UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-QSB
(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2005
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from _____ to _____
Commission File Number 0-25675
PATRON SYSTEMS, INC.
(Exact name of small business issuer as specified in its charter)
Delaware 74-3055158
(State or Other Jurisdiction of (IRS Employer Identification No.)
Incorporation or Organization)
500 N. Michigan Ave, Suite 300 60611
Chicago, IL
(Address of Principal Executive Offices) (Zip Code)
(312) 396-4031
(Issuer's Telephone Number)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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 |_| No |X|
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 55,796,712 shares of common stock
outstanding as of August 10, 2005.
Transitional Small Business Disclosure Format (Check one): Yes |_| No |X|
PATRON SYSTEMS, INC.
FORM 10-QSB QUARTERLY REPORT
----------------------------------
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
ITEM 1. FINANCIAL STATEMENTS...................................................3
Condensed Consolidated Balance Sheet at June 30, 2005 (unaudited)..............3
Condensed Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2005 and 2004 (unaudited).........4
Condensed Consolidated Statement of Stockholders' (Deficiency)
Equity for the Six Months Ended June 30, 2005 (unaudited).............5
Condensed Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2005 and 2004 (unaudited)...................6
Notes to Condensed Consolidated Financial Statements (unaudited)...............7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS..................................28
ITEM 3. CONTROLS AND PROCEDURES...............................................40
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS...........42
ITEM 6. EXHIBITS..............................................................43
Signatures....................................................................44
FORWARD LOOKING STATEMENTS
The following discussion and explanations should be read in conjunction with the
financial statements and related notes contained elsewhere in this Form 10-QSB.
Certain statements made in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements can be identified by terminology such as "may",
"will", "should", "expects", "intends", "anticipates", "believes", "estimates",
"predicts", or "continue" or the negative of these terms or other comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these forward-looking statements. Although
Patron Systems believes that expectations reflected in the forward-looking
statements are reasonable, it cannot guarantee future results, performance or
achievements. Moreover, neither Patron Systems nor any other person assumes
responsibility for the accuracy and completeness of these forward-looking
statements. Patron Systems is under no duty to update any forward-looking
statements after the date of this report to conform such statements to actual
results.
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
JUNE 30, 2005
------------
ASSETS
Current Assets:
Cash and cash equivalents ............................................... $ 317,625
Restricted cash ......................................................... 527,003
Accounts receivable, net ................................................ 139,379
Other current assets .................................................... 45,963
------------
Total current assets ................................................. 1,029,970
Property and equipment, net ............................................... 161,009
Deferred financing costs .................................................. 1,112,021
Intangible assets, net .................................................... 2,922,455
Goodwill .................................................................. 22,433,752
------------
Total assets ......................................................... $ 27,659,207
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable ........................................................ $ 1,458,663
Accrued payroll and related expenses .................................... 1,546,584
Accrued interest ........................................................ 644,932
Consulting agreement payable ............................................ 100,000
Demand notes payable .................................................... 1,007,556
Bridge notes payable .................................................... 5,643,457
Acquisition notes payable ............................................... 4,500,000
Notes payable (to creditors of acquired business, including
$1,655,548 to related parties) ........................................ 2,588,000
Expense reimbursements due to officers and stockholders ................. 174,337
Advances from stockholders .............................................. 1,650,000
Notes payable to officers and stockholders .............................. 284,212
Other current liabilities ............................................... 485,412
Amounts due under settlement with former officer ........................ 964,723
Deferred revenue ........................................................ 227,768
------------
Total current liabilities ............................................ 21,275,644
Note payable - stock repurchase obligation due to former officer .......... 1,738,667
------------
Total liabilities .................................................... 23,014,311
------------
Common stock subject to put right (2,000,000 shares) ...................... 1,000,000
------------
Stockholders' Equity
Preferred stock, par value $0.01 per share, 75,000,000 shares authorized,
none issued and outstanding ........................................... --
Common stock, par value $0.01 per share, 150,000,000 shares authorized,
42,117,616 shares issued and outstanding as of June 30, 2005 (net of
2,000,000 shares subject to put right) ................................. 421,176
Additional paid-in capital .............................................. 51,421,519
Common stock to be issued (16,016,320 shares) ........................... 798,835
Common stock repurchase obligation ...................................... (1,300,000)
Deferred compensation ................................................... (522,458)
Accumulated deficit ..................................................... (47,174,176)
------------
Total stockholders' equity ........................................... 3,644,896
------------
Total liabilities and stockholders' equity ........................... $ 27,659,207
============
See notes to condensed consolidated financial statements.
3
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
SIX MONTHS ENDED JUNE 30, THREE MONTHS ENDED JUNE 30,
---------------------------- ----------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
(Development (Development
Stage) Stage)
Revenue ............................................ $ 186,271 $ -- $ 137,411 $ --
------------ ------------ ------------ ------------
Cost of Sales
Cost of products/services ........................ 87,177 -- 56,173 --
Amortization of technology ....................... 139,668 -- 128,501 --
------------ ------------ ------------ ------------
Total cost of sales ............................ 226,845 -- 184,674 --
------------ ------------ ------------ ------------
Gross loss ....................................... (40,574) -- (47,263) --
------------ ------------ ------------ ------------
Operating Expenses
Salaries and related expenses .................... 1,914,965 140,489 1,456,279 30,000
Consulting expense (non-employee stock based
compensation) ................................. 952,875 159,125 444,375 81,625
Professional fees ................................ 707,133 136,788 562,732 107,864
General and administrative ....................... 343,067 325,178 98,823 54,184
Amortization of intangibles ...................... 38,877 -- 30,814 --
Stock based penalties under accomodation agreement 689,102 595,200 320,102 340,200
Assessment fee ................................... 370,000 -- 370,000 --
Loss on collateralized financing arrangement ..... 366,194 -- 366,194 --
Loss/(gain) associated with settlement agreement . (389,103) 438,667 (389,103) --
------------ ------------ ------------ ------------
Total operating expenses ...................... 4,993,110 1,795,447 3,260,216 613,873
Operating loss ..................................... (5,033,684) (1,795,447) (3,307,479) (613,873)
Interest income .................................... 19,250 38,500 -- 19,250
Interest expense ................................... (2,217,866) (66,176) (1,721,026) (33,088)
------------ ------------ ------------ ------------
Loss before income taxes ........................... (7,232,300) (1,823,123) (5,028,505) (627,711)
Income taxes ..................................... -- -- -- --
------------ ------------ ------------ ------------
Net loss ........................................... $ (7,232,300) (1,823,123) $ (5,028,505) (627,711)
============ ============ ============ ============
Net Loss Per Share - Basic and Diluted ............. ($ 0.13) ($ 0.05) ($ 0.08) ($ 0.02)
============ ============ ============ ============
Weighted Average Number of Shares Outstanding
- Basic and diluted ............................. 55,143,168 38,595,756 60,984,682 38,565,596
============ ============ ============ ============
See notes to condensed consolidated financial statements.
4
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' (DEFICIENCY) EQUITY (UNAUDITED)
FOR THE SIX MONTHS ENDED JUNE 30, 2005
ADDITIONAL SHARES OF VALUE OF
SHARES OF PAR VALUE PAID IN COMMON STOCK COMMON STOCK
COMMON STOCK COMMON STOCK CAPITAL TO BE ISSUED TO BE ISSUED
------------ ------------ ------------ ------------ ------------
Balance, January 1, 2005 (development stage) ........ 37,006,212 $ 370,062 $ 28,973,711 5,951,648 $ 4,671,400
Common stock issued in purchase business combinations
Complete Security Solutions, Inc. ................... -- -- 6,300,000 7,500,000 75,000
LucidLine, Inc. ..................................... -- -- 3,696,000 4,400,000 44,000
Entelagent Software Corporation ..................... -- -- 2,520,000 3,000,000 30,000
Common stock to be issued under accommodation
agreement as a penalty 1/1/05 through 3/31/05 .... -- -- -- 450,000 369,000
Amortization of deferred stock-based compensation ... -- -- -- -- --
Issuance of warrants and bridge notes to investors
1/1/05 through 3/31/05 ........................... -- -- 1,043,860 -- --
Issuance of warrants issued as purchase consideration -- -- 1,912,500 -- --
Issuance of warrants to transaction advisors ........ -- -- 255,000 -- --
Issuance of warrants to placement agent 1/1/05
through 6/30/05 .................................. -- -- 297,500 -- --
Common stock to be issued under accommodation
agreement as a penalty 4/1/05 through 6/30/05 .... -- -- -- 535,894 320,103
Common stock issued under collateralized financing
arrangement ...................................... 890,500 8,905 397,300 -- --
Common stock issued in lieu of cash ................. 1,000,000 10,000 939,000 (1,000,000) (949,000)
Common stock issued in purchase business combinations 3,220,904 32,209 2,705,559 (3,220,904) (2,737,768)
Common stock to be issued returned to Company in
settlement of consulting agreement payable ....... -- -- -- (100,000) (78,900)
Issuance of warrants to Bridge Note II investors .... -- -- 532,723 -- --
Issuance of warrants in connection with bridge loan
extension ........................................ -- -- 822,500 -- --
Issuance of warrants to placement agent ............. -- -- 80,867 -- --
Adjustment to shares issuable under compensation
arrangement ...................................... -- -- 945,000 (1,500,000) (945,000)
Net Loss ............................................ -- -- -- -- --
------------ ------------ ------------ ------------ ------------
BALANCE, JUNE 30, 2005 .............................. 42,117,616 $ 421,176 $ 51,421,519 16,016,320 $ 798,835
============ ============ ============ ============ ============
COMMON STOCK
REPURCHASE DEFERRED ACCUMULATED
OBLIGATION COMPENSATION DEFICIT TOTAL
------------ ------------ ------------ ------------
Balance, January 1, 2005 (development stage) ........ $ (1,300,000) $ (1,475,333) $(39,941,876) $ (8,702,036)
Common stock issued in purchase business combinations
Complete Security Solutions, Inc. ................... -- -- -- 6,375,000
LucidLine, Inc. ..................................... -- -- -- 3,740,000
Entelagent Software Corporation ..................... -- -- -- 2,550,000
Common stock to be issued under accommodation
agreement as a penalty 1/1/05 through 3/31/05 .... -- -- -- 369,000
Amortization of deferred stock-based compensation ... -- 952,875 -- 952,875
Issuance of warrants and bridge notes to investors
1/1/05 through 3/31/05 ........................... -- -- -- 1,043,860
Issuance of warrants issued as purchase consideration -- -- -- 1,912,500
Issuance of warrants to transaction advisors ........ -- -- -- 255,000
Issuance of warrants to placement agent 1/1/05
through 6/30/05 .................................. -- -- -- 297,500
Common stock to be issued under accommodation
agreement as a penalty 4/1/05 through 6/30/05 .... -- -- -- 320,102
Common stock issued under collateralized financing
arrangement ...................................... -- -- -- 406,205
Common stock issued in lieu of cash ................. -- -- -- --
Common stock issued in purchase business combinations -- -- -- --
Common stock to be issued returned to Company in
settlement of consulting agreement payable ....... -- -- -- (78,900)
Issuance of warrants to Bridge Note II investors .... -- -- -- 532,723
Issuance of warrants in connection with bridge loan
extension ........................................ -- -- -- 822,500
Issuance of warrants to placement agent ............. -- -- -- 80,867
Adjustment to shares issuable under compensation
arrangement ...................................... -- -- -- --
Net Loss ............................................ -- -- (7,232,300) (7,232,300)
------------ ------------ ------------ ------------
BALANCE, JUNE 30, 2005 .............................. $ (1,300,000) $ (522,458) $(47,174,176) $ 3,644,896
============ ============ ============ ============
5
PATRON SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
SIX MONTHS ENDED JUNE 30,
----------------------------
2005 2004
------------ ------------
(Development
Stage)
Cash Flows from Operating Activities
Net loss .................................................................. $ (7,232,300) $ (1,823,123)
============ ============
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization ............................................. 200,352 --
Amortization of deferred compensation ..................................... 952,875 --
Accretion related to warrants issued for notes payable .................... 1,177,040 --
Amortization of deferred financing costs .................................. 710,585 --
Common stock issued in lieu of cash for services .......................... -- 159,125
Stock based penalty on accomodation agreement ......................... 689,102 595,200
Costs of acquisitions not consummated .................................... -- 438,667
Gain on settlement of consulting agreement payable ........................ (228,900) --
Loss on collateralized financing arrangement .............................. 366,194 --
Gain on legal settlement .................................................. (389,103) --
Non-cash interest income .................................................. (19,250) (38,500)
Changes in assets and liabilities:
Restriced cash escrowed to settle liabilities assumed .................. (527,003) --
Prepaid expenses ....................................................... 51,487 (3,944)
Accounts receivable .................................................... (3,734) --
Other current assets ................................................... 46,625 --
Accounts payable ....................................................... (394,606) 60,990
Accrued interest ....................................................... (342,746) 66,175
Deferred revenue ....................................................... 28,017 --
Accrued payroll and payroll related expenses ........................... (1,015,946) 116,944
Other current liabilities .............................................. 373,556 --
Consulting agreements payable .......................................... (50,000) --
Other accrued expenses ................................................. (3,413) --
============ ============
Total adjustments ......................................................... 1,621,132 1,394,657
============ ============
NET CASH USED IN OPERATING ACTIVITIES ..................................... (5,611,168) (428,466)
============ ============
CASH FLOWS USED IN INVESTING ACTIVITIES
Cash payments in purchase business combinations ........................... (857,633) --
Cash acquired in purchase business combinations ........................... 416,397 --
Purchase of fixed assets .................................................. (47,816) --
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES ..................................... (489,052) --
============ ============
CASH FLOWS FROM FINANCING ACTIVITIES
Expenses financed by (repaid to) officers and stockholders ................ (372,747) 244,274
Advances from stockholders ................................................ 1,650,000 --
Deferred financing costs .................................................. (621,739) --
Proceed from issuance of common stock ..................................... -- 200,000
Proceeds from issuance of notes ........................................... -- 41,134
Repayments of amounts due under settlement with former officer ............ (200,000) --
Proceeds from issuance of bridge notes .................................... 3,500,000 --
Proceeds from issuance of notes, less fees ................................ 2,543,000 --
Repayments of advances from stockholders .................................. (126,570) (79,891)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ................................. 6,371,944 405,517
============ ============
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ...................... 271,724 (22,949)
CASH AND CASH EQUIVALENTS, beginning of period ............................ 45,901 22,957
------------ ------------
CASH AND CASH EQUIVALENTS, end of period .................................. $ 317,625 $ 8
------------ ------------
Supplemental Disclosures of Cash Flow Information:
Issuance of note under stock repurchase obligation ...................... $ -- $ 1,300,000
Obligation to repurchase 2,000,000 shares of common stock subject
to put right ......................................................... -- 1,000,000
Cash paid during the period for:
Interest ................................................................ 515,798 --
Supplemental non-cash investing and finanical activity
Current tangible assets acquired ...................................... $ 300,911 --
Non-current tangible assets acquired .................................. 2,756,470 --
Current liabilities assumed with acquisitions ......................... (8,379,271) --
Non-current liabilities assumed with acquisitions ..................... (439,126) --
Intangible assets acquired ............................................ 3,101,000 --
Goodwill recognized on purchase business combinations ................. 22,433,752 --
Non-cash consideration ................................................... (19,332,500) --
Cash acquired in purchase business combinations .......................... 416,397 --
------------
Cash paid to acquire businesses ...................................... $ 857,633
============
See notes to condensed consolidated financial statements.
6
PATRON SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2005
Note A - Basis of Interim Financial Statement Presentation
The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems, Inc. (the "Company," "Patron," "us," or "we") have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and the instructions to Form 10-QSB.
Accordingly, they do not include all the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. In the opinion of management all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position, results of operations and cash flows for all periods
presented have been made. The results of operations for the six-month period
ended June 30, 2005 are not necessarily indicative of the operating results that
may be expected for the entire year ending December 31, 2005.
Note B - The Company
Organization and Description of Business
Patron Systems, Inc., ("Systems") is a Delaware corporation formed in April 2002
to provide comprehensive, end-to-end information security solutions to global
corporations and government institutions.
Pursuant to an Amended and Restated Share Exchange Agreement dated October 11,
2002, Combined Professional Services ("CPS"), Systems and the stockholders of
Systems consummated a share exchange ("Share Exchange"), As a result of the
Share Exchange, the former stockholders of Systems became the majority
stockholders of CPS. Accordingly, Systems became the accounting acquirer of CPS
and the exchange was accounted for as a reverse merger and recapitalization of
Systems. CPS subsequently changed its name to Patron Systems, Inc. (the
"Company" or "Patron").
Development Stage Operations
In accordance with Statement of Financial Accounting Standard ("SFAS") No.7, the
Company was considered to be a development stage enterprise through December 31,
2004, as its activities principally consisted of raising capital and screening
potential acquisition candidates in the information and homeland security
segments. As described in Note E, the Company consummated acquisitions of three
businesses that have developed technologies, customer bases and are generating
revenue. Accordingly, the Company is no longer considered to be a development
stage enterprise effective for the six months ended June 30, 2005.
Note C - Liquidity and Financial Condition
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company incurred a net loss of
$7,232,300 for the six months ended June 30, 2005, which includes $3,529,603 of
non-cash charges for the fair value of common stock of the Company issued as
penalties under certain registration rights agreements, non-cash interest
expense and the amortization of deferred compensation under a stock based
compensation arrangement. The Company used net cash flows in its operating
activities of $5,611,168 during the six months ended June 30, 2005. The
Company's working capital deficiency at June 30, 2005 amounts to $20,245,674 and
the Company is continuing to experience shortages in working capital. The
Company is also involved in substantial litigation and is being investigated by
the Securities and Exchange Commission with respect to certain of its press
releases and its use of form S-8 to register shares of common stock issued to
certain consultants (Note Q). The Company cannot provide any assurance that the
outcome of these matters will not have a material adverse affect on its ability
to sustain the business. These matters raise substantial doubt about the
Company's ability to continue as a going concern. The accompanying financial
statements do not include any adjustments that may result from the outcome of
this uncertainty.
7
The Company expects to continue incurring losses for the foreseeable future due
to the inherent uncertainty that is related to establishing the commercial
feasibility of technological products and developing a presence in new markets.
The Company's ability to successfully integrate the acquired businesses
described in Note E is critical to the realization of its business plan. The
Company raised $7,693,000 of gross proceeds ($7,071,261 net proceeds after the
payment of certain transaction expenses) in financing transactions during the
six months ended June 30, 2005. The Company used $5,611,168 of these proceeds to
fund its operations (which includes a $1,388,000 escrow deposit for the payment
of liabilities assumed in business combinations), and a net of $489,052 in
investing activities, which principally includes the cash component of purchase
business combinations that the Company consummated during February and March of
2005 (net of cash acquired) and the purchase of property and equipment. In
addition, the Company repaid an aggregate of $499,317 of certain obligations due
to certain officers/stockholders. Subsequent to June 30, 2005 the Company raised
approximately $750,000 in additional gross funds in four capital financing
transactions. Net proceeds from these transaction amounted to $744,000 that were
used principally to fund operations (Note S).
The Company is currently in the process of attempting to raise additional
capital and has taken certain steps to conserve its liquidity while it continues
to integrate the acquired businesses. Although management believes that the
Company has access to capital resources, the Company has not secured any
commitments for additional financing at this time nor can the Company provide
any assurance that it will be successful in its efforts to raise additional
capital and/or successfully execute its business plan.
Note D - Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant inter-company transactions have
been eliminated.
Cash and Cash Equivalents
The Company considers all highly liquid securities purchased with original
maturities of three months or less to be cash equivalents.
Revenue Recognition
The Company derives revenues from the following sources: (1) sales of computer
software, which includes new software licenses and software updates and product
support revenues and (2) services, which include internet access, back-up,
retrieval and restoration services and professional consulting services.
The Company applies the revenue recognition principles set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and Exchange Commission Staff Accounting Bulletin ("SAB") 104 "Revenue
Recognition" with respect to all of its revenue. Accordingly, the Company
records revenue when (i) persuasive evidence of an arrangement exists, (ii)
delivery has occurred, (iii) the vendor's fee is fixed or determinable, and (iv)
collectability is probable.
The Company generates revenues through sales of software licenses and annual
support subscription agreements, which include access to technical support and
software updates (if and when available). Software license revenues are
generated from licensing the rights to use products directly to end-users and
through third party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of the Company's software sales are supported
by a written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
8
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. The Company uses the residual method
prescribed in SOP 98-9 to allocate revenues to delivered elements once it has
established vendor-specific evidence for such undelivered elements.
The Company provides its internet access and back-up, retrieval and restoration
services under contractual arrangements with terms ranging from 1 year to 5
years. These contracts are billed monthly, in advance, based on the
contractually stated rates. At the inception of a contract, the Company may
activate the customer's account for a contractual fee that it amortizes over the
term of the contract in accordance with Emerging Issues Task Force Issue
("EITF") 00-21 "Revenue Arrangements with Multiple Deliverables." The Company's
standard contracts are automatically renewable by the customer unless terminated
on 30 days written notice. Early termination of the contract generally results
in an early termination fee equal to the lesser of six months of service or the
remaining term of the contract.
Professional consulting services are billed based on the number of hours of
consultant services provided and the hourly billing rates. The Company
recognizes revenue under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19.
Accounts Receivable
The Company adjusts its accounts receivable balances that it deems to be
uncollectible. The allowance for doubtful accounts is the Company's best
estimate of the amount of probable credit losses in the Company's existing
accounts receivable. The Company reviews its allowance for doubtful accounts on
a monthly basis and determines the allowance based on an analysis of its past
due accounts. All past due balances that are over 90 days are reviewed
individually for collectability. Account balances are charged off against the
allowance after all means of collection have been exhausted and the potential
for recovery is considered remote.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets (generally
three to five years). Maintenance and repairs are charged to expense as
incurred; cost of major additions and betterments are capitalized. When property
and equipment is sold or otherwise disposed of, the cost and related accumulated
depreciation are eliminated from the accounts and any resulting gains or losses
are reflected in the statement of operations in the period of disposal.
Goodwill
SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested
for impairment at the reporting unit level (operating segment or one level below
an operating segment) on an annual basis (June 30th for the Company) and between
annual tests in certain circumstances. Application of the goodwill impairment
test requires judgment, including the identification of reporting units,
assigning assets and liabilities to reporting units, assigning goodwill to
reporting units, and determining the fair value. Significant judgments required
to estimate the fair value of reporting units include estimating future cash
flows, determining appropriate discount rates and other assumptions. Changes in
these estimates and assumptions could materially affect the determination of
fair value and/or goodwill impairment for each reporting unit. We have recorded
goodwill in connection with the Company's acquisitions described in Note E
amounting to $22,433,752. The Company has determined that no impairment charges
are necessary during the six months ended June 30, 2005.
9
Long Lived Assets
The Company periodically reviews the carrying values of its long lived assets in
accordance with SFAS 144 "Long Lived Assets" when events or changes in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their realizable value and records impairment charges when
necessary. The Company has determined that no impairment charges are necessary
during the six months ended June 30, 2005.
Stock Option Plans
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," the Company has elected to continue to follow the
intrinsic value method in accounting for its stock-based compensation
arrangements as defined by Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees," and related interpretations
including Financial Accounting Standards Board ("FASB") Interpretation No. 44
"Accounting for Certain Transactions Involving Stock Compensation," an
interpretation of APB No. 25.
The following table summarizes the pro forma operating results of the Company
had compensation expense for stock options granted to employees been determined
in accordance with the fair market value based method prescribed by SFAS No.
123. The Company has presented the following disclosures in accordance with SFAS
No. 148.
SIX MONTHS ENDED JUNE 30, THREE MONTHS ENDED JUNE 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
Net Loss, as reported ................. $ (7,232,300) $ (1,823,123) $ (5,028,505) $ (627,711)
(+) Stock-based compensation cost
reflected in the financial statements -- -- -- --
(-)Stock-based employee compensation
expense under fair value method ..... 370,556 408,889 185,278 204,444
------------ ------------ ------------ ------------
Pro-Forma Net Loss .................... $ (7,602,856) $ (2,232,012) $ (5,213,783) $ (832,155)
============ ============ ============ ============
Net Loss per Share-
Basic and Diluted, as reported ........ $ (0.13) $ (0.05) $ (0.08) $ (0.02)
============ ============ ============ ============
Basic and Diluted, pro-forma .......... $ (0.14) $ (0.06) $ (0.09) $ (0.02)
============ ============ ============ ============
Weighted Average Number of Shares
Basic and Diluted ................... 55,143,168 38,595,756 60,984,682 38,565,596
============ ============ ============ ============
Non-Employee Stock Based Compensation
The cost of stock based compensation awards issued to non-employees for services
are recorded at either the fair value of the services rendered or the
instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in EITF 96-18,
"Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services."
10
Common Stock Purchase Warrants
The Company accounts for the issuance of common stock purchase warrants issued
with registration rights in accordance with the provisions of EITF 00-19
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock."
Based on the provisions of EITF 00-19, the Company classifies as equity any
contracts that (i) require physical settlement or net-share settlement or (ii)
gives the company a choice of net-cash settlement or settlement in its own
shares (physical settlement or net-share settlement). The Company classifies as
assets or liabilities any contracts that (i) require net-cash settlement
(including a requirement to net cash settle the contract if an event occurs and
if that event is outside the control of the company) (ii) give the counterparty
a choice of net-cash settlement or settlement in shares (physical settlement or
net-share settlement).
Income Taxes
The Company accounts for income taxes pursuant to SFAS No. 109, Accounting for
Income Taxes. Deferred taxes arise from temporary differences, primarily
attributable to the use of the cash method for tax purposes and accrual method
for book purposes and net operating loss carry-forwards. The Company records
valuation allowances for deferred tax assets when circumstances indicate it is
more likely than not that the Company will not realize the benefit of its
deferred tax assets.
Net Loss per Share
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
As a result of the consummation of the Share Exchange described in Note B, the
Company included 1,200,000 stock options with an exercise price of $.01 per
share that it issued to certain employees during 2002 in its calculation of
weighted-average number of common shares outstanding for all periods presented.
Net loss per common share excludes the following outstanding options, warrants
and convertible notes as their effect would be anti-dilutive:
JUNE 30,
-------------------------------
2005 2004
---------- ----------
Options .............................. 5,850,000 3,925,000
Warrants ............................. 7,839,080 15,000
Convertible Notes .................... -- 120,462
---------- ----------
13,689,080 4,060,462
========== ==========
USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and revenue and expenses during the reporting
period. Actual results could differ from those estimates.
11
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheet for cash, accounts
receivable, accounts payable accrued expenses, advances from stockholders and
all note obligations classified as current liabilities approximate their fair
values based on the short-term maturity of these instruments. The carrying
amounts of the Company's convertible and subordinated note obligations, stock
repurchase obligation and common stock subject to put right approximate fair
value as such instruments feature contractual interest rates that are consistent
with current market rates of interest or have effective yields that are
consistent with instruments of similar risk, when taken together with any equity
instruments concurrently issued to holders.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board issued FASB
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46").
This interpretation of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," provides guidance for identifying a controlling interest
in a variable interest entity ("VIE") established by means other than voting
interest. FIN 46 also required consolidation of a VIE by an enterprise that
holds such controlling interest. In December 2003, the FASB completed its
deliberations regarding the proposed modifications to FIN No., 46 and issued
Interpretation Number 46R, "Consolidation of Variable Interest Entities - an
Interpretation of ARB 51" ("FIN No. 46 R"). The decisions reached included a
deferral of the effective date and provisions for additional scope exceptions
for certain types of variable interests. Application of FIN No. 46R is required
in financial statements of public entities that have interests in VIE's or
potential VIE's commonly referred to as special-purpose entities for periods
ending after December 15, 2003. Application by public issuers' entities is
required in all interim and annual financial statements for periods ending after
December 15, 2004. The adoption of this pronouncement did not have material
effect on the Company's financial statements.
In December 2004, the FASB issued SFAS No. 123R "Share Based Payment". This
statement is a revision of SFAS Statement No. 123, "Accounting for Stock-Based
Compensation" and supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees, and its related implementation guidance. SFAS 123R addresses all
forms of share based payment ("SBP") awards including shares issued under
employee stock purchase plans, stock options, restricted stock and stock
appreciation rights. Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date, based on the estimated number
of awards that are expected to vest and will result in a charge to operations
for stock-based compensation expense. The charge will be reflected in the
Company's Statements of Operations during periods in which such charges are
recorded, but will not affect its Balance Sheets or Statements or Cash Flows.
SFAS 123R is effective for public entities that file as small business
issuers--as of the beginning of the first annual reporting period of the fiscal
year that begins after December 15, 2005.
The Company is currently in the process of evaluating the effect that the
adoption of this pronouncement will have on its financial statements.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets". SFAS 153 amends APB Opinion No. 29 to eliminate the exception for
non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. A non-monetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS 153 are effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier
application is permitted for non-monetary asset exchanges occurring in fiscal
periods beginning after December 16, 2004. The provisions of this statement are
intended be applied prospectively. The adoption of this pronouncement is not
expected to have a material effect on the Company's financial statements.
EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on
Diluted Earnings per Share." The EITF reached a consensus that contingently
convertible instruments, such as contingently convertible debt, contingently
convertible preferred stock, and other such securities should be included in
diluted earnings per share (if dilutive) regardless of whether the market price
trigger has been met. The consensus became effective for reporting periods
ending after December 15, 2004. The adoption of this pronouncement did not have
a material effect on the Company's financial statements.
12
NOTE E - BUSINESS COMBINATIONS
MERGER WITH COMPLETE SECURITY SOLUTIONS, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with Complete Security Solutions, Inc. ("CSSI") became
effective. The merger was consummated pursuant to a definitive Supplemental
Agreement and the Agreement and Plan of Merger, entered into as of February 24,
2005, each among the Company, CSSI Acquisition Co. I, Inc., a wholly-owned
subsidiary of the Company and CSSI. Pursuant to the terms of the Supplemental
Agreement and Agreement and Plan of Merger with CSSI, CSSI Acquisition Co. I,
Inc. merged with and into CSSI, with CSSI surviving the merger as a wholly-owned
subsidiary of the Company.
CSSI sells computer software that supports real-time secure collection, delivery
and sharing of field-based report information for public safety agencies. The
Company believes that CSSI's electronic forms technology provides law
enforcement and other justice agencies with secure, real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system. The Company acquired CSSI because it believes that
such technologies fit within its strategic plan of building a business that
addresses the urgency of homeland and information security initiatives.
In connection with the CSSI merger, the Company issued 7,500,000 shares of
common stock in exchange for the outstanding shares of the common stock of CSSI,
and subordinated promissory notes in the aggregate principal amount of
$4,500,000 (the "Subordinated Notes") and warrants to purchase 2,250,000 shares
of common stock ("Purchase Warrants") in exchange for the outstanding shares of
the preferred stock of CSSI. The Purchase Warrants have a term of 5 years and an
exercise price of $0.70 per share. The Subordinated Notes and Purchase Warrants
were issued to Apex Investment Fund V, L.P. ("Apex"), The Northwestern Mutual
Life Insurance Company ("Northwestern"), and Advanced Equities Venture Partners
I, L.P. ("Advanced Equities").
The Subordinated Notes issued to the holders of the outstanding preferred stock
of CSSI have an initial term of 120 days (due on June 25, 2005), with the
Company's option to extend the term for an additional 60 days to August 24,
2005. The Subordinated Notes are interest free and automatically convert into
the securities offered by the Company at the first closing of a subsequent
financing for the Company, for such number of offered securities as could be
purchased for the principal amount being converted. If the Subordinated Notes
are not paid in full on or before the extended maturity date, each noteholder
will be issued a warrant (the "Penalty Warrant") entitling the holder to
purchase 3.84 shares of common stock for each $1.00 of principal amount then
outstanding. The Penalty Warrants issuable in connection with the non-payment of
the Subordinated Notes may only be exercised by a holder's delivery of its
subordinated promissory note in payment of the exercise price, the delivery of
which will result in the full satisfaction of all amounts of principal and
interest due and payable under such Subordinated Note. The Subordinated Notes
were not redeemed as of June 25, 2005 and the option to extend the term for an
additional 60 days (to August 24, 2005) was exercised.
The Company has agreed to register the resale of the 7,500,000 shares of common
stock issued to the holders of the outstanding common stock of CSSI and the
2,250,000 shares of common stock issuable upon the exercise of the warrants
issued to the holders of the outstanding preferred stock of CSSI at such time as
the Company next files a registration statement with the Securities and Exchange
Commission ("SEC") on a best efforts basis.
MERGER WITH LUCIDLINE, INC.
On February 25, 2005, pursuant to the filing of an Agreement and Plan of Merger,
the Company's merger with LucidLine, Inc. ("LucidLine") became effective. The
merger was consummated pursuant to a definitive Supplemental Agreement and the
Agreement and Plan of Merger entered into as of February 24, 2005, each among
the Company, LL Acquisition I Corp., a wholly-owned subsidiary of the Company
and LucidLine. Pursuant to the terms of the Supplemental Agreement and Agreement
and Plan of Merger with LucidLine, LL Acquisition I Corp. merged with and into
LucidLine, with LucidLine surviving the merger as a wholly-owned subsidiary of
the Company.
LucidLine provides high-speed Internet access, synchronized remote back-up,
retrieval, and restoration services to small and mid-size businesses. The
Company acquired LucidLine because it believes that LucidLine's information
13
protection technologies fit within its strategic plan of building a business
that addresses the urgency of homeland and information security initiatives.
In connection with the LucidLine merger, the Company issued 4,400,000 shares of
common stock and $200,000 of cash, in exchange for all of the outstanding shares
of LucidLine's common stock. The Company has agreed to register the resale of
the shares of common stock issued to the holders of the outstanding common stock
of LucidLine at such time as the Company next files a registration statement
with the SEC on a best efforts basis.
MERGER WITH ENTELAGENT SOFTWARE CORP.
On November 24, 2002, Patron, ESC Acquisition, Inc., a California corporation
and wholly-owned subsidiary of Patron ("Entelagent Mergerco"), and Entelagent
Software Corp., a California corporation ("Entelagent"), entered into an
Agreement and Plan of Merger, (the "Entelagent Merger Agreement") whereby
Entelagent Mergerco would be merged with and into Entelagent with Entelagent
surviving as a wholly owned subsidiary of Patron (the "Entelagent Merger").
Patron, Entelagent Mergerco and Entelagent also concurrently entered into a
Supplemental Agreement (the "Entelagent Supplemental Agreement").
On February 24, 2005, Patron entered into a definitive Amended and Restated
Supplemental Agreement pursuant to which Entelagent Mergerco would merge with
and into Entelagent, with Entelagent surviving the merger as a wholly-owned
subsidiary of Patron. The Amended and Restated Supplemental Agreement amended
and restated the Entelagent Supplemental Agreement.
Entelagent provides flexible and scalable real-time content-aware email
monitoring and post-event review of e-mail messages and their attachments as
well as infrastructure for knowledge management of archived e-mail messages and
attachments in all media. Entelagent's e-mail content monitoring technology
addresses the need for comprehensive internal security measures to safeguard
company intellectual capital. The Company acquired Entelagent because it
believes that Entelagent's information surveillance and protection technologies
fit within its strategic plan of building a business that addresses the urgency
of homeland and information security initiatives.
In connection with the Entelagent Merger, Patron issued 3,000,000 shares of
Patron's common stock in exchange for all of the outstanding shares of the
capital stock of Entelagent. Patron has agreed to register the resale of the
3,000,000 shares of common stock issued to the holders of the outstanding
capital stock of Entelagent at such time as Patron next files a registration
statement with the SEC on a best efforts basis. In addition, pursuant to the
terms of the Amended and Restated Supplemental Agreement, Patron also agreed to
(i) issue to certain officers, directors, stockholders and creditors of
Entelagent, in consideration of amounts owed by Entelagent to such parties,
promissory notes in the aggregate principal amount of $2,640,000, with interest
payable thereon at a rate of 8% per annum and maturing one year after the
completion of the merger and (ii) pay $1,388,000 in outstanding liabilities of
Entelagent from the net proceeds of the Interim Bridge Financing I completed on
February 28, 2005. Accordingly, the Company placed $1,388,000 of the proceeds it
received from the Interim Bridge Financing I financing transaction in an escrow
account to be specifically used for the payment of such liabilities. The
non-disbursed funds as of June 30, 2005 are presented as restricted cash in the
accompanying balance sheet.
Subsequent to the date of the acquisition, the Company modified its purchase
price allocation to offset approximately $52,000 of previously existing advances
against the note, which reduced the aggregate balance of the note to $2,588,000.
BUSINESS COMBINATION ACCOUNTING
The Company accounted for its acquisitions of CSSI, LucidLine and Entelagent
using the purchase method of accounting prescribed under SFAS 141 "Business
Combinations." Under the purchase method, the acquiring enterprise records any
purchase consideration issued to the sellers of the acquired business at their
fair values. The aggregate of the fair value of the purchase consideration plus
any direct transaction expenses incurred by the acquiring enterprise is
allocated to the assets acquired (including any separately identifiable
intangibles) and liabilities assumed based on their fair values at the date of
acquisition. The excess of cost of the acquired entities over the fair values of
identifiable assets acquired and liabilities assumed was recorded as goodwill.
The results of operations
14
for each of the acquired companies following the dates of each business
combination is included in the Company consolidated results of operations for
the quarter ended June 30, 2005.
The Company evaluated each of the aforementioned transactions to identify the
acquiring entity as required under SFAS 141 for business combinations effected
through an exchange of equity interests. Based on such evaluation the Company
determined that it was the acquiring entity in each transaction (and
cumulatively for all transactions) as (1) the larger portion of the relative
voting rights in the Company after each combination was retained by its
previously existing stockholders, (2) the previously existing stockholders,
through their retention of a majority of voting rights, retained the ability to
elect or appoint a voting majority of the governing body of the combined entity,
and (3) under the terms of the exchange of equity securities, the Company paid a
premium over the market value of the equity securities of the other combining
entities.
The following table provides a breakdown of the purchase price including the
fair value of purchase consideration issued to the sellers of the acquired
business and direct transaction expenses incurred by the Company in connection
with consummating these transactions:
CSSI LUCIDLINE ENTELAGENT TOTAL
----------- ----------- ----------- -----------
Cash ........................ $ -- $ 200,000 $ -- $ 200,000
Common Stock ................ 6,375,000 3,740,000 2,550,000 12,665,000
Subordinated promissory notes 4,500,000 -- -- 4,500,000
Common stock warrants ....... 1,912,500 -- -- 1,912,500
Transaction expenses ........ 398,128 154,611 359,894 912,633
----------- ----------- ----------- -----------
Total Purchase Price ..... $13,185,628 $ 4,094,611 $ 2,909,894 $20,190,133
=========== =========== =========== ===========
The fair value of common stock issued to the sellers as purchase consideration
was determined in accordance with the provisions of EITF 99-12 "Determination of
the Measurement Date for the Market Price of Acquirer Securities Issued in a
Purchase Business Combination." The fair value of subordinated notes issued to
the sellers as purchase consideration is considered to be equal to their
principal amounts due to the short-term maturity of those instruments. The
Company calculated the fair value of common stock purchase warrants issued to
the sellers as purchase consideration using the Black-Scholes option-pricing
model.
Transaction expenses, which include legal fees and transaction advisory services
directly related to the acquisitions amount to $912,633. Such fees include
$657,633 paid in cash and $255,000 for the fair value of 300,000 common stock
purchase warrants issued to Laidlaw & Company UK Ltd. ("Laidlaw") in its
capacity as a transaction advisor.
PRELIMINARY PURCHASE PRICE ALLOCATION
Under business combination accounting, the total preliminary purchase price was
allocated to CSSI's and LucidLine's net tangible and identifiable intangible
assets based on their estimated fair values as of February 25, 2005. The total
preliminary purchase price allocation for Entelagent's net tangible and
identifiable intangible assets was based on their estimated fair values as of
March 30, 2005. The preliminary allocation of the purchase price for these three
acquisitions is set forth below. The excess of the purchase price over the net
tangible and identifiable intangible assets was recorded as goodwill.
The Company assumed $476,594 of payroll and sales tax liabilities in its
acquisition of Entelagent that were in arrears at the date the transaction was
consummated (Note M). These liabilities have been estimated at their fair value
in the preliminary purchase price allocation. The settlement of these amounts is
in negotiation and could change, as this is a contingency that existed at the
date of acquisition.
15
CSSI LUCIDLINE ENTELAGENT TOTAL
------------ ------------ ------------ ------------
Fair value of tangible assets:
Cash ............................... $ 399,636 $ 9,563 $ 7,198 $ 416,397
Accounts receivable ................ 27,791 22,936 84,918 135,645
Employee receivables ............... 111,773 2,000 113,773
Other current assets ............... 45,177 326 5,990 51,493
------------ ------------ ------------ ------------
Total current assets ............... 584,377 34,825 98,106 717,308
Property and Equipment ............. 62,000 61,000 12,000 135,000
Other assets ....................... --
Advances to prospective affiliates . 2,621,470 -- -- 2,621,470
------------ ------------ ------------ ------------
Total tangible assets ............. 3,267,847 95,825 110,106 3,473,778
Liabilities assumed: ............... --
Accounts payable ................... (128,854) (32,473) (355,416) (516,743)
Advances from prospective affiliate (829,032) (2,363,359) (3,192,391)
Accrued expenses ................... --
and other current liabilities ... (357,391) -- (4,312,746) (4,670,137)
------------ ------------ ------------ ------------
Total current liabilities .......... (486,245) (861,505) (7,031,521) (8,379,271)
Long term liabilities .............. -- (93,796) (345,330) (439,126)
------------ ------------ ------------ ------------
Total liabilities assumed .......... (486,245) (955,301) (7,376,851) (8,818,397)
------------ ------------ ------------ ------------
Net tangible assets acquired ....... 2,781,602 (859,476) (7,266,745) (5,344,619)
Value of excess allocated to:
Developed technology .............. 670,000 -- 1,900,000 2,570,000
Customer relationships ............ 180,000 -- -- 180,000
Trademarks and tradenames ......... 55,000 -- 106,000 161,000
In-process research and
development .................... 190,000 -- -- 190,000
Goodwill .......................... 9,309,026 4,954,087 8,170,639 22,433,752
Purchase Price ...................... $ 13,185,628 $ 4,094,611 $ 2,909,894 $ 20,190,133
============ ============ ============ ============
The purchase price allocation is preliminary, based on management's estimates
and a valuation study performed by an independent outside appraisal firm that
has not yet been finalized. The Company considered its intention for future use
of the acquired assets, analyses of the historical financial performance of each
of the acquired businesses and estimates of future performance of each acquired
businesses' products and services. The Company made certain adjustments during
the quarter ended June 30, 2005 to its original purchase price allocation as a
result of having negotiated settlements of certain liabilities that it assumed
in its business combination with Entelagent and reevaluating the carrying
amounts of certain accounts receivable balances recorded in purchase accounting.
These changes resulted in a net decrease of $110,663 to the Company's previous
determination of goodwill. In addition, the Company reduced both other current
assets and current liabilities by $27,500 to offset a prepayment of a liability
that occurred prior to the acquisition. The Company's final determination of the
purchase price allocation could result in additional changes to the amounts
reflected in its preliminary estimate. The Company is in the process of
finalizing the information required to file its Form 8-K with the SEC and will
do so as soon as practicable.
16
PROFORMA FINANCIAL INFORMATION
The unaudited financial information in the table below summarizes the combined
results of operations of the Company and CSSI, LucidLine and Entelagent, on a
proforma basis, as if the companies had been combined as of the beginning of
each of the periods presented.
The unaudited proforma financial information for the six months ended June 30,
2005 combines the historical results for Patron for the six months ended June
30, 2005 and the historical results for CSSI and LucidLine for the period from
January 1, 2005 to February 24, 2005 and the historical results for Entelagent
for the period from January 1, 2005 to March 30, 2005. The unaudited proforma
financial results for the six months ended June 30, 2004 combines the historical
results for Patron for this period with the historical results for CSSI,
Entelagent and LucidLine for the six months ended June 30, 2004.
SIX MONTHS ENDED JUNE 30,
2005 2004
----------- -----------
Total revenues ................................... $ 345,240 $ 710,834
Net loss ......................................... (8,598,761) (3,257,153)
Pro forma net loss per share, basic and diluted .. $ (0.14) $ (0.06)
The proforma financial information is presented for informational purposes only
and is not indicative of the results of operations that would have been achieved
if the acquisitions of these three companies had taken place at the beginning of
each of the periods presented
NOTE F - OTHER CURRENT ASSETS
Other current assets consist of the following:
JUNE 30,
2005
--------
Employee receivables ....................... $ 9,039
Prepaid expenses ........................... 30,934
Deposits ................................... 5,990
--------
$ 45,963
========
NOTE G - PROPERTY AND EQUIPMENT
JUNE 30,
2005
---------
Computers ................................... $ 148,740
Furniture and Fixtures ...................... 34,076
---------
sub-total ............................... 182,816
less: accumulated depreciation .............. (21,807)
---------
Property and equipment, net ............. $ 161,009
=========
Depreciation expense for the six months ended June 30, 2005 was $21,807.
NOTE H - DEFERRED FINANCING COSTS
Deferred financing costs, which amount to $1,112,021, are presented net of
amortization and include cash fees of $305,160 plus $80,867 representing the
fair value of the 152,580 common stock purchase warrants issued to
17
Laidlaw in its capacity as the placement agent in the $2,543,000 Interim Bridge
Financing II (Note K). These deferred financing costs are being amortized over
120 days, which is the minimum term of the debt.
On June 28, 2005, the Company elected to extend the due date of the Interim
Bridge Financing I notes in exchange for 1,750,000 additional common stock
purchase warrants (the "Bridge I Extension Warrants") that were issued to the
investors in this transaction. The aggregate fair value of the warrants, which
amounted to $822,500 is also included in deferred financing costs and is being
amortized over 60 days to August 27, 2005, the extended due date of the notes.
The Company also incurred $316,579 of cash fees and $297,500 representing the
fair value of 350,000 common stock purchase warrants issued to Laidlaw in its
capacity as the placement agent in the $3,500,000 Interim Bridge Financing I
completed in February 2005. Fees incurred in connection with the Interim Bride 1
financing were fully amortized during the six months ended June 30, 2005.
The fair value of all of the aforementioned warrants was determined using the
Black-Scholes option-pricing model.
Amortization expense with respect to deferred financing costs amounted to
$699,905 for the six months ended June 30, 2005 and is included as a component
of interest expense in the accompanying statement of operations.
NOTE I - INTANGIBLE ASSETS
The components of intangible assets as of June 30, 2005 are set forth in the
following table:
NET BOOK ESTIMATED
PRELIMINARY ACCUMULATED VALUE AT USEFUL
FAIR VALUE AMORTIZATION JUNE 30, 2005 LIFE
---------- ---------- ----------- --------
Developed technology .............. $2,570,000 $ (139,669) $2,430,331 5 years
Customer relationships ............ 180,000 (15,000) 165,000 4 years
Trademarks and tradenames ......... 161,000 (11,208) 149,792 4 years
In-process research and development 190,000 (12,668) 177,332 5 years
---------- ---------- -----------
Property and equipment, net $3,101,000 $ (178,545) $ 2,922,455
========== ========== ===========
The Company classifies amortization of developed technology as a component of
cost of sales.
AMORTIZATION OF INTANGIBLE ASSETS
The amortization of intangible assets will result in the following additional
expense by year:
INTANGIBLE
YEARS ENDED DECEMBER 31, AMORTIZATION
------------------------ ------------
2005 $ 318,625
2006 637,250
2007 637,250
2008 637,250
2009 568,417
2010 123,663
----------
$2,922,455
==========
NOTE J - DEMAND NOTES PAYABLE
Through December 31, 2004, the Company borrowed an aggregate amount of $695,000
from four unrelated parties. These notes are payable on demand and bear interest
at the rate of 10% per annum. Interest expense on these notes amounted to
$35,750 and $35,750 for the six months ended June 30, 2005 and 2004,
respectively.
18
Entelagent Software Corporation entered into a note arrangement with Lok
Technology with a security interest in the Accounts Receivable of Entelagent
Software Corporation. At June 30, 2005, the balance outstanding on this note is
$312,556. The note bears interest at 15% per annum. Interest on this note
amounted to $23,442 for the six months ended June 30, 2005.
NOTE K - BRIDGE NOTES PAYABLE
INTERIM BRIDGE FINANCING I
On February 28, 2005, the Company completed a $3,500,000 financing (the "Interim
Bridge Financing I") through the issuance of 10% Senior Convertible Promissory
Notes (the "Bridge I Notes") and warrants to purchase up to 1,750,000 shares of
the Company's common stock ("Bridge I Warrants"). The warrants have a term of 5
years and an exercise price of $0.70 per share. The aggregate fair value of the
Bridge I Warrants amounts to $1,487,500. Prior to final maturity, the Bridge I
Notes may be converted into securities that would issuable at the first closing
of a subsequent financing by the Company, for such number of offered securities
that could be purchased for the principal amount being converted. The Bridge I
Notes had an initial term of 120 days (due on June 28, 2005) with interest at a
contractual rate of 10% per annum and featured an option for the Company to
extend the term for an additional 60 days to August 27, 2005.
In accordance with APB 14, the Company allocated $2,456,140 of the proceeds to
the Bridge I Notes and $1,043,860 of proceeds to the Bridge I Warrants. The
difference between the carrying amount of the Bridge I Notes and their
contractual redemption amount was accreted as interest expense to June 28, 2005,
their earliest date of redemption. Accretion of the aforementioned discount
amounted to $1,043,860 for the six months ended June 30, 2005 and is included as
a component of interest expense in the accompanying statement of operations.
On June 28, 2005, the Company elected to extend the contractual maturity date of
the Bridge I Notes for an additional 60 days to August 28, 2005, which caused
the contractual interest rate increased to 12% per annum. In addition, the
Company was required to issue the 1,750,000 additional warrants (the "Bridge I
Extension Warrants") to purchase such number of shares of common stock equal to
1/2 of a share for each $1.00 of principal amount outstanding. The Bridge I
Extension Warrants have a term of 5 years and an exercise price of $0.70 per
share. The Bridge I Warrants are included in Deferred Financing Costs at their
fair value, which amounts to $822,500.
If the Bridge I Notes are not paid in full on or before the extended maturity
date, each noteholder will be issued a warrant ("Bridge I Penalty Warrant")
entitling the holder to purchase 3.84 shares of common stock for each $1.00 of
principal amount then outstanding. The Bridge I Penalty Warrants would only be
exercisable by a holder's delivery of its Bridge I Note in payment of the
exercise price, the delivery of which will result in the full satisfaction of
all amounts of principal and interest due and payable under the Bridge I Note.
The Company has agreed to file with the SEC, a registration statement for the
resale of the restricted shares of the Company's common stock issuable upon
exercise of all of the warrants issued in this transaction, on a best efforts
basis.
Contractual interest expense on the Bridge I Notes amounted to $116,667 for the
six months ended June 30, 2005 and is included as a component of interest
expense in the accompanying statement of operations
The Company sold these securities to thirty-three accredited investors
introduced by Laidlaw, the placement agent in the Interim Bridge Financing I. As
described in Note H, the Company incurred $614,079 of fees in connection with
this transaction including $297,500 for the fair value of warrants to purchase
up to 350,000 shares of the Company's common stock (the "Placement Agent
Warrants") at an exercise price of $0.70 per share.
INTERIM BRIDGE FINANCING II
On June 6, 2005, the Company completed a $2,543,000 financing (the "Interim
Bridge Financing II") through the issuance of (i) 10% Junior Convertible
Promissory Notes (the "Bridge II Notes") and (ii) warrants to purchase up to
1,271,500 shares of common stock (the "Bridge II Warrants"). The warrants have a
term of 5 years and an exercise price of $0.60 per share. The aggregate fair
value of the Bridge II Warrants amounts to $673,895. Prior to maturity, the
Junior Convertible Promissory Notes may be converted into the securities offered
by the Company at the first closing of a subsequent financing for the Company,
for such number of offered securities as could be purchased for the principal
amount being converted.
19
In accordance with APB 14, the Company allocated $2,010,277 of the proceeds to
the Bridge II Notes and $532,723 of proceeds to the Bridge II Warrants. The
difference between the carrying amount of the Bridge II Notes and their
contractual redemption amount was accreted as interest expense to October 3,
2005, their earliest date of redemption. Accretion of the aforementioned
discount amounted to $133,180 for the six months ended June 30, 2005 and is
included as a component of interest expense in the accompanying statement of
operations.
The Bridge II Notes have an initial term of 120 days (due on various dates
beginning October 3, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an additional 60 days to various dates
beginning December 2, 2005. Upon the extension of the maturity date of the
Bridge II Notes, the contractual interest rate would increase to 12% per annum,
and the Company would be required to issue warrants (the "Bridge II Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to one-half of a share for each $1.00 of principal then outstanding. The Bridge
II Extension Warrants issuable upon extension of the maturity date of the Junior
Convertible Promissory notes feature a term of 5 years and an exercise price of
$0.60 per share. In addition, if the Bridge II Notes are not paid in full on or
before the extended maturity date, each noteholder will be issued a warrant
entitling the holder to purchase 3.84 shares of the Company's common stock for
each $1.00 of principal amount then outstanding (the "Bridge II Penalty
Warrants"). The Bridge II Penalty Warrants, if issued, would only be exercisable
by a holder's delivery of its Bridge II Notes in payment of the exercise price,
the delivery of which will result in the full satisfaction of all amounts of
principal and interest due and payable under the Bridge II Notes. The Company
has agreed to file with the SEC, a registration statement for the resale of the
restricted shares of its common stock issuable upon exercise of the Warrants on
a best efforts basis.
The Company sold these securities to seven accredited investors introduced by
Laidlaw, placement agent in the Interim Bridge Financing II. As described in
Note H, the Company incurred $386,027 of fees in connection with this
transaction including a cash fee of $305,160 and $80,867 for the fair value of
warrants to purchase 152,580 shares of the Company's common stock at an exercise
price of $0.60 per share.
NOTE L - RELATED PARTY TRANSACTIONS
EXPENSE REIMBURSEMENTS DUE TO OFFICERS AND STOCKHOLDERS
Certain stockholders and officers of the Company have paid expenses on the
Company's behalf since its inception, of which $174,337 remains outstanding at
June 30, 2005. The amounts payable to such officers and stockholders are due on
demand.
ADVANCES FROM STOCKHOLDERS
Certain stockholders have made working capital advances to the Company, the
unpaid balance of which amounts to $1,650,000 at June 30, 2005. These amounts,
which are non-interest bearing, are payable on demand. These advances include
the following: on March 31, 2005, the Company received an advance of $500,000
from Apex; on April 15, 2005, the Company received a $200,000 advance from Apex;
on May 2, 2005, the Company received a $200,000 advance from Apex; on June 15,
2005, the Company received a $750,000 advance from Apex. Apex is one of the
selling shareholders of CSSI and a current stockholder and warrant holder of the
Company.
20
In consideration of this financing, the parties have mutually agreed that Apex
will be offered the same terms as investors in the Interim Bridge Financing II,
described in Note K above. This mutual agreement was entered into on a verbal
basis. As of the date of this filing, the Company has finalized terms and is
currently in the process of finalizing definitive agreements and notes with
respect to the additional bridge financing. Accordingly, the Company has
classified the advance from Apex as Advances from Stockholders pending the
completion of the agreements and notes.
NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS
Notes payable to officers and stockholders bear interest at 10% and are due on
demand. Interest expense on these notes amounted to $6,438 for the three months
ended June 30, 2005 and $12,876 for the six months ended June 30, 2005.
CONSULTING AGREEMENT PAYABLE
On June 8, 2005, the Company negotiated a settlement regarding the Consulting
Agreement Payable with a related party. The terms of the settlement agreement
terminates the prior agreement and reduces the remaining payments due under the
contract to $150,000 including a $50,000 payment that was made upon the
execution of the agreement and two additional $50,000 payments including one to
be made upon the completion of a follow-on-financing by the Company and one not
later than September 30, 2005. The $150,000 reduction in payments was recorded
as a reduction of general and administrative expense during the quarter ended
June 30, 2005. Additionally, the settlement agreement terminates an obligation
for the Company to issue 100,000 shares of unrestricted stock. This stock
issuable under this commitment was recorded in 2004 as "Stock to be issued in
lieu of cash for services" in the amount of $78,900 and the 100,000 shares was
classified as shares to be issued. The termination of the stock issuance
obligation resulted in an additional reduction of $78,900 in general and
administrative expenses during the quarter ended June 30, 2005.
NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)
The notes issued to creditors of Entelagent described in Note E, include
$1,655,548 payable to related parties for settlement of accrued payroll, notes
payable and expense reimbursements. In addition, the Company offset $52,000 of
previously existing advances made to certain of the parties to reduce the note
to an aggregate carrying amount of $2,588,000. Aggregate interest expense on
this note amounts to $51,842 for the six months ended June 30, 2005.
RELATED PARTY PAYMENTS
During the three months ended June 30, 2005, the Company made payments to
related parties amounting to an aggregate of $514,867 from the $1,388,000
restricted cash escrow account established in connection with the Entelagent
Merger (Note E) to pay certain outstanding liabilities of Entelagent including
advances from shareholders, accounts payable and payroll liabilities.
During the three months ended June 30, 2005, the Company made a $200,000 payment
to Patrick J. Allin and the Allin Dynastic Trust under the terms of the
settlement agreement reached on June 6, 2005 (Note O).
NOTE M - OTHER CURRENT LIABILITIES
Other current liabilities principally consists of $476,594 of accrued payroll
and sales tax liabilities, the settlement of which is being negotiated, and
estimated penalties that the Company assumed in its acquisition of Entelagent
(Note E). These liabilities are intended to be paid from restricted cash.
21
NOTE N - DEFERRED REVENUE
Deferred revenue includes (1) $97,353 for the fair value of remaining service
obligations that the Company assumed on contracts in its acquisitions of CSSI
and Entelagent and (2) $130,415 for contracts on which the revenue recognition
is deferred until contract deliverables have been completed.
NOTE O - SETTLEMENT WITH PATRICK J. ALLIN, FORMER CHIEF EXECUTIVE OFFICER
On June 6, 2005, the Company entered into a settlement of certain employment and
indemnification related claims brought by Patrick J. Allin, the Company's former
Chief Executive Officer and a former member of the Company's Board of Directors,
against the Company during the year ended December 31, 2004. Pursuant to the
Settlement Agreement and Mutual Release dated June 2, 2005, among the Company,
Mr. Allin and The Allin Dynastic Trust, the Company agreed to pay to Mr. Allin,
in settlement of Mr. Allin's claims, an aggregate payment of One Million One
Hundred Fifty Thousand Dollars ($1,150,000) payable as follows: (i) $200,000
that was paid upon execution of the Settlement Agreement and Mutual Release and
(ii) Nine Hundred Fifty Thousand Dollars ($950,000) payable in cash and/or a
promissory note upon the consummation of a follow-on-financing by the Company.
The parties also agreed to release all claims existing as of the date of the
Settlement Agreement and Mutual Release. The Settlement Agreement and Mutual
Release terminates by its terms if the Company does not consummate a
follow-on-financing by August 15, 2005. As described in Note S, the Company and
Mr. Allin agreed to the termination date for an additional 120 days to December
13, 2005. The Company accrued an aggregate of $927,167 in amounts repayable to
Mr. Allin up through the date of his separation in February 2004. The difference
between the amounts accrued and the cash settlement, which difference amounts to
$216,507, was recorded in general and administrative expense in the quarter
ended March 31, 2004. The remaining amounts payable to Mr. Allin under this
provision of the settlement are presented net of the $200,000 payment made to
him upon the execution of the agreement and includes $31,230 of interest accrued
during the six months ended June 30, 2005.
Pursuant to the Settlement Agreement and Mutual Release, the Company also agreed
to purchase from Mr. Allin and The Allin Dynastic Trust an aggregate of four
million (4,000,000) shares of the Company's common stock as follows: (i) two
million (2,000,000) shares (the "Initial Shares") through the issuance of
promissory notes in the aggregate principal amount of One Million Six Hundred
Thousand Dollars ($1,600,000) and (ii) two million (2,000,000) shares (the
"Remainder Shares") through a cash payment from the proceeds of a
follow-on-financing by the Company, at a price per share equal to the lesser of
(a) $.50 per share or (b) 90% of the issue price or conversion price, as the
case may be, of the security issued in a follow-on-financing, provided however
that in the event that 90% of the issue price or conversion price, as the case
may be, of the security issued in the follow-on-financing is less than $.50 per
share, Mr. Allin and/or The Allin Dynastic Trust may, at their option, refuse to
sell any or all of the Remainder Shares to the Company. The Initial Shares are
to be held in escrow pursuant to a mutually agreed upon Escrow Agreement to be
subsequently entered into between the parties. Each of Mr. Allin and The Allin
Dynastic Trust have agreed to lock-up their shares until the shorter of (y) the
six month period subsequent to the consummation of a follow-on-financing and (z)
the date on which the next registration statement filed by the Company becomes
effective.
The promissory notes issued to purchase the Initial Shares bear interest at an
annual rate of 8%, with interest payments due and payable on the last day of
August, November, February and May during the term of the promissory notes, with
a maturity date of June 30, 2006. In addition, if the Company defaults on
certain terms under the promissory notes, and such default remains uncured for
five days, all payments under the promissory notes accelerate and the Company
agrees to confess to a judgment against the Company in a court of the promissory
note holder's choosing in Cook County, Illinois. In the alternative, the holders
of the promissory notes may demand that the shares purchased by the promissory
notes be returned in fulfillment of all obligations remaining under such
promissory notes.
As a result of this agreement to repurchase shares of common stock from Mr.
Allin and The Allin Dynastic Trust, the Company has recorded certain liabilities
and adjustments to stockholders' deficiency retroactively to the quarter ended
March 31, 2004.
For the Initial Shares the Company recorded a $1,738,667 note payable to Mr.
Allin with a corresponding increase of $1,600,000 in stockholders' deficiency
and a $138,667 charge to operations for interest payable through June 6, 2006.
For the Remainder Shares, the Company recorded a $1,000,000 put right as
temporary equity with a corresponding $300,000 charge to operations for the
intrinsic value of the put right on June 6, 2005 (fair value of common stock of
$.65 per share less the minimum conversion price of $50. per share) and a
$700,000 net increase in stockholders' deficiency. The aggregate charge of
$438,667 for the interest and the intrinsic value of the conversion option
embedded in the remainder shares is presented as a litigation loss in the
accompanying statement of operations for the six months ended June 30, 2004.
Common stock outstanding in the accompanying balance sheet is presented net of
the 2 million Initial Shares that are subject to the repurchase obligation.
22
On August 15, 2005, the Company entered into an agreement with Mr. Allin and the
Allin Dynastic Trust to provide Patron with up to an additional 120 days to
arrange the follow-on-financing (Note S).
NOTE P - ACCOMMODATION AGREEMENT
In November 2002, the Company entered into a financing arrangement with a third
party financial institution (the "Lender"), pursuant to which the Company would
borrow $950,000 under a note to be collateralized by the pledge of 950,000
shares of registered stock from five different stockholders. In connection with
this arrangement, the Company executed a series of Accommodation Agreements with
these stockholders wherein each stockholder pledged their shares in return for
the right to receive on or before November 17, 2003 the return of the pledged
shares, or replacement shares in the event of foreclosure, and one additional
share of common stock for every four shares pledged as compensation. The Company
also agreed to use "best efforts" to register these shares with the US
Securities and Exchange Commission 12 months from the date of issue.
In December 2002, the Company received approximately $450,000 of proceeds under
the note and provided the Lender the pledged shares. Since that date, no
additional proceeds were provided by the Lender and repeated attempts were made
by the Company to secure the additional proceeds. The Company has effectively
accounted for the Lender's failure to fund the facility and return the pledged
shares as a foreclosure on the loan collateral. Accordingly, the Company
recorded a $1,047,728 loss during the year ended December 31, 2002.
On March 13, 2003, the Company issued 1,200,000 replacement shares with an
aggregate fair value of $3,708,000 to the stockholders who pledged their shares
under the Accommodation Agreements. Accordingly, the Company recorded an
additional loss of $2,210,272 during the year ended December 31, 2003 for the
difference between the loss the Company recorded upon the Lender's foreclosure
of the collateral and the aggregate fair value of the replacement shares.
In addition, the Accommodation Agreements provided for the Company to pay a
penalty in the event of its failure to cause the replacement shares to be
registered on or before March 31, 2003. As a result, the Company has accrued a
penalty of 450,000 shares per quarter, which penalty amounted to $258,000 and
$340,200 in the three months ended June 30, 2005 and 2004, respectively. The
penalty amounted to $627,000 and $595,200 in the six months ended June 30, 2005,
and 2004, respectively.
STOCK PLEDGE ARRANGEMENT
In April 2004, a stockholder of the Company entered into a one-year stock loan
financing arrangement ("Stock Financing Facility") with a third party financial
institution (the "Lender I"), pursuant to which such stockholder committed to
obtain financing for the Company under a credit facility collateralized by the
pledge of 685,000 shares of registered stock (the "Pledged Stock") that was
pledged by a second stockholder (the "Pledging Stockholder"). In connection with
this arrangement, the Company executed an accommodation agreement with the
Pledging Stockholder committing to issue 685,000 shares of restricted stock (the
"Replacement Stock") on April 2, 2005 (the "Termination Date") in the event of a
loss of the Pledged Stock, plus a premium of 205,500 shares (the "Premium
Shares") for entering into the agreement. The Company also agreed to register
300,000 shares of restricted stock held by the Pledging Stockholder (the "Held
Stock") within thirty days of the agreement and to use its best efforts register
with the SEC, both the Replacement Stock and Premium Stock within 12 months from
their date of issue.
23
The Company received $40,012 of funds but was unable to recover the Pledged
Stock on the Termination Date. In addition, due to a delay in registering all of
the shares under this arrangement, the Company entered into a secondary
agreement with the Pledging Stockholder providing for: (1) the immediate
issuance of the Replacement Shares and Premium Shares; (2) registration of the
Replacement Shares, Premium Shares and Held Shares; (3) the retroactive accrual
of a penalty from May 2, 2004 through the date the registration statement is
filed payable in such number of shares that is equal to 15% of the Held Stock
(prorated for each fraction of a year); and (4) the accrual of an additional
penalty from April 2, 2005 through the date the registration statement is filed
equal to 15% of the Replacement Stock and Premium Stock (prorated for each
fraction of a year),.
The Company recorded a charge of $406,205 for the fair value of the Replacement
Stock and Premium Stock (890,500 shares) issuable to the Pledging Stockholder
under this arrangement. Such charge, net of $40,012 of advances received, is
presented as a loss on collateralized financing arrangement in the accompanying
statement of operations. The Company also recorded a $62,102 charge for the fair
value of 85,894 shares issuable to the Pledging Stockholder as penalties for the
delays in registering the stock. The charges associated with the penalties are
included in stock based penalties under accommodation agreements in the
accompanying statements of operation.
NOTE Q - COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
Sherleigh Associates Inc. Profit Sharing Plan ("Sherleigh") filed a complaint
against the Company, Patrick Allin, former Chief Executive Officer of the
Company, and Robert E. Yaw, the Company's non-executive Chairman, on February 3,
2004, in the United States District Court for the Southern District of New York
(the "Court") alleging common law fraud. The complaint alleged that Sherleigh
was fraudulently induced into purchasing 1,000,000 shares of Company common
stock in reliance upon certain of the Company's press releases and allegedly
false statements by Mr. Allin and Mr. Yaw, concerning the Company's plans to
acquire two target companies, TrustWave Corporation (currently a strategic
partner of the Company) and Entelagent (a current subsidiary of the Company),
and its financing arrangements regarding those acquisitions. Sherleigh seeks
rescission of its purchase agreement and return of its $2,000,000 purchase price
or compensatory damages to be proven at trial. Mr. Allin recently entered into a
settlement agreement with Sherleigh and is requesting that the Court include in
its dismissal order a finding that the settlement is reasonable and a
prohibition against any claims by the Company or Mr. Yaw against Mr. Allin for
contribution or indemnification with respect to Sherleigh's claims. The Company
has opposed Mr. Allin's request. The issue has been fully briefed but the Court
has not yet issued any ruling on Mr. Allin's request. Discovery has been
completed, but no trial date has been set by the Court. The Company believes the
Plaintiff's claims are without merit and intends to continue to defend against
them through trial, if necessary. The amount of loss, if any, with respect to
the claim cannot be predicted or quantified at this time and, therefore, no
amounts have been recorded on the books of the Company.
In April of 2005, Richard L. Linting, a former President of the Company's
Professional Services Group, filed a complaint against the Company and Robert E.
Yaw, II, the Company's non-executive Chairman, in the Circuit Court of Cook
County, Illinois alleging breach of his purported employment contract and
seeking sums allegedly owed under the employment contract in the amount of
$1,321,809, plus court costs and fees. The Company believes it has valid
defenses to the claims. Nonetheless, the Company has been working to settle this
claim with Mr. Linting and believes, based on discussions with legal counsel,
Mr. Linting will settle this matter for amounts of cash and stock approximately
equal to amounts already accrued on the Company's books as of the date of his
termination.
24
In December of 2004, Marie Graul, former Chief Financial Officer, informed the
Company of her intention to assert a claim against the Company for sums
allegedly owed under her employment agreement with the Company. The Company
believes it has valid defenses to the claims. Although the Company has been
working to settle this claim with Ms. Graul, the Company believes this claim
will enter arbitration proceedings. For Ms. Graul, the Company has recorded
accrued, but unpaid, salary of $95,139 from the start of her employment through
the date of separation, on July 17, 2003. In addition, Ms. Graul's employment
agreement specifies that if her agreement was terminated for any reason before
January 1, 2004, she would be entitled to a bonus of 25% of her base salary, or
$62,500. Therefore, the Company believes the total accrued, but unpaid payroll
due to Ms. Graul under the terms of her employment agreement is $157,639. Any
additional amounts the Company may owe Ms. Graul as a result of the arbitration
proceedings are not estimable at this time.
While the Company believes its has defenses to the claims noted above,
notwithstanding the fact that the Company intends to vigorously defend these
actions, there can be no assurance the Company will be successful in its defense
of any of these claims. In the event the Company is required to pay damages in
connection with any one or more of the claims asserted in these actions, such
payment could have a material adverse effect on the Company's business and
operations.
SETTLEMENT WITH COOK ASSOCIATES, INC.
On June 29, 2005, the Company entered into a settlement with Cook Associates,
Inc. ("Cook Associates") to settle all claims and potential claims related to
the lawsuit that had been filed by Cook Associates against the Company in
October 2004. Under the terms of the settlement, Cook Associates agreed to
dismiss its lawsuit and associated claim for $528,081 in damages and the Company
agreed to remove any and all conditions/restrictions that would prevent the
600,000 shares of Company common stock owned by Cook Associates from being
freely traded. The Company had previously recorded $389,103 of payables to Cook
Associates that it reversed following its execution of the settlement. The
reversal was recorded as a gain and is included in loss/(gain) on settlement
agreements in the accompanying statements of operations for the six and three
months ended June 30, 2005.
SEC INVESTIGATION
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating Officers to Take Testimony (C-03739-A, February 12, 2004)) (the
"Order") that a private investigation (the "SEC Investigation") be made to
determine whether certain actions of, among others, the Company, certain of its
officers and directors and others violated Section 5(a) and 5(c) of the
Securities Act and/or Section 10 and Rule 10b-5 promulgated under the Exchange
Act. Generally, the Order provides, among other things, that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8, filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the resale of, in the aggregate, 4,375,000 shares of common stock issued to
various consultants of the Company, and (ii) whether in connection with the
purchase or sale of shares of common stock, certain officers and directors of
the Company and others (a) sold common stock in violation of Section 5 of the
Securities Act and/or, (b) made misrepresentations and/or omissions of material
facts and/or employed fraudulent devices in connection with such purchases
and/or sales relating to certain of the Company's press releases regarding,
among other items, proposed mergers and acquisitions that were never
consummated. If the SEC brings an action against the Company, it could result
in, among other items, a civil injunctive order or an administrative
cease-and-desist order being entered against the Company, in addition to the
imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely the Company's ability to
have its common stock become listed on a stock exchange and/or quoted on the
NASD Bulletin Board or NASDAQ, the Company being able to sell its securities
and/or have its securities registered with the SEC and/or in various states
and/or the Company's ability to implement its business plan. To date, the
Company's legal counsel representing the Company in such matters has indicated
that the SEC Investigation is ongoing and the Staff has not indicated whether it
will or will not recommend that the SEC bring an enforcement action against the
Company, its officers, directors and/or others.
25
NOTE R - STOCKHOLDERS' EQUITY
ISSUANCE OF COMMON STOCK AS PURCHASE CONSIDERATION
On February 25, 2005 the Company committed to issue an aggregate of 11,900,000
shares of its common stock with an aggregate fair value of $10,115,000 as
purchase consideration to the sellers of CSSI and LucidLine (Note E). On
February 28, 2005, the Company committed to issue an additional 3,000,000 shares
of its common stock with an aggregate fair value of $2,550,000 as purchase
consideration to the sellers of Entelagent (Note E). The aforementioned
transactions were recorded as common stock to be issued in the statement of
stockholder's equity (deficiency). The Company issued 3,220,904 of these shares
to certain of the selling stockholders during the quarter ended June 30, 2005
and the remaining shares are presented as common stock to be issued in the
accompanying balance sheet at June 30, 2005.
ISSUANCE OF COMMON STOCK PURCHASE WARRANTS
On February 25, 2005, the Company issued 2,250,000 common stock purchase
warrants with a term of 5 years and an exercise price of $0.70 per share as a
portion of purchase consideration associated with the acquisition of the
preferred stock of CSSI (Note E). The aggregate fair value of these warrants
amounted to $1,912,500.
On February 28, the Company issued warrants to purchase up to 1,750,000 shares
of its common stock to the Bridge Notes investors described in Note H.
Additionally, the Company issued 350,000 common stock purchase warrants with an
aggregate fair value of $297,500 to the Placement Agent in the Interim Bridge
Financing I transaction.
On February 28, the Company also issued warrants for 300,000 shares at a $0.70
per share exercise price to Laidlaw and/or its designees in connection with the
receipt of acquisition related services for the Entelagent, LucidLine and CSSI
mergers (Note E). The aggregate fair value of these warrants amounted to
$255,000.
On June 6, 2005, the Company issued warrants to purchase up to 1,271,500 shares
of its common stock at $0.60 per share exercise price to the Interim Bridge
Financing II investors described in Note K. The fair value of the warrants
amounted to $282,556.
On June 30, 2005 the Company issued warrants for 152,580 shares at a $0.60 per
share exercise price to Laidlaw in connection with the Interim Bridge Financing
II financing. The aggregate fair value of these warrants amounted to $38,145 and
was accounted for as deferred financing costs.
On June 29, 2005, the Company issued warrants to purchase up to 1,750,000 shares
of its common stock at $0.70 per share exercise price, as Bridge Extension
Warrants, to the investors in Interim Bridge Financing I as described in Note K.
The fair value of the warrants, which amounts to $822,500, was accounted for as
a deferred financing cost.
All of the aforementioned warrants are reflected as an increase to additional
paid-in capital in the accompanying balance sheet and statement of stockholders'
(deficiency) equity at June 30, 2005.
ISSUANCE OF COMMON STOCK AS PENALTY UNDER AN ACCOMMODATION AGREEMENT
The Accommodation Agreements (Note P) provided for a penalty in the event the
Company failed to register the replacement shares on or before March 31, 2003.
The replacement shares were not registered on or before March 31, 2003. As a
result, the Company has accrued a penalty of 450,000 shares per quarter for the
five stockholders, in the aggregate. The Company recorded charges of $627,000
and $595,200, for the six months ended June 30, 2005 and 2004, respectively. The
Company intends to include the replacement and penalty shares in a registration
statement to be filed in 2005, at which time the penalty will cease to accrue.
The penalty shares are presented as common stock to be issued in the
accompanying balance sheet and statements of stockholders' (deficiency) equity
at June 30, 2005.
STOCK ISSUED UNDER STOCK PLEDGE ARRANGEMENT
The Company issued an aggregate of 890,500 shares of common stock (Replacement
Shares and Premium Shares) with an aggregate fair value of $406,205 and recorded
a commitment to issue an additional 85,576 shares of stock with a fair value of
$62,102 as penalties for the delays in registering the stock under the original
agreement (Note P).
STOCK ISSUED IN LIEU OF CASH FOR SERVICES
On June 8, 2005, the Company negotiated a settlement regarding the Consulting
Agreement Payable with a related party. As part of this agreement, an obligation
to issue 100,000 shares of unrestricted common stock previously recorded in the
quarter ended September 30, 2004 was terminated. This termination resulted in a
reduction in general and administrative expenses of $78,900 and the reduction of
100,000 shares from the Shares to be Issued classification.
26
NOTE S - SUBSEQUENT EVENTS
ADVANCES FROM STOCKHOLDERS
On July 1, 2005, the Company received an additional $200,000 advance from
Northwestern. On July 29, 2005, the Company received a $100,000 advance from
Advanced Equities, on August 3, 2005 the Company received a $250,000 advance
from Apex and on August 18, 2005, the Company received an additional $200,000
advance from Apex. Northwestern, Advanced Equities and Apex are current stock
and warrant holders of the Company. Expenses incurred in connection with
transaction include $6,000.
In consideration of this financing from Northwestern, Advanced Equities and
Apex, the parties have mutually agreed that Northwestern, Advanced Equities and
Apex will be offered the same terms as investors in the Interim Bridge Financing
II, described in Note K above. This mutual agreement was entered into on a
verbal basis. As of the date of this filing, the Company has issued definitive
documents to Northwestern and has finalized terms and is currently in the
process of finalizing definitive agreements and notes with respect to these
stockholder advances.
ALLIN SETTLEMENT AGREEMENT - EXTENSION OF TIME TO ARRANGE FINANCING
On August 15, 2005, the Company and Patrick J. Allin ("Allin") and the Allin
Dynastic Trust ("Allin Trust") entered into an agreement to provide Patron with
up to an additional 120 days to arrange the follow-on-financing described in
Note O. Under the terms of the time extension, 1) the Company agrees that the 6
month lockup period for the Allin and Allin Trust shares shall begin August 15,
2005. 2) the Company will pay Allin a penalty of $500 per day for each day after
August 15 that the $950,000 remains unpaid. 3) the Company will also pay the
Allin Trust a $100 per day penalty for each day after August 31 that the
interest on the promissory note to purchase the Allin Trust shares remains
unpaid provided that $8,000 of this interest is paid by September 15, 2005. If
the September 15th amount is not paid, the Company will pay a $250 per day
penalty commencing August 31, 2005 with all overdue interest and penalties to be
paid out of the follow-on-financing. If the promissory note interest of $16,000
due on November 30, 2005 is not paid by that date, an additional $250 per day
penalty will be paid. 4) the Company shall pay Allin a $100 per day penalty for
each day after August 31 that the interest on the promissory note to purchase
the Allin shares remains unpaid provided that $8,000 of this interest is paid by
September 15, 2005. If the September 15th amount is not paid, the Company will
pay a $250 per day penalty commencing August 31, 2005 with all overdue interest
and penalties to be paid out of the follow-on-financing. If the promissory note
interest of $16,000 due on November 30, 2005 is not paid by that date, an
additional $250 per day penalty will be paid. 5) At the end of the 120 day
extension period, if the Company has not completed its follow-on-financing and
made all payments to Allin and the Allin Trust due and owing under the amended
agreement, all payments under the amended agreement will become immediately due
and owing. Allin and the Allin Trust will have the option of keeping the Initial
and Remainder Shares or demanding payment of the associated notes. The Company
will confess to a judgment in a court of Allin's choosing for the $950,000 and
the promissory notes for purchase of the Allin Trust shares (if payment is
demanded for the notes to purchase shares). Any actions which would preclude the
Company making the payments under this agreement will accelerate all payments
due and the Company will confess to judgment. The parties are in the process of
finalizing a definitive agreement.
ROBERT CROSS, CHIEF EXECUTIVE OFFICER - EMPLOYMENT AGREEMENT
On July 1, 2005, the Company entered into an employment agreement (the
"Employment Agreement") with Robert W. Cross ("Mr. Cross"), the Company's Chief
Executive Officer. The term of the Employment Agreement is one year with
automatic one-year renewal unless Mr. Cross is provided with written notice of
non-renewal 90 days prior to expiration of the current term of the Employment
Agreement. The Employment Agreement provides for a base salary of $200,000 per
year with a non-recoverable draw of $100,000 (grossed up for taxes) during the
first six months of the Agreement. The Employment Agreement provides for a
performance bonus determined in accordance with revenue milestones established
by the Board of Directors on a quarterly basis Mr. Cross is eligible to receive
a bonus of up to 100% of base salary for each quarter that the Company achieves
the agreed upon revenue milestones. Additionally, the Employment Agreement
provides for the grant of 1,000,000 stock options at an exercise price of $0.65
per share with the options vesting 25% on July 1, 2005, 25% on September 30,
2005, 25% on December 31, 2005 and 25% on March 31, 2006. The options shall
expire on June 30, 2012. Finally, during the term of the Employment Agreement,
the Board of Directors shall nominate Mr. Cross to become a member of the Board
of Directors.
27
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
PATRON SYSTEMS, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
JUNE 30, 2005
The following discussion and analysis should be read in conjunction with the
Annual Report on Form 10-KSB, including the consolidated financial statements,
and the related notes thereto, for the years ended December 31, 2004, 2003 and
2002 of Patron Systems, Inc. and subsidiaries (collectively referred to as
"Patron," the "Company," "we," "us," or "our"). Except for historical
information contained herein, the matters discussed below are forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Such statements involve risks and uncertainties,
including, but not limited to, economic, governmental, political, competitive
and technological factors affecting our operations, markets, products, prices
and other factors discussed elsewhere in this report and other reports filed by
us with the Securities and Exchange Commission ("SEC"). These factors may cause
results to differ materially from the statements made in this report or
otherwise made by or on our behalf.
OVERVIEW
On February 25, 2005, we consummated the acquisitions of Complete Security
Solutions, Inc. ("CSSI") and LucidLine, Inc. ("LucidLine") pursuant to the
filings of Agreements and Plans of Merger with the Secretaries of State of the
States of Delaware and Illinois, respectively. On February 28, 2005, we
consummated a private placement with accredited investors in the amount of $3.5
million. On March 30, 2005, we consummated the acquisition of Entelagent
Software Corp. ("Entelagent") pursuant to the filing of an Agreement and Plan of
Merger with the Secretary of State of the State of California. From March 31,
2005 to June 30, 2005, we borrowed $1,650,000 from a shareholder, Apex
Investment Fund V, LP. During the three months ended June 30, 2005 we raised
approximately $3,693,000 in additional gross funds in four capital financing
transactions. Net proceeds from all of these transactions amounted to $3,387,840
which were used principally to fund operations and repay certain liabilities. We
discuss these transactions in further detail in this report.
Our acquisitions have allowed us to develop a platform for trusted security
services and next generation integrated security products, which we intend to
deliver to global corporations and government institutions. We intend to work
with organizations to ensure that global enterprises implement information
security policies, procedures and products that result in "trusted" information
environments.
We currently offer software solutions that fit into overall corporate compliance
and data protection initiatives by automatically finding, archiving and applying
persistent protection to sensitive data - beyond authentication - whenever,
wherever and however sensitive data is shared, accessed and stored. Additionally
we offer software solutions that support real-time secure collection, delivery
and sharing of field-based report information. This software allows law
enforcement and public-safety agencies to have real-time access to field
reporting data for use inside a department or in a multi-jurisdictional
information sharing system.
We also offer a range of services to corporate and government entities utilizing
fiber optics and data replication technologies to provide secure robust off-site
data backup, recovery, restoration, and retrieval services coupled with
high-speed data communication turnkey solutions. Our secure and scalable
high-speed data communication solutions facilitate seamless instantaneous backup
of mission critical business data and enable immediate access to data and
real-time restoration of critical business functionality in the event of a
crisis or disaster. Additionally, we offer our clients a comprehensive Risk and
Vulnerability Assessment (RAVA) evaluation service. This service provides
security and business impact assessments, which evaluate an organization's
compliance with both Homeland Security and NTSA standards.
Furthermore, we intend to address the homeland security requirements that are
being imposed on state, county and
28
municipal governments. The Company believes that we offer state, county and
municipal governments a unique group of product and service offerings focused on
their specific homeland security information infrastructure issues. This is
accomplished by utilizing the full range of our capabilities for evaluating and
assessing information infrastructure risks and vulnerabilities, combined with
our experience in designing, implementing and managing large, secure information
infrastructure systems. Also contributing is our extensive experience in
implementing real-time, secure data collection and the multi-jurisdictional
sharing of law enforcement and public-safety information combined with our
experience in developing and deploying software solutions which provide secure
data and content delivery and management.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the Condensed Consolidated Financial Statements and Notes thereto. Our
application of accounting policies affects these estimates and assumptions.
Actual results could differ from these estimates under different assumptions or
conditions.
BASIS OF PRESENTATION
In accordance with Statement of Financial Accounting Standard ("SFAS") No.7, we
considered our business to be a development stage enterprise through December
31, 2004, as our activities principally consisted of raising capital and
screening potential acquisition candidates in the information and homeland
security segments, During the quarter ended March 31, 2005, we effected business
combinations with CSSI, LucidLine and Entelagent. Each of the acquired
businesses has developed technologies, customer bases and generates revenue.
Accordingly, we no longer consider our business to be a development stage
enterprise effective for the six months ended June 30, 2005.
REVENUE RECOGNITION
We derive revenues from the following sources: (1) sales of computer software,
which includes new software licenses and software updates and product support
revenues and (2) services, which include internet access, back-up, retrieval and
restoration services and professional consulting services.
We apply the revenue recognition principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff Accounting Bulletin ("SAB") 104 "Revenue Recognition" with
respect to all of its revenue. Accordingly, we record revenue when (i)
persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii)
the vendor's fee is fixed or determinable, and (iv) collectability is probable.
We generate revenues through sales of software licenses and annual support
subscription agreements which include access to technical support and software
updates (if and when available). Software license revenues are generated from
licensing the rights to use our products directly to end-users and through third
party service providers.
Revenues from software license agreements are generally recognized upon delivery
of software to the customer. All of our software sales are supported by a
written contract or other evidence of sale transaction such as a customer
purchase order. These forms of evidence clearly indicate the selling price to
the customer, shipping terms, payment terms (generally 30 days) and refund
policy, if any. The selling prices of these products are fixed at the time the
sale is consummated.
Revenue from post contract customer support arrangements or undelivered elements
are deferred and recognized at the time of delivery or over the period in which
the services are performed based on vendor specific objective evidence of fair
value for such undelivered elements. Vendor specific objective evidence is
typically based on the price charged when an element is sold separately or, if
an element is not sold separately, on the price established by an authorized
level of management, if it is probable that the price, once established, will
not change before market introduction. We use the residual method prescribed in
SOP 98-9 to allocate revenues to delivered elements once it has established
vendor-specific evidence for such undelivered elements.
29
We provide internet access and back-up, retrieval and restoration services under
contractual arrangements with terms ranging from 1 year to 5 years. These
contracts are billed monthly, in advance, based on the contractually stated
rates. At the inception of a contract, we may activate the customer's account
for a contractual fee that it amortizes over the term of the contract in
accordance with Emerging Issues Task Force Issue ("EITF") 00-21 "Revenue
Arrangements with Multiple Deliverables." Our standard contracts are
automatically renewable by the customer unless terminated on 30 days written
notice. Early termination of the contract generally results in an early
termination fee equal to the lesser of six months of service or the remaining
term of the contract.
Professional consulting services are billed based the number of hours of
consultant services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.
Revenue from the resale of third-party hardware and software is recognized upon
delivery provided there are no further obligations to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract satisfies the requirements of
EITF 99-19.
BUSINESS COMBINATIONS
In accordance with business combination accounting, we allocate the purchase
price of acquired companies to the tangible and intangible assets acquired,
liabilities assumed, as well as in-process research and development based on
their estimated fair values. We have engaged a third-party appraisal firm to
assist management in determining the fair values of certain assets acquired and
liabilities assumed. Such a valuation requires management to make significant
estimates and assumptions, especially with respect to intangible assets.
Management makes estimates of fair value based upon assumptions believed to be
reasonable. These estimates are based on historical experience and information
obtained from the management of the acquired companies. Critical estimates in
valuing certain of the intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements, customer
contracts and acquired developed technologies; expected costs to develop the
in-process research and development into commercially viable products; the
acquired company's brand awareness and market position, as well as assumptions
about the period of time the acquired brand will continue to be used in the
combined company's product portfolio; and discount rates. These estimates are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur which may
affect the accuracy or validity of such assumptions, estimates or actual
results.
GOODWILL AND INTANGIBLE ASSETS
We account for Goodwill and Intangible Assets in accordance with SFAS No. 141,
"Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets." Under SFAS No. 142, goodwill and intangibles that are deemed to have
indefinite lives are no longer amortized but, instead, are to be reviewed at
least annually for impairment. Intangible assets continue to be amortized over
their estimated useful lives.
INCOME TAXES
We account for income taxes pursuant to SFAS No. 109, Accounting for Income
Taxes. Deferred taxes arise from temporary differences, primarily attributable
to the use of the cash method for tax purposes and accrual method for book
purposes and net operating loss carry-forwards.
NET LOSS PER SHARE
Basic net loss per common share is computed by dividing net loss by the
weighted-average number of common shares outstanding during the period. Diluted
net loss per common share also includes common stock equivalents outstanding
during the period if dilutive. Diluted net loss per common share has been
computed by dividing net loss by the weighted-average number of common shares
outstanding without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.
30
STOCK OPTION PLANS
As permitted under SFAS No. 148 "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended SFAS No. 123 "Accounting for
Stock-Based Compensation," we have elected to continue to follow the intrinsic
value method in accounting for our stock-based compensation arrangements as
defined by Accounting Principles Board ("APB") Opinion No. 25 "Accounting for
Stock Issued to Employees," and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44 "Accounting for
Certain Transactions Involving Stock Compensation," an interpretation of APB No.
25.
NON-EMPLOYEE STOCK BASED COMPENSATION
We record the cost of stock based compensation awards that we have issued to
non-employees for services at either the fair value of the services rendered or
the instruments issued in exchange for such services, whichever is more readily
determinable, using the measurement date guidelines enumerated in Emerging
Issues Task Force Issue ("EITF") 96-18, "Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2005 COMPARED TO THE THREE MONTHS ENDED JUNE 30,
2004.
For the three months ended June 30, 2005, our consolidated revenues amounted to
$137,411 compared to $0 for the three months ended June 30, 2004. The increase
is the result of business combinations that we consummated with CSSI and
LucidLine in February 2005 and Entelagent in March 2005.
Cost of Sales for the three months ended June 30, 2005 amounted to $184,674
compared to $0 for the three months ended June 30, 2004. Cost of sales during
the three months ended June 30, 2005 includes $128,501 associated with the
amortization of developed technology that we acquired from CSSI and Entelagent.
Operating expenses amounted to $3,260,216 for the three months ended June 30,
2005 as compared to $613,873 for the three months ended June 30, 2004, an
increase of $2,646,343. The increase includes approximately $1,426,000 for
salaries associated with an increase in the number of employees from acquired
businesses, approximately $363,000 for the amortization of a stock based
compensation arrangement that we entered into during the year ended December 31,
2004 (for corporate finance advisory services), approximately $455,000 for legal
and professional fees that we incurred principally in connection with bringing
the Company into compliance with its Securities and Exchange Commission
reporting obligations, approximately $31,000 for amortization of acquired
intangible assets, approximately $123,000 for increased general and
administrative expenses associated with the acquired businesses, $366,000 loss
on collateralized financing arrangement and $370,000 associated with the
preparation of a homeland security operational requirements assessment related
to Will County, Illinois. These increases were partially offset by a $20,000
reduction in expense associated with a penalty provision of an Accommodation
Agreement, the reversal of a $79,000 stock-based compensation charge realized
upon the settlement of a consulting agreement and a gain of approximately
$389,000 on the settlement of a legal claim.
Our consolidated loss from operations for the three months ended June 30, 2005
amounted to $3,307,479 compared to a loss of $613,873 for the same period in
2004. Our loss increased as a result of the increases and decreases in our
revenues and operating expenses discussed above.
Interest expense during the three months ended June 30, 2005 amounted to
$1,721,026 as compared to $33,088 for the three months ended June 30, 2004. The
increase is directly related to our issuances of notes and the increased
borrowings that we made to finance our acquisitions of CSSI, LucidLine and
Entelagent and fund our working capital needs. Non cash interest relating to
deferred financing costs and the accretion of debt discounts during the three
months ended June 30, 2005 amounted to approximately $854,000 compared to $0 in
same period in 2004. Amortization of deferred finance charges which have been
classified as interest expense was approximately $557,000 in the three months
ended June 30, 2005 compared to $0 in the same period in 2004. Interest income,
was $0 and $19,250 in the three months ended June 30, 2005 and 2004,
respectively. Interest income represents the interest earned from loans that we
made to Entelagent prior to our acquisition of that business on March 30, 2005.
31
For the three months ended June 30, 2005, the net loss was $5,028,505 or $(0.08)
per share on 60,984,682 weighted average shares outstanding compared to a net
loss of $627,711 or $(0.02) per share on 38,565,596 weighted average shares
outstanding for the three months ended June 30, 2004.
SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2004.
For the six months ended June 30, 2005, our consolidated revenues amounted to
$186,271 compared to $0 for the six months ended June 30, 2004. The increase is
the result of business combinations that we consummated with CSSI and LucidLine
in February 2005 and Entelagent in March 2005.
Cost of Sales for the six months ended June 30, 2005 amounted to $226,845
compared to $0 for the three months ended June 30, 2004. Cost of sales during
the three months ended June 30, 2005 includes $139,668 associated with the
amortization of developed technology that we acquired from CSSI and Entelagent.
Operating expenses amounted to $4,993,110 for the six months ended June 30, 2005
as compared to $1,795,447 for the six months ended June 30, 2004, an increase of
$3,197,663. The increase includes approximately $1,774,000 for salaries
associated with an increase in the number of employees from acquired businesses,
almost $794,000 for the amortization of stock based compensation arrangements,
approximately $570,000 for legal and professional fees that we incurred
principally in connection with bringing the Company into compliance with its
Securities and Exchange Commission reporting obligations, almost $39,000 for
amortization of acquired intangible assets, approximately $18,000 for increased
general and administrative expenses associated with the acquired businesses,
$366,194 loss on collateralized financing arrangement and a $370,000 expense
associated with the preparation of a homeland security operational requirements
assessment related to Will County, Illinois. These increases were partially
offset by a $439,000 reduction in expense associated with losses taken on
settlement agreements and a gain of approximately $389,000 on the settlement of
a legal claim
Our consolidated loss from operations for the six months ended June 30, 2005
amounted to $4,933,110 compared to a loss of $1,795,447 for the same period in
2004. Our loss increased as a result of the increases and decreases in our
revenues and operating expenses discussed above.
Interest expense during the six months ended June 30, 2005 amounted to
$2,217,866 as compared to $66,176 for the six months ended June 30, 2004. The
increase is directly related to our issuances of notes and the increased
borrowings that we made to finance our acquisitions of CSSI, LucidLine and
Entelagent and fund our working capital needs. Amortization of interest
accretion during the six months ended June 30, 2005 was approximately $1,177,000
compared to $0 in same period in 2004. Amortization of deferred finance charges
which have been classified as interest expense was approximately $711,000 in the
six months ended June 30, 2005 compared to $0 in the same period in 2004.
Interest income, was $19,250 and $38,500 in the six months ended June 30, 2005
and 2004, respectively. Interest income represents the interest earned from
loans that we made to Entelagent prior to our acquisition of that business on
March 30, 2005.
For the six months ended June 30, 2005, the net loss was $7,232,300 or $(0.13)
per share on 55,143,168 weighted average shares outstanding compared to a net
loss of $1,823,123 or $(0.05) per share on 38,595,756 weighted average shares
outstanding for the six months ended June 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
We incurred a net loss of $7,232,300 for the six months ended June 30, 2005,
which includes $3,729,955 of non-cash charges associated with the fair value of
common stock we issued as penalties under certain registration rights agreements
($689,102), amortization of deferred compensation under a stock based
compensation arrangement ($952,875), accretion related to warrants issued in
conjunction with notes payable ($1,177,040) amortization of deferred financing
costs ($710,586), and depreciation and amortization ($200,352). The non-cash
charges were offset by non-cash gains of $228,900 associated with the settlement
of a related party consulting agreement, $40,012 associated with the settlement
of an advance from a stockholder, a gain on legal settlement of $389,103 and
$19,250 non-cash interest income. Including the amounts above, we used net cash
flows in our operating activities of $5,611,168 during the six months ended June
30, 2005. Our working capital deficiency at June 30, 2005 amounts to $20,245,674
and we are continuing to experience shortages in working capital. We are also
involved in substantial litigation and are being investigated by the Securities
and Exchange Commission with respect to certain of our press releases and our
use of form S-8 to register shares of common stock that we issued to certain
consultants in prior periods. We cannot provide any assurance that the outcome
of these matters will not have a material adverse affect on our ability to
sustain the business. These matters raise substantial doubt about our ability to
continue as a going concern.
32
We expect to continue incurring losses for the foreseeable future due to the
inherent uncertainty that is related to establishing the commercial feasibility
of technological products and developing a presence in new markets. The
Company's ability to successfully integrate the acquired businesses described in
Note E is critical to the realization of its business plan. The Company raised
$7,693,000 of gross proceeds ($7,071,261 net proceeds after the payment of
certain transaction expenses) in financing transactions during the six months
ended June 30, 2005. The Company used $5,611,168 of these proceeds to fund its
operations (which includes a $1,388,000 escrow deposit for the payment of
liabilities assumed in business combinations), and a net of $489,052 in
investing activities, which principally includes the cash component of purchase
business combinations that the Company consummated (during February and March of
2005), net of cash acquired in the business combinations and the purchase of
property and equipment.. In addition, the Company repaid an aggregate of
$499,317 of certain obligations due to certain officer/stockholders. Subsequent
to June 30, 2005 the Company raised approximately $750,000 in additional gross
funds in four capital financing transactions. Net proceeds from these
transaction amounted to $744,000 that were used principally to fund operations.
We are currently in the process of attempting to raise additional capital and
have taken certain steps to conserve our liquidity while we continue to
integrate the acquired businesses. Although we believe that we have access to
capital resources, we have not secured any commitments for additional financing
at this time nor can we provide any assurance that we will be successful in our
efforts to raise additional capital and/or successfully execute our business
plan.
OFF-BALANCE SHEET ARRANGEMENTS
At June 30, 2005, we did not have any relationships with unconsolidated entities
or financial partnerships, such as entities often referred to as structured
finance, variable interest or special purpose entities, which would have been
established for the purpose of facilitating off-balance sheet arrangements or
other contractually narrow or limited purposes. As such, we are not exposed to
any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.
CAUTIONARY STATEMENTS AND RISK FACTORS
The risks noted below and elsewhere in this report and in other documents we
file with the SEC are risks and uncertainties that could cause our actual
results to differ materially from the results contemplated by the
forward-looking statements contained in this report and other public statements
we make.
RISKS RELATED TO OUR COMMON STOCK
THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
may become insolvent. As of June 30, 2005, our cash balance was $317,625 and we
had a working capital deficit of $20,245,674. This raises substantial doubt
about our ability to continue as a going concern. Historically, we have funded
our capital requirements with debt and equity financing. Our ability to obtain
additional equity or debt financing depends on a number of factors including our
financial performance and the overall conditions in our industry. If we are not
able to raise additional financing or if such financing is not available on
acceptable terms, we may liquidate assets, seek or be forced into bankruptcy,
and/or continue operations but suffer material harm to our operations and
financial condition. These measures could have a material adverse affect on our
ability to continue as a going concern.
33
INVESTORS MAY NOT BE ABLE TO ADEQUATELY EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR LIMITED OPERATING HISTORY, LACK OF REVENUES AND LACK OF PRODUCT
OFFERINGS.
We are at an early stage of executing our business plan and have no history of
offering information security capabilities. Combined Professional Services was
incorporated in Nevada in 1995 and Patron was incorporated in Delaware in 2002.
We have not had significant business operations since inception. As a result of
our limited history, it may be difficult to plan operating expenses or forecast
our revenues accurately. Our assumptions about customer or network requirements
may be wrong. The revenue and income potential of these products is unproven,
and the markets addressed by these products are volatile. If such products are
not successful, our actual operating results could be below our expectations and
the expectations of investors and market analysts, which would likely cause the
price of our common stock to decline.
We generated no revenue from operations through December 31, 2004 and relied on
financing generated from our capital raising activities to fund the
implementation of our business plan. We have incurred operating and net losses
and negative cash flows from operations since our inception. As of June 30,
2005, we had an accumulated deficit of approximately $47 million. We may
continue to incur operating and net losses, due in part to implementing our
acquisitions strategy, engaging in financing activities and expansion of our
personnel and our business development capabilities. We will continue to seek
financing for the acquisition of other acquisition targets that we may identify
in the future. We continue to believe that we will secure financing in the near
future, but there can be no assurance of our success. If we are unable to obtain
the necessary funding, it will materially adversely affect our ability to
execute our business plan and to continue our operations.
In addition, we may not be able to achieve or maintain profitability, and, even
if we do achieve profitability, the level of any profitability cannot be
predicted and may vary significantly from quarter to quarter.
THERE CAN BE NO GUARANTY THAT A MARKET WILL DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.
We currently have a limited offering of products. We intend to acquire products
through the acquisition of existing businesses. There is no guarantee, however,
that a market will develop for Internet security solutions of the type we intend
to offer. We cannot predict the size of the market for Internet security
solutions, the rate at which the market will grow, or whether our target
customers will accept our acquired products.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH MAY RESULT IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.
The market prices of the securities of technology-related companies have
historically been volatile and may continue to be volatile. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, if operating or
capital expenditures exceed our expectations and cannot be reduced
appropriately, or if some other event adversely affects us, the market price of
our common stock could decline. Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently very limited, but is expected to increase. Sales of substantial
shares in the future would depress the price of our common stock. In addition,
we currently do not receive any stock market research coverage by any recognized
stock market research or trading firm and our shares are not traded on any
national securities exchange. A larger and more active market for our common
stock may not develop.
Because of our limited operations history and lack of assets and revenues to
date, our common stock is believed to be currently trading on speculation that
we will be successful in implementing our acquisition and growth strategies.
There can be no assurance that such success will be achieved. The failure to
implement our acquisitions and growth strategies would likely adversely affect
the market price of our common stock. In addition, if the market for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor confidence or otherwise fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations and financial condition. The market price of our common stock also
might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate
34
fluctuations, could also cause the market price of our common stock to decline.
Our common stock has experienced, and is likely to continue to experience, these
fluctuations in price, regardless of our performance.
WE ARE CURRENTLY SUBJECT TO AN SEC INVESTIGATION.
Pursuant to Section 20(a) of the Securities Act and Section 21(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), the staff of
the SEC (the "Staff"), issued an order (In the Matter of Patron Systems, Inc. -
Order Directing a Private Investigation and Designating Officers to Take
Testimony (C-03739-A, February 12, 2004)) (the "Order") that a private
investigation (the "SEC Investigation") be made to determine whether certain of
our actions, among others, certain of its officers and directors and others (as
described below) violated Section 5(a) and 5(c) of the Securities Act and/or
Section 10 and Rule 10b-5 promulgated under the Exchange Act. Generally, the
Order provides, among other things, that the Staff is investigating (i) the
legality of two (2) separate Registration Statements filed by us on Form S-8,
filed on December 20, 2002 and on April 2, 2003, as amended on April 9, 2003
(collectively, the "Registration Statements"), covering the resale of, in the
aggregate, 4,375,000 shares of common stock issued to various of our
consultants, and (ii) whether in connection with the purchase or sale of shares
of common stock, certain of our officers, directors and others (a) sold common
stock in violation of Section 5 of the Securities Act and/or, (b) made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection with such purchases and/or sales relating to certain of
our press releases regarding, among other items, proposed mergers and
acquisitions that were never consummated. If the SEC brings an action against
us, it could result in, among other items, a civil injunctive order or an
administrative cease-and-desist order being entered against us, in addition to
the imposition of a significant civil penalty. Moreover, the SEC Investigation
and/or a subsequent SEC action could affect adversely our ability to have our
common stock listed on a stock exchange and/or quoted on the NASD Bulletin Board
or NASDAQ, our ability to sell our securities and/or have our securities
registered with the SEC and/or in various states and/or our ability to implement
its business plan. To date, our legal counsel representing us in such matters
has indicated that the SEC Investigation is ongoing and the Staff has not
indicated whether it will or will not recommend that the SEC bring an
enforcement action against us, our officers, directors and/or others.
THE CONCENTRATION OF OUR CAPITAL STOCK OWNERSHIP WITH INSIDERS IS LIKELY TO
LIMIT THE ABILITY OF OTHER STOCKHOLDERS TO INFLUENCE CORPORATE MATTERS.
As of August 10, 2005, the executive officers, directors and entities affiliated
with any of them together beneficially own approximately 19.0% of our
outstanding common stock. As a result, these stockholders may be able to
exercise control over matters requiring approval by our stockholders, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership might also have the effect of delaying or
preventing a change in our control that might be viewed as beneficial by other
stockholders.
FUTURE SALES OF SHARES BY EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO
DECLINE.
If our existing or future stockholders sell, or are perceived to sell,
substantial amounts of our common stock in the public market, the market price
of our common stock could decline. As of August 19, 2005, there are 55,796,712
shares of common stock outstanding, of which all but 45,367,462 shares are held
by directors, executive officers and other affiliates, the sale of which are
subject to volume limitations under Rule 144, various vesting agreements and our
quarterly and other "blackout" periods. Furthermore, shares subject to
outstanding options and warrants and shares reserved for future issuance under
our stock option plan will become eligible for sale in the public market to the
extent permitted by the provisions of various vesting agreements, the lock-up
agreements and Rule 144 under the Securities Act.
THE UNPREDICTABILITY OF AN ACQUIRED COMPANY'S QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.
The quarterly revenues and operating results of companies we may acquire will
likely continue to vary in the future due to a number of factors, many of which
are outside of our control. Any of these factors could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:
35
o the demand for our subsidiaries' current product offerings and
our future products;
o the length of sales cycles;
o the timing of recognizing revenues;
o new product introductions by us or our competitors;
o changes in our pricing policies or the pricing policies of our
competitors;
o variations in sales channels, product costs or mix of products
sold;
o our ability to develop, introduce and ship in a timely manner
new products and product enhancements that meet customer
requirements;
o our ability to obtain sufficient supplies of sole or limited
source components for our products;
o variations in the prices of the components we purchase;
o our ability to attain and maintain production volumes and
quality levels for our products at reasonable prices at our
third-party manufacturers;
o our ability to manage our customer base and credit risk and to
collect our accounts receivable; and
o the financial strength of our value-added resellers and
distributors.
Our operating expenses are largely based on anticipated revenues and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, lower than anticipated revenues for any reason could cause
significant variations in our operating results from quarter to quarter and,
because of our rapidly growing operating expenses, could result in substantial
operating losses.
OUR COMMON STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES. THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.
If at any time a company has net tangible assets of $5,000,000 or less and the
common stock has a market price per share of less than $5.00, transactions in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:
o make a special written suitability determination for the
purchaser;
o receive the purchaser's written agreement to a transaction
prior to sale;
o provide the purchaser with risk disclosure documents which
identify certain risks associated with investing in "penny
stocks" and which describe the market for these "penny stocks"
as well as a purchaser's legal remedies; and
o obtain a signed and dated acknowledgment from the purchaser
demonstrating that the purchaser has actually received the
required risk disclosure document before a transaction in a
"penny stock" can be completed.
If our common stock becomes subject to these rules, broker-dealers may find it
difficult to effectuate customer transactions and trading activity in our
securities may be adversely affected. As a result, the market price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.
RISKS RELATED TO OUR BUSINESS
WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.
Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently. The process of integrating could
cause an interruption of, or loss of momentum in, the activities of our business
and the loss of key personnel. The diversion of management's attention and any
delays or difficulties encountered in connection with our integration of
acquired operations could have an adverse effect on our business, results of
operations, financial condition or prospects. WE CURRENTLY DO NOT HAVE
SUFFICIENT REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES AND IF OPERATING LOSSES
CONTINUE, WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL THROUGH FINANCINGS WHICH
WE MAY NOT BE ABLE TO SECURE.
To achieve our intended growth, we will require substantial additional capital.
We have encountered difficulty and delays in raising capital to date and the
market environment for development stage companies, like ours, remains
36
particularly challenging. There can be no assurance that funds will be available
when needed or on acceptable terms. Technology companies in general have
experienced difficulty in recent years in accessing capital. Inability to obtain
additional financing may require us to delay, scale back or eliminate certain of
our growth plans which could have a material and adverse effect on our business,
financial condition or results of operations or to cease operations. Even if we
are able to obtain additional financing, such financing could be structured as
equity financing that would dilute the ownership percentage of any investor in
our securities.
DOWNTURNS IN THE INTERNET INFRASTRUCTURE, NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.
The market for our current products and other products we intend to offer
depends on economic conditions affecting the broader Internet infrastructure,
network security and related markets. Downturns in these markets may cause
enterprises and carriers to delay or cancel security projects, reduce their
overall or security-specific information technology budgets or reduce or cancel
orders for our current products and other products we intend to offer. In this
environment, customers such as distributors, value-added resellers and carriers
may experience financial difficulty, cease operations and fail to budget or
reduce budgets for the purchase of our current products or other products we
intend to offer. This, in turn, may lead to longer sales cycles, delays in
purchase decisions, payment and collection, and may also result in price
pressures, causing us to realize lower revenues, gross margins and operating
margins. In addition, general economic uncertainty caused by potential
hostilities involving the United States, terrorist activities, the decline in
specific markets such as the service provider market in the United States, and
the general decline in capital spending in the information technology sector
make it difficult to predict changes in the purchase and network requirements of
our potential customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on information technology. A decline in capital spending in the markets we
intend to serve may adversely affect our future revenues, gross margins and
operating margins and make it necessary for us to gain significant market share
from our future competitors in order to achieve our financial goals and achieve
profitability.
COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.
The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and
introduce new competitive products for the same markets and customers we intend
to serve with our products. These products may have better performance, lower
prices and broader acceptance than the products we currently offer or intend to
offer.
Many of our potential competitors have longer operating histories, greater name
recognition, large customer bases and significantly greater financial,
technical, sales, marketing and other resources than we have. In addition, some
of our potential competitors currently combine their products with other
companies' networking and security products. These potential competitors also
often combine their sales and marketing efforts. Such activities may result in
reduced prices, lower gross and operating margins and longer sales cycles for
the products we currently offer and intend to offer. If any of our larger
potential competitors were to commit greater technical, sales, marketing and
other resources to the markets we intend to serve, or reduce prices for their
products over a sustained period of time, our ability to successfully sell the
products we intend to offer, increase revenue or meet our or market analysts
expectations could be adversely affected.
FAILURE TO ADDRESS EVOLVING STANDARDS IN THE NETWORK SECURITY INDUSTRY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD
CAUSE OUR REVENUES TO DECLINE.
The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving industry standards. We expect to introduce our products and
enhancements to existing products to address current and evolving customer
requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced
security capabilities into our intended product offerings. Some of these
products and enhancements may require us to develop new hardware architectures
that involve complex and time-consuming processes. In developing and introducing
our intended product offerings, we have made, and will continue to make,
assumptions with respect to which features, security standards and performance
criteria will be required by our potential customers. If we implement features,
security standards and performance criteria that are different from
37
those required by our potential customers, market acceptance of our intended
product offerings may be significantly reduced or delayed, which would harm our
ability to penetrate existing or new markets.
Furthermore, we may not be able to develop new products or product enhancements
in a timely manner, or at all. Any failure to develop or introduce these new
products and product enhancements might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer deployments and, as a consequence, our revenues may be adversely
affected. In addition, the introduction of products embodying new technologies
could render existing products we intend to offer obsolete, which would have a
direct, adverse effect on our market share and revenues. Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating results to be below our expectations
and the expectations of investors and market analysts, which would likely cause
the price of our common stock to decline.
WE HAVE MATERIAL WEAKNESSES IN OUR FINANCIAL SYSTEMS, INTERNAL CONTROLS AND
OPERATIONS THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS,
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our ability to sell our intended product offerings and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls. Our
Chief Executive Officer and Acting Chief Financial Officer evaluated the
effectiveness of our disclosure controls and procedures in accordance with
Exchange Act Rules 13a-15 or 15d-15 and identified material weaknesses in our
internal control relating to, among other things, our limited segregation of
duties, ability to identify and record complex transactions including capital
financing transactions and business combinations and timely file our tax
returns. The identification of these material weaknesses has led our Chief
Executive Officer and Acting Chief Financial Officer to conclude that our
disclosure controls and procedures are currently not adequate to enable us to
record, process, summarize and report information required to be included in our
periodic SEC filings within the required time period.
We have limited management resources to date and are still establishing our
management and financial systems. Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources, systems, processes and
controls. To address these issues, we will need to continue to improve our
financial and managerial controls, reporting systems and procedures, and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.
IF OUR FUTURE PRODUCTS DO NOT INTEROPERATE WITH OUR END CUSTOMERS' NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED, WHICH COULD SIGNIFICANTLY REDUCE
OUR ANTICIPATED REVENUES.
Future products will be designed to interface with our end customers' existing
networks, each of which have different specifications and utilize multiple
protocol standards. Many end customers' networks contain multiple generations of
products that have been added over time as these networks have grown and
evolved. Our future products must interoperate with all of the products within
these networks as well as with future products that might be added to these
networks in order to meet end customers' requirements. If we find errors in the
existing software used in our end customers' networks, we may elect to modify
our software to fix or overcome these errors so that our products will
interoperate and scale with their existing software and hardware. If our future
products do not interoperate with those within our end customers' networks,
installations could be delayed or orders for our products could be cancelled,
which could significantly reduce our anticipated revenues.
AS A PUBLIC COMPANY, WE MAY INCUR INCREASED COSTS AS A RESULT OF RECENTLY
ENACTED AND PROPOSED CHANGES IN LAWS AND REGULATIONS RELATING TO CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.
Recently enacted and proposed changes in the laws and regulations affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased costs for us as we
evaluate the implications of these laws, regulations and standards and respond
to their requirements. These laws and regulations could make it more difficult
or more costly for us to obtain certain types of insurance, including director
and officer liability insurance, and we may be forced to accept reduced policy
limits and coverage or incur substantially higher costs to obtain the same or
similar coverage. The impact of these events could also make it more difficult
for us to attract and retain qualified persons to serve on our board of
directors,
38
board committees or as executive officers. We cannot estimate the amount or
timing of additional costs we may incur as a result of these laws and
regulations.
WE WILL DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A
RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO HIRE ADDITIONAL PERSONNEL OR
RETAIN EXISTING PERSONNEL, OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY WOULD BE
IMPAIRED.
Our future success depends upon the continued services of our executive
officers. The loss of the services of any of our key employees, the inability to
attract or retain qualified personnel in the future, or delays in hiring
required personnel, could delay the development and introduction of, and
negatively impact our ability to sell, our intended product offerings.
WE MIGHT HAVE TO DEFEND LAWSUITS OR PAY DAMAGES IN CONNECTION WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.
Because our intended product offerings and services provide and monitor network
security and may protect valuable information, we could face claims for product
liability, tort or breach of warranty. Anyone who circumvents our security
measures could misappropriate the confidential information or other property of
end customers using our products, or interrupt their operations. If that
happens, affected end customers or others may sue us. Defending a lawsuit,
regardless of its merit, could be costly and could divert management attention.
Our business liability insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.
WE COULD BECOME SUBJECT TO LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may become a party
to litigation in the future to protect our intellectual property or as a result
of an alleged infringement of another party's intellectual property. Claims for
alleged infringement and any resulting lawsuit, if successful, could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation could also force us to do one or more
of the following:
o stop or delay selling, incorporating or using products that
use the challenged intellectual property; and/or
o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology, which
license might not be available on reasonable terms or at all;
or redesign the products that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.
THE INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT ENHANCEMENTS COULD REQUIRE US TO OBTAIN SUBSTITUTE TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, we may be required to license technology from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms or at all. The inability to
obtain any third-party license required to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards or at greater cost, which could seriously harm our
business, financial condition and results of operations.
GOVERNMENTAL REGULATIONS AFFECTING THE IMPORT OR EXPORT OF PRODUCTS COULD
NEGATIVELY AFFECT OUR REVENUES.
Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and
domestic sales. The United States and various foreign governments have imposed
controls, export license requirements and restrictions on the import or export
of some technologies,
39
especially encryption technology. In addition, from time to time, governmental
agencies have proposed additional regulation of encryption technology, such as
requiring the escrow and governmental recovery of private encryption keys.
In particular, in light of recent terrorist activity, governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology. Additional regulation of encryption technology could delay or
prevent the acceptance and use of encryption products and public networks for
secure communications. This might decrease demand for our intended product
offerings and services. In addition, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete more effectively than we can in the domestic and
international network security market.
MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.
We have made no specific allocations of our cash or cash equivalents and
investments. Consequently, management will retain a significant amount of
discretion over the application of our cash or cash equivalents and investments
and could spend the proceeds in ways that do not improve our operating results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.
ITEM 3. CONTROLS AND PROCEDURES
Members of our management, including our Chief Executive Officer and Acting
Chief Financial Officer, have evaluated the effectiveness of our disclosure
controls and procedures, as defined by paragraph (e) of Exchange Act Rules
13(a)-15 or 15(d)-15. Based on that evaluation and the material weakness
described below, our Chief Executive Officer and Acting Chief Financial Officer
concluded that our disclosure controls and procedures were not adequate to
enable us to record, process, summarize and report information required to be
included in our periodic SEC filings within the required time period.
DISCLOSURE CONTROLS AND INTERNAL CONTROLS
Disclosure controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934, as amended, such as this Report, is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Disclosure controls are also designed with the
objective of ensuring that such information is accumulated and communicated to
our management, including our Chief Executive Officer and Senior Vice President,
Finance and Administration, as appropriate, to allow timely decisions regarding
required disclosure. Internal controls are procedures which are designed with
the objective of providing reasonable assurance that our transactions are
properly authorized, recorded and reported and our assets are safeguarded
against unauthorized or improper use, to permit the preparation of our financial
statements in conformity with generally accepted accounting principles.
Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not required to deliver management's report on control over our
financial reporting until our fiscal year ended December 31, 2006. Nevertheless,
we identified certain matters that would constitute material weaknesses (as
defined under the Public Company Accounting Oversight Board Auditing Standard
No. 2) in our internal controls over financial reporting.
We have identified deficiencies in our system of internal controls, which are
considered to be material weaknesses. These material weaknesses have led us to
conclude that we currently have an inadequate structure with respect to our
financial reporting systems. Until March of 2005, we had no central corporate
accounting department. Each of our subsidiaries separately maintained its own
books and records and independently controlled its cash disbursements and cash
receipts. The decentralized nature of our accounting system limits the
effectiveness of our internal control procedures and our ability to detect
potential misstatements and incorrect accounting and financial reporting. The
subsidiary accounting departments do not have the sophistication to critically
evaluate and implement new accounting pronouncements, and stock based
transactions for options, warrants and common stock. At times these transactions
were not recorded properly and required additional procedures and review and we
were required to record adjustments proposed by our independent registered
public accounting firm.
40
Certain of the material weaknesses we identified relate to our limited
segregation of duties. Segregation of duties within our company is limited due
to the fact that we have not had (until recently) any full-time employees since
February 10, 2004 and, until the completion of business combinations during the
quarter ended March 31, 2005, our Company's affairs have been managed by our
non-executive Chairman and Sole Director Robert E, Yaw, II. In addition, our
financial records up until that time were maintained by a former employee who
had been providing these services to us on a consulting basis. This condition
constituted a material weakness in our financial reporting system and a system
of internal controls that has affected our ability to timely close our books on
a quarterly and annual basis.
The second material weakness we identified is in our ability to implement the
requirements of complex accounting pronouncements. We have had difficulty with
ensuring that the accounting for our equity-based transactions is accurate and
complete. Since April 30, 2002 (Inception), we have consummated a series of
complex equity transactions involving the application of highly specialized
accounting principles. The equity based transactions that we have had difficulty
with specifically relate to stock to be issued under consulting agreements, the
penalty shares to be issued in connection with the Accommodation Agreements, and
the common stock to be repurchased in connection with the Allin Settlement
Agreement. We also experienced difficulty with applying the requirements of SFAS
141 "Business Combinations" and related pronouncement as it relates to our
acquisitions of CSSI, LucidLine and Entelagent. Although we believe that certain
of these events are unique and that our equity based transactions in the future
are likely to be substantially reduced, we are evaluating certain corrective
measures to provide us with the structure we need at such times that we may
engage in equity based transactions and consummate additional business
combinations in the future.
The third material weakness we identified is in our ability to implement a tax
reporting structure to file, on a timely basis, Federal and state tax returns.
This material weakness is primarily due to our limited segregation of duties.
Through our acquisitions of CSSI, LucidLine and Entelagent, we have
significantly increased the number of employees working for us and intend to
implement a tax reporting structure to address this deficiency.
We believe these material weaknesses resulted from continued working capital
deficiencies and a failure to generate cash flows from operations. Immediately
following our acquisitions, we appointed a Chief Executive Officer/Acting Chief
Financial Officer who is principally responsible for overseeing our financial
affairs. In addition, we increased our number of employees with our acquisitions
of Entelagent, LucidLine and CSSI and have begun the process of screening
candidates for key positions in our finance department. We believe that the
expansion of our operations and increase in the number of employees will enable
us to take corrective measures once we finish evaluating our existing
capabilities and our available resources to take such corrective measures.
Additionally, we expect to hire a Chief Financial Officer with public company
experience within the next twelve months and relieve our Chief Executive Officer
of his current Acting Chief Financial Officer duties.
We believe that any such risks are partially mitigated by the fact that we had
minimal assets and activities during our most recent reporting periods,
recordkeeping and authorization function were not being performed by the same
individual and the non-executive Chairman reviewed and approved all of our
transactions. However, we acknowledge that additional control procedures are
necessary to ensure that our transactions are properly recorded and that our
assets are appropriately safeguarded.
INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes in our internal control over financial reporting or in
other factors identified in connection with the evaluation required by paragraph
(d) of Exchange Act Rules 13(a)-15 or 15(d)-15 that occurred during the six
months ended June 30, 2005 or the four quarters ended December 31, 2004 that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.
41
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following unregistered equity securities have been issued by us during the
period from April 1, 2005 to June 30, 2005:
TITLE AND AMOUNT OF
SECURITIES GRANTED/ NAME OF NAME OR CLASS OF
DATE OF EXERCISE PRICE PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
GRANT IF APPLICABLE UNDERWRITER SECURITIES RECEIVED
-------- ---------------------- ----------- -------------------- -------------
April 890,500/COMMON STOCK NONE THEO VERMALEAN/ $0.00(1)
2005 FIBA CONSULTANTS
April 1,000,000/COMMON STOCK NONE FRANK MAZZOLA $0.00(2)
2005
1. On April 29, 2005, we agreed to issue 890,500 shares of common stock to
Theo Vermalean/FIBA Consultants for the pledging of shares in
connection with a collateralized financing arrangement.
2. On April 20, 2005, we agreed to issue 1,000,000 shares of common stock
to Frank Mazzola in lieu of cash in payment for consulting services.
These shares were previously in Common Stock to be Issued.
The following unregistered derivative securities (options and warrants) have
been issued by us during the period from April 1, 2005 to June 30, 2005:
TITLE AND AMOUNT OF
SECURITIES GRANTED/ NAME OF NAME OR CLASS OF
DATE OF EXERCISE PRICE PRINCIPAL PERSONS WHO RECEIVED CONSIDERATION
GRANT IF APPLICABLE UNDERWRITER SECURITIES RECEIVED
-------- ---------------------- ----------- -------------------- -------------
June 1,271,500/Common Stock None 7 Accredited Investors $0.00(1)
2005 Purchase Warrants in Interim Bridge
Financing II
June 152,580/Common Stock None Laidlaw & Company (UK) $0.00(2)
2005 Purchase Warrants Ltd.
June 1,750,000/Common Stock None 33 Accredited $0.00(3)
2005 Purchase Warrants Investors in Interim
Bridge Financing I
1. Beginning on June 6, 2005, we agreed to issue warrants to purchase up
to 1,271,500 shares of our common stock to 7 accredited investors who
invested in our Interim Bridge Financing II. The warrants have a term
of 5 years and an exercise price of $0.60 per share.
2. On June 30, 2005, we issued warrants to purchase up to 152,580 shares
of our common stock to Laidlaw & Company (UK) Ltd. In connection with
services rendered to us as the placement agent for Interim Bridge
Financing II. The warrants have a term of 5 years and an exercise price
of $0.60 per share.
3. On June 29, 2005, we issued warrants to purchase up to 1,750,000 shares
of our common stock to 33 accredited investors who invested in our
Interim Bridge Financing I. The warrants have a term of 5 years and an
exercise price of $0.70 per share.
The above unregistered securities were issued pursuant to an exemption from the
registration requirements of the Securities Act under Section 4(2) of the
Securities Act.
42
ITEM 6. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- ------------------------------------------------------------
10.1 Option Agreement, dated July 1, 2005, between Patron
Systems, Inc. and Robert Cross.
10.2 Employment Agreement, dated July 1, 2005, between Patron
Systems, Inc. and Robert Cross.
10.3 Form of Subscription Agreement among Patron Systems, Inc.
and each of the investors in Interim Bridge Financing II.
31.1 Certification of principal executive officer and acting
principal financial officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350. as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
43
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: August 22, 2005 PATRON SYSTEMS, INC.
--------------------
(Registrant)
/s/ Robert Cross
--------------------------------------------
By: Robert Cross
Its: Chief Executive Officer and
Acting Chief Financial Officer
44