Mosaic ImmunoEngineering Inc. - Annual Report: 2018 (Form 10-K)

Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended May 31, 2018

For the transition period from ___________ to _______________

Commission File Number 0-22182

PATRIOT SCIENTIFIC CORPORATION

(Exact name of registrant as specified in its charter)

(Registrant’s telephone number, including area code): (760) 795-8517

Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.00001 par value

___________________

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES [  ]  NO [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES [  ]  NO [X]

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X]  NO [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES [X] NO [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.   [  ]   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES [  ]  NO [X]

Approximate aggregate market value of the registrant’s common stock held by non-affiliates on November 30, 2017 was $3,198,730 based on a closing price of $0.0080 per share as reported on the OTC Pink. For purposes of this calculation, it has been assumed that all shares of the registrant's common stock held by directors, executive officers and shareholders beneficially owning five percent or more of the registrant's common stock are held by affiliates. The treatment of these persons as affiliates for purposes of this calculation is not conclusive as to whether such persons are, in fact, affiliates of the registrant.

On August 24, 2018, 401,392,948 shares of common stock, par value $0.00001 per share were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None

Table of Contents

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K, including all documents incorporated by reference herein, includes certain statements constituting “forward-looking” statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act and the Private Securities Litigation Reform Act of 1995, including statements concerning our beliefs, plans, objectives, goals, expectations, anticipations, estimates, intentions, operations, future results and prospects, and we rely on the “safe harbor” provisions in those laws. We are including this statement for the express purpose of availing ourselves of the protections of such safe harbors with respect to all such forward-looking statements. The forward-looking statements in this report reflect our current views with respect to future events and financial performance. In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future,” “estimates,” “may,” “could,” “should,” “would,” “will,” “shall,” “propose,” “continue,” “predict,” “plan” and similar expressions are generally intended to identify certain of the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date made. Any forward-looking statement is not a guarantee of future performance.

These forward-looking statements are subject to certain risks and uncertainties, and actual results may differ materially from those in the forward-looking statements as a result of various factors, including, but not limited to those items shown under “Item 1A. Risk Factors” and “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Part 2. You should read this report completely with the understanding that our actual results may differ materially from what we expect. Unless required by law, we undertake no obligation to publicly release the result of any revision of these forward-looking statements to reflect events or circumstances after the date they are made or to reflect the occurrence of unanticipated events.

PART I

The Company

Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”) is an intellectual-property licensing company with several patents (described below) covering the design of microprocessor chips. Chips with our patented technology are used throughout the world in products ranging from computers and cameras to printers, automobiles and industrial devices. Through our joint venture, Phoenix Digital Solutions, LLC (“PDS”), we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may have infringed on our patents.

Our business address is 2038 Corte Del Nogal, Suite 141, Carlsbad, California 92011; our main telephone number is (760) 795-8517. Our internet website page is located at http://www.ptsc.com. All of our reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available free of charge on our internet website. The information on, or that can be accessed through, our website is not part of this Annual Report.

PTSC is a corporation organized under Delaware law on March 24, 1992, and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987. In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form PDS. In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. During April 2012, we sold substantially all of the assets of PDSG.

Our Technology

The global semiconductor (or silicon “chip”) market has many segments and categories. The best-known - and most profitable - of these is the microprocessor segment. Microprocessor chips are the “brains” of most electronic and electrical devices throughout the world. Although microprocessors are often closely associated with personal computers (“PCs”), PCs account for only a small fraction of the microprocessor chips made and sold every year. The vast majority of microprocessors are used in everyday items like automobiles, digital cameras, cell phones, video game players, data networks, industrial flow-control valves, sensors, medical devices, weapons, home appliances, robots, security systems, televisions, and much more. These “embedded microprocessors” (so called because they’re embedded into another product) are far more ubiquitous than the chips inside personal computers. This is the market that our technology serves.

Phoenix Digital Solutions, LLC

On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore, an individual (“Moore”). We, TPL and Moore were parties to certain lawsuits filed by us alleging infringement (the “Infringement Litigation”) of seven U.S. patents issued dating back to 1989 on our microprocessor technology (the “Microprocessor Patents”) and a lawsuit also filed by us alleging claims for declaratory judgment for determination and correction of inventorship of the Microprocessor Patents (the “Inventorship Litigation”). The transactions described in the Master Agreement and related agreements (the “Transactions”) included the settlement or dismissal of the Inventorship Litigation.

Pursuant to the Master Agreement we caused certain of our respective interests in the Microprocessor Patents to be licensed to PDS, a joint venture limited liability company owned 50% by us and 50% by TPL, and PDS engaged TPL to commercialize the Microprocessor Patents pursuant to a Commercialization Agreement among PDS, TPL and us (the “Commercialization Agreement”). Under the Commercialization Agreement, PDS granted to TPL the exclusive right to grant licenses and sub-licenses of the Microprocessor Patents and to pursue claims against violators of the Microprocessor Patents, in each case, on behalf of PDS, us, TPL and Moore, and TPL agreed to use reasonable best efforts to commercialize the Microprocessor Patents in accordance with a mutually agreed business plan. Pursuant to the Commercialization Agreement, PDS agreed to a reimbursement policy with regard to TPL’s expenses incurred in connection with the commercialization of the Microprocessor Patents. All proceeds generated by TPL in connection with the commercialization of the Microprocessor Patents were paid directly to PDS. From the inception of the Commercialization Agreement to May 31, 2018, gross license revenues to PDS totaled $312,814,535.

Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (“LLC Agreement”). We and TPL each own 50% of the membership interests of PDS, and each member has the right to appoint one member of the three-member management committee. The TPL and PDS appointees are required to select a mutually acceptable third member of the management committee. Pursuant to the LLC Agreement, we and TPL must each contribute to the working capital of PDS and at the discretion of PDS’s management committee we may be obligated to make future contributions in equal amounts in order to maintain a working capital fund. The LLC Agreement provides that PDS shall indemnify its members, managers, officers and employees, to the fullest extent permitted by applicable law, for any liabilities incurred as a result of their involvement with PDS, if the person seeking indemnification acted in good faith and in a manner reasonably believed to be in the best interest of PDS.

On July 11, 2012, we entered into a Licensing Program Services Agreement (the “Program Agreement”) with PDS, TPL, and Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL) creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate Moore Microprocessor Patent (“MMP”) portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement extended through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense. On July 17, 2012, we entered into an Agreement with PDS, TPL, and Alliacense whereby we agreed to certain additional allocations of obligations relating to the Program Agreement. On July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015 Alliacense was terminated by PDS.

On August 10, 2016, PDS entered into an agreement with Alliacense and MMP Licensing, LLC to settle matters relating to Alliacense’s non-performance under terms of the Novation Agreement. The August 10, 2016 agreement required Alliacense to provide PDS’s second licensing company, Dominion Harbor Group (“DHG”), with certain materials and to cooperate with reasonable discovery requests relating to infringement litigation in the U.S. District Court for the Northern District of California. MMP Licensing, LLC will provide commercialization services to PDS for the MMP portfolio with respect to certain companies. The August 10, 2016 agreement, and the agreement retaining DHG as PDS’s second licensing company, will both expire on October 4, 2022.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted.

In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.

Licenses, Patents, Trade Secrets and Other Proprietary Rights

We rely on a combination of patents, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect our proprietary technologies. Our policy is to seek the issuance of patents that we consider important to our business to protect inventions and technology that support our microprocessor technology.

We have seven U.S., nine European, and three Japanese patents all of which expired between August 2009 and October 4, 2016. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration dates. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.

There can be no assurance that our patents will provide meaningful commercial advantages to us. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful.

We generally require all of our employees and consultants, including our management, to sign a non-disclosure and invention assignment agreement upon employment with us.

Products and Services

Our investment in the MMP portfolio represents virtually all of our business interests at this time. As our patents have expired, we are exploring developing or acquiring new lines of business.

Employees

At May 31, 2018, we have one full-time employee. We also engage consultants and part-time assistance, as needed.

Our future success depends in significant part upon the continued services of our key personnel. The competition for highly qualified personnel is intense, and there can be no assurance that we will be able to retain key employees. Our employee is not represented by a labor union, and we consider our relations with our employee to be good. Our employee is not covered by a key man life insurance policy.

Available Information

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Materials filed with the SEC can be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10 a.m. to 3 p.m. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our filings are available to the public at the website maintained by the SEC, http://www.sec.gov. We also make available, free of charge, through our web site at www.ptsc.com, our reports on Forms 10-K, 10-Q, and 8-K, and amendments to those reports, as soon as reasonably practicable after they are filed with or furnished to the SEC. The information on, or that can be accessed through, our website is not part of this Annual Report.

We urge you to carefully consider the following discussion of risks as well as other information contained in this Form 10-K. We believe the following to be our most significant risk factors as of the date this report is being filed. The risks and uncertainties described below are not the only ones we face.

We May Be Required To Fund Our Joint Venture’s Legal Costs.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. PDS has incurred significant legal costs in ongoing matters before the U.S. District Court and the U.S. Court of Appeals for the Federal Circuit. If PDS does not receive sufficient licensing revenues to pay these expenses, we may be required to pay these expenses. In the event the cost of legal actions exceeds our ability to fund these efforts, our options for additional sources of financing may be limited. 

We Have Reported Licensing Income In Prior Fiscal Years Which May Not Be Indicative Of Our Future Income.

We have entered into license agreements through our joint venture with TPL and have reported income from the joint venture for the fiscal years 2006 to 2011, 2013 to 2014 and 2016 to 2017. However, the joint venture has not generated significant licensing revenues since September 2013. Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which we allege have infringed on our patent portfolio, the possibility of legislative action regarding patent rights, the possible effect of new judicial interpretations of patent laws, and delays in obtaining information necessary for the successful deployment of licensing companies to represent the MMP Portfolio, we may not receive revenues from such agreements in the future consistent with amounts received in the past, and we may not receive future revenues from license agreements at all.

We Are Dependent Upon A Joint Venture For Substantially All Of Our Income.

In June 2005, we entered into the PDS joint venture with TPL, which as a result of agreements entered into in June 2005, July 2012 and July 2014, TPL and its licensing company affiliate Alliacense had been responsible for the licensing and enforcement of our microprocessor patent portfolio. This joint venture has been the source of substantially all of our income since June 2005. Therefore, in light of the absence of significant revenue from other sources we should be regarded as highly dependent on the success or failure of licensing and settlements occurring in conjunction with existing litigation efforts.

We Have Been Involved In Multiple Disputes With Our Joint Venture Partner.

We have been involved in multiple disputes with our joint venture partner TPL and its affiliate Alliacense. During times when there are only two appointed managers of the joint venture, a deadlock can exist on important issues that may not be resolved quickly. In the event of a protracted deadlock, the joint venture may not be able to take actions when appropriate or necessary. Previously we have had to initiate formal arbitration proceedings seeking the appointment of an independent manager to the management committee of the joint venture. Although an independent manager is currently in place, we have concluded that any future absences of an independent manager may have a negative impact on the licensing program and PDS’s business.

Our Joint Venture Is At Risk For Going Concern And An Inability To Meet Certain Obligations.

PDS, our joint venture with TPL, which received a going concern opinion since its May 31, 2011 financial statements, has experienced significant declines in revenues while at the same time incurring significant legal costs associated with pending litigation with companies which we allege have infringed on our patent portfolio.

PDS’s licensing revenues have declined over recent years to a point where PDS’s ability to make future payments is in substantial doubt unless licensing revenues substantially increase in the near term. In the event that PDS does not have the funds to pay one or more of the aforementioned costs, we and TPL must decide whether to contribute additional capital to PDS to fund such payments and due to TPL’s bankruptcy and reorganization, we may be required to pay these expenses without any contribution from TPL.

If We Fail To Maintain Effective Internal Controls Over Financial Reporting, The Price Of Our Common Stock May Be Adversely Affected.

We are required to establish and maintain appropriate internal controls over financial reporting. Failure to establish those controls, or any failure of those controls once established, could adversely impact our public disclosures regarding our business, financial condition or results of operations. Any failure of these controls could also prevent us from maintaining accurate accounting records and discovering accounting errors and financial fraud. 

During the fourth fiscal quarter ended May 31, 2018 we reduced the number of Company employees down from two to one. As a result, there were changes in our internal control over financial reporting that occurred during the fourth fiscal quarter ended May 31, 2018, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting stemming from the inability to segregate accounting duties amongst employed personnel. We are mitigating the potential impact of this change primarily through greater involvement of our Board of Directors in the review and monitoring of financial transaction processing and financial reporting, and the retention of third parties when possible.

Our Microprocessor Patents Have Expired.

We have seven U.S., nine European, and three Japanese patents that expired between August 2009 and October 4, 2016. While expired patents may have certain retrospective statutory benefits, their value as assets for licensing and cash generation is significantly diminished. Licensing revenues from these patents are our sole source of income.

A Successful Challenge To Our Intellectual Property Rights Could Have A Significant And Adverse Effect On Us.

A successful challenge to our ownership of our technology or the proprietary nature of our intellectual property could materially damage our business prospects. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. With respect to our core technologies, our patents have expired. Any issued patent may be challenged and invalidated. Any claims allowed from existing patents may not be of sufficient scope or strength to provide significant protection. Our competitors may also be able to design around our patents.

Vigorous protection and pursuit of intellectual property rights or positions characterize the fiercely competitive semiconductor industry, which has resulted in significant and often protracted and expensive litigation. Therefore, our competitors and others may assert that our technologies infringe on their patents or proprietary rights. Persons we believe are infringing our patents are likely to vigorously defend their actions and assert that our patents are invalid. Problems with patents or other rights could result in significant costs, and limit future license revenue. If infringement claims against us are deemed valid or if our infringement claims are successfully opposed, we may not be able to obtain appropriate licenses on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions or to defend against infringement claims. From time to time parties have petitioned the USPTO to re-examine certain of our patents. An adverse decision in litigation or in the re-examination process could have a very significant and adverse effect on our business.

We are party to a lawsuit regarding the MMP portfolio and have had mixed results in our litigation efforts to date. See footnote 9 to our consolidated financial statements and Part I, Item 3. “Legal Proceedings” in this Report on Form 10-K for more information.

In the event that the lawsuit regarding the MMP portfolio is not resolved in our favor, PDS may be liable for the opposing party’s attorneys’ fees and such outcome (or lack of an outcome) could weaken the MMP portfolio which would have a negative effect on PDS's ability to procure future license revenues and, therefore, adversely affect PDS’s and our cash flows.

Changes In U.S. Patent Law Could Diminish The Value Of Patents In General, Thereby Impairing Our Ability To Protect And Assert Our Patents.

The United States has enacted the America Invents Act of 2011, wide-ranging patent reform legislation. The United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. This combination of events has created uncertainty with respect to the value of patents, once obtained. Depending on decisions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to enforce our existing patents and patents that we might obtain in the future.

We Are Dependent On A Single Law Firm To Defend And Enforce Our Intellectual Property Rights.

A single law firm has been engaged to defend and enforce our intellectual property rights. Any significant interruption in their services, or the loss of their services for any reason, would have a material adverse effect on our ability to defend and prosecute such lawsuits and, therefore, have a material adverse effect on our business, financial condition and result of operations. The law firm’s services could be disrupted for a variety of reasons, and any disruption would have a material adverse effect on our business. Our inability to engage the services of a new law firm in a timely manner could have a substantial negative effect on our business.

A Change In Our Relationship With PDS Could Change The Way We Account For Our Interest In The Future.

Our investment in PDS is accounted for under the equity method, we record as part of other income or expense our share of the increase or decrease in the equity of this company in which we have invested. It is possible that, in the future, our relationships and/or our interests in or with this equity method investee could change. Such potential future changes could result in consolidation of such entity which could result in changes in our reported results.

We May Issue Preferred Stock, And The Terms Of Such Preferred Stock May Reduce The Value Of Our Common Stock.

We are authorized to issue up to a total of 5,000,000 shares of preferred stock in one or more series. Our Board of Directors may determine whether to issue shares of preferred stock without further action by holders of our Common Stock. If we issue shares of preferred stock, it could affect the rights or reduce the value of our Common Stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions. If we seek capital for our business, such capital may be raised through the issuance of preferred stock.

If A Large Number Of Our Shares Are Sold All At Once Or In Blocks, The Market Price Of Our Shares Would Most Likely Decline.

Most of our shareholders are not restricted in the price at which they can sell their shares. Shares sold at a price below the current market price at which our Common Stock is trading may cause the market price of our Common Stock to decline.

Our Common Stock is Quoted on the OTC Pink Current Information, Which Could Adversely Affect The Market Price And Liquidity Of Our Common Stock.

Our common stock is quoted on OTC Pink Current Information. The quotation of our shares on such marketplace may result in a less liquid market available for existing and potential stockholders to trade shares of our common stock, could depress the trading price of our common stock and could have a long-term adverse impact on our ability to raise capital in the future.

There can be no assurance that there will be an active market for our shares of common stock either now or in the future or that stockholders will be able to liquidate their investment or liquidate it at a price that reflects the value of the business. As a result, our stockholders may not find purchasers for our securities should they to desire to sell them.

The Market For Our Stock Is Subject To Rules Relating To Low-Priced Stock (“Penny Stock”) Which May Limit Our Ability To Raise Capital.

Our Common Stock is currently subject to the “penny stock rules” adopted pursuant to Section 15(g) of the Exchange Act. In general, the penny stock rules apply to non-NASDAQ or non-national stock exchange companies whose common stock trades at less than $5.00 per share or which have tangible net worth of less than $5,000,000 ($2,000,000 if the company has been operating for three or more years). Such rules require, among other things, that brokers who trade “penny stock” on behalf of persons other than “established customers” complete certain documentation, make suitability inquiries of investors and provide investors with certain information concerning trading in the security, including a risk disclosure document, quote information, broker’s commission information and rights and remedies available to investors in penny stocks. Many brokers have decided not to trade “penny stock” because of the requirements of the penny stock rules, and as a result, the number of broker-dealers willing to act as market makers in such securities is limited. The “penny stock rules,” therefore, may have an adverse impact on the market for our Common Stock and may affect our ability to raise additional capital if we decide to do so.

Our Share Price Could Decline As A Result Of Short Sales.

When an investor sells stock that he does not own, it is known as a short sale. The seller, anticipating that the price of the stock will go down, intends to buy stock to cover his sale at a later date. If the price of the stock goes down, the seller will profit to the extent of the difference between the price at which he originally sold it less his later purchase price. Short sales enable the seller to profit in a down market. Short sales could place significant downward pressure on the price of our Common Stock. Penny stocks which do not trade on an exchange, such as our Common Stock, are particularly susceptible to short sales.

Our Future Success Depends In Significant Part Upon The Continued Services Of Our Key Senior Management.

Our future success depends in significant part upon the continued services of our senior management. The competition for highly qualified personnel is intense, and we may not be able to retain our key employees or attract and retain additional highly qualified personnel in the future. Our employee is not represented by a labor union, and we consider our relations with our employee to be good. Our employee is not covered by a key man life insurance policy.

None.

We currently lease one office of approximately 151 square feet located at 2038 Corte Del Nogal, Suite 141, Carlsbad, California. The lease expires upon 60 days written notice of termination.

The current floor space provides adequate and suitable facilities for all of our corporate functions.

Litigation

Patent Litigation

We, TPL, and PDS (collectively referred to as “Plaintiffs”) are Plaintiffs in ongoing proceedings in the U.S. District Court for the Northern District of California where the Plaintiffs allege infringement of the US 5,809,336 patent (the “‘336 patent”) by: Huawei Technologies Co. Ltd., LG Electronics, Nintendo Co. Ltd., Samsung Electronics Co. Ltd., and ZTE Corporation (collectively referred to as “Defendants”). This litigation is proceeding in front of District Court Judge Vince Chhabria.

These ongoing proceedings relate to the proceedings filed by the Plaintiffs in February 2008 in the U.S. District Court for the Northern District of California alleging infringement of the US 5,440,749 patent (the “‘749 patent”), the US 5,530,890 patent (the “‘890 patent”) and the ‘336 patent against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We have settled with all defendants except those named in the first paragraph to this footnote.

On September 18, 2015, a Markman hearing was held before U.S. Magistrate Judge Grewal and, on September 22, 2015, he issued a claim construction report and recommendation. On September 25, 2015, as a result of the claim construction report and recommendation, Plaintiffs and defendants, with the exception of Huawei Technologies Co. Ltd., (“Huawei”) agreed to stay all proceedings pending resolution of Plaintiffs’ objections to the claim construction report and recommendation. Plaintiffs further stipulated that, under the claim construction provided by the report and recommendation, defendants’ products do not infringe the ‘336 patent, and, in the event that the Court does not materially modify the claim construction, Plaintiffs and defendants ask that the Court enter a final judgment of non-infringement. After Plaintiffs and Huawei filed opposing letter briefs with the Court, U.S. Magistrate Judge Grewal stayed the action against Huawei pending resolution of Plaintiffs’ objections to the claim construction. On October 6, 2015, Plaintiffs filed objections to the claim construction with District Court Judge Chhabria. Judge Chhabria rejected those objections on November 9, 2015. Based on that order, the parties stipulated to a judgment of non-infringement as to the ‘336 patent and such judgment was entered on November 13, 2015.

On December 7, 2015, Plaintiffs filed notices of appeal with the U.S. Federal Circuit appealing the district court’s claim construction. Plaintiffs filed their opening appellate brief on March 10, 2016. Defendants filed their response brief on May 23, 2016, with Plaintiffs filing their reply brief on June 23, 2016. On March 3, 2017, the U.S. Court of Appeals for the Federal Circuit rendered its decision modifying the claim construction that was issued in September 2016 by the U.S. District Court for the Northern District of California and has remanded the matter to the District Court for further proceedings.

On May 23, 2017, a case management conference was held in front of District Court Judge Chhabria, who ordered that Plaintiffs amend their infringement contentions on or before June 16, 2017. Judge Chhabria further ordered that Defendants submit any motion for summary judgment based on the amended infringement contentions and the modified claim construction by August 1, 2017. On June 5, 2017, the law firm of Banys, P.C., who had served as local counsel for PDS, withdrew as counsel. PDS continued to be represented by the law firm of Nelson Bumgardner, P.C. On June 16, 2017, Plaintiffs timely amended their infringement contentions. On July 13, 2017, all remaining counsel for each of Patriot, TPL, and PDS moved to withdraw as counsel and further moved to extend all currently pending case deadlines by 60 days for Plaintiffs to seek new counsel.

On September 13, 2017, the law firm of Bunsow De Mory LLP was entered before the U.S. District Court for the Northern District of California as successor counsel in representation of Patriot, PDS, and TPL.

The Defendants moved for summary judgment of non-infringement on September 29, 2017, and the Court held a hearing on Defendants’ motion on November 30, 2017. The Court granted Defendants’ motion and entered judgment of non-infringement on December 13, 2017.

Defendant Samsung submitted a bill of costs seeking $30,170 in taxable costs in the underlying district court proceedings; Plaintiffs filed an objection to significant portions of that request. On March 1, 2018, the Clerk of the District Court taxed costs in the amount $829.

Plaintiffs filed notices of appeal in these district court matters on January 5, 2018. The appeals were docketed and consolidated under lead case No. 18-1439, captioned as Technology Properties Limited v. Huawei Technologies Co., Ltd in the United States Court of Appeals for the Federal Circuit.  Briefing was complete on July 31, 2018. The court has not yet scheduled an oral argument. We expect that it may take up to eight to twelve months before a decision is received. 

Not applicable.

PART II

Our Common Stock is currently listed for trading in the OTC Pink operated by OTC Markets, Inc. under the symbol PTSC. Prices reported represent prices between dealers, do not include markups, markdowns or commissions and do not necessarily represent actual transactions. The market for our shares has been sporadic and at times very limited.

The following table sets forth the high and low closing bid quotations for our Common Stock for the fiscal years ended May 31, 2018 and 2017.

On August 24, 2018, the closing price of our stock was $0.01 per share and we had approximately 681 stockholders of record. Because most of our Common Stock is held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial owners represented by these record holders.

Dividend Policy

On February 22, 2007, our Board of Directors adopted a semi-annual dividend payment policy, subject to determination by our Board of Directors in light of our financial condition, other possible applications of our available resources, and relevant business considerations. We paid no dividends during the fiscal years ended May 31, 2018 and 2017 and have not paid any dividends since April 9, 2007.

Equity Compensation Plan Information

Our stockholders previously approved our 2006 Stock Option Plan. The following table sets forth certain information concerning aggregate stock options authorized for issuance under our 2006 Stock Option Plan as of May 31, 2018. For a narrative description of the material features of the plan, refer to footnote 7 of our consolidated financial statements.

As of May 31, 2018, there are no shares available for future issuance under our 2006 Stock Option Plan as the plan expired on March 31, 2016.

Recent Sale of Unregistered Securities

None.

Issuer Purchases of Equity Securities

None.

As a “smaller reporting company” as defined in Rule 12b-2 of the Exchange Act, we are not required to provide the information called for by this item.

THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS CONCERNING FUTURE EVENTS AND PERFORMANCE OF OUR COMPANY. YOU SHOULD NOT RELY ON THESE FORWARD-LOOKING STATEMENTS, BECAUSE THEY ARE ONLY PREDICTIONS BASED ON OUR CURRENT EXPECTATIONS AND ASSUMPTIONS. MANY FACTORS COULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED IN THESE FORWARD-LOOKING STATEMENTS. YOU SHOULD REVIEW CAREFULLY THE RISK FACTORS IDENTIFIED IN THIS REPORT AS SET FORTH BELOW AND UNDER THE CAPTION “RISK FACTORS.” WE DISCLAIM ANY INTENT TO UPDATE ANY FORWARD-LOOKING STATEMENTS TO REFLECT SUBSEQUENT ACTUAL EVENTS OR DEVELOPMENTS.

Overview

In June 2005, we entered into a series of agreements with TPL and others to facilitate the pursuit of unlicensed users of our intellectual property. Over the years we, TPL and TPL’s affiliate, Alliacense, have entered into various agreements regarding licensing and litigation of the MMP portfolio. Pursuant to a July 2014 Novation Agreement with Alliacense PDS engaged a second licensing agent for the MMP portfolio in October 2014 and on May 11, 2015 PDS terminated Alliacense as licensing agent due to the inability of Alliacense to fulfill its obligations under the Novation Agreement. In August 2016, PDS and Alliacense entered into an agreement which requires Alliacense to: cooperate with reasonable discovery requests, provide support to litigation counsel, and deliver certain materials to PDS’s second licensing agent. Pursuant to the August 2016 agreement, MMP Licensing, LLC will provide MMP portfolio commercialization services to PDS for certain companies. PDS is currently pursuing a litigation strategy, which includes an action before the U.S. Court of Appeals for the Federal Circuit stemming from litigation in U.S. District Court against multiple companies alleged to be infringers of the MMP portfolio. We continue to believe that the significant investment in legal effort and costs incurred to date at PDS is necessary for the protection of our interests in the MMP portfolio and its future success, although to date it has generated mixed results.

Management expects to continue to incur significant legal expenses for the continued operation of PDS. PDS has been incurring significant third-party costs for expert testimony, depositions and other related legal costs. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.

To the extent MMP portfolio license proceeds are insufficient; we expect working capital contributions may need to be made to PDS in the future. Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date, we have determined that it is in the best interests of the MMP licensing program that we contribute our 50% share of additional capital to PDS in the event license revenues received by PDS are insufficient.

On August 24, 2018, PDS’s cash balance was $328,542. Management’s plans for the continued operation of PDS rely on the ability of PDS to obtain license agreements to cover its operational costs. PDS has experienced a decline in licensing revenues and has not obtained significant license revenues since September 2013 and it is unclear when any additional licensing revenues may be generated.

Critical Accounting Policies and Estimates

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. We believe the following critical accounting policies affect our most significant estimates and judgments used in the preparation of our consolidated financial statements.

1.        Investments in Marketable Securities

We classify our investments in marketable securities in certificates of deposit at the time of purchase as held-to-maturity and reevaluate such classifications at each balance sheet date. Held-to-maturity investments consist of securities that we have the intent and ability to retain until maturity. These securities are recorded at cost and adjusted for the amortization of premiums and discounts, which approximates fair value. Cash inflows and outflows related to the sale and purchase of investments are classified as investing activities in our consolidated statements of cash flows.

2.        Investment in Affiliated Companies

We have a 50% interest in PDS. We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee and is recognized in the consolidated statements of operations in the caption “Equity in earnings (loss) of affiliated company” and also is adjusted by contributions to and distributions from PDS.

PDS, as an unconsolidated equity investee, recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.

We review our investment in PDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near-term prospects of PDS. If a decline in value is deemed to be other than temporary, we would recognize an impairment loss.

We own 100% of the preferred stock of Holocom. Prior to impairment, this investment was accounted for at cost since we did not have the ability to exercise significant influence over the operating and financial policies of Holocom.

3.       Income Taxes

We follow authoritative guidance in accounting for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under this guidance we may only recognize tax positions that meet a “more likely than not” threshold.

We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We are assessing our deferred tax assets under more likely than not scenarios in which they may be realized through future income.

With the exception for refundable alternative minimum tax (AMT) credits, we have determined that it was more likely than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses. As a result of this determination, and with the exception for the aforementioned refundable tax credits, we have recorded a full valuation allowance against our deferred tax assets.

On December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carryforward net operating losses previously accumulated and results in a revaluation of deferred tax assets and liabilities recorded on our consolidated balance sheet. Given that our current deferred tax assets, with the exception of those representing certain refundable tax credits, are offset by a full valuation allowance, these changes will have no net impact on our consolidated balance sheet. However, if we become profitable, we will receive a reduced benefit from such deferred tax assets.

4.       Assessment of Contingent Liabilities

We are involved as plaintiffs in patent infringement litigation, and from time to time various other legal matters which arise in the ordinary course of our business. We accrue for any estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.

RESULTS OF OPERATIONS

Comparison of fiscal 2018 and 2017

Selling, general and administrative expenses decreased from approximately $1,216,000 for the fiscal year ended May 31, 2017 to approximately $1,047,000 for the fiscal year ended May 31, 2018. The decrease consisted primarily of approximately $80,000 in board of directors’ fees due to a board member volunteering to cease taking board fees beginning in calendar 2018 and a portion of the remaining board member’s fees being paid by PDS; approximately $52,000 in insurance expense and approximately $33,000 in legal fees due to decreased activity in the TPL bankruptcy matter.

Our other income and expense for the fiscal years ended May 31, 2018 and 2017 included equity in the earnings (loss) of PDS of approximately $(243,000) and $1,155,000, respectively. Our investment in PDS is accounted for in accordance with the equity method of accounting for investments. The change in the earnings of PDS is due to the receipt of licensing revenues during fiscal 2017.

Loss before provision (benefit) for income taxes of approximately $(43,000) for the fiscal year ended May 31, 2017 increased to a loss before income taxes of approximately $(1,259,000) for the fiscal year ended May 31, 2018 due to the decrease in our equity in earnings of PDS.

Provision (benefit) for income taxes

During the fiscal years ended May 31, 2018 and 2017, we recorded a provision (benefit) for income taxes related to federal and California taxes of approximately $(50,000) and $2,400, respectively.

Net loss

We recorded a net loss for the fiscal years ended May 31, 2018 and 2017 of $(1,209,450) and $(45,368), respectively.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Our cash and cash equivalents and short-term investment balances decreased from approximately $3,183,000 as of May 31, 2017 to approximately $2,298,000 as of May 31, 2018. We also have a restricted cash balance amounting to approximately $22,000 and approximately $21,000 as of May 31, 2018 and 2017, respectively. Total current assets decreased from approximately $3,317,000 as of May 31, 2017 to approximately $2,327,000 as of May 31, 2018. Total current liabilities amounted to approximately $85,000 and approximately $57,000 as of May 31, 2018 and May 31, 2017, respectively. The change in our working capital position as of May 31, 2018 as compared with May 31, 2017 results primarily from our inability to receive distributions from PDS to cover our operating expenses.

Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date we have determined that it is in the best interests of the MMP licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainers and litigation related payments in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital may be required.

PDS has been incurring significant third-party costs for legal fees, expert testimony, depositions and other related litigation costs. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.

Cash Flows From Operating Activities

Cash used in operating activities for the fiscal years ended May 31, 2018 and 2017 was approximately $880,000 and $1,311,000, respectively. The principal components of the current fiscal year were the net loss of approximately $1,209,000 and deferred income taxes of approximately $52,000 offset by equity in loss of affiliated company of approximately $243,000 and accounts payable and accrued expenses of approximately $105,000. The principal components of the prior fiscal year were the net loss of approximately $45,000, equity in earnings of affiliated company of approximately $1,155,000 and prepaid expenses and other of approximately $97,000.

Cash Flows From Investing Activities

Cash provided by investing activities for the fiscal years ended May 31, 2018 and 2017 was approximately $2,199,000 and approximately $1,131,000, respectively. Cash activities for the current fiscal year were primarily attributable to sales and purchases of marketable securities. Cash activities for the prior fiscal year were primarily attributable to sales and purchases of marketable securities and distributions from PDS.

Capital Resources

Our current liquid cash resources are expected to provide the funds necessary to support our operations through at least the next twelve months from the date of this report. The cash flows from our interest in PDS represent our only significant source of cash generation. In the event of a continued decrease or interruption in MMP portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents and short-term investment position.

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers,” which was subsequently amended by ASUs 2015-14, 2016-08, 2016-10, 2016-12, and 2016-20. ASU 2014-09, as amended, supersedes the revenue recognition requirements in ASC Topic 605, “Revenue Recognition”, and creates a new ASC Topic 606 (“ASC 606”). ASU 2014-09, as amended, implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. The amendment also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include the capitalization and amortization of certain contract costs, ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The new revenue standards are effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period (fiscal year 2019 for the Company). Our adoption of this guidance effective June 1, 2019, will not have a significant impact on the financial statements of PDS.

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows – Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 provides guidance intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. The issue addressed in ASU 2016-15 that will affect the Company is classifying distributions received from equity method investments. The guidance provides an accounting policy election for classifying distributions received from equity method investments using either a cumulative earnings approach or a nature of distributions approach. ASU 2016-15 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years (fiscal 2019 for the Company). Early adoption is permitted. We have not yet determined the potential effects of the adoption of ASU 2016-15 on our consolidated financial statements.

In November 2016, the FASB issued ASU No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash”. ASU 2016-18 requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years (fiscal 2019 for the Company), with early adoption permitted. We are currently evaluating the effect ASU 2016-18 will have on our consolidated statements of cash flows.

On December 22, 2017, the United States Government passed the Tax Cuts and Jobs Act (“Tax Cuts Act”) that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carryforward net operating losses previously accumulated and results in a revaluation of deferred tax assets and liabilities recorded on our consolidated balance sheet. The Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) which provides guidance regarding accounting for the income tax effects of the Tax Cuts Act, including the impact of the Tax Cuts Act on deferred tax assets and liabilities for financial statements issued in the reporting period that includes the enactment date of December 22, 2017. Given that our current deferred tax assets, with the exception of those representing certain refundable tax credits, are offset by a full valuation allowance, these changes will have no net impact on our consolidated balance sheet. However, if we become profitable, we will receive a reduced benefit from such deferred tax assets.

As a “smaller reporting company” as defined in Rule 12b-2 of the Exchange Act, we are not required to provide the information called for by this item.

The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Report and begin on page F-1 with the index to consolidated financial statements.

None.

Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this report. Based on this evaluation, our Interim Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to our management, including our Interim Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of May 31, 2018 based on the criteria set forth in Internal Control — Integrated Framework – 2013 update issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, and after considering the controls implemented to mitigate the impact resulting from insufficient accounting personnel discussed below, our management concluded that our internal control over financial reporting was effective as of May 31, 2018.

This Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC that permit us to provide only management’s report in this Annual Report.

Changes in Internal Controls over Financial Reporting

During the fourth fiscal quarter ended May 31, 2018 we reduced the number of Company employees down from two to one. As a result, there were changes in our internal control over financial reporting that occurred during the fourth fiscal quarter ended May 31, 2018, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting stemming from the inability to segregate accounting duties amongst employed personnel. We are mitigating the potential impact of this change primarily through greater involvement of our Board of Directors in the review and monitoring of financial transaction processing and financial reporting, and the retention of third parties when possible. 

Inherent Limitations on Internal Control

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

In addition, projections of any evaluation of effectiveness to future periods are subject to risks that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

None.

PART III

Director Qualifications – We believe that individuals who serve on our Board should possess the requisite education and experience to make a significant contribution to the Board and bring a range of skills, diverse perspectives and backgrounds to its deliberations; and should have the highest ethical standards, a strong sense of professionalism and dedication to serving the interests of our stockholders. The following are qualifications, experience and skills for Board members which are important to our business:

The following table and biographical summaries set forth information, including principal occupation, business experience, other directorships and director qualifications concerning the members of our Board of Directors and our executive officer as of May 31, 2018. There is no blood or other familial relationship between or among our directors or executive officer.

CARLTON M. JOHNSON, JR. Carlton Johnson has served as a director of the Company since 2001, and is Chairman of the Executive Committee of the Board of Directors. From June 1996 through March 2013, Mr. Johnson served as in-house legal counsel for Roswell Capital Partners, LLC and related entities. Mr. Johnson has been admitted to the practice of law in Alabama since 1986, Florida since 1988 and Georgia since 1997. He has been a shareholder in the Pensacola, Florida AV- rated law firm of Smith, Sauer, DeMaria Johnson and was President-Elect of the 500 member Escambia-Santa Rosa Bar Association. He also served on the Florida Bar Young Lawyers Division Board of Governors. Mr. Johnson earned a degree in History/Political Science at Auburn University and a Juris Doctor at Samford University - Cumberland School of Law. Mr. Johnson served on the board of directors of Peregrine Pharmaceuticals, Inc., a publicly held emerging bio-tech company from 1999 through November 2017. From May 2009 to March 2012, Mr. Johnson served on the board of directors of Cryoport, Inc., a publicly held company providing cost-efficient frozen shipping to biopharmaceutical and biotechnology industries. Mr. Johnson served as chairman of Cryoport’s compensation committee and as a member of its audit committee and nomination and governance committee. From November 2009 to December 2011, Mr. Johnson served on the board of directors of ECOtality, Inc., a leader in clean electric transportation and storage technologies. Mr. Johnson served on the audit committee and nominating committee of ECOtality.

The Board of Directors concluded that Mr. Johnson should serve as a director in light of the extensive public company finance and corporate governance experience that he has obtained through serving on the boards and audit committees of Peregrine Pharmaceuticals, Inc., Cryoport, Inc., and ECOtality, Inc.

GLORIA H. FELCYN. Gloria Felcyn has served as a director of the Company since October 2002 and is the Chairman of the Audit Committee of the Board of Directors. From 1982 through April 2018, Ms. Felcyn was principal in her own certified public accounting firm, during which time she represented Helmut Falk Sr. and nanoTronics, along with other major individual and corporate clients in Silicon Valley. Following Mr. Falk’s death, Ms. Felcyn represented his estate and family trust as Executrix and Trustee of the Falk Estate and The Falk Trust.  Prior to establishing her firm, Ms. Felcyn worked for the national accounting firm of Hurdman and Cranston from 1969 through 1970 and Price Waterhouse & Co. in San Francisco and New York City from 1970 through 1976, during which period she represented major Fortune 500 companies. Subsequent to that, Ms. Felcyn worked in the field of international tax planning with a major real estate syndication company in Los Angeles until 1982 when she decided to start her own practice in Northern California.  Ms. Felcyn retired from public accounting effective April 2018. A major portion of Ms. Felcyn’s past practice was “Forensic Accounting”, which involves valuation of business entities and investigation of assets. Ms. Felcyn has published tax articles for “The Tax Advisor” and co-authored a book published in 1982, “International Tax Planning”. Ms. Felcyn has a degree in Business Economics from Trinity University and is a retired member of the American Institute of CPAs.

The Board of Directors concluded that Ms. Felcyn should serve as a director and the chairperson of the Audit Committee in light of the extensive financial and accounting experience that she has obtained over her career.

CLIFFORD L. FLOWERS. Cliff Flowers became our Chief Financial Officer and Secretary on September 17, 2007.  On October 5, 2009, Mr. Flowers was named Interim CEO and was elected a director of the Company on January 19, 2011. From May 2007 to September 17, 2007, Mr. Flowers was the interim CFO for BakBone Software Inc., working as a consultant on behalf of Resources Global Professionals, Inc.  From June 2004 through December 2006, Mr. Flowers was the senior vice president of finance and operations and CFO for Financial Profiles, Inc., a developer and marketer of software for the financial planning industry.  Prior to joining Financial Profiles, Mr. Flowers served as CFO of Xifin, Inc., a provider of hosted software services to the commercial laboratory marketplace.  Prior to Xifin, Mr. Flowers served for nine years in positions of increasing responsibility at Previo, Inc., a developer and marketer of various PC and server-based products, including back up and business continuity offerings.  As CFO of Previo, Mr. Flowers’ global responsibilities included all financial operations and legal affairs.  He earlier served as an audit manager with Price Waterhouse, LLP. Mr. Flowers is a graduate of San Diego State University with a B.S. summa cum laude in Business Administration with an emphasis in accounting.

The Board of Directors concluded that Mr. Flowers should serve as a director due to his leadership and financial experience combined with the perspective and experience he brings as our current Chief Financial Officer, interim Chief Executive Officer and Corporate Secretary.

Board Leadership Structure

Our bylaws provide that the Chairman of the Board shall preside over all meetings of the Board of Directors. Our bylaws also state that the Chairman of the Board shall serve as the Chief Executive Officer unless determined otherwise by our Board. Since October 5, 2009 our Chief Financial Officer has served as our interim CEO and our Board has not appointed a Chairman of the Board. During meetings of our Board of Directors, Mr. Johnson, an independent director, acts as Chairman of the Board.

Our independent directors meet in executive sessions without management present to evaluate whether management is performing its responsibilities in a manner consistent with the direction of the Board. Additionally, all Board committee members are independent directors. The committee chairs have authority to hold executive sessions without management present. The Board has determined that its current structure is in the best interests of the Company and its stockholders. We believe the independent nature of the Audit Committee and the Compensation Committee as well as the practice of regular meetings of the independent directors in executive session without Mr. Flowers present ensures that the Board maintains a level of independent oversight of management that is appropriate for the Company.

Board Risk Oversight

Our Board oversees and maintains our governance and compliance processes and procedures to promote the conduct of our business in accordance with applicable laws and regulations and with the highest standards of responsibility, ethics and integrity. As part of its oversight responsibility, our Board is responsible for the oversight of risks facing the Company and seeks to provide guidance with respect to the management and mitigation of those risks. Our board also delegates specific areas of risk to the Audit Committee which is responsible for the oversight of risk policies and processes relating to our financial statements and financial reporting processes. The Audit Committee reviews and discusses with management and the independent auditors significant risks and exposures to the Company and steps management has taken or plans to take to minimize or manage such risks. The Audit Committee meets in executive session with our Chief Financial Officer and our independent auditor at each regular meeting of the Audit Committee.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Exchange Act requires our directors, executive officers and persons who beneficially own 10% or more of a class of securities registered under Section 12 of the Exchange Act to file reports of beneficial ownership and changes in beneficial ownership with SEC. Directors, executive officers and greater than 10% stockholders are required by the rules and regulations of the SEC to furnish us with copies of all reports filed by them in compliance with Section 16(a).

Based solely on our review of the copies of such forms received by us, or written representations from reporting persons, we believe that our insiders complied with all applicable Section 16(a) filing requirements during fiscal year 2018.

Code of Ethics

We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Ethics is available on our website at www.ptsc.com under the link “Investors” and “Management Team”.

Audit Committee

We have an audit committee established in accordance with Section 3(a)(58)(A) of the Exchange Act, currently comprised of: Gloria H. Felcyn (Committee Chair) and Carlton M. Johnson, Jr. Each member of our Audit Committee (the “Audit Committee”) is independent as defined under the applicable rules of the SEC and NASDAQ Stock Market LLC (“NASDAQ”) listing standards. The Board of Directors has determined that Gloria H. Felcyn, who serves on the Audit Committee, is an “audit committee financial expert” as defined in applicable SEC rules.

Director Legal Proceedings

During the past ten years, no director, executive officer or nominee for our Board of Directors has been involved in any legal proceedings that are material to an evaluation of their ability or integrity to become our director or executive officer.

The following table summarizes the compensation of the named executive officers for the fiscal years ended May 31, 2018 and 2017. For fiscal 2018 and 2017, the named executive officers are our Interim Chief Executive Officer and our Chief Financial Officer.

Summary Compensation Table

For Fiscal Years Ended May 31, 2018 and 2017

All Other Compensation Table

For Fiscal Years Ended May 31, 2018 and 2017

The following table shows the number of shares covered by exercisable and un-exercisable options held by our named executive officers as of May 31, 2018.

Outstanding Equity Awards

As of May 31, 2018

Employment Contracts

In connection with Mr. Flowers’ appointment as Chief Financial Officer on September 17, 2007, we entered into an Employment Agreement (the “Flowers Agreement”) with Mr. Flowers for an initial 120-day term if not terminated pursuant to the Flowers Agreement, with an extension period of one year and on a day-to-day basis thereafter. On December 30, 2016, we entered into an amended and restated Employment Agreement (the “Amended and Restated Employment Agreement”) with Mr. Flowers. Pursuant to the Flowers Agreement, Mr. Flowers’ initial base salary was $225,000 per year and he is eligible to receive an annual merit bonus of up to 50% of his base salary, as determined in the sole discretion of the Board of Directors. Effective October 1, 2008, October 5, 2009 and December 15, 2011, Mr. Flowers’ base salary was increased to $231,750, $291,750 and $327,750, respectively. Also pursuant to the Flowers Agreement and on the date of the Flowers Agreement, Mr. Flowers received a fully vested grant of non-qualified stock options to purchase 150,000 shares of our Common Stock and a grant of non-qualified stock options to purchase 600,000 shares of our Common Stock vesting over four years. Mr. Flowers’ right to exercise the foregoing stock options became fully vested on October 9, 2009, in connection with his appointment as Interim CEO. The Flowers Agreement also provides for Mr. Flowers to receive customary employee benefits, including health, life and disability insurance.

Pursuant to the Amended and Restated Employment Agreement, 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 1.25 times 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.

Director Compensation

As described more fully below, this table summarizes the annual cash compensation for our non-employee directors during the fiscal year ended May 31, 2018.

Director Compensation

For Fiscal Year Ended May 31, 2018

Director Outstanding Equity Awards

As of May 31, 2018

Directors who are not our employees are compensated for their service as a director as shown in the table below:

Schedule of Director Fees

May 31, 2018

All retainers are paid in monthly installments.

Other

We reimburse all directors for travel and other necessary business expenses incurred in the performance of their services for us. 

The following table sets forth, as of August 24, 2018, the stock ownership of each of our officers and directors, of all our officers and directors as a group, and of each person known to us to be a beneficial owner of 5% or more of our Common Stock. The number of shares of Common Stock outstanding as of August 24, 2018, was 401,392,948. Except as otherwise noted, each person listed below is the sole beneficial owner of the shares and has sole investment and voting power over such shares. Each individual’s address is 2038 Corte Del Nogal, Suite 141, Carlsbad, California 92011-1478.

* Less than 1%

Transactions With Directors, Executive Officers and Principal Stockholders

There were no transactions, or series of transactions during the fiscal years ended May 31, 2018 or 2017, nor are there any currently proposed transactions, or series of transactions, to which we are a party, in which the amount exceeds $120,000, and in which to our knowledge any director, executive officer, nominee, five percent or greater stockholder, or any member of the immediate family of any of the foregoing persons, has or will have any direct or indirect material interest other than as described below.

Director Independence

Our Board of Directors has determined that a majority of the members of, and nominees to, our Board of Directors qualify as “independent,” as defined by the listing standards of NASDAQ. Consistent with these considerations, after review of all relevant transactions and relationships between each director and nominee, or any of his or her family members, and us, our senior executive management and our independent auditors, the Board of Directors has determined further that all of our directors and nominees are independent under the listing standards of NASDAQ. In making this determination, the Board of Directors considered that there were no new transactions or relationships between its current independent directors and the Company, its senior management and its independent auditors since last making this determination. Each member of our Audit Committee, and each member of the Compensation Committee of our Board of Directors, is independent as defined by the listing standards of NASDAQ.

Pursuant to the Policy on Engagement of Independent Auditor, the Audit Committee is directly responsible for the appointment, compensation and oversight of the independent auditor. The Audit Committee pre-approves all audit services and non-audit services to be provided by the independent auditor and has approved 100% of the audit, audit-related and tax fees listed below. The Audit Committee may delegate to one or more of its members the authority to grant the required approvals, provided that any exercise of such authority is presented at the next Audit Committee meeting for ratification.

Each audit, non-audit and tax service that is approved by the Audit Committee will be reflected in a written engagement letter or writing specifying the services to be performed and the cost of such services, which will be signed by either a member of the Audit Committee or by one of our officers authorized by the Audit Committee to sign on our behalf.

The Audit Committee will not approve any prohibited non-audit service or any non-audit service that individually or in the aggregate may impair, in the Audit Committee’s opinion, the independence of the independent auditor.

In addition, our independent auditor may not provide any services to our officers or Audit Committee members, including financial counseling or tax services.

Audit Fees

During the fiscal years ended May 31, 2018 and 2017, the aggregate fees billed by our principal accountants for professional services rendered for the audit of our annual consolidated financial statements, and reviews of quarterly consolidated financial statements included in our reports on Form 10-Q, and audit services provided in connection with other statutory or regulatory filings were $51,100 and $64,350, respectively.

Audit-Related Fees

None.

Tax Fees

During the fiscal years ended May 31, 2018 and 2017, the aggregate fees billed by our principal accountants for tax compliance, tax advice and tax planning rendered on our behalf were $9,618 and $8,500, respectively, which are related to the preparation of federal and state income tax returns.

All Other Fees

Our principal accountants billed no other fees for the fiscal years ended May 31, 2018 and 2017, except as disclosed above.

PART IV

(a)    The following documents are filed as a part of this report:

Patriot Scientific Corporation

Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of May 31, 2018 and 2017

Consolidated Statements of Operations for the Years Ended May 31, 2018 and 2017

Consolidated Statements of Stockholders’ Equity for the Years Ended May 31, 2018 and 2017

Consolidated Statements of Cash Flows for the Years Ended May 31, 2018 and 2017

Notes to Consolidated Financial Statements

Phoenix Digital Solutions, LLC

Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm

Balance Sheets as of May 31, 2018 and 2017

Statements of Operations for the Years Ended May 31, 2018 and 2017

Statements of Members’ Equity for the Years Ended May 31, 2018 and 2017

Statements of Cash Flows for the Years Ended May 31, 2018 and 2017

Notes to Financial Statements

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Patriot Scientific Corporation

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and Board of Directors 

Patriot Scientific Corporation

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of Patriot Scientific Corporation and subsidiaries (the "Company") as of May 31, 2018 and 2017, the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of May 31, 2018 and 2017, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting 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.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ KMJ Corbin & Company LLP

We have served as the Company's auditor since 2005.

Costa Mesa, California

August 29, 2018

Patriot Scientific Corporation

Consolidated Balance Sheets

See accompanying notes to consolidated financial statements

Patriot Scientific Corporation

Consolidated Statements of Operations

See accompanying notes to consolidated financial statements.

Patriot Scientific Corporation

Consolidated Statements of Stockholders’ Equity

See accompanying notes to consolidated financial statements.

Patriot Scientific Corporation

Consolidated Statements of Cash Flows

See accompanying notes to consolidated financial statements.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements

1. Organization and Business

Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”), was organized under Delaware law on March 24, 1992 and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987. In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form Phoenix Digital Solutions, LLC (“PDS”). In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. In January 2010, we sold the assets of Verras Medical, Inc. and in August 2010 we sold the Vigilys business line both formerly associated with PDSG. During April 2012, we sold substantially all of the assets of PDSG. In March 2018, we dissolved Plasma Scientific Corporation.

Through our joint venture PDS, we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may be infringing on our patents. As our patents have expired, we are exploring developing or acquiring new lines of business.

Liquidity and Management’s Plans

Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date, we have determined that it is in the best interests of the Moore Microprocessor Patent (“MMP”) licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainers and litigation related payments in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital may be required.

PDS had been incurring significant third-party costs for legal fees, expert testimony, depositions and other related litigation costs. We could be required to make capital contributions to PDS for any future litigation related costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

Our current liquid cash resources are expected to provide the funds necessary to support our operations through at least the next twelve months from the date of this report. The cash flows from our interest in PDS represent our only significant source of cash generation.  In the event of a continued decrease or interruption in MMP portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents and short-term investment position.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

2. Summary of Significant Accounting Policies

Basis of Consolidation

The consolidated balance sheets at May 31, 2018 and 2017 and consolidated statements of operations for the fiscal years ended May 31, 2018 and 2017 include our accounts and those of our wholly owned subsidiary PDSG which includes Crossflo Systems, Inc. (“Crossflo”). All significant intercompany accounts and transactions have been eliminated. During March 2018, we dissolved our inactive subsidiary Plasma Scientific Corporation.

Financial Instruments and Concentrations of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, cash equivalents, and investments in marketable securities.

We invest our cash and cash equivalents primarily in money market mutual funds and certificates of deposit. Cash and cash equivalents are maintained with high quality financial institutions, the composition and maturities of which are regularly monitored by management. At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation. We perform ongoing evaluations of these financial institutions to limit our concentration of risk exposure.

Fair Value of Financial Instruments

Our financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts payable and accrued expenses and other. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments. The fair value of our cash equivalents is determined based on quoted prices in active markets for identical assets or Level 1 inputs. The fair value of our investments in marketable securities is determined based on quoted prices in non-active markets for identical assets or Level 2 inputs. We believe that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations.

Cash Equivalents, Restricted Cash, and Marketable Securities

We consider all highly liquid investments acquired with a maturity of three months or less from the purchase date to be cash equivalents.

Restricted cash and cash equivalents at May 31, 2018 and 2017 consist of a savings account held as collateral for our corporate credit card account.

At May 31, 2017 our short-term marketable securities in the amount of $2,203,396 consisted of certificates of deposit with various financial institutions, with maturity dates between three months and twelve months from the purchase date.

Investments in Marketable Securities

We determine the appropriate classification of our investments at the time of purchase and reevaluate such designation at each balance sheet date. Our investments in marketable securities have been classified and accounted for as held-to-maturity based on management’s investment intentions relating to these securities. Held-to-maturity marketable securities are stated at amortized cost. Unrealized gains and losses, net of deferred taxes, are recorded as a component of other comprehensive income (loss). We follow the authoritative guidance to assess whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines in fair value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the consolidated statements of operations.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Summary of Significant Accounting Policies continued

Property, Equipment and Depreciation

Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to five years.  Major betterments and renewals are capitalized, while routine repairs and maintenance are charged to expense when incurred.

Investment in Affiliated Companies

We have a 50% interest in PDS. We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee and is recognized in the consolidated statements of operations in the caption “Equity in earnings (loss) of affiliated company” and also is adjusted by contributions to and distributions from PDS.

PDS, as an unconsolidated equity investee, recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.

We review our investment in PDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near term prospects of PDS. If the decline in value is deemed to be other than temporary, we would recognize an impairment loss.

We own 100% of the preferred stock of Holocom (see Note 5). Prior to impairment, this investment was accounted for at cost since we do not have the ability to exercise significant influence over the operating and financial policies of Holocom.

Treasury Stock

We account for treasury stock under the cost method and include treasury stock as a component of stockholders’ equity.

Income Taxes

We follow authoritative guidance in accounting for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under this guidance we may only recognize tax positions that meet a “more likely than not” threshold.

We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We assess our deferred tax assets annually under more likely than not scenarios in which they may be realized through future income.

With the exception for refundable alternative minimum tax (“AMT”) credits, we have determined that it was more likely than not that all of our deferred tax assets will not be realized in the future due to our continuing pre-tax and taxable losses. As a result of this determination, and with the exception for the aforementioned refundable tax credits, we have recorded a full valuation allowance against our deferred tax assets.

On December 22, 2017, the United States Government passed the Tax Cuts and Jobs Act (“Tax Cuts Act”) that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carryforward net operating losses previously accumulated and results in a revaluation of deferred tax assets and liabilities recorded on our consolidated balance sheet. The Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) which provides guidance regarding accounting for the income tax effects of the Tax Cuts Act, including the impact of the Tax Cuts Act on deferred tax assets and liabilities for financial statements issued in the reporting period that includes the enactment date of December 22, 2017. Given that our current deferred tax assets, with the exception of those representing certain refundable tax credits, are offset by a full valuation allowance, these changes will have no net impact on our consolidated balance sheet. However, if we become profitable, we will receive a reduced benefit from such deferred tax assets.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Summary of Significant Accounting Policies continued

Assessment of Contingent Liabilities

We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.

Earnings (Loss) Per Share

Basic earnings per share includes no dilution and is computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity.

For the fiscal years ended May 31, 2018 and 2017, potential common shares of 2,600,000 related to our outstanding options were not included in the calculation of diluted loss per share as we recorded a loss. Had we reported net income for the years ended May 31, 2018 and 2017, no shares of common stock would have been included in the calculation of diluted income per share using the treasury stock method.

In connection with our acquisition of Crossflo, which became a part of PDSG, we issued 2,844,630 escrow shares that are contingent upon certain representations and warranties made by Crossflo at the time of the merger agreement (see Note 9). We exclude these escrow shares from the basic income (loss) per share calculations and would have included the escrowed shares in the diluted income per share calculations if we reported net income.

Use of Estimates

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in the consolidated financial statements and accompanying footnotes. Actual results could differ from those estimates. On an ongoing basis we evaluate our estimates, including, but not limited to: fair values of investments in marketable securities, the use, recoverability, and /or realizability of certain assets, including investments in affiliated companies and deferred tax assets, and valuation of share-based compensation.

Intellectual Property Rights

PDS, our investment in affiliated company, relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We have seven U.S., nine European, and three Japanese patents all of which expired between August 2009 and October 4, 2016. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration dates. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Summary of Significant Accounting Policies continued

Recent Accounting Pronouncements

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows – Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 provides guidance intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. The issue addressed in ASU 2016-15 that will affect the Company is classifying distributions received from equity method investments. The guidance provides an accounting policy election for classifying distributions received from equity method investments using either a cumulative earnings approach or a nature of distributions approach. ASU 2016-15 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years (fiscal 2019 for the Company). Early adoption is permitted. We have not yet determined the potential effects of the adoption of ASU 2016-15 on our consolidated financial statements.

In November 2016, the FASB issued ASU No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash”. ASU 2016-18 requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years (fiscal 2019 for the Company), with early adoption permitted. The Company is currently evaluating the effect ASU 2016-18 will have on our consolidated statements of cash flows.

On December 22, 2017, the United States Government passed the Tax Cuts and Jobs Act (“Tax Cuts Act”) that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carryforward net operating losses previously accumulated and results in a revaluation of deferred tax assets and liabilities recorded on our consolidated balance sheet. The Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) which provides guidance regarding accounting for the income tax effects of the Tax Cuts Act, including the impact of the Tax Cuts Act on deferred tax assets and liabilities for financial statements issued in the reporting period that includes the enactment date of December 22, 2017. Given that our current deferred tax assets, with the exception of those representing certain refundable tax credits, are offset by a full valuation allowance, these changes will have no net impact on our consolidated balance sheet. However, if we become profitable, we will receive a reduced benefit from such deferred tax assets.

3. Cash, Cash Equivalents, Restricted Cash and Marketable Securities

We follow authoritative guidance to account for our marketable securities as held-to-maturity. Under this authoritative guidance we are required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. We determine fair value based on quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment or valuations by third party professionals. The three levels of inputs that we may use to measure fair value are:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

Level 2: Quoted prices in markets that are not active or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)

The following tables detail the fair value measurements within the fair value hierarchy of our cash, cash equivalents and investments in marketable securities:

We purchase certificates of deposit with varying maturity dates. The following table summarizes the purchase date maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2018:

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)

We purchase certificates of deposit with varying maturity dates. The following table summarizes the purchase date maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2017:

4. Property and Equipment

Property and equipment consisted of the following at May 31, 2018 and 2017:

Depreciation expense related to property and equipment was $763 and $826 for the years ended May 31, 2018 and 2017, respectively.

5. Investment 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 the technology which is the subject of the MMP portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes between them. 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.

We and TPL each own 50% of the membership interests of PDS, and 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. There had not been a third management committee member since May 2010; however, as a result of our initiation of arbitration seeking the appointment of a third member, on December 16, 2014, an independent manager to the PDS management committee was selected by the arbitrator. Pursuant to the LLC Agreement, we and TPL initially 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 was increased 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. If the management committee determines that additional capital is required, neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. No such contributions were made during the fiscal years ended May 31, 2018 and 2017. Distributable cash and allocation of profits and losses have been allocated to the members in the priority defined in the LLC Agreement.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Companies (continued)

On July 11, 2012, we entered into the Program Agreement with PDS, TPL, and Alliacense, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement continued through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense. On July 24, 2014, the Program Agreement was amended with PDS and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was terminated by PDS.

On August 10, 2016, PDS entered into an agreement with Alliacense and MMP Licensing, LLC to settle matters relating to Alliacense’s non-performance under terms of the Novation Agreement. The August 10, 2016 agreement required Alliacense to provide PDS’s second licensing company, Dominion Harbor Group (“DHG”), with certain materials and to cooperate with reasonable discovery requests relating to infringement litigation in the U.S. District Court for the Northern District of California. MMP Licensing, LLC will provide commercialization services to PDS for the MMP portfolio with respect to certain companies. PDS and Alliacense have agreed to cause the arbitration between the parties to be dismissed with prejudice. The August 10, 2016 agreement, and the agreement retaining DHG as PDS’s second licensing company, will both expire on October 4, 2022. Terms of the settlement agreement required PDS to pay Alliacense $84,000 within 24 hours after delivery of materials to PDS’s second licensing agent and to pay Alliacense $84,000 out of subsequent recoveries. PDS paid Alliacense $84,000 on each of August 11, 2016 and October 3, 2016.

During January 2013, TPL and Moore settled their litigation. Terms of the settlement included the payment by PDS to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever came first. Per terms of the agreement, PDS paid Moore $150,000 on the settlement date and paid Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning February 2014 through January 2017. During the fiscal year ended May 31, 2017, PDS expensed $166,674 pursuant to this contractual obligation. This expense is recorded in the accompanying PDS statement of operations for the fiscal year ended May 31, 2017 presented below.

Based on our analysis of current authoritative accounting guidance with respect to our investment in PDS, we continue to account for our investment in PDS under the equity method of accounting, and accordingly have recorded our share of PDS’s net loss during the fiscal year ended May 31, 2018 of $242,615 as a decrease in our investment. We have recorded our share of PDS’s net income during the fiscal year ended May 31, 2017 of $1,155,231 as an increase in our investment. Cash distributions of $883,600 received from PDS during the year ended May 31, 2017 have been recorded as a reduction in our investment. We have recorded our share of PDS’s net income and loss as “Equity in earnings (loss) of affiliated company” in the accompanying consolidated statements of operations for the years ended May 31, 2018 and 2017.

During the fiscal year ended May 31, 2017, PDS entered into licensing agreements with third parties, pursuant to which PDS recognized revenues of $3,000,000.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. In the event we are required to provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements. If we determine that it is appropriate to consolidate PDS, we would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date that we have the controlling financial interest.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Companies (continued)

PDS’s balance sheets at May 31, 2018 and 2017 and statements of operations for the years ended May 31, 2018 and 2017 are as follows:

Balance Sheets

Assets:

Liabilities and Members’ Equity:

Statements of Operations

We review our investment in PDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near term prospects of PDS. If a decline in value is deemed to be other than temporary, we would recognize an impairment loss.

Holocom, Inc.

We currently own 2,100,000 shares of preferred stock, equivalent to an approximate 46% ownership interest on an after converted basis, in Holocom, Inc. (“Holocom”), a California corporation that manufactures products that protect information transmitted over secure networks. The shares are convertible at our option into shares of Holocom’s common stock on a one-to-one basis. The 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 Holocom, as well as a liquidation preference of $0.40 per share, plus an amount equal to all declared but unpaid dividends.

In 2010, we determined that the inability of Holocom to meet its business plan, raise capital, and the general economic environment were indicators of impairment on our investment and we wrote-off our cost basis investment in Holocom. At May 31, 2018 and 2017, our investment in Holocom was valued at $0.

6. Accrued Expenses and Other

At May 31, 2018 and 2017, accrued expenses and other consisted of the following:

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

7. 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.

There were no share repurchases during the years ended May 31, 2018 and 2017.

2006 Stock Option Plan

The 2006 Stock Option Plan, as amended, which expired in March 2016, provided for the granting of options to acquire up to 10,000,000 shares, with a limit of 8,000,000 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). As of May 31, 2018, options to purchase 2,600,000 shares of common stock are outstanding under the 2006 Stock Option Plan.

Share-based Compensation

Summary of Assumptions and Activity

The fair value of share-based awards to employees and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from our stock options.

The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. The expected volatility is based on the historical volatilities of our common stock. These factors could change in the future, affecting the determination of share-based compensation expense in future periods.

A summary of option activity for the year ended May 31, 2018 is presented below:

The aggregate intrinsic value in the table above represents the differences in market price at the close of the fiscal year ($0.005 per share on May 31, 2018) and the exercise price of outstanding, in-the-money options (those options with exercise prices below $0.005 per share) on May 31, 2018.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

8. Income Taxes

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

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

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

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Income Taxes (continued)

On December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carryforward net operating losses previously accumulated and results in a revaluation of deferred tax assets and liabilities recorded on our consolidated balance sheet. Given that our current deferred tax assets, with the exception of those representing certain refundable tax credits, are offset by a full valuation allowance, these changes will have no net impact on our consolidated balance sheet. The estimated effect of the legislation was a reduction in the deferred tax assets and the corresponding valuation allowance of $3,693,088. Additionally, the AMT credit carryforwards will now be a refundable credit; therefore the valuation allowance on the federal AMT credits in the amount of $52,156 has been released.

While we are able to make reasonable estimates of the impact of the reduction in corporate rate, the final impact of the Tax Act may differ from these estimates due to, among other things, changes in our interpretations and assumptions, additional guidance that may be issued by the Internal Revenue Service, and actions we may take. We are continuing to gather additional information to determine the final impact.

We have federal and state net operating loss carryforwards available to offset future taxable income of approximately $25,318,746 and $18,238,385, respectively, at May 31, 2018. These carryforwards begin to expire in the years ending May 31, 2025 and 2028, respectively.

We follow authoritative guidance which defines 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. Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense. Interest and penalties relating to underpayment of income taxes are recorded in general and administrative expense. As of May 31, 2018, we are subject to U.S. Federal income tax examinations for the tax years May 31, 2007 through May 31, 2019, and we are subject to state and local income tax examinations for the tax years May 31, 2007 through May 31, 2019 due to the carryover of net operating losses related to PDSG from previous years.

We have no liability relating to unrecognized tax benefits under the authoritative guidance for the fiscal years ended May 31, 2018 and 2017.

Our continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. We do not expect our unrecognized tax benefits to change significantly over the next twelve months.

9. Commitments and Contingencies

Patent Litigation

We, TPL, and PDS (collectively referred to as “Plaintiffs”) are Plaintiffs in ongoing proceedings in the U.S. District Court for the Northern District of California where the Plaintiffs allege infringement of the US 5,809,336 patent (the “‘336 patent”) by: Huawei Technologies Co. Ltd., LG Electronics, Nintendo Co. Ltd., Samsung Electronics Co. Ltd., and ZTE Corporation (collectively referred to as “Defendants”). This litigation is proceeding in front of District Court Judge Vince Chhabria.

These ongoing proceedings relate to the proceedings filed by the Plaintiffs in February 2008 in the U.S. District Court for the Northern District of California alleging infringement of the US 5,440,749 patent (the “‘749 patent”), the US 5,530,890 patent (the “‘890 patent”) and the ‘336 patent against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We have settled with all defendants except those named in the first paragraph to this footnote.

On September 18, 2015, a Markman hearing was held before U.S. Magistrate Judge Grewal and, on September 22, 2015, he issued a claim construction report and recommendation. On September 25, 2015, as a result of the claim construction report and recommendation, Plaintiffs and defendants, with the exception of Huawei Technologies Co. Ltd., (“Huawei”) agreed to stay all proceedings pending resolution of Plaintiffs’ objections to the claim construction report and recommendation. Plaintiffs further stipulated that, under the claim construction provided by the report and recommendation, defendants’ products do not infringe the ‘336 patent, and, in the event that the Court does not materially modify the claim construction, Plaintiffs and defendants ask that the Court enter a final judgment of non-infringement. After Plaintiffs and Huawei filed opposing letter briefs with the Court, U.S.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

Magistrate Judge Grewal stayed the action against Huawei pending resolution of Plaintiffs’ objections to the claim construction.

On October 6, 2015, Plaintiffs filed objections to the claim construction with District Court Judge Chhabria. Judge Chhabria rejected those objections on November 9, 2015. Based on that order, the parties stipulated to a judgment of non-infringement as to the ‘336 patent and such judgment was entered on November 13, 2015.

On December 7, 2015, Plaintiffs filed notices of appeal with the U.S. Federal Circuit appealing the district court’s claim construction. Plaintiffs filed their opening appellate brief on March 10, 2016. Defendants filed their response brief on May 23, 2016, with Plaintiffs filing their reply brief on June 23, 2016. On March 3, 2017, the U.S. Court of Appeals for the Federal Circuit rendered its decision modifying the claim construction that was issued in September 2016 by the U.S. District Court for the Northern District of California and has remanded the matter to the District Court for further proceedings.

On May 23, 2017, a case management conference was held in front of District Court Judge Chhabria, who ordered that Plaintiffs amend their infringement contentions on or before June 16, 2017. Judge Chhabria further ordered that Defendants submit any motion for summary judgment based on the amended infringement contentions and the modified claim construction by August 1, 2017. On June 5, 2017, the law firm of Banys, P.C., who had served as local counsel for PDS, withdrew as counsel. PDS continued to be represented by the law firm of Nelson Bumgardner, P.C. On June 16, 2017, Plaintiffs timely amended their infringement contentions. On July 13, 2017, all remaining counsel for each of Patriot, TPL, and PDS moved to withdraw as counsel and further moved to extend all currently pending case deadlines by 60 days for Plaintiffs to seek new counsel.

On September 13, 2017, the law firm of Bunsow De Mory LLP was entered before the U.S. District Court for the Northern District of California as successor counsel in representation of Patriot, PDS, and TPL.

The Defendants moved for summary judgment of non-infringement on September 29, 2017, and the Court held a hearing on Defendants’ motion on November 30, 2017. The Court granted Defendants’ motion and entered judgment of non-infringement on December 13, 2017.

Defendant Samsung submitted a bill of costs seeking $30,170 in taxable costs in the underlying district court proceedings; Plaintiffs filed an objection to significant portions of that request. On March 1, 2018, the Clerk of the District Court taxed costs in the amount $829.

Plaintiffs filed notices of appeal in these district court matters on January 5, 2018. The appeals were docketed and consolidated under lead case No. 18-1439, captioned as Technology Properties Limited v. Huawei Technologies Co., Ltd in the United States Court of Appeals for the Federal Circuit. Briefing was complete on July 31, 2018. The court has not yet scheduled an oral argument. We expect that it may take up to eight to twelve months before a decision is received.

401(k) Plan

On March 29, 2018, we terminated our Section 401(k) plan pursuant to a plan to reduce corporate expenses. Our retirement plan complied with Section 401(k) of the Internal Revenue Code and all employees were eligible to participate in the plan. We matched 100% of elective deferrals subject to a maximum of 4% of the participant’s eligible earnings. Our participants vested 33% per year over a three year period in their matching contributions. Our matching contributions during the fiscal years ended May 31, 2018 and 2017 were $14,153 and $20,883, respectively.

Employment Contracts

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. On December 30, 2016, we entered into an amended and restated employment agreement with Mr. Flowers. Pursuant to the amended December 30, 2016 agreement, 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 1.25 times 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.

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

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. 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.

Escrow Shares

On August 31, 2009, we gave notice to the former shareholders of Crossflo and Union Bank of California (the “Escrow Agent”) under Section 2.5 of the Agreement and Plan of Merger between us and Crossflo (the “Agreement”), outlining damages incurred by us in conjunction with the acquisition of Crossflo, and seeking the return of 2,844,630 shares of our common stock held by the Escrow Agent.  Subsequently, former shareholders of Crossflo representing a majority of the escrowed shares responded in protest to our claim, delaying the release of the escrowed shares until a formal resolution is reached.  In the event we fail to prevail in our claim against the escrowed shares, we may be obligated to deposit into escrow approximately $256,000 of cash consideration due to the decline in our average stock price over the one-year escrow period, calculated in accordance with the Section 2.5 of the Agreement.  We have evaluated the potential for loss regarding our claim and believe that it is probable that the resolution of this issue will not result in a material obligation to the Company, although there is no assurance of this.  Accordingly, we have not recorded a liability for this matter.

Operating Lease

Our current facility operating lease is on a month to month basis. Rental expense is presented in the following table:

10. Subsequent Events

We have evaluated subsequent events after the balance sheet date and through the filing date of this Annual Report, and based on our evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying consolidated financial statements or disclosure in the notes thereto other than as disclosed in the accompanying notes.

Phoenix Digital Solutions, LLC

INDEX TO FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Members and Management Committee

Phoenix Digital Solutions, LLC

Opinion on the Financial Statements

We have audited the accompanying balance sheets of Phoenix Digital Solutions, LLC (the "Company") as of May 31, 2018 and 2017, the related statements of operations, members' equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of May 31, 2018 and 2017, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Going Concern

The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the financial statements, because of the uncertain nature of the negotiations that lead to license revenues, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting 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.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ KMJ Corbin & Company LLP

We have served as the Company’s auditor since 2005.

Costa Mesa, California

August 29, 2018

Phoenix Digital Solutions, LLC

Balance Sheets

See accompanying notes to financial statements.

Phoenix Digital Solutions, LLC

Statements of Operations

See accompanying notes to financial statements.

Phoenix Digital Solutions, LLC

Statements of Members’ Equity

Years Ended May 31, 2018 and 2017

See accompanying notes to financial statements.

Phoenix Digital Solutions, LLC

Statements of Cash Flows

See accompanying notes to financial statements.

Phoenix Digital Solutions, LLC

Notes to Financial Statements

1. Organization and Business

Phoenix Digital Solutions, LLC (the “Company” or “PDS”) is a Delaware limited liability company organized on June 7, 2005. Through a commercialization agreement dated June 7, 2005, as amended in July 2012, the Company holds the rights to certain patents of its members. The Company receives license fees from license agreements entered into between licensees and the Company, and distributes license fee proceeds to its members.

Basis of Presentation

The Company’s financial statements have been prepared using the accrual method of accounting in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.

Going Concern and Management’s Plans

At August 24, 2018, the Company’s cash balance was $328,542. The ability of PDS to continue as a going concern is dependent on its ability to generate or obtain sufficient cash to meet its obligations on a timely basis. The Company will need to generate proceeds from new license agreements or obtain equity or debt financing from its members to fund its planned operating expenses and working capital requirements for the foreseeable future. Currently, the Company has no commitments to obtain additional capital from sources outside of that which may be contributed by the members, and there can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all.

Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which the members believe have infringed on their patent portfolio, the possibility of legislative action regarding patent rights, and the possible effect of new judicial interpretations of patent laws, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past.

In the event the Company is unable to successfully generate proceeds from license agreements at historical levels or obtain additional capital, it is unlikely that the Company will have sufficient cash flows and liquidity to finance its business operations as currently contemplated. Accordingly, in the event new financing is not obtained, the Company will likely reduce general and administrative expenses, including legal fees, litigation activity and other licensing costs, until it is able to obtain sufficient financing to do so.

On March 20, 2013, Technology Properties Limited, Inc. (“TPL”) filed a petition under Chapter 11 of the United States Bankruptcy Code. On March 5, 2018, TPL’s Motion for Entry of Final Decree Closing Chapter 11 was granted. 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed, the above conditions raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

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 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 from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. The Company may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.

Financial Instruments and Concentration of Credit Risk

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

Cash is maintained with high quality financial institutions. At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation. The Company performs ongoing evaluations of these financial institutions to limit its concentration of risk exposure.

Legal Fees

For the year ended May 31, 2018, the Company’s current legal service provider accounted for $376,738 of legal costs associated with the litigation of the Moore Microprocessor Patent (“MMP”) portfolio. For the years ended May 31, 2018 and 2017, the Company’s prior legal service provider accounted for $11,298 and $18,188, respectively, of legal costs associated with the litigation of the MMP portfolio. These amounts are included in general and administrative expense in the accompanying statements of operations.  

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 licenses seven U.S., nine European, and three Japanese patents on PTSC’s microprocessor technology all of which expired between August 2009 and October 4, 2016. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration dates. The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Summary of Significant Accounting Policies (continued)

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers,” which was subsequently amended by ASUs 2015-14, 2016-08, 2016-10, 2016-12, and 2016-20. ASU 2014-09, as amended, supersedes the revenue recognition requirements in ASC Topic 605, “Revenue Recognition”, and creates a new ASC Topic 606 (“ASC 606”). ASU 2014-09, as amended, implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. The amendment also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include the capitalization and amortization of certain contract costs, ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The new revenue standards are effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period (fiscal year 2019 for the Company). Our adoption of this guidance effective June 1, 2019, will not have a significant impact on the financial statements of PDS.

3. Fair Value of Financial Instruments

The Company’s financial instruments consist of cash and its accounts payable and accrued expenses. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments.

4. Prepaid Expenses

At May 31, 2018 and 2017 prepaid expenses consist of:

5. Formation of Joint Venture and Commercialization Agreement

The Company, a joint venture, has two members: TPL and 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.

Contribution Requirements

Pursuant to the Company’s Limited Liability Company Operating Agreement (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 increased 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. If the management committee determines that additional capital is required, neither member is required to contribute more than $2,000,000 in any fiscal year. No contributions were made during the fiscal years ended May 31, 2018 and 2017. Distributable cash and allocation of profits and losses are allocated to the members in the priority defined in the LLC Agreement.

Joint Venture Contractual Agreements

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

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Formation of Joint Venture and Commercialization Agreement (continued)

On July 11, 2012, the Company entered into a Licensing Program Services Agreement (the “Program Agreement”) with PTSC, TPL, and Alliacense creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) between TPL and PTSC. Pursuant to the Program Agreement, the Company engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of the Company, TPL, and PTSC. The Program Agreement continued through the useful life of the MMP portfolio patents. On July 24, 2014, the Program Agreement was amended with the Company and Alliacense entering into the Amended Alliacense Services and Novation Agreement (the “Novation Agreement”). Pursuant to the Novation Agreement certain performance goals and incentives were established for Alliacense. The Novation Agreement also provided for the addition of a second licensing company, which was engaged on October 10, 2014, to complement the MMP licensing commercialization. However, Alliacense fulfilled only a portion of its obligations under the Novation Agreement associated with the deployment of the second licensing company and on May 11, 2015, Alliacense was terminated by PDS.

On August 10, 2016, the Company entered into an agreement with Alliacense and MMP Licensing, LLC to settle matters relating to Alliacense’s non-performance under terms of the Novation Agreement. The August 10, 2016 agreement required Alliacense to provide the Company’s second licensing agent, Dominion Harbor Group (“DHG”), with certain materials and to cooperate with reasonable discovery requests relating to infringement litigation in the U.S. District Court for the Northern District of California. MMP Licensing, LLC will provide commercialization services to the Company for the MMP portfolio with respect to certain companies. The Company and Alliacense have agreed to cause the arbitration between the parties to be dismissed with prejudice. The August 10, 2016 agreement, and the agreement retaining DHG as PDS’s second licensing company, will both expire on October 4, 2022. Terms of the settlement agreement required the Company to pay Alliacense $84,000 within 24 hours after delivery of materials to the Company’s second licensing agent and to pay Alliacense $84,000 out of subsequent recoveries. The Company paid Alliacense $84,000 on each of August 11, 2016 and October 3, 2016.

During January 2013, TPL and Moore settled their litigation. Terms of the settlement included payment by the Company to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever came first. Per terms of the agreement the Company paid Moore $150,000 on the settlement date and paid Moore $16,667 per month from August 2013 through January 2014 and paid Moore $20,833 per month from February 2014 through January 2017. For the fiscal year ended May 31, 2017, the Company expensed $166,674 related to this agreement.

Significant Contractual Legal Relationship

The Company has incurred legal fees from unrelated law firms to provide legal services for the commercialization of the MMP portfolio of microprocessor patents.

There were no accounts payable balances due to the Company’s current law firm as of May 31, 2018 and 2017.

Transactions with the Company’s current law firm for the fiscal years ended May 31, 2018 and 2017 were as follows:

Accounts payable balances due to the Company’s former law firm as of May 31, 2018 and 2017 were $1,826 and $1,961, respectively.

Transactions with this law firm for the fiscal years ended May 31, 2018 and 2017 were as follows:

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

6. Delinquent Accounts Payable

During the fiscal year ended May 31, 2017, the Company reversed approximately $6,900 of legal fees and other expenses previously expensed and recorded as accounts payable as the statute of limitations had expired. These reversals are recorded as a reduction of legal and other expenses in general and administrative expense in the accompanying statement of operations.

7. 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 duties and responsibilities under 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.

8. Related Party Transactions

A summary of related party transactions described above is as follows:

9. Subsequent Events

The Company has evaluated subsequent events after the balance sheet date and through the filing of this report, and based on its evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying financial statements or disclosure in the notes thereto other than as disclosed in the accompanying notes.