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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES
EXCHANGE ACT OF 1934
For quarterly period ended FEBRUARY 28, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____________ to _______________
Commission File Number 0-22182
PATRIOT SCIENTIFIC CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 84-1070278
(State or other jurisdiction of (I.R.S. Empl. Ident. No.)
incorporation or organization)
10989 VIA FRONTERA, SAN DIEGO, CALIFORNIA 92127
(Address of principal executive offices, ZIP Code)
(858) 674-5000
(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 NO ____
Indicate the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date:
COMMON STOCK, $.00001 PAR VALUE 102,175,544
(Class) (Outstanding at April 16, 2003)
PATRIOT SCIENTIFIC CORPORATION
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets as of February 28, 2003 (unaudited)
and May 31, 2002 3
Consolidated Statements of Operations for the three and nine months
ended February 28, 2003 and 2002 (unaudited) 4
Consolidated Statements of Cash Flows for the nine months ended
February 28, 2003 and 2002 (unaudited) 5
Notes to Unaudited Consolidated Financial Statements 6-16
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 17-23
Item 3. Quantitative and Qualitative Disclosure About Market Risk 23
PART II. OTHER INFORMATION 23
Item 1. Legal Proceedings 23
Item 2. Changes in Securities 23
Item 3. Defaults upon Senior Securities *
Item 4. Submission of Matters to a Vote of Security Holders *
Item 5. Other Information *
Item 6. Exhibits and Reports on Form 8-K 24
SIGNATURES 24
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-
OXLEY ACT OF 2002 25-26
* No information provided due to inapplicability of the item.
2
PART I- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PATRIOT SCIENTIFIC CORPORATION
CONSOLIDATED BALANCE SHEETS
February 28, May 31,
2003 2002
-------------------- --------------------
(Unaudited)
ASSETS (Notes 4 and 5)
Current assets:
Cash and cash equivalents $ 30,256 $ 88,108
Accounts receivable, net of allowance
of $10,000 and $6,000 for uncollectible accounts (Note 1) 1,945 4,797
Prepaid expenses 84,809 35,749
-------------------- --------------------
Total current assets 117,010 128,654
Property and equipment, net 186,519 285,488
Other assets, net 100,121 330,863
Patents and trademarks, net 188,543 189,521
-------------------- --------------------
$ 592,193 $ 934,526
==================== ====================
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Note payable, net of unamortized debt discount
of $0 and $189,516 (Notes 3 and 4) $ 635,276 $ 445,760
Notes payable to a related party 180,000 -
Accounts payable 410,309 385,255
Accrued liabilities 228,541 211,291
Current portion of capital lease obligation 6,055 5,116
-------------------- --------------------
Total current liabilities 1,460,181 1,047,422
8% Convertible debentures, net of debt discount of $898,840 418,660 315,198
and $192,802 (Notes 3 and 5)
Long term portion of capital lease obligation 12,064 16,731
Commitments and contingencies (Notes 3, 6, 7 and 9)
Stockholders' deficit: (Note 7)
Preferred stock, $.00001 par value; 5,000,000 shares
authorized none outstanding - -
Common stock, $.00001 par value; 200,000,000 shares
authorized; issued and outstanding 96,650,153 and 81,465,757 967 815
Additional paid-in capital 43,449,452 41,440,101
Accumulated deficit (44,669,131) (41,805,741)
Note receivable (Note 8) (80,000) (80,000)
-------------------- --------------------
Total stockholders' deficit (1,298,712) (444,825)
-------------------- --------------------
$ 592,193 $ 934,526
==================== ====================
See accompanying summary of accounting policies and notes to unaudited
consolidated financial statements.
PATRIOT SCIENTIFIC CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
------------------------------------- -------------------------------------
February 28, February 28, February 28, February 28,
2003 2002 2003 2002
----------------- ----------------- ------------------ -----------------
Net sales $ 41,390 $ 4,620 $ 86,439 $ 326,509
Cost of sales:
Product costs 6,671 2,194 18,660 242,772
Inventory obsolescence - - - 149,433
----------------- ----------------- ------------------ -----------------
Cost of sales 6,671 2,194 18,660 392,205
Gross profit (loss) 34,719 2,426 67,779 (65,696)
Operating expenses:
Research and development 167,230 257,795 540,735 1,129,042
Selling, general and
administrative 382,372 709,334 1,446,606 2,101,746
----------------- ----------------- ------------------ -----------------
549,602 967,129 1,987,341 3,230,788
----------------- ----------------- ------------------ -----------------
Operating loss (514,883) (964,703) (1,919,562) (3,296,484)
----------------- ----------------- ------------------ -----------------
Other income (expenses):
Interest income 3 15 188 378
Interest expense (327,781) (295,988) (944,016) (570,142)
----------------- ----------------- ------------------ -----------------
(327,778) (295,973) (943,828) (569,764)
----------------- ----------------- ------------------ -----------------
Net loss $ (842,661) $ (1,260,676) $ (2,863,390) $ (3,866,248)
Basic and diluted loss
per common share $ (0.01) $ (0.02) $ (0.03) $ (0.06)
================= ================= ================== =================
Weighted average number of
common shares outstanding
during the period (Note 1) 91,726,851 71,500,223 85,711,345 64,288,474
================= ================= ================== =================
See accompanying summary of accounting policies and notes to unaudited
consolidated financial statements.
PATRIOT SCIENTIFIC CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended
---------------------------------------------
February 28, 2003 February 28, 2002
--------------------- ---------------------
Decrease in Cash and Cash Equivalents
Operating activities:
Net loss $ (2,863,390) $ (3,866,248)
Adjustments to reconcile net loss
to cash used in operating activities:
Amortization and depreciation 155,875 180,187
Provision for doubtful accounts 4,000 70,600
Provision for inventory obsolescense - 149,433
Non-cash interest expense related to convertible
debentures, notes payable and warrants 837,341 546,425
Issuance of common stock and options for services
and litigation settlements 148,800 49,500
Changes in:
Accounts receivable (13,025) (46,614)
Inventories - 73,960
Prepaid expenses and other assets 177,515 (53,526)
Accounts payable and accrued liabilities 59,294 (56,588)
---------------------------------------------
Net cash used in operating activities (1,493,590) (2,952,871)
---------------------------------------------
Investing activities:
---------------------------------------------
Purchase of property, equipment and patents (51,761) (47,429)
---------------------------------------------
Financing activities:
Proceeds from the issuance of short term notes payable 180,000 1,440,000
Proceeds from the issuance of convertible debentures 1,184,500 -
Proceeds from the issuance of common stock 114,850 879,605
Principal payments for capital lease obligations (3,728) (2,040)
Proceeds from sales of accounts receivable 11,877 154,158
Proceeds from exercise of common stock
warrants and options - 73,833
---------------------------------------------
Net cash provided by financing activities 1,487,499 2,545,556
---------------------------------------------
Net decrease in cash and cash equivalents (57,852) (454,744)
Cash and cash equivalents, beginning of period 88,108 464,350
---------------------------------------------
Cash and cash equivalents, end of period $ 30,256 $ 9,606
---------------------------------------------
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest $ 12,301 $ 17,232
Warrants and options issued for prepaid services $ - $ 57,500
Common stock issued for prepaid services $ - $ 198,000
Capital lease obligation $ - $ 24,996
Common stock issued on conversion of debentures,
notes payable and accrued interest $ 391,990 $ 227,800
Debt discount $ 1,403,815 $ 834,929
Debt discount cancelled $ 248,948 $ -
-------------------------------------------
See accompanying summary of accounting policies and notes to unaudited
consolidated financial statements.
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The consolidated financial statements of Patriot Scientific Corporation
("Patriot") presented herein have been prepared pursuant to the rules of the
Securities and Exchange Commission for quarterly reports on Form 10-Q and do not
include all of the information and footnotes required by accounting principles
generally accepted in the United States of America. These statements should be
read in conjunction with our audited consolidated financial statements and notes
thereto for the year ended May 31, 2002.
In the opinion of management, the interim consolidated financial statements
reflect all adjustments of a normal recurring nature necessary for a fair
statement of the results for interim periods. Operating results for the three
and nine month periods are not necessarily indicative of the results that may be
expected for the year.
LOSS PER SHARE
We follow Statement of Financial Accounting Standards ("SFAS") No. 128,
"Earnings per Share." Under SFAS No. 128, basic loss per share is calculated as
loss available to common stockholders divided by the weighted average number of
common shares outstanding. Diluted loss per share is calculated as net loss
divided by the diluted weighted average number of common shares. The diluted
weighted average number of common shares is calculated using the treasury stock
method for common stock issuable pursuant to outstanding stock options and
common stock warrants. Common stock options and warrants of 55,684,705 and
13,840,170 for the nine months ended February 28, 2003 and 2002, respectively,
were not included in diluted loss per share for the periods as the effect was
antidilutive due to our recording losses in each of those periods. See Notes 5
and 7 for discussion of commitments to issue additional shares of common stock
and warrants.
SALE OF ACCOUNTS RECEIVABLE
We follow SFAS No. 140, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities," a replacement of SFAS No. 125. SFAS
No. 140 provides consistent standards for distinguishing transfers of financial
assets that are sales from transfers that are secured borrowings. A $400,000
factoring line we established with a bank enables us to sell selected accounts
receivable invoices to the bank with full recourse against us. These
transactions qualify for a sale of assets since (1) we have transferred all of
our rights, title and interest in the selected accounts receivable invoices to
the bank, (2) the bank may pledge, sell or transfer the selected accounts
receivable invoices, and (3) we have no effective control over the selected
accounts receivable invoices since we are not entitled to or obligated to
repurchase or redeem the invoices before their maturity and we do not have the
ability to unilaterally cause the bank to return the invoices. Under SFAS
No.140, after a transfer of financial assets, an entity recognizes the financial
and servicing assets it controls and the liabilities it has incurred,
derecognizes financial assets when control has been surrendered, and
derecognizes liabilities when extinguished. During the first nine months of
fiscal 2003, we sold $14,846 of our accounts receivable to a bank under the
factoring agreement for $11,877. Pursuant to the provisions of SFAS No. 140, we
reflected the transactions as sales of assets and established a receivable from
the bank for the retained amount less the costs of the transactions and less any
anticipated future loss in the value of the retained asset. The retained amount
was equal to 20% of the total accounts receivable invoices sold to the bank less
1% of the total invoices as an administrative fee and 1.75% per month of the
total outstanding accounts receivable invoices as a finance fee. The estimated
future loss reserve for each receivable included in the estimated value of the
retained asset was based on the payment history of the accounts receivable
customer. As of February 28, 2003, there were no qualifying accounts receivable
invoices available to factor resulting in no balance outstanding under the
factoring line and $400,000 remaining available for future factoring of accounts
receivable invoices.
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
RECLASSIFICATIONS
Certain items in the unaudited February 28, 2002 consolidated financial
statements have been reclassified to conform to the current presentation.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No.
123." SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosures in both annual
and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
Management is evaluating the adoption of this statement.
3. CONTINUED EXISTENCE AND MANAGEMENT'S PLAN
Our consolidated financial statements are presented on the going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. Our ability to continue as a going concern is
contingent upon our obtaining sufficient financing to sustain our operations. We
incurred a net loss of $2,863,390, $5,487,051 and $4,968,903 and negative cash
flow from operations of $1,493,590, $3,632,534 and $4,839,180 in the nine months
ended February 28, 2003 and the years ended May 31, 2002 and 2001, respectively.
At February 28, 2003, we had deficit working capital of $1,343,171 and cash and
cash equivalents of $30,256. We have historically funded our operations
primarily through the issuance of securities and debt financings. Cash and cash
equivalents decreased $57,852 during the nine months ended February 28, 2003.
We estimate our current cash requirements to sustain our operations for the next
twelve months through February 2004 to be $2.4 million. Since we are no longer
supporting the communications product line, we are assuming that there will be
no communications product revenue. We have a note payable to Swartz Private
Equity, LLC ("Swartz") of $635,276 at February 28, 2003 which was due in April
2003 and subsequent to the end of the quarter has been extended to March 1,
2004. We also have convertible debentures with a group of investors as of
February 28, 2003 aggregating $1,605,000 and advances of $87,500 on a
convertible debenture that closed subsequent to February 28, 2003. At the option
of the debenture holders, they may purchase additional debentures up to $1
million at any time during the next two years as long as the price of our common
stock is in excess of $0.20 per share. During the first nine months ended
February 28, 2003, we obtained $114,850 from the sale of equity to several
private investors and $180,000 from short term notes entered into with a related
party. Subsequent to February 28, 2003, we obtained an additional $5,500 from
the sale of equity to a private investor and $112,500 from the issuance of
additional convertible debentures net of advances discussed above.
If the optional amounts under the convertible debentures are not raised in
sufficient amounts, then we may not have funds sufficient to meet our cash
requirements. In such circumstances, we may need to secure additional short-term
debt, private placement debt and/or equity financings with individual or
institutional investors. In addition, we may need to make additional cost
reductions if our cash requirements cannot be met from external sources. We
expect that the $2.4 million requirement will be provided by:
o additional debt and/or equity financings; and
o proceeds from the exercise of outstanding stock options and warrants.
In addition, we have formulated additional cost reduction plans which can be
implemented if the required funds are
7
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
not obtainable. We also have remaining a $400,000 accounts receivable factoring
agreement with our bank; however, we have no eligible accounts receivable to
factor as of February 28, 2003.
We anticipate our future revenue to be derived primarily from the sale of
licenses and royalties. To receive this revenue, we may require additional
equipment, fabrication, components and supplies during the next twelve months to
support potential customer requirements and further develop our technologies.
Product introductions such as those currently underway for the Ignite I and
JUICEtechnology may require significant product launch, marketing personnel and
other expenditures that cannot be currently estimated. Further, if expanded
development is commenced or new generations of microprocessor technology are
accelerated beyond current plans, additional expenditures we cannot currently
estimate, may be required. It is possible therefore, that higher levels of
expenditures may be required than we currently contemplate resulting from
changes in development plans or as required to support new developments or
commercialization activities or otherwise.
If we are unable to obtain the necessary funds, we could be forced to
substantially curtail or cease operations which would have a material adverse
effect on our business. Further, there can be no assurance that we will be able
to timely receive shareholder approval to increase the number of authorized
shares or that required funds, if available, will be available on attractive
terms or that they will not have a significantly dilutive effect on our existing
shareholders. As such, there is substantial doubt about our ability to continue
as a going concern. The consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from our possible inability to continue as a going concern.
4. SECURED NOTE PAYABLE
On March 12, 2002, we replaced and superceded a previously issued Secured
Promissory Note with Swartz with an Amended Secured Promissory Note and
Agreement with an effective date of October 9, 2001 and an Addendum to Amended
Secured Promissory Note dated March 12, 2002. The amended note, which originally
was to mature on April 9, 2003, has been extended to March 1, 2004 and amounts
outstanding under the note bear interest at the rate of 5% per annum. Per the
addendum to the amended note, principal and interest payments are deferred until
March 1, 2004.
As part of the consideration for entering into the above amended note, we agreed
to issue warrants to Swartz related to each advance against the note. In
connection with each advance, we issued to Swartz a warrant to purchase a number
of shares of common stock equal to the amount of the advance multiplied by 8.25
at an initial exercise price equal to the lesser of (a) the factor of the
average of the volume weighted average price per share, as defined by Bloomberg
L.P., for each trading day in the period beginning on the date of the previous
advance and ending on the trading day immediately preceding the date of the
current advance multiplied by .70 or (b) the volume weighted average price per
share minus $0.05. In addition, if after March 12, 2002, we issue common stock
to any parties other than Swartz, we are obligated to issue to Swartz warrants
equal to 20% of the common stock so issued. The amended note also gave to Swartz
the right of first refusal and rights to participate in subsequent debt or
equity transactions had we entered into any through March 15, 2003.
As of February 28, 2003 we issued warrants to purchase up to 17,622,200 shares
of our common stock in accordance with the amended note agreements. The warrants
issued were valued using the Black-Scholes pricing model based on the expected
fair value at issuance and the estimated fair value was also recorded as debt
discount. See Note 7 to the consolidated financial statements for discussion of
the terms of the warrants
The note is secured by our assets.
All debt discounts were amortized as additional interest expense over the term
of the note payable. As of February 28, 2003, $1,107,238 had been reflected as
debt discount of which $917,722 and $189,516 was amortized to interest expense
during the year ended May 31, 2002 and the nine months ended February 28, 2003,
respectively.
8
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Advances against the note $1,790,000
Less amount applied against $30 million equity line of credit (227,800)
Less amount applied against $25 million equity line of credit (926,924)
Less debt discount
Total 1,107,238
Amount amortized to expense (1,107,238) --
--------- -------
Note payable at February 28, 2003 $ 635,276
On November 9, 2001, an offset of $227,800 from the sale of 2,500,000 shares of
common stock was applied against the final put under the $30 million equity line
of credit discussed below.
On May 30, 2002, an offset of $926,924 from the sale of 14,100,000 shares of
common stock was applied against the first and only put under the $25 million
equity line of credit discussed below.
5. 8% CONVERTIBLE DEBENTURES
OVERVIEW. From April 23, 2002 through February 28, 2003, we sold an aggregate of
$1,605,000 of 8% convertible debentures to a group of eleven investors. In
addition, at February 28, 2003, we have received advances totaling $87,500
against a convertible debenture that closed subsequent to the quarter. The
convertible debentures entitle the debenture holder to convert the principal and
unpaid accrued interest into our common stock for two years from the date of
closing. In addition, the debenture holders received warrants exercisable into a
number of our common shares.
NUMBER OF SHARES DEBENTURES MAY BE CONVERTED INTO. The debentures can be
converted into a number of our common shares at conversion prices that initially
equaled $0.05126 to $0.10289 per share.
RESETS OF CONVERSION PRICE AND CONVERSION SHARES. A reset date occurs on each
three month anniversary of the closing date of each debenture and on the date
the registration statement becomes effective, October 29, 2002 for the first
$1,000,000 of principal and March 7, 2003 for the second $605,000 of principal.
If the volume weighted average price for our common stock for the ten days
previous to the reset date is less than the conversion price in effect at the
time of the reset date, then the number of common shares issuable to the selling
shareholder on conversion will be increased. If the conversion price is reset,
the debenture can be converted into a number of our common shares based on the
following calculation: the amount of the debenture plus any unpaid accrued
interest divided by the reset conversion price which shall equal the volume
weighted average price for our common stock for the ten days previous to the
reset date. On October 29, 2002, the date the registration statement for the
first $1,000,000 of principal became effective, the conversion price for
debentures dated April 23, 2002 in an amount of $225,000 and June 10, 2002 in
amounts accumulating $775,000 were reset to $0.04457 from initial conversion
prices of $0.10289 and $0.08616. On March 7, 2003, the date the registration
statement for the second $605,000 of principal became effective, the conversion
price for debentures dated August 23, October 29 and December 16, 2002 and
January 24, 2003 in the amounts of $175,000, $180,000, $100,000 and $150,000,
respectively, were reset to $0.04722 from initial conversion prices ranging from
$0.05126 to $0.0727.
WARRANTS. Concurrent with the issuance of the convertible debentures, we issued
to the debenture holders warrants to purchase up to 24,094,009 shares of our
common stock. These warrants are exercisable for five years from the date of
issuance at initial exercise prices equal to 115% of the volume weighted average
price for our common stock for the ten days previous to the debenture date. The
warrant exercise price is subject to being reset on each six month anniversary
of its issuance. For the nine months ended February 28, 2003, warrants to
purchase up to 15,626,849 shares of our common stock had their exercise prices
reset from a range of $0.073 to $0.103 to a range of $0.047 to $0.073.
9
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
OPTIONS TO PURCHASE ADDITIONAL DEBENTURES. Subject to the price of our common
stock being equal to or greater than $0.20 per share and a two year limitation,
the debenture holders may purchase additional debentures equal to the value of
their initial debentures. The price at which the optional additional debentures
could be converted would initially equal 115% of the volume weighted average
price for our common stock for the ten days previous to the date on which the
optional additional debentures were closed. The optional additional debentures
would carry the same warrant amounts and reset privileges as the initial
debentures.
SHAREHOLDER APPROVAL. We may currently issue more than 20% of our outstanding
shares under the convertible debentures. If we become listed on the NASDAQ Small
Cap Market or NASDAQ National Market, then we must get shareholder approval to
issue more than 20% of our outstanding shares. Since we are currently a bulletin
board company, we do not need shareholder approval.
RESTRICTIVE COVENANTS. For a period of 18 months from the date of the
debentures, we are prohibited from certain transactions. These include the
issuance of any debt or equity securities in a private transaction which are
convertible or exercisable into shares of common stock at a price based on the
trading price of the common stock at any time after the initial issuance of such
securities; the issuance of any debt or equity securities with a fixed
conversion or exercise price subject to adjustment; and any private equity line
type agreements without obtaining the debenture holders' prior written approval.
RIGHT OF FIRST REFUSAL. The debenture holders have a right of first refusal to
purchase or participate in any equity securities offered by us in any private
transaction which closes on or prior to the date that is two years after the
issue date of each debenture.
REGISTRATION RIGHTS. We are responsible for registering the resale of the shares
of our common stock which will be issued on the conversion of the debentures. On
October 29, 2002 and March 7, 2003, registration statements covering $1,000,000
and $605,000 of debentures were declared effective by the Securities and
Exchange Commission.
As of February 28, 2003 we issued warrants to purchase up to 24,094,009 shares
of our common stock in accordance with the convertible debentures. The warrants
issued were valued using the Black-Scholes pricing model based on the expected
fair value at issuance and the estimated fair value was also recorded as debt
discount. See Note 7 to the consolidated financial statements for discussion of
the terms of the warrants. Debt discounts related to the warrant valuations are
to be amortized as additional interest expense over the term of the convertible
debenture. As of February 28, 2003, $1,141,697 has been reflected as debt
discount of which $123,480, $326,584 and $8,383 was amortized to interest
expense during the three and nine months ended February 28, 2003 and the year
ended May 31, 2002, respectively.
In addition, the convertible debentures contain beneficial conversion features.
Such features require us to allocate the proceeds received to both the warrants
and the debt and to calculate an intrinsic value for the debt portion if the per
share price allocated to debt is less than the fair market per share price as of
the first date the debenture is sold. Accordingly, during the three and nine
months ended February 28, 2003, we recorded $58,571 and $463,303 to additional
paid in capital to reflect the intrinsic value of the convertible debentures.
The intrinsic value of the beneficial conversion feature of the convertible
debenture is amortized to non-cash interest expense over the life of the
convertible debenture. Accordingly, we amortized to non-cash interest expense
$51,106 and $122,245 during the three and nine months ended February 28, 2003.
During the nine months ended February 28, 2003, holders converted debentures
accumulating $375,000 of principal and $16,990 of accrued interest into
8,794,937 shares of our common stock. The balance of unamortized debt discount
related to the beneficial conversion features and debt discount on the date of
conversion of $248,948 was charged to additional paid in capital.
The convertible debentures are secured by our assets.
10
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Convertbile debenture dated April 23, 2002 $ 225,000
Convertbile debentures dated June 10, 2002 775,000
Convertbile debenture dated August 23, 2002 175,000
Convertbile debentures dated October 29, 2002 180,000
Convertbile debenture dated December 16, 2002 100,000
Convertbile debenture dated January 24, 2003 150,000
Advances against debenture issued subsequent to Febrary 28, 2003 87,500
Less amounts converted to common stock (375,000)
Less debt discount
Total $ 1,605,000
Amount amortized to expense (457,212)
Amount cancelled on conversion (248,948) (898,840)
------------- -------------
Convertible debentures at February 28, 2003 $ 418,660
================
6. INVESTMENT AGREEMENTS
$5 MILLION EQUITY LINE OF CREDIT AGREEMENT
In February 1999, the Company entered into an investment agreement with Swartz.
The investment agreement entitled the Company, at the Company's option, to issue
and sell its common stock for up to an aggregate of $5 million from time to time
during a three-year period through February 24, 2002, subject to certain
conditions including (1) an effective registration statement must be on file
with the SEC registering the resale of the common shares, and (2) a limitation
on the number of common shares which could be sold to Swartz within a 30 day
time period based on the trading volume of the stock, among others. Swartz could
purchase the common stock from the Company at a discount ranging from 10% to 20%
depending on the price of the common stock. In addition to the common stock
purchased, Swartz received warrants to purchase an additional 15% of the common
stock equal to 110% of the market price as determined during the pricing period,
subject to further semi-annual price adjustments if the price of the common
stock goes down.
In July 1999, the Company amended and restated the investment agreement with
Swartz to eliminate the discretion of Swartz as to the timing of its purchase of
the Company's common stock.
The amended and restated investment agreement required Swartz, after the Company
put shares of common stock to it, to purchase the Company's common stock on the
twentieth day following the put. The previous agreement enabled Swartz, in its
sole discretion, to purchase the Company's common stock at any time during a
twenty-day period following the Company's put to it.
The registration statement went effective on October 5, 1999. As a result of an
increase in the market price and trading volume of the Company's common stock,
the Company completed the $5 million placement of shares in February 2000. The
total number of shares placed with Swartz was 13.9% of the total number of
shares outstanding at the time or 7,014,796 common shares at prices ranging from
$0.248 to $0.9775. The average price per share paid by Swartz was $0.71 compared
to the average closing price during the twenty day pricing periods of $1.34 per
share.
An additional 1,052,219 shares of common stock at exercise prices ranging
initially from $0.341 to $1.265 are issuable to Swartz upon the exercise of
warrants issued under the investment agreement. The warrants contain a reset
provision which may reduce the exercise price if the price, as defined in the
agreement, is lower on any
11
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
subsequent six month anniversary. As a result of the reset provision, the
exercise prices have been reduced to a range of $0.053 to $0.068 as of February
28, 2003. None of the warrants had been exercised as of February 28, 2003.
$30 MILLION EQUITY LINE OF CREDIT AGREEMENT
In May 2000, we entered into an investment agreement with Swartz. The investment
agreement entitled us , at our option, to issue and sell our common stock for up
to an aggregate of $30 million from time to time during a three- year period,
subject to certain conditions including among other items (1) an effective
registration statement being on file with the SEC registering the resale of the
common shares, and (2) a limitation on the number of common shares that could
have been sold to Swartz within a 30 day time period based on the trading volume
of the stock. Swartz could purchase the common stock from us at a discount. If
the market price was less than $1.00 per share, the discount was $.10 per share;
if the market price was between $1.00 to $1.99 per share, the discount was 10%;
and if the market price was $2.00 or greater, the discount was 7%. In addition
to the common stock purchased, Swartz received warrants to purchase an
additional 15% of the common stock equal to 110% of the market price as
determined during the pricing period, subject to further semi-annual price
adjustments if the price of our common stock goes down.
The registration statement went effective on June 23, 2000 and we received a
total of $4,381,601 from the sale of 12,000,000 shares of common stock . Per the
terms of the investment agreement, we issued ten five-year warrants for
1,800,000 shares of common stock exercisable initially at prices ranging from
$0.091 to $1.562. The warrants contain a reset provision which may reduce the
exercise price if the price, as defined in the agreement, is lower on any
subsequent six month anniversary. As a result of the reset provision, the
exercise prices have been reduced to a range of $0.033 to $0.0858 as of February
28, 2003. None of the warrants had been exercised as of February 28, 2003.
On September 17, 2001, we entered into a $25 million equity line of credit
agreement with Swartz, thereby, effectively concluding the $30 million equity
line of credit at the conclusion of the put in effect on that date.
On September 24, 2001, we entered into a waiver and agreement with Swartz
whereby Swartz was able to advance us $227,800 prior to the close of the final
put under the $30 million equity line of credit. The waiver and agreement
extended the time of the put beyond twenty days and redefined the price of the
put to be the lesser of the factor of (a) the volume weighted average price per
share, as defined by Bloomberg L.P., for each day of the put multiplied by .70
or (b) the volume weighted average price per share minus $0.05 multiplied by 20%
of the acceptable daily volume as defined in the waiver. At the discretion of
Swartz the 20% daily volume limitation could be increased up to 30% of the daily
volume. In addition, the waiver included the issuance of a purchase warrant to
purchase 2,125,000 shares of common stock at an initial exercise price of
$0.0911. The purchase warrant shares were issued to Swartz as restricted shares
subject to "piggyback" registration rights and are subject to repricings on each
six month anniversary if 110% of the lowest closing bid price for the five days
previous to the anniversary date is less than the initial or subsequent reset
exercise prices. As a result of the reset provision, the exercise price has been
reduced to $0.0858 as of February 28, 2003. None of the warrants had been
exercised as of February 28, 2003.
See Note 7 for further information on the warrants.
$25 MILLION EQUITY LINE OF CREDIT AGREEMENT
On September 17, 2001, we entered into an investment agreement with Swartz. The
investment agreement entitled us to issue and sell our common stock to Swartz
for up to an aggregate of $25 million from time to time during a three-year
period following the effective date of the registration statement. We filed a
registration statement on Form S-1 that was declared effective on November 5,
2001 for 15,000,000 shares of our common stock. We issued the 15,000,000 shares
of common stock to Swartz during the fiscal year ended May 31, 2002 to be
applied against a note payable that Swartz had issued to us.
12
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
We issued to Swartz a commitment warrant to purchase up to 900,000 shares of our
common stock concurrent with the execution of the investment agreement. This
warrant is exercisable through September 17, 2006 at an initial exercise price
of $0.22. The commitment warrant exercise price is subject to being reset on
each six month anniversary of its issuance. As a result of the reset provision,
the exercise price has been reduced to $0.0495 as of February 28, 2003. None of
the warrants had been exercised as of February 28, 2003.
RESTRICTIVE COVENANTS. For a period of two years after the termination of the
agreeement, we are prohibited from certain transactions. These include the
issuance of any debt or equity securities in a private transaction which are
convertible or exercisable into shares of common stock at a price based on the
trading price of the common stock at any time after the initial issuance of such
securities or with a fixed conversion or exercise price subject to adjustment
without obtaining Swartz's prior written approval.
RIGHT OF FIRST REFUSAL. Swartz has a right of first refusal to purchase any
variable priced securities offered by us in any private transaction which closes
on or prior to two years after the termination of the investment agreement and a
right of participation for any equity securities offered by us in any private
transaction which closes on or prior to two years after the termination of the
investment agreement.
WAIVER AND AGREEMENT. On March 12, 2002, we entered into an amended waiver and
agreement with Swartz which replaced and superseded all previous waivers and
agreements. This amended waiver and agreement extended the time of the put
beyond twenty days and redefined the price of the put to be the lesser of the
factor of (a) the volume weighted average price per share, as defined by
Bloomberg L.P., for each day of the put multiplied by .70 or (b) the volume
weighted average price per share minus $0.05 multiplied by 20% of the acceptable
daily volume as defined in the waiver. At the discretion of Swartz, the 20%
daily volume limitation could be increased up to 30% of the daily volume. In
addition, the amended waiver and agreement increased the intended put share
amount for the first put to 14,100,000 shares, which is the total number of
shares we had registered under the $25 million equity line of credit. On May 30,
2002 we closed the first put and effectively the $25 million equity line of
credit by applying the proceeds of $926,924 to the secured note payable
discussed below.
WARRANTS. In connection with closing the $25 million equity line of credit, we
issued to Swartz a commitment warrant to purchase 900,000 shares of our common
stock as discussed further in Note 7 to the consolidated financial statements.
This warrant was valued on the issuance date using the Black-Scholes pricing
model and the value was recorded as a debt discount.
7. STOCKHOLDERS' DEFICIT
The following table summarizes equity transactions during the nine months ended
February 28, 2003:
(Object omitted)
13
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Common
Shares Dollars
---------- ---------------------
Balance June 1, 2002 81,465,757 $ 41,440,916
Sale of common stock 3,609,459 114,850
Stock issued for services 2,380,000 132,800
Stock issued to settle litigation 400,000 16,000
Stock issued on conversion of
debentures and accrued interest 8,794,937 391,990
Non-cash interest and debt discount
related to warrants and debentures - 1,353,863
---------- ---------------------
Balance February 28, 2003 96,650,153 43,450,419
========== =====================
STOCK OPTIONS
At February 28, 2003, we had 17,500 options outstanding pursuant to our 1992 ISO
Stock Option Plan exercisable at $1.325 per share expiring in 2005; 50,000
options outstanding pursuant to our 1992 NSO Stock Option Plan exercisable at
$1.325 per share expiring in 2005; 1,976,500 options outstanding pursuant to our
1996 Stock Option Plan exercisable at a range of $0.0575 to $1.325 per share
expiring beginning in 2004 through 2007; and 2,340,000 options outstanding
pursuant to our 2001 Stock Option Plan exercisable at a range of $0.059 to $0.69
per share expiring beginning in 2004 through 2007.
Some of the options outstanding under these plans are not presently exercisable
and are subject to meeting vesting criteria.
WARRANTS
At February 28, 2003, we had warrants outstanding exercisable into 51,300,705
common shares at exercise prices ranging from $0.033 to $1.12 per share expiring
beginning in 2004 through 2007. During the nine months ended February 28, 2003,
we issued warrants to purchase 21,579,200 shares of common stock which are
subject to repricings at the six month anniversary of the issuance of the
warrant. At each anniversary date the warrants will be repriced to the lesser of
the initial exercise price or 110% of the lowest closing bid price of our common
stock for the five trading days ending on such six month anniversary date.
During the nine months ended February 28, 2003, warrants to purchase 15,456,937
shares of common stock with initial or reset exercise prices ranging from
$0.0571 to $0.1320 have been repriced to exercise prices ranging from $0.033 to
$0.0715.
During the nine months ended February 28, 2003, we issued to two individuals
warrants exercisable for five years into 1,000,000 common shares at an exercise
price of $0.05 per share. These individuals are acting as our marketing
representatives and the warrants are scheduled to vest based on sales activity
as defined in their contracts.
Also, during the nine months ended February 28, 2003, we issued to Swartz snap
shot warrants exercisable for five years into 4,734,050 common shares at
exercise prices, after reset provisions, ranging from $0.047 to $0.0592 per
share. These snap shot warrants were issued under an agreement with Swartz
whereby we will issue to Swartz warrants to purchase common shares equal to 20%
of any common stock or warrants we issue to parties other than Swartz or their
affiliates after March 12, 2002.
14
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
COMMON STOCK
During the nine months ended February 28, 2003, we sold to a group of individual
private investors a total of 3,609,459 shares of common stock at prices ranging
from $0.025 to $0.051 for an accumulated total of $114,850. The investors have
agreed to hold these shares for a minimum of one year.
In October 2002, we entered into an agreement with Barry Clark whereby he will
provide consulting services through April 2003 to help structure financing,
provide innovative capital resources and advise us on other strategic decisions.
In October 2002 we issued to Mr. Clark 2,000,000 shares of our common stock as
compensation for the consulting services. We recorded $110,000, the value of the
common stock on the day it was issued, as a prepaid expense and additional
paid-in capital of which, during the nine months ended February 28, 2003, we
amortized to expense $91,667 as non-cash compensation.
In October 2002, we entered into a settlement agreement with a former executive
officer of the Company. As part of the agreement, we issued to him 400,000
shares of our common stock. During the nine months ended February 28, 2003, we
recorded $16,000, the value of the common stock on the day of the settlement, as
litigation expense. The shares are subject to registration and were included in
our registration statement that went effective on March 7, 2003.
In December 2001, we entered into a series of agreements with iCapital
Corporation ("iCapital") and several principals of iCapital whereby they
provided consulting services through December 2002 to help structure financing,
provide innovative capital resources, identify and assist with merger and
acquisition opportunities and advise us on other strategic decisions. In January
2002, based on meeting several performance criteria, we issued to iCapital and
the principals of iCapital 2,200,000 shares of our common stock as compensation
for the consulting services. During our previous fiscal year, we recorded
$198,000, the value of the common stock on the day it was issued, as a prepaid
expense and additional paid-in capital of which, during the nine months ended
February 28, 2003, we amortized to expense $99,000 as non-cash compensation.
8. NOTE RECEIVABLE
In June 2000, we entered into a three-year, $80,000 Secured Promissory Note
Receivable with an individual who was, at the time of the issuance of the note,
an executive officer of Patriot. On September 25, 2000, he requested and was
relieved of his duties as an executive officer and director of Patriot. The note
bears interest at the rate of 6% per annum with interest payments due
semi-annually and the principal due at the maturity of the note. The individual
pledged 100,000 shares of our common stock that he held on the date of issuance
as security for this note.
9. LEGAL PROCEEDINGS
In January 1999, we were sued in the Superior Court of San Diego County,
California by the Fish Family Trust, a co-inventor of the original ShBoom
technology. The suit also named as defendants nanoTronics and Gloria Felcyn on
behalf of the Falk Family Trust. The suit sought a judgment for damages, a
rescission of the Technology Transfer Agreement and a restoration of the
technology to the co-inventor. In March 1999, we joined with nanoTronics and
Gloria Felcyn and filed our response and cross-complaint against the Fish Family
Trust. In November 2000, the judge issued a summary ruling in favor of the
defendants on all counts. The Fish Family Trust filed an appeal in January 2001.
Management believes that it is unlikely that the appellate court will overturn
the trial court's ruling and that the resolution of the appeal process will have
no impact on our financial position, income or cash flows.
10. SUBSEQUENT EVENT
In March 2003, we entered into an Antidilution Agreement and Addendum to
Warrants with Swartz whereby we agreed to increase the number of common shares
issuable to Swartz on the exercise of warrants from 20% to 30% of
15
PATRIOT SCIENTIFIC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
any equity shares issued to parties other than Swartz or its affiliates
subsequent to March 24, 2003. The number of shares issuable by the exercise of
the warrant continues to be calculated on the first day of each calendar
quarter. In addition, we agreed to extend the expiration date to December 31,
2006 on certain warrants that were to expire previous to December 31, 2006. In
exchange for these concessions, Swartz agreed to extend the due date from April
9, 2003 to March 1, 2004 on a note for $635,276 net of accrued interest and
unreserved, for a period the lesser of 1) one year, or 2) 90 days after the date
on which our common stock exceeds $0.375 for 10 consecutive trading days,
20,007,350 shares that have been reserved for the exercise of warrants.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR
FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE
CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF
FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, "FUTURE
PERFORMANCE AND RISK FACTORS." SEE ALSO OUR ANNUAL REPORT ON FORM 10-K FOR THE
YEAR ENDED MAY 31, 2002.
Our results of operations have been and may continue to be subject to
significant variations. The results for a particular period may vary due to a
number of factors. These include:
o Our major product line has had limited revenues
o We have incurred significant losses and may continue to do so
o Our independent certified public accountants have added an explanatory
paragraph to their opinion in which they expressed substantial doubt
about our ability to continue as a going concern
o The price and the trading volume of our common stock have an effect on
the amount of capital we can raise
o We will require additional financing
o We may need to increase our authorized shares
o Large block sales of our stock may decrease the price of our stock
o We may be impacted as a result of terrorism
o Our products may not be completed on time
o The market in which we operate is highly competitive
o Protection of our intellectual property is limited; there is a risk of
claims for infringement
o Our products are dependent on the Internet and Java
o Our stock is subject to penny-stock rules
CRITICAL ACCOUNTING POLICIES
We believe that the following represent our critical accounting policies:
Property, Equipment and Depreciation
Property and equipment are stated at cost. Depreciation is computed over the
estimated useful life of three to five years using the straight-line method.
Long-lived assets and certain identifiable intangibles to be held and used by
the Company are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. We continuously evaluate the recoverability of our long-lived
assets based on estimated future cash flows from and the estimated fair value of
such long-lived assets, and provide for impairment if such undiscounted cash
flows are insufficient to recover the carrying amount of the long-lived asset.
Patents and Trademarks
Patents and trademarks are carried at cost less accumulated amortization and are
amortized over their estimated useful lives of four years. The carrying value of
patents and trademarks is periodically reviewed and impairments, if any, are
recognized when the expected future benefit to be derived from an individual
intangible asset is less than its carrying value.
Revenue Recognition
We recognize revenue on the shipment to our customers of communication products,
microprocessor integrated chips and evaluation boards. We anticipate that in the
future we will also derive revenue from fees for the transfer of proven and
reusable intellectual property components or the performance of engineering
services. We anticipate to enter into licensing agreements that will provide
licensees the right to incorporate our intellectual property components in their
products with terms and conditions that we anticipate to vary by licensee.
Generally,
17
we anticipate these payments will include a nonrefundable technology license
fee, which will be payable upon the transfer of intellectual property, or a
nonrefundable engineering service fee, which generally will be payable upon
achievement of defined milestones. In addition, we anticipate these agreements
will include royalty payments, which will be payable upon sale of a licensee's
product, and maintenance and limited support fees. We will classify all revenue
that involves the future sale of a licensee's products as royalty revenue.
Royalty revenue will be generally recognized in the quarter in which a report is
received from a licensee detailing the shipments of products incorporating our
intellectual property components (i.e., in the quarter following the sale of
licensed product by the licensee). We will classify all revenue that does not
involve the future sale of a licensee's products, primarily license fees and
engineering service fees and maintenance and support fees, as contract revenue.
License fees will be recognized upon the execution of the license agreement and
transfer of intellectual property, provided no further significant performance
obligations exist and collectibility is deemed probable. Fees related to
engineering services contracts, which will be performed on a best efforts basis
and for which we will receive periodic milestone payments, will be recognized as
revenue over the estimated development period, using a cost-based percentage of
completion method. Annual maintenance and support fees, which will be renewable
by the licensee, will be classified as contract revenue and will be amortized
over the period of support, generally 12 months.
Research and Development Costs
Research and development costs are expensed as incurred.
Stock Options
The Company applies Accounting Principles Board ("APB") Opinion 25, "Accounting
for Stock Issued to Employees," and related Interpretations in accounting for
all stock option plans. Under APB Opinion 25, compensation cost has been
recognized for stock options granted to employees when the option price is less
than the market price of the underlying common stock on the date of grant.
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," requires the Company to provide pro forma information regarding
net income as if compensation cost for the Company's stock option plans had been
determined in accordance with the fair value based method prescribed in SFAS No.
123. To provide the required pro forma information, the Company estimates the
fair value of each stock option at the grant date by using the Black-Scholes
option-pricing model.
Use of Estimates
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
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 consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED FEBRUARY 28, 2003 AND
FEBRUARY 28, 2002
Net sales. Total net sales for the third fiscal quarter ended February 28, 2003
increased 795.9% to $41,390 from $4,620 for the corresponding period of the
previous fiscal year. This increase was due to continuing buys on our matured
communication products during the current quarter even after final buys had been
substantially completed during the previous fiscal year. We are currently
expending our efforts on marketing and sale of our microprocessor technology.
The microprocessor technology generated minimal revenue during the third fiscal
quarter ended February 28, 2003. We anticipate that future revenue will be
derived from up front license fees and royalties as a result of the shift in
focus to the commercialization of our microprocessor and related technology
intellectual property. Previously we focused primarily on the sale of silicon
products. We cannot estimate when significant revenue will be generated from the
microprocessor technology.
Cost of sales. Cost of sales as a percentage of net sales decreased to 16.1% in
the third fiscal quarter ended February 28, 2003 compared to 47.5% for the
corresponding period of the previous fiscal year. This significant decrease was
due to sales during the third quarter of 2003 not having associated costs due to
our having written off the communication product inventory during the previous
fiscal year. We decided on writing off the inventory as a
18
result of not being able to find a buyer for the communication product line and
our decision to focus future company revenue on the sale of licenses and
intellectual property related to our microprocessor technology versus the sale
of microprocessor silicon and related products. The winding down of the
communication product line did not impair any of our other assets. Also, as a
result of eliminating the communication product line, overhead expenses charged
to cost of sales the previous fiscal year are now being charged to general and
administrative expenses.
Research and development expenses decreased 35.1% from $257,795 for the third
fiscal quarter ended February 28, 2002 compared to $167,230 for the third fiscal
quarter ended February 28, 2003. This decrease was due primarily to a reduction
in consulting services compared to the previous fiscal year related to the
development of a new soft core version of the microprocessor technology in the
amount of $50,458 and a reduction in payroll expense as a result of downsizing
the department by six individuals during the second and third fiscal quarters of
the previous fiscal year in an amount of $27,147.
Selling, general and administrative expenses decreased 46.1% to $382,372 for the
third fiscal quarter ended February 28, 2003 compared to $709,334 for the third
fiscal quarter of the previous fiscal year. This decrease was due to a reduction
in executive, marketing and sales personnel in the amount of $181,269 as a
result of downsizing the company during the second and third fiscal quarters of
the previous fiscal year, a reduction in consulting expenses related to investor
relations of $98,455, and a reduction of $47,827 in professional fees related to
financings and litigation.
Other expenses for the third fiscal quarter ended February 28, 2003, were
$327,778 compared to other expenses of $295,973 for the corresponding period of
the previous fiscal year. This change resulted primarily from the recognition of
non-cash interest expense of $286,775 related to the amortization of the debt
discount associated with the issuance of warrants under a secured note payable
and convertible debentures coupled with interest expense of $41,006 related to
the note and debentures for the current fiscal period compared to $283,890 and
$12,098, respectively for the same fiscal period of the previous fiscal year.
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED FEBRUARY 28, 2003 AND
FEBRUARY 28, 2002
Net sales. Total net sales for the nine months ended February 28, 2003 decreased
73.5% to $86,439 from $326,509 for the corresponding period of the previous
fiscal year. This decrease was due to the final buys on our matured
communication products having been substantially completed the previous fiscal
year. We are currently expending our efforts on marketing and sale of our
microprocessor technology. The microprocessor technology generated minimal
revenue during the nine months ended February 28, 2003. We anticipate that
future revenue will be derived from up front license fees and royalties as a
result of the shift in focus to the commercialization of our microprocessor and
related technology intellectual property. Previously we focused primarily on the
sale of silicon products. We cannot estimate when significant revenue will be
generated from the microprocessor technology.
Cost of sales. Cost of sales as a percentage of net sales decreased to 21.6% in
the nine months ended February 28, 2003 compared to 120.1% for the corresponding
period of the previous fiscal year. This significant decrease was due to minor
sales during the first three quarters of 2003 not having associated costs due to
having previously written off the communication product line inventory. A
$149,433 write-down of the inventory to zero during the previous fiscal year was
a result of not being able to find a buyer for the communication product line
and our decision to focus future company revenue on the sale of licenses and
intellectual property related to our microprocessor technology versus the sale
of microprocessor silicon and related products. The winding down of the
communication product line did not impair any of our other assets. Also, as a
result of eliminating the communication product line, overhead expenses charged
to cost of sales the previous fiscal year are now being charged to general and
administrative expenses.
Research and development expenses decreased 52.1% from $1,129,042 for the nine
months ended February 28, 2002 compared to $540,735 for the nine months ended
February 28, 2003. This decrease was due primarily to a reduction in consulting
services compared to the previous fiscal year related to the development of a
new soft core version of the microprocessor technology in the amount of $131,120
and a reduction in payroll expense as a result of downsizing the department by
six individuals during the second and third fiscal quarters of the previous
fiscal year in an amount of $397,773.
19
Selling, general and administrative expenses decreased 31.2% to $1,446,606 for
the nine months ended February 28, 2003 compared to $2,101,746 for the nine
months of the previous fiscal year. This decrease was due primarily to a
reduction in executive, marketing and sales personnel in the amount of $485,382
as a result of downsizing the company during the second and third fiscal
quarters of the previous fiscal year and a reduction of $130,579 in professional
fees related to financings and litigation.
Other expenses for the nine months ended February 28, 2003, were $943,828
compared to other expenses of $569,764 for the corresponding period of the
previous fiscal year. This change resulted primarily from the recognition of
non-cash interest expense of $837,341 related to the amortization of the debt
discount associated with the issuance of warrants under a secured note payable
and convertible debentures coupled with interest expense of $106,675 related to
the note and debentures for the current fiscal period compared to $544,958 and
$25,184, respectively for the same fiscal period of the previous fiscal year.
INCOME TAXES
Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes.
Deferred tax assets consist primarily of income tax benefits from net operating
loss carry-forwards. A valuation allowance has been recorded to fully offset the
deferred tax asset as it is more likely than not that the assets will not be
utilized. The valuation allowance increased approximately $705,000 in the first
nine months of 2003, from $13,446,000 at May 31, 2002 to $14,151,000 at February
28, 2003.
LIQUIDITY AND CAPITAL RESOURCES
In connection with their report on our consolidated financial statements as of
and for the year ended May 31, 2002, Nation Smith Hermes Diamond, our
independent certified public accountants, expressed substantial doubt about our
ability to continue as a going concern because of recurring net losses and
negative cash flow from operations.
At February 28, 2003, we had deficit working capital of $1,343,171 and cash and
cash equivalents of $30,256. We have historically funded our operations
primarily through the issuance of securities and debt financings. Cash and cash
equivalents decreased $57,852 during the nine months ended February 28, 2003 due
to net cash used in operations of $1,493,590 offset by funds generated primarily
from the issuance of convertible debentures of $1,184,500 and short term notes
payable of $180,000. The net cash used in operations was $1,493,590 for the nine
months ended February 28, 2003 compared to $2,952,871 for the corresponding
period of the previous fiscal year. The decrease in cash required in operations
was due primarily to a $1,152,729 reduction in net loss as adjusted to reconcile
to cash used in operating activities coupled with a $231,041 change in prepaid
expenses and other assets between the two periods. Cash used in investing
activities was $51,761 for the nine months ended February 28, 2003 compared to
$47,429 for the corresponding period of the previous fiscal year. Cash provided
by financing activities was $1,487,499 for the nine months ended February 28,
2003 compared to $2,545,556 for the corresponding period of the previous fiscal
year. This decrease was primarily the result of a reduced issuance of common
stock of $838,588 during the current fiscal period compared to the corresponding
period of the previous fiscal year coupled with a reduction in the sale of
accounts receivable of $142,281.
We estimate our current cash requirements to sustain our operations for the next
twelve months through February 2004 to be $2.4 million. Since we are no longer
supporting the communications product line, we are assuming that there will be
no communications product revenue. We have a note payable to Swartz Private
Equity, LLC ("Swartz") of $635,276 at February 28, 2003 which was due in April
2003 and subsequent to the end of the quarter has been extended to March 1,
2004. We also have convertible debentures with a group of investors as of
February 28, 2003 aggregating $1,605,000 and advances of $87,500 on a
convertible debenture that closed subsequent to February 28, 2003. At the option
of the debenture holders, they may purchase additional debentures up to $1
million at any time during the next two years as long as the price of our common
stock is in excess of $0.20 per share. During the first nine months ended
February 28, 2003, we obtained $114,850 from the sale of equity to several
private investors and $180,000 from short term notes entered into with a related
party. Subsequent to February 28, 2003, we obtained an additional $5,500 from
the sale of equity to a private investor and $112,500 from the issuance of
additional convertible debentures net of advances discussed above.
20
If the optional amounts under the convertible debentures are not raised in
sufficient amounts, then we may not have funds sufficient to meet our cash
requirements. In such circumstances, we may need to secure additional short-term
debt, private placement debt and/or equity financings with individual or
institutional investors. In addition, we may need to make additional cost
reductions if our cash requirements cannot be met from external sources. We
expect that the $2.4 million requirement will be provided by:
o additional debt and/or equity financings; and
o proceeds from the exercise of outstanding stock options and warrants.
In addition, we have formulated additional cost reduction plans which can be
implemented if the required funds are not obtainable. We also have remaining a
$400,000 accounts receivable factoring agreement with our bank; however, we have
no eligible accounts receivable to factor as of February 28, 2003.
We anticipate our future revenue to be derived primarily from the sale of
licenses and royalties. To receive this revenue, we may require additional
equipment, fabrication, components and supplies during the next twelve months to
support potential customer requirements and further develop our technologies.
Product introductions such as those currently underway for the Ignite I and
JUICEtechnology may require significant product launch, marketing personnel and
other expenditures that cannot be currently estimated. Further, if expanded
development is commenced or new generations of microprocessor technology are
accelerated beyond current plans, additional expenditures we cannot currently
estimate, may be required. It is possible therefore, that higher levels of
expenditures may be required than we currently contemplate resulting from
changes in development plans or as required to support new developments or
commercialization activities or otherwise.
If we are unable to obtain the necessary funds, we could be forced to
substantially curtail or cease operations which would have a material adverse
effect on our business. Further, there can be no assurance that we will be able
to timely receive shareholder approval to increase the number of authorized
shares or that required funds, if available, will be available on attractive
terms or that they will not have a significantly dilutive effect on our existing
shareholders. As such, there is substantial doubt about our ability to continue
as a going concern. The consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from our possible inability to continue as a going concern.
NEW ACCOUNTING PRONOUNCEMENTS
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No.
123." SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosures in both annual
and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
Management is evaluating the adoption of this statement.
21
FUTURE PERFORMANCE AND RISK FACTORS
THIS REPORT CONTAINS A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH REFLECT OUR
CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL PERFORMANCE. OUR
FUTURE BUSINESS, OPERATING RESULTS AND FINANCIAL CONDITION ARE SUBJECT TO
VARIOUS RISKS AND UNCERTAINTIES, INCLUDING THOSE SUMMARIZED BELOW. READERS ARE
CAUTIONED NOT TO PLACE UNDUE RELIANCE ON FORWARD-LOOKING STATEMENTS
CONTAINED HEREIN, WHICH SPEAK ONLY AS OF THE DATE HEREOF. WE UNDERTAKE NO
OBLIGATION TO PUBLICLY REVISE THESE FORWARD-LOOKING STATEMENTS, TO REFLECT
EVENTS OR CIRCUMSTANCES THAT MAY ARISE AFTER THE DATE OF THIS REPORT.
Since the business combination with Metacomp, effective December 1996, we have
segregated our operations into microprocessor, communication, and radar/antenna
product lines.
The status of these three major technologies is as follows:
o Ignite I microprocessor technology. This technology is generating minor
amounts of revenue from the sale of evaluation boards, microprocessors and
initial license fees related to the intellectual property. We have ported
the VxWorks operating system and the Sun Microsystems personalJava virtual
machine to the microprocessor.
Although we anticipate the sales of licenses and royalties from the
microprocessor technology will be our main product line, it currently
accounted for only 10% of our revenue for the nine months ended February
28, 2003.
o High-speed data communications. Revenue from this technology was generated
primarily from mature communication products that completed their life
cycles. We have decided to concentrate our efforts on the Ignite I
microprocessor technology and have discontinued the sale of communication
products subsequent to the last buys that were shipped during the previous
fiscal year. Although minimal shipments of communications product accounted
for 90% of the revenue shipped during the first nine months ended February
28, 2003, future revenue will come from our microprocessor technologies.
o Radar and antenna. We sold the gas plasma antenna technology in August
1999. Our radar technology has not generated any revenue and we have
suspended further development of this technology in order to concentrate
our resources on the Ignite I microprocessor technology.
During at least the last three years, we have focused the majority of our
efforts on the Ignite I microprocessor technology. This technology is targeted
for the embedded controller and Java language processor marketplaces.
We have experienced in the past and may experience in the future many of the
problems, delays and expenses encountered by any business in the early stages of
development, some of which are beyond our control. We have had limited operating
history, have incurred significant cumulated losses, have only recently
commenced marketing and sales of our products and have not achieved a profitable
level of operations. There can be no assurance of future profitability. We may
require additional funds in the future for operations or to exploit our
technologies. There can be no assurance that any funds required in the future
can be generated from operations or that such required funds will be available
from other potential sources. The lack of additional capital could force us to
substantially curtail or cease operations and would therefore have a material
adverse effect on our business. Further there can be no assurance that any such
required funds, if available, will be available on attractive terms or that they
will not have a significantly dilutive effect on our existing shareholders. Our
technologies are in various stages of development. There can be no assurance
that any of the technologies in development can be completed to commercial
exploitation due to the inherent risks of new technology development limitations
on financing, competition, obsolescence, loss of key technical personnel and
other factors. Our development projects are high risk in nature, where
unanticipated technical obstacles can arise at any time and result in lengthy
and costly delays or result in determination that further development is
unfeasible. There can be no assurance that the technologies, if completed,
22
will achieve market acceptance sufficient to sustain us or achieve profitable
operations.
We rely primarily on patents to protect our intellectual property rights. There
can be no assurance that patents held by us will not be challenged and
invalidated, that patents will issue from any of our pending applications or
that any claims allowed from existing or pending patents will be sufficient in
scope or strength or be issued in all countries where our products can be sold
to provide meaningful protection or commercial advantage to us. Competitors may
also be able to design around our patents.
Our common shares are traded on the OTC Bulletin Board, are thinly traded and
are subject to special regulations imposed on "penny stocks." Our shares may
experience significant price and volume volatility, increasing the risk of
ownership to investors.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We are exposed to interest rate risk on investments of our excess cash. The
primary objective of our investment activities is to preserve capital. To
achieve this objective and minimize the exposure due to adverse shifts in
interest rates, we invest from time to time in high quality short-term maturity
commercial paper and money market funds operated by reputable financial
institutions in the United States. Due to the nature of our investments, we
believe that we do not have a material interest rate exposure.
As of February 28, 2003, our notes payable and convertible debentures to
corporations and individuals totaling $2.1 million bore interest at fixed rates
of 5% to 8%. Our capital lease obligation totaling $18,120 is discounted at a
fixed rate of interest of 22.7%.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In January 1999, we were sued in the Superior Court of San Diego County,
California by the Fish Family Trust, a co-inventor of the original ShBoom
technology. The suit also named as defendants nanoTronics and Gloria Felcyn on
behalf of the Falk Family Trust. The suit sought a judgment for damages, a
rescission of the Technology Transfer Agreement and a restoration of the
technology to the co-inventor. In March 1999, we joined with nanoTronics and
Gloria Felcyn and filed our response and cross-complaint against the Fish Family
Trust. In November 2000, the judge issued a summary ruling in favor of the
defendants on all counts. The Fish Family Trust filed an appeal in January 2001.
Management believes that it is unlikely that the appellate court will overturn
the trial court's ruling and that the resolution of the appeal process will have
no impact on our financial position, income or cash flows.
ITEM 2. CHANGES IN SECURITIES
(a) We offered and sold the following common stock, either for cash or in
consideration of services rendered as indicated below, without registration
under the Securities Act of 1933, as amended, and exemption for such sales from
registration under the Act is claimed in reliance upon the exemption provided by
Section 4(2) thereof on the basis that such offers and sales were transactions
not involving any public offering. Appropriate precautions against transfer have
been taken, including the placing of a restrictive legend on all certificates
evidencing such securities. All such sales were effected without the aid of
underwriters, and no sales commissions were paid.
23
Number of Aggregate Purchase Price Per
Name Date of Sale Shares Purchase Price Share
- ---------------- ------------------ ----------- -------------- ------------------
Lyle Armstrong February 13, 2003 88,889 $3,000 $0.034 Cash
Red Oak Inc. February 13, 2003 59,259 $2,000 $0.034 Cash
Orrin K. Noling February 24, 2003 162,338 $5,000 $0.031 Cash
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits -
99.8 Certification of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
99.9 Certification of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K - NONE
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
PATRIOT SCIENTIFIC CORPORATION
Date: April 18, 2003 By: /S/ LOWELL W. GIFFHORN
-------------------------
Executive Vice President and
Chief Financial Officer
(Principal Financial and
Accounting Officer and duly
authorized to sign on behalf
of the Registrant)
24
CEO CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-Q of Patriot Scientific
Corporation (the "Issuer") for the period ended February 28, 2003, as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Jeffrey E. Wallin, Chief Executive Officer of the Issuer, certify that:
1. I have reviewed the report being filed;
2. Based on my knowledge, the report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by the report;
3. Based on my knowledge, the financial statements, and other financial
information included in the report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the issuer as of, and for, the periods presented in the report;
4. I and the other certifying officers are responsible for establishing
and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the issuer and have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the issuer, including its consolidated
subsidiaries, is made known to them by others within those entities,
particularly during the period in which the periodic reports are being
prepared;
b. evaluated the effectiveness of the issuer's disclosure controls and
procedures as of a date within 90 days prior to the filing date of the
report (the "Evaluation Date"); and
c. presented in the report their conclusions about the effectiveness of
the disclosure controls and procedures based on their evaluation as of
the Evaluation Date;
5. I and the other certifying officers have disclosed, based on their most
recent evaluation, to the issuer's auditors and the audit committee of
issuer's board of directors (or persons performing the equivalent
function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the issuer's ability to record,
process, summarize and report financial data and have identified for
the issuer's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have a significant role in the issuer's internal
controls; and
6. I and the other certifying officers have indicated in the report
whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of their most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
/S/ JEFFREY E. WALLIN
------------------------
Name: Jeffrey E. Wallin
Title: President and CEO
Date: April 18, 2003
25
CFO CERTIFICATION PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-Q of Patriot Scientific
Corporation (the "Issuer") for the period ended February 28, 2003, as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Lowell W. Giffhorn, Chief Financial Officer of the Issuer, certify that:
1. I have reviewed the report being filed;
2. Based on my knowledge, the report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered
by the report;
3. Based on my knowledge, the financial statements, and other financial
information included in the report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the issuer as of, and for, the periods presented in the report;
4. I and the other certifying officers are responsible for establishing
and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the issuer and have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the issuer, including
its consolidated subsidiaries, is made known to them by others
within those entities, particularly during the period in which
the periodic reports are being prepared;
b. evaluated the effectiveness of the issuer's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of the report (the "Evaluation Date"); and
c. presented in the report their conclusions about the
effectiveness of the disclosure controls and procedures based
on their evaluation as of the Evaluation Date;
5. I and the other certifying officers have disclosed, based on their most
recent evaluation, to the issuer's auditors and the audit committee of
issuer's board of directors (or persons performing the equivalent
function):
d. all significant deficiencies in the design or operation of
internal controls which could adversely affect the issuer's
ability to record, process, summarize and report financial
data and have identified for the issuer's auditors any
material weaknesses in internal controls; and
e. any fraud, whether or not material, that involves management
or other employees who have a significant role in the issuer's
internal controls; and
6. I and the other certifying officers have indicated in the report
whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of their most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
/S/ LOWELL W. GIFFHORN
---------------------------
Name: Lowell W. Giffhorn
Title: Exec. V.P. and CFO
Date: April 18, 2003
26