UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the quarterly period ended June 30, 2003
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from to .
--------- ----------
Commission file number 0-23862
Fonix Corporation
(Exact name of registrant as specified in its charter)
Delaware 22-2994719
(State of Incorporation) (I.R.S. Employer Identification No.)
7
180 W. Election Road, Suite 200
Draper, UT 84020
(Address of principal executive offices, including zip code)
(801) 553-6600
(Registrant's telephone number,
including area code)
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 or No
------ -------
As of August 14, 2003, 24,845,471 shares of Class A voting common
stock, par value $0.0001 per share, were issued and outstanding.
FONIX CORPORATION
FORM 10-Q
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets - As of June 30, 2003 and December 31, 2002 2
Condensed Consolidated Statements of Operations and Comprehensive Loss for the
Three Months and Six Months Ended June 30, 2003 and 2002 3
Condensed Consolidated Statements of Cash Flows for the Three Months and Six Months
Ended March 31, 2003 and 2002 4
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk 30
Item 4. Evaluation of Disclosure Controls and Procedures 30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 31
Item 2. Changes in Securities 31
Item 3. Defaults Upon Senior Securities 31
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 6. Exhibits and Reports on Form 8-K 31
Fonix Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30 December 31,
ASSETS 2003 2002
- ------ ---------------- ---------------
Current assets:
Cash and cash equivalents $ 772 $ 23,739
Accounts receivable - 26,974
Convertible note receivable - 402,765
Inventory 32,338 51,937
Prepaid expenses and other current assets 170,258 185,429
---------------- ---------------
Total current assets 203,368 690,844
Property and equipment, net of accumulated depreciation of $1,842,404 and
$1,671,809, respectively 440,248 625,448
Investment in and note receivable from affiliate, net of unamortized discount of $0
and $58,548, respectively 1,078,369 1,259,320
Intangible assets, net of accumulated amortization of $0 and $299,457, respectively - 1,191,585
Goodwill, net of accumulated amortization of $2,295,598 2,631,304 2,631,304
Other assets 48,224 124,979
---------------- ---------------
Total assets $ 4,401,513 $ 6,523,480
================ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Series D Debentures, net of unamortized discount of $0 and $582,630, respectively $ 443,154 $ 917,370
Note payable to affiliate 1,000,000 1,000,000
Note payable - 250,000
Notes payable - related parties 493,175 493,175
Current portion of notes payable other 101,434 75,000
Accrued payroll and other compensation 7,599,653 5,265,809
Accounts payable 3,987,982 3,083,425
Accrued liabilities 1,513,967 1,737,267
Accrued liabilities - related parties 1,443,300 1,443,300
Bank overdraft 142,047 -
Deferred revenues 765,826 854,248
---------------- ---------------
Total current liabilities 17,490,538 15,119,594
---------------- ---------------
Long-term portion of notes payable, net of current portion 83,213 -
Long-term borrowings 8,827 3,312
---------------- ---------------
Total long-term liabilities 92,040 3,312
Total liabilities 17,582,578 15,122,906
---------------- ---------------
Commitments and contingencies (Notes 1, 3, 4, 5, 6, 7, 8, 9 and 12)
Stockholders' deficit:
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) 500,000 500,000
Common stock, $0.0001 par value; 800,000,000 shares authorized;
Class A voting, 19,652,488 and 12,306,333 shares outstanding, respectively 1,965 1,230
Class B non-voting, none outstanding - -
Additional paid-in capital 186,822,925 183,514,560
Outstanding warrants to purchase Class A common stock 1,334,000 1,360,000
Cumulative foreign currency translation adjustment 23,217 31,704
Accumulated deficit (201,863,172) (194,006,920)
---------------- ---------------
Total stockholders' deficit (13,181,065) (8,599,426)
---------------- ---------------
Total liabilities and stockholders' deficit $ 4,401,513 $ 6,523,480
================ ===============
See accompanying notes to condensed consolidated financial statements.
2
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- -----------------------------
2003 2002 2003 2002
------------- ------------- ------------- -------------
Revenues $ 631,733 $ 679,197 $ 1,221,403 $ 977,981
Impairment loss on capitalized software technology (821,986) - (821,986) -
Cost of revenues (102,691) (166,424) (182,908) (210,528)
------------- ------------- ------------- -------------
Gross (loss) profit (292,944) 512,773 216,509 767,453
------------- ------------- ------------- -------------
Expenses:
Selling, general and administrative 1,518,536 3,391,649 3,769,234 6,623,467
Impairment loss on intangible assets 302,100 - 302,100 -
Product development and research 1,083,770 2,590,988 2,758,883 4,714,724
------------- ------------- ------------- -------------
Total expenses 2,904,406 5,982,637 6,830,217 11,338,191
------------- ------------- ------------- -------------
Loss from operations (3,197,350) (5,469,864) (6,613,708) (10,570,738)
------------- ------------- ------------- -------------
Other income (expense):
Interest income 10,045 68,386 10,045 96,321
Interest expense (322,227) (47,759) (1,063,862) (105,508)
------------- ------------- ------------- -------------
Total other income (expense), net (312,182) 20,627 (1,053,817) (9,187)
------------- ------------- ------------- -------------
Loss from operations before equity in net
loss of affiliate (3,509,532) (5,449,237) (7,667,525) (10,579,925)
Equity in net loss of affiliate (77,005) (89,177) (188,727) (203,129)
------------- ------------- ------------- -------------
Net loss (3,586,537) (5,538,414) (7,856,252) (10,783,054)
Other comprehensive income (loss) -
foreign currency translation (26,832) (27,365) (8,487) (28,237)
------------- ------------- ------------- -------------
Comprehensive loss $ (3,613,369) $ (5,565,779) $ (7,864,739) $ (10,811,291)
============= ============= ============= =============
Basic and diluted net loss per common share $ (0.19) $ (0.47) $ (0.48) $ (1.00)
============= ============= ============= =============
See accompanying notes to condensed consolidated financial statements.
3
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 31,
-------------------------------
2003 2002
-------------- ---------------
Cash flows from operating activities:
Net loss $ (7,856,252) $ (10,783,054)
Adjustments to reconcile net loss to net cash
used in operating activities:
Non-cash compensation expense related to issuance of stock options - -
Additional compensation expense related to issue of stock options
and common stock - 11,944
Accretion of discount on note receivable from affiliate (7,776) (9,036)
Accretion of discount on note payable to affiliate - 34,193
Accretion of discount on note payable - 28,143
Amortization of investment in affiliate 83,652 -
Accretion of discount on Series D Debentures 867,730 -
Impairment loss on intangible assets 1,124,085 -
Depreciation and amortization 252,700 257,973
Equity in net loss of affiliate 105,075 203,129
Foreign exchange (gain)/loss (12,086) (26,199)
Changes in assets and liabilities:
Accounts receivable 26,974 (38,422)
Interest and other receivables (2,181) -
Inventory 19,599 9,074
Prepaid expenses and other current assets 17,352 (97,727)
Other assets 76,755 (236,147)
Accounts payable 1,018,325 578,584
Accrued payroll and other compensation 2,333,844 -
Accrued liabilities (193,547) 1,683,440
Accrued liabilities - related party - (8,333)
Deferred revenues (88,422) 84,943
Bank overdraft 142,047 -
-------------- ---------------
Net cash used in operating activities (2,092,126) (8,307,495)
-------------- ---------------
Cash flows from investing activities:
Repayment of notes receivable 402,765 -
Issuance of notes receivable - (805,000)
Purchase of property and equipment - (90,880)
Proceeds from sale of Healthcare Solutions Group - -
-------------- ---------------
Net cash provided by (used in) investing activities 402,765 (895,880)
-------------- ---------------
Cash flows from financing activities:
Proceeds from sale of Class A common stock, net 2,565,000 10,122,346
Proceeds of note payable to related parties - 358,308
Receipt of common stock subscription receivable - -
Payments on note payable to affiliate - (550,000)
Proceeds from long-term debt 5,515 -
Payments on Series D Debentures (650,000) -
Payments on note payable (250,000) (870,000)
Payments on other note payable (4,121) -
Principal payments on capital lease obligation - (19,767)
-------------- ---------------
Net cash provided by financing activities 1,666,394 9,040,887
-------------- ---------------
Net (decrease) increase in cash and cash equivalents (22,967) (162,488)
Cash and cash equivalents at beginning of period 23,739 201,401
-------------- ---------------
Cash and cash equivalents at end of period $ 772 $ 38,913
============== ===============
See accompanying notes to condensed consolidated financial statements.
4
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Six Months Ended
June 30,
-----------------------------
Supplemental disclosure of cash flow information: 2003 2002
-------------- --------------
Cash paid during the period for interest $ - $ 79,547
Supplemental Schedule of Non-cash Investing and Financing Activities:
For the Six Months Ended June 30, 2003:
Issued 2,108,569 shares of Class A common stock in conversion of
$406,846 of Series D Debentures principal and $26,154 of related accrued
interest
Issued 237,584 shares of Class A common stock valued at $285,100 as
consideration for deferment of Series D Debentures; issuance of shares
represented an increase to the discount to be amortized over the revised
term of the Series D Debentures
Converted $113,768 of accounts payable into a note payable
For the Six Months Ended June 30, 2002:
Warrants for the purchase of 450,000 shares of Class A common stock,
valued at $696,000, expired.
See accompanying notes to condensed consolidated financial statements.
5
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements of Fonix Corporation and subsidiaries (collectively, the
"Company" or "Fonix") have been prepared by the Company pursuant to the rules
and regulations of the Securities and Exchange Commission (the "SEC"). Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted pursuant to such rules
and regulations, although the Company believes that the following disclosures
are adequate to make the information presented not misleading.
These condensed consolidated financial statements reflect all adjustments
(consisting only of normal recurring adjustments) that, in the opinion of
management, are necessary to present fairly the financial position and results
of operations of the Company for the periods presented. The Company's business
strategy is not without risk, and readers of these condensed consolidated
financial statements should carefully consider the risks set forth under the
heading "Certain Significant Risk Factors" in the Company's 2002 Annual Report
on Form 10-K.
Operating results for the six months ended June 30, 2003, are not necessarily
indicative of the results that may be expected for the year ending December 31,
2003. The Company suggests that these condensed consolidated financial
statements be read in conjunction with the consolidated financial statements and
the notes thereto included in the Company's 2002 Annual Report on Form 10-K.
Business Conditions - The Company's revenues decreased from $679,197 for the
three months ended June 30, 2002, to $631,733 for the three months ended June
30, 2003, and increased from $977,981 for the six months ended June 30, 2002, to
$1,221,403 for the six months ended June 30, 2003. However, the Company has
incurred significant losses since inception, including a net loss of $7,856,252
for the six months ended June 30, 2003. The Company incurred negative cash flows
from operating activities of $2,092,126 during the six months ended June 30,
2003. As of June 30, 2003, the Company had an accumulated deficit of
$201,863,172, negative working capital of $17,287,170, accrued employee wages of
$7,599,653, and accounts payable over 60 days past due of $3,456,889. Sales of
products and revenue from licenses based on the Company's technologies have not
been sufficient to finance ongoing operations, although the Company has limited
capital available under its equity line of credit. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
The Company's continued existence is dependent upon several factors, including
the Company's success in (1) increasing license, royalty and services revenues,
(2) raising sufficient additional funding, and (3) minimizing operating costs.
The accompanying condensed consolidated financial statements do not include any
adjustments relating to the recoverability and classification of asset carrying
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern.
Net Loss Per Common Share - Basic and diluted net loss per common share are
calculated by dividing net loss attributable to common stockholders by the
weighted average number of shares of common stock outstanding during the period.
As of June 30, 2003 and 2002, there were outstanding common stock equivalents to
purchase 897,732 and 804,740 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.
6
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the three months and six months ended June
30, 2003 and 2002:
Three months ended June 30,
2003 2002
--------------------------------- ------------------------------
Per Share Per Share
Amount Amount Amount Amount
Net loss attributable to common stockholders $ (3,586,537) $ (0.19) $ (5,538,414) $ (0.47)
============== ======== =============== ========
Weighted average common shares outstanding 18,588,478 11,798,470
============== ===============
Six months ended June 30,
2003 2002
--------------------------------- ------------------------------
Per Share Per Share
Amount Amount Amount Amount
Net loss attributable to common stockholders $ (7,586,252) $ (0.47) $ (10,783,054) $ (1.00)
============= ======== =============== ========
Weighted average common shares outstanding 16,507,323 10,786,090
============= ===============
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 3 and 5).
Comprehensive Loss - Other comprehensive loss presented in the accompanying
condensed consolidated financial statements consists of cumulative foreign
currency translation adjustments.
Recently Enacted Accounting Standards - In January 2003, the Financial
Accounting Standards Board ("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
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.
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
7
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
from the sale of consulting and development services.
Revenues of all types are recognized when contingencies such as conditions of
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 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
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price protection. Revenue for these
products is recognized when the right of return on such products has expired,
typically 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, revenues 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
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 at June 30, 2003, and December 31, 2002, consisted of the
following:
June 30, December 31,
Description Criteria for Recognition 2003 2002
- ----------- ---------------------------------- ---------------------- --------------------
Deferred unit royalties Delivery of units to end users or
and licence fees expiration of contract $ 720,737 $ 794,737
Deferred customer Expiration of period covered by
support support agreement 45,089 59,511
---------------------- --------------------
Total deferred revenue $ 765,826 $ 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 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
8
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
software product have been completed and confirmed by testing. Costs to produce
or purchase speech software technology incurred subsequent to establishing
technological feasibility are capitalized. Capitalization of speech software
costs ceases when the product is available for general release to customers.
Costs to perform consulting or development services applications are charged to
cost of revenues in the period in which the corresponding revenues are
recognized. Cost of maintenance and customer support is charged to expense when
related revenue is recognized or when these costs are incurred, whichever occurs
first.
Capitalized speech 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 speech 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
speech 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 non- employees using the fair value method in accordance
with Statement of Financial Accounting Standards ("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 June 30, 2003, the Company has stock-based employee compensation plans. The
Company accounts for the plans under the recognition method and measurement
principles of Accounting Principals Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees," and the related 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:
Three Months Ended
June 30, June 30,
2003 2002
------------------ ------------------
Net loss:
As reported $ (3,586,537) $ (5,558,444)
------------------ ------------------
Deduct:
Total stock-based employee compensation
benefit (expense) determined under fair
value based method for all awards, net
of forfeitures 2,529 (119,181)
------------------ ------------------
Pro forma $ $
================== ==================
Basic and diluted net loss per common share:
As reported $ (0.19) $ (0.47)
------------------------------------------------- ------------------ ------------------
Pro forma $ (0.19) $ (0.48)
------------------------------------------------- ------------------ ------------------
9
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Six Months Ended
June 30, 2003 June 30, 2002
------------------ ------------------
Net loss:
As reported $ (7,856,252) $ (10,783,054)
------------------ ------------------
Deduct:
Total stock-based employee compensation
benefit expense determined under fair
value based method for all awards (93,459) (238,362)
------------------ ------------------
Pro forma $ (7,949,711) $ (11,021,416)
================== ==================
Basic and diluted net loss per common share:
As reported $ (0.48) $ (1.00)
Pro forma $ (0.48) $ (1.02)
Reclassifications - Certain reclassifications have been made in the prior period
condensed consolidated financial statements to conform with the current period
presentation.
2. 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.
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
for funding by Unveil under the line of credit were not met. 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.
During the first quarter of 2003, the Company entered into an agreement to
terminate the revolving line of credit and satisfy the convertible promissory
note with Unveil. In full settlement of the balance of $1,450,000 due under the
note, the Company received a payment of $410,000 and 1,863,636 shares of
Unveil's Series A Preferred Stock (the "Unveil Preferred Stock"). Accordingly,
the Company adjusted the estimated impairment, recorded in the third quarter of
2002, such that the carrying amount of the note receivable was equal to the
amount received in January 2003. The Company did not allocate value to the
Unveil Preferred Stock due to Unveil's overall financial condition.
3. 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 Company is not presently pursuing any development or collaboration projects
with Audium.
10
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 under a note (the "Audium Note"). The Audium Note bears interest
at a rate of five percent per year and has a term of four years. Additionally,
the Audium Note is convertible into shares of Audium Series A 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. 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," discussed below under "Note Payable to Affiliate") 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 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 at June 30, 2003, under the equity method and not as a research and
development arrangement.
11
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Accordingly, for the six months ended June 30, 2003, the Company recognized a
loss of $188,727, consisting of $105,075 to reflect the Company's share of
Audium's net loss for the six months ended June 30, 2003, and $83,652 for the
amortization of the difference between the purchase price of the Audium
Preferred Stock and the Company's portion of Audium's net stockholders' deficit
that is amortized on a straight-line basis over a period of eight years.
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 June 30, 2003, no further
write-down was deemed necessary based on the 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.
Through June 30, 2003, payments amounting to $1,800,000 had been made under the
Fonix note. At June 30, 2003, 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 will return 684,930 shares of Audium's
Preferred Stock in exchange for Audium's release of Fonix under the Fonix note.
Audium has not declared Fonix to be in default under the terms of the Fonix
Note.
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 Fonix
Note.
4. GOODWILL AND INTANGIBLE ASSETS
Goodwill resulted from the purchase of assets from Force Computers, Inc., and
from the acquisition of AcuVoice, Inc. The carrying value of goodwill remained
unchanged at $2,631,304 during the six months ended June 30, 2003. During 2002,
the Company engaged Houlihan Valuation Advisors ("Houlihan"), an independent
valuation firm, to assess the Company's goodwill for impairment. The resulting
appraisal indicated that goodwill was not impaired. The Company performed an
internal valuation of goodwill at June 30, 2003 based on the same factors used
by Houlihan, and determined that the carrying value of 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.
As of June 30, 2003, the Company modified its estimate of future cash flows to
be provided by its intangible assets and determined that the carrying amount of
intangibles was in excess of future cash flows provided by the intangibles.
Accordingly, the Company recorded a charge of $1,124,085 during the quarter
ended June 30, 2003, to fully impair the carrying value of the intangible
assets.
The components of intangible assets were as follows at June 30, 2003, and
December 31, 2002:
12
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
June 30,
2003 December 31, 2002
------------- -----------------------------------------------
Gross Net
Carrying Gross Carrying Accumulated Carrying
Amount Amount Amortization Amount
------------- ----------------- ----------------- ----------
Speech software technology $ - $ 978,582 $ (104,397) $ 874,185
Customer relationships - 306,000 (30,600) 275,400
Patents - 164,460 (164,460) -
------------- ----------------- ----------------- ----------
Total Amortizing Intangible Assets - $ 1,449,042 $ (299,457) 1,149,585
------------- ----------------- -----------------
Indefinite-lived Intangible Assets
Trademarks - 42,000
------------- ----------
Total Intangible Assets $ - $1,191,585
------------- ==========
5. NOTE PAYABLE
On December 14, 2001, 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, $36,327 for the year ended December 31, 2002.
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
were not to be released to Force unless the Company was delinquent or late with
respect to any payment under the note. Also, under the terms of the Asset
Purchase Agreement, Fonix was required to deposit all receipts from customers
acquired in this transaction into a joint depository account. Fonix had 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 had the right to withdraw
funds from the depository account until the deficiency in payment was covered,
at which time, Fonix could again have use of the funds. Through December 31,
2002, payments required under the note were made, except the final payment of
$250,000, which remained outstanding at December 31, 2002. During the first
quarter of 2003, additional payments amounting to $115,000 were made. The
remaining balance was paid during the second quarter of 2003; however, the
collateral shares of the Company's Class A common stock have not been released
from the escrow.
6. NOTES PAYABLE OTHER
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 18% annually and were originally due and
payable with accrued interest during the second and third quarters of 2003. The
Company and the lender agreed to extend the maturity date of the first $25,000
note to December 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. The value of the beneficial conversion option was not material.
During the first quarter of 2003, the Company entered into a promissory note
with an unrelated third party in the aggregate amount of $113,768. This note
accrues interest at 10% annually and requires monthly minimum payments of the
greater of $3,000 or 2% of aggregate proceeds from the Company's Third Equity
Line of Credit and subsequent Equity Lines of Credit until the note has been
fully paid. Under the loan agreement, the Company may not sell or transfer
assets outside of the ordinary course of business, or enter a transaction
resulting in a change of control, without written permission from the creditor.
Through June 30, 2003, principal payments totaling $4,121
13
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
were made under the promissory note.
7. 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
remained unpaid as of June 30, 2003. 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. To date, the lenders have deferred
all interest payments due from the Company. The entire principal, along with
unpaid accrued interest and any other unpaid charges or related fees, was
originally due and payable on June 10, 2003. The Company and the Lenders agreed
to extend the maturity date of the note to December 10, 2003. Since December 11,
2002, all or part of the outstanding balance and unpaid interest can 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 10 below). The
Equity Line Investor subsequently sold the pledged shares and applied $82,242 of
the proceeds as a 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 June 30, 2003, the Lenders had deferred the interest
payment due December 10, 2002, and had not converted any of the outstanding
balance or interest into common stock.
8. SERIES D CONVERTIBLE DEBENTURES
On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible
Debentures (the "Debentures"), due April 9, 2003, 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 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.
14
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 237,584 of the Collateral Shares to Breckenridge as consideration (the
"Released Shares") to Breckenridge for revising the terms of the purchase
agreement. The additional shares were accounted for as an additional discount of
$285,100. The value of the shares on the date issued will be amortized over the
modified term as interest expense. The Company did not make the last three
payments as scheduled. Related interest expense recognized during the three
months and six months ended June 30, 2003, was $249,251 and $867,730,
respectively.
If Breckenridge declares the Company 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 issuance 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 Released
Shares. The Company filed a registration statement on Form S-2, which became
effective February 14, 2003. Additionally, the Company filed another
registration statement on July 2, 2003, which was declared effective on July 7,
2003, which included shares issuable to Breckenridge upon conversion of the
Debentures. The Company is obligated to file such post-effective amendments as
necessary to keep the registration statements effective as required by the
registration rights agreement.
On March 26, 2003, the Company received a conversion notice from Breckenridge
wherein Breckenridge converted a principal amount of $242,933, plus $20,067 of
accrued interest under the Debentures. The Company subsequently issued 627,087
shares of the Company's Class A common stock. On May 9, 2003, the Company
received a conversion notice from Breckenridge wherein Breckenridge converted a
principal amount of $160,146, plus $9,854 of accrued interest under the
Debentures. The Company subsequently issued 1,481,482 shares of the Company's
Class A common stock. The outstanding principal balance due under the Debentures
at June 30, 2003 was $443,154.
9. 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 June 30, 2003, 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.
15
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
10. EQUITY LINES OF CREDIT
Equity Line of Credit - In August 2000, the Company entered into a Private
Equity Line Agreement ("Equity Line") with a third party investor ("Equity Line
Investor") which gave 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 was available to the Company through a mechanism of draws and puts
of stock. The Company was 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 was 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 funded 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 related 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 had 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 Line (see Note 7
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.
For the six months ended June 30, 2003, the Company received $2,625,000 in funds
drawn under the Third Equity Line, less commissions and fees of $64,120, and
issued 5,000,000 shares of Class A common stock to the Equity Line Investor.
Fourth Equity Line of Credit - On May 12, 2003, the Company entered into a
fourth private equity line agreement (the "Fourth Equity Line Agreement") with
the Equity Line Investor. The Company subsequently terminated the Fourth Equity
Line Agreement before any funds were advanced and before and shares were issued.
16
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
11. COMMON STOCK, STOCK OPTIONS AND WARRANTS
Reverse Stock Split - On March 24, 2003, the Company's shareholders approved a
one-for-forty reverse stock split of 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.
Class A Common Stock - During the six months ended June 30, 2003, 5,000,000
shares of Class A common stock were issued in connection with draws on the
equity lines (see Note 10), 237,584 shares were issued in connection with the
Breckenridge modification agreement and 2,108,569 shares were issued under
conversion notices from Breckenridge (see Note 8). No shares of Class A common
stock were issued as a result of the exercise of stock options or warrants
during the same period.
Stock Options - During the six months ended June 30, 2003, the Company granted
options to employees to purchase 261,125 shares of Class A common stock. The
options have exercise prices of $0.21 to $1.60 per share, which were the quoted
fair market values of the stock on the dates of grant. The options granted vest
over the three years following issuance. Options expire within ten years from
the date of grant if not exercised. Using the Black-Scholes pricing model, the
fair value of the employee options was $0.21 to $1.60 per share. As of June 30,
2003, the Company had a total of 851,482 options to purchase Class A common
shares outstanding.
Warrants - As of June 30, 2003, the Company had warrants to purchase a total of
46,250 shares of Class A common stock outstanding that expire through 2010.
12. LITIGATION, COMMITMENTS AND CONTINGENCIES
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.
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 owed to former and current employees during 2002. Under the
agreement the Company will pay an aggregate of $4,755,041 to certain former and
current employees in twenty-four installment payments. The first installment
payment was 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.
The Company did not have sufficient cash to pay the first installment payment
due May 1, 2003. The Company reached an agreement with the Department of Labor
to extend the commencement date for installment payments to August 1, 2003.
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.
13. SUBSEQUENT EVENTS
Fifth Equity Line of Credit - The Company entered, as of July 1, 2003, into a
fifth private equity line agreement (the "Fifth Equity Line Agreement") with the
Equity Line Investor, on terms substantially similar to those of the Third
Equity Line. Under the Fifth Equity Line Agreement, the Company has the right to
draw up to $20,000,000 against an equity line of credit ("the Fifth Equity
Line") from the Equity Line Investor. The Company is entitled under the Fifth
Equity Line Agreement to draw certain funds and to put to the Equity Line
Investor shares of the Company's Class A common stock in lieu of repayment of
the draw. The number of shares to be issued is determined by
17
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
dividing the amount of the draw by 90% of the average of the two lowest closing
bid prices of the Company's Class A common stock over the ten trading days after
the put notice is tendered. (By way of comparison, three of the Company's prior
equity line agreements used a seven-trading-day period to determine the
conversion price). The Equity Line Investor is required under the Fifth Equity
Line Agreement to tender the funds requested by the Company within two trading
days after the ten-trading-day period used to determine the market price.
In connection with the Fifth Equity Line Agreement, the Company granted
registration rights to the Equity Line Investor and filed a registration
statement on Form S-2, which covered the resales of the shares to be issued
under the Fifth Equity Line. To the best of the Company's knowledge, prior to
our putting shares to the Equity Line Investor in connection with the Fifth
Equity Line, the Equity Line Investor had sold all of the shares put to it in
connection with the Initial Equity Line, the Second Equity Line, and the Third
Equity Line, and held no shares of the Company's Class A common stock.
The Company entered into an agreement with the Equity Line Investor to terminate
the Third Equity Line, as well as the two prior equity lines, and cease further
draws or issuances of shares in connection with the Initial Equity Line, the
Second Equity Line, and the Third Equity Line. Additionally, the Fourth Equity
Line was terminated prior to any draws or puts of stock. As such, the only
active equity line of credit is the Fifth Equity Line.
Subsequent to June 30, 2003 and through August 14, 2003 the Company received
$489,994 in funds drawn under the Fifth Equity Line, less commissions and fees
of $77,668, and issued 3,187,443 shares of Class A common stock to the Equity
Line Investor.
Series D Debentures - On July 2, 2003, the Company received a conversion notice
from Breckenridge wherein Breckenridge converted a principal amount of $77,702,
plus $7,977 of accrued interest under the Debentures. The Company subsequently
issued 692,356 shares of the Company's Class A common stock. On July 28, 2003,
the Company received a conversion notice from Breckenridge wherein Breckenridge
converted a principal amount of $83,460, plus $3,167 of accrued interest under
the Debentures. The Company subsequently issued 798,780 shares of the Company's
Class A common stock. On August 12, 2003, the Company received a conversion
notice from Breckenridge wherein Breckenridge converted a principal amount of
$48,590, plus $1,410 of accrued interest under the Debentures. The Company
subsequently issued 514,404 shares of the Company's Class A common stock. After
these conversions, Debentures in the amount of $233,401 were outstanding.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This quarterly report on Form 10-Q contains, in addition to historical
information, forward-looking statements that involve substantial risks and
uncertainties. Actual results could differ materially from the results the
Company anticipates and which are discussed in the forward-looking statements.
Factors that could cause or contribute to such differences are discussed in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002.
To date, we have earned only limited revenue from operations and intend to
continue to rely primarily on financing through the sale of our equity and debt
securities to satisfy future capital requirements.
Overview
Since inception, we have devoted substantially all of our resources to research,
development and acquisition of software technologies that enable intuitive human
interaction with computers, consumer electronics, and other intelligent devices.
Through June 3, 2003, we have 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. We continue to emphasize delivery and sales of
our applications and solutions ("Products") while achieving technology upgrades
to maintain our perceived competitive advantages. 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."
In our current marketing efforts, we seek to form relationships with third
parties who can incorporate our 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 we presently have such
relationships and with which we may have similar relationships in the future
include developers of application software, operating systems, computers,
microprocessor chips, consumer electronics, automobiles, telephony, and other
products. We are currently in negotiation with customers and potential customers
to enter into additional third- party licensing, collaboration, co-marketing and
distribution arrangements.
Our revenues decreased from $679,197 for the three months ended June 30, 2002,
to $631,733 for the three months ended June 30, 2003, and increased from
$977,981 for the six months ended June 30, 2002, to $1,221,403 for the six
months ended June 30, 2003. However, we incurred significant losses since
inception, including a net loss of $7,856,252 for the six months ended June 30,
2003. We incurred negative cash flows from operating activities of $2,092,126
during the six months ended June 30, 2003. As of June 30, 2003, we had an
accumulated deficit of $201,863,172, negative working capital of $17,287,170,
accrued employee wages of $7,599,653, and accounts payable over 60 days past due
of $3,456,889. Sales of products and revenue from licenses based on our
technologies have not been sufficient to finance ongoing operations, although we
have limited capital available under our equity lines of credit. These matters
raise substantial doubt about our ability to continue as a going concern. Our
continued existence is dependent upon several factors, including our success in
(1) increasing license, royalty and services revenues, (2) raising sufficient
additional funding, and (3) minimizing operating costs. Until sufficient
revenues are generated from operating activities, we expected to continue to
fund our operations through the sale of our equity securities, primarily the
fifth equity line.
In 2002 and for the first six months of 2003, we experienced slower development
of markets for speech applications than had been anticipated due to several
factors. First, the limited resources with which we have been operating (due to
the delay in accessing funds from the third equity line) hampered our 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, we
have not been able to expedite such development. Further, the ongoing U.S.
economic slowdown has slowed customer acceptance in target markets, especially
in the telecommunications sector where previously expected recovery has yet to
materialize, and has in
19
fact deteriorated further. The occurrence of these conditions has caused us to
(i) reduce our emphasis on consumer applications because of the significant
resources required to develop retail markets, (ii) reduce our development and
marketing efforts in the computer telephony and server-based markets, and (iii)
increase our emphasis and focus on mobile and wireless applications, automotive
speech interface solutions, and assistive markets, where management believes we
enjoy the greatest technological and market advantage.
In order to assess future gross revenues, we have evaluated the life cycle of
our Products and the periods in which we will receive revenues from them.
Widespread deployment of speech applications, solutions, and interface products
is growing, especially for the Products we develop and market. 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. Our 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. We expect growth to continue for
four to six years, but expect the rate of growth to slow as the market matures
toward the end of that period.
Significant Accounting Policies
The discussion and analysis of our financial condition and results of operations
are based upon our 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 our 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.
We assess 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 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. No further impairment was deemed necessary at December
31, 2002. At June 30, 2003, the Company again tested the technology for
impairment and determined, based on estimated future cash flows from the speech
technology that the remaining balance had become impaired which resulted in
recognition of an impairment loss of $1,124,086 during the quarter ended June
30, 2003.
20
During the fourth quarter of 2001, management determined that its handwriting
recognition ("HWR") software 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.
Revenue Recognition - We recognize revenues in accordance with the provisions of
Statement of Position No. 97-2, "Software Revenue Recognition" and related
interpretations. We generate revenues from licensing the rights to its software
products to end users and from royalties. We also generate 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 our contracts are either
short-term in duration or we are 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 we reduce 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 us 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
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 June 30, 2003 and December 31, 2002, consisted of the
following:
June 30, December 31,
Description Criteria for Recognition 2003 2002
- ----------- ---------------------------------- ---------------------- --------------------
Deferred unit royalties Delivery of units to end users or
and licence fees expiration of contract $ 720,737 $ 794,737
Deferred customer Expiration of period covered by
support support agreement 45,089 59,511
---------------------- --------------------
Total deferred revenue $ 765,826 $ 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.
21
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 is 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.
We assess 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 - We account for our 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 our
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 our 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 we had accounted for our stock options granted under the
fair value method. This pro forma disclosure is presented in Note 1 of the
consolidated financial statements.
We account for our 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.
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 condensed consolidated
financial statements).
Recently Enacted Accounting Standards - In January 2003, the Financial
Accounting Standards Board ("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
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 VIEs
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
22
period beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a VIEs that it acquired before February 1, 2003.
Results of Operations
Three months ended June 30, 2003, compared with three months ended June 30, 2002
During the three months ended June 30, 2003, we recorded revenues of $631,733,
reflecting a decrease of $47,464 or 7.0% over the same period in the previous
year. The decrease is attributable to decreases in hardware sales and royalty
revenues, partially offset by increases in non-recurring engineering contracts
completed during the second quarter of 2003.
Cost of revenues were $924,677 for the three months ended June 30, 2003, an
increase of $758,253 or 455.6% over the same period in the previous year. The
increase is due to the impairment charge of approximately $822,000 (see Note 4
of the condensed consolidated financial statements). Without the effect of the
impairment charge cost of revenues decreased by approximately $64,000.
Discounting the one time impairment charge, the decrease is attributable to the
overall decrease in hardware sales and the associated cost of the hardware.
Selling, general and administrative expenses for the three months ended June 30,
2003, were $1,518,456, a decrease of $1,873,113, or 55.2% compared to the same
period in the previous year. The decrease includes decreases of approximately
$1,258,000 in compensation-related expenses due to reductions in personnel,
approximately $163,000 in legal and accounting expenses, approximately $149,000
in promotion and advertising expenses and approximately $180,000 in travel
related expenses. We recorded an impairment charge of $302,000 during the second
quarter of 2003, related to certain intangible assets (See Note 4 of the
condensed consolidated financial statements).
Product development and research expenses for the three months ended June 30,
2003, were $1,083,770, a decrease of $1,507,218 or 58.2% over the same period in
the previous year. The decrease resulted primarily from decreased
compensation-related expenses of approximately $1,126,000, consulting and
outside service-related expenses of approximately $281,000 related to product
application and development activities, and other operating expense of
approximately $90,000.
Six months ended June 30, 2003, compared with six months ended June 30, 2002
During the six months ended June 30, 2003, we recorded revenues of $1,221,403,
reflecting an increase of $243,422 or 24.9% over the same period in the previous
year. The majority of the increase is attributable to $205,232 in revenues
generated from licensing and $87,000 generated from non-recurring engineering
contracts completed during the first quarter of 2003.
Cost of revenues for the three months ended June 30, 2003, were $1,004,894, an
increase of $794,366 or 377.3% over the same period in the previous year. The
increase is due to the impairment charge of approximately $822,000 (see Note 4
of the condensed consolidated financial statements). Without the effect of the
impairment charge, cost of revenues decreased by approximately $28,000. The
decrease is attributable to the overall decrease in hardware sales and the
associated cost of the hardware.
Selling, general and administrative expenses for the six months ended June 30,
2003, were $3,769,234, a decrease of $2,854,233 or 43.1% over the same period in
the previous year. The decrease includes decreases of approximately $1,563,000
in compensation-related expenses due to reductions in personnel, approximately
$289,000 in legal and accounting expenses, approximately $126,000 in other
operating expenses primarily related to insurance for directors and officers,
approximately $176,000 in promotion and advertising expenses, and approximately
$347,000 in travel related expenses. We recorded an impairment charge of
$302,000 during the second quarter of 2003, related to certain intangible assets
(See Note 4 of the condensed consolidated financial statements).
Product development and research expenses for the six months ended June 30,
2003, were $2,758,883, a decrease of $1,955,841 or 41.5% over the same period in
the previous year. The decrease includes decreases of approximately $1,364,000
in compensation-related expenses due to reductions in personnel, approximately
$440,000 in consulting
23
expenses, and approximately $139,000 of other operating expenses.
Liquidity and Capital Resources
We must raise additional funds to be able to satisfy our cash requirements
during the next 12 months. Research and development, corporate operations, and
marketing expenses will continue to require additional capital. Because we
presently have only limited revenue from operations, we intend to continue to
rely primarily on financing through the sale of our equity and debt securities
to satisfy future capital requirements until such time as we are 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 services revenues. There can be no assurance that we will
be able to enter into such agreements. Furthermore, the issuance of equity or
debt securities which are or may become convertible into our equity securities
in connection with such financing could result in substantial additional
dilution to the our stockholders. At June 30, 2003, we had $16,325,000 available
to draw under the third equity line of credit, and we were negotiating the terms
of a fourth equity line of credit agreement. We subsequently terminated the
Fourth Equity Line Agreement before any funds were advanced and before any
shares were issued. The company subsequently entered into a fifth private equity
agreement on July 1, 2003 with the Equity Line Investor, on terms substantially
similar to those of the Third Equity Line. Under the agreement, we have the
right to draw up to $20,000,000 against an equity line of credit from the Equity
Line Investor.
Net cash used in operating activities of $2,092,126 for the six months ended
June 30, 2003, resulted principally from the net loss incurred of $7,856,252
offset by increases in accrued payroll and other compensationof $2,333,844,
non-cash expenses pertaining to depreciation, amortization and accretion of
$1,194,123, impairment charge on intangible assets of $1,124,085, accounts
payable of $1,018,325, and equity in net loss of affiliate of $105,075. Net cash
provided by investing activities of $402,765 for the six months ended June 30,
2003, consisted of collections under a convertible note payable of $402,765. Net
cash used in operating activities was offset by net cash provided by financing
activities of $1,666,394 consisting primarily of the receipt of $2,565,000 in
cash related to the sale of shares of Class A common stock offset, in part, by
$650,000 in payments on Series D Debentures and $250,000 in payments on other
notes payable.
We had negative working capital of $17,287,170 at June 30, 2003, compared to
negative working capital of $14,428,750 at December 31, 2002. Current assets
decreased by $487,476 to $203,368 from December 31, 2002, to June 30, 2003.
Current liabilities increased by $2,370,944 to $17,490,538 during the same
period. The change in working capital from December 31, 2002, to June 30, 2003,
was primarily attributable to the impairment of the intangible assets at June
30, 2003, collection of the convertible note receivable and the increase in
accrued payroll and other compensation. Total assets were $4,401,513 at June 30,
2003, compared to $6,523,480 at December 31, 2002.
Investment in Affiliate
In February 2001, we 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.
We are not presently pursuing any development or collaboration projects with
Audium.
Note Receivable - In connection with the collaboration agreement with Audium, in
February and May 2001 we advanced an aggregate of $400,000 to Audium as a bridge
loan under a note (the "Audium Note"). The Audium Note 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 to us 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.
24
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. We are 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, we closed a stock purchase agreement
with Audium, wherein we agreed to purchase up to $2,800,000 of Audium Preferred
Stock at a price of $1.46 per share. At closing, we 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 to us certain
registration rights after the closing of a public offering by Audium.
At closing, Audium issued 14 Audium Preferred Stock certificates to us, 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 us one certificate for 136,986 shares of Audium Preferred Stock.
The difference between the total purchase price of the Audium Preferred Stock
and our 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 period.
The investment in Audium does not provide us with rights to any technology
developed by Audium; we must obtain a license should we choose to do so. Also,
we would not own an interest sufficient to control Audium if we 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 at June 30, 2003, under the
equity method and not as a research and development arrangement.
Accordingly, for the six months ended June 30, 2003, the Company recognized a
loss of $188,727, consisting of $105,075 to reflect our share of Audium's net
loss for the six months ended June 30, 2003, and $83,652 for the amortization of
the difference between the purchase price of the Audium Preferred Stock and our
portion of Audium's net stockholders' deficit that is amortized on a
straight-line basis over a period of eight years.
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. We
evaluate 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 our financial
position or results of operation.
At December 31, 2001, we assessed the realizability of the investment in Audium
and we 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
25
investment due to overall decline in the economy and the potential impact on
related markets for Audium's products. As of June 30, 2003, no further
write-down was deemed necessary based on the 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.
Through June 30, 2003, payments amounting to $1,800,000 had been made under the
Fonix note. At June 30, 2003, we had an outstanding balance of $1,000,000 due
under the Fonix note. We are currently discussing with Audium the possibility
that we will return 684,930 shares of Audium's Preferred Stock in exchange for
Audium's release of us under the Fonix note. Audium has not declared us to be in
default under the terms of the Fonix Note.
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 we recorded a present value of $2,370,348 for the Fonix Note.
Note Payable
On December 14, 2001, we entered into an Asset Purchase Agreement with Force
Computers, Inc. ("Force"). As part of the consideration for the purchase price,
we 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 we
recorded a discount of $40,245 for the note payable. We recorded interest
expense of $4,098 from the purchase date through December 31, 2001, $37,854 for
the year ended December 31, 2002.
As collateral for the promissory note, 175,000 shares of our Class A common
stock were placed into escrow. Under the terms of the escrow, the shares were
not to be released to Force unless we were delinquent or late with respect to
any payment under the note. Also, under the terms of the Asset Purchase
Agreement, we were required to deposit all receipts from customers acquired in
this transaction into a joint depository account. We had 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 had the right to withdraw funds from the
depository account until the deficiency in payment was covered, at which time,
we could 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. During the first quarter of
2003, additional payments amounting to $115,000 were made. The remaining balance
was paid during the second quarter of 2003.
Series D Debentures
On October 11, 2002, we entered into a Securities Purchase Agreement with The
Breckenridge Fund, LLC (the "Debenture Holder"), an unaffiliated third party,
for the sale of our 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 our Class A common stock at a conversion price equal to the average of
the two lowest closing bid prices of the Class A common stock for the twenty
trading days immediately preceding the conversion date multiplied by 90%. The
Debentures were originally due April 9, 2003. On the earlier of December 20,
2002, or 45 days after the effective date of the registration statement fined in
connection with the transaction (the "Initial Payment Date") and each 30-day
anniversary of the Initial Payment Date, we were required to make principal
payments of $250,000, plus accrued interest.
We subsequently amended the terms of the purchase agreement with the Debenture
Holder to extend the repayment terms of the Debentures. Additionally, we agreed
to the release of 237,583 shares of the Collateral Shares to the Debenture
Holder as consideration (the "Released Shares") to the Debenture Holder for
revising the terms of the purchase agreement.
In connection with the sale of the Debentures, we issued, as collateral to
secure our performance under the Debenture, 2,083,333 shares of Class A common
stock (the "Collateral Shares"), which were placed into an escrow
26
pursuant to an escrow agreement. Under the escrow agreement, the Collateral
Shares will not be released to the Debenture Holder unless we are delinquent
with respect to payments under the Debenture. If we are delinquent under the
revised payment schedule, the Debenture Holder is entitled to receive a penalty
of five percent of the then- outstanding principal amount of the debenture,
payable in cash or shares released from the Collateral Shares. Additionally, as
further consideration for the sale of the Debentures, we issued 194,444 shares
to the Debenture Holder (the "Additional Shares").
In connection with the sale of the Debentures, we agreed to register the resale
of the shares underlying the Debentures, the Collateral Shares, and the
Additional Shares. We filed a registration statement (SEC File No. 333- 102767)
which registered the resale of up to 3,435,186 shares of stock issued or
issuable in connection with the Debentures. Through August 11, 2003, 894,588
shares remain available to be sold under that registration statement.
However, due to fluctuations in the price of the stock, and the formula for
determining the number of shares issuable upon conversion, we were obligated to
register the resale of additional shares issuable to the Debenture Holder. We
entered into a letter agreement (the "Letter Agreement") in which we agreed to
register an additional eight million, three hundred twenty-nine thousand, one
hundred sixty-seven (8,329,167) shares to cover the resale by the Debenture
Holder of the Additional Shares, the Released Shares, the remaining Collateral
Shares, and shares issuable upon conversion of the outstanding principal balance
of the Debentures. We filed a subsequent registration statement to register the
resale by the Debenture Holder of up to 8,329,167 shares.
Through June 30, 2003, we had paid $650,000 of the outstanding principal,
together with $54,350 in accrued interest. Additionally, through June 30, 2003,
the holder of the Debentures had converted $406,846 principal amount and $26,154
in interest into 2,108,569 shares of Fonix Class A common stock. Accordingly, as
of June 30, 2003, the outstanding principal balance of the Debentures was
$443,154. Subsequently, the holder of the Debentures converted $209,752
principal amount and $12,554 in interest into 2,005,540 shares of our Class A
common stock. Accordingly, as of August 14, 2003, the outstanding balance due
under the Debentures was $233,401.
Equity Lines of Credit
Equity Line of Credit - In August 2000, as entered into a Private Equity Line
Agreement ("Equity Line") with a third party investor ("Equity Line Investor")
which gave us 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 was
available to us through a mechanism of draws and puts of stock. We were 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 funded the amounts requested by the us 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 related 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, we entered into a second private
equity line agreement (the "Second Equity Line") with the Equity Line Investor.
Under the Second Equity Line, we had 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
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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, we entered into a third equity line
agreement (the "Third Equity Line") with the Equity Line Investor. Under the
Third Equity Line, we have the right to draw up to $20,000,000 under terms
substantially identical to the initial Equity Line. On June 27, 2002, we filed
with the SEC a registration statement on Form S-2 to register the resale of up
to 5,000,000 shares of our 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 to us $182,676 against future draws
on the Third Equity Line (see Note 10 to the condensed consolidated financial
statements). 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.
For the six months ended June 30, 2003, the Company received $2,625,000 in funds
drawn under the Third Equity Line, less commissions and fees of $64,120, and
issued 5,000,000 shares of Class A common stock to the Equity Line Investor. The
Company entered into an agreement with the Equity Line Investor to terminate the
Third Equity Line, as well as the two prior equity lines, and cease further
draws or issuances of shares in connection with the Initial Equity Line, the
Second Equity Line, and the Third Equity Line.
Fourth Equity Line of Credit - On May 12, 2003, we entered into a fourth private
equity line agreement (the "Fourth Equity Line Agreement") with the Equity Line
Investor. We subsequently terminated the Fourth Equity Line Agreement before any
funds were advanced and before any shares were issued.
Fifth Equity Line of Credit - We entered, as of July 1, 2003, into a fifth
private equity line agreement (the "Fifth Equity Line Agreement") with the
Equity Line Investor, on terms substantially similar to those of the Third
Equity Line. Under the Fifth Equity Line Agreement, we have the right to draw up
to $20,000,000 against an equity line of credit ("the Fifth Equity Line") from
the Equity Line Investor. We are entitled under the Fifth Equity Line Agreement
to draw certain funds and to put to the Equity Line Investor shares of our Class
A common stock in lieu of repayment of the draw. The number of shares to be
issued is determined by dividing the amount of the draw by 90% of the average of
the two lowest closing bid prices of our Class A common stock over the ten
trading days after the put notice is tendered. (By way of comparison, three of
our prior equity line agreements used a seven-trading- day period to determine
the conversion price). The Equity Line Investor is required under the Fifth
Equity Line Agreement to tender the funds requested by us within two trading
days after the ten-trading-day period used to determine the market price.
In connection with the Fifth Equity Line Agreement, we granted registration
rights to the Equity Line Investor and filed a registration statement on form
S-2, which covered the resales of the shares to be issued under the Fifth Equity
Line. To the best of our knowledge, prior to our putting shares to the Equity
Line Investor in connection with the Fifth Equity Line, the Equity Line Investor
had sold all of the shares put to it in connection with the Initial Equity Line,
the Second Equity Line, and the Third Equity Line, and held no shares of our
Class A common stock.
We have entered into an agreement with the Equity Line Investor to terminate the
Third Equity Line, as well as the two prior equity lines, and cease further
draws or issuances of shares in connection with the Initial Equity Line, the
Second Equity Line, and the Third Equity Line. Additionally, the Fourth Equity
Line was terminated prior to any draws or puts of stock. As such, the only
active equity line of credit is the Fifth Equity Line.
Stock Options and Warrants
Reverse Stock Split - On March 24, 2003, our shareholders approved a
one-for-forty reverse stock split to our 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.
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Class A Common Stock - During the six months ended June 30, 2003, 5,000,000
shares of Class A common stock were issued in connection with draws on the
equity lines (see Note 10 to the condensed consolidated financial statements),
237,584 shares were issued in connection with the Breckenridge modification
agreement and 2,108,569 shares were issued under conversion notices from
Breckenridge (see Note 8 to the condensed consolidated financial statements). No
shares of Class A common stock were issued as a result of the exercise of stock
options or warrants during the same period.
Stock Options - During the six months ended June 30, 2003, we granted options to
employees to purchase 261,125 shares of Class A common stock. The options have
exercise prices of $0.21 to $1.60 per share, which was the quoted fair market
values of the stock on the dates of grant. The options granted vest over the
three years following issuance. Options expire within ten years from the date of
grant if not exercised. Using the Black-Scholes pricing model, the fair value of
the employee options was $0.21 to $1.60 per share. As of June 30, 2003, we had a
total of 851,482 options to purchase Class A common shares outstanding.
Warrants - As of June 30, 2003, we had warrants to purchase a total of 46,250
shares of Class A common stock outstanding that expire through 2010.
Other
We presently have 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 our Mission Statement. Our objectives include:
o Delivering real speech solutions for human interaction with multiple
devices based on our 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 our speech-enabled Products provide a
superior competitive advantage compared to other technologies available in the
marketplace. In addition, we believe our market focus on speech-enabled Products
will be a substantial differentiator. To accomplish this objective, we intend to
proceed as follows:
Substantially Increase Marketing and Sales Activities. We intend to expand
our sales through partners, OEMs,
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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, we will
continue to develop and expand its sales and marketing teams in Asia,
Europe, and the United States.
Expand Strategic Relationships. We have a number of strategic collaboration
and marketing arrangements with developers and VARs. We intend 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 we are able to
identify "first mover" speech-enabling applications in which it can
integrate our Products and Core Technologies, we intend to investigate
investment opportunities so we can obtain preferred or priority
collaboration rights.
Continue to Develop Standard Speech Solutions Based on the Core
Technologies. We plan 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 our competitive advantages.
As we proceed to implement our strategy and to reach our objectives, we
anticipate 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. Our strategy
has significant risks, and shareholders and others interested in Fonix and our
Class A common stock should carefully consider the risks set forth under the
heading "Certain Significant Risk Factors" in the Company's 2002 Annual Report
on Form 10-K, Item 1, Part I.
As noted above, as of June 30, 2003, we had an accumulated deficit of
$201,863,172, negative working capital of $17,287,170, accrued employee wages
and other compensation of $7,599,653, and accounts payable over 60 days past due
of $3,456,889. Sales of products and revenue from licenses based on our
technologies have not been sufficient to finance ongoing operations, although we
have limited capital available under our equity lines of credit. These matters
raise substantial doubt about our ability to continue as a going concern. Our
continued existence is dependent upon several factors, including our success in
(1) increasing license, royalty and services revenues, (2) raising sufficient
additional funding, and (3) minimizing operating costs. Until sufficient
revenues are generated from operating activities, we expected to continue to
fund our operations through the sale of our equity securities, primarily the
fifth equity line. We are currently pursuing additional sources of liquidity in
the form of traditional commercial credit, asset based lending, or additional
sales of our equity securities to finance our ongoing operations. Additionally,
we are pursuing other types of commercial and private financing which could
involve sales of our assets or sales of one or more operating divisions. Our
sales and financial condition have been adversely affected by our reduced credit
availability and lack of access to alternate financing because of our
significant ongoing losses and increasing liabilities and payables. Over the
past 12 months, we have reduced our workforce by approximately 50%. This
reduction in force may adversely affect our ability to fill existing orders. As
we have noted in our annual report and other public filings, if additional
financing is not obtained in the near future, we will be required to more
significantly curtail our operations or seek protection under bankruptcy laws.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
To date, all of our revenues have been denominated in United States dollars and
received primarily from customers in the United States. Our exposure to foreign
currency exchange rate changes has been insignificant. We expect, however, that
future product license and services revenue may also be derived from
international markets and may be denominated in the currency of the applicable
market. As a result, operating results may become subject to significant
fluctuations based upon changes in the exchange rate of certain currencies in
relation to the U.S. dollar. Furthermore, to the extent that we engage in
international sales denominated in U.S. dollars, an increase in the value of the
U.S. dollar relative to foreign currencies could make our products less
competitive in international markets. Although we will continue to monitor our
exposure to currency fluctuations, we cannot assure that exchange rate
fluctuations will not adversely affect financial results in the future.
Item 4. Evaluation of Disclosure 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 consolidated 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.
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
We are 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 our
consolidated financial position, liquidity, or results of operations.
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits: The following Exhibits are filed with this Form 10-Q pursuant to
Item 601(a) of Regulation S-K:
Exhibit No. Description of Exhibit
31.1 Certification of President
31.2 Certification of Chief Financial Officer
32.1 Certification of President Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
b. Reports filed on Form 8-K during the three-month period ended June 30, 2003:
Current Report on Form 8-K filed April 4, 2003, relating to
effectiveness of Fonix Corporation's reverse stock split and change
in ticker symbol.
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Fonix Corporation
Date: August 19, 2003 /s/ Roger D. Dudley
--------------------------------------------------
Roger D. Dudley, Executive Vice President,
Chief Financial Officer
(Principal financial officer)
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