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 September 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.)
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 November 17, 2003, 51,537,808 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 September 30, 2003 and December 31, 2002 2
Condensed Consolidated Statements of Operations and Comprehensive Loss for the
Three Months and Nine Months Ended September 30, 2003 and 2002 3
Condensed Consolidated Statements of Cash Flows for the Three Months and Nine Months
Ended September 30, 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 31
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 32
Item 2. Changes in Securities 32
Item 3. Defaults Upon Senior Securities 32
Item 4. Submission of Matters to a Vote of Security Holders 32
Item 6. Exhibits and Reports on Form 8-K 32
Fonix Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
ASSETS 2003 2002
- ------
----------------- ----------------
Current assets:
Cash and cash equivalents $ 691 $ 23,739
Accounts receivable 3,289 26,974
Convertible note receivable - 402,765
Inventory 8,843 51,937
Prepaid expenses and other current assets 41,298 185,429
----------------- ----------------
Total current assets 54,121 690,844
Property and equipment, net of accumulated depreciation of $1,917,125
and $1,671,809, respectively 337,889 625,448
Investment in and note receivable from affiliate, net of unamortized
discount of $0 and $58,548, respectively 1,130,179 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 2,631,303 2,631,304
Other assets 17,633 124,979
----------------- ----------------
Total assets $ 4,171,125 $ 6,523,480
================= ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accrued payroll and other compensation $ 8,360,977 $ 5,265,809
Accounts payable 4,460,494 3,083,425
Accrued liabilities 1,598,755 1,737,267
Accrued liabilities - related parties 1,443,300 1,443,300
Note payable to affiliate 1,000,000 1,000,000
Deferred revenues 711,268 854,248
Notes payable - related parties 493,175 493,175
Current portion of notes payable other 107,015 75,000
Bank overdraft 178,358 -
Series D Debentures, net of unamortized discount of $0 and
$582,630, respectively - 917,370
Note payable - 250,000
----------------- ----------------
Total current liabilities 18,353,342 15,119,594
Long-term portion of notes payable, net of current portion 73,389 -
Long-term borrowings - 3,312
----------------- ----------------
Total long-term liabilities 73,389 3,312
Total liabilities 18,426,731 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, 35,471,106 and 12,306,333 shares outstanding,
respectively 3,547 1,230
Class B non-voting, none outstanding - -
Additional paid-in capital 188,562,111 183,514,560
Outstanding warrants to purchase Class A common stock 1,334,000 1,360,000
Cumulative foreign currency translation adjustment 25,965 31,704
Accumulated deficit (204,681,229) (194,006,920)
----------------- ----------------
Total stockholders' deficit (14,255,606) (8,599,426)
----------------- ----------------
Total liabilities and stockholders' deficit $ 4,171,125 $ 6,523,480
================= ================
See accompanying notes to condensed consolidated financial statements.
2
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(Unaudited)
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- -----------------------------
2003 2002 2003 2002
------------- ------------- ------------- -------------
Revenues $ 456,818 $ 834,076 $ 1,678,221 $ 1,812,057
Impairment loss on capitalized software technology - - (821,986) -
Cost of revenues (13,121) (207,360) (196,029) (417,888)
------------- ------------- ------------- -------------
Gross (loss) profit 443,697 626,716 660,206 1,394,169
------------- ------------- ------------- -------------
Expenses:
Selling, general and administrative 1,338,173 3,064,932 5,107,407 9,677,671
Impairment loss on convertible note receivable - 1,523,842 - 1,523,842
Impairment loss on intangible assets - - 302,100 -
Product development and research 1,123,018 2,038,170 3,881,901 6,763,622
------------- ------------- ------------- -------------
Total expenses 2,461,191 6,626,944 9,291,408 17,965,135
------------- ------------- ------------- -------------
Loss from operations (2,017,494) (6,000,228) (8,631,202) (16,570,966)
------------- ------------- ------------- -------------
Other income (expense):
Interest income 703 37,744 10,748 134,065
Interest expense (851,652) (62,056) (1,915,514) (167,564)
------------- ------------- ------------- -------------
Total other income (expense), net (850,949) (24,312) (1,904,766) (33,499)
------------- ------------- ------------- -------------
Loss from operations before equity in net loss
of affiliate (2,868,443) (6,024,540) (10,535,968) (16,604,465)
Equity in net income (loss) of affiliate 50,386 (130,950) (138,341) (334,077)
------------- ------------- ------------- -------------
Net loss (2,818,057) (6,155,490) (10,674,309) (16,938,542)
Other comprehensive income (loss) - foreign
currency translation 2,748 6,531 (5,739) (21,706)
------------- ------------- ------------- -------------
Comprehensive loss $ (2,815,309) $ (6,148,959) $ (10,680,048) $ (16,960,248)
============= ============= ============= =============
Basic and diluted net loss per common share $ (0.11) $ (0.51) $ (0.37) $ (1.51)
============= ============= ============= =============
See accompanying notes to condensed consolidated financial statements.
3
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
-------------------------------
2003 2002
-------------- ---------------
Cash flows from operating activities:
Net loss $ (10,674,309) $ (16,938,542)
Adjustments to reconcile net loss to net cash
used in operating activities:
Additional compensation expense related to issue of stock options
and common stock - 12,499
Interest expense related to issuance of common stock to Breckenridge 358,001 -
Accretion of discount on note receivable from affiliate (9,200) (13,983)
Accretion of discount on note payable to affiliate - 34,193
Accretion of discount on note payable - 28,143
Amortization of investment in affiliate 125,478 -
Accretion of discount on Series D Debentures 867,730 -
Impairment loss on convertible note receivable and related
accrued interet - 1,523,842
Impairment loss on intangible assets 1,124,085 -
Depreciation and amortization 355,060 401,385
Equity in net loss of affiliate 12,863 334,077
Foreign exchange gain (9,338) (21,706)
Changes in assets and liabilities:
Accounts receivable 23,685 (82,611)
Interest and other receivables 1,761 (112,639)
Inventory 43,094 (25,788)
Prepaid expenses and other current assets 142,370 (21,415)
Other assets 107,346 (1,504)
Accounts payable 1,490,837 2,010,341
Accrued payroll and other compensation 3,095,168 -
Accrued liabilities (95,968) 4,596,472
Accrued liabilities - related party - (8,333)
Other current liabilities - 1,392
Deferred revenues (142,980) 35,739
Bank overdraft 178,358 -
-------------- ---------------
Net cash used in operating activities (3,005,959) (8,248,438)
-------------- ---------------
Cash flows from investing activities:
Repayment of notes receivable 402,765 -
Issuance of notes receivable - (820,000)
Purchase of property and equipment - (78,699)
-------------- ---------------
Net cash provided by (used in) investing activities 402,765 (898,699)
-------------- ---------------
Cash flows from financing activities:
Proceeds from sale of Class A common stock, net 3,491,822 10,122,346
Proceeds of note payable to related parties - 359,060
Proceeds from other notes payable - 75,000
Payments on note payable to affiliate - (562,500)
Proceeds from long-term debt (3,312) -
Payments on Series D Debentures (650,000) -
Payments on note payable (250,000) (1,030,000)
Payments on other note payable (8,364) -
-------------- ---------------
Net cash provided by financing activities 2,580,146 8,963,906
-------------- ---------------
Net (decrease) increase in cash and cash equivalents (23,048) (183,231)
Cash and cash equivalents at beginning of period 23,739 201,401
-------------- ---------------
Cash and cash equivalents at end of period $ 691 $ 18,170
============== ===============
See accompanying notes to condensed consolidated financial statements.
4
Fonix Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Nine Months Ended
September 30,
-----------------------------
Supplemental disclosure of cash flow information: 2003 2002
-------------- --------------
Cash paid during the period for interest $ 3,689 $ 117,326
Supplemental Schedule of Non-cash Investing and Financing Activities:
For the Nine Months Ended September 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 Nine Months Ended September 30, 2002:
Issued 13,394,216 shares of Class A common stock for $1,064,970 in
subscriptions receivcable
Warrants for the purchase of 625,000 shares of Class A common stock,
valued at $1,472,400, 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 nine months ended September 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 $834,076 for the
three months ended September 30, 2002, to $456,818 for the three months ended
September 30, 2003, and decreased from $1,812,057 for the nine months ended
September 30, 2002, to $1,678,221 for the nine months ended September 30, 2003.
The Company has incurred significant losses since inception, including a net
loss of $10,674,309 for the nine months ended September 30, 2003. The Company
incurred negative cash flows from operating activities of $3,005,959 during the
nine months ended September 30, 2003. As of September 30, 2003, the Company had
an accumulated deficit of $204,681,229, negative working capital of $18,299,221,
accrued employee wages of $8,360,977, and accounts payable over 60 days past due
of $4,095,400. 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 an 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 September 30, 2003 and 2002, there were outstanding common stock
equivalents to purchase 864,163 and 772,414 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 nine months ended
September 30, 2003 and 2002:
Three months ended September 30,
2003 2002
---------------------------- ---------------------------------
Per Share Per Share
Amount Amount Amount Amount
---------------------------- ---------------------------------
Net loss attributable to common stockholders $ (2,818,057) $ (0.11) $ (6,155,490) $ (0.51)
=============== ========= =============== ===========
Weighted average common shares outstanding 25,432,861 12,060,264
=============== ===============
Nine months ended September 30,
2003 2002
---------------------------- ---------------------------------
Per Share Per Share
Amount Amount Amount Amount
---------------------------- ---------------------------------
Net loss attributable to common stockholders $ (10,674,309) $ (0.37) $ (16,938,542) $ (1.51)
=============== ========= =============== ===========
Weighted average common shares outstanding 29,112,833 11,215,482
=============== ===============
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. Originally FIN 46 applied 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, however the FASB subsequently delayed the effective date of
this provision until the first interim or annual period ending after December
15, 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
7
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
from licensing the rights to its software products to end users and from
royalties. It also generates service revenues from the sale of consulting and
development services.
Revenues of all types are recognized when 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 September 30, 2003, and December 31, 2002, consisted of the
following:
September 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 $ 690,852 $ 794,737
Deferred customer Expiration of period covered by
support support agreement 20,416 59,511
---------------------- --------------------
Total deferred revenue $ 711,268 $ 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
8
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 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 September 30, 2003, the Company had 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
Sep 30, Sep 30,
2003 2002
------------------ -------------------
Net loss:
As reported $ (2,818,057) $ (6,155,490)
------------------ -------------------
Deduct:
Total stock-based employee compensation
benefit (expense) determined under fair
value based method for all awards, net
of forfeitures (16,972) (119,181)
------------------ -------------------
Pro forma $ (2,835,029) $ (6,274,671)
================== ===================
Basic and diluted net loss per common share:
As reported $ (0.11) $ (0.51)
Pro forma $ (0.11) $ (0.52)
9
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Nine Months Ended
Sep 30, 2003 Sep 30, 2002
------------------ ---------------------
Net loss:
As reported $ (10,674,309) $ (16,938,542)
------------------ ---------------------
Deduct:
Total stock-based employee compensation
benefit expense determined under fair
value based method for all awards (110,431) (357,543)
------------------ ---------------------
Pro forma $ (10,784,740) $ (17,296,085)
================== =====================
Basic and diluted net loss per common share:
As reported $ (0.37) $ (1.51)
Pro forma $ (0.37) $ (1.54)
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,
discussed below under "Note Payable to Affiliate"), 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 potential methods of converting
the remaining balance due under the Audium Note.
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.
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 September 30, 2003, under the equity method and not as a research and
development arrangement.
11
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Audium has incurred losses since the Company acquired the Audium Preferred Stock
and as such, Audium does not have the ability to declare or pay preferred
dividends on the Preferred Stock. The Company recognized losses for the three
and nine months ended September 30, 2003 and 2002 as follows:
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
-------------------------------------- -------------------------------------
2003 2002 2003 2002
------------------ ------------------ ------------------ ------------------
Company share of Audium net
income (loss) $ 92,212 $ (89,124) $ (12,863) $ (208,602)
Amortization of difference
between purchase price of Audium
Preferred Stock and Company's
share of Audium's net
stockholders' deficit $ (41,826) $ (41,826) $ (125,478) $ (125,475)
------------------ ------------------ ------------------ ------------------
Total equity in income (loss) of $ 50,386 $ (130,950) $ (138,341) $ (334,077)
affiliate ================== ================== ================== ==================
A summary of the results of Audium's operations for the three and nine months
ended September 30, 2003 and 2002 are as follows:
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
-------------------------------------- -------------------------------------
2003 2002 2003 2002
------------------ ------------------ ------------------ ------------------
Revenues $ 69,044 $ 77,015 $ 431,450 $ 167,505
Operating expenses 508,342 409,992 1,537,591 946,876
------------------ ------------------ ------------------ ------------------
Loss from continuing operations (439,298) (332,977) (1,106,141) (779,371)
Other income 783,823 - 1,058,085 -
------------------ ------------------ ------------------ ------------------
Net income (loss) $ 344,525 $ (332,977) $ (48,056) $ (779,371)
================== ================== ================== ==================
Accordingly, for the nine months ended September 30, 2003, the Company
recognized a loss of $138,341, consisting of $12,863 to reflect the Company's
share of Audium's net loss for the nine months ended September 30, 2003, and
$125,478 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
12
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 September 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 was payable in 13 monthly
installments of $200,000 beginning on June 1, 2001, and bore no interest unless
an event of default occurs, in which case it will bear interest at 12 percent
per year. Through September 30, 2003, payments amounting to $1,800,000 had been
made under the Fonix note. At September 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 originally 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 nine months ended September 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 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 $1,124,086 during the quarter
ended June 30, 2003, to fully impair the carrying value of the intangible
assets.
13
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The components of intangible assets were as follows at September 30, 2003, and
December 31, 2002:
September
30, 2003 December 31, 2002
-------------- -----------------------------------------------
Gross Gross Net
Carrying 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.
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 dates of the notes 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 converting accounts payable of $113,768 to a note
payable. 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
14
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
a change of control, without written permission from the creditor. Through
September 30, 2003, principal payments totaling $8,364 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 September 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 September 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 was 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
were amortized over the
15
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
term of the Debentures as interest expense.
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 would 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 was amortized over the modified term as
interest expense. The Company did not make the last three payments as scheduled.
Breckenridge asserted its rights under the Debenture agreement for penalties as
the Company did not meet the prescribed payment schedule. Breckenridge asserted
a claim of $379,290 which the Company disputed. Both parties subsequently agreed
to satisfy the claim in full through the issuance of 1,550,000 shares of the
Company's Class A common stock with a value of $224,750. The Company transferred
the shares to Breckenridge on October 20, 2003, in full satisfaction of the
claim and recorded the penalty as interest expense.
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 in connection with the
Debentures. The Company was obligated to file such post-effective amendments as
necessary to keep the registration statements effective as required by the
registration rights agreement.
Through September 30, 2003, the Company had paid $650,000 of the outstanding
principal, together with $54,350 in accrued interest. Additionally, through
September 30, 2003, the holder of the Debentures converted the remaining
$850,000 principal amount and $40,609 in interest into 7,359,089 shares of Fonix
Class A common stock.
As part of the Debenture agreement, the Company was required to pay Breckenridge
a placement fee in the amount of $350,000 payable in stock at the conclusion of
the Debenture. The Company satisfied the obligation through the issuance of
2,000,000 shares of the Company's Class A common stock valued at $0.175 per
share. The Company recorded the expense as interest expense in the accompanying
financial statements.
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 September 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
16
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
shares of common stock for each share of Series A convertible preferred stock.
10. EQUITY LINES OF CREDIT
Third Equity Line of Credit - In June 2002, the Company entered into a third
equity line agreement (the "Third Equity Line") with a third party investor (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 nine months ended September 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 any shares were issued.
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 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. 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.
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.
For the nine months ended September 30, 2003 the Company received $968,411 in
funds drawn under the Fifth Equity Line, less commissions and fees of $74,501,
and issued 8,664,542 shares of Class A common stock to the Equity Line Investor.
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.
17
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Class A Common Stock - During the nine months ended September 30, 2003,
13,664,542 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, 2,000,000 shares were issued related to
the Breckenridge placement fee, 1,550,000 shares were issued related to the
Breckenridge penalty and 7,359,089 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 nine months ended September 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 September 30, 2003, the Company had a total of 817,913 options to purchase
Class A common shares outstanding.
Warrants - As of September 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 and
has made the required payments due under the modified agreement.
If not paid in cash, 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 - Subsequent to September 30, 2003 and through
November 17, 2003 the Company received $2,995,036 in funds drawn under the Fifth
Equity Line, less commissions and fees of $108,181, and issued 14,186,985 shares
of Class A common stock to the Equity Line Investor.
Series D Debentures - Pursuant to the fee agreeement as discussed above (See
Note 8 above), the Company was required to provide Breckenridge with $350,000
worth of the Company's Class A common stock. On October 22, 2003, the Company
subsequently issued an additional 377,717 shares of the Company's Class A common
stock with a value of $59,302 to Breckenridge in full satisfaction of the fee
agreement.
Common Stock Purchase Agreement - On October 24, 2003, the Company issued
1,043,478 shares of its common
18
FONIX CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
stock to the Breckenridge Fund, LLC for $240,000, which was received that day.
19
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 September 30, 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 $834,076 for the three months ended September 30,
2002, to $456,818 for the three months ended September 30, 2003, and decreased
from $1,812,057 for the nine months ended September 30, 2002, to $1,678,221 for
the nine months ended September 30, 2003. We have incurred significant losses
since inception, including a net loss of $10,674,309 for the nine months ended
September 30, 2003. We incurred negative cash flows from operating activities of
$3,005,959 during the nine months ended September 30, 2003. As of September 30,
2003, we had an accumulated deficit of $204,681,229, negative working capital of
$18,299,221, accrued employee wages of $8,360,977, and accounts payable over 60
days past due of $4,095,400. 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 an equity line 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 nine 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
20
materialize, and has in 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 types of 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, of which $821,986 was recorded in cost of
21
revenues.
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 September 30, 2003 and December 31, 2002,
consisted of the following:
September 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 $ 690,852 $ 794,737
Deferred customer Expiration of period covered by
support support agreement 20,416 59,511
---------------------- --------------------
Total deferred revenue $ 711,268 $ 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,
22
amortization and impairment of capitalized speech software costs, licensed
technology, and other related costs. Cost of service revenues consists of
personnel compensation and other related costs.
Software technology development and production costs - All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense. Technological feasibility is established when a product design
and a working model of the software product have been completed and confirmed by
testing. Costs to produce or purchase software technology incurred subsequent to
establishing technological feasibility are capitalized. Capitalization of
software costs ceases when the product is available for general release to
customers. Costs to perform consulting services or development of applications
are charged to cost of revenues in the period in which the corresponding
revenues are recognized. Cost of maintenance and customer support 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
23
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. Originally, FIN 46 applied in
the first fiscal year or interim period beginning after June 15, 2003, to
variable interest entities in which an enterprise holds a VIEs that it acquired
before February 1, 2003, however the FASB subsequently delayed the effective
date of this provision until the first interim or annual period ending after
December 15, 2003.
Results of Operations
Three months ended September 30, 2003, compared with three months ended
September 30, 2002
During the three months ended September 30, 2003, we recorded revenues of
$456,818, reflecting a decrease of $377,258 or 45.2% over the same period in the
previous year. The decrease is primarily attributable to decreases in hardware
sales, decreased revenues from non-recurring engineering projects and decreased
DecTalk royalty payments.
Cost of revenues were $13,121 for the three months ended September, a decrease
of $194,239 or 93.7% over the same period in the previous year. 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
September 30, 2003, were $1,338,173, a decrease of $1,726,759, or 56.3% compared
to the same period in the previous year. The decrease includes decreases of
approximately $1,030,000 in compensation-related expenses due to reductions in
personnel; approximately $170,000 in decreased insurance expenses related to
coverage for officers and directors; approximately $102,000 in other operating
expenses due primarily to limited resources; approximately $63,000 in decreased
legal and accounting expenses due to reduced litigation and regulatory filings;
approximately $61,000 in occupancy costs due to the termination of a lease;
approximately $51,000 in promotion and advertising due to limited resources,
approximately $53,000 in travel related expenses due to limited resources and
approximately $32,000 in depreciation due to various assets being fully
depreciated during 2003 and the lack of additional purchases due to limited
resources.
Product development and research expenses for the three months ended September
30, 2003, were $1,123,018, a decrease of $915,152 or 44.9% over the same period
in the previous year. The decrease resulted primarily from decreased
compensation-related expenses of approximately $915,000 due decreases in
personnel; approximately $23,000 in decreased amortization expenses due to the
write-down of intangible assets at June 30, 2003; approximately $15,000 in
travel related expenses due to limited resources, and approximately $15,000 in
occupancy costs due to the termination of a lease.
At September 30, 2002, the Company recorded an impairment loss in the amount of
$1,523,842 on its convertible note receivable from Unveil Corporation.
Management believed that Unveil's financial condition had declined and
recognition of the impairment was appropriate at that time.
Nine months ended September 30, 2003, compared with nine months ended September
30, 2002
During the nine months ended September 30, 2003, we recorded revenues of
$1,678,221, reflecting a decrease of $133,836 or 7.4% over the same period in
the previous year. The decrease is primarily attributable to decreased hardware
sales of approximately $260,000 and decreased DecTalk royalty revenues of
approximately $116,000, partially offset by increased NRE revenues of
approximately $142,000 and increased revenues from our Korean subsidiary of
approximately $124,000.
Cost of revenues for the nine months ended September 30, 2003, were $1,018,015,
an increase of $600,127 or 143.6% over the same period in the previous year. The
increase is due to the impairment charge of approximately $822,000 (see Note 4
to the condensed consolidated financial statements). Without the effect of the
impairment charge, cost of revenues decreased by approximately $222,000. The
decrease is attributable to the overall decrease in hardware sales and the
associated cost of the hardware.
24
Selling, general and administrative expenses for the nine months ended September
30, 2003, were $5,107,407, a decrease of $4,570,264 or 47.2% over the same
period in the previous year. The decrease results primarily from decreases of
approximately $2,600,000 in compensation-related expenses due to reductions in
personnel; approximately $400,000 in travel related expenses; approximately
$352,000 in legal and accounting expenses due decreased litigation and
regulatory filings; approximately $276,000 in other operating expenses primarily
related to insurance for directors and officers; approximately $227,000 in
promotion and advertising expenses due to limited resources; approximately
$86,000 in consulting expenses to decreased reliance on outside consultants, and
approximately $81,000 in occupancy expenses related to the termination of a
lease. We recorded an impairment charge of $302,000 during the second quarter of
2003, related to certain intangible assets (See Note 4 to the condensed
consolidated financial statements).
Product development and research expenses for the nine months ended September
30, 2003, were $3,881,901, a decrease of $2,881,721 or 42.6% over the same
period in the previous year. The decrease includes decreases of approximately
$2,279,000 in compensation-related expenses due to reductions in personnel;
approximately $378,000 in consulting expenses due to decreased reliance on
outside consultants; approximately $149,000 on travel related expenses due to
limited resources; and approximately $148,000 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. Our 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 we 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 September 30, 2003, we had $19,008,660
available to draw under the fifth equity line of credit.
Net cash used in operating activities of $3,005,959 for the nine months ended
September 30, 2003, resulted principally from the net loss incurred of
$10,674,309 offset by increases in accrued payroll and other compensation of
$3,095,168; non-cash expenses pertaining to depreciation, amortization and
accretion of $1,339,068; impairment charge on intangible assets of $1,124,085;
accounts payable of $1,490,837; interest expense associated with the issuance of
common stock to Breckenridge of $358,001 and equity in net loss of affiliate of
$12,863. Net cash provided by investing activities of $402,765 for the nine
months ended September 30, 2003, consisted of collections under a convertible
note receivable of $402,765. Net cash used in operating activities was offset by
net cash provided by financing activities of $2,580,146 consisting primarily of
the receipt of $3,491,822 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 $18,299,221 at September 30, 2003, compared
to negative working capital of $14,428,750 at December 31, 2002. Current assets
decreased by $636,723 to $54,121 from December 31, 2002, to September 30, 2003.
Current liabilities increased by $3,233,748 to $18,353,342 during the same
period. The change in working capital from December 31, 2002, to September 30,
2003, was primarily attributable to the impairment of the intangible assets at
June 30, 2003, collection of the convertible note receivable, utilization of
prepaid assets, decreased inventory and the increase in accrued payroll and
other compensation. Total assets were $4,171,125 at September 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
25
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 discussed below under
"Note Payable to Affiliate"), 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.
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 September 30, 2003, under
the equity method and not as a research and development arrangement.
Accordingly, for the nine months ended September 30, 2003, the Company
recognized a loss of $138,341, consisting of $12,863 to reflect our share of
Audium's net loss for the nine months ended September 30, 2003, and $125,478 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.
26
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 investment
due to overall decline in the economy and the potential impact on related
markets for Audium's products. As of September 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 September 30, 2003, payments amounting to $1,800,000 had been made under
the Fonix note. At September 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
27
was 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 filed 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 pursuant to an
escrow agreement. Under the escrow agreement, the Collateral Shares would not be
released to the Debenture Holder unless we are delinquent with respect to
payments under the Debenture. If we were 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 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.
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 September 30, 2003, we had paid $650,000 of the outstanding principal,
together with $54,350 in accrued interest. Additionally, through September 30,
2003, the holder of the Debentures had converted the remaining $850,000
principal amount and $40,609 in interest into 7,359,089 shares of Fonix Class A
common stock. Subsequent to September 30, 2003, we transferrred to Breckenridge
an additional 3,927,717 shares to fully satisfy all obligations under the
Debentures.
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.
28
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 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 nine months ended September 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, 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 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
29
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.
For the nine months ended September 30, 2003 we received $968,411 in funds drawn
under the Fifth Equity Line, less commissions and fees of $74,501, and issued
8,664,542 shares of Class A common stock to the Equity Line Investor.
Common Stock, 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.
Class A Common Stock - During the nine months ended September 30, 2003,
13,664,542 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 7,359,089 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 nine months ended September 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 September
30, 2003, we had a total of 817,913 options to purchase Class A common shares
outstanding.
Warrants - As of Setpember 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.
30
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 these objectives, we intend
to proceed as follows:
Substantially Increase Marketing and Sales Activities. We intend to
expand our sales through partners, OEMs, VARs, direct sales, and
existing sales channels, both domestically and internationally, who
will focus on the wireless and mobile devices, telephony and server
phone solutions, assistive and language learning devices, automotive
integrated multi-media systems, and end-to-end or distributive speech
systems. To address global opportunities, we will continue to develop
and expand our 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 we 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 September 30, 2003, we had an accumulated deficit of
$204,681,229, negative working capital of $18,299,221, accrued employee wages
and other compensation of $8,360,977, and accounts payable over 60 days past due
of $4,095,400. 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 an equity line 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.
31
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.
32
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 September 30,
2003:
NONE.
33
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: November 18, 2003 /s/ Roger D. Dudley
-------------------------------------------
Roger D. Dudley, Executive Vice President,
Chief Financial Officer
(Principal financial officer)
34