
Three Months Ended
September 30, 2009
|
|
||||||
|
|
Revenue Type
|
|
Revenues
|
|
% of Total
Revenues
|
|
||
|
Customer A
|
Subscription fees
|
|
$
|
850,788
|
|
82
|
%
|
|
|
Customer
B
|
Professional
service fees
|
|
411
|
|
-
|
%
|
||
|
Customer
C
|
Subscription
fees
|
74,465
|
7
|
%
|
||||
|
Customer
D
|
Professional
service fees
|
75,150
|
7
|
|||||
|
Others
|
Various
|
|
41,694
|
|
4
|
%
|
||
|
Total
|
|
|
$
|
1,042,508
|
|
100
|
%
|
|
|
|
|
Three Months Ended
September 30, 2008
|
|
|||||
|
|
Revenue Type
|
|
Revenues
|
|
% of Total
Revenues
|
|
||
|
Customer A
|
Subscription
fees
|
|
$
|
385,198
|
|
24
|
%
|
|
|
Customer
B
|
Professional
service fees
|
|
465,750
|
|
29
|
%
|
||
|
Customer
C
|
Subscription
fees
|
|
213,384
|
|
13
|
%
|
||
|
Customer
D
|
Professional
service fees
|
-
|
-
|
%
|
||||
|
Others
|
Various
|
|
547,125
|
|
34
|
%
|
||
|
Total
|
|
|
$
|
1,611,457
|
|
100
|
%
|
|
|
|
|
Nine Months Ended
September 30, 2009
|
|
|||||
|
|
Revenue Type
|
|
Revenues
|
|
% of Total
Revenues
|
|
||
|
Customer A
|
Subscription
fees
|
|
$
|
1,698,885
|
|
66
|
%
|
|
|
Customer
B
|
Professional
service fees
|
|
222,725
|
|
9
|
%
|
||
|
Customer
C
|
Subscription
fees
|
|
291,819
|
|
11
|
%
|
||
|
Customer
D
|
Professional
service fees
|
114,328
|
4
|
%
|
||||
|
Others
|
Various
|
|
257,404
|
|
10
|
%
|
||
|
Total
|
|
|
$
|
2,585,161
|
|
100
|
%
|
|
|
|
|
Nine Months Ended
September 30, 2008
|
|
|||||
|
|
Revenue Type
|
|
Revenues
|
|
% of Total
Revenues
|
|
||
|
Customer A
|
Subscription
fees
|
|
$
|
1,098,966
|
|
23
|
%
|
|
|
Customer
B
|
Professional
service fees
|
|
1,250,747
|
|
26
|
%
|
||
|
Customer
C
|
Subscription
fees
|
|
882,387
|
|
18
|
%
|
||
|
Customer
D
|
Professional
service fees
|
-
|
-
|
%
|
||||
|
Others
|
Various
|
|
1,582,150
|
|
33
|
%
|
||
|
Total
|
|
|
$
|
4,814,250
|
|
100
|
%
|
|
As of
September 30, 2009, two customers accounted for 62% and 38% of accounts
receivable, respectively. As
of December 31, 2008, one customer accounted for 93% of accounts
receivable.
Page 17 of
37
7. SUBSEQUENT EVENTS
Convertible Note
Financing.
On each
of October 5, 2009 and October 9, 2009 the Company sold a note in the principal
amount of $250,000 (total $500,000) to current noteholders with substantially
the same terms and conditions as the previously outstanding notes. On
November 6, 2009 the Company sold a note in the principal amount of $500,000 to
a current noteholder with substantially the same terms and conditions.The
Company will be obligated to pay interest on the New Notes at an annualized rate
of 8% payable in quarterly installments commencing three months after the
closing date. The Company plans to use the proceeds to meet ongoing working
capital and capital spending requirements.
The
Company’s corporate headquarters and research and development facility is
located in Durham, North Carolina near Research Triangle Park and consists of
approximately 9,837 square feet of office space held under a prepaid sublease
with an expiration date of September 2011. On November 3, 2009, the Company
received notice from the prime landlord of the office space that the Company’s
sub-landlord had defaulted on the prime lease, thereby giving the prime landlord
the right to terminate the Company’s sublease, and that the prime landlord was
seeking to renegotiate the occupancy terms for the Company’s office space. The
Company is currently engaged in discussions with the prime landlord to lease the
office space from the prime landlord on a prime lease basis.
We have
evaluated subsequent events through November 12, 2009.
Item 2.
Management’s Discussion and
Analysis of Financial Condition and Results of Operations
Information
set forth in this Quarterly Report on Form 10-Q contains various forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, or
the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or
the Exchange Act. Forward-looking statements consist of, among other things,
trend analyses, statements regarding future events, future financial
performance, our plan to build our business and the related expenses, our
anticipated growth, trends in our business, the effect of interest rate
fluctuations on our business, the potential impact of current litigation or any
future litigation, the potential availability of tax assets in the future and
related matters, and the sufficiency of our capital resources, all of which are
based on current expectations, estimates, and forecasts, and the beliefs and
assumptions of our management. Words such as “expect,” “anticipate,” “project,”
“intend,” “plan,” “estimate,” variations of such words, and similar expressions
also are intended to identify such forward-looking statements. These
forward-looking statements are subject to risks, uncertainties, and assumptions
that are difficult to predict. Therefore, actual results may differ materially
and adversely from those expressed in any forward-looking statements. Readers
are directed to risks and uncertainties identified under Part II, Item 1A, “Risk
Factors,” and elsewhere in this report, for factors that may cause actual
results to be different than those expressed in these forward-looking
statements. Except as required by law, we undertake no obligation to revise or
update publicly any forward-looking statements for any reason.
Overview
Overview
Through
our OneBiz™ platform, we develop and markets software products and services
targeted to small businesses that are delivered via a Software-as-a-Service, or
SaaS, model. We also provide website consulting and custom software development
services, primarily in the e-commerce retail and direct-selling organization
industries. We reach small businesses primarily through arrangements with
channel partners that private label our software applications and market them to
their customer bases through their corporate websites. We believe that these
relationships provide a cost and time effective process for us to market to a
diverse and fragmented yet very sizeable small-business sector. In
addition to our channel partner strategy, we also offer our SaaS products
directly to end-user small businesses through our OneBiz™ branded
website.
In the
second half of 2007, we commenced an overall evaluation of our software
development model as well as the potential applicability of currently available
development technologies. The outcome of this analysis was to develop a core
industry-standard platform for small business with an architecture designed to
integrate with a virtually unlimited number of other applications, services, and
existing infrastructures. These applications would include not only our own
small-business applications, which are currently being optimized, but also other
applications expected to arise from collaborative partnerships with third-party
developers and service providers. In addition, potential emerging-market
opportunities in the small-business segment designed to leverage social
networking and community building were identified. Our management
team believes that, but cannot assure, this platform and associated applications
will provide opportunities for new sources of revenue, including an increase in
subscription fees. As we near completion of the development of its
industry-standard platform, as evidenced by the release of OneBiz™ 1.1, in July
2009, the Company has begun increasing its emphasis on the sales and marketing
of the new platform.
In light
of our operating strategy involving the industry-standard platform, the
consolidation of all operations into our North Carolina headquarters, and other
factors including certain income tax advantages, it was concluded in the latter
part of 2008 that it was no longer necessary to operate with the Smart Commerce,
Inc. and Smart CRM, Inc. subsidiaries. As a result, an upstream merger was
completed as of December 31, 2008 that merged those subsidiaries with the parent
corporation
Page 18 of 37
Sources
of Revenue
We derive
revenues from the following sources:
|
·
|
Subscription
fees – monthly fees charged to customers for access to our SaaS
applications
|
|
·
|
License
fees – fees charged for perpetual or term licensing of platforms or
applications
|
|
·
|
Professional
service fees – fees related to consulting services, some of which
complement our other products and
applications
|
|
·
|
Other
revenues – revenues generated from non-core activities such as
syndication and integration fees; original equipment manufacturer, or OEM,
contracts; and miscellaneous other
revenues
|
The
Company’s current primary focus is to target those established companies that
have both a substantial base of small business customers as well as a
recognizable and trusted brand name in specific market segments. Our goal is to
enter into partnerships with these established companies whereby they
private-label our products and offer them to their small business customers. We
believe the combination of the magnitude of their customer bases and their
trusted brand names and recognition will help drive our subscription
volume.
Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. We make subscription sales either on a
subscription or on a “for fee” basis. Applications for which subscriptions are
available vary from our own portal to the websites of our partners.
Subscriptions are generally payable on a monthly basis and are typically paid
via credit card of the individual end user or the aggregating entity. We are
focusing our efforts on enlisting new channel partners as well as diversifying
with vertical intermediaries in various industries.
License
fees consist of perpetual or term license agreements for the use of the Smart
Online platform, the Smart Commerce platform, or any of our
applications.
We
generate professional service fees from our consulting services. For example, a
partner may request that we re-design its website to better accommodate our
products or to improve its own website traffic. We typically bill professional
service fees on a time and material basis. Hosting and maintenance fees are
generated as the services are provided.
Other
revenues primarily consist of non-core revenue sources such as syndication and
integration fees, miscellaneous web services, and OEM revenue generated through
sales of our applications bundled with products offered by other
manufacturers.
Cost
of Revenues
Cost of
revenues primarily is composed of salaries associated with maintaining and
supporting integration and syndication partners, the cost of domain name and
email registrations, and the cost of external hosting facilities associated with
maintaining and supporting our partners and end user customers.
Operating
Expenses
During
the fourth quarter of 2009, executive management intends to continue the
restructuring of the operations team that began early in the third quarter of
2009,, including additions to the software development and sales and marketing
functions. The restructuring that is taking place was precipitated by the
departure of several executive management personnel in May 2009; as noted in our
public filings.
Additionally,
management is undertaking the issuance of a series of releases of our OneBiz
platform in the fourth quarter of 2009 and the first quarter of 2010. These
releases will be designed to include additional functionality and integration,
as well as to include the addition of new applications we believe will be
attractive to small businesses. The restructuring in sales and marketing is
designed to accelerate the penetration of the small company market by continuing
to enhance our channel partner marketing strategy.
Page 19 of 37
We
continue to strengthen our iMart product offering which includes the custom
design and implementation of our direct selling and network marketing customers’
complex e-commerce web sites. In addition to the typical “product purchase”
tools that are featured in most e-commerce web sites, our capability includes
such features as back office inventory management, back office multiple
commission calculations, back office affiliate rebate calculations, bar code
scanning for event management, individualized independent distributer marketing
tools including a personalized web site and unique domain ID, and back office
team management functions for “network trees”. We plan to place increased sale
and marketing emphasis on the iMart product offering.
General and Administrative.
General and administrative expenses consist of salaries and related expenses for
executive, finance and accounting, legal, human resources, and information
technology personnel; professional fees; depreciation and amortization expenses;
insurance; and other corporate expenses, including facilities costs. We
anticipate general and administrative expenses will increase as we incur
additional professional fees and insurance costs related to the growth of our
business and our operations as a public company. We expect to continue to incur
material costs in 2009 related to the civil and criminal complaints filed in
September 2007, described in detail in Part I, Item 3, “Legal Proceedings,” in
our Annual Report on Form 10-K for the year ended December 31, 2008 and Part II,
Item 1, “Legal Proceedings,” in this report and the Quarterly Reports on Form
10-Q for the quarterly periods ended March 31, 2009 and June 30,
2009.
Sales and Marketing.
Historically, we spent limited funds on marketing, advertising, and public
relations, particularly due to our business model of partnering with established
companies with extensive small business customer bases. In June 2008, we engaged
a public relations firm and, as a result, our public relations expenses
increased in the third quarter and will continue to do so during the fourth
quarter of 2009. As we implement our sales and marketing strategy to take our
enhanced products to market, we also expect associated costs to increase in the
balance of 2009 due to targeting new partnerships, development of channel
partner enablement programs, additional sales and marketing personnel, and the
various percentages of revenues we may be required to pay to future partners as
marketing fees.
Research and Development.
Current US GAAP requires capitalization of certain software development costs
subsequent to the establishment of technological feasibility, with costs
incurred prior to this time expensed as research and development. Technological
feasibility is established when all planning, designing, coding, and testing
activities that are necessary to establish that the product can be produced to
meet its design specifications have been completed. Historically, we had not
developed detailed design plans for our SaaS applications, and the costs
incurred between the completion of a working model of these applications and the
point at which the products were ready for general release had been
insignificant. These factors, combined with the historically low revenue
generated by the sale of the applications that do not support the net realizable
value of any capitalized costs, resulted in the continued expensing of
underlying costs as research and development.
Beginning
in May 2008, we determined that it was strategically desirable to develop an
industry standard platform and enhance our current SaaS applications. A detailed
design plan indicated that the product was technologically feasible. In July
2008, development commenced, and all related costs from this point in time are
being capitalized in accordance with current US GAAP. Because of our scalable
and secure multi-user architecture, we are able to provide all customers with a
service based on a single version of our application. As a result, we do not
have to maintain multiple versions, which enables us to incur relatively low
development costs as compared to traditional enterprise software business
models. As we complete the core development of our new applications during the
balance of 2009, we expect that future research and development expenses will
decrease in both absolute and relative dollars.
Stock-Based Expenses. Our
operating expenses include stock-based expenses related to options, restricted
stock awards, and warrants issued to employees and non-employees. In the past,
these charges have been significant and are reflected in our historical
financial results. Effective January 1, 2006, we adopted US GAAP provisions
relating to the treatment of share-based payment, which resulted and will
continue to result in material costs on a prospective basis as long as a
significant number of options are outstanding. In June 2007, we limited the
issuance of awards under our 2004 Equity Compensation Plan, or the 2004 Plan, to
awards of restricted or unrestricted stock. In June 2008, we made options
available for grant under the 2004 Plan once again, primarily due to the adverse
tax
consequences to recipients of restricted stock upon the lapsing of
restrictions.
Critical
Accounting Policies and Estimates
Our
discussion and analysis of financial condition and results of operations are
based upon our consolidated financial statements, which we prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues, and
expenses and related disclosures of contingent assets and liabilities. “Critical
accounting policies and estimates” are defined as those most important to the
financial statement presentation and that require the most difficult,
subjective, or complex judgments. We base our estimates on historical experience
and on various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Under different assumptions and/or conditions, actual results of
operations may materially differ. We periodically reevaluate our critical
accounting policies and estimates, including those related to revenue
recognition, provision for doubtful accounts and sales returns, expected lives
of customer relationships, useful lives of intangible assets and property and
equipment, provision for income taxes, valuation of deferred tax assets and
liabilities, and contingencies and litigation reserves. Management has
consistently applied the same critical accounting policies and estimates which
are fully described in our Annual Report on Form 10-K for the year ended
December 31, 2008.
Page 20 of 37
We derive
revenue primarily from subscription fees charged to customers accessing our SaaS
applications; the perpetual or term licensing of software platforms or
applications; and professional services, consisting of consulting, development,
hosting, and maintenance services. These arrangements may include delivery in
multiple-element arrangements if the customer purchases a combination of
products and/or services. Because we license, sell, lease, or otherwise market
computer software, we use the residual method pursuant to current US GAAP
pronouncements. This method allows us to recognize revenue for a delivered
element when such element has vendor specific objective evidence, or VSOE, of
the fair value of the delivered element. If we cannot determine or maintain VSOE
for an element, it could impact revenues as all or a portion of the revenue from
the multiple-element arrangement may need to be deferred.
If
multiple-element arrangements involve significant development, modification, or
customization or if it we determine that certain elements are essential to the
functionality of other elements within the arrangement, we defer revenue until
all elements necessary to the functionality of the customer is provided. The
determination of whether the arrangement involves significant development,
modification, or customization could be complex and require the use of judgment
by our management.
Provisions
of US GAAP provide that if the arrangement does not require significant
development, modification, or customization, we recognize revenue when all of
the following criteria have been met:
|
1.
|
persuasive
evidence of an arrangement exists
|
|
2.
|
delivery
has occurred
|
|
3.
|
the
fee is fixed or determinable
|
|
4.
|
collectability
is probable
|
If at the
inception of an arrangement the fee is not fixed or determinable, we defer
revenue until the arrangement fee becomes due and payable. If we deem
collectability not probable, we defer revenue until we receive payment or
collection becomes probable, whichever is earlier. The determination of whether
fees are collectible requires the judgment of our management, and the amount and
timing of revenue recognition may change if different assessments are
made.
Under
other provisions of current US GAAP related to revenue arrangements with multiple
deliverables, we account for consulting, website design fees, and
application development services separately from the license of associated
software platforms when these services have value to the customer and there is
objective and reliable evidence of fair value of each deliverable. When
accounted for separately, revenues are recognized as the services are rendered
for time and material contracts, and when milestones are achieved and accepted
by the customer for fixed-price or long-term contracts. The majority of our
consulting service contracts are on a time and material basis and are typically
billed monthly based upon standard professional service rates.
Application
development services are typically fixed price and of a longer term. As such, we
account for these services as long-term construction contracts that require
revenue recognition to be based on estimates involving total costs to complete
and the stage of completion. The assumptions and estimates made to determine the
total costs and stage of completion may affect the timing of revenue
recognition, with changes in estimates of progress to completion and costs to
complete accounted for as cumulative catch-up adjustments. If the criteria for
revenue recognition on construction-type contracts are not met, we capitalize
the associated costs of such projects and include them in costs in excess of
billings on the balance sheet until such time that revenue recognition is
permitted.
Subscription
fees primarily consist of sales of subscriptions through private-label marketing
partners to end users. We typically have a revenue share arrangement with these
private-label marketing partners in order to encourage them to market our
products and services to their customers. Subscriptions are generally payable on
a monthly basis and are typically paid via credit card of the individual end
user or the aggregating entity. Any payments received in advance of the
subscription period are accrued as deferred revenue and amortized over the
subscription period.
Because
our customers generally do not have the contractual right to take possession of
the software we license or market at any time, we recognize revenue on hosting
and maintenance fees as the services are provided in accordance with current US
GAAP provisions relating to
arrangements that include the right to use software stored on another entity’s
hardware .
Page 21 of
37
Provision for Doubtful Accounts
– We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability, failure, or refusal of our customers to make
required payments. We evaluate the need for an allowance for doubtful accounts
based on specifically identified amounts that we believe to be potentially
uncollectible. Although we believe that our allowances are adequate, if the
financial conditions of our customers deteriorate, resulting in an impairment of
their ability to make payments, or if we underestimate the allowances required,
additional allowances may be necessary, which will result in increased expense
in the period in which we make such determination.
Impairment of Long-Lived
Assets – We record our long-lived assets, such as property and equipment,
at cost. We review the carrying value of our long-lived assets for possible
impairment at the earlier of annually in the fourth quarter or whenever events
or changes in circumstances indicate that the carrying amount of assets may not
be recoverable as provided for in the current US GAAP relating to the accounting for the impairment or
disposal of long-lived assets . We measure the recoverability of assets
to be held and used by comparing the carrying amount of the asset to future net
undiscounted cash flows expected to be generated by the asset. If we consider
such assets to be impaired, we measure the impairment as the amount by which the
carrying amount exceeds the fair value, and we recognize it as an operating
expense in the period in which the determination is made.
We report
assets to be disposed of at the lower of the carrying amount or fair value less
costs to sell. Although we believe that the carrying values of our long-lived
assets are appropriately stated, changes in strategy or market conditions or
significant technological developments could significantly impact these
judgments and require adjustments to recorded asset balances.
In
addition to the recoverability assessment, we also routinely review the
remaining estimated useful lives of our long-lived assets. Any reduction in the
useful-life assumption will result in increased depreciation and amortization
expense in the period when such determinations are made, as well as in
subsequent periods.
Income Taxes – We are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This involves estimating our current tax liabilities in each
jurisdiction, including the impact, if any, of additional taxes resulting from
tax examinations, as well as making judgments regarding our ability to realize
our deferred tax assets. Such judgments can involve complex issues and may
require an extended period to resolve. In the event we determine that we will
not be able to realize all or part of our net deferred tax assets, we would make
an adjustment in the period we make such determination. We recorded no income
tax expense in the first, second or third quarter of 2009, or in 2008 and 2007,
as we have experienced significant operating losses to date. If utilized, we may
apply the benefit of our total net operating loss carryforwards to reduce future
tax expense. Since our utilization of these deferred tax assets is dependent on
future profits, which are not assured, we have recorded a valuation allowance
equal to the net deferred tax assets. These carryforwards would also be subject
to limitations, as prescribed by applicable tax laws.
As a
result of prior equity financings and the equity issued in conjunction with
certain acquisitions, we have incurred ownership changes, as defined by
applicable tax laws. Accordingly, our use of the acquired net operating loss
carryforwards may be limited. Further, to the extent that any single-year loss
is not utilized to the full amount of the limitation, such unused loss is
carried over to subsequent years until the earlier of its utilization or the
expiration of the relevant carryforward period.
Overview
of Results of Operations for the Three Months Ended September 30, 2009 and
September 30, 2008
Total
revenues were $1,042,508 for the three months ended September 30, 2009 compared
to $1,611,457 for the same period in 2008, representing a decrease of $568,949,
or 35%. Gross profit decreased $590,502, or 49%, to $611,541 from $1,202,043.
Operating expenses increased $572,645 or 21%, to 3,309,069 from $2,736,424. Net
loss increased $1,474,717, or 106%, to $2,867,137 from $1,392,420.
Page 22 of 37
The
following table sets forth our consolidated statements of operations data
expressed as a percentage of revenues for the periods indicated:
|
Three
Months Ended
|
||||||||||||||||
|
September
30,
2009
|
%
of
Revenue
|
September
30,
2008
|
%
of
Revenue
|
|||||||||||||
|
REVENUES
|
||||||||||||||||
|
Subscription
Fees
|
$ | 908,007 | 87.1 | % | $ | 642,880 | 39.9 | % | ||||||||
|
Professional
service fees
|
63,200 | 6.1 | % | 574,970 | 35.7 | % | ||||||||||
|
License
fees
|
11,250 | 1.1 | % | 291,250 | 18.1 | % | ||||||||||
|
Hosting
Fees
|
33,751 | 3.2 | % | 70,856 | 4.4 | % | ||||||||||
|
Other
revenue
|
26,300 | 2.5 | % | 31,501 | 2.0 | % | ||||||||||
|
Total
Revenues
|
1,042,508 | 100.0 | % | 1,611,457 | 100.0 | % | ||||||||||
|
COST
OF REVENUES
|
430,967 | 41.3 | % | 409,414 | 25.4 | % | ||||||||||
|
GROSS
PROFIT
|
611,541 | 58.7 | % | 1,202,043 | 74.6 | % | ||||||||||
|
OPERATING
EXPENSES
|
||||||||||||||||
|
General
and administrative
|
2,355,353 | 225.9 | % | 1,115,398 | 69.2 | % | ||||||||||
|
Sales
and marketing
|
929,617 | 89.2 | % | 733,369 | 45.5 | % | ||||||||||
|
Research
and development
|
36,406 | 3.5 | % | 887,657 | 55.1 | % | ||||||||||
|
(Gain)/
Loss disposal of assets
|
(12,307 | ) | -1.2 | % | - | 0.0 | % | |||||||||
|
Total
operating expenses
|
3,309,069 | 317.4 | % | 2,736,424 | 169.8 | % | ||||||||||
|
Total
other income (expense)
|
||||||||||||||||
|
Interest
Expense (net)
|
(169,609 | ) | -16.3 | % | (150,510 | ) | -9.3 | % | ||||||||
|
Gain
on legal settlements (net)
|
- | 0.0 | % | 291,407 | 18.1 | % | ||||||||||
|
Other
income
|
- | 0.0 | % | 1,064 | 0.1 | % | ||||||||||
|
Total
Other Income (Expense)
|
(169,609 | ) | -16.3 | % | 141,961 | 8.8 | % | |||||||||
|
NET
LOSS
|
$ | (2,867,137 | ) | -275.0 | % | $ | (1,392,420 | ) | -86.4 | % | ||||||
Comparison
of the Results of Operations for the Three Months Ended September 30, 2009 and
September 30, 2008
Revenues. Total revenues for
the three months ended September 30, 2009 were $1,042,508 compared to $1,611,457
for the same period in 2008, representing a decrease of $568,949, or 35%. This
overall decrease in revenues was primarily attributable to decreases in
professional service fees and license fees, offset in part by an increase in
subscription fees.
Subscription Fees -
Subscription fees for the three months ended September 30, 2009 were $908,007
compared to $642,880 for the same period in 2008, representing an increase of
$265,127, or 41%. This increase is primarily due to an increase in active
subscribers to whom we provide e-commerce, domain name, email services, and
related event ticket sale services for use as members of one of our primary
customers, a direct-selling organization.
Professional Service Fees -
Professional service fees for the three months ended September 30, 2009 were
$63,200 compared to $574,970 for the same period in 2008, representing a
decrease of $511,770, or 89%. This decrease is primarily due to the loss a major
customer to whom we provided professional services.
License Fees - License fees
for the three months ended September 30, 2009 were $11,250 compared to $291,250
for the same period in 2008, representing a decrease of $280,000, or 96%. This
decrease is primarily due to the fact that there were no new licenses provided
during the third quarter of 2009.
Other Revenue - Other revenue
for the three months ended September 30, 2009 totaled $26,300 compared to
$31,501 for the same period in 2008. This revenue is generated from non-core
activities. We expect these revenue streams to continue to be insignificant in
the future as we continue our strategy of focusing on the growth of our
subscription and license revenues.
Cost
of Revenues
Cost of
revenues for the three months ended September 30, 2009 was $430,967 compared to
$409,414 for the same period in 2008, representing an increase of $21,553, or
5%. This increase is primarily due to more domain name registrations, credit
card processing fees, and business card printing for members of our
direct-selling organization customers.
Page 23 of 37
Operating
Expenses
Operating
expenses for the three months ended September 30, 2009 were $3,309,069 compared
to $2,736,424 for the same period in 2008, representing an increase of 572,645,
or 21%. This increase was primarily attributable to the write-off of
approximately $1.8 million related to the reserve for uncollectable amounts due
from the advancement of legal fees for the defense in criminal proceedings
against Dennis Michael Nouri and Reza Eric Nouri, a former officer and employee
of the Company. The expense is offset by a significant reduction in
the amount of research and development expense as well as the reduction of
administrative salaries and other operating expenses.
General and Administrative -
General and administrative expenses for the three months ended September 30,
2009 were $2,355,353 compared to $1,115,398 for the same period in 2008,
representing an increase of $1,239,955, or 111%. The increase was primarily
attributable to the establishment of a $1,804,763 bad-debt reserve for the
estimated uncollectable amounts due from the advancement of legal fees for the
defense in criminal proceedings against Dennis Michael Nouri and Reza Eric
Nouri, a former officer and employee of the Company. The amount of bad debt
expense for the prior period was $221,875. The increase is offset by
a decrease in administrative salaries of $116,000, a decrease in the amount of
amortization expense of $75,000, and reduction of other administrative
expenses.
Sales and Marketing - Sales
and marketing expenses for the three months ended September 30, 2009 were
$929,617 compared to $733,369 for the same period in 2008, representing an
increase of $196,248, or 27%. This increase is primarily attributable to the
increase in revenue sharing expense of $405,300 with one of our primary
customers, a direct-selling organization. The total increase is
offset by a reduction in wages of $110,000 and other expenses of
$99,000.
Research and Development -
Research and development expenses for the three months ended September 30, 2009
were $36,406 compared to $887,657 for the same period in 2008, representing a
decrease of $851,251, or 96%. This decrease is primarily due to the fact that a
new version of the OneBiz product was released in July of 2009 and the ongoing
development expenses are now classified as part of the cost of
operations.
Other
Income (Expense)
We
incurred net interest expense of $169,609 for the three months ended September
30, 2009 compared to net interest expense of $150,510 for the same period in
2008, representing an increase of $19,099, or 13%. During the three months ended
September 30, 2009, we carried a higher balance on our line of credit with
Paragon Commercial Bank and borrowed additional funds from the bond
noteholders.
Overview
of Results of Operations for the Nine Months Ended September 30, 2009 and
September 30, 2008
Total
revenues were $2,585,161 for the nine months ended September 30, 2009 compared
to $4,814,250 for the same period in 2008, representing a decrease of
$2,229,089, or 46%. Gross profit decreased $1,586,381, or 52%, to $1,459,260
from $3,045,641. Operating expenses decreased $249,966, or 3%, to $7,205,135
from $7,455,101. Net loss increased $1,670,463, or 37%, to $6,195,826from
$4,525,363.
The
following table sets forth our consolidated statements of operations data
expressed as a percentage of revenues for the periods indicated:
|
Nine
Months Ended
|
||||||||||||||||
|
September
30,
2009
|
%
of
Revenue
|
September
30,
2008
|
%
of
Revenue
|
|||||||||||||
|
REVENUES
|
||||||||||||||||
|
Subscription
Fees
|
$ | 2,049,930 | 79.3 | % | $ | 2,132,787 | 44.3 | % | ||||||||
|
Professional
service fees
|
261,699 | 10.1 | % | 2,011,497 | 41.8 | % | ||||||||||
|
License
fees
|
33,750 | 1.3 | % | 395,000 | 8.2 | % | ||||||||||
|
Hosting
Fees
|
139,005 | 5.4 | % | 166,534 | 3.5 | % | ||||||||||
|
Other
revenue
|
100,777 | 3.9 | % | 108,432 | 2.3 | % | ||||||||||
|
Total
Revenues
|
2,585,161 | 100.0 | % | 4,814,250 | 100.0 | % | ||||||||||
|
COST
OF REVENUES
|
1,125,901 | 43.6 | % | 1,768,609 | 36.7 | % | ||||||||||
|
GROSS
PROFIT
|
1,459,260 | 56.4 | % | 3,045,641 | 63.3 | % | ||||||||||
|
OPERATING
EXPENSES
|
||||||||||||||||
|
General
and administrative
|
4,112,993 | 159.1 | % | 3,456,054 | 71.8 | % | ||||||||||
|
Sales
and marketing
|
2,136,256 | 82.6 | % | 2,200,857 | 45.7 | % | ||||||||||
|
Research
and development
|
540,232 | 20.9 | % | 1,798,190 | 37.4 | % | ||||||||||
|
(Gain)/
Loss disposal of assets
|
415,654 | 16.1 | % | - | 0.0 | % | ||||||||||
|
Total
operating expenses
|
7,205,135 | 278.7 | % | 7,455,101 | 154.9 | % | ||||||||||
|
Total
other income (expense)
|
||||||||||||||||
|
Interest
Expense (net)
|
(455,951 | ) | -17.6 | % | (519,746 | ) | -10.8 | % | ||||||||
|
Gain
on legal settlements (net)
|
6,000 | 0.2 | % | 386,710 | 8.0 | % | ||||||||||
|
Other
income
|
17,133 | 0.4 | % | |||||||||||||
|
Total
Other Income (Expense)
|
(449,951 | ) | -17.4 | % | (115,903 | ) | -2.4 | % | ||||||||
|
NET
LOSS
|
$ | (6,195,826 | ) | -239.7 | % | $ | (4,525,363 | ) | -94.0 | % | ||||||
Page 24 of
37
Comparison
of the Results of Operations for the Nine Months Ended September 30, 2009 and
September 30, 2008
Revenues. Total revenues for
the nine months ended September 30, 2009 were $2,585,161 compared to $4,814,250
for the same period in 2008, representing a decrease of $2,229,089, or 46%. This
overall decrease in revenues was primarily attributable to an increase in
professional service fees.
Subscription Fees –
Subscription fees for the nine months ended September 30, 2009 were $2,049,930
compared to $2,132,787 for the same period in 2008, representing a decrease of
$82,857, or 4%. This decrease was due to a reduction in membership revenue from
a multi-level marketing organization that terminated its relationship with our
Company in June 2009.
Professional Service Fees -
Professional service fees for the nine months ended September 30, 2009 were
$261,699 compared to $2,011,497 for the same period in 2008, representing a
decrease of $1,749,798, or 87%. This decrease was due to the loss of a major
customer as reported in the report for the quarter ending June 30,
2009.
License Fees - License fees
for the nine months ended September 30, 2009 were $33,750 compared to $395,000
for the same period in 2008, representing a decrease of $361,250, or 91%. The
license revenue for the first nine months of 2008 was primarily related to a
single license agreement signed during 2007 under which $100,000 of the fee was
collected during the first quarter of 2008, but for which the revenue was
deferred at December 31, 2007 in accordance with the provisions of current US
GAAP; the ratable recognition of $30,000 of a term license that commenced in
June 2008; and the recognition of $280,000 in September 2008 relating to a
perpetual license. The license revenue for the first nine months of 2009 relates
to a single perpetual license agreement.
Hosting Fees – Hosting fees
for the nine months ended September 30, 2009 were $139,005 as compared to $
166,534 for the same period in 2008, representing a decrease of $27,529 or
17%. The decrease relates to the reduction in hosting services
required by the customer that no longer uses our Company’s services as described
in Professional Service fees above.
Other Revenue - Other revenue
for the nine months ended September 30, 2009 totaled $100,777 compared to
$108,432 for the same period in 2008. This revenue is generated from non-core
activities. We expect these revenue streams to continue to be insignificant in
the future as we continue our strategy of focusing on the growth of our
subscription and license revenues.
Cost
of Revenues
Cost of
revenues for the nine months ended September 30, 2009 was $1,125,901 compared to
$1,768,609 for the same period in 2008, representing a decrease of $642,708, or
36%. This decrease was primarily the result of the decrease of development
personnel previously involved with the development and servicing of the major
customer that left the Company during 2009
Operating
Expenses
Operating
expenses for the nine months ended September 30, 2009 were $7,205,135 compared
to $7,455,101 for the same period in 2008, representing a decrease of $249,966,
or 3%. This decrease was primarily attributable to a decrease in research and
development expenses because the OneBiz product was released in July
2009.
Page 25 of 37
General and Administrative -
General and administrative expenses for the nine months ended September 30, 2009
were $4,112,993 compared to $3,456,054 for the same period in 2008, representing
an increase of $656,939, or 19%. The increase was primarily attributable to the
establishment of $1,804,763 bad-debt reserve for the estimated uncollectable
amounts due from the advancement of legal fees for the defense in criminal
proceedings against Dennis Michael Nouri and Reza Eric Nouri, a former officer
and employee of the Company. The increase is offset by a decrease in
administrative salaries of $852,000, a decrease in the amount of amortization
expense of $181,000, a decrease in rent of $114,000 and reduction of other
administrative expenses.
Sales and Marketing - Sales
and marketing expenses for the nine months ended September 30, 2009 were
$2,136,256 compared to $2,200,857 for the same period in 2008, representing a
decrease of $64,601, or 3%. The decrease is primarily attributable to $244,000
decrease in payroll and benefit expense, decrease of $51,000 in travel related
expense, decrease of $49,000 in recruiting, advertising and lead
generation costs, decrease in computer and office expenses of
$52,000, offset by an increase in revenue sharing costs with
customers of $331,400.
Research and Development -
Research and development expenses for the nine months ended September 30, 2009
were $540,232 compared to $1,798,190 for the same period in 2008, representing a
decrease of $1,257,958, or 70%. This decrease is primarily due to the reduction
of ongoing development expense associated with the OneBiz product that was
released in July 2009. The continuing maintenance and upgrade expense
is now treated as part of the Cost of Revenues.
Impairment of Assets and
Gain (loss) in Disposal of Assets – During the nine month period ending
September 30, 2009 the Company recognized a loss from the reduction of the value
of an intangible asset in the amount of $438,228, the amount is offset by the
gain from the sale of fixed assets during 2009. The net
result of the transactions is $415,654.
Other
Income (Expense)
We
incurred net interest expense of $455,951 for the nine months ended September
30, 2009 compared to net interest expense of $519,746 for the same period in
2008, representing a decrease of $63,795, or 12%. Interest expense totaled
$494,582 and $562,430 and interest income totaled $38,631 and $42,684 during the
first nine months of 2008 and 2007, respectively. Interest expense decreased as
a result of the use of cash flow during the nine month period to reduce the
outstanding balance on the line of credit whenever possible.
During
the first nine months of 2009, we recognized $6,000 in other income from a gain
due to legal settlements, as compared to net gain of $386,710 for the
gain on legal settlements with our insurance carrier as described in Note 4,
“Commitments and Contingencies,” to the consolidated financial statements in
this report.
Provision
for Income Taxes
We have
not recorded a provision for income tax expense because we have been generating
net losses. Furthermore, we have not recorded an income tax benefit for the
third quarter of 2009 primarily due to continued substantial uncertainty based
on objective evidence regarding our ability to realize our deferred tax assets,
thereby warranting a full valuation allowance in our financial statements. We
have approximately $52,000,000 in net operating loss carryforwards, which may be
utilized to offset future taxable income.
Liquidity
and Capital Resources
At
September 30, 2009, our principal sources of liquidity were cash and cash
equivalents totaling $18,749 and current accounts receivable of $10,510. As of
November 6, 2009, our principal sources of liquidity were cash and cash
equivalents totaling approximately $69,000 and accounts receivable of
approximately $19,262. As of September 30, 2009, we had drawn
approximately $2.4 million on our $2.47 million line of credit with Paragon,
leaving approximately $70,000 available under the line of credit for our
operations. As of November 10, 2009, we had drawn approximately $2.05 million on
the Paragon line of credit, leaving approximately $420,000 available under the
line of credit for our operations, and we expect to continue to draw down on
this line of credit as needed for working capital purposes. During the third
quarter of 2008, management established automated sweeps among its accounts at
Paragon whereby all available cash at the end of each day is used to pay down
the line of credit with Paragon, the purpose of which is to reduce our interest
expense. This line of credit expires in February 2010 but is renewable if the
underlying irrevocable standby letter of credit remains in force. This letter of
credit is currently scheduled to expire in February 2010. As of November 12
2009, we also have the ability to call up to approximately $6.25 million of
additional funding from our convertible noteholders. On each of
October 5, 2009 and October 9, 2009 the Company sold a note in the principal
amount of $250,000 (total $500,000) to a current noteholder with substantially
the same terms and conditions as the previously outstanding notes. On
November 6, 2009 the Company sold a note in the principal amount of $500,000 to
a current noteholder with substantially the same terms and
conditions.
Page 26 of 37
During
the quarter ended September 30, 2009, our working capital deficit increased by
approximately $1,979,000 to approximately $5,227,000 compared to a working
capital deficit of $2,989,000 at December 31, 2008. As described more fully
below, the working capital deficit at September 30, 2009 is primarily
attributable to negative cash flows from operations, including a $213,010
decrease in accounts receivable, a $3,228,038 increase in notes
receivable, and a $126,004 decrease in prepaid expenses during the first
nine months of 2009.
Cash Flow from Operations.
Cash used in operations for the nine months ended September 30, 2009 totaled
$2,703,117, down from $3,979,958 for the same period in 2008. This decrease is
primarily due to the increase in accounts payable and accrued expenses offset by
the net increase in notes receivable and the related bad debt
expense.
Cash Flow from
Investing Activities. Cash
used in investing activities for the nine months ended September 30, 2009
totaled $176,038, down from $400,238 for the same period in 2008. This decrease
is primarily due to the fact that the Company acquired less computer equipment
and capitalized less software development in the first nine months of 2009
compared to the same period in 2008.
Cash Flow from Financing
Activities. Cash provided by financing activities for the nine months
ended September 30, 2009 totaled $2,879,302, up from $937,032 for the same
period in 2008. This increase is primarily due to cash raised in 2009 from debt
borrowings to help fund operations.
Debt Financing. On February
20, 2008, the Company entered into a revolving credit arrangement with Paragon
that is subject to annual renewal subject to mutual approval. The line of credit
advanced by Paragon is $2.47 million and can be used for general working
capital. Any advances made on the line of credit must be paid off no later than
February 19, 2010, subject to extension due to renewal, with monthly payments
being applied first to accrued interest and then to principal. The interest
shall accrue on the unpaid principal balance at the Wall Street Journal’s
published prime rate, but at no time shall the interest rate be less than 5.5%.
As of September 30, 2009, the line of credit was secured by an irrevocable
standby letter of credit in the amount of $2.5 million issued by HSBC with Atlas
as account party, expiring February 18, 2010. The Company also has agreed with
Atlas that in the event of our default in the repayment of the line of credit
that results in the letter of credit being drawn, the Company will reimburse
Atlas any sums that Atlas is required to pay under such letter of credit. At the
Company’s discretion, these payments may be made in cash or by issuing shares of
our common stock at a set per-share price of $2.50.
This line
of credit replaces our line of credit with Wachovia. As an incentive for the
letter of credit from Atlas to secure the Wachovia line of credit, the Company
entered into a stock purchase warrant and agreement with Atlas. Under the terms
of the agreement, Atlas received a warrant to purchase up to 444,444 shares of
our common stock at $2.70 per share within 30 business days of the termination
of the Wachovia line of credit or if the Company is in default under the terms
of the line of credit with Wachovia. In consideration for Atlas providing the
Paragon letter of credit, the Company agreed to amend the agreement to provide
that the warrant is exercisable within 30 business days of the termination of
the Paragon line of credit or if the Company is in default under the terms of
the line of credit with Paragon.
As of
September 30, 2009, the Company had $7.85 million aggregate principal amount of
convertible secured subordinated notes due November 14, 2010
outstanding. On November 14, 2007, in an initial closing, the Company
sold $3.3 million aggregate principal amount of secured subordinated convertible
notes due November 14, 2010, or the initial notes. In addition, the noteholders
committed to purchase on a pro rata basis up to $5.2 million aggregate principal
of secured subordinated notes in future closings upon approval and call by our
Board of Directors. On August 12, 2008, the Company exercised its option to sell
$1.5 million aggregate principal of additional secured subordinated notes due
November 14, 2010, or the additional notes, and together with the initial notes,
the notes, with substantially the same terms and conditions as the initial
notes. In connection with the sale of the additional notes, the noteholders
holding a majority of the aggregate principal amount of the notes outstanding
agreed to increase the aggregate principal amount of secured subordinated
convertible notes that they are committed to purchase from $8.5 million to $15.3
million. On November 21, 2008, the Company sold $500,000 aggregate
principal amount of notes, or the new notes, to two new investors with
substantially the same terms and conditions as the previously outstanding notes.
On each of January 6, 2009 and February 24, 2009, the Company sold $500,000
aggregate principal amount of notes to a current noteholder with substantially
the same terms and conditions as the previously outstanding
notes. Additional notes with similar terms of $500,000 each were sold
on April 3, 2009 and June 2, 2009. On each of July 16, 2009, August
26, 2009, September 8, 2009, October 5, 2009 and October 9, 2009 the Company
sold $250,000 aggregate principal amount of notes to current noteholders with
substantially the same terms and conditions as the previously outstanding
notes. On November 6, 2009 the Company sold $500,000 aggregate
principal amount of notes to a current noteholder with substantially the same
terms and conditions as the previously outstanding notes.
Also on
February 24, 2009, the noteholders holding a majority of the aggregate principal
amount of the notes outstanding agreed that we may sell up to $6 million
aggregate principal amount of notes to new investors or existing noteholders at
any time on or before December 31, 2009 with a maturity date of November 14,
2010 or later. In addition, the maturity date definition for each of the notes
was changed from November 14, 2010 to the date upon which the note is due and
payable, which is the earlier of (1) November 14, 2010, (2) a change of control,
or (3) if an event of default occurs, the date upon which noteholders accelerate
the indebtedness evidenced by the notes.
Page 27 of
37
The
formula for calculating the conversion price of the notes was also amended such
that the conversion price of each outstanding note and any additional note sold
in the future would be the same and set at the lowest “applicable conversion
price,” as described below.
The
Company is obligated to pay interest on the initial notes and the additional
notes at an annualized rate of 8% payable in quarterly installments commencing
three months after the purchase date of the notes. The Company is not permitted
to prepay the notes without approval of the holders of at least a majority of
the principal amount of the notes then outstanding.
On the
earlier of the maturity date of November 14, 2010 or a merger or acquisition or
other transaction pursuant to which our existing stockholders hold less than 50%
of the surviving entity, or the sale of all or substantially all of our assets,
or similar transaction, or event of default, each noteholder in its sole
discretion shall have the option to:
|
·
|
convert
the principal then outstanding on its notes into shares of our common
stock, or
|
|
·
|
receive
immediate repayment in cash of the notes, including any accrued and unpaid
interest.
|
If a
noteholder elects to convert its notes under these circumstances, the conversion
price will be the lowest “applicable conversion price” determined for each note.
The “applicable conversion price” for each note shall be calculated by
multiplying 120% by the lowest of:
|
·
|
the
average of the high and low prices of our common stock on the OTC Bulletin
Board averaged over the five trading days prior to the closing date of the
issuance of such note,
|
|
·
|
if
our common stock is not traded on the Over-The-Counter market, the closing
price of the common stock reported on the Nasdaq National Market or the
principal exchange on which the common stock is listed, averaged over the
five trading days prior to the closing date of the issuance of such note,
or
|
|
·
|
the
closing price of our common stock on the OTC Bulletin Board, the Nasdaq
National Market or the principal exchange on which the common stock is
listed, as applicable, on the trading day immediately preceding the date
such note is converted,
|
in each
case as adjusted for stock splits, dividends or combinations, recapitalizations
or similar events.
Payment
of the notes will be automatically accelerated if we enter voluntary or
involuntary bankruptcy or insolvency proceedings.
The notes
and the common stock into which they may be converted have not been registered
under the Securities Act or the securities laws of any other jurisdiction. As a
result, offers and sales of the notes were made pursuant to Regulation D of the
Securities Act and only made to accredited investors that were our existing
stockholders. The investors in the initial notes include (i) The Blueline Fund,
or Blueline, which originally recommended Philippe Pouponnot, one of our former
directors, for appointment to the Board of Directors; (ii) Atlas, an affiliate
that originally recommended Shlomo Elia, one of our current directors, for
appointment to the Board of Directors; (iii) Crystal Management Ltd., which is
owned by Doron Roethler, who subsequently became Chairman of our Board of
Directors and serves as the noteholders’ bond representative; and (iv) William
Furr, who is the father of Thomas Furr, who, at the time, was one of our
directors and executive officers. The investors in the additional notes are
Atlas and Crystal Management Ltd.
In
addition, if we propose to file a registration statement to register any of its
common stock under the Securities Act in connection with the public offering of
such securities solely for cash, subject to certain limitations, we must give
each noteholder who has converted its notes into common stock the opportunity to
include such shares of converted common stock in the registration. We have
agreed to bear the expenses for any of these registrations, exclusive of any
stock transfer taxes, underwriting discounts, and commissions.
On
November 6, 2007, Canaccord Adams Inc. agreed to waive any rights it held under
its January 2007 engagement letter with us that it may have with respect to the
convertible note offering, including the right to receive any fees in connection
with the offering.
We have
not yet achieved positive cash flows from operations, and our main sources of
funds for our operations are the sale of securities in private placements, the
sale of additional convertible notes, and bank lines of credit. We must continue
to rely on these sources until we are able to generate sufficient revenue to
fund our operations. We believe that anticipated cash flows from operations,
funds available from our existing line of credit, and additional issuances of
notes, together with cash on hand, and the anticipated extension of the due date
for the existing notes will provide sufficient funds to finance our operations
at least for the next 12 to 18 months, depending on our ability to achieve
strategic goals outlined in our annual operating budget approved by our Board of
Directors. Changes in our operating plans, lower than anticipated sales,
increased expenses, or other events may cause us to seek additional equity or
debt financing in future periods. There can be no guarantee that financing will
be available on acceptable terms or at all. Additional equity financing could be
dilutive to the holders of our common stock, and additional debt financing, if
available, could impose greater cash payment obligations and more covenants and
operating restrictions.
Page 28 of
37
Recent
Developments
On each
of October 2, 2009 and October 5, 2009 the Company sold $250,000 aggregate
principal amount of notes to a current noteholder with substantially the same
terms and conditions as the previously outstanding notes. On November
6, 2009 the Company sold $500,000 aggregate principal amount of notes to a
current noteholder with substantially the same terms and conditions as the
previously outstanding notes, as described in Note 3, “Notes
Payable.”
As
previously reported in the Company’s Form 8-K filed on June 4, 2009, Dennis
Michael Nouri and Reza Eric Nouri (together, the “Nouris”), a former officer and
employee of the Company, respectively, filed a complaint (the “Nouri Complaint”)
to bring a summary proceeding against the Company in the Court of Chancery of
the State of Delaware. The Nouri Complaint sought to compel the
Company to advance legal fees and costs in the amount of $826,798 incurred by
the Nouris in their defense of criminal proceedings brought against them by the
United States, and in their defense of civil proceedings brought against them by
the Securities and Exchange Commission and the Company’s stockholders, together
with future verified expenses that will be incurred by the Nouris in defending
the actions against them and the expenses incurred by the Nouris in prosecuting
the advancement action against the Company.
On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris. By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009. The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $2.4 million. Though the
Nouris have entered into an undertaking that requires them to repay to the
Company any amounts advanced by it in the event the Nouris are ultimately
determined not to be entitled to indemnification for the expenses incurred, it
is uncertain at this time that the Company will be able to recover such amounts
advanced without considerable expense to the Company, or whether the Company
will be able to recover any of the amounts advanced at all.
The
Company’s corporate headquarters and research and development facility is
located in Durham, North Carolina near Research Triangle Park and consists of
approximately 9,837 square feet of office space held under a prepaid sublease
with an expiration date of September 2011. On November 3, 2009, the Company
received notice from the prime landlord of the office space that the Company’s
sub-landlord had defaulted on the prime lease, thereby giving the
prime landlord the right to terminate the Company’s sublease, and that the prime
landlord was seeking to renegotiate the occupancy terms for the Company’s office
space. The Company is currently engaged in discussions with the prime landlord
to lease the office space from the prime landlord on a prime lease
basis.
Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 for a further description of material legal
proceedings.
Item 3. Quantitative and
Qualitative Disclosures About Market Risk
Not
applicable.
Item 4. Controls and
Procedures
Not
applicable.
Item 4T. Controls and
Procedures
Our
management, with the participation of our Interim Chief Executive
Officer, has evaluated the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this Quarterly Report on Form
10-Q. The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that information
required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the SEC’s rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company’s management, including its principal executive and principal
financial officers, as appropriate to allow timely decisions regarding required
disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, as ours are designed to do, and
management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based on such evaluation, our
Interim Chief Executive Officer and Interim Chief Financial Officer concluded
that, as of the end of the period covered by this Quarterly Report on Form 10-Q,
our disclosure controls and procedures were effective at the reasonable
assurance level.
Page 29 of 37
We
routinely review our internal control over financial reporting and from time to
time make changes intended to enhance the effectiveness of our internal control
over financial reporting. We will continue to evaluate the effectiveness of our
disclosure controls and procedures and internal control over financial reporting
on an ongoing basis and will take action as appropriate. There have been no
changes to our internal control over financial reporting, as such term is
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the
three months ended September 30, 2009 that we believe materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.
PART
II – OTHER INFORMATION
Item 1. Legal
Proceedings
Please
refer to Part I, Item 3 of our Annual Report on Form 10-K for the fiscal
year ended December 31, 2008 and Part II, Item 1 of our Quarterly Reports on
Form 10-Q for the quarterly periods ended March 31, 2009 and June 30, 2009 for a
description of material legal proceedings, including the proceedings discussed
below.
As
previously reported in the Company’s Form 8-K filed on June 4, 2009, Dennis
Michael Nouri and Reza Eric Nouri (together, the “Nouris”), a former officer and
employee of the Company, respectively, filed a complaint (the “Nouri Complaint”)
to bring a summary proceeding against the Company in the Court of Chancery of
the State of Delaware. The Nouri Complaint sought to compel the
Company to advance legal fees and costs in the amount of $826,798 incurred by
the Nouris in their defense of criminal proceedings brought against them by the
United States, and in their defense of civil proceedings brought against them by
the Securities and Exchange Commission and the Company’s stockholders, together
with future verified expenses that will be incurred by the Nouris in defending
the actions against them and the expenses incurred by the Nouris in prosecuting
the advancement action against the Company.
On July
29, 2009, the Court of Chancery granted summary judgment of the Nouri Complaint
in favor of the Nouris. By order dated August 6, 2009, the Company is
obligated to pay to the Nouris $826,798 in advanced expenses for legal services
performed by counsel to the Nouris through April 2009. The
total amount of the legal fees the Company will ultimately be required to
advance to the Nouris is expected to be in excess of $2.4 million, which amount
has been included in the accounts payable of the Company as of September 30,
2009. A current note receivable is recorded for the same amount due
from the individuals. Though the Nouris have entered into an undertaking that
requires them to repay to the Company any amounts advanced by it in the event
the Nouris are ultimately determined not to be entitled to indemnification for
the expenses incurred, it is uncertain at this time that the Company will be
able to recover such amounts advanced without considerable expense to the
Company, or whether the Company will be able to recover any of the amounts
advanced at all.
On
October 18, 2007, Robyn L. Gooden filed a purported class action lawsuit in the
United States District Court for the Middle District of North Carolina naming
us, certain of our current and former officers and directors, Maxim Group, LLC,
and Jesup & Lamont Securities Corp. as defendants. The lawsuit was filed on
behalf of all persons other than the defendants who purchased our securities
from May 2, 2005 through September 28, 2007 and were damaged. The complaint
asserts violations of federal securities laws, including violations of
Section 10(b) of the Exchange Act and Rule 10b-5. The complaint asserts
that the defendants made material and misleading statements with the intent to
mislead the investing public and conspired in a fraudulent scheme to manipulate
trading in the our stock, allegedly causing plaintiffs to purchase the stock at
an inflated price. The complaint requests certification of the plaintiff as
class representative and seeks, among other relief, unspecified compensatory
damages including interest, plus reasonable costs and expenses including counsel
fees and expert fees. On June 24, 2008, the court entered an order appointing a
lead plaintiff for the class action. On September 8, 2008, the plaintiff filed
an amended complaint which added additional defendants who had served as our
directors or officers during the class period as well as our independent
auditor.
At this
time, we are not able to determine the likely outcome of our currently pending
legal matters, nor can we estimate our potential financial exposure. If an
unfavorable resolution of any of these matters occurs, our business, results of
operations, and financial condition could be materially adversely
affected.
Page 30 of 37
Item 1A. Risk
Factors
We
operate in a dynamic and rapidly changing business environment that involves
substantial risk and uncertainty, and these risks may change over time. The
following discussion addresses some of the risks and uncertainties that could
cause, or contribute to causing, actual results to differ materially from
expectations. In evaluating our business, you should pay particular attention to
the descriptions of risks and uncertainties described below and in other
sections of this document and our other filings. These risks and uncertainties
are not the only ones we face. Additional risks and uncertainties not presently
known to us, which we currently deem immaterial, or that are similar to those
faced by other companies in our industry or business in general may also affect
our business. If any of the risks described below actually occurs, our business,
financial condition, or results of operations could be materially and adversely
affected.
Historically, we have operated at a
loss, and we continue to do so.
We have
had recurring losses from operations and continue to have negative cash flows.
If we do not become cash flow positive through additional financing or growth,
we may have to cease operations and liquidate our business. Our working capital,
including our revolving line of credit with Paragon and convertible note
financing, and the anticipated extension of the due date for the existing notes
should fund our operations for the next 12 to 18 months. As of November 10,
2009, we have approximately $420,000 available on our line of credit and $6.25
million available through our convertible note financing. Factors such as the
commercial success of our existing services and products, the timing and success
of any new services and products, the progress of our research and development
efforts, our results of operations, the status of competitive services and
products, the timing and success of potential strategic alliances or potential
opportunities to acquire technologies or assets, the charges filed against a
former officer and a former employee by the SEC and the United States Attorney
General, and the pending shareholder class action lawsuit may require us to seek
additional funding sooner than we expect. If we fail to raise sufficient
financing, we will not be able to implement our business plan and may not be
able to sustain our business.
In
addition, our current primary credit facilities consisting of the Paragon line
of credit and the convertible note financing both have maturity dates in
February and November 2010. Should we be unable to repay the principal then due
or extend maturity dates or obtain capital from new or renegotiated capital
funding sources, we will be unable to sustain our business. As of November 10,
2009, we have approximately $2.05 million outstanding on our line of credit and
$8.5 million aggregate principal amount of convertible notes
outstanding.
Our
independent registered public accountants for fiscal 2008 indicated that they
have substantial doubts that we can continue as a going concern. Their opinion
may negatively affect our ability to raise additional funds, among other things.
If we fail to raise sufficient capital, we will not be able to implement our
business plan, we may have to liquidate our business, and you may lose your
investment.
Sherb
& Co., LLP, our independent registered public accountants for fiscal 2008,
has expressed substantial doubt in their report included with our Annual Report
on Form 10-K for the year ended December 31, 2008 about our ability to continue
as a going concern given our recurring losses from operations and deficiencies
in working capital and equity, which are described in the first risk factor
above. This opinion could materially limit our ability to raise additional funds
by issuing new debt or equity securities or otherwise. If we fail to raise
sufficient capital, we will not be able to implement our business plan, we may
have to liquidate our business, and you may lose your entire investment. You
should consider our independent registered public accountants’ comments when
determining if an investment in us is suitable.
If we are unable to renegotiate an
extension of the due date for the outstanding bond debt, obtain conversion of
the debt to preferred stock or identify alternate financing sources,
the Company will be forced to liquidate our
business.
As of
November 12, 2009, the Company has $8,950,000 of outstand debt due the
bondholders. The current terms of the bonds indicate a due date of
November 14, 2010. If the Company is unable to repay the amount of
the principal on the due date or unable to renegotiate an extension of the due
date for the outstanding bond debt, obtain conversion of the debt to preferred
stock or identify alternate financing sources, the Company may be forced to
liquidate our business.
Current economic uncertainties in the
global economy could adversely impact our growth, results of operations, and our
ability to forecast future business.
Since
2008, there has been a downturn in the global economy, slower economic activity,
decreased consumer confidence, reduced corporate profits and capital spending,
adverse business conditions, and liquidity concerns. These conditions make it
difficult for our customers and us to accurately forecast and plan future
business activities, and they could cause our customers to slow or defer
spending on our products and services, which would delay and lengthen sales
cycles, or change their willingness to enter into longer-term licensing and
support arrangements with us. Furthermore, during challenging economic times our
customers may face issues gaining timely access to sufficient credit, which
could result in an impairment of their ability to make timely payments to us. If
that were to occur, we may be required to increase our allowance for doubtful
accounts and our results would be negatively impacted.
Page 31 of 37
We cannot
predict the timing, strength, or duration of any economic slowdown or subsequent
economic recovery. If the downturn in the general economy or markets in which we
operate persists or worsens from present levels, our business, financial
condition, and results of operations could be materially and adversely
affected.
Our
business is dependent upon the development and market acceptance of our
applications.
Our
future financial performance and revenue growth will depend, in part, upon the
successful development, integration, introduction, and customer acceptance of
our software applications. Thereafter, other new products either developed or
acquired, and enhanced versions of our existing applications will be critically
important to our business. Our business could be harmed if we fail to deliver
timely enhancements to our current and future solutions that our customers
desire. We also must continually modify and enhance our services and products to
keep pace with market demands regarding hardware and software platforms,
database technology, information security, and electronic commerce technical
standards. Our business could be harmed if we fail to achieve the improved
performance that customers want with respect to our current and future product
offerings. There can be no assurance that our products will achieve widespread
market penetration or that we will derive significant revenues from the sale or
licensing of our platforms or applications.
We
have not yet demonstrated that we have a successful business model.
We have
invested significantly in infrastructure, operations, and strategic
relationships to support our SaaS delivery model, which represents a significant
departure from the delivery strategies that other software vendors and we have
traditionally employed. To maintain positive margins for our small business
services, our revenues will need to continue to grow more rapidly than the cost
of such revenues. We anticipate that our future financial performance and
revenue growth will depend, in large part, upon our Internet-based SaaS business
model and the results of our sales efforts to reach agreements with syndication
partners with small business customer bases, but this business model may become
ineffective due to forces beyond our control that we do not currently
anticipate. Although we currently have various agreements and continue to enter
into new agreements, our success depends in part on the ultimate success of our
syndication
partners and referral partners and their ability to market our products and
services successfully. Our partners are not obligated to provide potential
customers to us and may have difficulty retaining customers within certain
markets that we serve. In addition, some of these third parties have entered,
and may continue to enter, into strategic relationships with our competitors.
Further, many of our strategic partners have multiple strategic relationships,
and they may not regard us as significant for their businesses. Our strategic
partners may terminate their respective relationships with us, pursue other
partnerships or relationships, or attempt to develop or acquire products or
services that compete with our products or services. Our strategic partners also
may interfere with our ability to enter into other desirable strategic
relationships. If we are unable to maintain our existing strategic relationships
or enter into additional strategic relationships, we will have to devote
substantially more resources to the distribution, sales, and marketing of our
products and services.
In
addition, our end users currently do not sign long-term contracts. They have no
obligation to renew their subscriptions for our services after the expiration of
their initial subscription period and, in fact, they have often elected not to
do so. Our end users also may renew for a lower-priced edition of our services
or for fewer users. These factors make it difficult to accurately predict
customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
a result of a number of factors, including when we begin charging for our
services, their dissatisfaction with our services, and their capability to
continue their operations and spending levels. If our customers do not renew
their subscriptions for our services or we are not able to increase the number
of subscribers, our revenue may decline and our business will
suffer.
Failure
to comply with the provisions of our debt financing arrangements could have a
material adverse effect on us.
Our
revolving line of credit from Paragon is secured by an irrevocable standby
letter of credit issued by HSBC with Atlas as account party. Our convertible
secured subordinated notes are secured by a first priority lien on all of our
unencumbered assets.
If an
event of default occurs under our debt financing arrangements and remains
uncured, then the lender could foreclose on the assets securing the debt. If
that were to occur, it would have a substantial adverse effect on our business.
In addition, making the principal and interest payments on these debt
arrangements may drain our financial resources or cause other material harm to
our business.
If
our security measures are breached and unauthorized access is obtained to our
customers’ data or our data, our service may be perceived as not being secure,
customers may curtail or stop using our service, and we may incur significant
legal and financial exposure and liabilities.
Our
service involves the storage and transmission of customers’ proprietary
information. If our security measures are breached as a result of third-party
action, employee error, malfeasance or otherwise and, as a result, unauthorized
access is obtained to our customers’ data or our data, our reputation could be
damaged, our business may suffer, and we could incur significant liability. In
addition, third parties may attempt fraudulently to induce employees or
customers to disclose sensitive information such as user names, passwords, or
other information in order to gain access to our customers’ data or our data,
which could result in significant legal and financial exposure and a loss of
confidence in the security of our service that would harm our future business
prospects. Because the techniques used to obtain unauthorized access, or to
sabotage systems, change frequently and generally are not recognized until
launched against a target, we may be unable to anticipate these techniques or to
implement adequate preventive measures. If an actual or perceived breach of
our security occurs, the market perception of the effectiveness of our security
measures could be harmed and we could lose sales and customers. In addition, our
new industry-standard platform may allow access by third-party technology
providers to access customer data. Because we do not control the transmissions
between our customers and third-party technology providers, or the processing of
such data by third-party technology providers, we cannot ensure the complete
integrity or security of such transmissions or processing.
Page 32 of 37
The
SEC action against us, the SEC and criminal actions brought against certain
former employees, and related stockholder and other lawsuits have damaged our
business, and they could damage our business in the future.
The
lawsuit filed against us by the SEC, the SEC and criminal actions filed against
a former officer and a former employee, the class action lawsuit filed against
us and certain current and former officers, directors, and employees, and the
lawsuit filed by a former executive officer against us have harmed our business
in many ways, and may cause further harm in the future. Since the initiation of
these actions, our ability to raise financing from new investors on favorable
terms has suffered due to the lack of liquidity of our stock, the questions
raised by these actions, and the resulting drop in the price of our common
stock. As a result, we may not raise sufficient financing, if necessary, in the
future.
Legal and
other fees related to these actions have also reduced our available cash. We
make no assurance that we will not continue to experience additional harm as a
result of these matters. The time spent by our management team and directors
dealing with issues related to these actions detracts from the time they spend
on our operations, including strategy development and implementation. These
actions also have harmed our reputation in the business community, jeopardized
our relationships with vendors and customers, and decreased our ability to
attract qualified personnel, especially given the media coverage of these
events.
In
addition, we face uncertainty regarding amounts that we may have to pay as
indemnification to certain current and former officers, directors, and employees
under our Bylaws and Delaware law with respect to these actions, and we may not
recover all of these amounts from our directors’ and officers’ liability
insurance policy carrier. Our Bylaws and Delaware law generally require us to
advance legal expenses to, current and former officers, directors and employees
against claims arising out of such person’s status or activities as our officer,
director or employee from such claims unless such person (i) did not act in good
faith and in a manner the person reasonably believed to be in or not opposed to
our best interests or (ii) had reasonable cause to believe his conduct was
unlawful. Also there is a stockholder class action lawsuit
pending against us and certain of our current and former officers, directors,
and employees. The SEC, criminal, and stockholder actions are more fully
described above under “Legal Proceedings” and in Part I, Item 3, “Legal
Proceedings,” in our Annual Report on Form 10-K for the year ended December 31,
2008..
Generally,
we are required to advance defense expenses prior to any final adjudication of
an individual’s culpability. The expense of indemnifying our current and former
directors, officers, and employees for their defense or related expenses in
connection with the current actions may be significant. Our Bylaws require that
any director, officer, employee, or agent requesting advancement of expenses
enter into an undertaking with us to repay any amounts advanced unless it is
ultimately determined that such person is entitled to be indemnified for the
expenses incurred. This provides us with an opportunity, depending upon the
final outcome of the matters and the Board’s subsequent determination of such
person’s right to indemnity, to seek to recover amounts advanced by us. However,
we may not be able to recover any amounts advanced if the person to whom the
advancement was made lacks the financial resources to repay the amounts that
have been advanced. If we are unable to recover the amounts advanced, or can do
so only at great expense, our operations may be substantially harmed as a result
of loss of capital.
As
reported in the Form 8-K filed by the Company on June 4, 2009, our insurance
coverage for advancement claims has been exhausted. As noted herein in Item 4,
“Commitments and Contingencies – Legal Proceedings”, by order dated August 6,
2009, the Company is obligated to pay to Dennis Michael Nouri and Reza Eric
Nouri $826,798 in advanced expenses for legal services performed by counsel to
the Nouris through April 2009. The total amount of the legal
fees the Company will ultimately be required to advance to the Nouris is
expected to be in excess of $2.4 million. In addition, a number of our current
and former employees were asked to appear as witnesses in the criminal
action and may seek advancement of legal expenses from us. Payment of these
amounts would adversely impact our financial condition and results of
operations, which could result in a significant reduction in the amounts
available to fund working capital, capital expenditures, and other general
corporate objectives and could ultimately require us to file for
bankruptcy.
Finally,
our insurance policies provide that, under certain conditions, our insurance
carriers may have the right to seek recovery of any amounts they paid to us or
the insured individuals. As of November 10, 2009, we do not know and
can offer no assurances about whether these conditions will apply or whether the
insurance carriers will change their position regarding coverage related to the
current actions. Therefore, we can offer no assurances that our insurance
carriers will not seek to recover any amounts paid under their policies from us
or the individual insureds. If such recovery is sought, then we may have to
expend considerable financial resources in defending and potentially settling or
otherwise resolving such a claim, which could substantially reduce the amount of
capital available to fund our operations and could ultimately require us to file
for bankruptcy.
Page 33 of 37
Our
executive management team has undergone significant changes and is critical to
the execution of our business plan and the loss of their services could severely
impact negatively on our business.
Our
executive management team has undergone significant changes since 2008,
including the resignation of our Chief Executive Officer on December 9, 2008,
the resignation of our Chairman of the Board and Interim Chief Executive Officer
on May 19, 2009. It may be difficult to attract highly qualified candidates to
serve on our executive management team on a permanent basis. If we cannot
attract and retain qualified personnel and integrate new members of our
executive management team effectively into our business, then our business and
financial results may suffer. In addition, all of our executive team works at
the same location, which could make us vulnerable to the loss of our entire team
in the event of a natural or other disaster. We do not maintain key man
insurance policies on any of our employees.
Compliance
with regulations governing public company corporate governance and reporting is
uncertain and expensive.
As a
public company, we have incurred and will continue to incur significant legal,
accounting, and other expenses that we did not incur as a private company. We
incur costs associated with our public company reporting requirements and with
corporate governance and disclosure requirements, including requirements under
Sarbanes-Oxley and new rules implemented by the SEC and the Financial Industry
Regulatory Authority, or FINRA. We expect these rules and regulations to
increase our legal and financial compliance costs and to make some activities
more time-consuming and costly.
We
currently are required to comply with the requirements of Section 404 of
Sarbanes-Oxley involving management’s assessment of our internal control over
financial reporting, and our independent accountant’s audit of our internal
control over financial reporting is required for fiscal 2010. To comply with
these requirements, we are evaluating and testing our internal controls, and
where necessary, taking remedial actions, to allow management to report on,
and our independent auditors to attest to, our internal control over financial
reporting. As a result, we have incurred and will continue to incur expenses and
diversion of management’s time and attention from the daily operations of
the business, which may increase our operating expenses and impair our
ability to achieve profitability.
Officers,
directors, and principal stockholders control us. This might lead them to make
decisions that do not align with the interests of minority
stockholders.
Our
officers, directors, and principal stockholders beneficially own or control a
large percentage of our outstanding common stock. Certain of these principal
stockholders hold warrants and convertible notes, which may be exercised or
converted into additional shares of our common stock under certain conditions.
The convertible noteholders have designated a bond representative to act as
their agent. We have agreed that the bond representative shall be granted access
to our facilities and personnel during normal business hours, shall have the
right to attend all meetings of our Board of Directors and its committees, and
to receive all materials provided to our Board of Directors or any committee of
our Board. In addition, so long as the notes are outstanding, we have agreed
that we will not take certain material corporate actions without approval of the
bond representative. The Chairman of our Board of Directors currently is serving
as the bond representative.
Our
officers, directors, and principal stockholders, acting together, would have the
ability to control substantially all matters submitted to our stockholders for
approval (including the election and removal of directors and any merger,
consolidation, or sale of all or substantially all of our assets) and to control
our management and affairs. Accordingly, this concentration of ownership may
have the effect of delaying, deferring, or preventing a change in control of us,
impeding a merger, consolidation, takeover, or other business combination
involving us, or discouraging a potential acquirer from making a tender offer or
otherwise attempting to obtain control of us, which in turn could materially and
adversely affect the market price of our common stock.
Any
issuance of shares of our common stock in the future could have a dilutive
effect on the value of our existing stockholders’ shares.
We may
issue shares of our common stock in the future for a variety of reasons. For
example, under the terms of our stock purchase warrant and agreement with Atlas,
it may elect to purchase up to 444,444 shares of our common stock at $2.70 per
share upon termination of, or if we are in breach under the terms of, our line
of credit with Paragon. In connection with our private financing in February
2007, we issued warrants to the investors to purchase an additional 1,176,471
shares of our common stock at $3.00 per share and a warrant to our placement
agent in that transaction to purchase 35,000 shares of our common stock at $2.55
per share. Upon maturity of their convertible notes, our noteholders may elect
to convert all, a part of, or none of their notes into shares of our common
stock at variable conversion prices. In addition, we may raise funds in the
future by issuing additional shares of common stock or other
securities.
Page 34 of 37
If we
raise additional funds through the issuance of equity securities or debt
convertible into equity securities, the percentage of stock ownership by our
existing stockholders would be reduced. In addition, such securities could have
rights, preferences, and privileges senior to those of our current stockholders,
which could substantially decrease the value of our securities owned by them.
Depending on the share price we are able to obtain, we may have to sell a
significant number of shares in order to raise the necessary amount of capital.
Our stockholders may experience dilution in the value of their shares as a
result.
Shares
eligible for public sale could adversely affect our stock price.
Future
sales of substantial amounts of our shares in the public market, or the
appearance that a large number of our shares are available for sale, could
adversely affect market prices prevailing from time to time and could impair our
ability to raise capital through the sale of our securities. At November 5, 2009
there were 18,332,542 shares of our common stock were issued and outstanding and
a significant number of shares may be issued upon the exercise of outstanding
options, warrants, and convertible notes.
In
addition, our stock historically has been very thinly traded. Our stock price
may decline if the resale of shares under Rule 144, in addition to the resale of
registered shares, at any time in the future exceeds the market demand for our
stock.
Our
stock price is likely to be highly volatile and may decline.
The
trading price of our common stock has been and is likely to continue to be
subject to wide fluctuations. Further, our common stock has a limited trading
history. Factors affecting the trading price of our common stock generally
include the risk factors described in this report.
In
addition, the stock market from time to time has experienced extreme price and
volume fluctuations that have affected the trading prices of many emerging
growth companies. Such fluctuations have often been unrelated or
disproportionate to the operating performance of these companies. These broad
trading fluctuations could adversely affect the trading price of our common
stock
Our
securities may be subject to “penny stock” rules, which could adversely affect
our stock price and make it more difficult for our stockholders to resell their
stock.
The SEC
has adopted rules that regulate broker-dealer practices in connection with
transactions in penny stocks. Penny stocks are generally equity securities with
a price of less than $5.00 per share (other than securities registered on
certain national securities exchanges or quotation systems, provided that
reports with respect to transactions in such securities are provided by the
exchange or quotation system pursuant to an effective transaction reporting plan
approved by the SEC).
The penny
stock rules require a broker-dealer, prior to a transaction in a penny stock not
otherwise exempt from those rules, to deliver a standardized risk disclosure
document prescribed by the SEC and certain other information related to the
penny stock, the broker-dealer’s compensation in the transaction, and the other
penny stocks in the customer’s account.
In
addition, the penny stock rules require that, prior to a transaction in a penny
stock not otherwise exempt from those rules, the broker-dealer must make a
special written determination that the penny stock is a suitable investment for
the purchaser and receive the purchaser’s written acknowledgment of the receipt
of a risk disclosure statement, a written agreement related to transactions
involving penny stocks, and a signed and dated copy of a written suitability
statement. These disclosure requirements could have the effect of reducing the
trading activity in the secondary market for our stock because it will be
subject to these penny stock rules. Therefore, stockholders may have difficulty
selling those securities.
If
we fail to evaluate, implement, and integrate strategic opportunities
successfully, our business may suffer.
From time
to time we evaluate strategic opportunities available to us for product,
technology, or business acquisitions or dispositions. If we choose to make
acquisitions or dispositions, we face certain risks, such as failure of an
acquired business to meet our performance expectations, diversion of management
attention, retention of existing customers of our current and acquired business,
and difficulty in integrating or separating a business’s operations, personnel,
and financial and operating systems. We may not be able to successfully address
these risks or any other problems that arise from our previous or future
acquisitions or dispositions. Any failure to successfully evaluate strategic
opportunities and address risks or other problems that arise related to any
acquisition or disposition could adversely affect our business, results of
operations, and financial condition.
Page 35 of 37
Item 2. Unregistered Sales
of Equity Securities and Use of Proceeds
During
the first, second and third quarter of fiscal 2009, we sold equity securities
totaling $219 and $876, respectively that were not registered under the
Securities Act, as described in our Current Reports on Form 8-K filed in
connection with such transactions.
The
following table lists all repurchases during the first and second and third
quarters of fiscal 2009 of any of our securities registered under
Section 12 of the Exchange Act by or on behalf of us or any affiliated
purchaser.
Issuer
Purchases of Equity Securities
|
Period
|
Total
Number of
Shares
Purchased
|
|
Average
Price
Paid Per
Share
|
|
Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
|
Maximum
Number of
Shares That May
Yet Be Purchased
Under the Plans or
Programs
|
|||||
|
January 1
– January 31, 2009
|
-
|
|
$
|
-
|
|
-
|
-
|
||||
|
February
1 – February 28, 2009
|
-
|
|
$
|
-
|
|
-
|
-
|
||||
|
March
1 – March 31, 2009 (1)
|
146
|
$
|
1.50
|
||||||||
|
April
1 – June 30, 2009
|
580
|
$
|
1.51
|
|
-
|
-
|
|||||
|
July
1 – September 30, 2009
|
-
|
-
|
-
|
-
|
|||||||
|
Total
|
726
|
|
$
|
1.50
|
|
-
|
-
|
||||
|
(1)
|
Represents
146 and 580 shares repurchased in connection with tax withholding
obligations under the 2004 Plan.
|
Item 6. Exhibits
The
following exhibits are being filed herewith and are numbered in accordance with
Item 601 of Regulation S-K:
|
Exhibit
No.
|
Description
|
|
|
31.1
|
Certification
of Principal Executive Officer Pursuant to Rule 13a-14(a) as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
|
|
|
31.2
|
Certification
of Principal Financial Officer Pursuant to Rule 13a-14(a) as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
|
|
32.1
|
Certification
of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 and shall not, except to the extent required by that Act, be
deemed to be incorporated by reference into any document or filed herewith
for the purposes of liability under the Securities Exchange Act of 1934,
as amended, or the Securities Act of 1933, as amended, as the case may
be.
|
|
|
32.2
|
Certification
of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This
exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 and shall not, except to the extent required by that Act, be
deemed to be incorporated by reference into any document or filed herewith
for the purposes of liability under the Securities Exchange Act of 1934,
as amended, or the Securities Act of 1933, as amended, as the case may
be.
|
Page 36 of 37
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
|
Smart
Online, Inc.
|
|
|
/s/
C. J. Meese, Jr.
|
|
|
C.
J. Meese, Jr.
|
|
|
Date:
November 16, 2008
|
Interim
Chief Executive Officer, President and Principal Executive
Officer
|
|
/s/
Thaddeus J. Shalek
|
|
|
Thaddeus
J. Shalek
|
|
|
Interim
Chief Financial Officer and
|
|
|
Date:
November 16, 2008
|
Principal
Accounting Officer
|
Page 37 of
37