Mosaic ImmunoEngineering Inc. - Annual Report: 2008 (Form 10-K)

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term (Years)				Aggregate Intrinsic Value
Options outstanding at June 1, 2007			7,245,000			$	0.40
Options granted			6,625,000			$	0.43
Options exercised			(1,282,846	)		$	0.15
Options forfeited			(4,392,154	)		$	0.45
Options outstanding at May 31, 2008			8,195,000			$	0.44				3.79			$	182,900
Options vested and expected to vest at May 31, 2008			7,998,519			$	0.44				3.77			$	182,900
Options exercisable at May 31, 2008			4,265,372			$	0.47				2.95			$	182,900

 

The aggregate intrinsic value in the table above represents the differences in market price at the close of the year ($0.27 per share on May 31, 2008) and the exercise price of outstanding, in-the-money options (those options with exercise prices below $0.27) on May 31, 2008.

As of May 31, 2008, there was approximately $977,602 of total unrecognized compensation cost related to employee stock option compensation arrangements.  That cost is expected to be recognized on a straight-line basis over the next 42 months.  Approximately $583,000 of the total unrecognized compensation cost relates to 2,000,000 performance options granted to our CEO and 200,000 performance options granted to our V.P of Business Development.  We are not currently recognizing compensation cost relating to these option grants as we have determined that it is not currently probable that the vesting conditions in the grants will be met.  When such vesting conditions are probable to be met, we will record the compensation cost for the grants.

F-18

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stock-Based Compensation (continued)

 

The following table summarizes employee and director stock-based compensation expense related to stock options under SFAS No. 123(R) for the fiscal years ended May 31, 2008 and 2007, which was recorded as follows:

 

		Year Ended				Year Ended
		May 31, 2008				May 31, 2007
Selling, general and administrative expense		$	502,770			$	2,356,000

Adoption of Recent Accounting Pronouncements

On June 1, 2007, we adopted FIN 48. This interpretation clarifies the application of SFAS No. 109 by defining criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in a company’s financial statements and also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  The adoption of FIN 48 on June 1, 2007 did not result in any cumulative effect adjustment to retained earnings.  Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense.  As of June 1, 2007, we are subject to U.S. Federal income tax examinations for the tax years May 31, 1991 through May 31, 2007, and we are subject to state and local income tax examinations for the tax years May 31, 1999 through May 31, 2007 due to the carryover of net operating losses from previous years.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principals and expands disclosures about fair value measurements.  The statement does not require new fair value measurements, but is applied to the extent that other accounting pronouncements require or permit fair value measurements.  The statement emphasizes that fair value is a market-based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability.  Companies that have assets and liabilities measured at fair value will be required to disclose information that enables the users of its financial statements to access the inputs used to develop those measurements.  The reporting entity is encouraged, but not required, to combine the fair value information disclosed under this statement with the fair value information disclosed under other accounting pronouncements.  SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We expect to adopt SFAS No. 157 on June 1, 2008.  In February 2008, the FASB released FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, which delayed the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) until the fiscal year beginning May 31, 2009.  We are in the process of evaluating the provisions of the statement, but do not anticipate that the adoption of SFAS No. 157 will have a material impact on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. SFAS No. 159 does not establish requirements for recognizing and measuring dividend income, interest income, or interest expense. This Statement does not eliminate disclosure requirements included in other accounting standards. SFAS No. 159 is effective in fiscal years beginning after November 15, 2007. We are in the process of evaluating the provisions of the statement, but do not anticipate that the adoption of SFAS No. 159 will have a material impact on our consolidated financial statements.

F-19

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Recent Accounting Pronouncements (continued)

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS No. 141(R) requires acquiring entities in a business combination to recognize the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors the information it needs to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) is effective in fiscal years beginning after December 15, 2008. We expect to adopt SFAS No. 141(R) on June 1, 2009.  We are currently assessing the impact the adoption of SFAS No. 141(R) will have on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 160 requires entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. SFAS No. 160 is effective in fiscal years beginning after December 15, 2008. We expect to adopt SFAS No. 160 on June 1, 2009.  We are currently assessing the impact the adoption of SFAS No. 160 will have on our consolidated financial statements.

3.  Accounts Receivable

Trade accounts receivable at May 31, 2008 is $538,500, of which $511,541 is held by SSDI.  At May 31, 2007, trade accounts receivable was $352,390, of which $348,890 was held by SSDI. No allowance for doubtful accounts has been recorded for the fiscal years ended May 31, 2008 or 2007.

At May 31, 2008, accounts receivable from our investee PDS was $7,501 with no such amount recorded at May 31, 2007.  The fiscal 2008 balance represents reimbursements we submit to PDS for our legal and related costs incurred in various legal matters of which we are listed as co-defendant with TPL.

4.  Notes Receivable

During fiscal year 2008, SSDI sold a membership interest in its subsidiary DataSecurus, LLC (now known as Talis) to an unrelated third party for $100,000 in cash and a $50,000 non-interest bearing note receivable due in June 2008.  On June 1, 2008, SSDI assigned the $50,000 note receivable to us and we agreed to reduce the amount of our line of credit with SSDI by the amount of the note receivable.  On June 26, 2008, we were paid in full by the third party debtor.

On May 30, 2008, we purchased a secured convertible promissory note from Crossflo Systems, Inc., a California corporation (“Crossflo”) with a face amount of $400,000.  Interest accrues on the note at a rate of 5.25% per annum and will be due with principal at the earlier of (i) September 30, 2008, (ii) consummation of a equity financing by Crossflo which closes on or before September 30, 2008, in which Crossflo  sells and issues shares of its convertible preferred stock resulting in aggregate gross proceeds to Crossflo of at least $2.5 million (a “Qualified Financing”), or (iii) upon or after the occurrence of an event of default, as defined.  The note is secured by substantially all assets of Crossflo.

The Crossflo note receivable is convertible at our option, at any time prior to September 30, 2008, into shares of Crossflo’s Series F convertible preferred stock equal to 4% of Crossflo’s then issued and outstanding equity securities. In addition, the entire principal is automatically convertible into shares of Crossflo’s Series F convertible preferred stock at the closing of a Qualified Financing. The number of shares of Series F convertible preferred stock to be issued upon automatic conversion of the principal amount is the greater of (i) 4% of Crossflo’s then issued and outstanding equity securities, and (ii) the principal amount divided by the per share purchase price paid by the investors participating in the Qualified Financing. Upon an event of default, as defined, the principal amount of the note may be converted into shares of Crossflo’s Series F convertible preferred stock equal to 4% of Crossflo’s then issued and outstanding equity securities. Upon maturity on September 30, 2008, the principal amount of the note will automatically be converted into shares of Crossflo’s Series F convertible preferred stock equal to 4% of Crossflo’s then issued and outstanding equity securities.

Upon conversion of the principal amount of the note pursuant to the above, we are entitled to receive shares of Crossflo’s common stock equal to all accrued and unpaid interest divided by $0.20.

F-20

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Notes Receivable (continued)

In connection with our purchase of the secured convertible promissory note from Crossflo, we also received a warrant to purchase 200,000 shares of Crossflo’s common stock at $0.20 per share.  Notwithstanding the foregoing, in the event a Qualified Financing is not consummated prior to September 30, 2008, the warrant will instead be exercisable into 1,000,000 shares of Crossflo’s common stock at $0.20 per share.  The warrant is exercisable until the earlier of (i) October 11, 2012, (ii) the closing of an underwritten public offering by Crossflo pursuant to a registration statement under the Securities Act, (iii) the closing of a merger or other reorganization by Crossflo with another entity, or (iv) the closing of a sale of all or substantially all of the assets of Crossflo.  The value attributed to the warrant was insignificant, and accordingly, the principal amount of the loan has been recorded as a note receivable at May 31, 2008.

As of May 31, 2008, the balance of the note receivable is $400,115, including accrued interest receivable of $115 recognized during the year ended May 31, 2008.

On November 22, 2006, we entered into a Revolving Line of Credit Facility Agreement (the “Line of Credit Agreement”) with Holocom Networks (“Holocom”) which provided for borrowings of up to $700,000 under a revolving line of credit extended by us to Holocom. On November 22, 2006, we advanced Holocom $350,000 and further advanced an additional $230,000 during the three months ended February 28, 2007. Borrowings under the Line of Credit Agreement were used by Holocom for its operating cash flow needs. The borrowings bore interest at the prime rate, as announced by Bank of America, plus 2% per annum, and interest-only payments were due monthly. Pursuant to the terms of the Line of Credit Agreement, all unpaid principal and accrued and unpaid interest was due February 22, 2007. Borrowings under the Line of Credit Agreement were collateralized by substantially all of the assets of Holocom.

 

During the quarter ended February 28, 2007, we determined that the outstanding borrowings under the Line of Credit Agreement of $589,551, which included accrued interest and late fees of $9,551, were uncollectible as Holocom was unable to make the required interest payments. As a result, we foreclosed on the assets of Holocom. At the foreclosure sale, we acquired the patents, trademarks, equipment, inventory, and certain other collateral of Holocom pursuant to the terms of a Security Agreement entered into between us and Holocom in connection with the Line of Credit Agreement.

 

We originally accounted for our loan receivable, and related accrued interest, due from Holocom at cost. In accordance with SFAS No. 114, Accounting by Creditors for Impairments of a Loan, based on current information and events, we determined that we were unable to collect all amounts due from Holocom according to the contractual terms of the Line of Credit Agreement. As a result, we determined that the loan receivable was impaired. Accordingly, we recorded an impairment loss of $339,551 during the three months ended February 28, 2007. The impairment loss was determined based on an independent valuation of the assets of Holocom acquired in the foreclosure sale and management’s analysis of the fair value of such assets at time of acquisition.

 

The fair value of the assets acquired in foreclosure of $250,000 was contributed to SSDI.

5. Inventory

Inventory at May 31, 2008, consisted of raw materials of $142,410 and finished goods of $245,731.  Inventory at May 31, 2007, consisted of raw materials of $46,361.

F-21

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

6. Investments in Marketable Securities

The following table summarizes unrealized losses on our investments in marketable securities based on the valuation by Houlihan Smith & Company Inc. at May 31, 2008:

	As of May 31, 2008
		Cost				Gross Unrealized  Losses				Estimated  Fair  Value
Short-term
Accrued interest - auction rate securities		$	288,099			$	—			$	288,099
Long-term
Auction rate securities			12,900,000				(372,325	)			12,527,675
Total		$	13,188,099			$	(372,325	)		$	12,815,774

As of May 31, 2008, we held auction rate securities with a par value totaling $12.9 million that failed to sell at auction.  In the event we need to access funds invested in these auction rate securities we would not be able to liquidate these securities until (i) a future auction of these securities is successful, (ii) they are refinanced and redeemed by the issuers, or (iii) a buyer is found outside of the auction process.  The investments consist of student loan auction rate instruments issued by various state agencies pursuant to the Federal Family Educational Loan Program (“FFELP”).  These investments are of high credit quality and the AAA credit ratings of the investments have been reaffirmed since May 2008.  These instruments are collateralized in excess of the underlying obligations, are insured by the various state educational agencies, and are guaranteed by the Department of Education as an insurer of last resort.  We have the intent and the ability to hold these investments until the anticipated recovery period.

Due to the uncertainty surrounding the timing of a market recovery, we have classified our auction rate securities as long- term investments in our consolidated balance sheet as of May 31, 2008.  As a result of temporary declines in the fair value of our auction rate securities, which we attribute to liquidity issues rather than credit issues, we have recorded an unrealized loss of $220,617 in other comprehensive income at May 31, 2008, which represents the gross valuation adjustment of $372,325, net of the related tax benefit of $151,708.

We will continue to evaluate the fair value of our investments in auction rate securities each reporting period for a potential other-than-temporary impairment.

During June 2008 we obtained a credit facility for as long as needed, which provides for financing up to 50% of the par value balance of our outstanding auction rate securities. The facility is collateralized by the full value of the outstanding auction rate securities, required no origination fee, and if drawn upon will bear interest at the federal funds rate plus 3%.

F-22

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

7. Property and Equipment

Property and equipment consisted of the following at May 31, 2008 and 2007:

 

		2008				2007
Computer equipment and software		$	50,802			$	42,270
Furniture and fixtures			72,981				72,454
Leasehold improvements			5,046				-
			128,829				114,724
Le LLess: accumulated depreciation and amortization			(60,325	)			(29,206	)
Net property and equipment		$	68,504			$	85,518

Depreciation and amortization expense related to property and equipment was $36,359, $24,352 and $24,591 for the years ended May 31, 2008, 2007 and 2006, respectively.

8. License Agreements

In February 2005, we entered into two separate licensing agreements with one customer for our patent portfolio and Ignite microprocessor technology. The aggregate amount of the two licenses was $3,050,000, of which $2,950,000 was for licensing fees and $100,000 was for maintenance services. Maintenance under the agreement is expected to be provided over a period not to exceed four years. Maintenance revenue recognized during the fiscal years ended May 31, 2008, 2007 and 2006 was $25,000 per year. The payment terms of the agreements required aggregate payments of $300,000 at the time of execution, three quarterly payments of $750,000 each on April 1, August 15, and November 15, 2005 and one final payment of $500,000 on February 15, 2006. The $500,000 payment due on February 15, 2006 was paid in March 2006. Total payments received in fiscal 2005 amounted to $1,050,000, and total payments received in fiscal 2006 amounted to $2,000,000. The agreements also provide for the future payment of royalties to us based on sales of product using the Ignite licensed technology. In connection with this license agreement, we became obligated to the co-inventor of the patent portfolio technology for $207,600 pursuant to a July 2004 agreement under which we were obligated to pay a percentage of all patent portfolio licensing proceeds to the co-inventor. The amount due under that license was payable in four installments of $51,900. The co-inventor of the patent portfolio technology filed a lawsuit against us seeking damages and/or enforcement of the July 2004 agreement. We challenged the enforceability of the agreement by counterclaim in that action. On February 14, 2007, a settlement of the litigation was finalized. Terms of the settlement required us to pay $3,400,000 in cash on February 14, 2007 and $3,000,000 on May 1, 2007, which amounted to approximately the debt claimed by the co-inventor to be owed to him under the July 2004 agreement. In addition, the settlement required us to make a donation of $15,000 on February 14, 2007 on behalf of Russell H. Fish III (“Fish”) to Maasai Power and Education Project, Inc., and to pay Fish the equivalent of 4% of 50% of the next $100 million of gross license fees as they are collected by PDS and as distributions are made to us, after excluding the first $20 million collected by PDS after December 1, 2006. Our commitment to make payments to Fish related to such future license revenues was limited to $2 million. During the fiscal years ended May 31, 2008 and 2007, we recorded $836,400 and $7,524,537, respectively in settlement and license expenses relating to royalty payments due to the Fish parties.  In January 2008, we made the final payment under the Fish settlement agreement.

9. Investments in Affiliated Companies

Phoenix Digital Solutions, LLC

On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of certain of our technology, pursuant to which we, TPL and Moore resolved all legal disputes between us. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (the “LLC Agreement”) into which we and Moore contributed our rights to certain of our technologies.

F-23

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investments in Affiliated Companies (continued)

We and TPL each own 50% of the membership interests of PDS, and each of us has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. Pursuant to the LLC Agreement, we and TPL agreed to establish a working capital fund for PDS of $4,000,000, of which our contribution was $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. We and TPL are obligated to fund future working capital requirements at the discretion of the management committee of PDS in order to maintain working capital of not more than $8,000,000. Neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined in the LLC Agreement. PDS has committed to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of PDS) for supporting efforts to secure licensing agreements by TPL on behalf of PDS. During the fiscal years ended May 31, 2008, 2007 and 2006, PDS paid $2,952,362, $3,871,602 and $2,500,000, respectively, to TPL pursuant to this commitment.

We are accounting for our investment in PDS under the equity method of accounting, and accordingly have recorded our share of PDS’ net income of $19,926,145, $48,965,084 and $27,848,363 during the years ended May 31, 2008, 2007 and 2006, respectively, as an increase in our investment. Cash distributions of $20,288,124, $50,034,029 and $25,895,449 received from PDS during the years ended May 31, 2008, 2007 and 2006, respectively, have been recorded as a reduction in our investment. Our investment in PDS of $2,521,990 and $2,883,969 at May 31, 2008 and 2007, respectively,  and has been recorded as “Investments in Affiliated Companies”.  We have recorded our share of PDS’ net income as “Equity in Earnings of Affiliated Companies” in the accompanying consolidated statements of income for the years ended May 31, 2008, 2007 and 2006.

Concurrently with forming PDS, we entered into a license agreement with a third party pursuant to which we received $10,000,000.  This amount was recorded as license revenue during the year ended May 31, 2006. In connection with entering into the license agreement and forming PDS, we incurred various cash and non-cash expenses. Direct, incremental cash costs incurred with the transactions included $170,000 paid to a committee of our board of directors for their efforts in consummating the transactions, approximately $1,328,000 paid to certain of our warrant holders to obtain their approval of the agreement and release of their lien and blocking rights. Additionally, $960,000 was paid to the co-inventor of the technology.

We also granted new warrants and agreed to re-price other outstanding warrants in order to obtain the necessary approvals from certain security interest holders as well as to obtain the release of their security interests in our intellectual property, and to finalize the LLC Agreement. We granted a warrant to TPL to acquire up to 3,500,000 shares of our common stock at a per share price of $0.125. The warrant has a term of seven years. At the date of grant, the right to acquire 1,400,000 common shares vested. The right to acquire the remaining 2,100,000 shares will vest in 700,000 increments only upon our common stock attaining a per share stock price of $0.50, $0.75 and $1.00. On February 21, 2006, February 22, 2006 and March 1, 2006 the rights to acquire the remaining 700,000 share increments vested as our stock price reached $0.50, $0.75 and $1.00, respectively. As additional consideration to the warrant holders for providing approval for the transaction, we agreed to reset the per share exercise price of approximately 35,000,000 warrants to $0.015 for which the warrant holders also conveyed other warrants to acquire 12,000,000 shares back to us. Further, we issued additional warrants to acquire approximately 290,000 shares of our common stock at a per share price of $0.03. The warrants issued and re-priced were valued using a Monte Carlo simulation model and the following assumptions: volatility of 101% to 229%, no dividends, risk-free interest rates of approximately 3.5% to 5.1%, and contractual terms ranging from two to seven years. The fair value of the warrants issued and re-priced in excess of previously recorded expense was approximately $83,000 and the fair value of the reconveyed warrants was approximately $622,000. These amounts, together with the direct, incremental cash costs previously described, are recorded as an expense and included in settlement and license expense in the year ended May 31, 2006.

During the years ended May 31, 2008, 2007 and 2006, TPL entered into licensing agreements with third parties, pursuant to which PDS received aggregate proceeds of approximately $59,283,000, $110,879,000 and $60,000,000, respectively.

F-24

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investments in Affiliated Companies (continued)

The condensed balance sheets of PDS at May 31, 2008 and 2007 and statements of income of PDS for the years ended May 31, 2008, 2007 and 2006 are as follows:

Condensed Balance Sheets

ASSETS:

		2008				2007
Cash and cash equivalents		$	8,260,288			$	6,989,847
Prepaid expenses			-				175,000
Total assets		$	8,260,288			$	7,164,847

LIABILITIES AND MEMBERS’ EQUITY:

Accounts payable and accrued expenses		$	3,204,519			$	1,385,118
Income taxes payable			11,790				11,790
Members’ equity			5,043,979				5,767,939
Total liabilities and members’ equity		$	8,260,288			$	7,164,847

Condensed Statements of Income

		2008				2007				2006
License revenues		$	59,282,971			$	110,878,985			$	60,000,000
Operating expenses			18,627,032				12,189,575				4,486,955
Operating income			40,655,939				98,689,410				55,513,045
Interest income			216,902				421,407				183,682
Income before income taxes			40,872,841				99,110,817				55,696,727
Provision for income taxes			11,790				11,790				-
Net income		$	40,861,051			$	99,099,027			$	55,696,727

Talis Data Systems, LLC

On May 16, 2008, we paid $400,000 to acquire a 15.09% share in Talis, a company that produces multi-domain computer and network security products to government, military, and enterprise customers. Talis develops and markets PCs incorporating the company's Datagent security device, a patented, hardware based data security solution that avoids the vulnerability of software–based approaches.

On August 1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing additional shares offered by Talis, as well as acquiring shares from minority shareholders which included the acquisition of all Talis shares previously held by SSDI. The acquisition of SSDI’s Talis shares was made for $100,000 in cash and a reduction on their outstanding line of credit of $219,000.

F-25

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investments in Affiliated Companies (continued)

We are accounting for our investment in Talis under the equity method of accounting, as our limited liability company share is deemed more than minor.  We have recorded our share of Talis’ net loss of $8,376 during the period ended May 31, 2008 as a decrease in our investment.  Our investment in Talis is $391,624 at May 31, 2008 and has been recorded as “Investments in Affiliated Companies”.  We have recorded our share of Talis’ net loss as “Equity in Earnings of Affiliated Companies” in the accompanying consolidated statement of income for the year ended May 31, 2008.

10. Consolidated Variable Interest Entity

On February 2, 2007, we invested an aggregate of $370,000 in SSDI for 2,100,000 shares of convertible preferred stock. This represents all of SSDI’s preferred stock and a 46% ownership interest in SSDI, a California corporation that manufactures products that protect information transmitted over secure networks. The investment consisted of certain assets contributed by us to SSDI valued at $250,000 and cash of $120,000. The shares are convertible at our option into shares of SSDI’s common stock on a one-to-one basis. The convertible preferred stock entitles us to receive non-cumulative dividends at the per annum rate of $0.04 per share, when and if declared by the Board of Directors of SSDI. The investment in SSDI’s convertible preferred stock also entitles us to a liquidation preference of $0.40 per share, plus an amount equal to all declared but unpaid dividends.

On March 27, 2007, we entered into an 18-month revolving line of credit with SSDI for a maximum amount of $500,000. The line of credit matures on September 27, 2008. If we do not provide notice to SSDI at least 90 days prior to the maturity date, the maturity date automatically extends 12 months. The line of credit is collateralized by all assets presently owned or hereafter acquired by SSDI. The carrying value of the collateral is approximately $765,861 at May 31, 2008. The creditors of SSDI do not have recourse to our other assets. During the fiscal years ended May 31, 2008 and 2007 we advanced $250,000 and $250,000, respectively, under terms of the agreement.  The total amount drawn on the line of credit at May 31, 2008 is $500,000 of which $100,000 has been repaid. On June 18, 2008, we gave SSDI notice under terms of the line of credit that we would not be extending the maturity date by the additional twelve month period provided for in the line of credit. As a result, the line of credit will terminate, and full payment of any outstanding balance will be due on September 27, 2008.

The line of credit carries a floating interest rate which is defined as the prime rate as announced by Bank of America. At May 31, 2008, the interest rate on the note was 5.00%. SSDI is required to make minimum monthly payments on the line consisting of unpaid and accrued interest on the first day of the month following the initial advance.

During the quarter ended February 29, 2008 we subordinated our interest in the repayment of principal due under the revolving line of credit, up to a maximum of $100,000, for the benefit of a customer of SSDI.

As a result of the line of credit, we have a variable interest in SSDI, a variable interest entity, and we have determined that we are the primary beneficiary as we absorb more than half of the variable interest entity’s expected losses. FIN 46(R) requires us to consolidate SSDI as long as we are deemed to be the primary beneficiary. The equity interests of SSDI not owned by us are reported as a minority interest in our May 31, 2008 and 2007 consolidated balance sheets.  As of May 31, 2007, the noncontrolling interest in SSDI, which we are required to consolidate as we are the primary beneficiary, has been reduced to zero due to the initial allocation of losses prior to the period in which we were required to consolidate. If a noncontrolling interest has been reduced to zero, the primary beneficiary must absorb any losses that are in excess of the value of the noncontrolling interest’s equity. For the period in which we were initially required to consolidate, March 27, 2007 through May 31, 2007 we absorbed $169,913 of SSDI’s losses as we are the primary beneficiary.  For the fiscal year ended May 31, 2008, SSDI had net income of $285,319 after taxes.  Under the provisions of FIN 46 (R), we are able to recover our absorbed losses before allocating income to the noncontrolling interest.  At May 31, 2008 the minority interest presented in our consolidated financial statements is $115,406, the amount of SSDI’s fiscal 2008 net income after taxes less our absorbed losses during fiscal 2007.

Prior to initial consolidation, we recognized a $126,746 impairment loss on our investment for the losses of SSDI for the period February 2007 through March 26, 2007.

 

F-26

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Consolidated Variable Interest Entity (continued)

Upon initial consolidation of the variable interest entity, on March 27, 2007, $251,146 of current assets, $43,199 of net property and equipment, $47,240 of other assets, $98,331 of current liabilities and no minority interest were included on the consolidated balance sheet.

During the three months ended August 31, 2007, SSDI sold a membership interest in DataSecurus, LLC (now known as Talis Data Systems, LLC) to an unrelated third party for $100,000 in cash and a $50,000 note receivable due June 1, 2008.  On June 1, 2008, SSDI assigned this note receivable to us and we agreed to reduce the amount of our line of credit with SSDI by the amount of the note.  On June 26, 2008 we were paid in full by the third party debtor.

 SSDI has a 2007 Stock Option Plan that covers its employees, directors, and consultants and provides for the granting of options to acquire up to 500,000 shares of SSDI’s common stock.  The options under this plan are not tied to our common stock and do not have a dilutive effect on our shareholders.  Any option granted under the plan must be exercised within ten years of the date they are granted.  During the fiscal year ended May 31, 2008, SSDI granted options to purchase 393,500 shares of its common stock at $0.10 per share under this plan.  At May 31, 2008, options to purchase 354,500 shares of SSDI’s common stock are outstanding, 45,900 of the outstanding options are exercisable due to vesting provisions within the options and 39,000 shares have been forfeited/cancelled.

 

The weighted average grant date fair value of SSDI’s options granted during the fiscal year ended May 31, 2008 was $0.06 per option.

As of May 31, 2008, there was approximately $13,095 of total unrecognized compensation cost related to employee stock option compensation arrangements.  That cost is expected to be recognized by SSDI on a straight-line basis over the next 24 months.

During the fiscal year ended May 31, 2008, SSDI recognized $7,201 of employee, consultant and director stock-based compensation expense related to stock options under SFAS No. 123(R).

11. Accrued Expenses and Other

At May 31, 2008 and 2007, accrued expenses and other consisted of the following:

		2008				2007
Accrued lease obligation		$	4,006			$	7,279
Deferred maintenance fee			18,750				43,750
Compensation and benefits			210,153				75,068
Deferred material credit			95,377				163,399
Accrued expenses			45,562				-
Royalties payable			-				797,000
		$	373,848			$	1,086,496

12. Convertible Debentures

From fiscal 2002 through fiscal 2005, we raised approximately $5,400,000 through the issuance of convertible debentures, having stated interest rates ranging from 8% to 12%, to a limited group of investors. The convertible debentures entitled the debenture holders to convert the principal, and any accrued interest thereon, into shares of our common stock for up to two years from the date of issuance.

F-27

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Convertible Debentures (continued)

The debentures were initially convertible into shares of common stock at conversion prices ranging from approximately $0.02 to $0.10 per share. The debentures contained provisions which allowed for the conversion rate to be reset on a periodic basis based on a comparison of the market price of our common stock to the conversion price of the debentures. On the measurement dates when the market price was less than the conversion rate, a new conversion rate was set based on a weighted average of the market price for the ten days prior to the reset measurement date.

Concurrent with the issuance of the convertible debentures, we issued the debenture holders warrants to purchase shares of our common stock. These warrants are exercisable for five years from the date of issuance at either initial negotiated exercise prices or prices equal to 115% of the volume weighted average price for our common stock for the ten days previous to the debenture date. The warrant exercise price is generally subject to being reset on each six-month anniversary of its issuance; however, if the warrant holder elects to have the warrant shares registered, then the exercise price is fixed at the price in effect on the date of the election.

Except for one debenture issued on March 23, 2004, we are responsible for registering the resale of the shares of our common stock which will be issued on the conversion of the debentures. As of May 31, 2008, there have been seven registration statements. The convertible debentures were secured by substantially all our assets.

The terms of the convertible debentures included certain features that were considered embedded derivative financial instruments, such as the conversion feature and a reset conversion feature which provided for a conversion of the debentures into shares of our common stock at a rate which was determined to be variable. Because the debentures were not conventional convertible debt, we were also required to record the related warrants at their fair values. In addition, under the provisions of EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, as a result of entering into the convertible debenture agreements, we were required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date.

During the year ended May 31, 2006, the value of the warrant and derivative liabilities increased by $2,456,736 which is reflected as a component of other income (expense) in the accompanying consolidated statement of income.

During the year ended May 31, 2006, we entered into two reset agreements with the debenture holders to fix the conversion price of the then outstanding debentures at their current price. We determined that one of the debt modifications did not result in a debt extinguishment under EITF Issue No. 96-19, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, or EITF Issue No. 05-7, Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues. In connection with the reset agreement of one of the outstanding debentures, we issued 7,000,000 warrants to the debenture holder as consideration for entering into the reset agreement. We determined that the issuance of the warrants, in connection with the reset agreement, resulted in a debt extinguishment under EITF Issue No. 96-19. Accordingly, we recorded the fair value of the warrants issued of $445,427 as a loss on debt extinguishment in the accompanying consolidated statement of income for the year ended May 31, 2006.

During the year ended May 31, 2006, holders of debentures with a principal balance of $880,668 converted their debentures, together with accrued interest thereon of $118,369, into 30,819,187 shares of our common stock.  As of May 31, 2006, all outstanding debentures were repaid or converted into shares of our common stock.

As a result of the settlement of the remaining debentures during 2006, we reclassified $6,743,935 related to the fair values of all outstanding warrants at the date of settlement to additional paid-in capital.

We recorded the fair value of the derivative instruments and warrants as a debt discount which was amortized to interest expense over the term of the convertible debentures. During the year ended May 31, 2006, we recorded interest expense of $412,879 related to the amortization of the debt discount. If the total fair value of the derivative instruments and warrants was in excess of the proceeds received on the convertible debentures, we recorded the excess as additional interest expense. Since no convertible debentures or warrants in connection with convertible debentures were issued during the year ended May 31, 2006, no excess fair value was recorded during fiscal 2006.

 

F-28

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

13. Stockholders’ Equity

Share Repurchases

During July 2006, we commenced our Board of Director approved stock buyback program in which we repurchase our outstanding common stock from time to time on the open market.  The repurchase plan has no maximum number of shares and is solely at the discretion of the Board of Directors. The repurchase plan has no set expiration date.

The following table summarizes share repurchases during the years ended May 31, 2008 and 2007:

		2008				2007
Number of shares repurchased			8,096,721				13,467,527
Aggregate cost		$	3,891,094			$	8,832,078

Dividends

During February 2007, we announced dividends of $0.02 per share to shareholders and qualified warrant holders of record as of March 6, 2007. The dividend of $8,114,774 was paid on April 9, 2007. During this time, we announced a semi-annual dividend policy contingent upon our financial condition, other possible applications of available resources, and relevant business considerations.

During February 2006, we announced a dividend of $0.02 per share of common stock for stockholders of record and qualified warrant holders as of February 24, 2006. The dividend of $8,114,378 was paid in March 2006. In March 2006, we announced a dividend of $0.04 per share of common stock for stockholders of record and qualified warrant holders as of March 31, 2006. The dividend of $16,583,959 was paid in April 2006

Private Stock Offerings

On July 22, 2005, 625,000 shares of common stock valued at $0.13 per share (based on the fair value on the date of issuance) were issued to the co-inventor of certain technology. We recorded an expense of $81,250 in connection with the issuance of these shares.

On March 21, 2006, 193,548 shares of common stock valued at $1.53 per share (based on the fair value on the date of issuance) were issued to a former debenture holder in connection with a dispute regarding the number of shares of common stock issued upon conversion. We recorded an expense of $296,129 in connection with the issuance of these shares.

On November 5, 2007, 200,000 shares of common stock valued at $0.50 per share (based on the fair value on the date of issuance) were issued to a former officer in connection with a legal settlement.  We recorded an expense of $100,000 in connection with the issuance of these shares.

Warrants

At May 31, 2006, we had warrants outstanding to purchase 53,349,220 common shares at exercise prices ranging from $0.02 to $1.00 per share, expiring at various dates through 2012. Some of those outstanding warrants were not exercisable as of May 31, 2006 as they were subject to meeting vesting criteria. During the year ended May 31, 2006, we issued warrants to purchase 12,457,049 shares of common stock, investors exercised warrants to purchase 8,728,544 shares of common stock for proceeds of $470,657 and investors exercised warrants of 44,110,139 to purchase 41,245,473 shares of common stock on a cashless basis. During the year ended May 31, 2006, we cancelled warrants to purchase 13,391,727 shares of our common stock. Included in the aforementioned warrants issued during the year ended May 31, 2006 were warrants to purchase 300,000 shares of common stock issued to a consultant. The value of these warrants of $176,866 was recorded as an expense during the year ended May 31, 2006. We also granted new warrants and agreed to re-price certain outstanding warrants in

F-29

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

order to obtain the necessary approvals from certain security interest holders as well as to obtain the release of their security interests in our intellectual property, and to finalize the LLC Agreement to form PDS.   As additional consideration to the warrant holders for providing approval for the transaction, we agreed to reset the per share exercise price of approximately 35,000,000 warrants to $0.015 for which the warrant holders also conveyed other warrants to acquire 12,000,000 shares back to us (see Note 9).

Effective January 11, 2006, we entered into a warrant redemption agreement with a warrant holder, whereby at our option, we agreed to redeem certain warrants representing the right to acquire an aggregate of up to 10,000,000 shares of our common stock, through April 2006. The warrants may be redeemed in quantities not to exceed 2,000,000 warrants in any one calendar month, at a price equal to the product of (a) the volume weighted average of the daily volume weighted average prices of our common stock for all trading days in the applicable calendar month, minus the exercise price of the warrant, multiplied by (b) the number of shares being redeemed from that warrant. On February 3, 2006, we agreed to redeem 2,000,000 warrants for $252,420 and payment for the redemption occurred in March 2006.

Effective February 9, 2006, we entered into “Reset Agreements” with certain warrant holders and received waivers from the warrant holders with regard to certain terms of certain warrants held by the warrant holders. Under the terms of the Reset Agreements, we and the warrant holders agreed to amend the terms of (i) each of the warrants held by the warrant holders such that the exercise price of the warrants is no longer subject to downward resets based on the trading price of our common stock, and (ii) each of the debentures held by the warrant holders such that the conversion price of the debentures is fixed at its current level. No additional expense was required for the modification of the exercise price of the warrants since the new fixed price of the warrants was equal to the original exercise price at date of issuance or was equal to the then reset price in effect for which we had previously recognized an expense for the modification. Under the terms of the Reset Agreements, we and the warrant holders also agreed to amend all of the agreements entered into between us and the warrant holders that limit the ability of the warrant holders to be the beneficial owner of more than 4.99% of our common stock to be amended to provide that the warrant holders may not, through the exercise of warrants, the conversion of debentures, or otherwise, be the beneficial owner of more than 9.99% of our common stock.

Under the terms of the waiver agreements, the warrant holders agreed to amend their rights under the terms of certain warrants held by each of them to receive a payment in the event of a payment of a dividend by us. Prior to entering into the waiver agreements, if at any time after the issuance date of the subject warrants, we made any distributions to holders of our common stock, the warrant holders would be entitled to receive a payment equal to the amount of such distribution which would have been payable to them had they owned the shares of common stock issuable upon exercise of the subject warrants as of the record date for the distribution. Under the terms of the waiver agreement, if the market price of our common stock on the record date for a distribution is greater than or equal to $0.15 per share, the payment to the warrant holders would be reduced to the amount which would be payable to the warrant holders had they engaged in a cashless exercise of the subject warrants as of the record date for the distribution. In consideration for entering into the agreements, we issued warrants for the right to acquire 7,000,000 shares of our common stock to one warrant holder and recognized a loss on debt extinguishment of $445,427 (see Note 12).

In connection with a previous debt agreement, we entered into an Antidilution Agreement (the “Antidilution Agreement”) with Swartz Private Equity, LLC (“Swartz”) wherein we were obligated to issue to Swartz warrants equal to 11% of the common stock issued between January 28, 2002 and March 11, 2002, 20% of the common stock issued between March 12, 2002 and April 1, 2003, and after April 1, 2003, 30% of the common stock issued to any parties other than Swartz. There were no warrants issued during the years ended May 31, 2007 or 2006 in connection with the Antidilution agreement. On October 10, 2006, we entered into an Approval Rights Agreement and Termination of Antidilution Agreement and Addendum to Warrants (the “Termination Agreement”) with Swartz to terminate the Antidilution Agreement. In consideration for entering into the Termination Agreement, we agreed that through May 31, 2008 we would obtain Swartz’s written approval at least 30 days prior to entering into (i) any acquisition of any business entity or asset of any kind where the aggregate number of shares of common stock and derivative securities (on a fully diluted basis) issued as consideration for the acquisition equals or exceeds 10% of the number of shares of our common stock outstanding at the time of the acquisition (on a fully diluted basis) or (ii) any acquisition (regardless of size) by us of any business entity or asset of any kind that is not unanimously approved by our board of directors.

F-30

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

At May 31, 2007, we had warrants outstanding to purchase 12,060,915 common shares at exercise prices ranging from $0.02 to $1.00 per share, expiring at various dates through 2012. Some of those outstanding warrants were not exercisable as of May 31, 2007 as they were subject to meeting vesting criteria. During the year ended May 31, 2007, investors exercised warrants to purchase 1,272,500 shares of common stock for proceeds of $172,250 and investors exercised warrants of 40,000,805 to purchase 38,681,396 shares of common stock on a cashless basis. During the year ended May 31, 2007, 15,000 warrants expired and 1,319,409 warrants were cancelled due to cashless exercises.

At May 31, 2008, we had warrants outstanding to purchase 300,000 common shares at exercise prices ranging from $0.20 to $1.00 per share, expiring at various dates through 2011.  During the year ended May 31, 2008, we issued no warrants to purchase shares of common stock, an investor exercised warrants to purchase 125,000 shares of common stock for proceeds of $6,250, 1,933,259 warrants expired or were cancelled due to cashless exercises, 3,700,000 warrants were exercised utilizing the cashless method of exercise for 2,702,656 shares, and we repurchased 7,000,000 warrants for $2,760,900 under terms of our warrant repurchase agreement with Lincoln Ventures, LLC.

On August 1, 2008, we issued a warrant to purchase 250,000 shares of our common stock for $0.23 per share to our institutional investor relations firm.  The warrant is subject to vesting provisions.

The following table presents outstanding warrants at May 31, 2008 and 2007:

		2008			2007
Issued in conjunction with:
Convertible debentures			-		560,915
Anti-dilution agreements			-		-
Equity lines of credit			-		-
Waiver agreements			-		7,000,000
Other			300,000		4,500,000
Total warrants outstanding			300,000		12,060,915

1996 Stock Option Plan

Effective March 1996, as amended, we adopted the 1996 Stock Option Plan. Under the 1996 Stock Option Plan, which expired March 24, 2006, options to purchase up to 4,000,000 shares of our common stock may be granted to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 1996 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal year ended May 31, 2006, we granted options to purchase 50,000 shares of common stock at market value, under the 1996 Stock Option Plan. As of May 31, 2008, options to purchase 100,000 shares of common stock are outstanding under the 1996 Stock Option Plan. The options outstanding continue to be governed by the terms of the 1996 Stock Option Plan.

F-31

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

2001 Stock Option Plan

The 2001 Stock Option Plan, which expires in February 2011, provides for the granting of options to purchase up to 3,000,000 shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2001 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal years ended May 31, 2008, 2007 and 2006, we granted options to purchase 699,000, 230,000 and 145,000 shares of our common stock, respectively, at market value, under this plan. As of May 31, 2008, options to purchase 874,000 shares of common stock are outstanding under the 2001 Stock Option Plan.

2003 Stock Option Plan

The 2003 Stock Option Plan, which expires in 2013, provides for the granting of options to acquire up to 6,000,000 shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2003 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal years ended May 31, 2008 and 2006, we granted options to purchase 3,723,000 and 1,550,000 shares of our common stock, respectively, at market value, under this plan. There were no grants made under the 2003 Stock Option Plan during the fiscal year ended May 31, 2007. As of May 31, 2008, options to purchase 2,973,000 shares of common stock are outstanding under the 2003 Stock Option Plan.

2006 Stock Option Plan

The 2006 Stock Option Plan, which expires in 2016, provides for the granting of options to acquire up to 5,000,000 shares, with a limit of 3,000,000 Incentive Stock Option (“ISO”) shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2006 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). On March 11, 2008 we amended our 2006 Stock Option Plan to increase the total number of shares of our common stock issuable under the plan from 5,000,000 to 7,000,000.  Shareholders will be asked to ratify the amendment to the plan at our next annual meeting.  During the fiscal years ended May 31, 2008, 2007 and 2006, we granted options to purchase 2,203,000, 1,070,000 and 2,050,000 shares of our common stock, respectively, under this plan, 200,000, 70,000 and 192,857 shares, respectively, of which were ISOs. In connection with May 31, 2006 option grants, we recognized compensation expense of $120,000 related to options granted below the fair market value of our common stock at the date of grant. As of May 31, 2008, options to purchase 4,248,000 shares of common stock are outstanding under the 2006 Stock Option Plan.

On June 5, 2006, we issued options to acquire 1,500,000 shares of our common stock at a per share price of $0.165 to an officer outside of the above referenced plans.

F-32

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

A summary of the status of our stock option plans and warrants as of May 31, 2008, 2007 and 2006 and changes during the years ended on those dates is presented below:

 

		Options								Warrants
		Shares				Weighted Average Exercise Price				Shares				Weighted Average Exercise Price
Outstanding, June 1, 2005			7,148,000			$	0.13				109,122,581			$	0.04
Granted			3,795,000				0.46				12,457,049				0.09
Cancelled/Expired			(1,387,000	)			0.30				(13,391,727	)			0.05
Repurchased			-				-				(2,000,000	)			0.02
Exercised			(4,096,000	)			0.09				(52,838,683	)			0.03
Outstanding, May 31, 2006			5,460,000				0.34				53,349,220				0.05
Granted			2,800,000				0.39				-				-
Cancelled/Expired			(500,000	)			0.09				(1,334,409	)			0.03
Exercised			(515,000	)			0.08				(39,953,896	)			0.03
Outstanding, May 31, 2007			7,245,000				0.40				12,060,915				0.10
Granted			6,625,000				0.43				-				-
Cancelled/Expired			(4,392,154	)			0.45				(1,933,259	)			0.09
Repurchased			-				-				(7,000,000	)			0.08
Exercised			(1,282,846	)			0.15				(2,827,656	)			0.12
Outstanding, May 31, 2008			8,195,000			$	0.44				300,000			$	0.57
Exercisable, May 31, 2006			5,115,000			$	0.35				52,849,220			$	0.05
Exercisable, May 31, 2007			7,245,000			$	0.40				11,685,915			$	0.10
Exercisable, May 31, 2008			4,265,372			$	0.47				300,000			$	0.57
Weighted average fair value of options and warrants granted during the year ended May 31, 2006						$	0.49							$	0.19
Weighted average fair value of options granted during the year ended May 31, 2007						$	0.82							$	-
Weighted average fair value of options granted during the year ended May 31, 2008						$	0.32							$	-

Included in the above table are certain options and warrants for which vesting is contingent based on various future performance measures.

 

F-33

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

The following table summarizes information about stock options and warrants outstanding at May 31, 2008:

	Range of Exercise Prices	Outstanding			Exercisable
		Number Outstanding	Weighted Average Remaining Contractual Life (Years)	Weighted Average Exercise Price	Number Exercisable	Weighted Average Exercise Price
Options	$ 0.05-0.20	1,350,000	1.82	$0.13	1,350,000	$0.13
	0.30-0.50	4,625,000	4.66	0.41	695,372	0.43
	0.60-0.90	2,220,000	3.16	0.68	2,220,000	0.68
	$ 0.05-0.90	8,195,000	3.79	$0.44	4,265,372	$0.47
Warrants	$ 0.20-1.00	300,000	2.72	$0.57	300,000	$0.57

14. Income Taxes

The provision (benefit) for income taxes is as follows for the years ended May 31:

		2008				2007				2006
Current:
Federal		$	12,540,914			$	-			$	-
State			3,973,734				972,064				-
Total current			16,514,648				972,064				-
Deferred:
Federal			(7,615,720	)			7,767,761				-
State			(2,472,899	)			2,015,208				-
Total deferred			(10,088,619	)			9,782,969				-
Total provision		$	6,426,029			$	10,755,033			$	-

No provision for income taxes was recorded for the year ended May 31, 2006 due to the significant net operating loss carryforwards.

F-34

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Income Taxes (continued)

The reconciliation of the effective income tax rate to the Federal statutory rate is as follows for the years ended May 31:

		2008				2007				2006
Statutory federal income tax rate			35.0	%			34.0	%			34.0	%
State income tax rate, net of Federal effect			6.1	%			5.7	%			-	%
Change in tax rate			1.3	%			-	%			-	%
Change in deferred tax related to non cash compensation			2.2	%			-	%			-	%
Foreign tax credit			(3.7	) %			-	%			-	%
Other			-	%			0.3	%			-	%
(Decrease) increase in valuation allowance			(0.6	) %			(8.7	) %			(34.0	) %
Effective income tax rate			40.3	%			31.0	%			-	%

Deferred tax assets and liabilities reflect the net tax effect of temporary differences between the carrying amount of asset and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of our deferred tax assets are as follows as of May 31:

		2008				2007
Current deferred tax assets (liabilities):
Net operating loss carryforwards		$	-			$	1,894,097
Accruals and state taxes			1,412,500				376,257
Basis difference in fixed assets			-				-
Basis difference in intangibles			-				-
Investment in affiliated companies			-				-
Credits			-				242,411
Less: valuation allowance			(21,668	)			(72,790	)
Total net deferred tax asset			1,390,832				2,439,975
Long-term deferred tax assets (liabilities):
Investment in affiliated company			(2,682,823	)			(14,128,084	)
Basis difference in fixed assets			(1,918	)			(2,870	)
Basis difference in intangibles			927,088				1,072,117
Stock based compensation expense			235,779				835,893
Impairment of note receivable			148,859				-
Deferred state taxes			94,796				-
Other comprehensive loss			163,227				-
Capital loss carryover			29,811				-
Total net long-term deferred tax liability			(1,085,181	)			(12,222,944	)
Net deferred tax asset (liability)		$	305,651			$	(9,782,969	)

F-35

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Income Taxes (continued)

At May 31, 2008, the $21,668 valuation allowance above relates entirely to SSDI as management has not determined that it is more likely than not that the deferred tax asset relating to various accruals will be realized.  For federal and state tax purposes, SSDI is not consolidated with our corporate income tax filings. SSDI is consolidated however, in the components of our net deferred tax assets and liabilities as indicated above.

During fiscal year 2007, the valuation allowance of $2,872,255 relating to our deferred tax assets was released as we determined that we would utilize our net operating loss carryforwards and other deferred tax assets. For federal and state tax purposes, SSDI is not consolidated with our corporate income tax filings. SSDI is consolidated however, in the components of our net deferred tax assets and liabilities as indicated above. The $72,790 valuation allowance above relates entirely to SSDI as management has not determined that it is more likely than not that the deferred tax asset relating to net operating loss carryforwards will be realized.

During fiscal year 2008, we have utilized our remaining federal net operating loss carryforward of approximately $4,870,000 and our general business credit carryforward of $242,411.

On June 1, 2007, we adopted FIN 48. This interpretation clarifies the application of SFAS No. 109, Accounting for Income Taxes, by defining criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in a company’s financial statements and also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  The adoption of FIN 48 on June 1, 2007 did not result in any cumulative effect adjustment to retained earnings.  Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense.  As of June 1, 2007, we are subject to U.S. Federal income tax examinations for the tax years May 31, 1991 through May 31, 2007, and we are subject to state and local income tax examinations for the tax years May 31, 1999 through May 31, 2007 due to the carryover of net operating losses from previous years.

15. Commitments and Contingencies

Litigation

Patent Litigation

On February 8, 2008, the Company, TPL and Alliacense Ltd. were named as defendants in three separate lawsuits filed in the United States District Court for the Northern District of California by Asustek Computer, Inc., HTC Corporation, and Acer, Inc., and affiliated entities of each of them. On February 13, 2008, the Asustek claims were amended to include claims against MCM Portfolio, LLC (Alliacense and MCM Portfolio are TPL-related entities), which do not involve the Company.

The Asustek case seeks declaratory relief that its products do not infringe enforceable claims of our '336, '584 and '749 patents.  The Asustek case also seeks a similar declaration with respect to two patents owned by TPL that are not a part of the MMP Portfolio, and as such the Company is not engaged in this aspect of the litigation and defense.  The Acer case seeks declaratory relief that its products do not infringe enforceable claims of our '336, '584 and '749 patents.  The HTC case similarly seeks declaratory relief that its products do not infringe enforceable claims of those three patents and our '148 patent.

On April 25, 2008, the Company and TPL filed five patent infringement lawsuits in the Eastern District of Texas against HTC, Acer and Asustek.  These suits allege infringement by HTC and Acer with respect to our '336 '749 '584 and '148 patents; and by Asustek with respect to our '336, '749 and '584 patents.  On June 4, 2008, the Company and TPL filed patent infringement lawsuits against those parties in the Eastern District of Texas with respect to our '890 patent of the MMP Portfolio.  Motions to dismiss or transfer the Northern District of California actions to the Eastern District of Texas are currently pending with hearings set for August 29, 2008 in the Acer case and September 19, 2008 for the HTC and Asustek

F-36

---

 

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

cases.  At that point we expect to learn where the T-3 (“Acer, Asustek and HTC”) litigation will proceed.  Responsive pleadings in those cases are due at varying times in mid-August and early September 2008.  Similar to the actions in the Northern District of California, the Asustek action in the Eastern District of Texas is inclusive of matters with respect to two patents owned by TPL that are not a part of the MMP Portfolio, and as such we are not engaged in this aspect of the litigation and defense.

Lowell Giffhorn Arbitration

On September 23, 2005, Lowell Giffhorn, a former executive officer and a former director of the Company, submitted a demand for arbitration with the American Arbitration Association related to the termination of Mr. Giffhorn's employment with the Company. Mr. Giffhorn asserted that the termination of his employment with the Company was unlawful, retaliatory, wrongful, violated public policy, violated the covenant of good faith and fair dealing and violated securities laws. Mr. Giffhorn sought damages of approximately $4,500,000 (excluding claims for punitive damages and attorney’s fees). On November 1, 2007, the Company and Mr. Giffhorn reached a settlement where Mr. Giffhorn was given $500,000 and 200,000 shares of restricted Company stock in exchange for a comprehensive release of all claims against the Company.  We have recorded these costs in selling, general and administrative expenses for fiscal year ended May 31, 2008.

401(k) Plan

We have a retirement plan that complies with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. We match 50% of each participant’s voluntary contributions, subject to a maximum contribution of 6% of the participant’s compensation. Participants vest 33% per year over a three year period in our contributions. Our matching contributions during the fiscal years ended May 31, 2008, 2007 and 2006 were $9,596, $11,397 and $1,833, respectively.

Employment Contracts

During the quarter ended August 31, 2005, we terminated two of our officers, each of whom had an employment contract with us. One of the officers agreed to accept as severance approximately $150,000 and to have the maturity date of options held by him extended for one year. Further, we agreed to accelerate the vesting of all outstanding options held by the officer and to extend their term to June 2006. We recorded an expense of approximately $125,000 related to this option modification in the year ended May 31, 2006.

On June 5, 2007, Mr. Pohl, our outgoing chief executive officer retired. As a result, we recorded a severance charge of $100,000 based on terms of his employment agreement which provided for salary continuation.

In connection with Mr. Turley’s appointment as President and Chief Executive Officer, and commencing on June 5, 2007, we entered into an employment agreement with Mr. Turley for a one-year term.  Pursuant to the agreement, if Mr. Turley was terminated without cause, he was entitled to his then current salary level for the remaining term of his agreement conditional upon the execution of a general release.  On February 28, 2008, Mr. Turley resigned.  As a result, we recorded a one-time severance charge of $95,192 during the fiscal year 2008 in full discharge of all remaining obligations to Mr. Turley.

 

In connection with Mr. Flowers’ appointment as the Chief Financial Officer, and commencing on September 17, 2007, we entered into an employment agreement with Mr. Flowers for an initial 120-day term if not terminated pursuant to the agreement, with an extension period of one year and on a continuing basis thereafter.  Pursuant to the agreement, if Mr. Flowers is terminated without cause or resigns with good reason within the first two years of employment, he is entitled to receive an amount equal to his annual base salary for the greater of (i) 6 months or (ii) the period remaining in the extended one-year term.  If Mr. Flowers is terminated without cause or resigns with good reason any time after two years of continuous employment, he is entitled to receive an amount equal to 12 months of his annual base salary.  Mr. Flowers is also entitled to certain payments upon a change of control of the Company if the surviving corporation does not retain him. All such payments are conditional upon the execution of a general release.

 

F-37

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

In connection with Mr. Goerner’s appointment as Interim President and Chief Executive Officer, and commencing on February 29, 2008 (the “Effective Date”), we entered into an Employment Agreement (the “Agreement”) with Mr. Goerner, terms of which were finalized May 19, 2008. The agreement is for an initial 120-day term if not terminated pursuant to the agreement, with an extension period of one year and on a continuing basis thereafter.  Pursuant to the Agreement, Mr. Goerner is to receive a base salary of $250,000 per year and is eligible to receive a bonus of 100% of his base salary at the time his position is converted by the Board of Directors to standing President/CEO or nine months from the effective date of the agreement.  If Mr. Goerner is terminated without cause during the nine month period after the effective date he shall receive a pro-rata portion of the bonus based on the term of his actual employment with us.  Also pursuant to the Agreement and on the date of the Agreement, Mr. Goerner received a grant of incentive stock options to purchase 250,000 shares of our common stock and non-qualified stock options to purchase 50,000 shares of our common stock.  Mr. Goerner also received a grant of non-qualified stock options to purchase 700,000 shares of our common stock to vest upon conversion of his position to standing President/CEO or nine months from the effective date of the agreement, whichever is first to occur and Mr. Goerner also received a grant of non-qualified stock options to purchase 2,000,000 shares of our common stock to vest upon meeting performance conditions outlined in the grant.  The Agreement also provides for Mr. Goerner to receive customary employee benefits, including health, life and disability insurance, and an automobile allowance.

Pursuant to the agreement, if Mr. Goerner is terminated without cause within the first year of employment, after the initial 120-day term, he is entitled to receive an amount equal to his base salary for the period remaining in the agreement.  Payments are conditional upon the execution of a general release.

Guarantees and Indemnities

We have made certain guarantees and indemnities, under which we may be required to make payments to a guaranteed or indemnified party. We indemnify our directors, officers, employees and agents to the maximum extent permitted under the laws of the State of Delaware and California for SSDI. In connection with our facility leases, we have indemnified our lessors for certain claims arising from the use of the facilities. The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying consolidated balance sheets.

Operating Leases

We have a non-cancelable operating lease agreement for our Carlsbad, California office facility. Future minimum lease payments required under the operating lease are $73,710 in fiscal year 2009. Rent expense for the fiscal years ended May 31, 2008, 2007 and 2006 was $113,734, $92,928 and $30,976, respectively.

SSDI subleases their Carlsbad, California office facility which expired in June 2008 with a month-to-month option until not later than December 2008.  Future minimum lease payments required under the operating lease are $7,351 in fiscal year 2009.  Rent expense for the fiscal year ended May 31, 2008 and the fourth quarter of fiscal 2007 was $89,082 and $15,138, respectively.

SSDI leases their Anaheim, California warehouse facility under a lease which expires November 30, 2009.  Future minimum lease payments required under the operating lease are $75,432 in fiscal year 2009 and $31,430 in fiscal year 2010.  Rent expense for the fiscal year ended May 31, 2008 and the fourth quarter of fiscal 2007 was $58,800 and $14,700, respectively.

SSDI subleases a  San Diego, California office facility under a lease which began September 1, 2007 and expires August 31, 2008.  Future minimum lease payments required under the operating lease are $4,500 in fiscal year 2009.  Rent expense for the fiscal year ended May 31, 2008 was $13,500.

F-38

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

Earn-Out Agreement

SSDI entered into an earn-out agreement with a former debt holder of Holocom Networks upon our contribution of the foreclosure sale collateral of Holocom Networks to SSDI. The agreement required the former debt holder to release all of his rights to any Holocom collateral in exchange for receiving 3% of the net sales (defined as cash revenues actually received less credits or discounts and other claims of customers) of SSDI’s protected distribution system products for a period of 48 months from the foreclosure sale date of February 2, 2007. The earn-out is to be paid each calendar quarter. A liability for payment under this agreement of $29,747 is included in accounts payable in the accompanying consolidated balance sheet at May 31, 2008.  Amounts paid under the earn-out agreement for the fiscal year ended May 31, 2008 and the fourth quarter of fiscal 2007 were $62,570 and $6,783, respectively.

16. Segment Information

SSDI began operations in February 2007 and we consolidated SSDI in our financial statements in March 2007. SSDI is an operating segment under SFAS No. 131, Disclosures About Segments of an Enterprise, as revenue is 10% or more of the total revenue of all operating segments.

SSDI is engaged in the business of developing and manufacturing network-security hardware to government, military, and other high-security facilities. There is no inter-segment revenue and the accounting policies for segment reporting are the same as for us as a whole.

The “all other” category includes the results for Patriot Scientific Corporation.

Operating segment net revenue, operating income (loss) and income (loss) before taxes for each of the years ended May 31 were as follows:

		2008				2007				2006
Net revenue:
SSDI		$	3,649,898			$	558,484			$	-
All other			58,320				80,300				10,309,709
Total net revenue		$	3,708,218			$	638,784			$	10,309,709
Operating income (loss):
SSDI		$	146,131			$	(176,432	)		$	-
All other			(5,749,624	)			(14,587,407	)			3,911,640
Total operating income (loss)		$	(5,603,493	)		$	(14,763,839	)		$	3,911,640

		2008				2007				2006
Income (loss) before taxes:
SSDI		$	297,235			$	(169,913	)		$	-
All other			15,632,521				34,616,133				28,672,688
Total income (loss) before taxes		$	15,929,756			$	34,446,220			$	28,672,688

F-39

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Segment Information (continued)

All sales were to unaffiliated customers within the United States.

Sales and accounts receivable concentration information for SSDI for the years ended May 31 were as follows:

 

	2008			2007
	Sales	% of sales	% of A/R	Sales	% of sales	% of A/R
Anixter	$1,354,494	37%	16%	$461,494	85%	85%
Graybar Electric Company, Inc.	$889,724	24%	38%	-----	----	-----
Victory Global Solutions	$370,301	10%	6%	-----	----	-----

Operating segment depreciation and amortization for each of the years ended May 31and total assets at May 31 were as follows:

		2008				2007				2006
Depreciation and amortization:
SSDI		$	21,877			$	22,740			$	-
All other			28,828				42,121				59,415
Total depreciation and amortization		$	50,705			$	64,861			$	59,415

		2008				2007
Total assets:
SSDI		$	1,383,941			$	642,871
All other			24,047,961				33,771,758
Total assets		$	25,431,902			$	34,414,629

17. Subsequent Events

During the period June 1, 2008 through August 8, 2008, we purchased 1,966,160 shares of our common stock at an aggregate cost of $400,906 pursuant to our stock buyback program.

On June 1, 2008, SSDI assigned its note receivable of $50,000 to us and we agreed to reduce the amount of our line of credit with SSDI by the amount of the note.  On June 26, 2008, we were paid in full by the third party debtor.

On June 18, 2008, we gave SSDI notice under terms of the line of credit that we would not be extending the maturity date by the additional twelve month period provided for in the line of credit. As a result, the line of credit will terminate, and full payment of any outstanding balance will be due on September 27, 2008.

During June 2008, we obtained a credit facility, for as long as needed, which provides for financing up to 50% of the par value balance of our outstanding auction rate securities. The facility is collateralized by the full value of the outstanding auction rate securities, required no origination fee, and if drawn upon will bear interest at the federal funds rate plus 3%.

On July 11, 2008, we invested approximately $149,000 to purchase preferred shares of an unrelated private company which is a networking provider of software to facilitate the transfer of video content to mobile devices.  We are accounting for our investment using the cost method as we do not own any of the voting common stock of the company.

F-40

---

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Subsequent Events (continued)

During July 2008, SSDI obtained a credit facility for up to $300,000 from a third party, at an interest rate based on the Wall Street Journal Prime plus 1% (floating) with a floor of 6%.  The credit facility term extends to May 1, 2009, and is guaranteed by Patriot.

On August 1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing additional shares offered by Talis, as well as acquiring shares from minority shareholders which included the acquisition of all Talis shares previously held by SSDI. The acquisition of Talis shares previously owned by SSDI was made for $100,000 in cash and a reduction on their outstanding line of credit of $219,000. After the purchase of SSDI’s Talis shares and the June 1 assignment of the $50,000 note receivable from SSDI, SSDI’s outstanding balance on its Patriot line of credit was reduced to $131,000.

On August 1, 2008, SSDI paid $56,000 on its Patriot line of credit reducing the principal balance to $75,000.

On August 1, 2008, we issued a warrant to purchase 250,000 shares of our common stock for $0.23 per share to our institutional investor relations firm.  The warrant is subject to vesting provisions.

On August 4, 2008, we announced our intent to acquire Crossflo for $10 million comprised of cash and stock with an effective completion date of September 1, 2008, subject to approval by Crossflo’s shareholders.

On August 8, 2008, we purchased a secured convertible promissory note with an attached warrant for common stock from Crossflo with a face amount of $417,750.  Terms of the note are the same as those outlined in Note 4.

 

 

F-41

---

Phoenix Digital Solutions, LLC

INDEX TO FINANCIAL STATEMENTS

	Page
Report of Independent Registered Public Accounting Firm		F-43
Financial Statements:
Balance Sheets		F-44
Statements of Income		F-45
Statements of Members’ Equity		F-46
Statements of Cash Flows		F-47
Notes to Financial Statements		F-48

 

 

F-42

---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Members

Phoenix Digital Solutions, LLC

We have audited the accompanying balance sheets of Phoenix Digital Solutions, LLC (the "Company") as of May 31, 2008 and 2007, and the related statements of income, members' equity and cash flows for each of the years in the three-year period ended May 31, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above, present fairly, in all material respects, the financial position of Phoenix Digital Solutions, LLC as of May 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended May 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

/s/ KMJ Corbin & Company LLP

Irvine, California

August 14, 2008

F-43

---

Phoenix Digital Solutions, LLC

Balance Sheets

May 31,		2008				2007
ASSETS
Current assets:
Cash and cash equivalents		$	8,260,288			$	6,989,847
Prepaid expenses			-				175,000
Total current assets		$	8,260,288			$	7,164,847
LIABILITIES AND MEMBERS’ EQUITY
Current liabilities:
Accounts payable		$	3,204,519			$	1,225,118
Accrued expenses			-				160,000
Income tax payable			11,790				11,790
Total current liabilities			3,216,309				1,396,908
Commitments and Contingencies
Members’ equity			5,043,979				5,767,939
Total liabilities and members’ equity		$	8,260,288			$	7,164,847

See accompanying notes to financial statements.

 

F-44

---

Phoenix Digital Solutions, LLC

Statements of Income

Years Ended May 31,		2008				2007				2006
License revenues		$	59,282,971			$	110,878,985			$	60,000,000
Operating expenses:
General and administrative			18,627,032				12,189,575				4,486,955
Operating income			40,655,939				98,689,410				55,513,045
Other income:
Interest income			216,902				421,407				183,682
Income before income taxes			40,872,841				99,110,817				55,696,727
Provision for income taxes			11,790				11,790				-
Net income		$	40,861,051			$	99,099,027			$	55,696,727

See accompanying notes to financial statements.

 

F-45

---

Phoenix Digital Solutions, LLC

Statements of Members’ Equity

Balance June 1, 2005		$	-
Contributions			4,000,000
Net income			55,696,727
Distributions			(52,064,781	)
Balance May 31, 2006			7,631,946
Contributions			-
Net income			99,099,027
Distributions			(100,963,034	)
Balance May 31, 2007			5,767,939
Contributions			-
Net income			40,861,051
Distributions			(41,585,011	)
Balance May 31, 2008		$	5,043,979

See accompanying notes to financial statements.

 

F-46

---

Phoenix Digital Solutions, LLC

Statements of Cash Flows

Years Ended May 31,		2008				2007				2006
Operating activities:
Net income		$	40,861,051			$	99,099,027			$	55,696,727
Adjustments to reconcile net income to net cash provided by operating activities:
Changes in operating assets and liabilities:
Prepaid expenses			175,000				(160,000	)			(15,000	)
Accounts payable and accrued expenses			1,819,401				1,236,356				148,762
Income tax payable			-				11,790				-
Net cash provided by operating activities			42,855,452				100,187,173				55,830,489
Financing activities:
Contributions from members			-				-				4,000,000
Distributions to members			(41,585,011	)			(100,963,034	)			(52,064,781	)
Net cash used in financing activities			(41,585,011	)			(100,963,034	)			(48,064,781	)
Net increase (decrease) in cash and cash equivalents			1,270,441				(775,861	)			7,765,708
Cash and cash equivalents, beginning of year			6,989,847				7,765,708				-
Cash and cash equivalents, end of year		$	8,260,288			$	6,989,847			$	7,765,708
Supplemental Disclosure of Cash Flow Information
Cash payments for income taxes		$	12,590			$	13,390			$	12,590

See accompanying notes to financial statements.

 

F-47

---

Phoenix Digital Solutions, LLC

Notes to Financial Statements

1. Organization and Business

Phoenix Digital Solutions, LLC (the “Company”) is a Delaware limited liability company organized on June 7, 2005. Through a commercialization agreement dated June 7, 2005, the Company holds the rights to certain patents of its members. The Company receives license fees from license agreements entered into between licensees and a member of the Company and distributes license fee proceeds to its members.

2. Summary of Significant Accounting Policies

Limited Liability Company Operating Agreement

As a limited liability company, each member’s liability is limited to the capital invested. Allocation of profits, losses and distributions is in accordance with the terms as defined in the operating agreement.

The Company is treated as a partnership for federal income tax purposes. Consequently, federal income taxes are not payable by the Company. The Company’s net income or loss is allocated among the members in accordance with the operating agreement of the Company and members are taxed individually on their share of the Company’s earnings. The State of California assesses a limited liability company a fee based on the Company’s income in addition to a flat limited liability company tax.  Accordingly the financial statements reflect a provision for these California taxes.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts and disclosures. Accordingly, actual results could differ from those estimates.

Revenue Recognition

The Company recognizes revenue upon receipt of the license proceeds from the licensee at which time all obligations of the Company have been performed under the license agreements.

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less at the date of acquisition to be cash equivalents.

Financial Instruments and Concentrations

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents.

Credit Risk

The Company’s balance of cash maintained with its bank exceeds the Federal Deposit Insurance Corporation’s insured limit of $100,000. The Company limits its exposure of loss by maintaining its cash with financially stable financial institutions.

Intellectual Property Rights

The Company relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. The Company currently has seven U.S. patents, one European patent, and one Japanese patent issued. A successful challenge to its ownership of the technology or the proprietary nature of the intellectual property would materially damage the Company’s business prospects. Any issued patent may be challenged and invalidated.

 

F-48

---

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

3. Formation and Commercialization Agreement

The Company has two members: Technology Properties Limited Inc. (“TPL”), and Patriot Scientific Corporation (“PTSC”). Each member owns 50% of the membership interests of the Company. Each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. Pursuant to the LLC Agreement, the members agreed to establish a working capital fund for the Company of $4,000,000, of which each member contributed $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. The members are obligated to fund future working capital requirements at the discretion of the management committee of the Company in order to maintain working capital of not more than $8,000,000. Neither member is required to contribute more than $2,000,000 in any fiscal year. Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined in the LLC Agreement.

On June 7, 2005, the Company entered into a Commercialization Agreement with TPL and PTSC. This Commercialization Agreement allows TPL to commercialize the patent portfolio by entering into settlement and/or license agreements, suing in the name of TPL, PTSC, the Company and Charles Moore, and manage the use of the patent portfolio by third parties.

Under terms of the Commercialization Agreement, the Company is required to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance) to TPL for TPL’s supporting efforts to secure licensing agreements for the Company. During the years ended May 31, 2008, 2007 and 2006, the Company paid $2,952,362, $3,871,602 and $2,500,000, respectively, to TPL pursuant to the agreement. The Company is also required to reimburse TPL for payment of all legal and third-party expert fess and other related third party costs and expenses. During the years ended May 31, 2008, 2007 and 2006, the Company paid $12,894,053, $5,914,000 and $1,021,357, respectively, to TPL pursuant to the agreement.  All of the amounts are recorded in general and administrative expense in the accompanying statements of income.

4. Commitments and Contingencies

Guarantees and Indemnities

Under the LLC Operating Agreement, the Company indemnifies its members, managers, officers and employees from any damages and liabilities by reason of their management or involvement in the affairs of the Company as long as the indemnitee acted in good faith and in the best interests of the Company.

Under the Commercialization Agreement, the Company and PTSC hold harmless TPL and its representatives with respect to all claims of any nature by or on behalf of the Company and PTSC related to the preparation, execution and delivery of the Commercialization Agreement.

The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying balance sheets.

5. Related Party Transactions

At May 31, 2008, PDS had accounts payable balances of approximately $3,197,000 and $7,500 to TPL and PTSC, respectively.

F-49

---

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

DATED: August 14, 2008

PATRIOT SCIENTIFIC CORPORATION   /S/ FREDERICK C. GOERNER Frederick C. Goerner President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature		Title	Date
/S/ FREDERICK C. GOERNER Frederick C. Goerner		President and Chief Executive Officer	August 14, 2008
/S/ CLIFFORD L. FLOWERS Clifford L. Flowers		Chief Financial Officer and Principal Accounting Officer	August 14, 2008
/S/ CARLTON M. JOHNSON Carlton M. Johnson		Director	August 14, 2008
/S/ GLORIA H. FELCYN Gloria H. Felcyn		Director	August 14, 2008
/S/ HELMUT FALK, JR Helmut Falk, Jr.		Director	August 14, 2008
/S/ HARRY L. TREDENNICK Harry L. Tredennick		Director	August 14, 2008
/S/ DONALD E. SCHROCK Donald E. Schrock		Director	August 14, 2008