Neonode Inc. - Quarter Report: 2008 September (Form 10-Q)

Delaware		94-1517641
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

 

USA 4000 Executive Parkway, Suite 200, San Ramon, CA., 94583

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USA (925) 355-7700

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PART I	Financial Information
Item 1	Financial Statements
Condensed Balance Sheets as of
September 30, 2008 and December 31, 2007		3
Condensed Statements of Operations for the
three and nine months ended September 30, 2008 and 2007		4
Condensed Statements of Cash Flows for the
nine months ended September 30, 2008 and 2007		5
Notes to Condensed Financial Statements		6
Item 2	Management's Discussion and Analysis of Financial
	Condition and Results of Operations	24
Item 3	Quantitative and Qualitative Disclosures about
	Market Risk
Item 4	Controls and Procedures	36
PART II	Other Information
Item 6	Exhibits	38
SIGNATURES		41
EXHIBITS

 

NEONODE INC

Notes to the Consolidated Financial Statements

(Unaudited)

1. Interim Period Reporting

The condensed consolidated balance sheet of Neonode Inc (the Company) as of December 31, 2007 is derived from audited consolidated financial statements. The unaudited interim condensed consolidated financial statements, include all adjustments, consisting of normal recurring adjustments except as otherwise explained in these financial statements, that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations and cash flows for the interim periods. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of expected results for the full 2008 fiscal year.

The accompanying financial data as of September 30, 2008 and for the three and nine months ended September 30, 2008, and 2007 has been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally contained in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes contained in our audited Consolidated Financial Statements and the notes thereto for the fiscal year ended December 31, 2007.

Liquidity

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the ordinary course of business. We have incurred net operating losses and negative operating cash flows since inception. As of September 30, 2008, we had an accumulated deficit of $90.4 million. We expect to incur additional losses and may have negative operating cash flows through the end of 2008 and beyond. The report of our independent registered public accounting firm in respect of the 2007 fiscal year includes an explanatory going concern paragraph regarding substantial doubt as to our ability to continue as a going concern, which indicates an absence of obvious or reasonably assured sources of future funding that will be required by us to maintain ongoing operations.

We are not generating sufficient cash from the sale of our products to support our operations and have been incurring significant losses. During the nine months ended September 30, 2008, we raised approximately $8.2 million net cash proceeds though the sale of our securities. (See Note 5 Stockholders’ Equity). Unless we are able to increase our revenues and decrease expenses substantially in addition to securing additional sources of financing, we will not have sufficient cash to support our operations through the end of 2008. We are currently evaluating different financing alternatives including but not limited to selling shares of our common or preferred stock or issuing notes that may be converted into shares of our common stock which could result in the issuance of additional shares. We are also proposing to convert our convertible debt and a majority of our accounts payable to shares of our common or preferred stock which would result in the issuance of additional shares.

 

In addition to raising additional cash from the sale of our securities and conversion of debt and accounts payable to equity, we have taken steps to restructure our operations and reduce our monthly operational cash expenses. Our target is to reduce our operational cash expenses to an amount less than $300,000 per month. Management and the board of directors have determined that the liquidation basis of accounting is not yet appropriate during this period and that we are evaluating all financing alternatives. We continue to pursue and support customers for our N2 mobile handsets and are developing our technology offerings. We also revised our business plan so that we now focus the majority of our efforts on capitalizing on the special features of our technology and our core engineering competence through licensing our technology to third party companies.

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Our unrestricted cash balance on September 30, 2008 totals $55,000. On October 22, 2008, our Swedish subsidiary, Neonode AB, filed for company reorganization in compliance with the Swedish reorganization act (1996:764). Mr. Anders W. Bengtsson of the Stockholm based law firm Nova was appointed to administrate the process. Under Swedish law, the reorganization process provides an initial period of three months to allow us to restructure and recapitalize our subsidiary, Neonode AB, in an orderly fashion. Should it be deemed necessary we can file for an extension period of additional three months to complete the reorganization. In accordance with 16 § of the Swedish act of reorganization, a Neonode AB creditors’ meeting was held at the district court of Stockholm, Sweden November 11, 2008. At that meeting the creditors of Neonode AB were offered a settlement proposal to convert the amounts owed by Neonode AB to shares of common stock of Neonode Inc. The creditors present at the meeting agreed to allow Neonode AB until January 22, 2009 to get all the creditors to accept the proposed settlement agreement.

 

We will not be able to continue operations through the end of December 2008, unless we are able to convert Neonode AB’s accounts payable to equity and raise at least $2 million through the sale of Neonode Inc. equity or debt financial instruments. If the creditors of Neonode AB do not accept the proposed settlement agreement, Neonode AB may be forced to enter bankruptcy liquidation proceedings as defined under the bankruptcy laws of Sweden. If that occurs, all the Neonode AB intellectual property and proprietary assets will be transferred to Neonode Inc. under an intercompany borrowing asset pledge agreement between Neonode Inc and Neonode AB. If Neonode AB is forced to liquidate under bankruptcy, Neonode Inc. would continue to operate as a technology licensing company if Neonode Inc. is successful in raising at least $2 million through the sale of Neonode Inc. equity or debt financial instruments.

 

There is no assurance that we will be successful in convincing creditors of our subsidiary Neonode AB to convert their accounts payable to our common stock, reducing our operating expense, generate cash flow from operations or in obtaining sufficient funding from any source on acceptable terms, if at all. If we are unable to generate cash flow from our operations or secure additional funding, and stockholders, if required, do not approve such financing, we would have to curtail certain expenditures which we consider necessary for optimizing the probability of success of executing on our business plan. If we are unable to obtain additional funding for operations, we may not be able to continue operations as proposed, requiring us to modify our business plan, curtail various aspects of our operations or cease operations. In such event, investors may lose a portion or all of their investment.

2. Summary of Significant Accounting Policies

For a complete list of significant accounting policies these condensed consolidated financial statements should be read in conjunction with the financial statements and notes contained in our audited Consolidated Financial Statements and the notes thereto for the fiscal year ended December 31, 2007.

Fiscal Year

 

Our fiscal year is the calendar year.

Principles of Consolidation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include the accounts of Neonode Inc. and its subsidiary based in Sweden, Neonode AB. All significant inter-company accounts and transactions have been eliminated in consolidation.

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Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires making estimates and assumptions that affect, at the date of the financial statements, the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. Significant estimates include but are not limited to collectibility of accounts receivable, carrying value of inventory, estimated useful lives of long-lived assets, recoverable amounts and fair values of intangible assets, and the fair value of securities such as options and warrants issued for stock-based compensation and in certain financing transactions.

Reclassification

Certain items have been reclassified from the presentation made in the prior year.

Restricted Cash

As of December 31, 2007, we provided bank guaranties totaling $5.7 million as collateral for the performance of our obligations under our agreement with our manufacturing partner. The outstanding bank guaranties expired on December 29, 2007 and the funds were released by our bank to cash on January 2, 2008. As of September 30, 2008, we provided a cash deposit totaling $148,000 related to the lease on our new headquarters office in Stockholm, Sweden, which is restricted to us from using in our operations.

Segment information

We have one reportable segment. The segment is evaluated based on consolidated operating results. We currently operate in one industry segment; the development and selling of multimedia mobile phones. To date, we have carried out substantially all of our operations through our subsidiary in Sweden, although we do carry out some development activities together with our manufacturing partner in Malaysia.

Effects of Recent Accounting Pronouncements

The following are expected effects of recent accounting pronouncements. We are required to analyze these pronouncements and determined the effect, if any, the adoption of these pronouncements would have on our results of operations or financial position.

In December 2007, the Financial Accounting Standards Board (FASB) issued Statement on Financial Accounting Standards (SFAS) No. 141 (revised 2007), Business Combinations (SFAS No. 141R). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS No. 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141R is effective as of the beginning of an entity’s fiscal year that begins after 15 December 2008, and will be adopted by us in the first quarter of 2009. The adoption of SFAS 141R will affect the way we account for any acquisitions made after January 1, 2009.

In September 2006, the FASB issued SFAS 157, Fair Value Measurements . The standard provides guidance for using fair value to measure assets and liabilities. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. The statement is effective for us beginning in fiscal year 2008. In February 2008, the FASB issued FASB Staff Position (FSP) SFAS 157-2, Effective Date of FASB Statement No. 157 (FSP SFAS 157-2) that deferred the effective date of SFAS No. 157 for one year for certain nonfinancial assets and nonfinancial liabilities.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS 160 establishes new standards that will govern the accounting for and reporting of noncontrolling interests in partially owned subsidiaries. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008 and requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements shall be applied prospectively. We are currently evaluating the potential impact of this statement.

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In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133 , as amended and interpreted, which requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. Disclosing the fair values of derivative instruments and their gains and losses in a tabular format provides a more complete picture of the location in an entity’s financial statements of both the derivative positions existing at period end and the effect of using derivatives during the reporting period. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended and its related interpretations (together SFAS 133), and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. . We do not expect the adoption of SFAS 161 to have a material impact on our financial position, and we will make all necessary disclosures upon adoption, if applicable.

 

In April 2008, the FASB issued EITF 07-05, Determining whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock. (EITF 07-05). EITF 07-05 provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in paragraph 11(a) of FAS 133. EITF 07-05 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and early application is not permitted. We are evaluating what effect EITF 07-05 will have on our financial position and operating results.

 

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. SFAS 162 is effective sixty days following the SEC's approval of PCAOB amendments to AU Section 411, The Meaning of 'Present fairly inconformity with generally accepted accounting principles. We are currently evaluating the potential impact, if any, of the adoption of SFAS 162 on our consolidated financial statements.

 

In May 2008, the FASB issued FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). This FSP clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants. Additionally, this FSP specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We are evaluating what effect FSP APD 14-1 will have on our financial position and operating results.

 

3.  Inventories

At September 30, 2008 and December 31, 2007, inventories consisted of parts, materials and finished products as follows (in thousands):

		September 30,			December 31,
		2008			2007
Parts and materials		$	—		$	247
Finished goods held at customer locations			—			1,243
Finished goods held at manufacturing partner			1,413			5,120
Total inventories		$	1,413		$	6,610

Parts and materials consist of components purchased by us in order to reduce the production lead time of our products. Finished goods held at manufacturing partner locations consist of N2 phones and accessories located at our manufacturing partner or with our web sales partner. Finished goods held at customer locations consists of N2 phones that have been shipped to distributors but remain in their inventories at the end of the period for which revenue has been deferred.

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In January 2008, we discovered a technical issue that affected the quality of the reception of our phones in the 900 Megahertz bandwidth and lower. As a result, we undertook a voluntary program to recall and modify the phones that our customers held in inventory in order to bring the quality of the reception up to our standards. Due to the recall, we stopped all shipments of our N2 phones during the first quarter of 2008, and our customers withheld payment of amounts due to until such time as we are able to return the modified phones to them. As the modifications were completed we redistributed the inventory that had not been paid for to new customers or are holding it in our inventory for future shipment to new customers. We completed the product modification in May 2008.

 

We have experienced limited success in selling our N2 mobile phone since introduction in the third quarter of 2007 and reevaluated our selling efforts and the potential markets for the N2 during the second quarter of 2008. Based upon this reevaluation, we decided that it was probable that we may have to reduce the selling price of our N2 phones and/or offer our customers substantial incentives in order to sell the N2. As a result of our revaluation, we recorded a $7.7 million write-down of our inventory during the second quarter of 2008 and an additional $2.1 million in the quarter ended September 30, 2008 for a total inventory write-down of $9.8 million in the nine months ended September 30, 2008 reducing the value of our inventory to $1.4 million which is the estimated realizable value after selling costs of our inventory.

 

4.   Convertible Debt and Notes Payable

Our convertible debt and notes payable consists of the following (in thousands):

		September 30,			December 31,
		2008			2007
Senior Convertible Secured August 2007 Bridge Notes (face value $2,800)		$	2,706		$	2,634
Senior Convertible Secured Notes September 2007 (face value $3,053 at September 30, 2008 and $3,085 at December 31, 2007)			1,100			1,112
Loan - Almi Företagspartner			68			120
Capital leases – office copying machines			89			72
Total			3,963			3,938
Unamortized debt discount			2,600			3,746
Total debt, net of debt discount			1,363			192
Less: short-term portion of long-term debt			1,291			132
Long-term debt		$	72		$	60

Future maturities of notes payable (in thousands):

Year ended December 31,		Future Maturity of  Notes Payable
2008 remaining		$	2,844
2009			24
2010			3,053
Thereafter			-
Total principal payments		$	5,921

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Loan Default

We failed to pay the $63,000 interest payment that was due on September 30, 2008. As a result, we are in default as defined under the Senior Convertible Secured Notes September 2007. Under the terms of default the interest rate has been increased from the higher of LIBOR plus 3 percent or 8% to 10.5 percent effective September 30, 2008 and the note holders can, at their option, demand immediate repayment of the notes.

Senior Convertible Secured August Bridge Notes

On August 8, 2007, we made an offering of convertible notes pursuant to a Note Purchase Agreement (August Bridge Notes or Bridge Notes), dated as of July 31, 2007, amended August 1, 2007, September 26, 2007 and March 24, 2008. The August Bridge Notes are convertible into the units described below. We received $3,250,000 from the Bridge Note offering and issued an option to an investor/financial advisor to invest $750,000, at the same terms and conditions as the Bridge Notes. The August Bridge Notes originally matured on December 31, 2007, however the maturity of these notes was extended to December 31, 2008.

The August Bridge Notes, due December 31, 2008, bear 8% per annum interest and are convertible into purchase units that are made up of a combination of shares of our common stock, convertible debt and warrants. The note holders have a right to convert their notes plus accrued interest anytime before December 31, 2008 into purchase units. Each purchase unit of $3,000 is comprised of one $1,500 three-year promissory note bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 600 shares of our common stock and 5 year warrants to purchase 696.5 shares of our common stock at a price of $1.27 per share. For accounting purposes, the embedded conversion feature was determined to meet the definition of a derivative and was recorded as liability. This was because the holder of the notes could convert debt and accrued interest, where interest is at the greater of 8% or LIBOR plus 3%, and therefore, the total number of shares the instrument could be convertible into was not fixed. Accordingly, the embedded conversion feature is bifurcated from the debt host instrument and treated as a liability, with the offset to debt discount. The related warrants were also recorded as a liability for the same reason.

The fair value of the embedded conversion feature related to the Bridge Notes was calculated at September 26, 2007 using the Black-Scholes option pricing model and amounted to $3.3 million. The assumptions used when calculating the fair value of the embedded conversion feature related to the Bridge Notes were a term of 0.76 years, volatility of 99% and a risk-free interest rate of 4.16%. The $3.3 million fair value was recorded as “Embedded derivatives of convertible debt” and a debt discount. The debt discount exceeded the amount of recorded debt, which resulted in a charge for the three and nine months ended September 30, 2007of $654,000 for the difference between the debt discount and the value of the debt. The remaining debt discount balance is allocated to interest expense based on the effective interest rate method, with an effective interest rate of 393%, over the remaining term of the notes. The value of the embedded conversion feature is revalued at each period-end and the liability is adjusted with the offset recorded as “Non-cash financial items.”

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At September 30, 2008, the fair value of the embedded conversion feature related to the Bridge Notes amounted to $1.2 million resulting in a $16,000 increase and $881,000 decrease for the three and nine months ended September 30, 2008 compared to the fair value of the embedded conversion feature related to the Bridge Notes of $1.2 million and $2.1 million at June 30, 2008 and December 31, 2007, respectively. The assumptions used when calculating the fair value of the embedded conversion feature related to the Bridge Notes at September 30, 2008 were a term of 0.25 years, volatility of 131.0% and a risk-free interest rate of 0.9%.

August Bridge Notes Extension Warrants

On September 26, 2007, the August Bridge Note holders that had not converted their debt were given three year warrants to purchase up to 219,074 shares (1^st Extension Warrants) of our common stock at a price of $3.92 per share in exchange for an agreement to extend the term of their notes from the original date of December 31, 2007 until June 30, 2008. The fair value of the warrants issued to the holders of the remaining Bridge Notes was calculated at September 26, 2007 as $706,000 using the Black-Scholes option pricing model. The assumptions used for the when calculating the fair value of the 1^st Extension Warrants were a term of 0.76 years, volatility of 116% and a risk-free interest rate of 4.16%. The 1^st Extension Warrants were classified as a liability pursuant to the guidance provided in paragraph 17 of EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The fair value of the warrants was recorded as a debt issuance cost and is allocated to interest expense based on the effective interest rate method over the nine month term of the notes with the offsetting entry to a liability. As a result of the extension of the loan maturity period, the agreement to delay conversion of the bridge notes and the issuance of the 1^st Extension Warrants, the modifications were significant enough to trigger debt extinguishment accounting resulting in a debt extinguishment charge for the three and nine months ended September 30, 2007 amounting to $540,000. The liability for the 1^st Extension Warrants issued to the August Bridge Note holders is revalued at the end of each reporting period and the change in the liability is recorded as “Non-cash financing items.”

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At September 30, 2008, the liability related to the 1st Extension Warrants amounted to $6,000 resulting in a $15,000 decrease and $602,000 decrease for the three and nine months ended September 30, 2008 compared to the fair value of the 1st Extension Warrants of $21,000 and $607,000 at June 30, 2008 and December 31, 2007, respectively. The assumptions used when calculating the fair value of the 1st Extension Warrants at September 30, 2008 were a term of 2.0 years, volatility of 169.71% and a risk-free interest rate of 2.0%.

On May 21, 2008, the August Bridge Note holders that had not converted their debt were given additional three year warrants (2^nd Extension Warrants) to purchase up to 510,294 shares of our common stock at a price of $1.45 per share in exchange for an agreement to extend the term of their notes from June 30, 2008 until December 31, 2008. The 2^nd Extension Warrants were classified as a liability pursuant to the guidance provided in paragraph 17 of EITF 00-19. The liability for the 2^nd Extension Warrants issued to the August Bridge Note holders is revalued at the end of each reporting period using the Black-Scholes option pricing model and the change in the liability is recorded as “Non-cash financing items.”

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At September 30, 2008, the liability related to the 2nd Extension Warrants amounted to $695,000 resulting in a $1,000 increase for the three month period ended September 30, 2008, and $147,000 decrease from issuance compared to the fair value of these warrants of $694,000 and $842,000 at June 30, 2008 and May 21, 2008, respectively. The assumptions used when calculating the fair value of the 2nd Extension Warrants at September 30, 2008 were a term of 2.6 years, volatility of 156.01% and a risk-free interest rate of 2.2%.

Option to Invest in Bridge Notes

The initial fair value of the option to purchase $750,000 of the August Bridge Notes at a future date issued on August 8, 2007 amounted to $716,000 based on the Black-Scholes option pricing model. The assumptions used when calculating the fair value of the option to invest were a term of 0.39 years, volatility of 99% and interest rate of 4.16%. The fair value of the option to invest was recorded as a deferred financing fee to be allocated to interest expense using the effective interest rate method over the nine month term of the notes with the offset recorded as other current liability. The liability for the option to purchase additional August Bridge Notes is revalued at the end of each reporting period and the change in the liability is recorded as “Non-cash financing items.”

On April 17, 2008, the option holder exercised $375,000 of the original $750,000 option amount and was issued a note, at the same terms and conditions as the August Bridge Notes. The option to invest the $375,000 unexercised portion was extended until December 31, 2008 in conjunction with the May 2008 financing. The exercise reduced the liability for the option by $314,000.

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At September 30, 2008, the liability related to the remaining option amounted to $149,000, resulting in a $175,000 decrease and $326,000 decrease for the three and nine months ended September 30, 2008 compared to the fair value of these warrants of $324,000 and $475,000 at June 30, 2008 and December 31, 2007, respectively. The assumptions used when calculating the fair value of the warrants at September 30, 2008 were a term of 0.25 years, volatility of 131.0% and a risk-free interest rate of 0.9%.

On May 21, 2008, the option holder who exercised a portion of the option to invest in the August Bridge Notes converted an aggregate of $375,000 of debt into the common stock and warrants issued in the May 21, 2008 repricing described below. Upon conversion, we issued 295,275 shares of our common stock and 5-year warrants to purchase 590,550 shares of our common stock at an exercise price of $1.45 per share.

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Senior Convertible Secured Notes September 26, 2007 Financing

On September 26, 2007, we sold $5.7 million of securities in a private placement, comprised of $2.9 million of three-year promissory notes bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 952,499 shares of our common stock, and 5 year warrants to purchase 1,326,837 shares of our common stock at a price of $3.92 per share.

In addition, on September 26, 2007, certain holders of the August Bridge Notes converted an aggregate of $454,900 of debt and accrued interest into units offered in the September 26, 2007 financing. The debt holders of the August Bridge Notes that were converted received $227,450 three-year promissory notes bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 75,817 shares of our common stock and 5-year warrants to purchase 105,612 shares of our common stock at a price of $3.92 per share. The fair value of the 5-year warrants totaled $340,000 and was calculated using the Black-Scholes option pricing model.

The total issuance of securities and debt on September 26, 2007 to investors and Bridge Note holders who converted was $3.1 million of three-year promissory notes bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 1,028,316 shares of our common stock and 5-year warrants to purchase 1,432,449 shares of our common stock at a price of $3.92 per share.

The embedded conversion feature of the convertible debt issued on September 26, 2007 meets the definition of a derivative financial instrument and is classified as a liability in accordance with SFAS 133 and EITF 00-19. The note holder has the right to convert the debt and accrued interest and the interest rate is calculated at the greater of 8% or LIBOR plus 3%, and therefore, the total number of shares of our common stock that the convertible note can be convertible into is not fixed. Accordingly, the embedded conversion features are revalued on each balance sheet date and marked to market with the adjusting entry to “Non-cash financial items.” The fair value of the conversion feature related to the September 26, 2007 convertible notes totaled $1.4 million at September 26, 2007. The fair value of the conversion feature was recorded as a debt discount. On the issuance date, we allocated the proceeds first to the warrants based on their fair value with the remaining balance allocated between debt, $771,000, and equity, $669,000, based on their relative fair values.

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At September 30, 2008, the liability related to the embedded conversion feature of the convertible debt amounted to $0, as the right of the company to repurchase the notes expired September 25, 2008, resulting in a $1,000 and $1.4 million decrease for the three and nine months ended September 30, 2008 compared to the fair value of the embedded conversion feature of the convertible debt of $1,000 and $1.4 million at June 30, 2008 and December 31, 2007, respectively.

The warrants issued in conjunction with the September 26, 2007 financing meet the definition of a liability pursuant to the provisions of EITF No. 00-19. The fair value of the warrants issued in conjunction with issuance of shares of our common stock and convertible debt totaled $4.3 million on its issue date and was recorded as a liability. The fair value of the warrants on the date of issuance was calculated using the Black-Scholes option pricing model. The assumptions used for the fair value calculation of the warrants were a term of 5 years, volatility of 116% and a risk-free interest rate of 4.2%. 

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At September 30, 2008, the liability related to the warrants amounted to $1.5 million resulting in a $51,000 increase and $2.5 million decrease for the three and nine months ended September 30, 2008 compared to the fair value of these warrants of $1.4 million and $4.0 million at June 30, 2008 and December 31, 2007, respectively. The assumptions used when calculating the fair value of the warrants at September 30, 2008 were a term of 4.0 years, volatility of 133.87% and a risk-free interest rate of 2.6%.

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As part of the September 26, 2007 Private Placement, we issued 142.875 unit purchase warrants to Empire Asset Management Company (Empire) for financial advisory services provided in connection with the placement. Each unit purchase warrant has a strike price of $3,250 and is comprised of a $1,500 three-year promissory note, bearing the higher of LIBOR plus 3% or 8% interest per annum, convertible into shares of our common stock at a conversion price of $3.50 per share, 500 shares of our common stock and a five-year warrant to purchase 696.5 shares of our common stock at a purchase price of $3.92 per share. At the date of issuance, the fair value of the unit purchase warrants issued to Empire totaled $614,000 and was included in the issuance costs related to the September financing. The assumptions used for the Black-Scholes option pricing model were a term of five years, volatility of 99% and a risk-free interest rate of 4.2%. The liability for the option to purchase additional units is revalued at the end of each reporting period and the change in the liability is recorded as “Non-cash financing items”.

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At September 30, 2008, the liability related to the unit purchase warrants amounted to $124,000 resulting in a $8,000 and $385,000 decrease for the three and nine months ended September 30, 2008 compared to the fair value of these unit purchase warrants of $132,000and $509,000 at June 30, 2008 and December 31, 2007, respectively. The assumptions used when calculating the fair value of the unit purchase warrants at September 30, 2008 were a term of 4.0 years, volatility of 114.0% and a risk-free interest rate of 2.63%.

May 21, 2008 Warrant Repricing

On May 21, 2008, we offered our existing warrant holders an opportunity to exercise Neonode common stock purchase warrants on a discounted basis and to receive two new common stock purchase warrants with an exercise price of $1.45 for each outstanding warrant exercised. In all, 8,009,586 new warrants were issued, including 590,550 to the option holder who converted the 375,000 of debt. The warrants were classified as a liability pursuant to the guidance provided in paragraph 17 of EITF 00-19. The warrants were recorded among “Liability for warrants to purchase common stock” and are valued at fair valued at the end of each reporting period using the Black-Scholes option pricing model. The fair value of the warrants totaled $13.8 million. The assumptions used for the calculation of the fair value were a term of 5 years, volatility of 110.28% and interest rate of 3.09%.

·

At September 30, 2008, the liability related to the warrants amounted to $10.4 million, resulting in a $245,000 decrease for the three months ended September 30, 2008, and $3.4 million decrease from issuance, compared to the fair value of these warrants of $10.6 million and $13.8 million at June 30, 2008 and May 21, 2008, respectively. The assumptions used when calculating the fair value of the warrants at September 30, 2008 were a term of 4.6 years, volatility of 127.35% and a risk-free interest rate of 2.9%.

 

Anti-Dilution Feature

Common Stock

The September 26, 2007 financing agreement contains anti-dilution features for each of the common stock, convertible debt and the warrants whereby these instruments are protected separately for 18 months against future private placements made at lower share prices. On March 4, 2008, we issued 1,800,000 shares of common stock to investors of a private placement at a price of $2.50 per shares. The issuance of these shares triggered the anti-dilution feature related to common stock issued in the September 26, 2007 financing transaction. As a result we were required to issue an additional 207,492 shares of our common stock to investors in the September 26, 2007 financing. The fair value of the anti-dilution feature was calculated at March 31, 2008, using the Black-Scholes option pricing model.

·

At September 30, 2008, the iability related to the common stock anti-dilution feature amounted to $2.9 million, resulting in a $0.3 million increase for the three months ended September 30, 2008, and a $1.4 million increase since the initial valuation, compared to the fair value of the common stock anti-dilution feature of $2.6 million and $1.5 million at June 30, 2008 and March 31, 2008, respectively. The assumptions used when calculating the fair value of the common stock anti-dilution feature at September 30, 2008 were a term of 0.5 years, volatility of 215.28% and a risk-free interest rate of 1.6%.

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Warrants

As part of the May 21, 2008 financing transaction, we issued 400,480 warrants at a price of $1.27 per share and an additional 800,959 warrants at a price of $1.27 per share to Empire for financial advisory services provided in connection with the transaction. At the date of issuance, the fair value of the warrants issued to Empire totaled $2.0 million and was included in the issuance costs related to the May 21, 2008 financing transaction. The assumptions used for the Black-Scholes option pricing model were a term of 5 years, volatility of 110.28% and a risk-free interest rate of 3.09%. (see Note 5 Stockholders’ Equity)

·

At September 30, 2008, the liability related to the warrants amounted to $1.5 million, resulting in a $0 and $0.5 million decrease for the three months ended September 30, 2008, and since issuance compared to the fair value of the warrants of $1.5 million and $2.0 million at June 30, 2008 and May 21, 2008, respectively. The assumptions used when calculating the fair value of the warrants at September 30, 2008 were a term of 4.64 years, volatility of 127.35% and a risk-free interest rate of 2.9%.

The issuance of the warrants to Empire triggered the anti-dilution feature related to the warrants issued in the September 26, 2007 financing transaction. As a result, we were required to reduce the exercise price to $1.27 from $3.92 of the warrants issued to investors in the September 26, 2007 financing. The result of the reduction in the exercise price of the warrants was calculated at May 21, 2008, using the Black-Scholes option pricing model. The assumptions used for the Black-Scholes option pricing model related to the anti-dilution feature were a term of 0.84 years, volatility of 117.89% and a risk-free interest rate of 1.99%. The value of the re-priced warrants at May 21, 2008, increased by $213,000 and was recorded in “Non-cash charges for conversion features and warrants.” The fair value of the anti-dilution feature related to the warrants is calculated at the end of each reporting period and included in the total liability for the warrants. The assumptions used when calculating the fair value of the warrant anti-dilution feature at September 30, 2008 were a term of 0.5 years, volatility of 215.28% and a risk-free interest rate of 1.6%.  

Derivatives

As discussed above, the senior secured, bridge and promissory notes issued above contain embedded conversion features. Pursuant to SFAS 133 and EITF 00-19 the conversion features are considered embedded derivatives and are included in “Embedded derivative of convertible debt.” At the time of issuance of the senior secured notes, the fair value of the conversion feature was recorded as a debt discount and amortized to interest expense over the expected term of the senior secured notes using the effective interest rate method. Changes in the fair value of the conversion feature are recorded in “Non-cash charges for conversion features and warrants.” During the three months ended September 30, 2008 and 2007, we recorded a charge of $641,000 and $1.5 million of interest expense associated with the amortization of the debt discounts along with a charge of $15,000 and $18.7 million associated with the changes in the fair value of embedded conversion features recorded as liabilities, respectively.

During the nine months ended September 30, 2008 and 2007, we recorded charges of $1.1 million and $1.6 million of interest expense associated with the amortization of the debt discounts along with a (benefit)/charge of $(2.6) million and $35.4 million associated with the changes in the fair value of embedded conversion features recorded as liabilities, respectively.

Loan Agreement with Almi Företagspartner

On April 6, 2005, Neonode AB entered into a loan agreement with Almi Företagspartner (“Almi”) in the amount of SEK 2,000,000, or approximately $336,000 U.S. Dollars based on the September 30, 2008 exchange rate, with 40,000 detachable warrants in Neonode AB (corresponding to 72,000 warrants when converted into Neonode Inc. shares). The loan has an expected credit period of 48 months with an annualized interest rate of 2%. We were not required to make any repayments of principal for the first nine months. Quarterly repayments of principal thereafter amounted to SEK 154,000, or approximately $24,000 U.S. Dollars based on average exchanges rates for the nine month period ending September 30, 2008. We have the right to redeem the loan at any time prior to expiration subject to a prepayment penalty of 1%, on an annualized basis, of the outstanding principal amount over the remaining term of the loan. A floating charge (chattel mortgage) of SEK 2,000,000, or approximately $336,000 U.S. Dollars, is pledged as security.

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The warrants have a term of five years with a strike price of $10.00. The warrants may be called by us for $0.10 should the price of our common stock trade over $12.50 on a public exchange for 20 consecutive days. The warrants were analyzed under EITF 00-19, and were determined to be equity instruments. In accordance with Accounting Principles Board Opinion no. (APB) 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, because the warrants are equity instruments, we have allocated the proceeds of the second Almi loan between the debt and detachable warrants based on the relative fair values of the debt security and the warrants themselves. To calculate the debt discount related to the warrants, the fair market value of the warrants was calculated using the Black-Scholes options pricing model. The assumptions used for the Almi loan debt discount were a term of five years, volatility of 30% and a risk-free interest rate of 4.50%.The aggregate debt discount amounted to $42,000 and is amortized over the expected term of the loan agreement.

 

5.  Stockholders’ Deficit

On January 28, 2008, a holder of convertible notes issued on September 26, 2007 elected to convert an aggregate amount of debt and accrued interest amounting to $35,000. The conversion resulted in the issuance of 10,000 shares of common stock at $3.50. The debt discounts, conversion features and deferred financing fees that related to the loans that were converted amounted to an aggregate of $20,000. The net amount of $15,000 was recorded in equity.

On March 4, 2008, we sold $4.5 million in securities in a private placement to accredited investors. We sold 1,800,000 shares (Investor Shares) of our common stock, for $2.50 per share. After placement agent fees and offering expenses, we received net cash proceeds of approximately $4,000,000.

In addition, we issued an aggregate of 207,492 shares of common stock to investors who participated in the September 26, 2007 private placement pursuant to anti-dilution provisions contained in the September 26, 2007 Private Placement Subscription Agreement. Empire acted as financial advisor in the private placement and received compensation in connection with the private placement of approximately $450,000 in cash and 120,000 shares of our common stock valued at $152,400 on the date of issuance.

On May 21, 2008, we completed a $5.1 million, net cash proceeds to us of $4.1 million, private placement, primarily to prior security holders, directors, affiliates of management and institutional investors. We offered our existing warrant holders an opportunity to exercise Neonode common stock purchase warrants on a discounted basis. In all, 4,004,793 outstanding warrants were exercised at a strike price of $1.27 per warrant (including $375,000 of surrender of debt). We issued 4,004,793 shares of our common stock and two new common stock purchase warrants, with an exercise price of $1.45, for each outstanding warrant exercised. A total of 8,009,586 new common stock purchase warrants were issued to investors who surrendered or purchased shares under the warrant exchange offer. We also extended the maturity date of $2.85 million of convertible debt that was due on June 30, 2008 until December 31, 2008 by issuing the note holders 510,293 common stock purchase warrants, with an exercise price of $1.45. Empire acted as financial advisor for the transaction and was paid a cash fee of approximately $510,000 and received a warrant to purchase 400,480 shares of our common stock at $1.27 per share and a warrant to purchase 800,959 shares of our common stock at $1.45 per share.

After the financings, we have approximately 30 million shares of common stock, 13.3 million warrants to purchase our common stock and 1.5 million employee stock options outstanding.

6.  Fair Value Measurement of Assets and Liabilities

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements  (FAS 157), which became effective for us on January 1, 2008. FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements about fair value measurements. FAS 157 does not mandate any new fair-value measurements and is applicable to assets and liabilities that are required to be recorded at fair value under other accounting pronouncements. Implementation of this standard did not have a material effect on our results of operations or consolidated financial position.

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In February 2008, the FASB issued FASB Staff Position (FSP) FAS No. 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive Accounting Pronouncements That Address Leasing Transactions  (FSP 157-1), which became effective for the company on January 1, 2008. This FSP excludes FASB Statement No. 13,  Accounting for Leases , and its related interpretive accounting pronouncements from the provisions of FAS 157.

 

Also in February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157, which delayed our application of FAS 157 for certain nonfinancial assets and liabilities until January 1, 2009. In this regard, the major categories of assets and liabilities for which we will not apply the provisions of FAS 157 until January 1, 2009, are long-lived assets that are measured at fair value upon impairment and liabilities for asset retirement obligations.

 

Our implementation of FAS 157 for financial assets and liabilities on January 1, 2008, had no effect on our existing fair-value measurement practices but requires disclosure of a fair-value hierarchy of inputs we use to value an asset or a liability. The three levels of the fair-value hierarchy are described as follows:

 

Level 1: Quoted prices (unadjusted) in active markets for identical assets and liabilities. We had no level 1 assets or liabilities.

 

Level 2: Inputs other than Level 1 that are observable, either directly or indirectly. We use Level 2 inputs, primarily prices obtained through third-party broker quotes for the valuation of certain warrants and embedded derivatives.

 

Level 3: Unobservable inputs. We did not have assets or liabilities without observable market values that would require a high level of judgment to determine fair value (level 3 inputs).

The following tables shows the classification of our liabilities at September 30, 2008 that are subject to recurring fair value measurements and the roll-forward of these liabilities from December 31, 2007:

		September  30, 2008			Prices in  Active  Markets  for  Identical  Assets  (Level 1)			Other  Observable  Inputs  (Level 2)			Unobservable  Inputs  (Level 3)
Warrants issued with debt		$	14,311		$	-		$	14,311		$	-
Embedded conversion features			1,214			-			1,214			-
Anti-dilution feature in debt contracts			2,948			-			2,948			-
Total Liabilities at Fair Value		$	18,473		$	-		$	18,473		$	-

For the common stock, convertible loans and warrants issued under the September 26, 2007 financing agreement, we assigned a probability to the re-pricing scenarios pursuant to the anti-dilution provisions. At September 30, 2007 and at December 31, 2007, we did not consider a re-pricing likely and therefore set the probability to zero.

We issued common stock on March 4, 2008 pursuant to a private placement subscription agreement for $2.50 per share. This triggered the re-pricing feature on the equity portion of the September financing resulting in the issuance of 207,492 shares of our common stock based on a re-priced amount of $2.50 per common share. In addition, as part of a financing transaction completed on May 21, 2008, we issued certain warrants with an exercise price of $1.27. This triggered the re-pricing feature on the warrant portion of the September 26, 2007 financing resulting in re-pricing warrants to purchase 1,432,449 shares of our common stock at $3.92 per share to a new exercise price of $1.27 per share. The warrant holders of the warrants issued in the September 26, 2007 financing are not entitled to additional shares of our common stock as a result of the re-pricing, but rather just a reduction in the exercise price. We also determined that it was probable that additional common stock would be issued in the future and that there may be future re-pricing of outstanding warrants. In order to determine the value of the re-pricing features included with the common stock and warrants issued under the September 27, 2007 financing agreement, we used the Black-Scholes option pricing model. The variables used in the Black-Scholes model at September 30, 2008 for the re-pricing feature related to common stock included a stock price of $0.12, a re-priced strike price of $2.50, volatility of 215.28%, and a risk-free interest rate of 1.6%. The variables used in the Black-Scholes model for the re-pricing feature related to warrants containing a re-pricing feature included a stock price of $0.12, a warrant strike price of $1.27, volatility of 133.87%, and a risk-free interest rate of 2.63%.

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7.  Stock-Based Compensation

We have several approved stock option plans for which stock options and restricted stock awards are available to grant to employees, consultants and directors. All employee and director stock options granted under our stock option plans have an exercise price equal to the market value of the underlying common stock on the grant date. There are no vesting provisions tied to performance conditions for any options, as vesting for all outstanding option grants was based only on continued service as an employee, consultant or director. All of our outstanding stock options and restricted stock awards are classified as equity instruments.

Stock Options

As of September 30, 2008, we had four equity incentive plans:

	·	The 1996 Stock Option Plan (the 1996 Plan), which expired in January 2006, we will not grant any additional equity awards out of the 1996 Plan;
	·	The 1998 Non-Officer Stock Option Plan (the 1998 Plan), which expired in June 2008, we will not grant any additional equity awards out of the 1998 Plan ;
	·	The 2007 Neonode Stock Option Plan (the Neonode Plan), we will not grant any additional equity awards out of the Neonode Plan; and
	·	The 2006 Equity Incentive Plan (the 2006 Plan).

We also had one non-employee director stock option plan as of September 30, 2008:

·

The 2001 Non-Employee Director Stock Option Plan (the Director Plan).

The following table details the outstanding options to purchase shares of our common stock pursuant to each plan at September 30, 2008:

 

Plan		Options   Outstanding			Available  for Issue			Outstanding  Options  Vested
1996 Plan			61,000			—			61,000
1998 Plan			72,395			—			35,900
Neonode Plan			943,463			—			943,563
2006 Plan			381,505			550,857			59,165
Director Plan			42,500			—			15,500
Total			1,500,863			550,857			1,115,128

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A summary of the combined activity under all of the stock option plans is set forth below:

		Weighted Average Number of Shares			Exercise Price Per Share			Weighted  Average Exercise  Price
Outstanding at December 31, 2007			2,434,732		$	1.42 - $27.50		$	2.58
Granted			570,000			0.60 - 3.45			3.17
Cancelled or expired			(1,482,869	)		1.84 - 8.49			2.52
Exercised			(21,000	)		1.84 - 1.84			1.84
Outstanding at September 30, 2008			1,500,863		$	0.60 - $27.50		$	2.87

The 1996 Plan terminated effective January 17, 2006 and the 1998 Plan terminated effective June 15, 2008 and although we can no longer issue stock options out of the plans, the outstanding options at the date of termination will remain outstanding and vest in accordance with their terms. Options granted under the Director Plan vest over a one to four-year period, expire five to seven years after the date of grant and have exercise prices reflecting market value of the shares of our common stock on the date of grant. Stock options granted under the 1996, 1998 and 2006 Plans are exercisable over a maximum term of ten years from the date of grant, vest in various installments over a one to four-year period and have exercise prices reflecting the market value of the shares of common stock on the date of grant.

The Neonode Plan has been designed for participants (i) who are subject to Swedish income taxation (each, a Swedish Participant) and (ii) who are not subject to Swedish income taxation (each, a Non-Swedish Participant). The options issued under the plan to the Non-Swedish Participant are five year options with 25% vesting immediately and the remaining vesting over a three year period. The options issued to Swedish participants are vested immediately upon issuance. The fair value of the options issued out of the Neonode Plan at the date of issuance was calculated using the Black-Scholes option pricing model. These calculations assumed risk free interest rates ranging from 4.5% to 4.875%, a volatility of 50% and share prices ranging from $4.69 to $4.78. We will not grant any additional equity awards out of the Neonode Plan.

·

Develop Business to Business (B2B) opportunities to integrate our technology into third party company’s products.

 

 

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2008			2007			2008			2007
Net sales			100	%		100	%		100	%		100	%
Cost of sales			248			88			489			63
Gross profit (loss)			(148	)		12			(389	)		37
Product research and development			27			87			111			187
Sales and marketing			41			56			131			98
General and administrative			57			83			184			209
Total operating expenses			125			226			426			494
Operating loss			(273	)		(214	)		(815	)		(457	)
Interest and other income			—			20			1			31
Interest and other expense			(8	)		(57	)		(9	)		(56	)
Foreign currency exchange rate gain (loss)			(49	)		—			(29	)		—
Non-cash items related to debt discounts and deferred financing fees and the valuation of conversion features and warrants			(31	)		(1,865	)		(231	)		(2,347	)
Net loss			(361	)%		(2,116	)%		(1,083	)%		(2,829	)%

 

 

 

 

·

A decrease in the number of employees in our engineering department from 10 employees to 6 employees; and

·

an significant decrease in engineering design projects related expenditures related to the development of the N2 and future products and the elimination of all outside engineering design services and consultants used in the design process of mobile products.