SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 2002, or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from to .
------ ----------
Commission File No. 0-23862
Fonix Corporation
(Exact name of registrant as specified in its charter)
Delaware 87-0380088
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
180 W. Election Road, Suite 210
Draper, Utah 84020
(Address of principal executive offices with zip code)
(801) 553-6600
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Class A Common
Stock ($0.0001 par value per share)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days: Yes [X] No[ ].
The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $9,185,369, calculated using a closing price of
$0.0137 per share on March 21, 2003. For purposes of this calculation, the
registrant has included only the number of shares directly held by its officers
and directors as of March 21, 2003 (and not counting shares beneficially owned
on that date), in determining the shares held by non-affiliates. As of March 21,
2003, there were issued and outstanding 670,496,603 (16,762,415 post-reverse
stock split) shares of the Company's Class A common stock.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Page 1
Fonix Corporation
2002 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Part I
Page
Item 1. Business 3
Item 2. Properties 26
Item 3. Legal Proceedings 27
Item 4. Submission of Matters to a Vote of Security Holders 27
Part II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 29
Item 6. Selected Financial Data 31
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 32
Item 8. Financial Statements and Supplementary Data 52
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 52
Part III
Item 10. Directors and Executive Officers of the Registrant 54
Item 11. Executive Compensation 56
Item 12. Security Ownership of Certain Beneficial
Owners and Management 60
Item 13. Certain Relationships and Related Transactions 61
Part IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 63
Page 2
PART I
ITEM 1. BUSINESS
THIS ANNUAL REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY
THE COMPANY AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD
CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION
ENTITLED "FORWARD-LOOKING STATEMENTS" AND ELSEWHERE IN THIS ANNUAL REPORT. THE
FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH THE COMPANY'S FINANCIAL
STATEMENTS AND RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS DOCUMENT.
General
Fonix Corporation, a Delaware corporation ("Fonix" or the "Company"),
delivers speech interface solutions and applications ("Products") that empower
people to interact conversationally with information systems and computing
devices. Fonix Products are based on the Company's speech-enabling technologies,
which include text- to-speech ("TTS") and neural network-based automated speech
recognition ("ASR"). ASR and TTS technologies are sometimes collectively
referred to in this report as "Core Technologies." The Company believes its
intuitive speech-enabling Products enhance user productivity and efficiency in a
broad range of markets including mobile and wireless devices; embedded speech
solutions for automotive applications; computer telephony and server
applications; assistive and language learning applications for everyday use with
computers and electronic devices; and end-to-end distributive speech processing
and connectivity.
Prior to 2002, the Company was focused on research and development
("R&D") and prototype development projects for customized applications. The R&D
and prototype development utilized the Core Technologies and development and
marketing of multiple operating systems and hardware platforms. The transition
from R&D and prototype development to standard speech Products began in 2002.
The Company expects to leverage its standard speech Products across multiple
platforms, multiple products, and markets.
The Company currently markets speech Products that utilize its Core
Technologies to software developers, consumer electronics manufacturers,
micro-processor manufacturers, third-party product developers, operating system
developers, network developers, and wireless operators, as well as directly to
consumers. The Company currently focuses its marketing efforts toward embedded
systems for automotive applications and wireless and mobile electronic devices,
server-based solutions for telephony voice-activated applications, and
enterprise distributive speech solutions. The Company pursues revenue
opportunities through generation of royalty fees, product and technology
licenses, product sales, non-recurring engineering fees, and support agreements.
Speech-enabled Products are a value-added interface solution for
computing and communications devices. The Company believes that manufacturers of
consumer electronics products, software developers, wireless operators,
telephony distributors, system integrators, and value added re-sellers ("VARs")
can simplify the use and increase the functionality of their products and
services by integrating the Company's Products, resulting in broader market
opportunities and significant competitive advantage. Fonix Products support
multiple hardware and software platforms, are environment and speaker
independent, optimize cost and power efficiencies, provide easy integration
within a relatively small memory requirement for embedded applications, and
enhance scalability for high channel capacity for computer telephony and
server-based systems.
The Company believes that it is well positioned to serve markets that
are rapidly adopting speech-enabled solutions and applications. As memory
requirements, noise robustness, recognition accuracy, and efficiency of speech
solutions become increasingly critical, Fonix expects that its Products will
provide compelling solutions to meet highly competitive customer demands.
Page 3
Market Focus
Newly streamlined and focused operations have resulted in delivery of
Fonix Products in five primary market areas:
o Wireless /mobile devices and game consoles: Cell phones, personal
data assistants ("PDAs"), PDAs with PhoneEdition, "smartphones,"
and entertainment game consoles.
o Telephony and server applications: Automated phone directory
applications.
o Everyday speech interface applications: "e.Speech(TM)" for
Assistive, language learning, and PC and PDA applications.
o End-to-end: Distributive speech solution; embedded devices
connected to servers.
o Automotive: Speech enabled interface with automotive multi-media
systems and electronic functions.
FONIX MOBILE/WIRELESS AND GAME CONSOLES
Fonix provides intuitive speech interface Products for mobile and
wireless devices, such as PDAs, PDAs with Phone Edition, new "smartphones,"
other mobile phones, game consoles, web pads, wireless communication devices,
and other consumer electronics. Fonix believes that in many cases, a significant
deterrent to full functionality and more widespread use of these powerful and
small computing devices is the current dependence on a keyboard, touch screen
and/or computer mouse to interface with the device. Fonix also believes that
speech- enabling applications that provide an intuitive user interface will
increase the utility of these devices and improve access to information. Other
product development initiatives that may drive additional interest in
speech-enabling solutions include electronic books; wearable computers; smart
toys and appliances such as VCRs, answering machines, wireless climate control
systems; and command-and-control applications.
The handheld device market has experienced radical change as devices
have added more powerful processors, more memory, and wireless connection
capabilities. Technologies like Wi-Fi (802.11), Bluetooth, and 2.5-3G wireless
have changed the way consumers use their devices. Handheld devices are no longer
just an address book or calendar; now, these devices are being used for
activities such as accessing the Internet, and providing real time e-mail, and
navigation. As the line between PDAs and mobile phones starts to blur and a new
category of devices--smartphones--emerges, access to information and device
functionality increase with the use of speech enabling solutions and
applications. And as these devices become smaller, voice solutions become
attractive means to easily and safely access the Internet, manage e-mail, and
even navigate applications on these devices. Fonix Products for mobile/wireless
devices are described below.
o Fonix VoiceSuite
Fonix offers a fully integrated solution under the Fonix
VoiceSuite(R) umbrella. The first Product of the VoiceSuite is Fonix
VoiceDialTM. Fonix VoiceDial is a totally interactive, hands-free software
application that enables a user to place calls by number or by contact name,
fully integrated with Microsoft Outlook(R), with no voice training required. A
user simply speaks the number or name and Fonix VoiceDial makes the call. With
Fonix VoiceDial, true mobility is now possible through the power of speech.
Fonix has announced support for the following devices:
Microsoft PocketPC(R) Phone Edition Devices
Page 4
T-Mobile Pocket PC Phone Edition
AT&T Siemens SX56
O2 XDA
HP Journada 928
Hitachi Multimedia Communicator
Samsung i700
Microsoft Smartphone Devices
Orange SPV
Bluetooth Devices
Bluetooth enabled Microsoft PocketPC 2002 PDA
Sony-Ericsson T68i mobile phone
Bluetooth headset
Fonix also expects to support devices with Symbian and Palm operating
systems. Subject to resource allocation and cooperation with Symbian and Palm,
Fonix expects to deliver the VoiceSuite on Symbian and Palm devices in 2003.
Future Fonix VoiceSuite Products include Fonix VoiceEmail(TM), Fonix
VoiceInternet(TM), and Fonix VoiceCalendar(TM).
o Fonix VoiceEmail features the ability to conduct
"e-mail triage" by voice. Access, respond and
have emails read to the user through the device.
o Fonix VoiceInternet features the ability to
navigate the Internet by voice. It also allows
for access to databases on business websites.
o Fonix VoiceCalendar features the ability to
manage a calendar, including rescheduling
appointments.
All components of the Fonix VoiceSuite are currently available or
Fonix ancipates that they will be available in spring/summer of 2003. The Suite
will support American and UK English, German, French, and Spanish with
additional languages in development. Fonix is developing additional solutions
based on Microsoft PocketPC Phone Edition, Microsoft Smartphone, Microsoft
PocketPC, Symbian, and Palm operating systems.
o Platforms, Ports, Processors
Fonix supports multiple microprocessors ("Chips") and operating
systems ("OS"). The following chart identifies some of the Chips and OS
platforms Fonix supports:
Page 5
- -------------------------------------- -----------------------------------------------------------------------------
Types of Operating Systems
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
No OS
Support
Types of Microprocessors Win32 WinCE VxWorks QNX Linux Required
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Analog Devices
Blackfin ADSP-21535 o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
ARM
ARM o o
ARM 9 o o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Epson
S1C33 Family
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Hitachi
SH-3 o
SH-4 o o o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Intel
SA-1110 o
PXA250 o o
X86 o o o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
MIPS
MIPS 32-bit processor Family o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Motorola
MGT5100 o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
NeoMagic
MiMagic3 (NMS7210) o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
TI
OMAP1510 (ARM9 core only) o
- -------------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
o Game Consoles
In February 2003, the Microsoft Xbox(R) Development Kit with Fonix
ASR was first available for game developers. Game developers for the Microsoft
Xbox are now able to easily add Fonix speaker-independent ASR to games. Fonix
speaker-independent speech recognition allows the game developer to author
multiple vocabulary sets and select between various active vocabularies. These
vocabularies may then be used as voice-activated commands during game play.
Fonix is working to deliver similar solutions for game consoles offered by other
manufacturers. Fonix also intends in the future to offer services to help game
developers successfully deliver speech-enabled games.
o Fonix Mobile/Wireless and Game Consoles Market Opportunities
As new developments and initiatives drive interest in speech-enabled
mobile and wireless solutions, Fonix is well positioned to meet demand and grow
with the market. Fonix's partners and OEMs provide significant potential to
reach users in many market areas.
Page 6
Fonix has already seen significant early market response to
VoiceDial. With the additional support for German, French, and Spanish, Fonix
will extend its sales efforts to better address the European market. Further,
subject to continued market growth, Fonix intends to add support for additional
languages in order to address more markets.
Specific to VoiceDial, Fonix expects to deliver in the following
channels:
o Original Equipment Manufacturers ("OEM"): The first
VoiceDial contract delivered the Product on the Hewlett
Packard ("HP") Journada(R)928 WDA. Fonix is aggressively
pursuing additional OEM opportunities with its partners:
Microsoft, Intel, TI, Accelent, NeoMagic, HP, Hitachi,
Siemens, O2, and Samsung. There is also an opportunity to
include VoiceDial on media delivered with devices. For
example, mobile carriers, retailers, or OEMs could all
include applications on CDs or memory cards. These
applications could be fully licensed versions or 15- day
trials that require payment to unlock. Recent devices have
been delivered with trial programs included on memory cards
or on CDs. This allows OEMs to deliver additional
functionality to customers without additional expense.
o Mobile Operators: Fonix will attempt to market VoiceDial
and future applications in the Fonix VoiceSuite through
mobile operators, such as AT&T Wireless, T-Mobile, Orange,
Vodaphone, and Verizon. Fonix anticipates that the use of
VoiceDial will increase the monthly air time use of
wireless devices. Early analysis indicates that making it
easier for customers to access all of their contacts likely
will result in an increase in air time.
Fonix speech applications also offer mobile operators the
ability to add additional high margin accessory sales to
their store operations. Because most mobile operators
subsidize their handset sales, the accessory market is
attractive for additional revenue. Fonix Products could be
delivered in many methods including having boxes on the
shelf, loading software directly on the device, or
over-the-air activation.
o Innovative Retail Opportunities: The market for speech
applications sold over the Internet is beginning to mature.
Handango, PocketGear, PocketPC Passion, and others will
allow Fonix to distribute VoiceDial in high traffic
Internet locations without the distribution costs of
working with retail stores. Fonix also provides its
Products on its website.
o Bundled Solutions: Other complementary solutions are also
channels for Fonix distribution. Companies like Travroute
have integrated Fonix solutions into their applications.
Fonix foresees partners shipping the full VoiceDial
functionality as a complement to their applications and
devices.
Fonix has several competitors in the speaker-independent speech
market. Companies like ART, Voice Signal, and Neuvoice all deliver
speaker-dependent and speaker-independent solutions. Other speech companies like
IBM and Speechworks may introduce competitive products.
Page 7
FONIX TELEPHONY AND SERVER
Fonix Speak@Me(R) provides telephony and server-based solutions for
automated phone directory and database information systems. Fonix believes that
traditional operator systems and other means of accessing information are
becoming antiquated. Significant employee and personal time is lost trying to
access information through keypad directories or because calls are blocked after
hours. Also, information stored or transferred through servers, PBX, or
databases may not be easily accessed through non-integrated platforms.
Voice-automated systems are capable of integrating these markets and meeting
customer expectations of competitive costs, easy installation with minimal
change to their existing infrastructure, and a simple user interface.
o Speak@Me
Speak@Me is a user-friendly and intuitive Product for telephony and
server-based systems. Designed to fit easily into existing telephone systems,
Speak@Me is a complete package of easy-to-use personal and professional
services.
ConnectMe(R), the first Product in the Speak@Me suite, is the latest
in ASR innovation designed to transform the way businesses connect incoming and
outgoing phone calls. A voice-automated telephone operator, ConnectMe provides
an efficient, professional means of handling incoming calls.
ConnectMe 2.0 is scheduled for release in the second quarter of 2003.
Additional modules for the Speak@Me Suite, with expected availability in the
second half of 2003, include:
o NotifyMe: System generated notifications via a phone call
with TTS.
o ScheduleMe: Call a calendar and have it read aloud with TTS.
o ReadMe: Voice-activated (user) database queries--have email,
Web, or any info read aloud.
o AuthorizeMe: Security layer authentication by phone
notification.
o Government - 511 System: United States federal, state, and
local governments are increasingly providing citizens with
vital information on traffic, weather, road conditions, and
other transportation information. These systems are
generally accessed via telephone by dialing "511." Fonix,
along with partner Meridian Environmental Technology, Inc.,
is providing a "511 System." Current markets include
Montana, South Dakota, North Dakota, Kansas, and Nebraska.
Future targets include common-boundary states Oregon, Idaho,
Wyoming, Colorado, and Illinois. Competition in the 511
arena includes TellMe and IBM's WebSphere.
Fonix Telephony and Server Opportunities
Fonix is positioned to be a primary competitor in telephony products
via ConnectMe and the Speak@Me Suite. The selling points for ConnectMe include
the system's appeal to customer satisfaction, immediate ROI, consumer safety,
easy installation and maintenance, and its ability to bring a professional
"voice" to companies' telephone operator systems. Fonix's market strategy is to
identify user/customers' resellers and, as the Products' popularity increases,
push its value upward through VARs and distributors. Possible competitors in the
telephony/server markets include Phonetic Systems, Locus Dialog, and Avaya.
Fonix expects that as the market grows significant pricing pressure will
develop, resulting in smaller margins.
Page 8
FONIX EVERYDAY SPEECH, OR e.SPEECH(TM)
Fonix e.Speech, or "everyday speech," provides speech interface
Products for disabled, non-English language, and professional and personal
users. e.Speech allows users to access information with simple and easy voice
interface to computers and devices. e.Speech truly enhances the Fonix mission of
Freedom of Speech(TM). Fonix believes older device interfaces (like keypads) or
lesser quality TTS engines are antiquated and inadequate for users with special
needs or disabilities. Fonix e.Speech Products provide a user-intuitive
interface that can greatly increase the everyday functionality of assistive
users. Fonix also believes that a smaller memory requirement and ability to
recognize the user's voice in many languages allows the same or similar
technology to be applied effectively to language learning markets in an
expanding global community. Finally, Fonix e.Speech Products for PDAs and PCs
brings superior functionality to everyone, whether a user wants Web pages read
aloud or to launch applications on a PDA by speaking to the device.
o e.Speech for the Assistive Market
e.Speech has an established position in the assistive market based on
the wide acceptance and long-term history of Fonix's DECtalk TTS (acquired from
Force Computers, Inc., in December 2001). Fonix has a significant and
market-leading base of installed users in the assistive TTS market. Many users
rely on the Fonix DECtalk "Perfect Paul" or "Whispery Wendy" as their
voice-of-choice to read their e-mail, the daily news, or as their voice to the
outside world. In addition, Fonix is expanding its Products for the assistive
market to incorporate the full line of Fonix TTS offerings, including a
high-quality concatenated TTS and a high-recognition rate ASR. These offerings
meet assistive users' needs whether someone has a learning disability requiring
a more natural voice or a disabled user who requires voice-activated input
methods. Current OEM partners in the assistive market include Dynavox, GW Micro,
Prentke-Romich, Kurweil Education Systems, and Toby Churchill.
o e.Speech Language Learning
In the language learning market, the Company is attempting to
capitalize on Fonix DECtalk's small memory footprint and high intelligibility
and Fonix's ASR's high recognition rates capabilities. Language learning is an
emerging market, especially in the Asian markets. Several OEMs, including
Eintech and TopGrade, are selling handheld devices that allow individuals to
speak a word in their native language (like Korean) and have the text read back
to them in English. Fonix TTS provides this function to mass-market OEM devices.
This is a growing market outside the U.S. and one that Fonix expects will soon
emerge domestically as well.
The Company currently works with OEMs, government agencies, software
providers, and VARs who can take its languange learning Products and offer them
to their customers in devices that meet the needs of their unique markets. Fonix
is the TTS engine of choice for Asian language learning companies such as
Eintech and TopGrade. Fonix's other partners in the Asian market include E-Star
Lab, NEC Custom Technica, Kodensha, Dream C&C, and Dico. These channels expand
the Company's ability to serve millions of individuals while generating revenue
on already existing technologies that can be diverse in their final application.
Fonix's goal is to become the primary supplier of speech solutions for OEMs
providing language learning devices and systems.
o e.Speech for PDA and PC
Fonix e.Speech Products apply the intuitive use of voice to tasks
that users perform everyday. Many of these Products are appropriate for multiple
markets--assistive, mobile and wireless, and business and home users.
o Fonix VoiceAlert(TM) gives users the ability to
have scheduled meetings read aloud from a PDA
telling details like who they will meet with and
where-- all without looking at the screen.
Page 9
o Fonix VoiceDirector(TM) allows users to launch
desktop shortcuts or commonly used files and
applications with the command of the user's
voice.
o Fonix iSpeak(TM) reads e-mail, digital books,
documents, and websites in a natural,
human-sounding voice.
Fonix is also developing Products for different consumer electronic
devices, such as cordless phones, toys, home audio, and MP3 Players.
o e.Speech Market Opportunity
Revenue potential in these markets is significant as world markets
evolve. In the assistive market, more governments are recognizing the benefits
of providing accessibility to their diabled citizens. Fonix expects significant
market expansion as governments enact new regulations supporting and funding the
use of speech-based solutions.
Also, with the acceptance of the Internet and an increasingly global
economy, more people need to "speak" a foreign language. Fonix believes that
language learning tools, including translators, will be a profitable market,
with an estimated expansion of over 100% annually for the next few years. Fonix
believs that its ASR speech recognition and small footprint TTS offerings
currently meet the market's needs and will continue to do so.
Memory sizing and voice quality pose the major risks in these markets
areas. As devices are able to use larger memory and more powerful CPUs, the
Fonix advantage of a smaller footprint may diminish. Also, there is an inherent
requirement in many of these markets for intelligibility more so than
naturalness. If the market emphasis shifts to naturalness, the format-based
solutions like Fonix DECtalk will lose some of their advantages. To minimize
these risks, Fonix also offers a concatenated TTS that offers a higher level of
naturalness using a larger footprint.
e.Speech primary competitors include ScanSoft, IBM, NextUp
Technologies, Premier Assistive Technology, and Speechworks. However, the
Company believes that its advantages in format technologies and current market
positioning will allow it to compete in these spaces over the next few years.
FONIX END-TO-END: DISTRIBUTED SPEECH SOLUTIONS
End-to-end speech solutions are connected and/or wireless systems
where an embedded device (usually a mobile device such as a cell phone or PDA)
works with a network element such as a database or application server. The
mobile device communicates with a network system via a data communication path,
and the two ends exchange speech grammars, images, control signals, and other
information. Generally, application software runs at both ends and speech
software--ASR and/or TTS--runs at least at one end.
Fonix is proficient at both "ends"--embedded mobile devices and
servers--but has a particular strength on the embedded end. The objective of the
end-to-end marketing effort is to drive sales of embedded software, including
Product and ASR and TTS technology sales. By offering an end-to-end solution,
Fonix can capitalize on its competitive strength, reach new markets, and command
higher prices.
Examples of end-to-end Products include:
o Distributed Voice Dialing: Fonix offers an embedded
voice-dialing product, VoiceDial, that runs on a
handheld device. It also offers a network Product,
ConnectMe, accessed by telephone. These end-to-end
Products allow customers to place calls using either
the handheld device or via telephone to the network
equipment and still have access to the same contact
list. If the customer adds a new name to the contact
list on the handheld
Page 10
unit, for example, the two ends can synchronize
so that the new name is also available on the
network system.
o Multimodal Applications: Companies such as Oracle and
Glenayre offer network solutions where an application
server sends commands to a speech server. In this
configuration, the application server controls the
dialog flow and the speech server supports ASR and TTS
software. If the Company adds a handheld device with
Fonix software, the handheld can communicate with the
application server in place of the speech server. The
Company is working with Oracle to build a connection
between the Company's handheld software and the Oracle
application server so that the Company can approach
customers who want application access via both modes.
o Maps & Directions: Users speak a location, and ASR
software on the handheld device recognizes the voice
command. A network server then provides maps, which are
displayed on the handheld, and directions, which are
read aloud by the handheld unit using TTS software.
o Engineering Info: A maintenance worker requests a
schematic or parts diagram with a keyboardless tablet.
The request is recognized by embedded ASR software and
sent to a database server. The required information is
uploaded to the tablet and displayed on the LCD screen.
o End-to-End Sales & Market Opportunities
Fonix's primary end-to-end marketing approach is to offer only the
embedded end and work with partners who supply the network end. Partners may be
network equipment or software vendors, telecommunications carriers, and mobile
equipment manufacturers. These partners will contribute technology on the
network side for a better product solution which will in turn help Fonix access
a wider customer base. Currently, Fonix's most active partner is Oracle. Oracle
offers a network application server and the Company is working cooperatively to
build a software interface between Oreacle's server and the Company's handheld
software.
Fonix's competitors are primarily other embedded speech software
vendors like ART, ScanSoft, and Speechworks. Fonix's partners also have
competitors; for example Oracle, competes with Microsoft. However, Fonix is not
precluded from working with our partners' competitors.
An end-to-end strategy has some inherent risks. The end-to-end market
is still emerging, and it is a new direction for Fonix, so the market size and
the Company's ability to capitalize are untested. Also, building the interface
and applications for an end-to-end solution requires investment. Finally, there
are several competing protocols the Company might use to connect to the network,
such as SALT, VoiceXML, and other proprietary solutions. Fonix lacks the
resources to support all possibilities from the start, so there is some risk if
the Company chooses to develop one protocol that differs from the needs of
potential customers and partners. Despite these risks, however, Fonix intends to
seek end-to-end solutions and partners to capitalize on the market and revenue
potentials. End-to-end opens up new markets, such as companies who are deploying
network solutions and want to support mobile devices also.
FONIX AUTOMOTIVE VOICE INTERFACE SOLUTIONS
Fonix provides speech applications for fully integrated multimedia
automotive solutions. These applications, now available in complete market-ready
solutions, can be quickly deployed and adopted by the automotive electronics
marketplace, and are based on our proprietary ASR and TTS technologies. These
solutions are ideal for automotive environments in that they are highly noise
robust, require no user training, are available in
Page 11
many language options, require minimal computing resources, and are available in
a wide variety of automotive- qualified hardware configurations.
Automotive OEMs continue to develop and market systems that can
provide drivers and passengers optimized access to information but not at the
cost of safety. Voice-activated response and control systems are the natural
next step in driver safety and convenience. Fonix speech software is designed to
work as a natural voice interface inside a car for controlling and managing
complex system functions. Navigation, climate control, and Internet and cell
phone access are just the beginning of the hands-free and safety-minded
environment voice- activated technologies provide. As automotive telematics and
multimedia systems become more complex, Fonix voice interface solutions
significantly increase security, productivity, and passenger/driver satisfaction
for those interacting with in-car systems.
Fonix is executing a well-defined strategy to win large volume
automotive OEM business and drive significant revenues through its automotive
unit. The Company believes that it can develop and deliver production- ready,
automotive-qualified, voice interface products for telematics and multimedia
systems to automotive OEM and Tier 1 suppliers worldwide. The Company sees
long-term return in the cross-platform application of the Core Technologies with
little or no new development. Fonix believes that the technical implementation
of the delivered software package can be done in a short period of time with
predictable results. The portability of Fonix voice interface products allows
the automotive partner to create its own dedicated solution platform and to
reuse many parts of a solution for another production line.
o Applications for Independent and Integrated Automotive
Solutions
The automotive industry requires highly robust, reusable, cost
effective software components that can be easily and repeatedly deployed. Fonix
Products fit this need by creating the following standard independent(stand-
alone) and integrated/open high-end Products:
o Hands-free phone: Speaker-independent continuous digit
and word recognition; speaker- dependent voice tags,
contact management (i.e. Microsoft Outlook(R)); system
integration
o Navigation: Letter-to-word decoder incorporating N-best
recognition results, integration with standard
navigation databases (i.e. Navtech)
o Automotive Master Control System: Auto HVAC voice
control, interior system voice control
o Radio/Audio: Auto radio/CD voice control, entertainment
system control
o Onboard Diagnostic Control System: Miscellaneous
automotive diagnostics controlled via ASR and/or TTS
o Internet: E-mail and Internet access
o Fonix Automotive Opportunities
Fonix recognizes that automotive speech interface solutions require a
partnering strategy to be successful. Fonix has and will continue to partner and
joint-market with the leading silicon, operating systems, and Tier 1 suppliers
to create compelling solutions for automotive OEMs. The Company continually
works with its partners' sales and marketing organizations to define, create,
and deploy speech interface solutions required by the automotive industry.
Current Fonix automotive partners include: Motorola, Hitachi, Yazaki North
America, Volkswagen North America, Mitsubishi, Intel, Analog Devices, QNX, Sun
Microsystems, and WindRiver. Fonix has also had
Page 12
discussions directly with multiple Tier 1 suppliers such as Lear Automotive
Systems, Yazaki North America, JCI and other OEMs to drive large-volume,
recurring revenue business.
Major competitors include IBM (Via Voice, Pervasive Computing),
Scansoft, and Speechworks. Fonix believes that it can execute the current plan
to create the standard Products described above. As these Products are created
and proven, Fonix must enter into supplier relationships--in many instances
replacing established suppliers--to create long-term, recurring revenue
situations. There can be no assurance that Fonix can establish such supplier
relationships or that if it does, such relationships will result in significant
Product sales in this market.
Employees
As of March 21, 2003, the Company employed 95 people. Of this total,
56 were employed in product development and delivery, 17 were employed in sales
and marketing, and 22 were employed in strategic development, administration and
support.
RECENT DEVELOPMENTS
Grants of Stock Options
During 2002, Fonix granted options to purchase 157,225 shares of
Class A common stock as follows:
Grantee Number of Shares Exercise Prices
- ------- ---------------- ---------------
Directors and Executive Officers 72,500 $2.00 - $3.60
Employees 84,725 $2.00 - $5.60
The term of all of these stock options is ten years from the date of
grant and all were granted at the quoted market price on the date of grant.
During 2002, 124,543 options were canceled or forfeited and no options expired
without exercise. As of December 31, 2002, the Company had a total of 634,652
options outstanding, of which 443,183 were exercisable at a weighted average
exercise price of $90.80.
2002 Employee Compensation Plan
On February 6, 2003, the Fonix Board of Directors adopted the 2002
Employee Compensation Plan (the "2002 Plan"). Shares of Class A common stock
issued under the 2002 Plan will be in partial payment of wages and salaries
earned by employees during the plan period, which runs from December 1, 2002,
through May 31, 2003. The plan period may be extended by the Board of Directors.
Each current employee has agreed to the terms of the 2002 Plan.
The maximum aggregate number of shares that may be issued under the
2002 Plan is 150,000,000 Shares (3,750,000 post-Reverse Stock Split shares). The
2002 Plan will be administered by the Board of Directors or a committee of the
Board. Shares under the 2002 Plan may be issued only to employees of Fonix.
Employees subject to the 2002 Plan were required to provide the
Company with a notice of election to participate in the 2002 Plan and to
indicate the amount of compensation to be deferred during the plan period. The
deferred compensation of employees electing to participate in the 2002 Plan may
be paid, at the option of the employee, in shares of the Company's Class A
common stock, in cash, or in a combination of the two. The payment of deferred
compensation will commence June 30, 2003.
As of March 26, 2003, no employee had notified the Company of the
ratio of cash and Class A common stock to be issued under the 2002 Plan, and no
shares or cash had been issued or paid to employees under the 2002 Plan.
Page 13
The Company intends to seek shareholder approval of the 2002 Plan at
its 2003 Annual Meeting of Shareholders.
U.S. Department of Labor Settlement Agreement
On March 5, 2003, the Company entered into a settlement agreement
with the U.S. Department of Labor relating to back wages not paid to former and
current employees during 2002. Under this agreement the Company will pay all
amounts owed in twenty-four installment payments to each former and current
employee. The first installment payment is due May 1, 2003. The remaining
payments are due on the first day of each month, until paid in full. If any of
the installment payments are more than fifteen days late, the entire balance may
become due and payable.
Employees may elect to receive a portion of their wages in registered
shares of the Company's Class A common stock. However, the amount that
represents minimum wage and overtime, if any, as defined in the Fair Labor
Standards Act of 1938, may not be paid with the Company's Class A common stock.
Page 14
CERTAIN SIGNIFICANT RISK FACTORS
The short- and long-term success of the Company is subject to certain risks,
many of which are substantial in nature and outside the control of the Company.
You should consider carefully the following risk factors, in addition to other
information contained herein. All forward-looking statements contained herein
are deemed by the Company to be covered by and to qualify for the safe harbor
protection provided by the Private Securities Litigation Reform Act of 1995. You
should understand that several factors govern whether any forward-looking
statement contained herein will or can be achieved. Any one of those factors
could cause actual results to differ materially from those projected herein.
These forward-looking statements include plans and objectives of management for
future operations, including the strategies, plans and objectives relating to
the products and the future economic performance of the Company and its
subsidiaries discussed above. In light of the significant uncertainties inherent
in the forward-looking statements included herein, the inclusion of any such
statement should not be regarded as a representation by the Company or any other
person that the objectives or plans of the Company will be achieved.
The Company's substantial and continuing losses since inception, coupled with
significant ongoing operating expenses, raise doubt about its ability to
continue as a going concern.
Since inception, the Company has sustained substantial losses. Such
losses continue due to ongoing operating expenses and a lack of revenues
sufficient to offset operating expenses. The Company had negative working
capital of $14,428,750 at December 31, 2002. The Company has raised capital to
fund ongoing operations by private sales of the Company's securities, some of
which sales have been highly dilutive and involve considerable expense. In the
Company's present circumstances, there is substantial doubt about its ability to
continue as a going concern absent significant sales of the Company's existing
products, substantial revenues from new licensing or co- development contracts,
or continuing large sales of its securities.
The Company incurred net losses of $19,897,564, $31,059,791, and
$22,761,229 for the years ended December 31, 2002, 2001 and 2000, respectively.
As of December 31, 2002, the Company had an accumulated deficit of $194,006,920,
and owed trade payables of $3,083,425, of which $2,232,149 were more than 60
days past due.
The Company expects to spend significant amounts to enhance its
products and technologies, expand domestic and international sales and
operations and fund further Product development. As a result, it will need to
generate significant additional revenue to achieve profitability. Even if the
Company does achieve profitability, it may not be able to sustain or increase
profitability on a quarterly or annual basis. If it does not achieve and
maintain profitability, the market price for the Company's common stock may
further decline, perhaps substantially, and the Company may have to curtail or
cease its operations.
The "going concern" paragraph in the reports of the Company's independent
certified public accountants for the years ended December 31, 2002, 2001 and
2000 raises doubts about the Company's ability to continue as a going concern.
The independent certified public accountants' reports for the
Company's financial statements for the years ended December 31, 2002, 2001, and
2000 include an explanatory paragraph regarding substantial doubt about the
Company's ability to continue as a going concern. This may have an adverse
effect on the Company's ability to obtain financing for operations and to
further develop and market products.
If the Company does not receive additional capital when and in the amounts
needed in the near future, its ability to continue as a going concern is in
substantial doubt.
The Company anticipates incurring substantial sales and marketing,
product development and research and general operating expenses in the future
that will require substantial amounts of additional capital on an ongoing
Page 15
basis. It will most likely have to obtain such capital from sales of its equity,
convertible equity and/or debt securities. Obtaining future financing may be
costly and will likely be dilutive to existing stockholders. The Company
previously established three equity lines of credit with an unaffiliated third
party (the "Equity Line Investor") upon which the Company drew to pay operating
expenses, but the Company has either drawn the maximum amount available or have
no registered shares of Class A common stock available to put to the Equity Line
Investor under two of those equity lines. The Company also has entered into a
third equity line with the Equity Line Investor, and has prepared and filed a
prospectus, and the registration statement of which it is a part, to register
the sale of up to 5,000,000 shares of Fonix Class A common stock by the Equity
Line Investor. As of March 21, 2003, the Company had drawn $2,500,000 on the
third equity line.
If the Company is not able to obtain adequate financing under the
third equity line or from other financing sources when and in the amounts
needed, and on terms that are acceptable, the Company's operations, financial
condition and prospects could be materially and adversely affected, and the
Company could be forced to curtail its operations or sell part or all of its
assets, including our Core Technologies, or seek protection under bankruptcy
laws.
Continuing debt obligations could impair the Company's ability to continue as a
going concern.
As of December 31, 2002, the Company had debt obligations of
$1,738,857. Additionally, at March 21, 2003, unpaid compensation payable to
current and former employees was approximately $5,265,000 and vendor accounts
payable was approximately $3,083,000. At present, the Company's revenues from
existing licensing arrangements and products are not sufficient to offset its
ongoing operating expenses or to pay in full its current debt obligations.
Although the Company has negotiated with its current and former
employees and vendors regarding payment terms of these unpaid amounts, and the
Company has entered into an agreement with the United States Department of Labor
to pay past due employee wages over a 24-month period, if the Company is unable
to generate sufficient revenues from operations or obtain sufficient additional
capital from the sale of its equity or debt securities, the Company may not be
able to satisfy its obligations to its current and former employees and vendors.
There is substantial risk, therefore, that the existence and extent
of the debt obligations described above could adversely affect the Company's
business, operations and financial condition, and the Company may be forced to
curtail its operations, sell part or all of its assets, including the Core
Technologies, or seek protection under bankruptcy laws. Additionally, there is
substantial risk that the current or former employees or the Company's vendors
could bring lawsuits to collect the unpaid amounts. In the event of lawsuits of
this type, if the Company is unable to negotiate settlements or satisfy its
obligations, the Company could be forced into bankruptcy.
Certain Risks Associated With the Reverse Stock Split.
At a Special Meeting of Shareholders held March 24, 2003, in Salt
Lake City, Utah, the Company's shareholders approved a reverse stock split (the
"Reverse Stock Split") of the Company's Class A common stock at a ratio of one
(1) new share for forty (40) old shares. Risks relating to the Reverse Split
include, but are not limited to, the following:
There can be no assurance that the total market capitalization of the
Class A common stock after the proposed reverse stock split will be
equal to or greater than the total market capitalization before the
proposed reverse stock split or that the per share market price of
the Class A common stock following the reverse stock split will
either exceed or remain higher than the current per share market
price.
There can be no assurance that the market price per new share of the
Class A common stock (the "New Shares") after the reverse stock split will rise
or remain constant in proportion to the reduction in the number of old shares of
the Class A common stock (the "Old Shares") outstanding before the Reverse Stock
Split. For example,
Page 16
based on the market price of the Old Shares on February 7, 2003, of $0.02 per
share, there can be no assurance that the post-split market price of the New
Shares would be $0.80 per share or greater.
Accordingly, the total market capitalization of the Class A common
stock after the Reverse Stock Split may be lower than the total market
capitalization before the Reverse Stock Split and, in the future, the market
price of the New Shares following the Reverse Stock Split may not exceed or
remain higher than the market price prior to the proposed Reverse Stock Split.
In many cases, the total market capitalization of a company following a reverse
stock split is lower than the total market capitalization before the reverse
stock split.
There can be no assurance that the Reverse Stock Split will result in
a per share price that will attract institutional investors and
brokers.
While the Board of Directors believes that a higher stock price may
help generate investor interest, there can be no assurance that the Reverse
Stock Split will result in a per share price that will attract institutional
investors and brokers, or that any higher stock price achieved as a result of
the Reverse Stock Split will be maintained.
There can be no assurance that the Reverse Stock Split will result in
a per share price that will increase the Company's ability to attract
and retain employees and other service providers.
While the Board of Directors believes that a higher stock price may
help the Company attract and retain employees and other service providers who
are less likely to work for a company with a low stock price, there can be no
assurance that the Reverse Stock Split will result in a per share price that
will increase the Company's ability to attract and retain employees and other
service providers.
A decline in the market price for the New Shares after the Reverse
Stock Split may result in a greater percentage decline than would
occur in the absence of a Reverse Stock Split, and the liquidity of
the New Shares could be adversely affected following a Reverse Stock
Split.
The market price of the New Shares Stock will also be based on the
Company's performance and other factors, some of which are unrelated to the
number of shares outstanding. If the market price of the New Shares declines,
the percentage decline as an absolute number and as a percentage of the
Company's overall market capitalization may be greater than would occur in the
absence of the Reverse Stock Split. In many cases, both the total market
capitalization of a company and the market price of a share of such company's
common stock following a Reverse Stock Split are lower than they were before the
Reverse Stock Split. Furthermore, the liquidity of the New Shares could be
adversely affected by the reduced number of shares that will be outstanding
after the Reverse Stock Split.
Holders of Fonix Class A common stock are subject to the risk of
additional and substantial dilution to their interests as a result of
the Reverse Stock Split.
The following table sets forth the approximate number of shares that
will be authorized for issuance, issued and outstanding, authorized and reserved
for issuance, and authorized but unissued as a result of the adoption of the
Reverse Stock Split. The table below does not take into effect the additional
New Shares that will be issued to holders of fractional shares.
Page 17
Shares Authorized
Shares Authorized Shares Issued and Shares Reserved for but Unissued and
for Issuance Outstanding Issuance Unreserved
Prior to Reverse 800,000,000 555,784,693 115,456,303 128,759,004
Stock Split
(February 7, 2003 -
record date for
Special Meeting of
Shareholders)
Following 1 for 40 800,000,000 13,894,618 2,886,408 783,218,974
Reverse Split
The Reverse Stock Split will not reduce the number of shares
authorized for issuance. As such, issuance by the Company of additional shares
which remain authorized for issuance will have a dilutive effect on the holders
of New Shares.
The Company's issuances of shares following the Reverse Stock Split
likely will result in overall dilution to market value and relative
voting power of previously issued Class A common stock, which could
result in substantial dilution to the value of shares held by
shareholders prior to implementation of the Reverse Stock Split.
The issuance by the Company of Class A common stock following the
Reverse Stock Split in capital raising transactions may result in substantial
dilution to the equity interests of holders of New Shares. Specifically, the
issuance of a significant amount of additional New Shares will result in a
decrease of the relative voting control of the Class A common stock issued and
outstanding prior to the issuance of Class A common stock following the Reverse
Stock Split. Additionally, holders of New Shares likely will experience
increased dilution with decreases in market value of Class A common stock in
relation to the Company's issuances of shares following the Reverse Stock Split,
which could have a material adverse impact on the value of their shares.
Holders of Fonix Class A common stock are subject to the risk of additional and
substantial dilution to their interests as a result of the issuances of Class A
common stock in connection with the third equity line and the Debentures.
Introduction
In addition to the Class A common stock registered in connection with
the third equity line, the Company has also registered 3,435,185 shares of Class
A common stock in connection with the sale of $1,500,000 Series D Convertible
Debentures (the "Debentures") to a third party. As of March 26, 2003, the
balance due under the debentures was $607,067.
The following table describes the number of shares of Class A common
stock that would be issuable, assuming the hypothetical conversion of the total
remaining outstanding principal amount of the Debentures as of March 26, 2003,
by the holder of the Debentures (excluding the issuance of shares of Class A
common stock as payment of interest on the Debentures at the date of
conversion), and that the full amount available under the third equity line had
been put to the Equity Line Investor (irrespective of the availability of
registered shares), and further assuming that the applicable conversion or
exercise prices at the time of such conversion or put were the following
amounts:
Page 18
Shares of Class A Common Stock
Issuable
- --------------------------------- ---------------------------------------------- ----------------------------
Shares issuable
Upon Conversion Shares issuable
of Series D upon puts
Hypothetical Conversion/ Convertible aggregating Total Class A Common
Exercise Price Debentures $20,000,000 Stock Issuable
- --------------------------------- --------------------- -------------------- ----------------------------
$0.02 30,353,350 1,000,000,000 1,030,353,350
$0.03 20,235,567 666,666,667 686,902,233
$0.04 15,176,675 500,000,000 515,176,675
$0.05 12,141,340 400,000,000 412,141,340
$0.10 6,070,670 200,000,000 206,070,670
$0.15 4,047,113 133,333,333 137,380,447
$0.25 2,428,268 80,000,000 82,428,268
$0.50 1,214,134 40,000,000 41,214,134
$0.80 758,834 25,000,000 25,758,834
Given the formulas for calculating the shares to be issued upon
conversion of the Debentures and in connection with puts under the third equity
line, there effectively is no limitation on the number of shares of Class A
common stock which may be issued in connection with conversion of the
Debentures, except for the number of shares registered under the prospectus and
registration statement covering the resale of shares by the holder of the
Debentures, or with a put under the third equity line, except for the number of
shares registered under the prospectus and the registration statement covering
the resale of shares issued in connection with the third equity line. If the
market price of the Class A common stock decreases, the number of shares of
Class A common stock issuable in connection with the Debentures and the third
equity line will increase and, accordingly, the aggregate amount of draws under
the third equity line will decrease. Accordingly, despite the Company's right to
draw up to $20,000,000 under the third equity line Agreement, the Company may
run out of shares registered under the prospectus and the related registration
statement to issue to the Equity Line Investor in connection with draws. In such
an event, the Company would be required to, and would, file additional
registration statements to cover the resale of additional shares issuable under
the third equity line. The following table demonstrates the correlation between
share price decline and decreases in aggregate draw amounts available, given the
maximum 200,000,000 shares of Class A common stock registered under the
prospectus and the related registration statement covering shares issuable under
the third equity line:
Shares issuable upon puts, up to a Maximum draws available, up to
Hypothetical Conversion Price maximum of 5,000,000 $20,000,000
$0.02 5,000,000 $100,000
$0.03 5,000,000 $150,000
$0.04 5,000,000 $200,000
$0.05 5,000,000 $250,000
$0.10 5,000,000 $500,000
$0.15 5,000,000 $750,000
$0.25 5,000,000 $1,250,000
$0.50 5,000,000 $2,500,000
$0.80 5,000,000 $4,000,000
The Company's issuances of shares in connection with conversions of principal
amounts of the Debentures or under the third equity line likely will result in
overall dilution to market value and relative voting power of previously issued
common stock, which could result in substantial dilution to the value of shares
held by shareholders.
Historically, the issuance of Class A common stock to the Equity Line
Investor under the first two equity lines has resulted in substantial dilution
to the equity interests of all holders of Class A common stock, except the
Equity Line Investor. The issuance of Class A common stock in connection with
conversions of the Debentures or with draws under the third equity line may
result in substantial dilution to the equity interests of holders of Fonix Class
A common stock other than the holder of the Debentures or the Equity Line
Investor. Specifically, the issuance of a significant amount of additional Class
A common stock will result in a decrease of the relative voting control of the
Class A common stock issued and outstanding prior to the issuance of Class A
common stock in connection with conversions of Debentures or the third equity
line. Furthermore, public resales of Class A common stock by the holder of the
Debentures or by the Equity Line Investor following the issuance of Class A
common stock in connection with conversions of the Debentures or with puts under
the third equity line, respectively, likely will depress the prevailing market
price of the Class A common stock. Even prior to the time of actual conversions,
exercises, and public resales, the market "overhang" resulting from the mere
existence of the Company's obligation to honor such conversions or exercises
could depress the market price of its Class A common stock.
Existing shareholders likely will experience increased dilution with decreases
in market value of Class A common stock in relation to the Company's issuances
of shares upon conversion of the Debentures or under the third equity line,
which could have a material adverse impact on the value of their shares.
The formulas for determining the number of shares of Class A common
stock to be issued upon conversion of the Debentures or under the third equity
line are based, in part, on the market price of the Class A common stock and in
both cases includes a discount from the market price equal to 90% of the average
of the two lowest closing bid prices of the Class A common stock over a
specified trading period. As a result, the lower the market price of the
Company's Class A common stock at and around the time the Debenture holder were
to convert some or all of the Debentures or the Company were to put shares under
the third equity line, the more shares of Class A common stock the Debenture
holder or Equity Line Investor would receive. Any increase in the number of
shares of Class A common stock issued upon conversion of Debentures puts of
shares as a result of decreases in the prevailing market price would compound
the risks of dilution described in the preceding paragraph.
There is an increased potential for short sales of the Class A common stock due
to the sales of shares put to the Equity Line Investor in connection with the
third equity line, which could materially effect the market price of the stock.
Downward pressure on the market price of the Class A common stock
that likely will result from sales of the Class A common stock by the Equity
Line Investor issued in connection with a put under the third equity line could
encourage short sales of Class A common stock by the Equity Line Investor.
Significant amounts of such short selling could place further downward pressure
on the market price of the Company's Class A common stock.
Certain restrictions on the extent of puts may have little, if any, effect on
the adverse impact of the Company's issuance of shares under the third equity
line, and as such, the Equity Line Investor may sell a large number of shares,
resulting in substantial dilution to the value of shares held by existing
shareholders.
The Company is prohibited from putting shares to the Equity Line
Investor under the third equity line if such put would result in that investor
holding more than 4.999% of the then outstanding Class A common stock. These
restrictions, however, do not prevent the Equity Line Investor from selling
shares of Class A common stock received in connection with a put, and then
receiving additional shares of Class A common stock in connection with a
subsequent put. In this way, the Equity Line Investor could sell more than
4.999% of the outstanding Class A common stock in a relatively short time frame
while never holding more than 4.999% at one time.
Page 19
In addition to the dilution described above, issuances of shares of Fonix Class
A common stock upon conversion of the Debentures by the debenture holder may
result in substantial dilution to the value of shares held by existing
shareholders.
The following table identifies the total principal amount of the
Debentures outstanding as of March 26, 2003 ($607,067), and the total number of
shares of Class A common stock that would be issuable, assuming that the full
amount of the Debentures were converted by the holder, and further assuming that
the applicable conversion or exercise prices at the time of such conversion or
exercise were the following amounts. The calculations below exclude the issuance
of shares of Class A common stock as payment of interest on the Debentures at
the date of conversion.
Shares
issuable upon
conversion of
Hypothetical Conversion principal amount of
Price $607,067
$0.02 30,353,350
$0.03 20,235,567
$0.04 15,176,675
$0.05 12,141,340
$0.10 6,070,670
$0.15 4,047,113
$0.25 2,428,268
$0.50 1,214,134
$0.80 758,834
Given the structure of the conversion formulas applicable to the
Debentures, there effectively is no limitation on the number of shares of Class
A common stock into which the Debentures may be converted. If the market price
of the Class A common stock decreases, the number of shares of Class A common
stock issuable upon conversion of the Debentures continues to increase.
Applicable accounting rules require the Company periodically to assess the value
of its intangible assets and recognize any decline in value. As a result of that
requirement, the Company recently has recognized a significant impairment of
certain speech software technology in the accompanying consolidated financial
statements. Any further reduction of the carrying value of the Company's
intangible assets could have a material adverse impact on the Company's
financial position.
Applicable accounting rules require the Company to assess the value
of its intangible assets periodically or as circumstances dictate, and to
recognize any change in value of those assets. The Company tested its speech
software technology for impairment in December 2001and in December 2002. Due to
the down-turn in the software industry and the U.S. economy in general,
management revised estimated net future cash flows from the speech software
technology (the Core Technologies), which resulted in recognition of an
impairment loss of $5,832,217 during the fourth quarter of 2001. The impairment
loss was charged to cost of revenues. Management determined in December 2002
that no additional impairment had occured in 2002 which required recognition of
impariment loss in 2002.
Page 20
Future assessments required by the applicable accounting rules may
require recognition of additional impairments to the Company's speech software
technology or other intangible assets. Any additional impairments could further
reduce the Company's asset base, which reduction could have a material adverse
impact on the Company's ability to borrow or otherwise raise capital.
The Company has a limited Product offering and many of its key technologies are
still in the product development stage.
Presently, there are a limited number of commercially available
Products incorporating the Company's Core Technologies. For the Company to be
ultimately successful, sales from these Products must be substantially greater.
An additional element of its business strategy is to achieve revenues through
strategic alliances, co-development arrangements, and license arrangements with
third parties. For example, the Company has entered into licensing and
joint-marketing agreements with Intel, Microsoft, HP, Panasonic, Epson, and
others. These agreements provide for joint marketing and application development
for end-users or customers. There can be no assurance that these collaboration
agreements will produce license or other agreements which will generate
significant revenues for the Company.
The market for many of the Company's technologies and Products is largely
unproven and may never develop sufficiently to allow it to capitalize on its
technology and Products.
The market for speech-enabled Products is relatively new and rapidly
evolving. Additionally, the Company's Products are new and, in many instances,
represent a significant departure from technologies which already have found a
degree of acceptance in the speech-enabled technologies marketplace. The
Company's financial performance will depend, in part, on the future development,
growth, and ultimate size of the market for speech-enabled applications and
products generally, and applications and products incorporating its Products.
Accordingly, in order to achieve commercial acceptance of the Core Technologies
and its Products, the Company will have to educate prospective customers,
including large, established companies, about the uses and benefits of
speech-enabled software in general and its products in particular. If these
efforts fail, or if speech-enabled software platforms do not achieve commercial
acceptance, the Company's business could be harmed or even fail.
The Products which incorporate the Company's Core Technologies will
be competing with more conventional means of information processing such as data
entry, access by keyboard, mouse or touch-tone telephone. The Company believes
that there is a substantial potential market for applications and products
incorporating advanced speech-enabled technologies. Nevertheless, such a market
for the Company's Products may never develop to the point that profitable
operations can be achieved or sustained.
Speech-enabling Products may not achieve widespread acceptance by businesses or
telecommunications carriers, which could limit the Company's ability to grow its
business.
The market for speech-enabled products and applications is relatively
new and rapidly evolving. The Company's ability to increase revenue in the
future depends on the acceptance of speech-enabling products and applications by
both its customers and end users. The adoption and integration of
speech-enabling products and applications could be hindered by the perceived
costs of these new products and applications, as well as the reluctance of
enterprises that have invested substantial resources in existing applications to
replace their current systems with these new products and applications.
Accordingly, in order to achieve commercial acceptance, the Company will have to
educate prospective customers, including large, established companies, about the
uses and benefits of speech-enabling products and applications in general and
its Products in particular. If these efforts fail, or if speech-enabling
products and technology platforms do not achieve commercial acceptance, the
Company's business will not develop or may subsequently fail.
Continued development of the market for the Company's Products also
will depend upon the following factors over which the Company has little or no
control:
Page 21
o widespread deployment of speech-enabling applications by third
parties, which is driven by consumer demand for services having a
voice user interface;
o demand for new uses and applications of speech-enabling
technology, including adoption of speech-enabled interfaces by
companies that operate web sites;
o adoption of industry standards for speech-enabling and related
technologies; and
o continuing improvements in hardware technology that may reduce
the costs of speech-enabling technology solutions.
The delivery of the Company's Products to end users is dependent upon third-
party integration and may be subject to delays and cancellations that are beyond
its control.
Because the Company is pursuing third-party integration of its
Products into mass market, general business, automotive and personal electronics
products, and computing solutions, lead time to revenue recognition will be
longer than software products directly released into consumer channels. Purchase
of the Company's Products often requires a significant expenditure by a
customer. Accordingly, the decision to purchase the Company's Products typically
requires significant pre-purchase evaluation. The Company spends significant
time educating and providing information to prospective customers regarding the
use and benefits of its Products. During this evaluation period, the Company may
expend substantial sales, marketing and management resources.
Further, the Company's Products sold and integrated into customer
applications and products are subject to both customer production schedules and
customer success in marketing their own products and generating product sales.
The Company's revenues are thus subject to delays and possible cancellation
resulting from customer integration risks and delays.
In cases where the Company's contract with its customers specifies
milestones or acceptance criteria, it may not be able to recognize license or
services revenue until these conditions are met. The Company has in the past and
may in the future experience unexpected delays in recognizing revenue.
Consequently, the length of the Company's sales and implementation cycles and
the varying order amounts for its Products make it difficult to predict the
quarter in which revenue recognition may occur and may cause license and
services revenue and operating results to vary significantly from period to
period. These factors could cause the Company's stock price to be volatile or to
decline.
Competition from other industry participants and rapid technological change
could impede the Company's ability to achieve profitable operations.
The computer hardware and software industries are highly and
intensely competitive. In particular, the speech-enabled technologies market
sector and, specifically, the ASR, computer voice and communications industries
are characterized by rapid technological change. Competition in the
speech-enabled technologies market is based largely on marketing ability and
resources, distribution channels, technology and product superiority and product
service and support. The development of new technology or material improvements
to existing technologies by the Company's competitors may render the Company's
Products less attractive or even obsolete. Accordingly, the Company's success
will depend upon its ability to continually enhance the Core Technologies and
its Products to keep pace with or ahead of technological developments and to
address the changing needs of the marketplace. Barriers to entry in the software
industry are low, and as the market for various speech-enabled products expands
and matures, the Company expects more entrants into this already competitive
arena.
Page 22
The Company's Products can have a long sales cycle and, as a result, its
quarterly operating results and its stock price may fluctuate.
The sales cycles for the Company's Products are generally six to
twelve months but may be shorter or longer depending on the size and complexity
of the order, the amount of services to be provided and whether the sale is made
directly by the Company or indirectly through an OEM, VAR or systems integrator.
The length of the sales cycles could adversely impact the Company's operating
results.
The Company's current and potential competitors, some of whom have greater
resources and experience than it does, may develop products and technologies
that may cause a decline in demand for, and the prices of, the Company's
Products.
A number of companies have developed, or are expected to develop,
products that compete with the Company's Products and technologies. Competitors
in the speech technology software market include IBM, SpeechWorks International,
Nuance, and ScanSoft. The Company expects additional competition from other
companies, including Microsoft, which has made investments in and acquired voice
interface technology companies. Furthermore, the Company's competitors may
combine with each other, and other companies may enter its markets by acquiring
or entering into strategic relationships with its competitors. Current and
potential competitors have established, or may establish, cooperative
relationships among themselves or with third parties to increase the abilities
of their speech and language technology products to address the needs of the
Company's prospective customers.
Many of the Company's current and potential competitors have longer
operating histories, significantly greater financial, technical, product
development and marketing resources, greater name recognition and larger
customer bases than the Company does. The Company's present or future
competitors may be able to develop products comparable or superior to those it
offers, adapt more quickly to new technologies, evolving industry trends and
standards, or customer requirements than it does, or devote greater resources to
the development, promotion and sale of their products than it does. Accordingly,
the Company may not be able to compete effectively in its markets, and
competition may intensify and may harm the Company's business.
The Company's failure to respond to rapid change in the speech-enabled
technologies market could cause the Company to lose revenue and harm its
business.
The speech-enabled technologies industry is relatively new and
rapidly evolving. The Company's success will depend substantially upon its
ability to enhance its existing Products and to develop and introduce, on a
timely and cost-effective basis, new technologies, Products and features that
meet changing end-user requirements and incorporate technological advancements.
If the Company is unable to develop new Products and enhanced functionalities or
technologies to adapt to these changes, or if it cannot offset a decline in
revenue from existing Products with sales of new Products, the Company's
business will suffer.
Commercial acceptance of the Company's Products will depend, among
other things, on:
o the ability of its Products to meet and adapt to the needs of its
target markets;
o the performance and price of its Products and its competitors'
products; and
o its ability to deliver customer services directly and through its
resellers, VARs and OEM partners.
Page 23
Any software defects in the Company's Products could harm its business and
result in litigation.
Complex software products such as the Company's may contain errors,
defects and bugs. With the planned release of any Product, the Company may
discover these errors, defects and bugs and, as a result, Products may take
longer to develop than expected. In addition, the Company may discover that
remedies for errors or bugs may be technologically infeasible. Delivery of
Products with undetected production defects or reliability, quality, or
compatibility problems could damage the Company's reputation. Errors, defects or
bugs could also cause interruptions, delays or a cessation of sales to its
customers. The Company could be required to expend significant capital and other
resources to remedy these problems. In addition, customers whose businesses are
disrupted by these errors, defects and bugs could bring claims against us which,
even if unsuccessful, would likely be time- consuming and could result in costly
litigation and payment of damages.
In order to increase the Company's international sales, the Company must
increase the foreign language capacities of its Products. If it is unable to do
so, it may be unable to grow its revenue and execute its business strategy.
The Company intends to expand its international sales, which requires
a significant investment to create and refine different language models for each
particular language or dialect. These language models are required to create
versions of products that allow end users to speak the local language or dialect
and be understood. If the Company fails to develop additional foreign language
capacity of its Products, its ability to address international market
opportunities and to grow its business will be limited.
The Company may encounter difficulties in managing its growth, which could
prevent it from executing its business strategy.
The Company's growth has placed, and continues to place, a
significant strain on its resources. To accommodate this growth, the Company
must continue to upgrade a variety of operational and financial systems,
procedures and controls and hire additional employees to support increased
business and product development activity. This has resulted in increased
responsibilities for the Company's management. The Company's systems, procedures
and controls may not be adequate to support its operations. If the Company fails
to improve its operational, financial and managerial information systems, or to
hire, train, motivate or manage its employees, its business could be harmed or
fail.
The Company may incur a variety of costs to engage in future acquisitions of
companies, products or technologies, and the anticipated benefits of those
acquisitions may never be realized.
The Company may make acquisitions of, or significant investments in,
complementary companies, products or technologies, such as the recent purchase
of assets from Force Computers, Inc. discussed elsewhere herein, although no
material acquisitions or investments are currently pending. Any future
acquisitions would be accompanied by risks such as:
o difficulties in assimilating the operations and employees of
acquired companies;
o diversion of the Company's management's attention from ongoing
business concerns;
o the Company's potential inability to maximize its financial and
strategic position through the successful incorporation of
acquired technology and rights into its products and services;
o additional expense associated with amortization of acquired
assets;
o maintenance and implementation of uniform standards, controls,
procedures and policies; and
Page 24
o impairment of existing relationships with employees, suppliers
and customers as a result of the integration of new management
employees.
The Company cannot guarantee that it will be able to successfully
integrate any business, products, technologies or employees that it might
acquire in the future, and its failure to do so could harm its business.
If the Company is unable to hire and retain technical, sales and marketing and
operational employees, its business could be harmed.
The Company intends to hire additional employees, including software
engineers, sales and marketing employees and operational employees. Competition
for hiring these individuals is intense, especially in the Salt Lake City area
where the Company is headquartered, and it may not be able to attract,
assimilate, or retain additional highly qualified employees in the future. The
failure to attract, integrate, motivate and retain these employees could harm
its business.
The Company's stock price is volatile, and an investor may not be able to resell
its shares at or above the purchase price.
In recent years, the stock market in general, and the OTC Bulletin
Board and the securities of technology companies in particular, has experienced
extreme price and trading volume fluctuations. These fluctuations have often
been unrelated or disproportionate to the operating performance of individual
companies. These broad market fluctuations may materially adversely affect its
stock price, regardless of operating results.
The Company's operations and financial condition could be adversely affected by
its failure or inability to protect its intellectual property or if its
technologies are found to infringe the intellectual property of a third party.
Dependence on proprietary technology
The Company's success is heavily dependent upon its proprietary
technology. Certain elements of the Company's Core Technologies are the subject
of seven patents issued and allowed by the United States Patent and Trademark
Office and 10 other patent applications which are pending. In addition to its
patents, the Company relies on a combination of copyright and trademark laws,
trade secrets, confidentiality procedures and contractual provisions to protect
its proprietary rights. Such means of protecting the Company's proprietary
rights may not be adequate because such laws provide only limited protection.
Despite precautions that the Company takes, it may be possible for unauthorized
third parties to duplicate aspects of its technologies or the current or future
products or technologies of its business units or to obtain and use information
that it regards as proprietary. Additionally, its competitors may independently
develop similar or superior technology. Policing unauthorized use of proprietary
rights is difficult, and some international laws do not protect proprietary
rights to the same extent as United States laws. Litigation periodically may be
necessary to enforce the Company's intellectual property rights, to protect its
trade secrets or to determine the validity and scope of the proprietary rights
of others.
Risks of the Company's infringement upon the technology of unrelated
parties or entities
The Company is not aware and does not believe that any of its
technologies or products infringe the proprietary rights of third parties.
Nevertheless, third parties may claim infringement with respect to its current
or future technologies or products or products manufactured by others and
incorporating its technologies. The Company expects that developers of
speech-enabled technologies increasingly will be subject to infringement claims
as the number of products and competitors in the industry grows and the
functionality of products in different industry segments overlaps. Responding to
any such claims, whether or not they are found to have merit, could be time
consuming, result in costly litigation, cause development delays, or require us
to enter into royalty or license
Page 25
agreements. Royalty or license agreements may not be available on acceptable
terms or at all. As a result, infringement claims could have a material adverse
affect on its business, operating results, and financial condition.
The Company is subject to the risk that certain key personnel, including key
scientific employees and independent contractors named below, on whom it
depends, in part, for the Company's operations, will cease to be involved with
the Company.
The Company is dependent on the knowledge, skill and expertise of
several key scientific and business development employees, including John A.
Oberteuffer, Ph.D., Dale Lynn Shepherd, R. Brian Moncur, Doug Jensen, Edward A.
Bruckert, Tim Cross, Tim Hong, Paul Clayson, John Oelfke, K. H. Kim, Kurt
Flygare and Rolf-Juergen Bruess; independent contractors including C. Hal Hansen
and Tony R. Martinez, Ph.D.; and executive officers, including Thomas A.
Murdock, Roger D. Dudley and William A. Maasberg, Jr. The loss of any of the key
personnel listed above could materially and adversely affect its future business
efforts. Although it has taken reasonable steps to protect its intellectual
property rights including obtaining non-competition and non-disclosure
agreements from all of its employees and independent contractors, if one or more
of the Company's key scientific employees, executive employees or independent
contractors resigns from Fonix to join a competitor, to the extent not
prohibited by such person's non-competition and non-disclosure agreement, the
loss of such personnel and the employment of such personnel by a competitor
could have a material adverse effect on the Company. The Company does not
presently have any key man life insurance on any of its employees except Mr.
Dudley, for whom it carries a policy with a face amount of $4 million. The
Company is the named beneficiary.
The Company has no dividend history and has no intention to pay dividends in the
foreseeable future.
The Company has never paid dividends on or in connection with any
class of its common stock and does not intend to pay any dividends to common
stockholders for the foreseeable future.
There may be additional unknown risks which could have a negative effect on the
Company and its business.
The risks and uncertainties described in this section are not the
only ones facing the Company. Additional risks and uncertainties not presently
known to the Company or that it currently deems immaterial may also impair its
business operations. If any of the foregoing risks actually occur, its business,
financial condition, or results of operations could be materially adversely
affected. In such case, the trading price of its Class A common stock could
decline.
ITEM 2. PROPERTIES
The Company owns no real property. Commencing in October 1996, the
Company leased a 25,600 square foot facility in Draper, Utah, from an
unaffiliated third party at which it conducts its principal scientific research,
product development and sales and marketing activities. The Company's lease of
that facility is for a term of eight years, with a right to terminate after five
years, which right the Company did not exercise in 2001. Provided that the
Company is not in default under the lease, the Company has the option to extend
the lease for five additional years. The average base monthly lease payment over
the eight-year life of the lease for that facility is $28,389.
In addition to the Draper facility, the Company subleased office
space at market rates from SCC Asset Management, Inc., formerly Studdert
Companies Corporation ("SCC"). SCC is owned and controlled by three individuals,
two of whom are executive officers and directors of the Company. (See "Certain
Relationships and Related Transactions," and "Security Ownership of Certain
Beneficial Owners and Management"). The two executive officers and a former
executive officer of the Company personally guaranteed these leases in favor of
SCC's landlord. The subleases required monthly rental payments of $10,368.
During October 2002, the Company assumed SCC's lease obligation. The subleases
were terminated effective February 2003. On March 18, 2003, the Company executed
a promissory note with the landlord in the amount of $113,768 covering outanding
lease
Page 26
obligations. The note bears annual interest at 10% and is payable in monthly
installments of $3,000 commencing April 10, 2003.
The Company leases approximately 2,507 square feet of office space in
Waltham, Massachusetts, where it conducts sales and marketing for its Products
and product development for certain Core Technologies. This lease expires
December 31, 2003, and requires monthly rental payments of $3,551.
Effective May 25, 1999, the Company entered into an agreement to
sublease a Cupertino, California facility to an unrelated third party. The
agreement requires the sublessee to pay the monthly rent of $31,651 directly to
the lessor through the end of the lease term on May 31, 2003. In the event the
sublessee fails to make timely payments, the Company could be required to cover
deficiencies in payments.
The Company believes that the facilities described above are adequate
for its current operating needs.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in claims and actions arising in the ordinary
course of business. In the opinion of management, after consultation with legal
counsel, the ultimate disposition of these matters will not materially affect
the consolidated financial position, liquidity or results of operations of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
2002 Annual Meeting of Shareholders
On July 12, 2002, the Company held its Annual Meeting of Shareholders
in Boston, Massachusetts. The record date for the meeting was May 24, 2002, on
which date there were 12,070,147 shares of the Company's Class A common stock
outstanding.
The first matter voted upon at the meeting was the election of
directors. The following directors were elected:
SHARES SHARES
DIRECTOR VOTED IN FAVOR VOTED AGAINST
- -------- -------------- -------------
Thomas A. Murdock 9,985,780 278,654
Roger D. Dudley 9,984,033 280,402
John A. Oberteuffer, Ph.D 10,122,581 141,853
William A. Maasberg, Jr. 10,085,989 178,445
Mark S. Tanner 10,090,106 174,328
The second matter voted upon at the meeting was the approval of a
proposed amendment to the Company's Certificate of Incorporation to increase the
authorized capital stock of the Company to include 800,000,000 shares of Class A
Common Stock. The results of the voting were 9,935,830 shares in favor, 294,172
shares against, and 34,433 shares withheld or abstaining.
March 2003 Special Meeting of Shareholders
On March 24, 2003, the Company held a Special Meeting of Shareholders
in Salt Lake City, Utah. The record date for the meeting was February 7, 2003,
on which date there were 15,915,367 shares of the Company's
Page 27
Class A common stock issued, of which 2,020,750 shares were held as collateral
under escrow agreements and were not entitled to vote.
The first matter voted upon at the special meeting was the approval
of the Board of Directors' selection of Hansen, Barnett & Maxwell as the
Company's independent certified public accountants for the fiscal year ending
December 31, 2002. The results of the voting were 11,343,679 shares in favor,
185,011 shares against, and 152,555 shares withheld or abstaining.
The second matter voted upon at the special meeting was to consider
and act upon a proposed amendment to the Company's certificate of incorporation
to effect a reverse stock split of the Company's Class A common stock at a ratio
of one share for forty shares. The results of the voting were 10,325,475 shares
in favor, 1,240,197 shares against, and 55,573 shares withheld or abstaining.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Fonix Class A common stock is listed on the OTC Bulletin Board under
the trading symbol FONX. The following table shows the range of high and low
sales price information for Class A common stock as quoted on the OTC Bulletin
Board for the four quarters of calendar 2002 and 2001. The quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commissions and may
not represent actual transactions. The quotations also do not reflect price
adjustments which will occur as a result of the Reverse Stock Split (see
"Reverst Stock Split" below).
Calendar Year 2002 Calendar Year 2001
----------------------- ----------------------
High Low High Low
---- ----- ----- ----
First Quarter $0.13 $0.04 $ 0.95 $ 0.31
Second Quarter $0.16 $0.06 $ 0.61 $ 0.28
Third Quarter $0.08 $0.05 $ 0.32 $ 0.06
Fourth Quarter $0.06 $0.04 $ 0.24 $ 0.07
As of March 21, 2003, there were 14,571,081 shares of Fonix Class A
common stock outstanding, held by approximately 1,036 holders of record and
40,000 beneficial holders. This number of beneficial holders represents an
estimate of the number of actual holders of the Company's stock, including
beneficial owners of shares held in "nominee" or "street" name. The actual
number of beneficial owners is not known to the Company.
The Company has never declared any dividend on its Class A common
stock and it is expected that earnings, if any, in future periods will be
retained to further the development and sale of the Company's speech- enabling
technologies and products. No dividends can be paid on the Class A common stock
until such time as all accrued and unpaid dividends on outstanding preferred
stock, if any, have been paid.
Reverse Stock Split
At a special meeting of shareholders held on March 24, 2003, the
Company's shareholders approved a Reverst Stock Split of the Company's Class A
common stock at a ratio of one share for forty shares. The Company will file an
amendment to its Certificate of Incorporation (as amended) with the Delaware
Secretary of State, stating that the effective date of the Reverse Stock Split
will be 12:01 a.m., April 4, 2003. The shares presented in this Annual Report
have been presented on a post-split basis.
Page 28
Securities authorized for issuance under equity compensation plans
The following table sets forth information about the Company's equity
compensation plans, including the number of securities to be issued upon the
exercise of outstanding options, warrants, and rights; the weighted average
exercise price of the outstanding options, warrants, and rights; and the number
of securities remaining available for issuance under the specified plan.
Number of securities
Number of securities to Weighted average remaining available for
be issued upon exercise exercise price of future issuance under
of outstanding options, outstanding options, equity compensation
Plan Category warrants, and rights warrants, and rights plans
-------------------------- ------------------------- ---------------------------
Equity compensation
plans approved by 685,902 $62.60 162,630
shareholders
Equity compensation
plans not approved by -- -- --
shareholders
Total 685,902 $62.60 162,630
2002 Employee Compensation Plan
On February 6, 2003, the Fonix Board of Directors adopted the 2002
Employee Compensation Plan (the "2002 Plan"). Shares of Class A common stock
issued under the 2002 Plan will be in partial payment of wages and salaries
earned by employees during the plan period, which runs from December 1, 2002,
through May 31, 2003. The plan period may be extended by the Board of Directors.
Each current employee has agreed to the terms of the 2002 Plan.
The maximum aggregate number of shares that may be issued under the
2002 Plan is 150,000,000 Shares (3,750,000 post-Reverse Stock Split shares). The
2002 Plan will be administered by the Board of Directors or a committee of the
Board. Shares under the 2002 Plan may be issued only to employees of Fonix.
Employees subject to the 2002 Plan were required to provide the
Company with a notice of election to participate in the 2002 Plan and to
indicate the amount of compensation to be deferred during the plan period. The
deferred compensation of employees electing to participate in the 2002 Plan may
be paid, at the option of the employee, in shares of the Company's Class A
common stock, in cash, or in a combination of the two. The payment of deferred
compensation will commence June 30, 2003.
As of March 26, 2003, no employee had notified the Company of the
ratio of cash and Class A common stock to be issued under the 2002 Plan, and no
shares or cash had been issued or paid to employees under the 2002 Plan.
The Company intends to seek shareholder approval of the 2002 Plan at
its 2003 Annual Meeting of Shareholders.
Page 29
Recent Sales of Unregistered Equity Securities
For the year ended December 31, 2001, the Company received $5,510,000
in funds drawn under the first equity line, less commissions and fees of
$165,300, and issued 658,829 shares of Class A common stock to the Equity Line
Investor. The shares were issued without registration under the 1933 Act in
reliance on Section 4(2) of the Securities Act of 1933, as amended (the "1933
Act"), and the rules and regulations promulgated thereunder. The resales of the
shares were subsequently registered under registration statements on Form S-2.
Between May 25, 2001 and December 31, 2001, the Company received
$13,425,000 in funds drawn under a second equity line, less commissions and fees
of $497,750, and issued 2,950,325 shares of Class A common stock to the Equity
Line Investor. Subsequent to December 31, 2001, the Company received $4,643,164
in funds drawn under the second equity line, less commissions and fees of
$139,295, and issued 83,897,735 shares of Class A common stock to the Equity
Line Investor. The shares were issued without registration under the 1933 Act in
reliance on Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder. The resales of the shares were subsequently registered
under registration statements on Form S-2.
For the year ended December 31, 2002, the Company received $9,362,663
in funds drawn under the first equity line and second equity line, less
commissions and fees of $274,630, and issued 3,356,998 shares of Class A common
stock to the Equity Line Investor. Subsequent to December 31, 2002, through
March 21, 2003, the Company received $2,500,000 in funds drawn under the third
equity line, less commissions and fees of $64,150, and issued 2,866,412 shares
of Class A common stock to the Equity Line Investor. The shares were issued
without registration under the 1933 Act in reliance on Section 4(2) of the 1933
Act and the rules and regulations promulgated thereunder. The resales of the
shares by the Equity Line Investor were subsequently registered under
registration statements on Form S-2.
Page 30
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial information set forth below is
derived from the Company's consolidated balance sheets and statements of
operations as of and for the years ended December 31, 2002, 2001, 2000, 1999,
and 1998. The data set forth below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the consolidated financial statements and related notes thereto
included in this Report.
For the Year Ended December 31,
2002 2001 2000 1999 1998
-------------- ------------- ------------- -------------- --------------
Statement of Operations Data:
Revenues $ 3,064,719 $ 581,684 $ 656,853 $ 439,507 $ 2,604,724
Cost of Revenues 553,404 9,898,769 1,851,876 2,009,723 1,238,400
Selling, general and administrative expenses 12,029,997 11,646,139 10,751,597 9,498,753 8,817,643
Product development and research 8,192,664 8,123,453 5,871,414 7,909,228 13,060,604
Amortization of intangible assets 30,600 604,105 604,105 604,105 473,867
Impairment loss on investment in affiliate -- 823,275 -- -- --
Purchased in-process research and development -- -- 474,000 -- 9,315,000
Other expense, net (581,294) (173,221) (3,991,348) (3,698,789) (6,507,245)
Loss from continuing operations (18,855,788) (30,687,278) (22,810,677) (19,949,196) (36,843,475)
Equity in loss of affiliate (456,692) (372,513) -- -- --
Loss from discontinued operations -- -- -- (2,187,080) (6,275,307)
Gain (loss) on extraordinary items -- -- 49,448 473,857 --
Net loss (19,897,564) (31,059,791) (22,887,487) (21,662,419) (43,118,782)
Basic and diluted net loss per common share $ (1.73) $ (5.20)$ (6.42) $ (12.40) $ (36.40)
Basic and diluted weighted average number of common 11,471,564 5,978,281 4,067,107 1,918,243 1,312,780
shares outstanding
As of December 31,
-------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
----------------- ---------------- ----------------- ---------------- -----------------
Balance Sheet Data:
Current assets $ 690,844 $ 1,269,124 $ 3,752,210 $ 480,885 $ 20,638,070
Total assets 6,523,480 8,599,028 17,517,373 19,173,147 61,912,791
Current liabilities 15,119,594 7,370,392 3,571,854 5,285,681 35,317,045
Long-term debt, net of current portion 3,312 -- 19,767 3,971,107 --
Stockholders' (deficit) equity (8,599,426) 1,228,636 13,925,752 8,086,359 24,765,746
Page 31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY
THE COMPANY AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD
CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION
ENTITLED "FACTORS AFFECTING FUTURE OPERATING RESULTS" AND UNDER THE HEADING
"CERTAIN SIGNIFICANT RISK FACTORS" IN ITEM 1 PART I OF THIS REPORT, ABOVE.
The following discussion of the results of operations and financial
condition should be read in conjunction with the consolidated financial
statements and notes thereto included elsewhere in this report.
Overview
Since inception, Fonix has devoted substantially all of its resources
to research, development and acquisition of software technologies that enable
intuitive human interaction with computers, consumer electronics, and other
intelligent devices. Through December 31, 2002, the Company has incurred
significant cumulative losses, and losses are expected to continue until the
effects of recent marketing and sales efforts begin to take effect, if ever. The
Company continues to emphasize delivery and sales of its applications and
solutions ("Products") while achieving technology upgrades to maintain its
perceived competitive advantages.
In its current marketing efforts, the Company seeks to form
relationships with third parties who can incorporate the Company's
speech-enabling Products into new or existing products. Such relationships may
be structured in any of a variety of ways including traditional technology
licenses, collaboration or joint marketing agreements, co-development
relationships through joint ventures or otherwise, and strategic alliances. The
third parties with whom Fonix presently has such relationships and with which it
may have similar relationships in the future include developers of application
software, operating systems, computers, microprocessor chips, consumer
electronics, automobiles, telephony, and other products. The Company is
currently in negotiation with customers and potential customers to enter into
additional third-party licensing, collaboration, co-marketing and distribution
arrangements.
The Company's revenues increased from $581,684 for the year ended
December 31, 2001 to $3,064,719 for the year ended December 31, 2002. However,
the Company incurred negative cash flows from operating activities of $9,531,623
during the year ended December 31, 2002. Sales and licensing of Products have
not been sufficient to finance ongoing operations. As of December 31, 2002, the
Company had negative working capital of $14,428,750 and an accumulated deficit
of $194,006,920. The Company has drawn all capital available under its initial
and second equity lines. A third equity line is in place and $17,500,000 remains
available to the Company under that equity line. The Company's continued
existence is dependent upon several factors, including the Company's success in
(1) increasing license, royalty, Product sales, and services revenues, (2)
raising sufficient additional equity and debt funding through the use of the
third equity line or other facilities, and (3) minimizing and reducing operating
costs. Until sufficient revenues are generated from operating activities, the
Company expects to continue to fund its operations through the sale of its
equity securities, primarily the third equity line.
In 2002, the Company experienced slower development of markets for
speech applications than had been anticipated due to several factors. First, the
limited resources with which the Company has been operating (due to the delay in
accessing funds from the third equity line) have hampered the Company's ability
to aggressively support marketing and sales as originally anticipated.
Additionally, time and resources required to develop certain Products have been
greater than originally anticipated, and, with limited resources available, the
Company has not been able to expedite such development. Further, the ongoing
U.S. economic slowdown has slowed customer acceptance in
Page 32
target markets, especially in the telecommunications sector where previously
expected recovery has yet to materialize, but has deteriorated further. The
occurrence of these conditions has caused the Company to (i) reduce its emphasis
on consumer applications because of the significant resources required to
develop retail markets, (ii) reduce its development and marketing efforts in the
computer telephony and server-based markets, and (iii) increase its emphasis and
focus on mobile and wireless applications, automotive speech interface solutions
and assistive markets, where management believes the Company enjoys the greatest
technological and market advantage.
The Company assesses unamortized capitalized computer software costs
for possible write down based on net realizable value of each related product.
Net realizable value is determined based on the estimated future gross revenues
from a product reduced by the estimated future cost of completing and disposing
of the product, including the cost of performing maintenance and customer
support.
In order to assess future gross revenues, the Company has evaluated
the life cycle of its Products and the periods in which it will receive revenues
from them. Widespread deployment of speech applications, solutions and interface
products is growing, especially for the Products the Company develops and
markets. However, certain speech Products, specifically those which are useful
in the telecommunications segment, have been severely impacted by declining
market conditions over the past 18 to 24 months. Nevertheless, speech
applications and interface solutions useful in devices such as smart-phones,
PDAs, cell phones, assistive devices for the sight-impaired, and other mobile
and wireless devices are beginning to enjoy user acceptance and market demand.
The Company's experience has indicated that original equipment manufacturers
("OEMs"), value added resellers ("VARs"), software developers and other users
typically integrate a new application or interface product such as speech
initially into only one or two products. Then, as market and user acceptance of
the technology increases, as applications are proven reliable, and as cost of
production and delivery decreases on a per-unit basis, the applications
typically are expanded into broader product lines. As a result, initial sales
volumes in early OEM integration periods are expected to be low, but will grow
at a substantial pace in subsequent periods as (i) OEM customers expand product
offerings and (ii) the customers of OEMs commit to and release speech
applications in their products. The Company expects growth to continue for four
to six years, but expects the rate of growth to slow as the market matures
toward the end of that period.
Significant Accounting Policies
The discussion and analysis of the Company's financial condition and
results of operations are based upon the Company's consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial
statements requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of sales and expenses during the reporting period. Significant accounting
policies and areas where substantial judgements are made by management include:
Accounting Estimates - The preparation of financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosures of contingent assets and
liabilities at the date of the financial statements, and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
Valuation of Long-lived Assets - The carrying values of the Company's
long-lived intangible assets are reviewed for impairment on a quarterly basis or
otherwise whenever events or changes in circumstances indicate that they may not
be recoverable.
The Company assesses unamortized capitalized software costs for
possible write down based on net realizable value of each related product. Net
realizable value is determined based on the estimated future gross revenues from
a product reduced by the estimated future cost of completing and disposing of
the product, including
Page 33
the cost of performing maintenance and customer support. The amount by which the
unamortized capitalized costs of a software product exceed the net realizable
value of that asset is written off.
The speech software technology was tested for impairment in December
2001 and December 2002. Due to the down-turn in the software industry and the
U.S. economy, operating losses and cash used in operating activities during the
fourth quarter of 2001 were greater than anticipated. Based on that trend,
management revised estimated net future cash flows from the speech technology,
which resulted in recognition of an impairment loss of $5,832,217 during the
fourth quarter of 2001. The impairment loss was charged to cost of revenues. No
further impairment was deemed necessary at December 31, 2002.
During the fourth quarter of 2001, management determined that its
handwriting recognition software ("HWR") technology was impaired. Without
immediate customer prospects or current license agreements, management has
chosen not to provide further funding to develop or market the HWR technology.
Accordingly, the unamortized balance of $2,056,295 was recorded in cost of
revenues in 2001.
With respect to the Company's other long-lived assets, the Company
projects undiscounted cash flows to be generated from the use of the asset and
its eventual disposition over the remaining life of the asset. If projections
indicate that the carrying value of the long-lived asset will not be recovered,
the carrying value of long-lived assets is reduced by the estimated excess of
the carrying value over the projected discounted cash flows.
Management does not consider any of the Company's other long-lived
assets to be impaired at December 31, 2002. However, should the Company's
marketing and sales plans not materialize in the near term, the realization of
the Company's intangible assets could be severely and negatively impacted. The
accompanying consolidated financial statements have been prepared based on
management's estimates of realizability, which estimates may change due to
factors beyond the control of the Company. (See "Recently Enacted Accounting
Standards" below).
Revenue Recognition - The Company recognizes revenues in accordance
with the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition" and related interpretations. The Company generates revenues from
licensing the rights to its software products to end users and from royalties.
It also generates service revenues from the sale of consulting and development
services.
Revenues of all types are recognized when acceptance of
functionality, rights of return, and price protection are confirmed or can be
reasonably estimated, as appropriate. Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer. The completed-contract method is used
because the Company's contracts are either short-term in duration or the Company
is unable to make reasonably dependable estimates of the costs of the contracts.
Revenue for hardware units delivered is recognized when delivery is verified and
collection assured.
Revenue for products distributed through wholesale and retail
channels and through resellers is recognized upon verification of final
sell-through to end users, after consideration of rights of return and price
protection. Typically, the right of return on such products has expired when the
end user purchases the product from the retail outlet. Once the end user opens
the package, it is not returnable unless the medium is defective. Price
protection is offered to distributors in the event the Company reduces the price
on any specific product. Such price protection is generally offered for a
specific time period in which the distributor must make a claim. Resulting
revenue recognized reflects the reduced price. Slotting fees paid by the Company
for favorable placement in retail outlets are recorded as a reduction in gross
revenues.
When arrangements to license software products do not require
significant production, modification or customization of software, revenue from
licenses and royalties are recognized when persuasive evidence of a licensing
arrangement exists, delivery of the software has occurred, the fee is fixed or
determinable, and collectibility is probable. Post-contract obligations, if any,
generally consist of one year of support including such services as
Page 34
customer calls, bug fixes, and upgrades. Related revenue is recognized over the
period covered by the agreement. Revenues from maintenance and support contracts
are also recognized over the term of the related contracts.
Revenues applicable to multiple-element fee arrangements are
bifurcated among the elements such as license agreements and support and upgrade
obligations using vendor-specific objective evidence of fair value. Such
evidence consists primarily of pricing of multiple elements as if sold as
separate products or arrangements. These elements vary based upon factors such
as the type of license, volume of units licensed, and other related factors.
Deferred revenue as of December 31, 2002, consisted of the following:
Description Criteria for Recognition Amount
- ----------- ------------------------ -----------------
Deferred unit royalties and Delivery of units to end users or expiration of
licence fees contract $ 797,737
Deferred customer support Expiration of period covered by support
agreement 59,511
-----------------
Total deferred revenue $ 854,248
=================
Cost of revenues - Cost of revenues from license, royalties, and
maintenance consists of costs to distribute the product (including the cost of
the media on which it is delivered), installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs. Cost of service revenues consists
of personnel compensation and other related costs.
Software technology development and production costs - All costs
incurred to establish the technological feasibility of speech software
technology to be sold, leased, or otherwise marketed are charged to product
development and research expense. Technological feasibility is established when
a product design and a working model of the software product have been completed
and confirmed by testing. Costs to produce or purchase software technology
incurred subsequent to establishing technological feasibility are capitalized.
Capitalization of software costs ceases when the product is available for
general release to customers. Costs to perform consulting services or
development of applications are charged to cost of revenues in the period in
which the corresponding revenues are recognized. Cost of maintenance and
customer support are charged to expense when related revenue is recognized or
when these costs are incurred, whichever occurs first.
Capitalized software technology costs are amortized on a
product-by-product basis. Amortization is recognized from the date the product
is available for general release to customers as the greater of (a) the ratio
that current gross revenue for a product bears to total current and anticipated
future gross revenues for that product or (b) the straight-line method over the
remaining estimated economic life of the products. Amortization is charged to
cost of revenues.
The Company assesses unamortized capitalized software costs for
possible write down on a quarterly basis based on net realizable value of each
related product. Net realizable value is determined based on the estimated
future gross revenues from a product reduced by the estimated future cost of
completing and disposing of the product, including the cost of performing
maintenance and customer support. The amount by which the unamortized
capitalized costs of a software product exceed the net realizable value of that
asset is written off.
Stock-based Compensation Plans - The Company accounts for its
stock-based compensation issued to employees and directors under Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees." Under APB Opinion No. 25, compensation related to stock options, if
any, is recorded if an option's exercise price on the measurement date is below
the fair value of the Company's common stock, and amortized to expense over the
vesting period. Compensation expense for stock awards or purchases, if any, is
recognized if the
Page 35
award or purchase price on the measurement date is below the fair value of the
Company's common stock, and is recognized on the date of award or purchase.
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock Based Compensation," requires pro forma information regarding net loss and
net loss per common share as if the Company had accounted for its stock options
granted under the fair value method. This pro forma disclosure is presented in
Note 1 of the consolidated financial statements.
The Company accounts for its stock-based compensation issued to
non-employees using the fair value method in accordance with SFAS No. 123 and
related interpretations. Under SFAS No. 123, stock-based compensation is
determined as either the fair value of the consideration received or the fair
value of the equity instruments issued, whichever is more reliably measurable.
The measurement date for these issuances is the earlier of the date at which a
commitment for performance by the recipient to earn the equity instruments is
reached or the date at which the recipient's performance is complete. The
Company has adopted the disclosure requirements of SFAS No. 148 in the
accompanying financial statements.
Imputed Interest Expense and Income - Interest is imputed on
long-term debt obligations and notes receivable where management has determined
that the contractual interest rates are below the market rate for instruments
with similar risk characteristics (see Notes 5 and 7 to the consolidated
financial statements).
Recently Enacted Accounting Standards - In July 2001, the Financial
Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations"
and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141
eliminates the "pooling-of-interests" method of accounting for acquisitions and
requires separate accounting for certain intangibles acquired in such
transactions. SFAS No. 142 also changes the accounting for goodwill and
intangible assets with indefinite lives from an amortization method to an
impairment-only approach.
The Company adopted the provisions of SFAS No. 142 on January 1,
2002. Under the new standard, goodwill and intangible assets deemed to have
indefinite lives are no longer amortized, but are subject to annual impairment
tests. The Company has reassessed the estimated useful lives of other intangible
assets and will continue to amortize the costs of those assets over their
estimated useful lives. As of January 1, 2002, amortized intangible assets
consisted of the following:
Gross Carrying Accumulated
Amount Amortization
--------------------------- ---------------------------
Speech software technology $ 978,582 $ --
Customer relationships 306,000 --
Patents 164,460 145,522
--------------------------- ---------------------------
Total $ 1,449,042 $ 145,522
=========================== ===========================
Intangible assets not subject to amortization as of January 1, 2002
consisted of goodwill with a net carrying value of $2,631,304 and trademarks
with a carrying value of $42,000. These assets are considered to have indefinite
useful lives.
Except for capitalized speech software technology that is amortized
on the basis described below, amortization of intangible assets subject to
amortization is computed on a straight-line basis over their estimated useful
lives. The weighted-average estimated remaining amortization periods are as
follows: total - 8.7 years; speech software technology - 8.7 years; customer
relationships - 9.0 years. Intangible assets
Page 36
subject to amortization will not have any significant residual value at the end
of their estimated useful lives. As of December 31, 2002, estimated amortization
of intangible assets for the following five years is as follows:
For the Years Ending December 31: Amount
---------------------
2003 $ 134,996
2004 134,996
2005 134,996
2006 124,100
2007 124,100
During 2002, the Company engaged Houlihan Valuation Advisors, an
independent valuation firm, to assess the Company's goodwill for impairment. The
resulting appraisal indicated no impairment and goodwill was not considered
impaired. However, should the Company's marketing and sales plans not
materialize in the near term, the realization of the Company's goodwill and
other intangible assets could be severely and negatively impacted.
The effects on loss from continuing operations, net loss and basic
and diluted loss per share of excluding goodwill amortization for the years
ended December 31, 2002, 2001, and 2000 are as follows:
2002 2001 2000
------------------------------------- ------------------
Loss from continuing operations, as reported $ (19,897,564) $ (31,059,791) $ (22,810,677)
Loss from continuing operations, excluding goodwill amortization $ (19,897,564) $ (30,455,686) $ (22,206,572)
================== ================= ==================
Net loss, as reported $ (19,897,564) $ (31,059,791) $ (22,761,229)
Add back goodwill amortization -- 604,105 604,105
------------------ ----------------- ------------------
Net loss, excluding goodwill amortization $ (19,897,564) $ (30,455,686) $ (22,157,124)
================== ================= ==================
Basic and diluted loss per share:
Loss from continuing operations, as reported $ (1.73) $ (5.20) $ (5.61)
Loss from continuing operations, excluding goodwill amortization $ (1.73) $ (5.09) $ (5.46)
================== ================= ==================
Net loss, as reported $ (1.73) $ (5.20) $ (5.60)
Net loss, excluding goodwill amortization $ (1.73) $ (5.09) $ (5.45)
================== ================= ==================
In August 2001, the FASB issued SFAS No. 143 , "Accounting for Asset
Retirement Obligations." This statement establishes financial accounting and
reporting standards for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The Company's
adoption of this statement on January 1, 2002, did not have a material effect on
the Company's financial position or results of operations.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long- Lived Assets." This statement establishes
financial accounting and reporting standards for the impairment or disposal of
long-lived assets. The adoption of this statement on January 1, 2002, did not
have a material effect on the Company's financial position or results of
operations. See Note 2 to the condensed consolidated financial statements for
the year ended December 31, 2002, included in this report.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." Among other provisions, this statement modifies the criteria for
classification of gains or losses on debt extinguishment such that they are not
required to be classified as extraordinary items if they do not meet the
criteria for classification as extraordinary items in APB Opinion No. 30,
"Reporting the Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." The Company will be required to apply the provisions
of this standard to transactions occurring after December 31, 2002. The adoption
of
Page 37
this standard in 2003 is not expected to have a material effect on the Company's
financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." The statement requires companies
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
Examples of costs covered by the standard include lease termination costs and
certain employee severance costs that are associated with a restructuring,
discontinued operation, plant closing, or other exit or disposal activity. The
Company will be required to apply this statement prospectively for any exit or
disposal activities initiated after December 31, 2002. The adoption of this
standard is not expected to have a material effect on the Company's financial
position or results of operations.
In December 2002, SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure -- an amendment of FASB No. 123" was
issued. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. It also amends disclosure requirements of
SFAS No. 123 requiring disclosures in both annual and interim financial
statements about the method of accounting for stock based employee compensation
and the effect of the method used on reported results. The transition guidance
and annual disclosure provisions of this statement are effective for fiscal
years ending after December 15, 2002. The interim disclosure provisions are
effective for financial reports containing financial statements for interim
periods beginning after December 15, 2002. At this time, the pronouncement is
not expected to have any impact on The Company's reported results of operations
and financial position as it continues to account for its stock compensation
plans under the provisions of APB Opinion No. 25, "Accounting for Stock Issued
to Employees." The Company has adopted the disclosure requirements of SFAS No.
148 in the accompanying financial statements.
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45."),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN 45 elaborates on the
existing disclosure requirements for most guarantees. It also clarifies that at
the time a company issues a guarantee, the company must recognize an initial
liability for the fair value, or market value, of the obligation it assumes
under that guarantee and must disclose that information in its interim and
annual financial statements. The initial recognition and measurement provisions
apply on a prospective basis to guarantees issued or modified after December 31,
2002. The Company does not expect the recognition and measurement provisions of
FIN 45 to have a material effect on future interim or annual financial
statements.
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46."),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN 46 provides guidance on the identification of entities for which control is
achieved through means other than through voting rights ("variable interest 45
entities" or "VIEs") and how to determine when and which business enterprise
should consolidate the VIE (the "primary beneficiary"). This new model for
consolidation applies to an entity in which either (1) the equity investors do
not have a controlling financial interest, or (2) the equity investment at risk
is insufficient to finance that entity's activities without receiving additional
subordinated financial support from other parties. In addition, FIN 46 requires
that both the primary beneficiary and all other enterprises with a significant
variable interest in a VIE make additional disclosures. FIN 46 applies toVIEs
created after January 31, 2003, and to VIEs in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a VIEs that it acquired before February 1, 2003.
Reclassifications and restatements - Certain reclassifications have
been made in the prior years' consolidated financial statements to conform with
the current year presentation. The consolidated financial statements for the
year ended December 31, 2000 previously presented amortization of capitalized
software technology as an expense in the amount of $1,824,440. The consolidated
financial statements for the year ended December 31, 2000 have been restated to
present amortization of capitalized software technology as a cost of revenues in
accordance with generally accepted accounting principles. The restatement had no
effect on loss before
Page 38
extraordinary item, net loss or on basic and diluted net loss per common share
for the year ended December 31, 2000.
Results of Operations
Fiscal Year 2002 Compared to 2001
During 2002, the Company recorded revenues of $3,064,719, an increase
of $2,483,035 from $581,684 in 2001. The increase in 2002 was due primarily to
revenues generated from the acquisition of the DecTalk assets from Force
Computers, Inc. and the overall increase in non-recurring engineering contracts
during 2002.
Cost of revenues was $657,801 in 2002, a decrease of $9,240,968 from
$9,898,769 in 2001. This decrease was due to the impairment losses that were
recognized on handwriting recognition in the amount of $2,056,295, and certain
speech related technologies in the amount of $5,832,217 during 2001. The
remaining difference was a net increase of $367,587 related primarily to DecTalk
sales recognized in 2002.
Selling, general and administrative expenses were $11,929,390 for
2002 and $11,646,139 for 2001, an increase of $283,251. The increase was
primarily due to an increase in compensation expense due to personnel added for
sales and marketing of $333,113, increased consulting costs of $226,182, and
increases in other operating expenses of $1,716,294, primarily due to the
impairment losses recognized in conjunction with the Unveil Technologies note
receivable. These increases were partially offset by a decrease in legal
expenses of $393,130, decreased travel expenses of $394,029, and decreased other
general and administrative expenses of $68,046.
The Company incurred research and product development expenses of
$8,192,664 during 2002 and $8,123,453 during 2001, an increase of $69,211. The
overall increase was due to increased consulting costs of $182,477, increased
software license fees of $114,062, increased travel and occupancy related costs
of $54,102, partially offset by reduced compensation related costs of $441,292.
Net other expense was $581,294 for 2002, an increase of $408,073 from
2001. The overall increase is due to interest expense associated with the
additional debt the Company incurred during 2002.
Fiscal Year 2001 Compared to 2000
During 2001, the Company recorded revenues of $581,684, a decrease of
$75,169 from $656,853 for 2000. The decrease in 2001 was due in part to the poor
economic conditions in the telecommunications sector of the economy, where much
of the Company's revenue has been generated in the past. Furthermore, sales and
marketing efforts did not increase revenues, in spite of considerable progress
in developing partnerships in key markets. Also, certain advance payments
received for royalties were not recognized.
Cost of revenues was $9,898,769 in 2001, an increase of $8,046,893
from $1,851,876 in 2000. This increase was a result of impairment losses
recognized on handwriting recognition in the amount of $2,056,295, and certain
speech related technologies in the amount of $5,832,217. These losses were
recognized due to declining market conditions and diminishing customer prospects
for those technologies. The remaining increase of $158,381 was the result of
increased costs of licensing royalties and maintenance earned in 2001 as well as
engineering projects completed and recorded in 2001.
Selling, general and administrative expenses were $11,646,139 for
2001 and $10,751,597 for 2000, an increase of $894,542. The change was a result
of increases of $1,492,025 in compensation-related expenses due to personnel
added for sales and marketing efforts, $193,689 in occupancy costs, $496,518 in
legal fees related to acquisitions, regulatory filings, litigation, intellectual
property protection, and other general corporate activities, $480,452 in
travel-related expenses, and $392,751 in promotion and advertising expenses
resulting from increased sales and marketing efforts. These increases were
offset, in part, by a decrease of $2,033,024 in consulting and outside services
incurred in 2000 but not repeated in 2001, and a decrease of $107,128 in other
operating expenses.
Page 39
The Company incurred research and product development expenses of
$8,123,453 during 2001, an increase of $2,252,038 from 2000. The greatest
portion of this increase was a result of $2,043,181 in additional
compensation-related expenses incurred by adding engineering and product
development personnel for development of product applications and solutions. In
addition to this increase, $299,864 of additional expenses were incurred by
consultants and outside service providers in development of speech-enabling
applications and solutions for customers. Future development efforts will
continue to focus on product applications and solutions utilizing the
speech-enabling technologies developed to date.
In 2001, the Company recognized an impairment of its investment in
affiliate, Audium Corporation, that was acquired earlier in the year. The
write-down was a result of a decrease in the estimated cash flows expected to be
realized from the investment due to overall decline in the economy and the
potential impact on related markets for Audium's products.
Net other expense was $173,221 for 2001, a decrease of $3,818,127
from 2000. Financing activities in 2001 were accomplished through equity lines
of credit rather than debt securities or sales of preferred stock. Accordingly,
interest expense incurred in 2001 was $3,818,309 less than in 2000. A beneficial
conversion feature of $3,447,623 was recorded in 2000 in connection with the
issuance of a convertible promissory note, along with other interest incurred on
the obligation. Interest income decreased by $58,910 due to lower cash balances
maintained throughout the year.
Selected Quarterly Operations Data
The following tables set forth selected unaudited statement of
operations data for each of the quarters in the years ended December 31, 2002
and 2001. This data has been derived from the Company's unaudited financial
statements that have been prepared on the same basis as the audited financial
statements and, in the opinion of management, include all adjustments,
consisting of normal recurring adjustments, necessary for a fair presentation of
the information when read in connection with the financial statements and the
related notes. The Company's quarterly operating results have varied
substantially in the past and may vary substantially in the future. Conclusions
about the Company's future results for any period should not be drawn from the
selected unaudited statement of operations data, either for any particular
quarter or taken as a whole.
For the Quarter Ended
-------------------------------------------------------------------------------------
March 31, June 30, September 30, December 31,
2002 2002 2002 2002
------------------- ------------------- --------------------- ---------------------
(Unaudited)
------------------- ------------------- --------------------- ---------------------
Net sales $ 298,785 $ 679,197 $ 834,076 $ 1,252,661
Loss before equity in net loss of affiliate (5,130,686) (5,449,237) (6,024,540) (2,836,410)
Net loss (5,244,640) (5,538,414) (6,155,490) (3,007,782)
Basic and diluted loss before extraordinary
item per common share (0.40) (0.40) (0.40) (0.40)
Basic and diluted loss per common share (0.40) (0.40) (0.40) (0.40)
Page 40
For the Quarter Ended
-------------------------------------------------------------------------------
March 31, June 30, September 30, December 31,
2001 2001 2001 2001
---------------- ---------------- --------------------- --------------------
(Unaudited)
---------------- ---------------- --------------------- --------------------
Net sales $ 132,713 $ 107,568 $ 265,646 $ 75,757
Loss before equity in net loss of affiliate and
extraordinary item (4,248,617) (6,349,338) (5,744,449) (14,344,870)
Net loss (4,248,617) (6,508,306) (5,883,600) (14,419,262)
Basic and diluted loss before extraordinary
item per common share (0.80) (1.20) (0.80) (1.20)
Basic and diluted loss per common share (0.80) (1.20) (0.80) (1.20)
Liquidity and Capital Resources
The Company must raise additional funds to be able to satisfy its
cash requirements during the next 12 months. Product development, corporate
operations, and marketing expenses will continue to require additional capital.
Because the Company presently has only limited revenue from operations, the
Company intends to continue to rely primarily on financing through the sale of
its equity and debt securities to satisfy future capital requirements until such
time as the Company is able to enter into additional third-party licensing,
collaboration, or co-marketing arrangements such that it will be able to finance
ongoing operations from license, royalty, and sales revenue. There can be no
assurance that the Company will be able to enter into such agreements.
Furthermore, the issuance of equity or debt securities which are or may become
convertible into equity securities of the Company in connection with such
financing could result in substantial additional dilution to the stockholders of
the Company.
During 2002 the Company experienced a delay in obtaining
effectiveness of the registration statement describing the shares of Class A
common stock issuable in connection with the third equity line during which time
the Company was unable to draw funds from the third equity line. Consequently,
the Company's cash resources were for a time limited to collections from
customers, which were not sufficient to cover the Company's operating expenses.
As a result, payments to employees and vendors were delayed beginning in June
2002. Employees were paid through June 15, 2002. Subsequent to June 30, 2002,
advances were made to certain employees on the basis of financial need as
determined by the individual circumstances of each employee. Payments amounting
to approximately $278,000 were made on this basis through March 21, 2003.
Between July 21, 2002 and March 21, 2003, 50 employees of Fonix quit or were
terminated. No stoppage in work occurred as a result of nonpayment or delayed
payment of compensation, nor were deliveries to customers effected. Certain
payments to vendors deemed to be critical to the Company's ongoing operations
were made. To date, no critical services have been stopped as a result of
nonpayment or delayed payment. At March 21, 2003, unpaid compensation payable to
current and former employees amounted to approximately $6,364,000, and vendor
accounts payable amount to approximately $3,110,000.
Several former employees filed suits against the Company to collect
past due wages or filed complaints with the State of Utah Labor Commission
asserting past due wage claims. The Company has settled several of these suits
and is negotiating to settle the remaining suits on terms substantially similar
to those offered to current employees who are also owed past due wages.
In order to meet some of the Company's ongoing operating obligations,
on October 11, 2002, the Company entered into an agreement with Breckenridge
Fund, LLC, ("Breckenridge") an unaffiliated third party, for the sale of the
Company's Series D 12% Convertible Debentures (the "Debentures") in an aggregate
principal amount of $1,500,000. The Debentures are due April 9, 2003. On the
earlier of December 20, 2002, or 45 days after the
Page 41
effective date of a registration statement filed in connection with the
Debentures (the "Initial Payment Date") and each 30-day anniversary of the
Initial Payment Date, the Company was required to make principal payments of
$250,000, plus accrued interest. The Company subsequently amended the repayment
terms of the purchase agreement with Breckenridge. Under the amended agreement,
the Company was were required to pay $100,000 on January 21, 2003; $150,000 on
January 24, 2003; $150,000 on January 30, 2003; $350,000 on February 18, 2003;
$250,000 on March 20, 2003; $250,000 on April 20, 2003; and $250,000 on May 11,
2003. There are no penalties for prepayment. Additionally, the Company agreed to
the release of 237,583 shares of Class A common stock held in escrow in
connection with the Debentures to Breckenridge as consideration (the "Released
Shares") to the Breckenridge for revising the terms of the purchase agreement
(see additional description of the Debentures below).
The Company had $3,064,719 in revenue and a comprehensive loss of
$19,868,701 for the year ended December 31, 2002. Net cash used in operating
activities of $9,954,382 for the year ended December 31, 2002, resulted
principally from the net loss incurred of $19,897,564, offset by non-cash
expenses pertaining to the impairment loss on the convertible note of
$1,113,842, increase in accrued payroll of $5,265,809, increase in accounts
payable of $1,997,714, increase in accrued liabilities of $775,968, depreciation
and amortization of $501,428, and equity in net loss of affiliate of $456,692.
Net cash used in investing activities of $963,038 for the year ended December
31, 2002, consisted of reductions in the convertible note receivable of $880,000
and the purchase of equipment of $83,038. Net cash used in operating and
investing activities was offset by net cash provided by financing activities of
$10,739,758 consisting primarily of the receipt of $10,504,8600 in cash related
to the sale of shares of Class A common stock, the receipt of $917,370 in cash
from the issuance of the Series D Debentures, and the receipt of $415,550 in
cash from related party loans, offset, in part, by $1,580,000 in payments on
notes payable.
The Company had negative working capital of $14,428,750 at December
31, 2002, compared to negative working capital of $6,101,268 at December 31,
2001. Current assets decreased by $578,280 to $690,844 from December 31, 2001,
to December 31, 2002. Current liabilities increased by $7,749,202 to $15,119,594
during the same period. The change in working capital from December 31, 2001, to
December 31, 2002, reflects, in part, the collection of subscriptions
receivable, plus an overall increase in accrued payroll, accounts payable,
accrued liabilities and notes payable due primarily to the Company's inability
to raise capital while the registration statement for the third equity line was
under review by the Securities and Exchange Commission. Total assets were
$6,523,480 at December 31, 2002, compared to $8,599,028 at December 31, 2001.
Convertible Notes Receivable
On December 1, 2001, Fonix, as lender, established a revolving line
of credit and convertible promissory note with Unveil Technologies, Inc.
("Unveil"), that permitted Unveil to draw up to $2,000,000 for operations and
other purposes. Unveil is a developer of natural language understanding
solutions for customer resource management ("CRM") applications. The Company
desired to obtain a license to Unveil's applications when completed and the
Company made the loan to Unveil to facilitate and expedite the development and
commercialization of Unveil's voice-enabled CRM software. The balance due under
the line of credit is secured by Unveil's CRM software and related source code
held in escrow and other assets of Unveil. The Company is a senior creditor to
Unveil. The unpaid principal, together with interest accrued thereon, is due and
payable on December 31, 2002, and is convertible into common shares of Unveil at
the Company's option. Based upon borrowings through December 31, 2002, such
conversion at that date would have represented approximately 12 percent of the
ownership of Unveil. However, in connection with a bridge loan of $150,000
provided to Unveil on December 5, 2002, by a third party, the Company
subordinated its right to receive payment on its loan or convert its loan into
Unveil shares until either the bridge loan is paid, or May 5, 2003.
During the year ended December 31, 2002, Unveil drew $880,000 on the
line of credit, bringing total draws on the line of credit to $1,450,000 as of
December 31, 2002. Due to limited resources available to the Company, only
minimal requests for funding by Unveil under the line of credit have been met.
This limitation in funding has resulted in a deterioration of Unveil's financial
condition and has caused Unveil to slow its development process. Accordingly,
due to Unveil's financial condition, the Company recorded an impairment loss as
of
Page 42
December 31, 2002 in the amount of $1,523,842, consisting of the outstanding
balance on the line of credit plus accrued interest thereon as of that date.
Subsequent to December 31, 2002, the Company entered into an
agreement to terminate the revolving line of credit and convertible promissory
note with Unveil. In full payment of the balance due under the note, the Company
received a payment of $410,000 and 1,863,636 shares of Unveil's Series A
Preferred Stock. Accordingly, the Company adjusted the estimated impairment,
recorded in the third quarter, such that the carrying amount of the note
receivable was equal to the amount subsequently received in January 2003. The
Company did not place a value on the Preferred Stock due to Unveil's overall
financial condition.
Investment In Audium Corporation
In February 2001, the Company entered into a collaboration agreement
with Audium Corporation ("Audium") to provide an integrated platform for
generating Voice XML solutions for Internet and telephony systems. Audium is a
mobile application service provider that builds and operates mobile applications
that allow access to Internet information and to complete online transactions
using any telephone. The collaboration includes integration of the Company's
technologies with Audium's mobile applications development capability.
Note Receivable - In connection with the collaboration agreement with
Audium, in February and May 2001, the Company advanced an aggregate of $400,000
to Audium as a bridge loan (the "Audium Note"). The loan bears interest at a
rate of 5 percent per year, has a term of four years and is convertible into
shares of Audium Series A Convertible Preferred Stock ("Audium Preferred
Stock"). The Audium Note is convertible into shares of Audium Preferred Stock at
a price of $1.46 per share in the event of (i) Audium's raising an additional
$2,000,000 prior to October 6, 2002, (ii) Audium's merger or consolidation,
(iii) a qualified public offering of Audium's common stock, (iv) an event of
default under a note payable from Fonix (see Fonix Note below), or (v) Audium's
aggregate gross revenues for the months of January through June 2003 exceeding
$1,000,000. The Audium Note is secured by Audium's intellectual property.
Further, at the closing, Audium granted the Company a fully paid, worldwide,
non- exclusive license to Audium's software to make, manufacture, and use the
software and any derivative works if Audium declares bankruptcy or ceases to do
business.
Management determined that a 12 percent annual interest rate better
reflects the risk characteristics of the Audium Note. Accordingly, interest was
imputed at 12 percent and the Audium Note was recorded at its original present
value of $302,909. For the years ended December 31, 2002 and 2001, the Company
recorded interest income of $39,501 and $29,663, respectively, including
contractual and imputed interest. The Company is currently discussing the
possibility of converting the remaining balance due under the Audium Note for
additional shares of Audium's Common Stock.
Investment in Affiliate - In April 2001, the Company closed a stock
purchase agreement with Audium, wherein the Company agreed to purchase up to
$2,800,000 of Audium Preferred Stock at a price of $1.46 per share. At closing,
the Company paid $200,000 in cash and gave Audium a non-interest bearing note
(the "Fonix Note") for the remaining $2,600,000. Interest on the Fonix Note was
imputed at 12 percent resulting in a present value of $2,370,348. The resulting
purchase price of the Audium Preferred Stock was $2,570,348.
Each share of Audium Preferred Stock is convertible into one share of
Audium's common stock. Holders of Audium Preferred Stock are entitled to eight
percent cumulative dividends, a liquidation preference in excess of the original
purchase price plus any declared but unpaid dividends, anti-dilution rights, and
voting rights equal to the corresponding number of common shares into which it
is convertible. The stock purchase agreement also entitles Fonix to elect one
member of Audium's board of directors. Audium also granted Fonix certain
registration rights after the closing of a public offering by Audium.
At closing, Audium issued 14 Audium Preferred Stock certificates to
Fonix, each certificate for 136,986 shares, and delivered one certificate in
exchange for the initial payment of $200,000. The remaining certificates are
held by Audium as collateral for the Fonix Note under the terms of a security
agreement. For each payment of
Page 43
$200,000 or multiple payments that aggregate $200,000, Audium will release to
Fonix one certificate for 136,986 shares of Audium Preferred Stock.
The difference between the total purchase price of the Audium
Preferred Stock and the Company's portion of Audium's net stockholders' deficit
at the time of the purchase was $2,700,727, which was allocated to capitalized
software technology. The excess purchase price allocated to the capitalized
software technology was amortized on a straight-line basis over a period of
eight years through December 31, 2001. After the impairment in the investment in
Audium discussed below, the remaining excess purchase price was $1,588,002 and
is being amortized over the remaining portion of the eight year period.
The investment in Audium does not provide the Company with rights to
any technology developed by Audium; the Company must obtain a license should it
choose to do so. Also, the Company would not own an interest sufficient to
control Audium, if the Company were to convert the Audium Note to Audium
Preferred Stock. As a result, management has determined that it is appropriate
to account for the investment, which represents 26.7 percent of Audium's voting
stock, under the equity method and not as a research and development
arrangement.
Audium has incurred losses since the Company acquired the Audium
Preferred Stock and as such, Audium does not have the ability to declare or pay
preferred dividends on the Preferred Stock. The Company recognized losses for
the year ended 2002 and the period from April 11, 2001 through December 31, 2001
as follows:
Year Ended Period Ended
December 31, December 31,
2002 2001
-------------------- -----------------------
Company share of Audium net loss $ 289,391 $ 97,789
Amortization of difference between purchase price of Audium
Preferred Stock and Company's share of Audium's net
stockholders' deficit $ 167,301 $ 274,724
-------------------- -----------------------
Total equity in loss of affiliate $ 456,692 $ 372,513
==================== =======================
A summary of the results of Audium's operations for the years ended
December 31, 2002 and 2001, and net assets as of December 31, 2002, is as
follows:
2002 2001
----------------------- -----------------------
Net sales $ 475,336 $ 466,949
Loss from operations (1,129,063) (820,912)
Net loss (1,083,859) (862,274)
Current assets $ 1,501,205 $ 539,464
Total assets 2,816,639 1,458,882
Current liabilities 1,664,207 625,544
Total liabilities 2,064,207 1,048,139
Net assets $ 752,432 $ 410,743
The fair value of this investment is determined based on Audium's
estimated future net cash flows considering the status of Audium's product
development. The Company evaluates this investment for impairment annually and
more frequently if indications of decline in value exist. An impairment loss
that is other than temporary is recognized during the period it is determined to
exist. An impairment is determined to be other-than-temporary if estimated
future net cash flows are less than the carrying value of the investment. If
projections indicate that the carrying value of the investment will not be
recoverable, the carrying value is reduced by the estimated excess of the
carrying value over the estimated discounted cash flows. There is a reasonable
possibility that in the near future estimated future cash flows from the
investment in Audium could change and that the effect of the change could be
material to the Company's financial position or results of operation.
At December 31, 2001, the Company assessed the realizability of the
investment in Audium and the Company wrote down the investment by $823,275. The
write-down was a result of a decrease in the estimated cash flows expected to be
realized from the investment due to overall decline in the economy and the
potential impact on related markets for Audium's products. As of December 31,
2002, no further write-down was deemed necessary based on th estimated future
cash flows of the investment.
Note Payable to Affiliate - The Fonix Note is payable in 13 monthly
installments of $200,000 beginning on June 1, 2001, and bears no interest unless
an event of default occurs, in which case it will bear interest at 12 percent
per year. No events of default have occurred to date. The Fonix Note is secured
by shares of Audium Preferred Stock as described above.
Management determined that a 12 percent annual interest rate reflects
the risk characteristics of the Fonix Note. Accordingly, interest has been
imputed at 12 percent and the Company recorded a present value of $2,370,348 for
the note payable. For the years ended December 31, 2002 and 2001, the Company
recorded interest expense of $95,303 and $164,405, respectively, related to this
note. Through December 31, 2002, payments amounting to $1,800,000 had been made
under the Fonix note. At December 31, 2002, the Company had an outstanding
balance of $1,000,000 due under the Fonix note. The Company and Audium are
currently discussing the possibility that Fonix return 684,930 shares of
Audium's Preferred Stock in exchange for Audium's release of Fonix under the
Fonix note.
Promissory Note
On December 14, 2001, the Company entered into an Asset Purchase
Agreement with Force Computers, Inc. As part of the purchase price, Fonix issued
a non-interest bearing promissory note in the amount of $1,280,000. Management
determined that a seven percent annual interest rate reflects the risk
characteristics of the this promissory note. Accordingly, interest has been
imputed at seven percent and the Company recorded a discount of $40,245 for the
note payable. From the purchase date through December 31, 2001, the Company
recorded interest expense of $4,098 related to this promissory note.
As collateral for the promissory note, 175,000 shares of the
Company's Class A common stock were placed into escrow. Under the terms of the
escrow, the shares will not be released to Force unless the Company is
delinquent or late with respect to any payment under the note. Also, under the
terms of the Asset Purchase Agreement, Fonix is required to deposit all receipts
from customers acquired in this transaction into a joint depository account.
Fonix has the right to withdraw such funds; however, in the event of default on
any payments to Force under the terms of the promissory note, Force has the
right to withdraw funds from the depository account until the deficiency in
payment is covered, at which time, Fonix may again have use of the funds.
Through December 31, 2002, payments required under the note have been made,
except the final payment of $250,000, which remained outstanding at December 31,
2002. Subsequent to December 31, 2002, additional payments amounting to $115,000
were made. The Company expects to pay the remaining balance due under the note
during the first and second quarters of 2003. Effective March 13, 2003, Force
exercised its right to withdraw all funds deposited in the joint account as
described above until Force receives the remaining balance due under the
promissory note.
Page 44
Notes Payable - Related Parties
Two executive officers of the Company (the "Lenders") sold shares of
Class A common stock owned by them and advanced the resulting proceeds amounting
to $333,308 to the Company under the terms of a revolving line of credit and
related promissory note. The funds were advanced for use in Company operations.
The advances bear interest at 10 percent per annum, payable on a semi-annual
basis. The entire principal, along with unpaid accrued interest and any other
unpaid charges or related fees, is due and payable on June 10, 2003. After
December 11, 2002, all or part of the outstanding balance and unpaid interest
may be converted at the option of the Lenders into shares of Class A common
stock. The conversion price is the average closing bid price of the shares at
the time of the advances. If converted, the conversion amount is divided by the
conversion price to determine the number of shares to be issued to the Lenders.
To the extent the market price of the Company's Class A common stock is below
the conversion price at the time of conversion, the Lenders are entitled to
receive additional shares equal to the gross dollar value received from the
original sale of the shares. A beneficial conversion option of $14,917 was
recorded as interest expense in connection with this transaction. The Lenders
may also receive additional compensation as determined appropriate by the Board
of Directors. The Lenders subsequently pledged 30,866 shares of Class A common
stock to the Equity Line Investor in connection with an advance of $182,676 to
the Company under the third equity line (see Note 12 to the condensed
consolidated financial statements for the year ended December 31, 2002, included
with this report). The Equity Line Investor subsequently sold the pledged shares
and applied the proceeds in reduction of the advance. The value of the pledged
shares of $82,242 was treated as an additional advance from the Lenders.
The aggregate advances of $415,550 from the Lenders are secured by
the Company's intellectual property rights and other assets. As of December 31,
2002, the Lenders had deferred the interest payment due December 10, 2003, and
had not converted any of the outstanding balance nor interest thereon into Class
A common stock.
Notes Payable
The Company had unsecured demand notes payable to former stockholders
of an acquired entity in the aggregate amount of $75,000 outstanding as of
December 31, 2002. The Company is attempting to negotiate a reduced payoff of
these notes.
Series D Debentures
On October 11, 2002, the Company entered into a Securities Purchase
Agreement with Breckenridge Fund, LLC ("Breckenridge"), an unaffiliated third
party, for the sale of the Company's Series D 12% Convertible Debentures (the
"Debentures") in the aggregate principal amount of $1,500,000. The outstanding
principal amount of the Debentures is convertible at any time at the option of
the holder into shares of the Company common stock at a conversion price equal
to the average of the two lowest closing bid prices of the Company's Class A
common stock for the twenty trading days immediately preceding the conversion
date multiplied by 90%. The Debentures are due April 9, 2003. On the earlier of
December 20, 2002, or 45 days after the effective date of a registration
statement filed to cover the resale of shares issued in connection with the
Debentures (the "Initial Payment Date") and each 30-day anniversary of the
Initial Payment Date, the Company was required to make principal payments of
$250,000, plus accrued interest.
In connection with the sale of the Debentures, the Company issued, as
collateral uinder the Debenture, 2,083,333 shares of Class A common stock (the
"Collateral Shares"), which were placed into an escrow pursuant to an escrow
agreement. Under the escrow agreement, the Collateral Shares will not be
released to Breckenridge unless the Company is delinquent with respect to
payments under the Debenture. If the Company is delinquent under the revised
payment schedule, Breckenridge is entitled to receive a penalty of five percent
of the then-outstanding principal amount of the Debentures, payable in cash or
shares released from the Collateral Shares. Additionally, as further
consideration for the sale of the Debentures, the Company issued 194,494 shares
to Breckenridge (the "Additional Shares").
Page 45
The Company subsequently amended the repayment terms of the purchase
agreement with Breckenridge. Under the amended agreement, the Company is
required to pay $100,000 on January 21, 2003; $150,000 on January 24, 2003;
$150,000 on January 30, 2003; $350,000 on February 18, 2003; $250,000 on March
20, 2003; $250,000 on April 20, 2003; and $250,000 on May 11, 2003. There are no
penalties for prepayment. Additionally, the Company agreed to the release of
237,583 of the collateral shares to Breckenridge as consideration (the "Released
Shares") to Breckenridge for revising the terms of the purchase agreement.
In connection with the sale of the Debentures, the Company agreed to
register the resale of the Class A common stock underlying the Debentures, the
Collateral Shares, and the Additional Shares. A registration statement
describing those shares was declared effective February 14, 2003.
Through March 26, 2003, the Company has paid $650,000 of the
outstanding principal, together with $62,050 in accrued interest. Additionally,
through March 26, 2003, the holder of the Debentures has converted $242,933
principal amount and $12,367 in interest into 25,083,453 shares of Fonix Class A
common stock. Accordingly, as of March 26, 2003, the outstanding principal
balance of the Debentures is $607,067
The following table identifies the total principal amount of the
Debentures outstanding, and the total number of shares of Class A common stock
that would be issuable, assuming that the full amounts of the Debentures
outstanding as of March 21, 2003, were converted by Breckenridge, and further
assuming that the applicable conversion or exercise prices at the time of such
conversion or exercise were the following amounts. The calculations below
exclude the issuance of shares of Class A common stock as payment of interest on
the Debentures at the date of conversion.
Shares
issuable upon
conversion of
Hypothetical Conversion principal amount of
Price $607,067
$0.02 30,353,350
$0.03 20,235,567
$0.04 15,176,675
$0.05 12,141,340
$0.10 6,070,670
$0.15 4,047,113
$0.25 2,428,268
$0.50 1,214,134
$0.80 758,834
Equity Lines of Credit
On August 8, 2000, the Company entered into a Private Equity Line
Agreement (the "Initial Equity Line") with Queen LLC, a private investor
("Equity Line Investor"), which gave the Company the right to draw up to
$20,000,000 for operations and other purposes through a mechanism of draws and
puts of stock. As of May 7, 2002, the Company had drawn the full $20,000,000
under the Initial Equity Line, which resulted in the issuance of 2,046,915
shares of our Class A common stock, and no funds remained available to be drawn
on the Initial Equity Line. Consequently, on May 8, 2002, Fonix and the Equity
Line Investor amended the Equity Line to increase the balance available under
the Equity Line from $20,000,000 to $22,000,000. As of June 24, 2002, 230,173
shares of
Page 46
Class A common stock were issued in connection with draws of $617,324 against
the additional $2,000,000 available under the Initial Equity Line. Accordingly,
we received a total of $20,617,324 in draws under the Initial Equity Line and we
issued an aggregate of 2,277,088 shares of our Class A common stock to the
Equity Line Investor under the terms of the Initial Equity Line.
During the year ended December 31, 2002, 1,017,323 shares of Class A
common stock were issued in connection with draws of $3,633,817. As of December
31, 2002, $1,382,676 remains unutilized under the initial Equity Line.
On April 6, 2001, the Company entered into a second equity line
agreement (the "Second Equity Line") with the Equity Line Investor. Under the
Second Equity Line, the Company has the right to draw up to $20,000,000 under
terms substantially identical to the Initial Equity Line.
During the year ended December 31, 2002, 2,339,675 shares of Class A
common stock were issued in connection with draws of $5,728,846. From the
inception of the Second Equity Line through December 31, 2002, 2,950,325 shares
of Class A common stock were issued in connection with draws under the Second
Equity Line of $13,425,000. As of December 31, 2002, $846,154 remained undrawn
under the Second Equity Line.
The following table summarizes the transactions completed under the
first two equity lines to date:
Weighted Average Number
Average of Shares Issued Total Shares Issued
Equity Line Conversion Price Per Draw Under Equity Line
- ----------- ---------------- -------- -----------------
Initial Equity Line $9.12 113,854 2,277,088
Second Equity Line $3.64 294,389 5,290,000
On June 27, 2002, the Company entered into a third equity line
agreement (the "Third Equity Line") with the Equity Line Investor. Under the
Third Equity Line, the Company has the right to draw up to $20,000,000 under
terms substantially identical to the Second Equity Line.
Specifically, under the Third Equity Line, the Company is entitled to
draw funds and to "put" to the Equity Line Investor shares of Class A common
stock in lieu of repayment of the draw. The number of shares issued is
determined by dividing the dollar amount of the draw by 90 percent of the
average of the two lowest closing bid prices of Class A common stock over the
seven trading-day period following the date the Company tenders the put notice.
The following information is provided to demonstrate the operation of
the "put" formula and the shares of Class A common stock that would be issuable
upon a hypothetical draw of $1,000,000:
Hypothetical closing bid prices
(seven trading days following the date of the put notice):
Trading day 1 $0.04
Trading day 2 $0.05
Trading day 3 $0.04
Trading day 4 $0.03
Trading day 5 $0.02
Trading day 6 $0.03
Trading day 7 $0.04
Conversion rate: (90% of average of two lowest closing bid prices)
Page 47
Trading day 4 $0.03
Trading day 5 $0.02
Average $.025
90% of average $0.0225
Conversion calculation: $1,000,000/ $0.0225 = 44,444,444 shares put to
Equity Line Investor.
Through March 21, 2003, the Company has tendered put notices to draw
an aggregate of $3,500,000 on the Third Equity Line. Through March 21, 2003, the
Company has issued 3,616,412 shares of Class A common stock to the Equity Line
Investor in connection with these put notices.
Stock Options and Warrants
During 2002, the Company granted options to purchase 157,225 shares
of Class A common stock at exercise prices ranging from $2.00 to $5.60 per
share. All options were granted at the quoted market price at the date of grant.
Of the options granted during this period, 20,000 vested immediately and the
balance of 137,225 vest over the three years following issuance. If not
exercised, all options expire within ten years from the date of grant. As of
December 31, 2002, the Company had options outstanding to purchase 634,652
shares of Class A common stock.
The Company's option plans provide for stock appreciation rights that
allow the grantee to receive shares of its Class A common stock equivalent in
value to the difference between the designated exercise price and the fair
market value of the Company's stock at the date of exercise. As of December 31,
2001, there were options to purchase 833 shares of Class A common stock at a
price of $40.00 per share outstanding, which options included stock appreciation
rights. However, these options expired during 2002.
As of March 26, 2002, the Company had warrants to purchase a total of
51,250 shares of Class A common stock outstanding.
Summary of Contractual Obligations
The following summary reflects payments due under long-term
obligations as of December 31, 2002:
Contractual Obligations Payments Due By Year
Total Less Than One to
One Three
Notes payable $ 1,818,175 $ 1,818,175 $ --
Debentures 917,370 917,370 --
Long-term debt 3,312 -- 3,312
Operating lease obligations 912,535 582,642 329,893
----------------- ------------------ -----------------
Total contractual cash obligations $ 3,651,392 $ 3,318,187 $ 333,205
----------------- ------------------ -----------------
Related-Party Transaction
In February 2000, the Company entered into an agreement to purchase
from John A. Oberteuffer, an executive officer and director of the Company, all
of Dr. Oberteuffer's rights and interests in certain methods and apparatus for
integrated voice and pen input for use in computer systems. In payment for Dr.
Oberteuffer's technology, the Company granted Dr. Oberteuffer 15,000 warrants to
purchase our Class A common stock at an exercise price of $40.00 per share. The
warrants were valued using the Black-Scholes method of valuation and resulted in
a value of $31.60 per warrant for the 15,000 warrants, or an aggregate value of
$474,000. The warrants expire February 10, 2010. Also, the Company granted Dr.
Oberteuffer the right to repurchase the technology from
Page 48
Fonix at fair market value if the Company subsequently determined not to
commercialize the pen/voice technologies or products.
In February 2000, the Company was actively pursuing development and
licensing opportunities in HWR and desired to procure the rights to Dr.
Oberteuffer's in-process development. However, there was no assurance at the
time that the development of the project would result in revenue opportunities
when completed, so the cost was charged to in-process research and development
in the current period.
The Company since has determined that there is no substantial benefit
to pursuing the market for our HWR technology, including the technology acquired
from Dr. Oberteuffer and as such, the balance of goodwill from all HWR
acquisitions was written off in 2001. The Company's decision to cease efforts to
commercialize our HWR technologies may trigger Dr. Oberteuffer's right to
repurchase the pen/voice technologies acquired from him.
Other
The Company presently has no plans to purchase new research and
development or office facilities.
Outlook
Corporate Mission Statement and Objectives
"Empowering people with conversational speech solutions for systems and devices"
is the Company's Mission Statement. The Company's objectives include:
o Delivering real speech solutions for human interaction with
multiple devices based on the Company's Core Technologies.
o Becoming the platform for current and next generation
speech-enabling applications and products.
o Developing leading market position through differentiating
solution strategy.
o Focusing on clearly quantified market solutions.
o Creating customer awareness and mind-share.
o Beating competition by increased value-added solutions,
portability and ease of use.
o Developing positive monthly cash flow from sales.
o Delivering predictable revenue and earnings.
o Providing return on shareholder equity.
Most speech recognition products offered by other companies are based
on technologies that are largely in the public domain and represent nothing
particularly "new" or creative. The Fonix speech Products and Core Technologies
are based on proprietary technology that is protected by various patents and
trade secrets. Management believes the Company's speech-enabled Products provide
a superior competitive advantage compared to other technologies available in the
marketplace. In addition, the Company believes its market focus on speech-
enabled Products will be a substantial differentiator. To accomplish this
objective, the Company intends to proceed as follows:
Page 49
Substantially Increase Marketing and Sales Activities. The Company
intends to expand its sales through partners, OEMs, VARs, direct
sales, and existing sales channels, both domestically and
internationally, who will focus on the wireless and mobile devices,
telephony and server phone solutions, assistive and language learning
devices, automotive integrated multi-media systems, and end-to-end or
distributive speech systems. To address global opportunities, the
Company will continue to develop and expand its sales and marketing
teams in Asia, Europe, and the United States.
Expand Strategic Relationships. The Company has a number of strategic
collaboration and marketing arrangements with developers and VARs.
The Company intends to expand such relationships and add additional
similar relationships, specifically in the wireless and mobile
devices, assistive and language learning devices, automotive systems,
and end-to-end solutions. Further, when the Company is able to
identify "first mover" speech-enabling applications in which it can
integrate its Products and Core Technologies, the Company intends to
investigate investment opportunities so the Company can obtain
preferred or priority collaboration rights.
Continue to Develop Standard Speech Solutions Based on the Core
Technologies. The Company plans to continue to invest resources in
the development and acquisition of standard speech solutions and
enhancements to the Core Technologies of speech-enabling
technologies, developer tools, and development frameworks to maintain
its competitive advantages.
As the Company proceeds to implement its strategy and to reach its objectives,
it anticipates further development of complementary technologies, added product
and applications development expertise, access to market channels and additional
opportunities for strategic alliances in other industry segments. The strategy
adopted by the Company has significant risks, and shareholders and others
interested in the Company and its Class A common stock should carefully consider
the risks set forth under the heading "Certain Significant Risk Factors" in Item
1, Part I, above.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements:
Reports of Independent Public Accountants F-2
Consolidated Balance Sheets as of December 31, 2002 and 2001 F-5
Consolidated Statements of Operations for the Years Ended December 31, 2002, 2001, and 2000 F-6
Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2000, 2001, and 2002 F-7
Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001, and 2000 F-8
Notes to Consolidated Financial Statements F-10
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
Change in Certifying Public Accountants
On July 16, 2002, the Company engaged the accounting firm of Hansen
Barnett & Maxwell ("HBM") as the Company's independent public accountants to
review the Company's interim financial statements and to audit its financial
statements beginning with the fiscal year ending December 31, 2002. The Company
terminated its relationship with and dismissed its former independent public
accountant, Arthur Andersen LLP ("Andersen"), effective with the appointment of
HBM. The dismissal of Andersen and the appointment of HBM as the Company's
Page 50
new independent public accountant were approved by the Company's Audit Committee
and Board of Directors on July 12, 2002.
During the period from the date of Andersen's engagement as the
Company's independent public accountants to July 16, 2002, the Company did not
consult with HBM on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure.
During the most recent fiscal years ended December 31, 2001 and 2000,
and the interim period subsequent to December 31, 2001, through the date of
dismissal of Andersen, there were no disagreements with Andersen on any matter
of accounting principles or practices, financial statement disclosure, or
auditing scope or procedure that would have caused Andersen to make references
in their report to such disagreements.
Andersen's report on the financial statements of the Company for the
year ended December 31, 2001, contained no adverse opinion or disclaimer of
opinion and was not modified as to audit scope or accounting principles, except
that Andersen's report dated February 26, 2002, contained an explanatory
paragraph regarding the Company's ability to continue as a going concern.
Similarly, Andersen's report on the financial statements of the Company for the
year ended December 31, 2000, contained no adverse opinion or disclaimer of
opinion and was not modified as to audit scope or accounting principles, except
that Andersen's report dated March 29, 2001, contained an explanatory paragraph
regarding the Company's ability to continue as a going concern.
The Company filed with the Commission a current report on Form 8-K on
July 17, 2002, disclosing the termination of its engagement with Andersen, its
engagement of HBM, and other information required to be disclosed in connection
therewith. The Company provided Andersen with a copy of the current report and
requested that Andersen furnish a letter addressed to the Commission stating
whether Andersen agrees with the above statements. In response, a representative
of Andersen advised the Company that Andersen would no longer provide letters
relating to its termination as a audit client's independent public accountant,
and that Andersen's inability to provide such letters had been discussed with
the Staff at the Commission.
Page 51
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth certain information concerning the
executive officers and directors of the Company as of March 21, 2003:
Name Age Position
Thomas A. Murdock (1)* 59 Director, President & Chief Executive Officer
Roger D. Dudley (2)* 50 Director, Executive Vice President & Chief Financial Officer
John A. Oberteuffer, Ph.D. 62 Director, Vice President & Chief Technology Officer
William A. Maasberg, Jr (1) (2) 63 Director, Chief Operating Officer
Rolf-Juergen Bruess 54 President, Fonix International
(1) Member, Compensation Committee
(2) Member, Audit Committee
* Committee Chairman
All directors hold office until the next annual meeting of the
stockholders of the Company or until their successors have been elected and
qualified. The officers of the Company are elected annually and serve at the
pleasure of the Board of Directors.
THOMAS A. MURDOCK is a co-founder of the Company and has served as an
executive officer and member of the Company's board of directors since
June 1994. He has been the Company's chief executive officer since
January 26, 1999. Mr. Murdock also has served as president of SCC
Asset Management Inc., formerly Studdert Companies Corporation
("SCC"), a related party, since 1992. For much of his career, Mr.
Murdock was a commercial banker and a senior corporate executive with
significant international emphasis and experience. Mr. Murdock also
serves as a director of KLS Enviro Resources, Inc.("KLS") and SCC.
ROGER D. DUDLEY is a co-founder of the Company and has served as an
executive officer and member of the Company's board of directors since
June 1994. Mr. Dudley currently serves as the Company's executive vice
president and chief financial officer. After several years at IBM in
marketing and sales, he began his career in the investment banking
industry. He has extensive experience in corporate finance, equity and
debt private placements and asset management. Mr. Dudley also serves
as a director of KLS and SCC and Audium Corporation.
JOHN A. OBERTEUFFER, Ph.D. has been a director of the Company since
March 1997, vice president since January 1998 and chief technology
officer since March 2001. He is the founder and former president of
Voice Information Associates, Inc. ("VIA"), a consulting group that
publishes the monthly newsletter, ASRNews. Dr. Oberteuffer also is
president of the American Voice Input/Output Society ("AVIOS"). He was
formerly vice president of Voice Processing Corp. (now merged with
Voice Control Systems, Inc.), and also was founder and CEO of Iris
Graphics, which was acquired by Seitex Corp. Dr. Oberteuffer received
his bachelor's and master's degrees from Williams College, and his
Ph.D. in Physics from Northwestern University. He was a member of the
research staff at Massachusetts Institute of Technology for five
years.
WILLIAM A. MAASBERG, Jr. became a director of the Company in
September 1999 and was named chief operating officer February 1,
2000. From December 1997 through February 1999, Mr. Maasberg was vice
president and general manager of the AMS Division of Eyring
Corporation which manufactures multi- media electronic work
instruction software application. He was also a co-founder and
principal in Information Enabling Technologies, Inc. ("IET"), and
LIBRA Corporation ("LIBRA"), two companies focusing on software
application development, and served in several key executive
positions with both IET
Page 52
and LIBRA from May 1976 through November 1997. Mr. Maasberg worked for
IBM Corporation from July 1965 through May 1976 in various capacities.
He received his B.S. Degree from Stanford University in Electrical
Engineering and his M.S. in Electrical Engineering from the University
of Southern California.
ROLF-JUERGEN BRUESS is president of Fonix International and advisor
for strategic implementation and marketing. He has over 20 years of
senior and management experience in semiconductors, communications,
consumer and automotive electronics, strategic technical marketing and
sales with Siemens AG and Mannesmann VDO. He managed 1,500 world-wide
engineering and sales personnel achieving $750 million in annual
sales.
Compliance With Section 16(a) of the Exchange Act
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's officers and directors, and persons who beneficially own more than 10%
of a registered class of the Company's equity securities, to file reports of
ownership and changes in ownership with the Securities and Exchange Commission.
Officers, directors and greater than 10% shareholders are required by regulation
of the Securities and Exchange Commission to furnish the Company with copies of
all Section 16(a) forms which they file. Based solely on its review of the
copies of such forms furnished to the Company during the fiscal year ended
December 31, 2002, the Company is aware of the following untimely filings:
Thomas A. Murdock received options to purchase 18,750 shares of the
Company's Class A common stock on January 17, 2002, and options to purchase
5,000 shares of the Company's Class A common stock on March 5, 2002.
Additionally, Mr. Murdock, as trustee of a voting trust (the "Voting Trust"),
sold 128,750 shares held in the Voting Trust from June 7 to July 5, 2002. Mr.
Murdock loaned the proceeds of the sales to the Company. In return, Mr. Murdock
received from the Company a promissory note in the principal amount of $207,775,
which became convertible into shares of the Company's Class A common stock on
December 12, 2002. The sales of the shares and the acquisition of the options
and the convertible promissory note were reported on a Form 5 filed on February
14, 2003.
Roger D. Dudley received options to purchase 18,750 shares of the
Company's Class A common stock on January 17, 2002, and options to purchase
5,000 shares of the Company's Class A common stock on March 5, 2002.
Additionally, 35,673 shares of the Company's Class A common stock owned by Mr.
Dudley and held in the Voting Trust, were sold from the Voting Trust in June
2002. Mr. Dudley loaned the proceeds of the sales to the Company. In return, Mr.
Dudley received from the Company a promissory note in the principal amount of
$207,775, which became convertible into shares of the Company's Class A common
stock on December 12, 2002. Further, Mr. Dudley pledged 30,866 shares of Class A
common stock to secure an advance to the Company by a third-party lender. The
pledgee executed on the pledged shares and sold the shares in October and
November 2002. The sales of the shares and the acquisition of the options and
the convertible promissory note were reported on a Form 5 filed February 14,
2003.
William A. Maasberg, Jr., received options to purchase 7,500 shares
of the Company's Class A common stock on January 17, 2002, and options to
purchase 5,000 shares of the Company's Class A common stock on March 5, 2002.
The acquisition of the options was reported on a Form 5 filed February 14, 2003.
John O. Oberteuffer received options to purchase 7,500 shares of the
Company's Class A common stock on January 17, 2002, and options to purchase
5,000 shares of the Company's Class A common stock on March 5, 2002. The
acquisition of the options was reported on a Form 5 filed February 14, 2003.
Mark S. Tanner received options to purchase 5,000 shares of the
Company's Class A common stock on March 5, 2002. The transaction will be
reported on a Form 5 to be filed. Mr. Tanner resigned as a member of the Board
of Directors on July 27, 2002.
Page 53
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the
compensation paid or accrued to all persons serving as the Company's chief
executive officer and the Company's most highly compensated executive officers
other than its chief executive officer who were serving as executive officers at
December 31, 2002 and whose annual compensation exceeded $100,000 during such
year (collectively the "Named Executive Officers"):
Summary Compensation Table
Annual Compensation Long-Term Compensation
Other Securities Underlying
Name and Principal Position Year Salary Annual Bonus Options/SARs (8)
- --------------------------- ---- -------------------- ------------------- ------------------------
Thomas A. Murdock (1) 2000 $ 320,804 -- 46,250/0
Chief Executive Officer & President 2001 $ 315,057 -- 17,500/0
2002 $ 315,096 (2) -- 23,750/0
Roger D. Dudley (1) 2000 $ 320,845 -- 46,250/0
Executive Vice President & Chief 2001 $ 314,895 -- 17,500/0
Financial Officer 2002 $ 315,487 (3) -- 23,750/0
William A. Maasberg (4) 2000 $ 208,411 -- 13,750/0
Chief Operating Officer 2001 $ 226,584 -- 11,250/0
2002 $ 226,584 (5) -- 12,500/0
John A. Oberteuffer (6) 2000 $ 227,348 -- 8,750/0
Vice President & Chief Technology 2001 $ 234,716 -- 11,250/0
Officer 2002 $ 225,420 (7) -- 12,500/0
(1) The Company has executive employment agreements with Messrs.
Murdock and Dudley that were initiated November 1, 1996 and
amended effective January 31, 2000 to extend the term of the
agreement and reduce the base compensation. The material
terms of each executive employment agreement with Messrs.
Murdock and Dudley are identical and are as follows: the
annual base salary for each executive officer is $309,400
and may be adjusted upward in future years as deemed
appropriate by the board of directors. The expiration date
is December 31, 2005. As bonus compensation for extending
the term of each agreement at a compensation level less than
provided in the original agreement, each executive was
granted options to purchase 35,000 options of the Company's
Class A common stock at an exercise price of $1.01. The
options expire July 19, 2010.
Each such executive officer also is entitled to customary
insurance benefits, office and support staff and the use of
an automobile. In addition, if any executive is terminated
without cause during the contract term then all salary then
and thereafter due and owing under the executive employment
agreement shall, at the executive's option, be immediately
paid in a lump sum payment to the executive officer and all
stock options, warrants and other similar rights granted by
the Company and then vested or earned shall be immediately
granted to the executive officer without restriction or
limitation of any kind.
Each executive employment agreement contains a
non-disclosure, confidentiality, non-solicitation and
non-competition clause. Under the terms of the
non-competition clause, each executive has agreed that for
a period of one year after the termination of his
employment with the Company the executive will not engage
in any capacity in a business which competes with or may
compete with the Company.
Page 54
(2) Because of the Company's inability to access the Third
Equity Line during much of 2002, the Company did not pay
Mr. Murdock $114,259 of his compensation due for 2002.
(3) Because of the Company's inability to access the Third
Equity Line during much of 2002, the Company did not pay
Mr. Dudley $141,808 of his compensation due for 2002.
(4) The Company has an employment agreement with Mr. Maasberg
that was effective February 1, 2000. The terms of the
agreement establish the annual base salary of $225,000,
which may be adjusted upward in future years as deemed
appropriate by the board of directors. Mr. Maasberg is
entitled to customary insurance benefits, office and
support staff. In addition, if any executive is terminated
without cause during the contract term then all salary then
and thereafter due and owing under the employment agreement
shall, at the executive's option, be immediately paid in a
lump sum payment to the executive officer and all stock
options, warrants and other similar rights granted by the
Company and then vested or earned shall be immediately
granted to the executive officer without restriction or
limitation of any kind. The employment contract expired
January 31, 2003. The Company has extended the employment
contract through December 31, 2003.
The employment agreement contains a non-disclosure,
confidentiality, non-solicitation and non- competition
clause. Under the terms of the non-competition clause, Mr.
Maasberg has agreed that for a period of 18 months after
the termination of his employment with the Company the
executive will not engage in any capacity in a business
which competes with or may compete with the Company.
(5) Because of the Company's inability to access the Third
Equity Line during much of 2002, the Company did not pay
Mr. Maasberg $102,824 of his compensation due for 2002.
(6) The Company has an employment agreement with Mr.
Oberteuffer that was effective February 1, 2000 and
subsequently amended effective April 1, 2001. The terms of
the agreement establish the annual base salary of $235,000,
which may be adjusted upward in future years as deemed
appropriate by the board of directors. Mr. Oberteuffer is
entitled to customary insurance benefits, office and
support staff, and the use of an automobile. In addition,
if any executive is terminated without cause during the
contract term then all salary then and thereafter due and
owing under the employment agreement shall, at the
executive's option, be immediately paid in a lump sum
payment to the executive officer and all stock options,
warrants and other similar rights granted by the Company
and then vested or earned shall be immediately granted to
the executive officer without restriction or limitation of
any kind. The employment contract expired January 31, 2003.
The Company has extended the employment contract through
December 31, 2003.
The employment agreement contains a non-disclosure,
confidentiality, non-solicitation and non- competition
clause. Under the terms of the non-competition clause, Mr.
Oberteuffer has agreed that for a period of 18 months after
the termination of his employment with the Company the
executive will not engage in any capacity in a business
which competes with or may compete with the Company.
(7) Because of the Company's inability to access the Third
Equity Line during much of 2002, the Company did not pay
Dr. Oberteuffer $99,125 of his compensation due for 2002.
(8) All options granted in 2002, 2001, and 2000 were granted
pursuant to the Company's 1998 Stock Option Plan.
Page 55
Option Grants in Fiscal Year 2002
Potential Realizable Value at
Assumed Annual Rates of
Individual Grants Stock Price Appreciation for
Option Term
(a) (b) (c) (d) (e) (f) (g)
Number of % of Total
Securities Options to Exercise
Underlying Employees in Price Expiration
Name Options Granted Fiscal Year ($/share) Date 5% 10%
(#)
- --------------------------- ----------------- --------------- ----------- --------------- --------------- ---------------
Thomas A. Murdock 18,750 11.9% $3.60 1/17/12 $109,950 $175,078
5,000 3.2% $2.00 3/4/12 $16,289 $25,937
Roger D. Dudley 18,750 11.9% $3.60 1/17/12 $109,950 $175,078
5,000 3.2% $2.00 3/4/12 $16,289 $25,937
William A. Maasberg, Jr. 7,500 4.8% $3.60 1/17/12 $43,980 $70,031
5,000 3.2% $2.00 3/4/12 $16,289 $25,937
John A. Oberteuffer 7,500 4.8% $3.60 1/17/12 $43,980 $70,031
5,000 3.2% $2.00 3/4/12 $16,289 $25,937
Aggregated Option/SAR Exercises in Last Fiscal Year
and Related December 31, 2002 Option/SAR Values
(a) (b) (c) (d) (e)
Number of Securities
Underlying Unexercised Value of In-the-Money
Options/SARs at December Options/SARs at December
31, 2002 31, 2002
Shares Acquired Exercisable/Unexercisable Exercisable/Unexercisable
Name on Exercise (#) Value Realized ($) (#) ($)
- ---------------------- -------------------- ---------------------- --------------------------- ----------------------------
Thomas A. Murdock 0 $ 0 103,925/28,750 $0/$0
Roger D. Dudley 0 $ 0 99,167/27,083 $0/$0
William A. Maasberg, Jr. 0 $ 0 28,750/13,750 $0/$0
John A. Oberteuffer 0 $ 0 34,833/11,667 $0/$0
Board of Directors Meetings, Committees and Director Compensation
The Company's board of directors took action at five duly noticed
meetings of the board during 2002. Each director attended (in person or
telephonically) all of the meetings of the Company's board of directors. During
2002, the Company's board of directors had the following committees: Audit
Committee, comprised of Messrs. Dudley (chairman) and Maasberg; and Compensation
Committee, comprised of Messrs. Murdock (chairman) and Maasberg. These standing
committees conducted meetings in conjunction with meetings of the full board of
directors.
Page 56
Compensation of Directors
Prior to April 1996, the Company's directors received no compensation
for their service. The Company historically has reimbursed its directors for
actual expenses incurred in traveling to and participating in directors'
meetings, and the Company intends to continue that policy for the foreseeable
future. On March 30, 1996, the Company's board of directors adopted, and the
Company's shareholders subsequently approved, the Company's 1996 Directors'
Stock Option Plan (the "Directors' Plan"). Under the Directors' Plan, members of
the Board as constituted on the date of adoption received options to purchase
5,000 shares of the Company's Class A common stock for each year (or any portion
thereof consisting of at least six months) during which such persons had served
on the board for each of fiscal years 1994 and 1995 and were granted 5,000
shares for each of fiscal years 1996 through 2002, which options vested after
completion of at least six months' service on the board during those fiscal
years. These options have terms of ten years. Similar grants have been made to
the Company's directors under the Company's 1998 Stock Option Plan, as set forth
elsewhere in this report.
Directors who are executive officers are also entitled to participate
under the 2002 Employee Compensation Plan, described elsewhere in this Report.
Page 57
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.
The following table sets forth, as of March 21, 2003, the number of
shares of Common Stock of the Company beneficially owned by all persons known to
be holders of more than five percent of the Company's Common Stock and by the
executive officers and directors of the Company individually and as a group.
Unless indicated otherwise, the address of the stockholder is the Company's
principal executive offices, 180 West Election Road, Suite 200, Draper, Utah
84020.
Name and Address of 5%
Beneficial Owners, Executive Number of Shares
Officers, and Directors Beneficially Owned Percent of Class (1)
Thomas A. Murdock 562,824(2) 3.01%
Chairman of the Board & Chief
Executive Officer
Roger D. Dudley 313,812(3) 1.70%
Executive Vice President & Chief
Financial Officer, Director
John A. Oberteuffer, Ph.D. 52,333(4) *
Vice President & Chief Technology
Officer, Director
William A. Maasberg 33,978(5) *
Chief Operating Officer, Director
All Officers and Directors as a 962,948 5.04%
Group (4 persons)
* Less than 1 percent.
(1) Percentages rounded to nearest 1/100th of one percent. Except as
indicated in the footnotes below, each of the persons listed
exercises sole voting and investment power over the shares of Common
Stock listed for each such person in the table.
(2) Includes 40,000 shares of Common Stock deposited in a voting trust
(the "Voting Trust") as to which Mr. Murdock is the sole trustee and
416,635 shares of Common Stock issuable as of February 4, 2003, into
the Voting Trust under a convertible promissory note (the
"Convertible Note") held by Mr. Murdock and Mr. Dudley. Persons who
have deposited their shares of Common Stock into the Voting Trust
have dividend and liquidation rights ("Economic Rights") in
proportion to the number of shares of Common Stock they have
deposited in the Voting Trust, but have no voting rights with respect
to such shares. All voting rights associated with the shares
deposited into the Voting Trust are exercisable solely and
exclusively by the Trustee of the Voting Trust. The Voting Trust
expires, unless extended according to its terms, on the earlier of
September 30, 2003, or any of the following events: (i) the Trustee
terminates it; (ii) the participating shareholders unanimously
terminate it; or (iii) the Company is dissolved or liquidated.
Although as the sole trustee of the Voting Trust Mr. Murdock
exercises the voting rights of all of the shares deposited into the
Voting Trust, and accordingly has listed all shares in the table
above, he has no economic or pecuniary interest in any of the shares
deposited into the Voting Trust except for 208,318 shares issuable as
of February 4, 2003, under the Convertible Note as to which he will
directly own Economic Rights when issued. Also includes 70 shares
owned directly by Mr. Murdock, 702 shares (including shares issuable
upon the exercise of options) beneficially owned by members of Mr.
Murdock's immediate family residing
Page 58
in the same household, and 105,417 shares of Common Stock underlying
stock options owned by Mr. Murdock and exercisable presently or
within 60 days of February 4, 2003. Does not include 20,833 options
which are not exercisable presently or within 60 days of February 4,
2003.
(3) Includes (i) 208,318 shares of Common Stock issuable as of February
4, 2003, under the Convertible Note which will be deposited into the
Voting Trust when issued, (ii) 70 shares owned directly by Mr.
Dudley; (iii) 8 shares owned by Mr. Dudley's minor children; and (iv)
105,417 shares underlying stock options exercisable presently or
within 60 days of February 4, 2003. Does not include 20,833 options
which are not exercisable presently or within 60 days of February 4,
2003.
(4) Consisting of options or warrants exercisable presently or within 60
days of February 4, 2003. Does not include 9,167 options which are
not exercisable presently or within 60 days of February 4, 2003.
(5) Consisting of 19,200 shares owned directly by Mr. Maasberg, 165
shares owned by Mr. Maasberg's minor children, and 33,333 options
exercisable presently or within 60 days of February 4, 2003. Does not
include 9,167 options which are not exercisable presently or within
60 days of February 4, 2003.
--------------------------------------------------------------
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
SCC Asset Management Inc. ("SCC") (formerly Studdert Companies Corp.)
SCC is a Utah corporation that provides investment and management
services. The officers, directors and owners of SCC are Stephen M. Studdert,
former chairman and CEO of the Company, and Thomas A. Murdock and Roger D.
Dudley, each of whom is a director and executive officer of the Company.
The Company subleased from SCC office space located at 60 East South
Temple Street, Salt Lake City, Utah. The subleases, which expired in December
2002 and February 2003, required the Company to pay the actual monthly rental of
$10,368 and all common area charges payable under the lease with SCC's landlord.
During October 2002, the Company assumed SCC's lease obligation (see
"Properties").
On March 18, 2003, the Company executed a promissory note with the
landlord in the amount of $113,768 covering the outstanding lease obligations
under the subleases. The note bears annual interest at 10% and is payable in
monthly installments of $3,000.
John A. Oberteuffer
In February 2000, the Company entered into an agreement to purchase
from John A. Oberteuffer, an executive officer and director of the Company, all
of Dr. Oberteuffer's rights and interests in certain methods and apparatus for
integrated voice and pen input for use in computer systems. In payment for Dr.
Oberteuffer's technology, the Company granted Dr. Oberteuffer 15,000 warrants to
purchase the Company's Class A common stock at an exercise price of $1.00 per
share. The warrants expire February 10, 2010. Also, the Company granted Dr.
Oberteuffer the right to repurchase the technology from the Company at fair
market value if the Company subsequently determines not to commercialize the
pen/voice technologies or products.
Loans from Senior Management to Company
Two executive officers of the Company (the "Lenders") sold shares of
Class A common stock owned by them and advanced the resulting proceeds amounting
to $333,308 to the Company under the terms of a revolving line of credit and
related promissory note. The funds were advanced for use in Company operations.
The advances bear interest at 10 percent per annum, payable on a semi-annual
basis. The entire principal, along with unpaid accrued interest and any other
unpaid charges or related fees, is due and payable on June 10, 2003. Any time
after
Page 59
December 11, 2002, all or part of the outstanding balance and unpaid interest
may be converted at the option of the Lenders into shares of Class A common
stock. The conversion price is the average closing bid price of the shares at
the time of the advances. If converted, the conversion amount is divided by the
conversion price to determine the number of shares to be issued to the Lenders.
To the extent the market price of the Company's Class A common stock is below
the conversion price at the time of conversion, the Lenders are entitled to
receive additional shares equal to the gross dollar value received from the
original sale of the shares. A beneficial conversion feature of $14,917 was
recorded as interest expense in connection with this transaction. The Lenders
may also receive additional compensation as determined appropriate by the Board
of Directors. The Lenders subsequently pledged 30,866 shares of Class A common
stock to the Equity Line Investor in connection with an advance of $182,676 to
the Company under the Third Equity Line (see Note 11 to the condensed
consolidated financial statements for the year ended December 31, 2002, included
with this report). The Equity Line Investor subsequently sold the pledged shares
and applied the proceeds in reduction of the advance. The value of the pledged
shares of $82,242 was treated as an additional advance from the Lenders.
The aggregate advances of $415,550 from the Lenders are secured by
the Company's intellectual property rights and other assets.
Page 60
PART IV
ITEM 14. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. The Company's
chief executive officer and chief financial officer, after evaluating the
effectiveness of the Company's "disclosure controls and procedures" (as defined
in the Securities Exchange Act of 1934, Rules 13a-14(c) and 15-d-14(c)) as of a
date (the "Evaluation Date") within 90 days before the filing date of this
quarterly report, have concluded that, as of the Evaluation Date, the Company's
disclosure controls and procedures were adequate and designed to ensure that
material information relating to the Company and its subsidiaries would be made
known to them by others within those entities.
(b) Changes in Internal Controls. There were no significant changes
in the Company's internal controls, or, to the Company's knowledge, in other
factors that could significantly affect these controls subsequent to the
Evaluation Date.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) Documents filed as part of this Form 10-K:
1. Consolidated Financial Statements (included in Part II, Item 8)
Consolidated Balance Sheets as of December 31, 2001 and 2000
Consolidated Statements of Operations for the Years Ended
December 31, 2001, 2000 and 1999
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2001, 2000 and 1999
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2001, 2000 and 1999
Notes to Consolidated Financial Statements
2. Financial Statement Schedules: None
3. Exhibits: The following Exhibits are filed with this Form 10-K
pursuant to Item 601(a) of Regulation S-K:
Exhibit No. Description of Exhibit
21 Subsidiaries of Registrant
99 Certification of President and Chief Financial
Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(B) Reports filed on Form 8-K during the last quarter of the fiscal year ended
December 31, 2002:
NONE
Page 61
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Fonix Corporation
Date: March 28, 2003 By: /s/ Thomas A. Murdock
---------------- -------------------------------------------
Thomas A. Murdock, President and
Chief Executive Officer
Date: March 28, 2003 By: /s/ Roger D. Dudley
---------------- ------------------------------------------------
Roger D. Dudley, Executive Vice President Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated:
/s/ Thomas A. Murdock
- -----------------------------------------
Thomas A. Murdock, President and
Chief Executive Officer
March 28, 2003
- --------------------
Date
/s/ Roger D. Dudley
- ----------------------------------------------
Roger D. Dudley, Executive Vice President
Director
March 28, 2003
- --------------------
Date
/s/ William A. Maasberg
- ---------------------------------------
William A. Maasberg, Jr., Director
March 28, 2003
- --------------------
Date
/s/ John A. Oberteuffer
- -----------------------------------------------
John A. Oberteuffer, Ph.D., Director
March 28, 2003
- --------------------
Date
Page 62
CERTIFICATION
I, Thomas A. Murdock, certify that:
1. I have reviewed this annual report on Form 10-K of Fonix Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report.
Date: March 28, 2003
/s/ Thomas A. Murdock
- -------------------------------------------
Thomas A. Murdock
President and Chief Executive Officer
(Principal Executive Officer)
63
CERTIFICATION
I, Roger D. Dudley, certify that:
1. I have reviewed this annual report on Form 10-K of Fonix Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report.
Date: March 28, 2003
/s/ Roger D. Dudley
- -----------------------------------------------
Roger D. Dudley
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer)
64
FONIX CORPORATION AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
Report of Hansen, Barnett & Maxwell, Independent Certified Public Accountants F-2
Copy of Report of Arthur Andersen LLP, Independent Public Accountants F-4
CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 2002 and 2001 F-5
Consolidated Statements of Operations and Comprehensive Loss for the Years Ended
December 31, 2002, 2001, and 2000 F-6
Consolidated Statements of Stockholders' Equity (Deficit) for the Years Ended
December 31, 2000, 2001, and 2002 F-7
Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001, and 2000 F-8
Notes to Consolidated Financial Statements F-10
F-1
HANSEN, BARNETT & MAXWELL (801) 532-2200
A Professional Corporation Fax (801) 532-7944
CERTIFIED PUBLIC ACCOUNTANTS 5 Triad Center, Suite 750
Salt Lake City, Utah 84180
Member of Baker Tilly International www.hbmcpas.com
Member of AICPA SEC Practice Section
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and the Shareholders
Fonix Corporation
We have audited the accompanying consolidated balance sheets of Fonix
Corporation and subsidiaries as of December 31, 2002 and 2001, and the related
consolidated statements of operations and comprehensive loss, stockholders'
equity (deficit), and cash flows for the years then ended. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits. The consolidated financial statements of Fonix Corporation and
subsidiaries for the year ended December 31, 2000 were audited by other auditors
who have ceased operations. In their report dated March 29, 2001, those auditors
expressed an unqualified opinion on those financial statements and stated that
certain matters raised substantial doubt about the Company's ability to continue
as a going concern.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Fonix Corporation
and subsidiaries as of December 31, 2002 and 2001, and the results of their
operations and their cash flows for the years then ended in conformity with
accounting principles generally accepted in the United States of America.
As described in Note 6, these financial statements have been revised
to include the transitional disclosures required by Statement of Financial
Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets,"
which was adopted by the Company as of January 1, 2002. Our audit procedures
with respect to the disclosures in Note 6 for 2000 included (a) agreeing loss
before extraordinary item, as reported, and net loss, as reported, to the
consolidated financial statements and the adjustments for amortization expense
recognized in those periods related to goodwill to the Company's underlying
records obtained from management, and (b) testing the mathematical accuracy of
the reconciliation of loss before extraordinary items excluding goodwill
amortization and net loss excluding goodwill amortization to loss before
extraordinary items, as reported, and net loss, as reported, respectively, and
the related loss-per-share amounts. In our opinion, the disclosures for 2000 in
Note 6 are appropriate. However, we were not engaged to audit, review, or apply
any procedures to the 2000 consolidated financial statements of the Company
other than with respect to such adjustments and such disclosures and,
accordingly, we do not express an opinion or any other form of assurance on the
2000 consolidated financial statements taken as a whole.
(Continued)
F-2
HANSEN, BARNETT & MAXWELL
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
(CONTINUED)
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has incurred significant losses
and negative cash flows from operating activities during the years ended
December 31, 2002. As of December 31, 2002, the Company had an accumulated
deficit of $194,006,920, and negative working capital of $14,428,750.
The Company has incurred additional liabilities for unpaid
compensation payable to current and former employees amounting to approximately
$5,266,000, vendor accounts payable amounting to approximately $3,083,000, and
current accrued liabilities of approximately $3,180,000. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans with respect to these matters are also described in Note 1.
The accompanying consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
HANSEN, BARNETT & MAXWELL
/s/ HANSEN, BARNETT & MAXWELL
Salt Lake City, Utah
March 28, 2003
F-3
The following is a copy of the report of Arthur Andersen LLP signed and dated
March 29, 2001, on the consolidated financial statements of Fonix Corporation
and subsidiaries as of December 31, 2000 and 1999, and for each of the three
years in the period ended December 31, 2000. The report makes reference to the
consolidated balance sheets of Fonix Corporation and subsidiaries as of December
31, 2000 and 1999, and to the consolidated statements of operations,
stockholders' equity and cash flows for the years ended December 31, 1999 and
1998, none of which are included herein. Arthur Andersen LLP has ceased
operations and has not reissued the report.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Fonix Corporation:
We have audited the accompanying consolidated balance sheets of Fonix
Corporation (a Delaware corporation) and subsidiaries as of December 31, 2000
and 1999, and the related consolidated statements of operations, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 2000. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Fonix
Corporation and subsidiaries as of December 31, 2000 and 1999, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2000 in conformity with accounting principles
generally accepted in the United States.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has incurred significant losses
and negative cash flows from operating activities since its inception. The
Company expects these losses and negative cash flows from operating activities
to continue at least through December 31, 2001. As of December 31, 2000, the
Company has minimal tangible net worth of $983,988, an accumulated deficit of
$143,040,284, minimal working capital of $180,356 and $224,436 of accounts
payable over 60 days past due. These matters raise substantial doubt about the
Company's ability to continue as a going concern. Management's plans with
respect to these matters are also described in Note 1. The accompanying
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
ARTHUR ANDERSEN LLP
Salt Lake City, Utah
March 29, 2001
F-4
Fonix Corporation and Subsidiaries
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31, December 31,
2002 2001
-------------- -------------
Current assets:
Cash and cash equivalents $ 23,739 $ 201,401
Subscriptions receivable - 852,970
Accounts receivable 26,974 32,210
Convertible note receivable 402,765 -
Inventory 51,937 37,154
Prepaid expenses and other current assets 185,429 145,389
-------------- -------------
Total current assets 690,844 1,269,124
Property and equipment, net of accumulated depreciation of $1,671,809
and $1,314,960, respectively 625,448 903,159
Convertible note receivable - 630,000
Investment in and note receivable from affiliate net of unamortized discount of
$58,548 and $77,691, respectively 1,259,320 1,696,869
Intangible assets, net of accumulated amortization of $299,457 and $145,522, respectively 1,191,585 1,345,520
Goodwill, net of accumulated amortization of $2,295,598 2,631,304 2,631,304
Other assets 124,979 123,052
-------------- -------------
Total assets $ 6,523,480 $ 8,599,028
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Series D Debentures, net of unamortized discount of $582,630 $ 917,370 $ -
Note payable to affiliate, net of unamortized discount of $0 and $65,247, respectively 1,000,000 1,484,753
Note payable, net of unamortized discount of $0 and $40,245 250,000 1,239,755
Notes payable - related parties 493,175 77,625
Notes payable other 75,000 -
Accrued payroll 5,265,809 -
Accounts payable 3,083,425 1,085,711
Accrued liabilities 1,737,267 961,299
Accrued liabilities - related parties 1,443,300 1,451,633
Deferred revenues 854,248 1,049,849
Capital lease obligation, current portion - 19,767
-------------- -------------
Total current liabilities 15,119,594 7,370,392
Long-term borrowings 3,312 -
-------------- -------------
Total liabilities 15,122,906 7,370,392
-------------- -------------
Commitments and contingencies (Notes 1, 5, 6, 13, 14, 16 and 17)
Stockholders' equity:
Preferred stock, $0.0001 par value; 50,000,000 shares authorized; Series
A, convertible; 166,667 shares outstanding
(aggregate liquidation preference of $6,055,012 at December 31, 2002 and 2001) 500,000 500,000
Common stock, $0.0001 par value; 800,000,000 shares authorized;
Class A voting, 12,306,333 and 8,754,891 shares outstanding, respectively 1,230 875
Class B non-voting, no shares outstanding - -
Additional paid-in capital 183,514,560 172,019,653
Outstanding warrants to purchase Class A common stock 1,360,000 2,832,400
Deferred consulting expenses - (17,777)
Cumulative foreign currency translation adjustment 31,704 2,841
Accumulated deficit (194,006,920) (174,109,356)
-------------- -------------
Total stockholders' (deficit) equity (8,599,426) 1,228,636
-------------- -------------
Total liabilities and stockholders' equity $ 6,523,480 $ 8,599,028
============== =============
See accompanying notes to consolidated financial statements.
F-5
Fonix Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
Years Ended December 31,
------------------------------------------------------
2002 2001 2000
----------------- ----------------- ----------------
Revenues:
Licenses, royalties and maintenance $ 1,845,848 $ 452,484 $ 567,621
Hardware 348,666 - -
Services 870,205 129,200 89,232
----------------- ----------------- ----------------
3,064,719 581,684 656,853
----------------- ----------------- ----------------
Cost of revenues:
Licenses, royalties and maintenance 245,341 138,308 27,436
Hardware 209,915 - -
Services 98,148 47,509 -
Amortization of capitalized software technology 104,397 1,824,440 1,824,440
Impairment loss on capitalized software technology - 7,888,512 -
----------------- ----------------- ----------------
657,801 9,898,769 1,851,876
----------------- ----------------- ----------------
Gross profit (loss) 2,406,918 (9,317,085) (1,195,023)
----------------- ----------------- ----------------
Expenses:
Selling, general and administrative 11,929,390 11,646,139 10,751,597
Product development and research 8,192,664 8,123,453 5,871,414
Amortization of intangibles 30,600 604,105 604,105
Impairment loss on investment in affiliate - 823,275 -
Impairment loss on convertible note receivable 1,113,842 - -
Purchased in-process research and development - - 474,000
----------------- ----------------- ----------------
Total expenses 21,266,496 21,196,972 17,701,116
----------------- ----------------- ----------------
Loss from operations (18,859,578) (30,514,057) (18,896,139)
----------------- ----------------- ----------------
Other income (expense):
Interest income 81,351 80,373 139,283
Interest expense (662,645) (185,802) (4,004,111)
Other - (67,792) (126,520)
----------------- ----------------- ----------------
Total other expense, net (581,294) (173,221) (3,991,348)
----------------- ----------------- ----------------
Loss from continuing operations before equity in net loss of
affiliate and income tax benefit (19,440,872) (30,687,278) (22,887,487)
Equity in net loss of affiliate (456,692) (372,513) -
Income tax (expense) benefit - - 76,810
----------------- ----------------- ----------------
Loss from continuing operations (19,897,564) (31,059,791) (22,810,677)
Extraordinary item - gain on forgiveness of debt, net of
income taxes of $29,416 in 2000 - - 49,448
----------------- ----------------- ----------------
Net loss (19,897,564) (31,059,791) (22,761,229)
Other comprehensive income - foreign currency translation 28,863 2,841 -
----------------- ----------------- ----------------
Comprehensive loss $ (19,868,701) $ (31,056,950) $ (22,761,229)
================= ================= ================
Basic and diluted net loss per common share $ (1.73) $ (5.20) $ (5.60)
================= ================= ================
See accompanying notes to consolidated financial statements.
F-6
Fonix Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
Preferred Stock Common Stock Additional
--------------------- ------------------------ Paid-in
Shares Amount Shares Amount Capital
---------- ------------ ------------ ----------- -------------
BALANCE, DECEMBER 31, 1999 548,390 9,595,910 3,088,383 309 112,781,465
Conversion of promissory note - - 288,619 29 7,590,842
Beneficial conversion features on promissory note - - - - 3,447,623
Conversions of Series C debentures - - 259,634 26 4,262,038
Sale of Series F preferred shares 316,036 2,750,000 - - -
Beneficial conversion features on Series D
preferred stock - 236,400 - - -
Conversions of preferred stock to common stock (527,186) (10,622,745) 594,480 59 10,622,686
Reclassification of common stock subject to redemption - - 45,045 5 1,829,995
Exercise of repricing rights - - 114,214 11 (11)
Issuance of common stock under equity line of credit - - 312,317 31 3,854,271
Shares issued upon settlement of litigation - - 6,504 1 81,294
Issuance of common stock for services - - 46,552 5 2,016,672
Issuance of stock options and warrants for
services and technology - - - - 234,856
Appreciation of warrants issued for services - - - - -
Extension of option expiration dates - - - - 52,067
Exercise of stock options and stock appreciation rights - - 19,177 2 1,094,865
Exercise of warrants - - 7,500 1 392,999
Expiration of warrants - - - - 661,850
Amortization of deferred consulting expenses - - - - -
Preferred stock dividends - 2,941,051 - - -
Net loss for the year ended December 31, 2000 - - - - -
---------- ------------ ------------ ----------- -------------
BALANCE, DECEMBER 31, 2000 337,240 4,900,616 4,782,425 478 148,923,512
Conversions of preferred stock to common stock (170,573) (4,409,897) 362,438 36 4,409,861
Issuance of common stock under equity lines of credit - - 3,609,154 361 18,271,589
Issuance of stock options for services - - - - 33,360
Exercise of stock options - - 875 - 9,801
Issuance of warrants - - - - -
Expiration of warrants - - - - 371,530
Amortization of deferred consulting expenses - - - - -
Preferred stock dividends - 9,281 - - -
Cumulative foreign currency translation adjustment - - - - -
Net loss for the year ended December 31, 2001 - - - - -
---------- ------------ ------------ ----------- -------------
BALANCE, DECEMBER 31, 2001 166,667 500,000 8,754,891 875 172,019,653
Issuance of common stock under equity lines of credit - - 3,356,998 335 9,081,723
Expiration of warrants - - - - 1,472,400
Amortization of deferred consulting expenses - - - - (17,777)
Cumulative foreign currency translation adjustment - - - -
Beneficial Conversion Feature on promissory note - - - - 14,917
Shares issued related to Series D financing - - 194,444 19 943,644
Net loss for the year ended December 31, 2002 - - - - -
---------- ------------ ------------ ----------- -------------
166,667 500,000 12,306,333 1,230 183,514,560
========== ============ ============ =========== =============
Cumulative
Outstanding Foreign
Warrants Deferred Currency
to Purchase Consulting Translation Accumulated
Common Stock Expenses Adjustment Deficit Total
---------------- ------------- ----------- ------------- ----------
BALANCE, DECEMBER 31, 1999 2,850,530 (435,051) - (116,706,803) 8,086,359
Conversion of promissory note - - - - 7,590,871
Beneficial conversion features on promissory note - - - - 3,447,623
Conversions of Series C debentures - - - - 4,262,064
Sale of Series F preferred shares - - - - 2,750,000
Beneficial conversion features on Series D
preferred stock - - - (236,400) -
Conversions of preferred stock to common stock - - - - -
Reclassification of common stock subject to redemption - - - - 1,830,000
Exercise of repricing rights - - - - -
Issuance of common stock under equity line of credit - - - - 3,854,302
Shares issued upon settlement of litigation - - - - 81,295
Issuance of common stock for services - - - - 2,016,677
Issuance of stock options and warrants for
services and technology 530,250 - - - 765,106
Appreciation of warrants issued for services 537,500 (537,500) - - -
Extension of option expiration dates - - - - 52,067
Exercise of stock options and stock appreciation rights - - - - 1,094,867
Exercise of warrants (115,000) - - - 278,000
Expiration of warrants (661,850) - - - -
Amortization of deferred consulting expenses - 972,551 - - 972,551
Preferred stock dividends - - - (3,335,852) (394,801)
Net loss for the year ended December 31, 2000 - - - (22,761,229) (22,761,229)
---------------- ------------- ----------- ------------- ------------
BALANCE, DECEMBER 31, 2000 3,141,430 - - (143,040,284) 13,925,752
Conversions of preferred stock to common stock - - - - -
Issuance of common stock under equity lines of credit - - - - 18,271,950
Issuance of stock options for services - (30,000) - 3,360
Exercise of stock options - - - - 9,801
Issuance of warrants 62,500 - - - 62,500
Expiration of warrants (371,530) - - - -
Amortization of deferred consulting expenses - 12,223 - - 12,223
Preferred stock dividends - - - (9,281) -
Cumulative foreign currency translation adjustment - - 2,841 - 2,841
Net loss for the year ended December 31, 2001 - - - (31,059,791) (31,059,791)
---------------- ------------- ----------- ------------- ------------
BALANCE, DECEMBER 31, 2001 2,832,400 (17,777) 2,841 (174,109,356) 1,228,636
Issuance of common stock under equity lines of credit - - - - 9,082,058
Expiration of warrants (1,472,400) - - - -
Amortization of deferred consulting expenses - 17,777 - - -
Cumulative foreign currency translation adjustment - - 28,863 - 28,863
Beneficial Conversion Feature on promissory note - - - - 14,917
-
Shares issued related to Series D financing - - - - 943,663
-
Net loss for the year ended December 31, 2002 - - - (19,897,564) (19,897,564)
---------------- ------------- ------------------------- ------------
1,360,000 - 31,704 (194,006,920) (8,599,426)
================ ============= =========== ============= ============
See accompanying notes to consolidated financial statements.
F-7
Fonix Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
----------------------------------------------
2002 2001 2000
-------------- --------------- -------------
Cash flows from operating activities:
Net loss $ (19,897,564) $ (31,059,791) $(22,761,229)
Adjustments to reconcile net loss to net cash
used in operating activities:
Issuance of common stock for services - - 1,328,100
Non-cash expense related to issuance of debentures,
warrants, preferred and common stock - 62,500 4,725,201
Non-cash compensation expense related to issuance and
extension of stock options - 15,583 914,922
Beneficial Conversion option on promissory note 14,917 - -
Non-cash portion of purchased in-process research and development - - 474,000
Accretion of discount on note receivable from affiliate (19,143) (19,400) -
Accretion of discount on note payable to affiliate 65,247 164,405 -
Accretion of discount on note payable 40,245 - -
Accretion of discount on note payable - related party 392,925 - -
Amortization of deferred loan costs 34,795 - -
Loss on disposal of property and equipment 13,256 68,736 126,520
Impairment loss on capitalized software technology - 7,888,513 -
Impairment loss on convertible note receivable 1,113,842 - -
Depreciation and amortization 501,428 2,850,362 3,093,612
Impairment loss on investment in affiliate - 823,275 -
Equity in net loss of affiliate 456,692 372,513 -
Income tax benefit - - (76,810)
Gain on forgiveness of debt - - (49,448)
Changes in assets and liabilities, net of effects of acquisitions:
Accounts receivable 5,236 118,227 53,029
Inventory (14,783) (37,154) -
Prepaid expenses and other current assets (81,442) (89,684) 8,127
Accrued interest on funds held in escrow - 151,006 (113,003)
Other assets (1,927) (18,364) 1,176
Accounts payable 1,997,714 430,359 (543,529)
Accrued payroll 5,265,809 - -
Accrued liabilities 775,968 407,851 120,638
Accrued liabilities - related party (8,333) (112,500) (250,001)
Other current liabilities (19,767) - -
Deferred revenues (195,601) 372,778 549,222
Cumulative foreign currency translation adjustment 28,863 2,841 -
-------------- --------------- -------------
Net cash used in operating activities (9,531,623) (17,607,944) (12,399,473)
-------------- --------------- -------------
Cash flows from investing activities, net of effects of acquisitions:
Issuance of note receivable (880,000) (630,000) -
Purchase of property and equipment (83,038) (586,106) (239,908)
Issuance of note receivable from affiliate - (302,909) -
Investment in affiliate - (200,000) -
Purchase of assets from Force Computers, Inc. - (220,223) -
Proceeds from sale of property and equipment - 400 -
Proceeds from sale of HealthCare Solutions Group - 2,000,000 -
-------------- --------------- -------------
Net cash provided by investing activities (963,038) 61,162 (239,908)
-------------- --------------- -------------
Cash flows from financing activities:
Proceeds from sale of Class A common stock, net 9,935,029 17,418,980 3,854,302
Payments on note payable to affiliate (550,000) (1,050,000) -
Principal payments on capital lease obligation - (44,225) (28,312)
Proceeds from exercise of stock options and warrants - 9,801 744,866
Proceeds from issuance of convertible promissory note payable
and convertible debentures, net - - 7,500,000
Proceeds from sale of preferred stock, net - - 1,750,000
Proceeds from other notes payable 75,000 - -
Proceeds from other long-term debt 3,312 - -
Payments on other notes payable (1,030,000) - -
Proceeds from note payable to related party 415,550 - -
Proceeds from issuance of Series D Debentures 1,468,108 - -
-------------- --------------- -------------
Net cash provided by (used in) financing activities 10,316,999 16,334,556 13,820,856
-------------- --------------- -------------
Net (decrease) increase in cash and cash equivalents (177,662) (1,212,226) 1,181,475
Cash and cash equivalents at beginning of the year 201,401 1,413,627 232,152
-------------- --------------- -------------
Cash and cash equivalents at end of the year $ 23,739 $ 201,401 $ 1,413,627
============== =============== =============
See accompanying notes to consolidated financial statements.
F-8
Fonix Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Years Ended December 31,
--------------------------------------------
Supplemental disclosure of cash flow information: 2002 2001 2000
-------------- -------------- --------------
Cash paid during the year for interest $ 60,189 $ 171,494 $ 455,047
Cash paid during the year for income taxes 3,791 2,986 2,606
Supplemental schedule of non-cash investing and financing activities:
For the year ended December 31, 2002:
Warrants for 20,625 shares of Class A common stock valued at
$1,472,400 expired
Amortization of deferred conslitng expense in the amount of $17,777
For the year ended December 31, 2001:
Preferred stock dividends of $9,281 were accrued on Series D and
Series F preferred stock.
Converted 164,500 shares of Series D preferred stock and related
dividends of $320,949 into 349,461 shares of Class A common stock.
Converted 6,073 shares of Series F preferred stock and related
dividends of $6,853 into 12,977 shares of Class A common stock.
Issued warrants for the purchase of 250,000 shares of Class A common
stock as consideration for a perpetual, nonexclusive technology
license valued at $62,500.
Issued a non-interest bearing promissory note in the amount of
$2,600,000 to purchase 4,270 shares of Series A preferred stock of
Audium Corporation.
Issued a non-interest bearing promissory note in the amount of
$1,280,000 to purchase tangible and intangible assets from Force
Computers, Inc.
Entered into a capital lease obligation for equipment in the amount of
$29,064.
Issued a note payable for purchase of equipment in the amount of
$19,039.
Issued 1,828 shares of Class A common stock for $852,970 in
subscription receivable.
For the Year Ended December 31, 2000:
Accrued preferred stock dividends of $191,051 on Series D and Series F
preferred stock.
Converted 217,223 shares of Series D preferred stock and related
dividends of $255,600 into 385,909 shares of Class A common stock.
Converted 309,963 shares of Series F preferred stock and related
dividends of $34,042 into 208,571 shares of Class A common stock.
Recorded preferred stock dividends of $2,750,000 related to the
beneficial conversion features of Series F convertible preferred
stock.
Converted $7,500,000 of principal and $90,870 of interest from the
convertible promissory note into 288,619 shares of Class A common
stock.
Issued 15,000 warrants valued at $474,000 to an executive officer and
director of the Company as consideration for the rights to certain pen
and voice input technology.
Issued 5,709 shares of Class A common stock to two former directors of
the Company upon the exercise of 400,000 options as stock appreciation
rights.
Converted $3,971,107 in principal of Series C convertible debentures
and related interest of $290,957 into 259,634 shares of Class A common
stock.
Issued 114,214 shares of Class A common stock upon the exercise of
repricing rights associated with the common stock subject to
redemption.
Issued 31,250 shares of Class A common stock to an unrelated party for
consulting fees valued at $1,328,100.
Issued 15,302 shares of Class A common stock valued at $688,578 as
payment for liquidation damages and a restructuring fee in connection
with the Series D preferred stock agreement.
Recorded interest expense of $3,447,623 for a beneficial conversion
feature on a promissory note.
Entered into a capital lease obligation for equipment in the amount of
$92,304.
Dividends totaling $514,800 were accrued relating to the liquidation
damage provision of the Series D preferred stock.
Issued 6,504 shares of Class A common stock having a market value of
$81,295 in settlement of litigation.
Issued 1,125 warrants valued at $11,250 for consulting services.
See accompanying notes to consolidated financial statements.
F-9
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations - Fonix Corporation and subsidiaries (collectively, the
"Company"or "Fonix") is engaged in developing, acquiring and marketing
proprietary speech-enabling technologies. The Company's speech-enabling
technologies include automated speech recognition ("ASR") and text-to-speech
("TTS"). The Company offers its speech-enabling technologies to markets for
embedded automotive and wireless and mobile devices, computer telephony and
server solutions and personal software for consumer applications. The Company
has received various patents for certain elements of its core technologies and
has filed applications for other patents covering various aspects of its
technologies. The Company seeks to develop relationships and strategic alliances
with third-party developers and vendors in telecommunications, computers,
electronic devices and related industries, including producers of application
software, operating systems, computers and microprocessor chips. Revenues are
generated through licensing of speech-enabling technologies, maintenance
contracts and services.
Business Condition - The Company generated revenues of $3,065,000, incurred a
net loss of $19,898,000 and had negative cash flows from operating activities
totaling $9,942,000 for the year ended December 31, 2002. As of December 31,
2002, the Company had an accumulated deficit of $194,007,000, negative working
capital of $14,429,000, accrued employee wages of $5,266,000, and accounts
payable over 60 days past due of $2,232,000. As of December 31, 2002 the Company
was not able to draw on its third equity line of credit as it had not yet been
declared effective by the SEC. The Company expects to continue to incur
significant losses and negative cash flows from operating activities through at
least December 31, 2003, primarily due to significant expenditure requirements
associated with marketing and developing its speech-enabling technologies.
The Company's cash resources are limited to collections from customers, draws on
the equity line and loans, which are not sufficient to cover operating expenses.
As a result, payments to employees and vendors have been delayed since June
2002. Employees have been paid through June 15, 2002. Subsequent to June 30,
2002, advances have been made to certain employees on the basis of financial
need as determined by the individual circumstances of each employee. Payments
amounting to approximately $278,000 have been made on this basis through
December 31, 2002. Forty-five employees of Fonix have quit or been terminated
between July 1, 2002 and December 31, 2002. No stoppage in work has occurred as
a result of nonpayment or delayed payment of compensation to date, nor have
deliveries to customers been effected. Certain payments to vendors deemed to be
critical to the Company's ongoing operations have been made. To date, no
critical services have been stopped as a result of nonpayment or delayed
payment. At December 31, 2002, unpaid compensation payable to current and former
employees amounted to approximately $5,266,000 and vendor accounts payable
amount to approximately $3,083,000. The Company has not been declared in default
under the terms of any material agreements.
These factors, as well as the risk factors set out elsewhere in the Company's
Annual Report on Form 10-K, raise substantial doubt about the Company's ability
to continue as a going concern. The accompanying financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
Management plans to fund the operations of the Company through proceeds from
sales of debt and equity securities and cash flows from license and royalty
arrangements. There can be no assurance that management's plans will be
successful.
Consolidation - The accompanying consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries, Fonix Korea Sales
Group, Ltd., Fonix/AcuVoice, Inc. and Fonix/Papyrus, Inc. All significant
intercompany balances and transactions have been eliminated in consolidation.
Investments in 20 to 50 percent owned affiliates are accounted for using the
equity method (see Note 5).
Accounting Estimates - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosures of contingent assets and liabilities
at the date of the financial statements, and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from those
estimates.
Fair Value of Financial Instruments - The book values of the Company's assets
and liabilities approximate their fair values. The estimated fair values have
been determined using appropriate market information and valuation
F-10
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
methodologies.
Concentration of Credit Risks - The Company's cash and cash equivalents are
maintained in bank deposit accounts which occasionally may exceed federally
insured limits. Cash equivalents consist of highly liquid securities with
maturities of three months or less when purchased. The Company has not
experienced any losses with respect to these deposits. In the normal course of
business, the Company provides credit terms to its customers. Accordingly, the
Company performs on-going credit evaluations of its customers and maintains
allowances for possible losses, which when realized, have been within the range
of management's expectations.
Cash and Cash Equivalents - The Company considers all highly liquid, short-term
investments with a maturity of three months or less to be cash equivalents.
Subscriptions Receivable - Proceeds from certain sales of the Company's equity
securities prior to December 31, 2001 had not been received by the Company as of
year end. The cash proceeds were subsequently received in January 2002.
Inventory - Inventory, consisting primarily of retail products, is stated at the
lower of cost (first-in, first-out method) or market value.
Valuation of Long-lived Assets - The carrying values of the Company's long-lived
assets are reviewed for impairment whenever events or changes in circumstances
indicate that they may not be recoverable. If such an event were to occur, the
Company would project undiscounted cash flows to be generated from the use of
the asset and its eventual disposition over the remaining life of the asset. If
projections were to indicate that the carrying value of the long-lived asset
will not be recovered, the carrying value of the long-lived asset, other than
software technology, is reduced by the estimated excess of the carrying value
over the projected discounted cash flows. The determination whether the carrying
value of software technology is recoverable is discussed below. See "Software
Technology Development and Production Costs."
During 2001, the Company recognized impairment losses relating to its speech
software technology, its handwriting recognition software technology, and its
investment in Audium Corporation. Management does not consider any of the
Company's other long-lived assets to be impaired at December 31, 2002. However,
should the Company's marketing and sales plans not materialize in the near term,
the realization of the Company's intangible assets could be severely and
negatively impacted. The accompanying consolidated financial statements have
been prepared based on management's estimates of realizability, which estimates
may change due to factors beyond the control of the Company. See "Recently
Enacted Accounting Standards" below.
Intangible Assets - Customer relations, trademarks and patents are amortized
over their estimated useful lives unless they are deemed to have indefinite
useful lives. For intangible assets subject to amortization, an impairment is
recognized if the carrying amount is not recoverable and the carrying amount
exceeds the fair value of the intangible asset. Intangible assets deemed to have
indefinite useful lives, primarily trademarks, are not amortized and are tested
for impairment annually or when circumstances indicate that they may not be
recoverable. An impairment exists if the carrying value of the indefinite lived
intangible asset exceeds its fair value. The accounting for speech software
technology is discussed above.
Goodwill - The excess of the cost of businesses acquired over the fair value of
net tangible and intangible assets represents goodwill. Goodwill related to
purchase acquisitions completed prior to June 30, 2001 was amortized on a
straight-line basis over its estimated useful life through December 31, 2001.
Effective January 1, 2002, amortization of goodwill ceased and thereafter,
goodwill is tested for impairment annually or whenever events or changes in
circumstances indicate that it may not be recoverable. An impairment of goodwill
is deemed to exist if the carrying value of the related reporting unit
(presently the entire Company) exceeds its estimated fair value.
Revenue Recognition - The Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, "Software Revenue Recognition" and
related interpretations. The Company generates revenues from licensing the
rights to its software products to end users and from royalties. It also
generates service revenues from the sale of consulting and development services.
F-11
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Revenues of all types are recognized when acceptance of functionality, rights of
return, and price protection are confirmed or can be reasonably estimated, as
appropriate. Revenues from development and consulting services are recognized on
a completed-contract basis when the services are completed and accepted by the
customer. The completed-contract method is used because the Company's contracts
are either short-term in duration or the Company is unable to make reasonably
dependable estimates of the costs of the contracts. Revenue for hardware units
delivered is recognized when delivery is verified and collection assured.
Revenue for products distributed through wholesale and retail channels and
through resellers is recognized upon verification of final sell-through to end
users, after consideration of rights of return and price protection. Typically,
the right of return on such products has expired when the end user purchases the
product from the retail outlet. Once the end user opens the package, it is not
returnable unless the medium is defective. Price protection is offered to
distributors in the event the Company reduces the price on any specific product.
Such price protection is generally offered for a specific time period in which
the distributor must make a claim. Resulting revenue recognized reflects the
reduced price. Slotting fees paid by the Company for favorable placement in
retail outlets are recorded as a reduction in gross revenues.
When arrangements to license software products do not require significant
production, modification or customization of software, revenue from licenses and
royalties are recognized when persuasive evidence of a licensing arrangement
exists, delivery of the software has occurred, the fee is fixed or determinable,
and collectibility is probable. Post- contract obligations, if any, generally
consist of one year of support including such services as customer calls, bug
fixes, and upgrades. Related revenue is recognized over the period covered by
the agreement. Revenues from maintenance and support contracts are also
recognized over the term of the related contracts.
Revenues applicable to multiple-element fee arrangements are bifurcated among
the elements such as license agreements and support and upgrade obligations
using vendor-specific objective evidence of fair value. Such evidence consists
primarily of pricing of multiple elements as if sold as separate products or
arrangements. These elements vary based upon factors such as the type of
license, volume of units licensed, and other related factors.
Deferred revenue as of December 31, 2002, consisted of the following:
Description Criteria for Recognition Amount
- ----------- ------------------------ -----------------
Deferred unit royalties and Delivery of units to end users or expiration of
licence fees contract $ 794,737
Deferred customer support Expiration of period covered by support agreement 59,511
-----------------
Total deferred revenue $ 854,248
=================
Cost of revenues from license, royalties, and maintenance consists of costs to
distribute the product (including the cost of the media on which it is
delivered), installation and support personnel compensation, amortization and
impairment of capitalized speech software costs, licensed technology, and other
related costs. Cost of service revenues consists of personnel compensation and
other related costs.
Software technology development and production costs - All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense. Technological feasibility is established when a product design
and a working model of the software product have been completed and confirmed by
testing. Costs to produce or purchase software technology incurred subsequent to
establishing technological feasibility are capitalized. Capitalization of
software costs ceases when the product is available for general release to
customers. Costs to perform consulting or development services are charged to
cost of revenues in the period in which the corresponding revenues are
recognized. Cost of maintenance and customer support are charged to expense when
related revenue is recognized or when these costs are incurred, whichever occurs
first.
Capitalized software technology costs are amortized on a product-by-product
basis. Amortization is recognized from the date the product is available for
general release to customers as the greater of (a) the ratio that current gross
revenue
F-12
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for a product bears to total current and anticipated future gross revenues for
that product or (b) the straight-line method over the remaining estimated
economic life of the products. Amortization is charged to cost of revenues.
The Company assesses unamortized capitalized software costs for possible write
down on a quarterly basis based on net realizable value of each related product.
Net realizable value is determined based on the estimated future gross revenues
from a product reduced by the estimated future cost of completing and disposing
of the product, including the cost of performing maintenance and customer
support. The amount by which the unamortized capitalized costs of a software
product exceed the net realizable value of that asset is written off.
Stock-based Compensation Plans - The Company accounts for its stock-based
compensation issued to employees and directors under Accounting Principles Board
("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Under APB
Opinion No. 25, compensation related to stock options, if any, is recorded if an
option's exercise price on the measurement date is below the fair value of the
Company's common stock, and amortized to expense over the vesting period.
Compensation expense for stock awards or purchases, if any, is recognized if the
award or purchase price on the measurement date is below the fair value of the
Company's common stock, and is recognized on the date of award or purchase.
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock Based Compensation," requires pro forma information regarding net loss and
net loss per common share as if the Company had accounted for its stock options
granted under the fair value method. Pro forma information presented in Note 13.
The Company accounts for its stock-based compensation issued to non-employees
using the fair value method in accordance with SFAS No. 123 and related
interpretations. Under SFAS No. 123, stock-based compensation is determined as
either the fair value of the consideration received or the fair value of the
equity instruments issued, whichever is more reliably measurable. The
measurement date for these issuances is the earlier of the date at which a
commitment for performance by the recipient to earn the equity instruments is
reached or the date at which the recipient's performance is complete.
At December 31, 2002, the Company has stock-based employee compensation plans
(See Note 14). The Company accounts for the plan under the recognition method
and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued
to Employees", and the releated Interpretations. Had compensation expense for
these options been determined in accordance with the method prescribed by SFAS
No. 123, "Accounting for Stock-Based Compensation", the Company's net loss per
common share would have been increased to the pro forma amounts indicated below
for the years ended December 31, 2002, 2001, and 2000:
2002 2001 2000
------ ------ -----
Net loss:
As reported $ (19,897,564) $(31,059,791) $(22,761,229)
Pro forma (20,374,288) (31,909,481) (30,602,028)
Basic and diluted net loss per common share:
As reported $ (1.73) $ (5.20) $ (5.60)
Pro forma (1.78) (5.33) (7.52)
Advertising Costs - Advertising costs are expensed when incurred. Total
advertising expense was $116,160 and $114,356 for the years ended December 31,
2002 and 2001, respectively.
Income Taxes - The Company recognizes deferred income tax assets or liabilities
for the expected future tax consequences of events that have been recognized in
the financial statements or tax returns. Deferred income tax assets or
liabilities are determined based upon the difference between the financial and
income tax bases of assets and liabilities using enacted tax rates expected to
apply when differences are expected to be settled or realized.
Net Loss Per Common Share - Basic and diluted net loss per common share are
calculated by dividing net loss
F-13
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
attributable to common stockholders by the weighted-average number of shares of
common stock outstanding during the year. At December 31, 2002, 2001, and 2000,
there were outstanding common stock equivalents to purchase 636,652 shares,
678,012 shares and 963,525 shares of common stock, respectively, that were not
included in the computation of diluted net loss per common share as their effect
would have been anti-dilutive, thereby decreasing the net loss per common share.
The following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the years ended December 31, 2002, 2001,
and 2000:
2002 2001 2000
---------------------------- --------------------------- --------------------------
Loss Loss Loss
Per Per Per
Loss Share Loss Share Loss Share
---------------- ---------- --------------- ---------- -------------- ----------
Loss from continuing operations $ (19,897,564) $ (31,059,791) $ (22,810,677)
Preferred stock dividends - (9,281) (3,335,852)
---------------- --------------- --------------
Net loss from continuing
operations attributable to
common shareholders (19,897,564) $ (1.73) (31,069,072) $ (5.20) (26,146,529) $ (6.43)
Extraordinary item, net of taxes - - - - 49,448 -
---------------- ---------- --------------- ---------- -------------- ----------
Net loss attributable to common
stockholders $ (19,897,564) $ (1.73) $ (31,069,072) $ (5.20) $ (26,097,081) $ (6.42)
================ ========== =============== ========== ============== ==========
Weighted-average common shares
outstanding 11,471,564 5,978,281 4,067,107
================ =============== ==============
Imputed Interest Expense and Income - Interest is imputed on long-term debt
obligations and notes receivable where management has determined that the
contractual interest rates are below the market rate for instruments with
similar risk characteristics (see Notes 5 and 7).
Foreign Currency Translation - The functional currency of the Company's Korean
subsidiary is the South Korean won. Consequently, assets and liabilities of the
Korean operations are translated into United States dollars using current
exchange rates at the end of the year. All revenue is invoiced in South Korean
won and revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.
Comprehensive Income - Other comprehensive income presented in the accompanying
consolidated financial statements consists of cumulative foreign currency
translation adjustments. The Company had no items of comprehensive income or
loss prior to April 1, 2001.
Recently Enacted Accounting Standards - In July 2001, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 141, "Business Combinations" and SFAS
No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the
"pooling-of-interests" method of accounting for acquisitions and requires
separate accounting for certain intangibles acquired in such transactions. The
application of this standard did not have an impact on the Company's financial
position and results of operations.
SFAS No. 142 changes the accounting for goodwill and intangible assets with
indefinite lives from an amortization method to an impairment-only approach. On
January 1, 2002, the Company adopted the requirements of SFAS No. 142 and
discontinued amortization of goodwill and intangible assets with indefinite
lives. Other intangible assets will continue to be amortized over their
respective useful lives.
During 2002, the Company engaged Houlihan Valuation Advisors, an independent
valuation firm, to assess the Company's goodwill and intangible assets with
indefinite lives for impairment. The resulting appraisal indicated no
impairment, and the application of the test for impairment required by SFAS No.
142 had no effect on the Company's
F-14
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
financial position or results of operations, except for the change in
amortization of goodwill and intangible assets with indefinite lives described
in the preceding paragraph.
In August 2001, the FASB issued SFAS No. 143 , "Accounting for Asset Retirement
Obligations." This statement establishes financial accounting and reporting
standards for obligations associated with the retirement of tangible long- lived
assets and the associated asset retirement costs. The Company's adoption of this
statement on January 1, 2002, did not have a material effect on the Company's
financial position or results of operations.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." This statement establishes financial accounting
and reporting standards for the impairment or disposal of long-lived assets. The
adoption of this statement on January 1, 2002, did not have a material effect on
the Company's financial position or results of operations. See Note 2.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
Among other provisions, this statement modifies the criteria for classification
of gains or losses on debt extinguishment such that they are not required to be
classified as extraordinary items if they do not meet the criteria for
classification as extraordinary items in APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." The Company will be required to apply the provisions of this
standard to transactions occurring after December 31, 2002. The adoption of this
standard in 2003 is not expected to have a material effect on the Company's
financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." The statement requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. Examples of costs
covered by the standard include lease termination costs and certain employee
severance costs that are associated with a restructuring, discontinued
operation, plant closing, or other exit or disposal activity. The Company will
be required to apply this statement prospectively for any exit or disposal
activities initiated after December 31, 2002. The adoption of this standard is
not expected to have a material effect on the Company's financial position or
results of operations.
In December 2002, SFAS No. 148, "Accounting for Stock-Based Compensation --
Transition and Disclosure -- an amendment of FASB No. 123" was issued. SFAS No.
148 amends SFAS No. 123 to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation. It also amends disclosure requirements of SFAS No. 123
requiring disclosures in both annual and interim financial statements about the
method of accounting for stock based employee compensation and the effect of the
method used on reported results. The transition guidance and annual disclosure
provisions of this statement are effective for fiscal years ending after
December 15, 2002. The interim disclosure provisions are effective for financial
reports containing financial statements for interim periods beginning after
December 15, 2002. At this time, the pronouncement is not expected to have any
impact on the Company's reported results of operations and financial position as
it continues to account for its stock compensation plans under the provisions of
APB Opinion No. 25, "Accounting for Stock Issued to Employees."
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"), "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others". FIN 45 elaborates on the existing
disclosure requirements for most guarantees. It also clarifies that at the time
a company issues a guarantee, the company must recognize an initial liability
for the fair value, or market value, of the obligation it assumes under that
guarantee and must disclose that information in its interim and annual financial
statements. The initial recognition and measurement provisions apply on a
prospective basis to guarantees issued or modified after December 31, 2002. The
Company does not expect the recognition and measurement provisions of FIN 45 to
have a material effect on future interim or annual financial statements.
F-15
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN 46 provides guidance on the identification of entities for which control is
achieved through means other than through voting rights ("variable interest 45
entities" or "VIEs") and how to determine when and which business enterprise
should consolidate the VIE (the "primary beneficiary"). This new model for
consolidation applies to an entity in which either (1) the equity investors do
not have a controlling financial interest or, (2) the equity investment at risk
is insufficient to finance that entity's activities without receiving additional
subordinated financial support from other parties. In addition, FIN 46 requires
that both the primary beneficiary and all other enterprises with a significant
variable interest in a VIE make additional disclosures. FIN 46 applies to
variable interest entities created after January 31, 2003, and to VIEs in which
an enterprise obtains an interest after that date. It also applies in the first
fiscal year or interim period beginning after June 15, 2003, to VIEs in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
The Company does not expect the provisions of FIN 46 to have a material effect
on future interim or annual financial statements.
2. ACQUISITION
DECtalk Assets - On December 14, 2001, the Company entered into an Asset
Purchase Agreement with Force Computers, Inc., under which the Company purchased
from Force tangible and intangible assets (the "DECtalk Assets"). The Company
agreed to pay $150,000 in cash at closing and $1,280,000 in the form of a
non-interest-bearing promissory note (see Note 7).
The purchase price of $1,459,978, including direct acquisition costs of $70,223,
was allocated as follows:
Accounts receivable........................$ 18,566
Furniture and equipment.................... 64,350
Speech software technology................. 935,000
Customer relationships..................... 306,000
Trademark.................................. 42,000
Goodwill................................... 94,062
------------
Total Purchase Price.......................$ 1,459,978
============
At December 31, 2002, the Company had an outstanding balance under the
promissory note of $250,000 due to Force Computers, Inc., which amount the
Company expects to pay during the first and second quarters of 2003.
3. CONVERTIBLE NOTES RECEIVABLE
On December 1, 2001, the Company, as the lender, established a revolving line of
credit and received a convertible promissory note from Unveil Technologies, Inc.
("Unveil"), that permitted Unveil to draw up to $2,000,000 for operations and
other purposes. Unveil is a developer of natural language understanding
solutions for customer resource management ("CRM") applications. Fonix desired
to obtain a license to Unveil's CRM applications when completed and made the
loan to Unveil to facilitate and expedite the development and commercialization
of Unveil's speech- enabled CRM software. Draws on the line of credit bear
interest at an annual rate of seven percent, which interest was payable
quarterly beginning June 30, 2002. The Company extended the interest due date to
December 31, 2002. The balance due under the line of credit is secured by
Unveil's CRM software and related source code and other assets of Unveil. The
Company is a senior creditor to Unveil. The unpaid principal, together with
interest accrued thereon, is due and payable on December 31, 2002, and is
convertible into common shares of Unveil at the Company's option. Based upon
borrowings through December 31, 2002, such conversion at that date would have
represented approximately 12 percent of the issued and outstanding common stock
of Unveil.
During the year ended December 31, 2002, Unveil drew $880,000 on the line of
credit, bringing total draws on the line of credit to $1,450,000 as of December
31, 2002. Due to limited resources available to the Company, additional requests
F-16
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for funding by Unveil under the line of credit have not been met. This
limitation in funding has resulted in a deterioration of Unveil's financial
condition and has caused Unveil to slow its development process. Accordingly,
due to Unveil's financial condition, the Company estimated an impairment loss
during the third quarter of 2002 in the amount of $1,523,842, consisting of the
outstanding balance on the line of credit plus accrued interest thereon as of
that date. The Company advanced an additional $60,000 to Unveil in October 2002.
This advance was treated as a research and development expense.
Subsequent to December 31, 2002, the Company entered into an agreement to
terminate the revolving line of credit and satisfy the convertible promissory
note with Unveil. In full payment of the balance due under the note, the Company
received a payment of $410,000 and 1,863,636 shares of Unveil's Series A
Preferred Stock. Accordingly, the Company adjusted the estimated impairment,
recorded in the third quarter, such that the carrying amount of the not
receivable was equal to the amount subsequently received in January, 2003. The
Company did not place a value on the Preferred Stock due to Unveil's overall
financial condition.
4. PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation is computed on a
straight-line basis over the estimated useful lives of the assets as follows:
Furniture and fixtures 5 years
Computer equipment 3 to 5 years
Leasehold improvements 1.5 to 8 years
Leasehold improvements are amortized over the shorter of the useful life of the
applicable asset or the remaining lease term. Maintenance and repairs are
charged to expense as incurred and major improvements are capitalized. Gains or
losses on sales or retirements are included in the consolidated statements of
operations in the year of disposition. Depreciation expense was $347,493,
$383,982 and $635,783 for the years ended December 31, 2002, 2001, and 2000,
respectively. Property and equipment consisted of the following at December 31,
2002 and 2001:
2002 2001
--------------- ----------------
Computer equipment $ 1,223,415 $ 1,166,731
Furniture and fixtures 981,523 959,069
Leasehold improvements 92,319 92,319
--------------- ----------------
2,297,257 2,218,119
Less accumulated depreciation and amortization (1,671,809) (1,314,960)
--------------- ----------------
Net Property and Equipment $ 625,448 $ 903,159
=============== ================
5. INVESTMENT IN AFFILIATE
In February 2001, the Company entered into a collaboration agreement with Audium
Corporation ("Audium") to provide an integrated platform for generating Voice
XML solutions for Internet and telephony systems. Audium is a mobile application
service provider that builds and operates mobile applications that allow access
to Internet information and to complete online transactions using any telephone.
The collaboration includes integration of the Company's technologies with
Audium's mobile applications development capability.
Note Receivable - In connection with the collaboration agreement with Audium, in
February and May 2001, the Company advanced an aggregate of $400,000 to Audium
as a bridge loan (the "Audium Note"). The loan bears interest at a rate of 5
percent per year, has a term of four years and is convertible into shares of
Audium Series A Convertible Preferred Stock ("Audium Preferred Stock"). The
Audium Note is convertible into shares of Audium Preferred Stock at a price of
$1.46 per share in the event of (i) Audium's raising an additional $2,000,000
prior to October 6, 2002, (ii) Audium's merger or consolidation, (iii) a
qualified public offering of Audium's common stock, (iv) an event of default
under a note
F-17
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
payable from Fonix (see Fonix Note below), or (v) Audium's aggregate gross
revenues for the months of January through June 2003 exceeding $1,000,000. The
Audium Note is secured by Audium's intellectual property. Further, at the
closing, Audium granted the Company a fully paid, worldwide, non-exclusive
license to Audium's software to make, manufacture, and use the software and any
derivative works if Audium declares bankruptcy or ceases to do business.
Management determined that a 12 percent annual interest rate better reflects the
risk characteristics of the Audium Note. Accordingly, interest was imputed at 12
percent and the Audium Note was recorded at its original present value of
$302,909. For the years ended December 31, 2002 and 2001, the Company recorded
interest income of $39,501 and $29,663, respectively, including contractual and
imputed interest. The Company is currently discussing the possibility of
converting the remaining balance due under the Audium Note for additional shares
of Audium's Common Stock.
Investment in Affiliate - In April 2001, the Company closed a stock purchase
agreement with Audium, wherein the Company agreed to purchase up to $2,800,000
of Audium Preferred Stock at a price of $1.46 per share. At closing, the Company
paid $200,000 in cash and gave Audium a non-interest bearing note (the "Fonix
Note") for the remaining $2,600,000. Interest on the Fonix Note was imputed at
12 percent resulting in a present value of $2,370,348. The resulting purchase
price of the Audium Preferred Stock was $2,570,348.
Each share of Audium Preferred Stock is convertible into one share of Audium's
common stock. Holders of Audium Preferred Stock are entitled to eight percent
cumulative dividends, a liquidation preference in excess of the original
purchase price plus any declared but unpaid dividends, anti-dilution rights, and
voting rights equal to the corresponding number of common shares into which it
is convertible. The stock purchase agreement also entitles Fonix to elect one
member of Audium's board of directors. Audium also granted Fonix certain
registration rights after the closing of a public offering by Audium.
At closing, Audium issued 14 Audium Preferred Stock certificates to Fonix, each
certificate for 136,986 shares, and delivered one certificate in exchange for
the initial payment of $200,000. The remaining certificates are held by Audium
as collateral for the Fonix Note under the terms of a security agreement. For
each payment of $200,000 or multiple payments that aggregate $200,000, Audium
will release to Fonix one certificate for 136,986 shares of Audium Preferred
Stock.
The difference between the total purchase price of the Audium Preferred Stock
and the Company's portion of Audium's net stockholders' deficit at the time of
the purchase was $2,700,727, which was allocated to capitalized software
technology. The excess purchase price allocated to the capitalized software
technology was amortized on a straight-line basis over a period of eight years
through December 31, 2001. After the impairment in the investment in Audium
discussed below, the remaining excess purchase price was $1,008,002 and is being
amortized over the remaining portion of the 8-year peroid.
The investment in Audium does not provide the Company with rights to any
technology developed by Audium; the Company must obtain a license should it
choose to do so. Also, the Company would not own an interest sufficient to
control Audium, if the Company were to convert the Audium Note to Audium
Preferred Stock. As a result, management has determined that it is appropriate
to account for the investment, which represents 26.7 percent of Audium's voting
stock, under the equity method and not as a research and development
arrangement. Audium has incurred losses since the Company acquired the Audium
Preferred Stock and as such, Audium does not have the ability to declare or pay
preferred dividends on the Preferred Stock. The Company recognized losses for
the year ended 2002 and the period from April 11, 2001 through December 31, 2001
as follows:
F-18
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Year Ended Peroid Ended
December 31, December 31,
2002 2001
------------------- ------------------
Company share of Audium net loss $ 289,391 $ 97,789
Amortization of difference between purchase price of Audium
Preferred Stock and Company's share of Audium's net
stockholders' deficit $ 167,301 $ 274,724
------------------- ------------------
Total equity in loss of affiliate $ 456,692 $ 372,513
=================== ==================
A summary of the results of Audium's operations for the years ended December 31,
2002 and 2001, and net assets as of December 31, 2002, is as follows:
2002 2001
--------------- ----------------
Net sales $ 475,336 $ 466,949
Loss from operations (1,129,063) (820,912)
Net loss (1,083,859) (862,274)
Current assets $ 1,501,205 $ 539,464
Total assets 2,816,639 1,458,882
Current liabilities 1,664,207 625,544
Total liabilities 2,064,207 1,048,139
Net assets $ 752,432 $ 410,743
The fair value of this investment is determined based on Audium's estimated
future net cash flows considering the status of Audium's product development.
The Company evaluates this investment for impairment annually and more
frequently if indications of decline in value exist. An impairment loss that is
other than temporary is recognized during the period it is determined to exist.
An impairment is determined to be other-than-temporary if estimated future net
cash flows are less than the carrying value of the investment. If projections
indicate that the carrying value of the investment will not be recoverable, the
carrying value is reduced by the estimated excess of the carrying value over the
estimated discounted cash flows. There is a reasonable possibility that in the
near future estimated future cash flows from the investment in Audium could
change and that the effect of the change could be material to the Company's
financial position or results of operation.
At December 31, 2001, the Company assessed the realizability of the investment
in Audium and the Company wrote down the investment by $823,275. The write-down
was a result of a decrease in the estimated cash flows expected to be realized
from the investment due to overall decline in the economy and the potential
impact on related markets for Audium's products. As of December 31, 2002, no
further write-down was deemed necessary based on th eestimated future cash flows
of the investment.
Note Payable to Affiliate - The Fonix Note is payable in 13 monthly installments
of $200,000 beginning on June 1, 2001, and bears no interest unless an event of
default occurs, in which case it will bear interest at 12 percent per year. No
events of default have occurred to date. The Fonix Note is secured by shares of
Audium Preferred Stock as described above.
Management determined that a 12 percent annual interest rate reflects the risk
characteristics of the Fonix Note. Accordingly, interest has been imputed at 12
percent and the Company recorded a present value of $2,370,348 for the note
payable. For the years ended December 31, 2002 and 2001, the Company recorded
interest expense of $95,303 and $164,405, respectively, related to this note.
Through December 31, 2002, payments amounting to $1,800,000 had been made under
the Fonix note. At December 31, 2002, the Company had an outstanding balance of
$1,000,000 due under the Fonix note. The Company and Audium are currently
discussing the possibility that Fonix return 684,930 shares of Audium's
Preferred Stock in exchange for Audium's release of Fonix under the Fonix note.
F-19
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. GOODWILL AND INTANGIBLE ASSETS
Goodwill resulted from the purchase of assets from Force Computers, Inc. and
from the acquisition of AcuVoice, Inc. Goodwill amortization expense was $0,
$604,105, and $604,105 during the years ended December 31, 2002, 2001 and 2000,
respectively. The carrying value of goodwill remained unchanged at $2,631,304
during the year ended December 31, 2002. During 2002, the Company engaged
Houlihan Valuation Advisors, an independent valuation firm, to assess the
Company's goodwill for impairment. The resulting appraisal indicated that
goodwill was not impaired. However, should the Company's marketing and sales
plans not materialize in the near term, the realization of the Company's
goodwill and other intangible assets could be severely and negatively impacted.
The components of intangible assets were as follows:
December 31, 2002 December 31, 2001
------------------------------------------ ------------------------------------
Gross Net Gross Net
Carrying Accumulated Carrying Carrying Accumulated Carrying
Amount Amortization Amount Amount Amortization Amount
------------- ---------------- ----------- ----------- --------------- -----------
Speech software technology $ 978,582 $ 104,397) $ 874,185 $ 978,582 $ - $ 978,582
Customer relationships 306,000 (30,600) 275,400 306,000 - 306,000
Patents 164,460 (164,460) - 164,460 (145,522) 18,938
------------- ---------------- ----------- ----------- --------------- ------------
Total Amortizing Intangible Assets $ 1,449,042 $ (299,457) 1,149,585 $ 1,449,042 $ (145,222) 1,303,520
------------- ---------------- ----------- ----------- ---------------
Indefinite-lived Intangible Assets
Trademarks 42,000 42,000
---------- -----------
Total Intangible Assets $1,191,585 $ 1,345,520
========== ===========
Speech software technology amortization expense was $104,397, $1,824,440, and
$1,824,440, during the years ended December 31, 2002, 2001, and 2000,
respectively, and was charged to cost of revenues. The cost of patents include
direct costs incurred by the Company in applying for patents covering its
internally developed speech software technologies. Patent amortization expense
was $18,938, $24,946, and $29,284 during the years ended December 31, 2002,
2001, and 2000, respectively, and was charged to selling, general and
administrative expense. Amortization expense related to customer relationships
was $30,600, $0, and $0 during the years ended December 31, 2002, 2001, and 2000
respectively, and was charged to selling, general and administrative expense.
The speech software technology was tested for impairment in December 2001. Due
to the down-turn in the software industry and the U.S. economy, operating losses
and cash used in operating activities during the fourth quarter of 2001 were
greater than anticipated. Based on that trend, management revised estimated net
future cash flows from the technology, which resulted in recognition of an
impairment loss of $5,832,217 during the fourth quarter of 2001. The impairment
loss was charged to cost of revenues.
During the fourth quarter of 2001, management of the Company determined that its
handwriting recognition software ("HWR") technology was impaired. Without
immediate customer prospects or current license agreements, management has
chosen not to provide further funding to develop or market the HWR technology.
Accordingly, the unamortized balance of $2,056,295 was recorded in cost of
revenues in 2001.
Based on the analysis of estimated net future cash flows from the various
intangible assets, no further impairment was deemed necessary for the year ended
December 31, 2002.
The Company has reassessed the estimated useful lives of other intangible assets
and will continue to amortize the costs of those assets over their estimated
useful lives.
Intangible assets not subject to amortization as of January 1, 2002 consisted of
goodwill with a net carrying value of $2,631,304 and trademarks with a carrying
value of $42,000. These assets are considered to have indefinite useful lives.
F-20
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Except for capitalized speech software technology that is amortized on the basis
described in Note 1, amortization of intangible assets subject to amortization
is computed on a straight-line basis over their estimated useful lives. The
weighted-average estimated remaining amortization periods are as follows: total
- - 8.7 years; speech software technology - 8.7 years; and customer relationships
- - 9.0 years. Intangible assets subject to amortization will not have any
significant residual value at the end of their estimated useful lives. As of
December 31, 2002, estimated amortization of intangible assets for the following
five years is as follows:
For the Years Ending December 31: Amount
------------------
2003 $ 134,996
2004 134,996
2005 134,996
2006 124,100
2007 124,100
During 2002, the Company engaged Houlihan Valuation Advisors, an independent
valuation firm, to assess the Company's goodwill for impairment. The resulting
appraisal indicated no impairment and goodwill was not considered impaired.
However, should the Company's marketing and sales plans not materialize in the
near term, the realization of the Company's goodwill and other intangible assets
could be severely and negatively impacted.
Adoption of SFAS No. 142 - The Company adopted the provisions of SFAS No. 142 on
January 1, 2002. Under the new standard, goodwill and intangible assets deemed
to have indefinite lives are no longer amortized, but are subject to annual
impairment tests.
The effects on loss from continuing operations net loss and basic and diluted
loss per share of excluding goodwill amortization for the years ended December
31, 2002, 2001 and 2000 are as follows:
2002 2001 2000
--------------- -------------- ----------------
Loss from continuing operations, as reported $ (19,897,564) $(31,059,791) $ (22,810,677)
Loss from continuing operations, excluding goodwill
amortization $ (19,897,564) $(30,455,686) $ (22,206,572)
=============== ============== ================
Net loss, as reported $ (19,897,564) $(31,059,791) $ (22,761,229)
Add back goodwill amortization -- 604,105 604,105
--------------- -------------- ----------------
Net loss, excluding goodwill amortization $ (19,897,564) $(30,455,686) $ (22,157,124)
=============== ============== ================
Basic and diluted loss per share:
Loss from continuing operations, as reported $ (1.73) $ (5.20) $ (5.61)
Loss from continuing operations, excluding goodwill
amortization $ (1.73) $ (5.09) $ (5.46)
=============== ============== ================
Net loss, as reported $ (1.73) $ (5.20) $ (5.60)
Net loss, excluding goodwill amortization $ (1.73) $ (5.09) $ (5.45)
=============== ============== ================
7. PROMISSORY NOTE
As discussed in Note 2, the Company entered into an Asset Purchase Agreement
with Force Computers, Inc. ("Force"). As part of the consideration for the
purchase price Fonix issued a non-interest bearing promissory note on December
14, 2001 in the amount of $1,280,000. Installment payments under the note were
due over the 12 month period following the date of purchase. Management
determined that a seven percent annual interest rate reflects the risk
characteristics of this promissory note. Accordingly, interest has been imputed
at seven percent and the Company recorded a discount of $40,245 for the note
payable. The Company recorded interest expense of $4,098 from the purchase date
through December 31, 2001 and $37,854 for the year ended December 31, 2002,
related to this promissory note.
F-21
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As collateral for the promissory note, 175,000 shares of the Company's Class A
common stock were placed into escrow. Under the terms of the escrow, the shares
will not be released to Force unless the Company is delinquent or late with
respect to any payment under the note. Also, under the terms of the Asset
Purchase Agreement, Fonix is required to deposit all receipts from customers
acquired in this transaction into a joint depository account. Fonix has the
right to withdraw such funds; however, in the event of default on any payments
to Force under the terms of the promissory note, Force has the right to withdraw
funds from the depository account until the deficiency in payment is covered, at
which time, Fonix may again have use of the funds. Through December 31, 2002,
payments required under the note have been made, except the final payment of
$250,000, which remained outstanding at December 31, 2002. Subsequent to
December 31, 2002, additional payments amounting to $115,000 were made.
Effective March 13, 2003, Force exercised its right to withdraw all funds
deposited in the joint account, as described above, until Force receives the
remaining balance due under the promissory note.
8. NOTES PAYABLE
During the second and third quarters of 2002, the Company entered into
promissory notes with an unrelated third party in the aggregate amount of
$75,000. These notes accrue interest at 12% annually and are due and payable
with accrued interest during the second and third quarters of 2003. The notes
have a conversion feature that allows the holder to convert all or any portion
of the principal amount and accrued interest into shares of the Company's Common
Stock. The conversion price is calculated as the arithmetic average of the last
closing bid price on each trading day during the five consecutive trading days
immediately preceding the conversion.
9. RELATED-PARTY NOTES PAYABLE
In connection with the acquisition of certain entities in 1998, the Company
issued unsecured demand notes payable to former stockholders of the acquired
entities in the aggregate amount of $1,710,000. Of the notes payable, $77,625
remain unpaid as of December 31, 2002. During 2000, the holders of these notes
made demand for payment and the Company commenced negotiating with the holders
of these notes to reduce the outstanding balance. No additional demands have
been made and no payments have been made by the Company to the holders of these
notes.
During 2002, two executive officers of the Company (the "Lenders") sold shares
of the Company's Class A common stock owned by them and advanced the resulting
proceeds amounting to $333,308 to the Company under the terms of a revolving
line of credit and related promissory note. The funds were advanced for use in
Company operations. The advances bear interest at 10 percent per annum, which
interest is payable on a semi-annual basis. The entire principal, along with
unpaid accrued interest and any other unpaid charges or related fees, is due and
payable on June 10, 2003. After December 11, 2002, all or part of the
outstanding balance and unpaid interest may be converted at the option of the
Lenders into shares of Class A common stock of the Company. The conversion price
is the average closing bid price of the shares at the time of the advances. To
the extent the market price of the Company's shares is below the conversion
price at the time of conversion, the Lenders are entitled to receive additional
shares equal to the gross dollar value received from the original sale of the
shares. A beneficial conversion option of $14,917 was recorded as interest
expense in connection with this transaction. The Lenders may also receive
additional compensation as determined appropriate by the Board of Directors.
In October 2002, the Lenders pledged 30,866 shares of the Company's Class A
common stock to the Equity Line Investor in connection with an advance of
$182,676 to the Company under the Third Equity Line (see Note 12 below). The
Equity Line Investor subsequently sold the pledged shares and applied $82,242 of
the proceeds in reduction of the advance. The value of the pledged shares of
$82,242 was treated as an additional advance from the Lenders.
The aggregate advances of $415,550 are secured by the Company's intellectual
property rights. As of December 31, 2002, the Lenders had deferred the interest
payment due December 10, 2003 and had not converted any of the outstanding
balance nor interest into common stock.
F-22
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. SERIES D CONVERTIBLE DEBENTURES
On October 11, 2002, the Company issued $1,500,000 of Series D 12% convertible
debentures (the "Debentures") and 194,444 shares of Class A common stock to
Breckenridge Fund, LLC ("Breckenridge"), an unaffiliated third party, for
$1,500,000 before offering costs of $118,282. The outstanding principal amount
of the Debentures is convertible at any time at the option of the holder into
shares of the Company's common stock at a conversion price equal to the average
of the two lowest closing bid prices of the Company's Class A common stock for
the twenty trading days immediately preceding the conversion date multiplied by
90%. The Debenture and accrued interest were originally due April 9, 2003.
The Company determined that Breckenridge had received a beneficial conversion
option on the date the Debentures were issued. The net proceeds of $1,381,718,
were allocated to the Debentures and to the Class A common stock based upon
their relative fair values and resulted in allocating $524,445 to the
Debentures, $571,111 to the related beneficial conversion option, $372,552 to
the 194,444 shares of Class A common stock, less $86,390 of deferred loan costs.
The resulting $975,555 discount on the Debentures and the deferred loan costs
are being amortized over the term of the Debentures as interest expense. Related
interest expense recognized during 2002 was $427,720.
In connection with the issuance of the Debentures, the Company issued, as
collateral to secure its performance under the Debenture, 2,083,333 shares of
Class A common stock (the "Collateral Shares"), which were placed into an escrow
pursuant to an escrow agreement. Under the escrow agreement, the Collateral
Shares will not be released to Breckenridge unless the Company is delinquent
with respect to payments under the Debenture.
The Debentures were originally due April 9, 2003. However, the Company and
Breckenridge agreed in January 2003 to modify the terms of the Debentures
requiring the following principal payments plus accrued interest: $400,000 in
January 2003; $350,000 in February 2003; $250,000 in March 2003; $250,000 in
April 2003; and $250,000 in May 2003. Additionally, the Company agreed to
release 237,583 of the Collateral Shares to Breckenridge as consideration (the
"Released Shares") to Breckenridge for revising the terms of the purchase
agreement.
If the Company is delinquent under the revised payment schedule, Breckenridge is
entitled to receive a penalty of five percent of the then-outstanding principal
amount of the Debentures, payable in cash or shares released from the Collateral
Shares.
In connection with the sale of the Debentures, the Company entered into a
registration rights agreement in which the Company agreed to register the resale
of the shares underlying the Debentures, the Collateral Shares, and the
Additional Shares. The Company filed a registration statement on Form S-2, which
became effective February 14, 2003. The Company plans to file such
post-effective amendments as necessary to keep the registration statement
effective as required by the registration rights agreement.
11. PREFERRED STOCK
The Company's certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company's board
of directors may designate.
Series A Convertible Preferred Stock - At December 31, 2002, there were 166,667
shares of Series A convertible preferred stock outstanding. Holders of the
Series A convertible preferred stock have the same voting rights as common
stockholders, have the right to elect one person to the board of directors and
are entitled to receive a one time preferential dividend of $2.905 per share of
Series A convertible preferred stock prior to the payment of any dividend on any
class or series of stock. At the option of the holders, each share of Series A
convertible preferred stock is convertible into one share of Class A common
stock and in the event that the common stock price has equaled or exceeded $10
for a 15 day period, the shares of Series A convertible preferred stock are
automatically converted into Class A common stock. In the event of liquidation,
the holders are entitled to a liquidating distribution of $36.33 per share and a
conversion of Series A convertible preferred stock at an amount equal to .0375
shares of common stock for each share of Series A convertible preferred stock.
F-23
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. CONVERTIBLE PROMISSORY NOTE AND EQUITY LINES OF CREDIT
Convertible Promissory Note - In June 2000, the Company executed a convertible
promissory note (the "2000 Note") with a private investor in the amount of
$7,500,000, against which the Company was permitted to draw funds as needed for
operating purposes. The 2000 Note bore interest at six percent annually,
compounded monthly, and was due September 30, 2001. Principal drawn under the
terms of the 2000 Note was designated as the "Initial Investment Amount" under
the Private Equity Line Agreement described below. The investor had the right to
convert, at its option, all or any portion of the outstanding principal and
interest into shares of Class A common stock at the lesser of $0.75 or 85
percent of the average of the three lowest closing bid prices of Class A common
stock in the 20-day trading period prior to the date of conversion. During 2000,
the Company drew the entire amount available under the 2000 Note and recorded
$106,348 as interest expense. Principal and interest were converted into 288,619
shares of Class A common stock. The Company also recorded a beneficial
conversion feature as interest expense in the amount of $3,447,623 related to
borrowings under the 2000 Note.
Equity Line of Credit - In August 2000, the Company entered into a Private
Equity Line Agreement ("Equity Line") with the same investor ("Equity Line
Investor") which gives the Company the right to draw up to $20,000,000 for
operations and other purposes. The Initial Investment Amount of $7,500,000 was
drawn as part of the 2000 Note described above. The balance remaining under the
Equity Line is available to the Company through a mechanism of draws and puts of
stock. The Company is entitled to draw funds and to "put" to the Equity Line
Investor shares of Class A common stock in lieu of repayment of the draw. The
number of shares issued is determined by dividing the dollar amount of the draw
by 90 percent of the average of the two lowest closing bid prices of Class A
common stock over the seven trading-day period following the date the Company
tenders the put notice. The Equity Line Investor funds the amounts requested by
the Company within two trading days after the seven trading-day period.
From its inception through December 31, 2000, draws taken under the Equity Line,
excluding the Initial Investment Amount, amounting to $3,973,508, less
commissions and related fees of $119,206, were converted into 312,317 shares of
Class A common stock. During 2001, draws amounting to $5,510,000, less
commissions and related fees of $165,300, were converted into 658,829 shares of
Class A common stock.
For the year ended December 31, 2002, the Company received $3,633,817 in funds
drawn under the Equity Line, less commissions and fees of $84,825, and issued
1,017,323 shares of Class A common stock to the Equity Line investor.
Second Equity Line of Credit - In April 2001, the Company entered into a second
private equity line agreement (the "Second Equity Line") with the Equity Line
Investor. Under the Second Equity Line, the Company has the right to draw up to
$20,000,000 under terms substantially identical to the initial Equity Line.
From the inception of the Second Equity Line through December 31, 2001, draws
under the Second Equity Line amounting to $13,425,000, less commissions and fees
of $497,750, were converted to 2,950,325 shares of Class A common stock.
For the year ended December 31, 2002, the Company received $5,728,846 in funds
drawn under the Second Equity Line, less commissions and fees of $189,805, and
issued 2,339,675 shares of Class A common stock to the Equity Line investor.
Third Equity Line of Credit - In June 2002, the Company entered into a third
equity line agreement (the "Third Equity Line") with the Equity Line Investor.
Under the Third Equity Line, the Company has the right to draw up to $20,000,000
under terms substantially identical to the Initial Equity Line. On June 27,
2002, the Company filed with the SEC a registration statement on Form S-2 to
register the resale of up to 5,000,000 shares of the Company's Class A common
stock by the Equity Line Investor, which became effective during January 2003.
During the third and fourth quarters of 2002, the Equity Line Investor advanced
the Company $182,676 against future draws on the Third Equity
F-24
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Line (see Note 9 above). The balance owing on the advance is included in accrued
liabilities in the accompanying financial statements at December 31, 2002. As of
December 31, 2002, no shares had been issued under the Third Equity Line.
Subsequent to December 31, 2002, through March 21, 2003, the Company received
$2,500,000 in funds drawn under the Third Equity Line, less commissions and fees
of $64,150, and issued 2,866,412 shares of Class A common stock to the Equity
Line investor. The shares were issued without registration under the 1933 Act in
reliance on Section 4(2) of the Securities Act of 1933, as amended (the "1933
Act"), and the rules and regulations promulgated thereunder. The resales of the
shares by the Equity Line investor were subsequently registered under
registration statements on Form S-2.
13. COMMON STOCK AND COMMON STOCK SUBJECT TO REDEMPTION
Reverse Stock Split - On March 24, 2003, the Company's shareholders approved a
one-for-forty reverse stock split to its outstanding Class A common stock and
common stock options and warrants. The stock split has been retroactively
reflected in the accompanying consolidated financial statements for all periods
presented.
Common Stock - On July 12, 2002, shareholders approved an amendment to the
Company's Certificate of Incorporation to increase the authorized capital stock
of the Company from 500,000,000 shares to 800,000,000 shares. The Company can
issue these shares as either Class A voting Common Stock or Class B non-voting
Common Stock.
During 2002, the Company issued 3,551,442 shares of Class A common stock. Of
such shares, 3,356,998 shares were issued upon conversion of draws on the equity
lines, and 194,444 were issued in connection with the sale of the Company's
Series D Debentures (See Note 10 above).
During 2001, the Company issued 3,972,466 shares of Class A common stock. Of
such shares, 3,609,154 shares were issued upon conversion of draws on the equity
lines, 362,438 were issued in connection with the conversion of Series D
preferred shares and 875 were issued in connection with the exercise of options.
At the annual meeting of shareholders held on July 18, 2001, the shareholders of
the Company approved an increase in the number of common shares authorized from
300,000,000 to 500,000,000.
During 2000, the Company issued 1,648,997 shares of Class A common stock. Of
such shares,854,114 shares were issued upon the conversion of convertible
debentures with related interest and preferred stock with related dividends,
600,936 were issued upon conversion of draws on the Equity Line and 2000 Note,
26,677 shares were issued upon the exercise of warrants, options and stock
appreciation rights, 114,214 shares were issued upon exercise of repricing
rights (see below), 6,504 shares were issued upon the settlement of litigation,
and 46,552 were issued to consultants as consideration for services rendered.
By vote of the shareholders at the annual meeting held October 29, 1999, the
issuance of 1,985,000 shares of Class B Non-Voting common stock was approved.
The Class B shares are authorized, but have not yet been exchanged for the
corresponding Class A shares held in escrow in connection with an acquisition
that occurred in 1998. The shares held in escrow have been excluded from the
calculation of basic net loss per common share for the year ended December 31,
2002, 2001, and 2000.
Voting Trust - As of December 31, 2002, 40,000 shares of the Company's
outstanding Class A common stock were held in a voting trust as to which the
president and chief executive officer of the Company is the sole trustee.
Persons who have deposited their shares of the Company's Class A common stock
into the voting trust have dividend and liquidation rights in proportion to the
number of shares of the Company's Class A common stock they have deposited in
the voting trust, but have no voting rights with respect to such shares. All
voting rights associated with the shares deposited into the voting trust are
exercisable solely and exclusively by the trustee of the voting trust. The
voting trust expires, unless extended according to its terms, on the earlier of
September 30, 2003 or any of the following events: (i) the trustee terminates
it; (ii) the participating stockholders unanimously terminate it; or (iii) the
Company is dissolved or liquidated.
F-25
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Common Stock Subject to Redemption - In 1998, the Company entered into a private
placement agreement with an unaffiliated investor, pursuant to which the Company
received $1,980,000 in net proceeds in exchange for 45,045 shares of Class A
common stock, an equal number of repricing rights, both subject to certain
repurchase rights, and warrants to purchase 5,000 shares of Class A common stock
at $1.67 per share for a term of three years. Each repricing right entitled the
holder to receive a number of additional shares of Class A common stock for no
additional consideration according to a formula based on the lowest closing bid
price of the Company's Class A common stock during a 15 day period. On February
14, 2000, the repricing rights were exercised and the Company issued an
additional 114,214 shares of Class A common stock.
14. STOCK OPTIONS AND WARRANTS
Common Stock Options - In 1998, the Company's board of directors and
shareholders approved the 1998 Stock Option and Incentive Plan for directors,
employees and other persons acting on behalf of the Company, under which the
aggregate number of shares authorized for issuance was 250,000. In 2000, the
Company's board of directors approved an increase in the number of shares under
the Plan from 250,000 to 500,000. As of December 31, 2002, shares available for
grant under this plan were 7,544.
In 1997, the Company's board of directors approved the 1997 Stock Option and
Incentive Plan for directors, employees and other persons acting on behalf of
the Company, under which the aggregate number of shares authorized for issuance
is 187,500. As of December 31, 2002, shares available for grant under this plan
were 97,442.
In 1996, the Company's board of directors and shareholders approved the 1996
Directors' Stock Option Plan, under which the aggregate number of shares of
Class A common stock authorized for issuance is 135,000. The plan provides that
each director shall receive options to purchase 5,000 shares of Class A common
stock for services rendered as a director during each entire calendar year or
portion of a calendar year in excess of six months. The exercise price of such
options is the closing market price of the Class A common stock on the date the
options are granted. The option term is 10 years from date of grant. As of
December 31, 2002, shares available for grant under this plan were 65,000.
In 1996, the Company's board of directors approved a Long-Term Stock Investment
and Incentive Plan for officers, key employees and other persons acting on
behalf of the Company under which the aggregate number of shares authorized for
issuance is 22,500. The exercise price of these options is the closing market
price of the Class A common stock on the date the options are granted. The term
of the plan is 10 years and options are subject to a three-year vesting
schedule, pursuant to which one-third of the total number of options granted may
be exercised each year. As of December 31, 2002, shares available for grant
under this plan were 22,125.
In 1999, the Company granted options to purchase 10,000 shares of Class A common
stock to new members of the board of directors, waiving the requirement that
they serve for six months prior to such granting. In 2002 and 2001,
options to purchase 25,000 shares and 37,500 shares, respectively, of Class A
common stock, were issued to directors who were also executive officers of the
Company for compensation and other services rendered to the Company.
A summary of options granted under the Company's various stock option plans for
the years ended December 31, 2002,
F-26
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2001 and 2000 is presented below:
2002 2001 2000
------------------------- ----------------------------- ------------------------------
Weighted Weighted Weighted
Average Average Average
Stock Exercise Stock Exercise Stock Exercise
Options Price Options Price Options Price
----------- ------------ -------------- ------------- -------------- --------------
Outstanding at beginning of the year 601,970 $ 73.60 496,443 $ 118.80 358,898 $ 162.40
Granted 157,225 3.20 203,374 8.80 177,902 26.00
Exercised - - (875) 15.60 (23,467) 40.00
Forfeited or canceled (124,543) 27.20 (96,971) 169.20 (16,889) 183.60
----------- -------------- --------------
Outstanding at end of the year 634,652 65.60 601 971 73.60 496,444 118.80
=========== ============== ==============
Exercisable at the end of the year 443,183 $ 90.80 424,548 $ 100.00 473,075 $ 122.80
=========== ============== ==============
A summary of options outstanding and options exercisable under the Company's
various stock option plans at December 31, 2002 is presented below:
Options Outstanding Options Exercisable
- ------------------------------------------------------------------------ -----------------------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices Outstanding Life Price Exercisable Price
- -------------------- ---------------- ------------- --------------- ------------------ ---------------
$ 2.00 - 7.60 238,284 9.0 years $ 4.40 75,047 $ 4.80
8.40 - 35.60 112,403 7.5 years 14.00 89,000 13.20
40 00 - 71.20 136,491 6.8 years 44.00 131,662 44.40
130.00 - 206.40 54,850 3.9 years 164.40 54,850 164.40
240.00 - 340.00 92,625 4.5 years 257.60 92,625 257.60
---------------- -----------------
$ 2.00 - 340.00 634,625 7.2 years 65.60 443,183 90.80
================ =================
The weighted average fair value of options granted during the years ended
December 31, 2002, 2001 and 2000 were $3.20, $7.60 and $25.60, respectively.
The fair value of options and warrants is estimated on the date granted using
the Black-Scholes option pricing model with the following weighted-average
assumptions used for grants during 2001, 2000 and 1999:
2002 2001 2000
------ ------ -----
Risk-free interest rate 4.99% 4.66% 6.08%
Expected dividend yield 0.0% 0.0% 0.0%
Expected exercise lives 5 years 5 years 5 years
Expected volatility 137% 132% 130%
The estimated fair value of options granted is subject to the assumptions made,
and if the assumptions were to change the estimated fair value amounts could be
significantly different.
F-27
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Warrants - A summary of warrants granted by the Company during the years ended
December 31, 2002, 2001 and 2000 is presented below:
2002 2001 2000
---------------------- ---------------------- -------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
----------- ---------- ----------- ---------- ---------- -------------
Outstanding at beginning of the year 71,875 $ 82.40 86,750 $ 82.40 75,625 $ 108.40
Granted -- -- 6,250 13.20 23,625 37.20
Exercised -- -- -- -- (7,500) 37.20
Forfeited (20,625) 249.60 (21,125) 36.80 (5,000) 325.20
---------- ---------- ----------
Outstanding at end of the year 51,250 25.60 71,875 90.00 86,750 82.40
========= ========= =========
Exercisable at end of the year 51,250 25.60 71,875 90.00 86,750 82.40
========= ========= =========
Stock Appreciation Rights - The option plans described above also provide for
stock appreciation rights that allow the grantee to receive shares of Class A
common stock equivalent in value to the difference between the designated
exercise price and the fair market value of Class A common stock at the date of
exercise. In 2000, stock appreciation rights related to 10,000 outstanding stock
options with a weighted average exercise price of $47.20 were exercised
resulting in the recording of $628,000 of selling, general and administrative
expense. As of December 31, 2001, there were options to purchase 833 shares of
Class A common stock outstanding which provided for stock appreciation rights.
However, these options and the related stock appreciation rights expired during
2002.
15. RELATED-PARTY TRANSACTIONS
Purchase of Technology Rights - In February 2000, the Company entered into an
agreement to purchase from an executive officer and director of the Company, all
of his rights and interests in certain methods and apparatus for
F-28
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
integrated voice and pen input for use in computer systems. In payment for this
technology, the Company granted the executive officer warrants to purchase
15,000 shares of the Company's Class A common stock at an exercise price of
$40.00 per share. The warrants expire on February 10, 2010, and were valued at
$474,000 using a Black-Scholes option pricing model. This amount was recorded as
in-process research and development expense in 2000. Also, the Company granted
the executive officer the right to repurchase the technology from the Company at
fair market value if the Company subsequently determines not to commercialize
the technologies.
SCC Asset Management Inc. - SCC Asset Management, Inc. ("SCC"), formerly
Studdert Companies Corp., is a Utah corporation that previously provided
investment and management services to the Company. Two of the officers,
directors and owners of SCC are directors and executive officers of the Company.
A third officer, director and owner of SCC is a former director and executive
officer of the Company. The Company rents office space under subleases from SCC.
Payments under the leases are guaranteed by three officers, owners and directors
of SCC noted above. The subleases require monthly payments of $10,368. Expenses
relating to the sublease amounted to $137,166 in 2002, $149,261 in 2001, and
$111,196 in 2000. During October 2002, the Company assumed SCC's lease
obligation. The leases were terminated effective February 2003. On March 18,
2003, the Company executed a promissory note with Zions Securities, the lessor,
in the amount of $113,768 covering outstanding lease payments. The note bears
interest at 10% and is payable in monthly installments of $3,000 commencing
April 10, 2003.
Other Transactions - In December 1999, the Company issued warrants to purchase
6,250 shares of the Company's Class A common stock to a law firm which provides
legal services to the Company having a weighted-average exercise price of $12.40
and a term of five years. During 2002, 2001 and 2000, the Company incurred
expenses of approximately $756,599, $847,000, and $505,000, respectively, to the
law firm for services provided to the Company.
16. RESEARCH AND PRODUCT DEVELOPMENT
Synergetics - Prior to March 1997, the Company's ARS and TTS research and
development activities were conducted solely by Synergetics, pursuant to product
development and assignment contracts (collectively, the "Synergetics
Agreement"). Under that arrangement, Synergetics provided personnel and
facilities, and the Company financed the Synergetics research and development
activities on an as-required basis and the Company was obligated to pay to
Synergetics a royalty of 10 percent (the "Royalty") of net revenues from sales
of products incorporating Synergetics' "VoiceBox" technology as well as
technology derivatives thereof. In 2000, the Company and Synergetics entered
into a modification agreement whereby the Company paid Synergetics $28,000 to
cancel the obligation of the Company to pay the Royalty. Under the terms of the
Synergetics Agreement, as modified, the Company incurred no expenses in 2002 and
2001 and $28,000 in 2000 for research and development efforts. The Company has
no further obligations to Synergetics.
Adiva - During 1998 and 1999, the Company utilized the research and development
services of Adiva. The president of Adiva is also the president of Synergetics
and IMC2. In 2000, the Company terminated its relationship with Adiva and made a
final payment of $85,000 in settlement of the relationship.
IMC2 - In March 1998, the Company entered into a professional services agreement
with IMC2, a research and development entity, to provide assistance to the
Company in the continuing development of specific ASR technologies. The
president of IMC2 is also the president of Synergetics and Adiva. The agreement
was for an initial term of 36 months and required the Company to make monthly
payments of $22,000. In February 2001, the Company and IMC2 agreed to extend the
contract on a month-to-month basis. Under the terms of the agreement, the
Company expended $282,000 in 2002, $391,000 in 2001, and $264,000 in 2000 for
research and development efforts provided by IMC2.
Advocast - In July 1997, the Company entered into an arrangement with Advocast,
Inc. ("Advocast"), an Internet research and development entity, whereby Advocast
assisted the Company in development of technologies to create and locate
searchable databases on the Internet through the use of interactive video and
voice technologies. Under the terms of the arrangement, the Company paid
$816,750 in 1998 and $705,005 in 1997 for Advocast research and development
F-29
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
efforts.
On November 25, 1998, Advocast issued 60,200 shares of Advocast Series A 6%
convertible preferred stock ("Advocast Preferred Stock") to the Company and the
chief executive officer of the Company became a director of Advocast. The
Advocast Preferred Stock, if converted to Advocast common stock, represented
less than 20 percent of the total outstanding shares of Advocast voting common
stock. Advocast is a development stage company with minimal operations and no
market for its stock. As a result, there was substantial uncertainty as to the
value of the Advocast Preferred Stock and the Company did not record a value for
the Advocast shares in its consolidated financial statements.
On February 26, 2001, Fonix agreed to provide to Advocast an additional $100,000
of financing under the terms of a six percent secured convertible debenture due
February 26, 2002. Fonix advanced $57,498 under the debenture. The debenture was
convertible into shares of Advocast common stock at a rate of $8.62 per share at
the option of Fonix. Furthermore, Fonix had the right to convert its Advocast
Preferred Stock into additional principal under the debenture at a rate of $25
per share of Advocast Preferred Stock. If converted, the resulting balance due
under the debenture was subject to the same terms of conversion into Advocast
common stock or became due and payable six months following the original due
date of the convertible debenture. Advocast and Fonix also agreed that Advocast
would provide consulting services to Fonix for development of Internet
applications of the Company's technologies. The term of the agreement was three
months and could be renewed at the Company's option for an additional three
months. Fonix paid $30,000 to Advocast pursuant to the consulting agreement.
On June 18, 2001, Fonix canceled the debenture, terminated the consulting
agreement, agreed that Advocast could redeem the Advocast Preferred Stock owned
by Fonix and issued warrants to Advocast for the purchase of 6,250 shares of
Fonix Class A common stock at an exercise price of $13.20 per share in return
for a perpetual, fully paid-up, nonexclusive license to certain technology
developed by Advocast for Internet speech applications. The warrants were valued
using the Black-Scholes option pricing model with the following weighted average
assumptions: risk free interest rate 4.2%, expected dividend yield of 0%,
volatility of 130%, and expected life of 3.0 years. The $10.00 fair value per
share or $62,500 was recorded as product development costs on the date of the
transaction. Fonix has no further obligation to provide funding, management
consultation and development services, or technology to Advocast.
17. INCOME TAXES
At December 31, 2002 and 2001, net deferred income tax assets, before
considering the valuation allowance, totaled $44,495,738 and $37,549,884,
respectively. The amount of and ultimate realization of the benefits from the
deferred income tax assets is dependent, in part, upon the tax laws in effect,
the Company's future earnings, and other future events, the effects of which
cannot be determined. The Company has established a valuation allowance for all
deferred income tax assets not offset by deferred income tax liabilities due to
the uncertainty of their realization. The net change in the valuation allowance
was an increase of $6,945,854 for 2002 and $7,390,463 for 2001.
At December 31, 2002, the Company has unused federal net operating loss
carryforwards available of approximately $109,273,000 and unused state net
operating loss carryforwards of approximately $100,553,000 which may be applied
against future taxable income, if any, and which expire in various years from
2008 through 2022. The Internal Revenue Code contains provisions which likely
will reduce or limit the availability and utilization of these net operating
loss carryforwards. For example, limitations are imposed on the utilization of
net operating loss carryforwards if certain ownership changes have taken place
or will take place. The Company has not performed an analysis to determine
whether any such limitations have occurred.
The temporary differences and carryforwards which give rise to the deferred
income tax assets as of December 31, 2002 and 2001 are as follows:
F-30
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Deferred income tax assets: 2002 2001
--------------- ---------------
Net operating loss carryforwards:
Federal $ 37,152,792 $ 31,039,516
State 3,318,246 2,724,704
Research and development credits 2,389,974 2,366,311
Impairment of convertible note receivable 415,463 --
Accrued liabilities 816,201 800,197
Deferred revenues 288,241 389,515
Other 114,821 229,641
--------------- ---------------
Total deferred income tax assets valuation
allowance 44,495,738 37,549,884
Valuation allowance (44,495,738) (37,549,884)
--------------- ---------------
Net deferred income tax assets $ - $ -
=============== ===============
A reconciliation of income taxes at the federal statutory rate to the Company's
effective rate is as follows:
Year Ended December 31,
2002 2001 2000
---------- ---------- ----------
Federal statutory income tax rate 34.0 % 34.0 % 34.0 %
State and local income tax rate, net of federal benefit 3.3 3.3 3.3
Non-deductible items (2.5) (14.0) (14.8)
Valuation allowance (34.8) (22.3) (22.2)
---------- ---------- ----------
Effective income tax rate 0.0 % 0.0 % 0.3 %
------------------------- ========== ========== ==========
18. COMMITMENTS AND CONTINGENCIES
Executive Employment Agreements - The Company has employment agreements with two
executive officers that were initiated November 1, 1996 and amended effective
January 31, 2000 to extend the term of the agreements and reduce the base
compensation. The current annual base salary for each executive officer is
$309,400 and may be adjusted upward in future years as deemed appropriate by the
Company's board of directors. During 2002, the executive officers agreed to
accept reduced cash compensation pursuant to the Company's 2002 Employee
Compensation Plan (See Note 22 below). The expiration date of the agreements is
December 31, 2005. In July 2000, as compensation for extending the term of each
agreement at a compensation level less than provided in the original agreement,
each executive was granted options to purchase 35,000 shares of the Company's
Class A common stock at an exercise price of $40.04. These options vested
immediately and expire on July 19, 2010.
In the event that, during the contract term, both a change of control occurs,
and within six months after such change in control occurs, the executive's
employment is terminated by the Company for any reason other than cause, death,
or retirement, the executive shall be entitled to receive an amount in cash
equal to all base salary then and thereafter payable within 30 days of
termination.
Another executive officer of the Company resigned in January 1999 and his
employment agreement was canceled. He subsequently entered into a separation
agreement pursuant to which he was paid $250,000 per year for the years ended
December, 31, 2000 and 2001, and $100,000 for the year ended December 31, 2002.
The Company has no further obligations to this former executive.
During 2000, the Company entered into employment contracts with two other
executive officers which expire in January 31, 2003. At expiration, these
agreements were extended to December 31, 2003. The minimum annual salaries
required by these agreements total $460,000. The executive employees are also
entitled to other normal benefits extended to executives and employees of the
Company. In the event that, during the contract term, both a change of control
occurs and, within six months after such change in control was to occurs, the
executive officers' services are terminated by the Company for any reason other
than cause, death or retirement, the executive officers shall be entitled to
receive an
F-31
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
amount in cash equal to all base salary then and thereafter payable within 30
days of termination. The agreements contain non-disclosure, confidentiality,
non-solicitation and non-competition clauses. Under the terms of the non-
competition clause, each executive has agreed that for a period of 18 months
after the termination of his employment with the Company the executive will not
engage in any capacity in a business which competes with or may compete with the
Company.
Professional Services Agreements - In 2001, the Company entered into a
professional services agreement with a marketing consultant. The terms of the
agreement require monthly payments of $20,000 for a period of 24 months. Also,
in connection with the agreement, the Company issued options to purchase 12,500
shares of Class A common stock. Because the Company can cancel the agreement and
all the services have yet to be provided, the measurement date for the options
has yet to be determined, and the options will be revalued throughout the term
of the agreement. At December 31, 2002 the options were valued at $1.20 per
share using the Black-Scholes option pricing model assuming: a risk-free
interest rate of 4.62 percent; expected dividend yield of 0 percent; expected
exercise life of five years; and expected volatility of 130 percent. The
resulting amount was recorded as deferred consulting expense has been fully
amortized at Decembe 31, 2002.
In July 2000, the Company entered into professional services agreements with two
consulting firms. In connection with these agreements, the Company issued a
total of 25,000 shares of Class A common stock. The stock was valued at
$1,015,600 using the fair value of the Class A common stock on the date each
contract commenced and was recorded as deferred consulting expense and amortized
as general and administrative expense over the period of service.
In May 2000, the Company issued 6,250 shares of Class A common stock (having a
market value of $312,500 at that date) to an unrelated third party in
consideration for services rendered in connection with equity financing
transactions.
In January 2000, the Company issued warrants to purchase 7,500 shares of Class A
common stock for services rendered by a professional services firm. The warrants
have a three-year life, exercise prices ranging from $11.20 to $50.00 per share
and vested during the year ended December 31, 2000.
In December 1999, the Company entered into professional services agreements with
two consulting firms. In connection with these agreements, the Company issued
25,000 shares of Class A common stock. The stock was valued at $375,000 using
the fair value of the Class A common stock on the date each contract commenced
which amount was recorded as deferred consulting expense and amortized as
general and administrative expense over the period of service in 2000 and 1999.
In December 1999, the Company issued warrants to purchase 25,000 shares of Class
A common stock to professional advisors and consultants. The warrants were
valued at $10.40 per share using the Black-Scholes option pricing model assuming
a risk-free interest rate of 6.33 percent, expected dividend yield of 0 percent;
expected exercise life of five years, and expected volatility of 130 percent.
The resulting amount was recorded as deferred consulting expense and amortized
as general and administrative expense over the period of service in 2000.
Babel Infovox AB ("Infovox") is a Swedish telecommunications company that has
developed multiple language capability for integration into TTS applications. In
October 2000, the Company entered into a revenue sharing arrangement with
Infovox that provides that Fonix will pay a percentage of revenue to Infovox for
Fonix licenses of TTS technology that include languages other than American
English provided by Infovox. In connection with this agreement, the Company has
made prepayments of $20,000, against which payments due to Infovox are credited.
Through December 31, 2002, the Company had credited $3,529 against this
prepayment.
Operating Lease Agreements - The Company leases certain facilities and equipment
used in its operations. The amount of commitments for non-cancelable operating
leases in effect at December 31, 2002, were as follows:
F-32
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Year ending December 31,
2003 $ 582,642
2004 317,296
2005 12,597
--------------
$ 912,535
The Company incurred rental expense, net of subleases, of $663,310, $627,304,
and $413,382 during 2002, 2001, and 2000, respectively, related to these leases.
As of March 21, 2003, the Company has outstanding lease payments due under these
leases of approximately $413,000.
Effective May 14, 1999, the Company entered into an agreement to sublease 10,224
square feet of its Draper, Utah facility to an unrelated third party. The
agreement required the sublessee to pay $13,961 per month, or approximately 40
percent of the Company's monthly obligation under the primary lease agreement.
The sublease agreement expired December 31, 2000.
Effective May 25, 1999, the Company entered into an agreement to sublease its
Cupertino, California facility to an unrelated third party. The agreement
requires the sublessee to pay $331,651 per month through May 31, 2003.
Forgiveness of Trade Payables and Accrued Interest - The Company negotiated
reductions in amounts due various trade vendors amounting to $78,864 in 2000.
These amounts have been accounted for as an extraordinary item in the
accompanying consolidated statements of operations.
19. LITIGATION
The Company is involved in various claims and proceedings arising in the
ordinary course of business. Management believes, after consultation with legal
counsel, that the ultimate disposition of these matters will not materially
impact the consolidated financial position, liquidity or results of operations
of the Company.
20. EMPLOYEE PROFIT SHARING PLAN
The Company has a 401(k) profit sharing plan covering essentially all of its
full-time employees. Under the plan, employees may reduce their salaries, in
amounts allowed by law, and contribute the salary reduction amount to the plan
on a pretax basis. The plan also allows the Company to make matching and profit
sharing contributions as determined by the board of directors. To date, no
matching or profit sharing contributions have been made by the Company.
21. SIGNIFICANT CUSTOMERS
Of the Company's revenues for 2002 and 2001, $3,057,199 and $567,411 were from
sources in the United States and $7,520 and $14,273 were from South Korea. All
of the Company's revenues for 2000 were sourced from the United States. During
2002, DynaVox Systems accounted for 13.3% or $406,348 and Epson accounted for
13.2% or $404,545 of the Company's total revenues. In 2001, no single customer
generated more than 10 percent of the Company's total revenue. Of the $656,853
of revenues in 2000, $125,000 was from Motorola and $87,250 was from NuvoMedia,
Inc.
No other customer accounted for more than 10 percent of the Company's total
revenues for the years presented.
22. SUBSEQUENT EVENTS
Convertible Note Receivable - Subsequent to December 31, 2002, the Company
entered into an agreement to terminate the revolving line of credit and
convertible promissory note with Unveil (See Note 4 above). In full payment of
the balance due under the note, the Company received a payment of $410,000 and
1,863,636 shares of Unveil's Series A Preferred Stock. Accordingly, the Company
reversed a portion of the write-off taken in the third quarter equal to the
F-33
Fonix Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
amount subsequently received in January 2003. The Company did not place a value
on the Preferred Stock due to Unveil's overall financial condition.
Third Equity Line - In January 2003, the Company's registration statement
covering the third equity line was declared effective by the SEC. Through March
21, 2003, the Company received $2,500,000 in funds drawn under the Third Equity
Line, less commissions and fees of $64,150, and issued 3,541,412 shares of Class
A common stock to the Equity Line investor. The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the Securities
Act of 1933, as amended (the "1933 Act"), and the rules and regulations
promulgated thereunder. The resales of the shares by the Equity Line investor
were subsequently registered under registration statements on Form S-2.
Series D Debentures - As of March 26, 2003, the outstanding balance on the
Series D Debentures was $607,067. The Company has made payments on the
Debentures of $669,350 during 2003. Breckenridge has also converted a principal
amount of $242,933 and was issued 627,086 shares.
Special Meeting of Shareholders - On March 24, 2003, the Company held a Special
Meeting of Shareholders in Salt Lake City, Utah. The record date for the meeting
was February 7, 2003, on which date there were 15,915,367 shares of the
Company's Class A common stock issued, of which 2,020,750 shares were held as
collateral under escrow agreements and were not entitled to vote.
The first matter voted upon at the special meeting was the approval of the Board
of Directors' selection of Hansen, Barnett & Maxwell as the Company's
independent public accountants for the fiscal year ending December 31, 2002. The
results of the voting were 11,343,679 shares in favor, 185,011 shares against,
and 152,555 shares withheld or abstaining.
The second matter voted upon at the special meeting was to consider and act upon
a proposed amendment to the Company's certificate of incorporation to effect a
reverse stock split of the Company's Class A common stock at a ratio of one
share for forty shares. The results of the voting were 10,385,475 shares in
favor, 1,240,197 shares against, and 55,573 shares withheld or abstaining. The
anticipated effective date of the reverse stock split is April 4, 2003.
U.S. Department of Labor Settlement Agreement - On March 5, 2003, the Company
entered into a settlement agreement with the U.S. Department of Labor relating
to back wages not paid to former and current employees during 2002. Under this
agreement the Company will pay all amounts owed in twenty-four installment
payments to each former and current employee. The first installment payment is
due May 1, 2003. The remaining payments are due on the first day of each month,
until paid in full. If any of the installment payments are more than fifteen
days late, the entire balance may become due and payable.
Employees may elect to receive a portion of their wages in registered shares of
the Company's Class A common stock. However, the amount that represents minimum
wage and overtime, if any, as defined in the Fair Labor Standards Act of 1938,
may not be paid with the Company's Class A common stock.
F-34