SWK Holdings Corp - Quarter Report: 2012 September (Form 10-Q)

 Unaudited Interim Financial Information

The unaudited condensed consolidated financial statements have been prepared by the Company and reflect all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the interim financial information. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the year ending December 31, 2012. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) have been condensed or omitted under the rules and regulations of the Securities and Exchange Commission (“SEC”). These unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with the audited financial statements and notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on March 30, 2012. The year-end condensed consolidated balance sheet data was derived from the Company's audited financial statements, but does not include all disclosures required by US GAAP.

The Company's 1999 Stock Incentive Plan (the “1999 Stock Incentive Plan”), as successor to the 1997 Stock Option Plan (the “1997 Stock Option Plan”), provided for options to purchase shares of the Company's common stock to be granted to employees, independent contractors, officers, and directors. The plan expired in July 2009. Options were granted at an exercise price equivalent to the closing fair market value on the date of grant. All options were granted at the discretion of the Company's Board of Directors and had a term not greater than 10 years from the date of grant. On December 23, 2009, in connection with the Asset Sale, all stock options, except those held by non-employee Directors, were accelerated to be fully vested and exercisable. As a result of the termination of all employees on December 23, 2009, all unexercised stock options held by employees were cancelled on March 31, 2010 in accordance with the Asset Purchase Agreement in the Asset Sale. The only remaining outstanding options as of September 30, 2012 are those held by some of the Company's current directors.

At September 30, 2012, there were no options available for grant under the 1999 Stock Incentive Plan, and the Company had $0 of total unrecognized stock-based compensation expense under this Plan. At September 30, 2012, there were 1.4 million shares reserved for equity awards under the 2010 Stock Incentive Plan, and the Company had $0.2 million of total unrecognized stock option compensation expense, net of estimated forfeitures, that will be recognized over the weighted average remaining period of 2.2 years. At September 30, 2012, the Company had $60,000 of total unrecognized restricted stock compensation expense, net of estimated forfeitures, that will be recognized over the weighted average remaining period of 1.8 years.

Employee stock-based compensation expense recognized for time-vesting options in the three and nine months ended September 30, 2012, and September 30,2011, uses the Black-Scholes option pricing model for estimating the fair value of options granted under the Company's equity incentive plans. Risk-free interest rates for the options were taken from the Daily Federal Yield Curve Rates on the grant dates for the expected life of the options as published by the Federal Reserve. The expected volatility was based upon historical data and other relevant factors such as the Company's changes in historical volatility and its capital structure, in addition to mean reversion. The expected forfeiture rate of employee stock options for the three and nine months ended September 30, 2012, and September 30, 2011 was calculated using the Company's historical terminations data. Employee stock-based compensation expense recognized for market performance-vesting options uses a binomial lattice model for estimating the fair value of options granted under the Company's equity incentive plans.

There were 1,500,000 stock options granted in the nine months ended September 30, 2012; no stock options were granted in the three months ended September 30, 2012. There were no options exercised in either period. In addition, there were 17,500 and 1,247,500 shares of restricted stock granted in the three and nine months ended September 30, 2012, respectively. In the three months and nine months ended September 30, 2011, there were no options granted or exercised.

On January 31, 2012, the Board of Directors approved a change in the compensation plan for directors. In lieu of cash payments to our directors historically paid for Board service, the Board approved an automatic, annual grant of 35,000 shares of restricted common stock for each of our non-executive directors on January 31 of each year, starting with 2012. The restricted shares fully vest on the first anniversary of the grant date and are forfeited if the director does not complete the full year of service.

On May 14, 2012, the Board of Directors granted the former, Interim Chief Executive Officer, and Interim Chief Financial Officer, 750,000 and 375,000 shares of restricted stock, respectively, in connection with their separation agreements. Shares are forfeited if not vested within five years from the date of the grant, and vest when the Company's average closing stock price exceeds certain levels for sixty consecutive calendar days. Thirty-three percent of each award vests when the average closing stock price of the common stock exceeds $1.66, $2.07, and $2.49, respectively. There is no requisite service period with respect to these grants, therefore the entire grant date fair value of these awards of $345,000 has been expensed during the nine months ended September 30, 2012.

The stock-based compensation expense recognized by the Company for the three and nine months ended September 30, 2012, was $410,000 and $516,000, respectively. The stock-based compensation expense recognized by the Company for the three and nine months ended September 30, 2011, was $23,000 and $63,000, respectively.

Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to and should be read in conjunction with, our audited consolidated financial statements, and the MD&A included in our Annual report on Form 10-K for the year ended December 31, 2011 (“Annual Report”), as well as our unaudited condensed consolidated financial statements and the accompanying notes include in this report.

Following an extensive strategic process, on October 26, 2009, we entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”) with Kay Technology Corp., Inc. (“Kay Technology”). Pursuant to this agreement, on December 23, 2009, we sold substantially all of our assets to Kay Technology (the “Asset Sale”) in exchange for cash consideration of $40.6 million. In addition, Kay Technology assumed certain of KANA's liabilities in the transaction. Of the $40.6 million in consideration, $38.6 million was paid in cash to us at closing and $1.0 million was paid into escrow to satisfy our indemnification obligations for certain specified contingencies. An additional $1.0 million was paid into escrow to satisfy our obligations under any potential downward “true-up” adjustments to the purchase price following the closing (the “Purchase Price Escrow”). During the second quarter of 2010, we received the full amount of the $1.0 million Purchase Price Escrow. In December 2010 and March 2011, we received approximately $482,000 and $167,000, respectively, from the indemnification escrow; the remainder of this escrow was paid to Kay Technology for allowable expenses in resolving the matters covered by the escrow. As of September 30, 2012, no other funds remain in escrow.
 

The Company has net operating loss carryforwards (“NOLs”) and believes that the ability to utilize these NOLs is an important and substantial asset. We believe that the foregoing business strategies can create value for our stockholders, and produce prospective taxable income (or the ability to generate capital gains) that might permit the Company to utilize the NOLs. We are unable to assure investors that we will find suitable financing opportunities or that we will be able to utilize our existing NOLs.

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (ASU) No. 2011-12, "Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05". In June 2011, the FASB issued ASU No. 2011-05, "Comprehensive Income (Topic 220): Presentation of Comprehensive Income". Both ASU's are effective for interim reporting periods beginning after December 15, 2011. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in equity. In addition, items of other comprehensive income that are reclassified to profit or loss are required to be presented separately on the face of the financial statements. This guidance is intended to increase the prominence of other comprehensive income in financial statements by requiring that such amounts be presented either in a single continuous statement of income and comprehensive income or separately in consecutive statements of income and comprehensive income. ASU 2011-12 defers the changes in ASU 2011-05 that pertain to how, when and where reclassification adjustments are presented. We adopted this guidance as of January 1, 2012, retrospectively for the all periods presented. The adoption of ASU 2011-05 did not have a material impact on the condensed consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, "Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS." This ASU provides a consistent definition of fair value to ensure that the fair value measurement and disclosure requirements are similar between generally accepted accounting principles in the United States of America (“U.S. GAAP”) and International Financial Reporting Standards. This ASU changes certain fair value measurement principles and enhances the disclosure requirements and is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. The adoption of this ASU did not have a material impact on our condensed consolidated financial statements.

The Company had no comparable revenues for the three and nine months ended September 30, 2011, as a result of the Asset Sale.

We recorded a $167,000 gain from the collection of escrow funds from the Asset Sale for the nine months ended September 30, 2011. No such gain was recorded in the three months ended September 30, 2011, nor in the three and nine months ended September 30, 2012.

Interest and other income, net consists primarily of interest income and the change in fair value of warrant liability. Income from the decrease in the fair value of our warrants was $0 and $2,000 for the three months ended September 30, 2012, and September 30, 2011, respectively. Income from the decrease in the fair value of our warrants was $0 and $30,000 for the nine months ended September 30, 2012, and September 30, 2011, respectively. Interest income consists of interest earned on cash and cash equivalents and was approximately $44,000 and $67,000 for the three months ended September 30, 2012, and September 30, 2011, respectively. Interest income was approximately $134,000 and $193,000 for the nine months ended September 30, 2012, and September 30, 2011, respectively. The decrease in interest income related to lower interest rates and lower cash balances in the three and nine months ended September 30, 2012, compared to the same periods in 2011.

As of September 30, 2012, we had $37.0 million in cash and cash equivalents compared to $38.2 million in cash and cash equivalents at December 31, 2011. As of September 30, 2012, we had working capital of $36.9 million, compared to working capital of $38.1 million as of December 31, 2011.

We had negative cash flow from operating activities of $1.2 million for the nine months ended September 30, 2012, which included a $1.7 million net loss, which was partially offset by a $0.5 million increase in non-cash expenses included in earnings. We had negative cash flow from operating activities of $0.9 million for the nine months ended September 30, 2011, which included a $0.7 million net loss, a $0.2 million gain from the collection of escrow funds from the Asset Sale, and a $0.1 million decrease in payables.

As of September 30, 2012, the Company did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.

Prior to commencing our strategic plan, the primary objective of our activities was to preserve cash. During the nine months ended September 30, 2012, our cash and cash equivalents were deposited in accounts at well capitalized financial institutions. The fair value of our cash and cash equivalents at September 30, 2012, approximated its carrying value.

In connection with the preparation of this report, our management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective.

There was no change in our internal control over financial reporting during the three months ended September 30, 2012, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

In October 2007, a lawsuit was filed in the United States District Court for the Western District of Washington by Ms. Vanessa Simmonds against certain of the underwriters of the Company's initial public offering. The plaintiff alleges that the underwriters violated Section 16(b) of the Exchange Act, by engaging in short-swing trades, and seeks disgorgement of profits from the underwriters in amounts to be proven at trial. On February 28, 2008, Ms. Simmonds filed an amended complaint. The suit names the Company as a nominal defendant, contains no claims against the Company and seeks no relief from the Company. This lawsuit is one of more than fifty similar actions filed in the same court. On July 25, 2008, the underwriter defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. In addition, certain issuer defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. The Company entered into a stipulation with the plaintiff, entered as an order by the Court, that the Company is not required to answer or otherwise respond to the amended complaint. Accordingly, the Company did not join the motion to dismiss filed by certain issuers. On March 12, 2009, the Court dismissed the complaint in this lawsuit with prejudice. On April 10, 2009, the plaintiff filed a notice of appeal of the District Court's order, and thereafter the underwriter defendants filed a cross appeal to a portion of the District Court's order that dismissed thirty (30) of the cases without prejudice following the moving issuers' motion to dismiss. On May 22, 2009 the Ninth Circuit issued an order granting the parties' joint motion to consolidate the 54 appeals and 30 cross-appeals. On December 2, 2010, the Ninth Circuit affirmed dismissal of the lawsuits against the 30 issuer defendants on the grounds of inadequate demand, but ordered the district court to dismiss these lawsuits with prejudice. The Ninth Circuit reversed dismissal on statute of limitations grounds, but remanded all of the remaining cases to the district court with instructions to allow the underwriter defendants and/or the remaining issuer defendants to file motions to dismiss for inadequate demand. On December 16, 2010, plaintiff and the underwriter defendants separately petitioned for a rehearing and a rehearing en banc, which petitions were denied on January 18, 2011. On January 25 and 26, 2011, the Ninth Circuit granted the motions of the underwriter defendants and of the plaintiff to stay the issuance of the court's mandate pending those parties' respective petitions for writ of certiorari to the United States Supreme Court. The plaintiffs and the underwriter defendants filed petitions for writ of certiorari on April 5, 2011 and April 15, 2011, respectively. On June 27, 2011, the Supreme Court granted the underwriter defendants' petition for writ of certiorari and denied the plaintiff's petition for writ of certiorari. On November 29, 2011 the Supreme Court heard oral argument. On March 26, 2012 the Court reversed the Ninth Circuit's ruling that plaintiffs claim was not barred by the applicable statute of limitations, and remanded for further proceedings on plaintiff's alternative claim that the statute of limitations was extended by the doctrine of equitable tolling. Upon remand to the District Court, on June 11, 2012, plaintiff filed a notice of voluntary dismissal, thereby concluding the matter.

Information regarding the Company's risk factors appears in “Part I. – Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the SEC on March 30, 2012. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, except as noted below:

Changes in market conditions could negatively impact our revenues.

Our revenues will be generated through interest and royalty income, as well as advisory fees and other types of fee income. These revenue streams are dependent on market conditions, prevailing interest rates, availability of financing sources and the confidence of clients and customers in our ability to perform our obligations. Revenues from advisory fees are more volatile than interest or royalty income on our cash and cash equivalents.

Any prepayments by clients with respect to interest or royalty payments may adversely impact our cash flows and results of operations. Additionally, the Company may not be able to identify alternative opportunities to redeploy such capital.

Current market conditions, including lower liquidity levels in the market, could significantly reduce our fee income. In addition, if our clients and customers become concerned about our ability to meet our obligations on a transaction, it may become more difficult for us to originate new transactions, which could further negatively impact our fee income and have a material adverse effect on our business. If the capital markets are disrupted or if we otherwise fail to produce increased fees and other income, it could adversely affect our financial position and results of operations.