UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period _______________ to _______________
Commission File No. 0-25831
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NetWolves Corporation
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(Exact name of registrant as specified in its charter)
New York 11-2208052
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization
4002 Eisenhower Blvd, Tampa, Florida 33634-7511
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (813) 286-8644
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.0033 par value
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(Title of Class)
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 by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [X ].
The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on June 30,
2003 as reported on the NASDAQ, was approximately $13,500,000. Shares of Common
Stock held by each executive officer and director and by each person who owns 5%
or more of the outstanding Common Stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliates status is not
necessarily a conclusive determination for other purposes.
As of September 24, 2003, the Registrant had outstanding 15,867,571 shares of
Common Stock.
Documents incorporated by reference:
Part III (Items 10, 11, 12 and 13) Registrant's definitive proxy statement to be
filed pursuant to Regulation 14A of the Securities Exchange Act of 1934.
NETWOLVES CORPORATION AND SUBSIDIARIES
FORM 10-K
TABLE OF CONTENTS
PART I
ITEM 1 Business .........................................................1
ITEM 2 Properties .......................................................19
ITEM 3 Legal Proceedings ................................................20
ITEM 4 Submission of Matters to a Vote of Security Holders ..............20
PART II
ITEM 5 Market for Registrant's Common Equity and Related Stockholder
Matters ..........................................................21
ITEM 6 Selected Financial Data ..........................................21
ITEM 7 Management's Discussion and Analysis of Financial Condition and
Results of Operations ............................................23
ITEM 7aQuantitative and Qualitative Disclosure About Market Risk ........31
ITEM 8 Financial Statements and Supplementary Data ......................31
ITEM 9 Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure .............................................32
ITEM 9a Controls and Procedures .........................................32
PART III
Incorporated by reference to Registrant's definitive proxy statement to be
filed pursuant to Regulation 14A of the Securities Exchange Act of 1934.
PART IV
ITEM 14 Exhibits, Financial Statements Schedules, and Reports on Form
8-K ............................................................33
SIGNATURES ............................................................34
PART I
ITEM 1. BUSINESS
This Annual Report on Form 10-K, the exhibits hereto and the information
incorporated by reference herein contain "forward looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended (the
"Securities Act") and Section 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), and such forward looking statements involve risks
and uncertainties. When used in this report, the words "expects", "anticipates",
"estimates" and similar expressions are intended to identify forward looking
statements. Such statements are subject to risks and uncertainties that could
cause actual results to differ materially from those projected. These risks and
uncertainties include those discussed below under "Risk Factors" and those
discussed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations" or incorporated by reference herein. NetWolves
Corporation undertakes no obligation to publicly release any revisions to these
forward looking statements to reflect events or circumstances after the date
this Report is filed with the Securities and Exchange Commission or to reflect
the occurrence of unanticipated events.
Overview
We operate primarily in three distinct segments. The first is the technology
segment, consisting of NetWolves Technologies Corp. (NWT), which is engaged in
network and security infrastructure. The second segment is the
telecommunications segment, consisting of Norstan Network Services, Inc. (NNSI),
a managed communication services provider. The third segment is the management
and consulting segment in the automotive industry through our subsidiary, TSG
Global Web, Inc. Because its operations will not be material to us on a going
forward basis, we are not providing any additional business information on this
segment.
We have achieved an offering of managed products and services that meet the
necessary requirements for organizations to move off of expensive private data
networks while attaining the benefits and flexibility of public data network.
Additionally, our proprietary technology provides a high level of security
through its integrated approach to management, monitoring and interoperability
for small and medium remote enterprise locations (locations with less than 300
network users). We offer products and services that provide complete system
solutions to organizations needing cost effective network security features
(firewall, virtual private networking, routing, intrusion detection, content
filtering, email, etc.) delivered on low cost commodity hardware with
Internet-based expansion capabilities. Our patent pending system technology
enables organizations to achieve corporate Information Technology (IT) and
e-business initiatives through the deployment of easily installable perimeter
office security platforms, coupled with secure remote monitoring and management
("SRM2 TM") system. SRM2 TM provides centralized management capabilities for
hundreds or thousands of remote locations without risking networking integrity
by opening an administrative port on the remote device through which outsiders
can gain access to information on the system. We also provide cost-effective,
value-added expansion technologies such as intelligent fail-over, which means
that if one circuit for gaining access to information fails, the system would
automatically switch to an alternative circuit.
NNSI, acquired in July 2002, manages multiple source (any combination of network
providers such as MCI Worldcom, Sprint, AT&T, Covad, etc.) voice (long distance
and local) and data (Internet) services throughout the United States.
Additionally, NNSI has the required Federal Communications Commission (FCC)
licensing necessary to aggregate all services provided to a single customer on a
single bill. For the year ended June 30, 2003, NNSI's net sales were
approximately $20,350,000. As a result of this acquisition, we expect to
increase our managed security services revenues by selling into NNSI's existing
customer base.
Background
NetWolves, LLC was an Ohio limited liability company formed on February 13,
1998, which was merged into Watchdog Patrols, Inc. ("Watchdog") on June 17,
1998. Watchdog, the legal surviving entity of the merger, was incorporated under
the laws of the State of New York on January 5, 1970. As a result of the merger
and subsequent sale of Watchdog's existing business, Watchdog changed its name
to NetWolves.
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NWT Products and Services
The NetWolves Security Suite ("NSS") and WolfPac Security Platforms offer
sophisticated, yet easy-to- administer devices for securely connecting people
and offices to the Internet by combining a wide range of functionality and
communications choices. This functionality includes Internet access, firewall
security, web access control, e-mail, IP routing, web server, caching server,
and file sharing in an easy-to- configure integrated software and hardware
solution. NetWolves' WolfPac Security Platforms work with a variety of access
methods to the Internet including North American T1/56K, European E1 standards,
ISDN lines, DSL, cable or satellite modems.
When NetWolves' WolfPac Security Platform resides between a company's local-area
network and an Internet service, it provides shared Internet access for a few or
up to hundreds of users. The Internet provides one of today's most
cost-effective means of communication, and through use of the WolfPac Security
Platforms, an organization with many locations can create numerous intercompany
online communities.
The WolfPac Security Platforms also contain advanced firewall security systems
that enable businesses to implement company-wide network security policies,
protecting a company's valuable data assets from unauthorized users. The WolfPac
Security Platforms cost substantially less than the purchase of its
functionality found via the traditional, integrated or patchwork approach by
using individual products serving only one function. Each application within the
server is designed to work together using integrated hardware and software with
a common interface. This facilitates expansion and support of the converging
voice and data information.
Keeping data secure is one of the main functions of our WolfPac Security
Platform. Companies significantly reduce private data network costs by
installing VPN (virtual private network) applications and utilizing the Internet
to maintain data privacy, which is accomplished through the use of a protocol
and security procedures, sending encrypted data over the Internet. The primary
benefit of the VPN is providing the client communication services at
significantly reduced costs by utilizing public data network rather than private
data network. Businesses are implementing a similar process called client or
remote VPN, allowing employees to communicate with their company's network at
any time from outside the workplace, using a laptop or desktop computer and
client VPN software. This cost-effective solution makes businesses more
productive by giving remote users secure access to corporate resources.
With our Intelligent Fail-over solution, the WolfPac Security Platform has the
ability to continuously monitor application level performance. Simultaneously,
the WolfPac Security Platform monitors performance levels of the VPN tunnel that
pass through the primary interface by conducting scheduled interval tests. If
the primary interface fails or the VPN tunnel does not meet established
performance criteria, the WolfPac Security Platform will automatically fail over
to a secondary interface and permit the data to reach its intended destination,
securely and reliably using RIP, OSPF or BGP protocols.
The World Wide Web is a broad universe of network-accessible information. To
enable employers to keep employees focused on business issues, most WolfPac
Security Platforms include Web Access Control as an optional feature. Using Web
Access Control, a client's system administrator can block or permit access to
the Internet and specific web sites. If a business owner or teacher needs to
enforce or implement an acceptable usage policy to keep employees productive or
students from inappropriate sites, this is accommodated through Web Access
Control.
E-mail allows electronic messages to be delivered over the Internet to specific
individuals and groups. It is one of the fastest, most cost-effective ways to
deliver messages, documents, web pages, and secured information. Many WolfPac
Security Platform models include as a standard or an optional feature an
integrated mail server that supports a virtually unlimited number of accounts.
WolfPac Security Platforms incorporate an Internet Protocol (IP) router. The
Internet Protocol is the language the Internet "speaks" in order to communicate.
A router is a device, or in some cases, software that determines the next
network point to which a packet of data should be forwarded toward its
destination. The router is connected to at least two networks and decides which
way to send each information packet based on its current understanding of the
state of the networks to which it is connected.
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More advanced WolfPac Security Platforms incorporate a web caching server, which
stores web pages visited by users. This speeds up browsing and optimizes
Internet services by allowing the user to see previously visited web pages after
only one or several letters of the page.
Typically, using a web browser, a user attempting to access information on the
Internet performs a Domain Name System (DNS) lookup. DNS is the Internet service
that converts understandable web site names (for example www.netwolves.com) into
computer readable web site numbers or IP addresses (IP numbers are meaningful
only to those who need to know them and not to the average web user). By
integrating a DNS caching server directly into the WolfPac Security Platform,
Internet traffic is reduced and web site address look-up time is faster,
therefore increasing the overall performance of the system.
A Dynamic Host Configuration Protocol (DHCP) server integrated into the WolfPac
Security Platform allows for easy management when adding computers to the
existing company network. It saves time and allows network administrators to
work more efficiently, eliminating the need for a person to travel to a remote
location to configure a new computer with an IP address.
A web based Administrative Interface (AI) allows the network administrator to
configure the various subsystems of the NSS. The NSS becomes completely
transparent to the Internet user. Likewise, because the NSS is easy to set-up,
it will feel transparent to the administrator. This is particularly true should
changes be required following initial installation. Since all administration of
the NSS is performed through a web browser, the administrator can work from any
workstation on the LAN.
Features of NetWolves Security Suite
Our security products offer the following standard features:
-- Securely connects any number of users in a small geographic area (LAN)
simultaneous to the Internet through a dedicated connection.
-- Hierarchical caching, which are rules that tell a computer to look for
the data stored locally before accessing the Internet for data, gives
the WolfPac Security Platform more efficient web viewing and greater
ability to transfer data from one file to another.
-- Any number of users can send and receive e-mail individually, while
sharing one Internet service provider account.
-- A firewall protects the LAN from Internet-borne attacks.
-- An advanced network address translation module allows the creation of
powerful address translation rules for greater firewall flexibility.
-- Files that store events for review at a later date ensure appropriate
use of Internet resources.
-- Scalability allows Internet usage to grow as a company expands.
-- Can be used as a stand-alone firewall to protect the resources of a
private network from users outside on a public network.
-- Easily manage internal and external proxy services.
Optional Features of NetWolves Security Suite Our Security Suite also offers the
following optional features:
-- Web access control allows the network administrator to effectively
block or deny access to the Internet and specific web sites.
-- The Virtual Private Networking (VPN) module provides a process for
encrypting data for secure transmission over public networks and
supports Internet Key Exchange (IKE) and IPSec (a security protocol).
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-- Intrusion Detection System (IDS) is a real time, network-based system
designed to detect, report, and terminate unauthorized activity
throughout the network.
-- Intelligent Failover with virtual redundant router protocol (VRRP)
establishes a wide area network (WAN) connection on a WolfPac Security
Platform slave if WAN connection on WolfPac Security Platform master
is lost or fails to meet minimum VPN performance criteria.
-- NetMetrics provides a means for measuring two performance parameters:
the time required to load a single web page from the Internet, and the
time it takes to send an email to a specified account and receive a
reply from that same account. Net Metrics also provides the monitoring
mechanism within Intelligent Failover.
Firewall and Security Functions
We believe that security is an essential element of any Internet connectivity
solution. For this reason, our WolfPac Security Platform includes high-end
firewall security protection, without requiring the purchase of additional
components.
Our platforms are designed to protect a company's private data and systems from
outside intruders with its firewall security system, incorporating three
separate firewall technologies:
-- Stateful packet filters verify that all incoming data packets coming
from the Internet have been requested by an authorized user on the
LAN.
-- Proxy applications prevent unauthorized Internet applications from
accessing the LAN.
-- Network Address Translation ("NAT"), which is a conversion of public
addresses to and from private addresses, makes the network invisible
to outside Internet users by hiding the internal network's addresses
of each sender or receiver of information.
-- All packets of data entering the WolfPac Security Platform from the
Internet are first checked for validity against a series of stateful
packet filters. Data is then forwarded to proxy applications that
further inspect the contents of the packets for potential security
violations. If the data is determined to be valid by both the stateful
packet filters and proxy applications, it is allowed to enter the
secure LAN.
-- WolfPac Security Platforms are designed with fully configurable
firewalls and network address translation rules that give the network
administrator greater flexibility in allowing or denying incoming and
outgoing data.
Secure Remote Management and Monitoring Services ("SRM2 TM")
Under our SRM2 TM umbrella, product architecture planners believe that Managed
Security Services (MSS) will play an even more important role in future security
plans. Since a customer base already exists within our Platforms, the
security-monitoring infrastructure will significantly reduce costs and provide
effective and economical network managed security services to our clients.
SRM2 TM is comprised of the following product subsystems:
-- SRM2 TM Monitoring & Notification provides monitoring, notification,
paging and alarming capabilities of remote WolfPac Security Platforms.
In addition, the firewall status, VPN tunnel status and Administrative
Interface configuration status of all remote end points are monitored
and logged.
-- SRM2 TM Management and Configuration manages and configures remote end
points individually or by groups, including complete operating system
upgrades. Remote end points are capable of failover to an alternate
SRM2 TM server in the event that the primary server is inaccessible.
This service also allows user access to specific information about
remote Platforms (individually or by groups) via a monitoring console.
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Specific information includes firewall status, the number of active
VPN connections, traffic statistics, intrusion detection data,
activity logs, and administrative Interface configuration data.
-- SRM2 TM Intrusion Detection provides host and network based intrusion
detection capabilities for remote WolfPac Security Platforms. The IDS
information is then transferred from each remote end point to a
database, where it can be accessed by the monitoring console.
-- SRM2 TM Anti-Virus stipulates both protection (security) of remote
WolfPac Security Platforms from hardware glitches, software bugs and
any attempts to sabotage client data, and damage control through
immediate detection. Activity logs are transferred from each remote
end point to a database, where it can be accessed by the monitoring
console.
-- SRM2 TM VPN provides the network manager with the ability to connect
separate business locations, using the IP infrastructure rather than
through private mediums such as leased lines.
-- Security Policy Management is the process by which the client's
security policy is created, defined, or redefined to reflect security
management processes enabled by advent of our products and services.
This policy reflects particularly the rules governing remote end point
security and the processes guiding how security platforms are managed
and configured to ensure specified protections.
-- Firewall Policy Management is the process by which the client's
firewall security policy is created to reflect the methods by which
NetWolves firewall platforms are to be utilized to ensure network
protection. This policy sets forth the rules governing remote end
point security and the processes guiding how the firewall platform is
utilized to manage and configure the client network.
NNSI Products and Services
NNSI provides multiple source long distance services and related consulting and
professional services throughout the United States. NNSI provides voice services
consisting of switched and dedicated inbound/outbound long distance, travel
cards, conference calling and local services, and data services consisting of IP
dedicated and dial-up services, broadband services, frame relay and private
line.
NNSI's methodology includes completing a thorough needs assessment to understand
the current infrastructure and future requirements of the prospective customer.
Upon completion of the assessment, NNSI designs a custom, unique and flexible
solution utilizing multi-carrier alternatives under one contract, one invoice
and support structure. Its account teams, strategic industry relationships and
robust information and billing system allow NNSI to deliver a single source
solution utilizing the best of what is available to solve the customer's
communication and network needs.
Voice Services
-- Switched and dedicated inbound/outbound long distance
-- Travel cards
-- Conference Calling
-- Local services
Data services
-- IP Dedicated and Dial-up Services
-- Broadband Services (including DSL, Cable and Satellite)
-- Frame Relay
-- Private Line
Integrated Information and Billing Systems
NNSI's consolidated billing platform offers maximum flexibility in managing
networks by providing the information needed in a format most useful to a
customer's organization. This results in immediate and long-term cost savings
for the customer. The end result is one easy-to-read invoice that streamlines
your telecommunication expenses.
5
Production Process
The process used to produce our technology products begins with hardware
configuration, installing the appropriate version of our software, configuring
client-specific software components, followed by a unit testing process.
Raw/prefabricated materials, components, and subassemblies required for
production include motherboards, CPU's, cases, Ethernet cards, network
communication cards, hard drives, memory, CPU fans and power supplies. We
believe that these materials are available from several companies and that
alternative sources of supply are currently available.
Licensing and Intellectual Property
We consider certain features of our products, including their methodology and
technology, to be proprietary. We rely on a combination of trade secret,
copyright and trademark laws, contractual provisions and certain technology and
security measures to protect our proprietary intellectual property. We generally
enter into confidentiality agreements with our employees, consultants, business
partners and major customers. We own copyrighted works of authorship in computer
programs, including, but not limited to, portions of the FoxOS (operating
system), products related to FoxOS, and various proprietary enhancements to
publicly available open source system software; as well as traditional media,
including, but not limited to, marketing materials, documentation and white
papers. Applications for registration of those copyrights have been filed with
respect to some of these works, and further applications are expected to be
filed in the near future.
On June 21, 2000, we filed a patent application with the U.S. Patent and
Trademark Office for technology that provides secure, centralized remote
management and monitoring of networks using the Internet. This SRM2 TM system
has enabled us to expand the use of its technology to Fortune 1000 organizations
with multiple worldwide locations such as General Electric.
Notwithstanding our efforts to protect our proprietary rights, existing trade
secret, copyright, and trademark laws afford only limited protection. Despite
our efforts to protect our proprietary rights and other intellectual property,
unauthorized parties may attempt to copy aspects of our products, obtain and use
information that we regard as proprietary or misappropriate our copyrights,
trademarks, trade dress and similar proprietary rights. In addition, the laws of
some foreign countries do not protect proprietary rights to as great an extent
as do the laws of the United States. Our means of protecting our proprietary
rights may not be adequate. In addition, our competitors might independently
develop similar technology or duplicate our products or circumvent any patents
or our other intellectual property rights.
We do not intend to sell or transfer title of our products to our clients,
though this structure may change as we expand our operations. We intend to
license products pursuant to licensing and maintenance agreements for which
extended payment terms may be offered. In the case of extended payment term
agreements, the customer is contractually bound to equal monthly fixed payments.
In the case of extended payment term agreements, maintenance may be bundled for
the length of the payment term. Thereafter, in both instances, the customer may
purchase maintenance annually.
In connection with the acquisition of NNSI, we obtained Certificates of Public
Convenience and Necessity, which enable NNSI to resell long distance services
within the state obtained. NNSI is subject to regulation from the Public Utility
Commissions in each specific state.
Manufacturing
We currently use a hybrid manufacturing and assembly model to produce our
internet security products. The enclosures for our WolfPac Security Platforms
are manufactured by Florida Metal Stamping, Inc. ("FMS") of Largo, Florida. FMS
is an ISO 9002 certified manufacturer, fabricator and assembler of enclosures
for major electronic systems manufacturers. SED Corp. ("SED") of Tucker, Georgia
supplies the motherboards and most other electronic components for our WolfPac
Security Platforms. Electronic components and custom enclosure components for
significant future builds will be outsourced to one or numerous manufacturers.
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While we have no long-term agreement with FMS or SED, we believe that
alternative manufacturers and suppliers are available in the event we seek to
change or expand upon manufacturers of our products since the components used
for assembly are commoditized.
General Electric Agreement
On June 29, 2000, General Electric Company ("GE") entered into a six year
agreement with us for the master purchase, license and support services of
NetWolves' security, remote monitoring and configuration management system. GE,
after extensive due diligence in looking for the all-in-one small office
solution for network management, interconnectivity and security, chose our
products for deployment throughout their enterprise.
The contract is for a term of six years and can be extended for four additional
one-year periods unless prior notice of non-renewal is given by either party as
defined in the agreement. The contract provides for us to receive a fee upon
shipment of each unit, and an additional one-time configuration fee.
Additionally, upon shipment of each unit, GE has the right to purchase from us
support service and annual monitoring and management service on an annual basis
("Annual Services"). The Annual Services shall continue at the same rate per
annum, at GE's discretion, provided that GE requests such services at any time
during a subsequent year. GE is required to pay fees for Annual Services in full
from the expiration date of the prior year period and revenue generated from the
Annual Services is recognized over the service period.
GE has commenced the process of using our products for interconnectivity of its
worldwide offices. Our products enable GE's offices to interact with each other,
utilizing NetWolves advanced firewall security. NetWolves believes that this
agreement further validates our technology and innovations within the firewall
and network security markets. Network security is one of the most formidable
challenges facing Fortune 1000 companies, and with its new SRM2 TM system,
NetWolves can offer the appropriate solutions.
On September 26, 2002, we entered into a three year agreement with General
Electric Consumer Finance, the consumer financing arm of the General Electric
Company. The agreement covers the use of our internet security technology by
General Electric Consumer Finance in all of its offices worldwide, encompassing
36 countries. The first rollouts of our products have been completed in Germany,
are underway in Japan and are being scheduled for Australia.
NNSI Customers
NNSI currently works with more than 400 customers, ranging from start-up
organizations to large well- established corporations. Approximately 32% of the
sales in our telecommunications segment were made to Swift Transportation during
the year ended June 30, 2003, and Swift continues to be the largest customer for
these products. We expect that Swift will remain the major customer for our
telecommunications products and represent a significant percentage of its
revenues for the next six to twelve months. If we lose Swift as a customer, or
if Swift fails to utilize substantial quantities of our services, our revenues
will be adversely affected, efforts to expand the markets for these services may
be impaired or delayed, and we may not achieve profitability.
Business Partners
Our business partners include the following companies:
-- Sprint
-- MCI WorldCom
-- Broadwing Communications
-- BellSouth
-- SBC Communications
-- Qwest (subagent to Global Communications)
-- Covad
-- NCR
A major portion of our revenues during the year ended June 30, 2003 were derived
from resales by NNSI of telecommunications services. We depend on two major
suppliers - - Sprint and MCI, for the telecommunications services NNSI provides
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to its customers. Although there are other sources of telecommunications
services, other providers do not offer exactly the same types of services,
coverage area or reliability of service. As a result, the loss of services from
one or both of these suppliers could cause disruptions and delays to our
customers, drain the resources of our personnel, cause a loss of customers or
business volume, and substantially decrease our revenues.
Competition
Current and potential competitors in our markets include, but are not limited
to, the following, all of whom sell world-wide or have a presence in most of the
major markets for such products: security appliance suppliers such as Watchguard
Technologies, Inc., NetScreen Technologies, Inc., SonicWALL, Inc., enterprise
firewall software vendors such as Check Point Software and Axent Technologies;
network equipment manufacturers such as IBM, Cisco Systems, Lucent Technologies,
Nortel Networks, 3COM and Nokia; computer or network component manufacturers
such as Intel Corporation; operating system software vendors such as Microsoft
Corporation, Novell, Inc. and Sun Microsystems, Inc; and carriers such as MCI
WorldCom, AT&T and Sprint. We expect competition to intensify as more companies
enter the Internet security market and compete for market share. In addition,
companies currently in the server market may continue to change product
offerings in order to capture further market share. Many of these companies have
substantially greater financial and marketing resources, research and
development staffs, manufacturing and distribution facilities than us. There can
be no assurance that our current and potential competitors will not develop
products that may or may not be perceived to be more effective or responsive to
technological change than ours, or that current or future products will not be
rendered obsolete by such developments. Furthermore, increased competition could
result in price reductions, reduced margins or loss of market share, any of
which could have a material adverse effect on our business operating results and
financial condition.
We believe that an important competitive factor in our technology business
segment is the cost effective integration of many services in a single unit. In
this regard, we believe that we compare favorably to our competitors in the
markets we serve in price and overall cost of ownership, including
administrative and maintenance costs. However, equally important are other
factors, including but not limited to, product quality and scope of performance,
product reliability, availability, upgradability, and technical service and
support. Our ability to compete will depend upon, among other factors, our
ability to anticipate industry trends, invest in product research and
development, and effectively manage the introduction of new or upgraded products
to our existing and future customers.
In our telecommunications business segment, we compete at the Fortune 2000 level
specifically focusing on companies with multiple locations with complex voice
and data needs. Our primary advantage over our competition is that we are large
enough to manage large, complex corporate networks, and yet small enough to stay
agile or quick to change our solutions as the market and the customers needs
change. Most organizations in our market space are facilities based having a
large investment in technology with a high carrying cost. Since we are a
non-facilities based provider, our overhead remains small and we can quickly
change to meet changing technology.
Sales and Marketing
Our marketing and sales strategy is to position ourselves as a leading IP
network solutions provider. To accomplish this objective, we intend to enter
into multi-national reseller agreements with system integrators, Internet
Service Providers (ISP's), Competitive Local Exchange Carriers (CLEC's), and
Incumbent Local Exchange Carriers (ILEC's),
In addition, our direct sales force is focused on opening large and medium scale
domestic and multi- national opportunities for firewalls; caching, hosting, and
email servers, web access filtering systems, Intrusion Detection and anti-virus.
Our NNSI subsidiary also actively solicits a broad range of communication
carrier services (leased line and frame relay circuits, internet access, long
distance, and other broadband circuits) from mid-market and large-scale
prospects. Our direct and channel sales approach allows us to take advantage of
the personal business contacts of our senior stockholders and executive
management team while building channel sales potential in the large, medium and
low end of the market.
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We also seek to enter into agreements and partnerships with providers of
services, software and hardware products that enhance the functionality of our
product lines. This functionality is geared to enhance our security system's
functionality and advance our entry into markets that include education,
finance, medical, legal, petroleum, government, travel, hotel, entertainment and
auto industries. Agreements and partnerships currently under consideration
include applications for Intrusion Detection, web access content filtering and
anti-virus detection and deletion.
We intend to recruit sales representatives and sales engineering consultants in
two North American regional areas; Eastern and Western United States, managed
initially by our Director of Sales and Marketing and by two Regional Managers in
the future. Field Sales Representatives are currently in place in New York,
Tampa, Phoenix, and Minnetonka. They are supported by an in-house telemarketing
organization based in Tampa, Florida and by customer support facilities based in
Tampa and Minnetonka. Our sales engineers work closely with our field sales
representatives and perform important pre and post- sales functions, including
systems analysis, product demonstrations, pilot evaluation program configuration
and implementation, and customizing solutions for various end user and value
added reseller clients.
We have implemented marketing initiatives to support sales and distribution of
our products and services and to communicate and promote corporate initiatives
and direction. Our sales and marketing management employees are responsible for
our award winning web site, product white papers and sales collateral programs
development, lead generation programs, customer support, systems analysis,
systems evaluation and pilot programs, and market awareness of NetWolves and its
products. Marketing programs include public relations, product seminars,
industry conferences and trade shows, coop advertising, telemarketing and direct
mail. Our marketing employees also contribute to both the product development
direction and strategic planning processes by providing product/market research
and conducting focused competitive product surveys.
We have devoted our marketing and sales resources to attract competent and
professional marketing and sales management personnel, define current and long
range market needs, develop security products that exceed the defined market
requirements, generate leads with multi-national business enterprises, establish
pilot security product evaluations with Fortune 1000 organizations, and close
sales after successful pilot evaluation programs.
Engineering and development
The Internet and the computer hardware and software industry are characterized
by rapid technological change, which requires ongoing development and
maintenance of products. It is customary for modifications to be made to
products as experience with their use grows or changes in manufacturer's
hardware and software are required.
Our engineering and development group is comprised of a core team of engineers
who specialize in different areas of security and product development.
NetWolves' team has experience in a variety of industries, including information
security, designing networking protocols, building interfaces, designing
databases, and computer telephony. Their expertise is used in the design of our
core products and seeking enhanced functionality to meet future customer needs.
As of September 15, 2003, our engineering and development group consists of 13
employees. We seek to recruit highly qualified employees and our ability to
attract and retain such employees will be a principal factor in our success in
achieving and maintaining a leading technological position.
Engineering and development expenses were approximately $1,596,000, $1,703,000
and $1,893,000 exclusive of capitalized software development costs of
approximately $0, $73,000 and $116,000 for the years ended June 30, 2003, 2002
and 2001, respectively. We intend to increase our investment in product
development and believe that our future product offerings will depend, in part,
on our ability to develop, manufacture and market new products and enhancements
to existing products on a cost-effective and timely basis.
Employees
As of September 15, 2003, we employed approximately 69 full-time employees (4 of
which are covered by employment agreements). Approximately 13 of these employees
are involved in engineering and development, 24 in sales and marketing, 8 in
finance and 24 in general administration and operations. In addition, we
9
have retained independent contractors on a consulting basis who support
engineering and marketing functions. To date, we believe we have been successful
in attracting and retaining skilled and motivated individuals. Our success will
depend in large part upon our continued ability to attract and retain qualified
employees. We have never experienced a work stoppage and our employees are not
covered by a collective bargaining agreement. We believe that we have good
relations with our employees.
RISK FACTORS
You should carefully consider the factors described below and other information
contained in this report. The risks and uncertainties described below are not
the only ones we face. Additional risks and uncertainties not presently known to
us, which we currently deem immaterial or which are similar to those faced by
other companies in our industry or business in general, may also impair our
business operations. If any of the following risks actually occurs, our
business, financial condition or results of operations could be materially and
adversely affected. In such case, the trading price of our common stock could
decline, and you may lose all or part of your investment. This report also
contains forward-looking statements that involve risks and uncertainties. Please
refer to "Forward-Looking Statements" included elsewhere in this report.
Financial Risks
We have incurred losses since inception and may never be profitable, which could
result in a decline in the value of our common stock and a loss of your
investment.
We sustained net losses of $6,410,574, $11,630,610 and $20,631,492 for our
fiscal years ended June 30, 2003, 2002 and 2001, respectively. We continue to
sustain losses during the current fiscal year, and we cannot guarantee that we
will achieve profitability in the future. We recognized net operating revenues
of $21,159,459, $738,748 and $1,425,138 for our fiscal years ended June 30,
2003, 2002 and 2001, respectively. Norstan Network Services, Inc. (NNSI), which
we acquired in July 2002 has had profitable operations for its most recent
fiscal year, and revenue of approximately $20,350,000 for the year ended June
30, 2003. Although this acquisition has increased our operating revenue on a
consolidated basis, NNSI revenue has not been sufficient to offset expenses of
our other operations. We expect to make substantial additional expenditures in
order to develop the markets and distribution channels for our Internet security
solutions business, expand support functions as we increase our marketing and
sales efforts, and invest in continuing research and development. At the same
time, because our Internet security solutions business is relatively new, we are
subject to all the general risks inherent in, and the difficulties,
complications, delays and expenses typically involved in growing a business.
Consequently, we expect that operating losses may continue.
If we do not raise substantial additional capital in amounts sufficient to fund
operating expenses, we may be forced to discontinue certain operations or may be
unable to continue as a going concern.
In order to develop our Internet security solutions business to the point where
it is generating operating profits and cash flows from operations, we require
substantial funds. We believe that some of our requirements will be met by
anticipated operating profits of NNSI and funds recently raised through equity
offerings. Our exact requirements will depend, in part, on the magnitude of
NNSI's operating profits, if any, and the level of orders received and products
delivered under our agreements with General Electric and other third parties. We
have successfully raised approximately $14,700,000 in net proceeds from equity
offerings since July 1, 2002 through September 25, 2003, and intend to raise
additional funds, if necessary, through private offerings of equity securities
or through debt financing. However, no assurance can be given that proceeds from
these offerings will satisfy all of our requirements. Even though we have raised
enough capital to meet our anticipated requirements for the next 12 months, we
cannot make assurances that we will be able to develop our business to the point
of generating consolidated net operating profits and cash flows from operations.
If funds from these sources are not sufficient to offset operating expenses, we
plan to institute cost-saving measures that will not only reduce overhead, but
also curtail operations in certain business segments. We cannot assure you that
such measures, if implemented, will be sufficient to offset all of our operating
expenses. If the capital we raise from sales of securities is not sufficient to
10
fund the balance of our operating expenses after we implement these cost-cutting
measures, there is substantial doubt that we will be able to continue as a going
concern.
Our issuance of equity securities to raise capital may be on terms that are
detrimental to existing shareholders.
In order to meet our capital requirements, we may continue to offer equity
securities for sale, and shareholders will experience additional dilution. Any
new equity securities we issue may have rights, preferences or privileges senior
to those of existing holders of common stock. See "Future sales of a large
number of shares of our common stock may cause our stock price to decline."
Risks Related to Our Business
If we do not succeed in establishing effective sales, marketing and distribution
systems, we will not expand our business sufficiently to achieve profitability.
To increase market awareness and expand our Internet security solutions
business, we must establish effective sales and marketing systems and
distribution channels for our products. To date, we have a limited number of
personnel devoted to sales of these products, and have made limited sales,
primarily based on efforts by members of management. Those sales, to the General
Electric Company and its affiliate, General Electric Consumer Finance (together,
"GE"), demonstrate the value of our products to potential markets. We intend to
expand our customer base through sales of our security solutions products to
NNSI's established customers who fall within our target markets. Our future
profitability depends, in part, on increasing sales of our Internet security
solutions business.
The loss of the main customer of our telecommunications segment will adversely
affect our telecommunications revenues.
Approximately 32% of the sales in our telecommunications segment were made to
Swift Transportation for the year ended June 30, 2003, and Swift continues to be
the largest customer for these products. We expect that Swift will remain the
major customer for our telecommunications products and represent a significant
percentage of our revenues for the next six to twelve months. If we lose Swift
as a customer, or if Swift fails to order substantial quantities of our
products, our revenues will be adversely affected, efforts to expand the markets
for these products may be impaired or delayed, and we may not achieve
profitability.
The long sales and implementation cycles for our security solutions may delay
expansion of our markets.
An end user's decision to purchase Internet security solutions typically
involves a significant commitment of resources and a lengthy evaluation and
product qualification process by a number of people in different locations. The
nature of these products and services requires us to spend considerable time
educating the end user and providing information regarding their use and
benefits. Budgetary constraints and the need for multiple approvals within an
enterprise may also delay purchasing decisions by prospective customers. As a
result, the time between initial contact with a potential customer and
conclusion of a sale of these products typically comprises a period of several
months and is subject to delays, many of which are beyond our control. We hope
to shorten the sales cycle for these products by leveraging NNSI's relationships
with its existing customers to introduce them to our Internet security
solutions.
We cannot assure you, however, that we will be successful in reducing the sales
cycle for these products in the future or that any reduction will be substantial
enough to have a material impact on our revenues or results of operations. If we
are successful in expanding our markets, we expect a lessening of the impact of
the long sales cycle on our revenues and operating results.
We will not achieve profitability if we cannot compete successfully for sales of
our internet security products and services.
Success of our Internet security solutions business depends upon our ability to
gain market share for our products. Our target markets are the small to medium
sized companies that demand both a connection to the Internet and to their
11
business partners, and enterprise customers, such as government agencies and
educational institutions. If we fail to penetrate our target markets and/or book
substantial sales of our products, our operations and prospects will suffer.
Gaining market acceptance will depend, in part, upon our ability to demonstrate
the advantages of our products over technology offered by other companies. See
"Risk Related to Our Industry - If we are unable to compete successfully in the
markets for Internet Security Solutions and telecommunications services, we may
not increase our revenues or achieve profitability."
The loss by NNSI of its two main suppliers of telecommunications services would
have a substantial, negative effect on our revenues.
A major portion of our revenues during the year ended June 30, 2003 were derived
from resales by NNSI of telecommunications services. We depend on two major
suppliers - - Sprint and MCI, for the telecommunications services NNSI provides
to its customers. Although there are other sources of telecommunications
services, other providers do not offer exactly the same types of services,
coverage area or reliability of service. As a result, the loss of services from
one or both of these suppliers could cause disruptions and delays to our
customers, drain the resources of our personnel, cause a loss of customers or
business volume, and substantially decrease our revenues.
Our Internet security solutions are complex and may contain undetected errors or
result in failures that could inhibit or delay market acceptance of our
products, impede our growth and increase our operating costs.
Our Internet security solutions are quite complex and may contain undetected
errors or bugs or experience failures. In particular, the Internet network
environment is characterized by a wide variety of standard and non-standard
configurations and errors, failures and bugs in third party platforms and
applications that make pre-release testing for programming or compatibility
errors very difficult, time- consuming and expensive. Furthermore, we believe no
amount of testing can guarantee that errors, failures or bugs will not be found
in new products or releases which we ship commercially. Product failures, if
they occur, could result in our having to replace all affected products without
being able to book revenue for the replacements, or we may be required to refund
the purchase price of defective products. Any of these errors, bugs or failures
discovered after commercial release could require significant expenditures of
capital and resources, and cause interruptions, delays or cessation of service
to our customers, and result in:
-- adverse publicity and damage to our reputation;
-- failure to achieve or delay in achieving market acceptance;
-- loss of customers;
-- loss or delay in revenues;
-- diversion of development resources;
-- increased service and warranty costs;
-- costly litigation; and
-- diversion of management's attention and depletion of financial and
other resources.
We may have to defend lawsuits or pay damages in connection with any alleged or
actual failure of our Internet security solutions or telecommunications
services, which could significantly increase our operating costs and have a
material adverse effect on our results of operations and financial condition.
Because we provide and monitor network security and protect confidential and
potentially valuable information from transmission errors, viruses and security
breaches, we could face claims by customers or third parties for product
liability, tort or breach of warranty. Anyone who circumvents our security
systems could misappropriate confidential information or other property of our
customers or interrupt their operations. In this event, we could be forced to
defend lawsuits by customers and third parties. In addition, we may face
liability for breaches caused by faulty installation of our products. Although
we attempt to reduce the risk of losses from claims through contractual warranty
disclaimers and limitations on liability, these provisions may be unenforceable.
Some courts have held that limitations on liability in standard software or
computer contracts are unenforceable under certain conditions. Defending
lawsuits, regardless of the merits, is generally costly, and we do not currently
carry errors and omissions insurance. As a result, any lawsuits brought against
us alleging failures of our security solutions products or services could
significantly increase our operating costs and have a material adverse effect on
our results of operations and financial condition.
12
Any breach of network security could injure the reputation of our Internet
security solutions products, reduce our customer base and adversely affect our
revenues.
The success of our Internet security solutions business depends on our ability
to provide effective Internet security. Any breach of network security in one of
our end user's Internet security systems, whether or not the breach results from
any malfunction or defect in our products or services, could damage our
reputation. This, in turn, could result in our loss of actual or potential
customers and distribution partners. Because techniques used by computer hackers
to access or disrupt networks change often and are usually not recognized until
used against a target, we may not anticipate these techniques and protecting our
customers against them. Companies such as ours, in the business of providing
network security, may themselves be more likely to be the targets of attacks by
hackers. If we are unable to protect our internal systems or those of our end
users against penetration by hackers, our reputation may suffer, we may lose
actual or prospective customers and our revenues may be adversely affected.
If we are unable to maintain the services of either contract manufacturer for
our Internet security products, or if manufacturers cannot fill larger orders on
a timely basis if we experience growth in sales, we could experience delays or
interruptions in product shipments to our customers.
Manufacturing and assembly of the hardware components of our Internet security
products is performed by two contract manufacturers. We do not have long-term
contracts with either manufacturer. As a result, we currently depend on
manufacturers of our hardware components who are not obligated to provide them
on a long-term basis. Although each of these manufacturers has provided products
at reasonable cost with acceptable quality, they may not meet our future demands
at all, or in a timely or cost-effective manner or with consistent quality,
especially if we experience substantial sales growth. Although we believe that
there are many manufacturers who could produce our hardware components with
acceptable quality, we may nevertheless experience disruptions in our Internet
security solutions business if we are required to change or add manufacturers.
Any disruptions of this type could result in a loss of customers or orders and a
related decline in revenues.
Failure to manage our operations if they expand could impair our future growth.
If we are able to expand our operations, particularly those of our Internet
security solutions business, the expansion will place significant strain on our
management, financial controls, operating systems, personnel and other
resources. Our ability to manage future growth, should it occur, will depend to
a large extent upon several factors, including our ability to do the following,
particularly in relation to our Internet security solutions business:
-- build and train our sales force;
-- establish and maintain relationships with end users and distributors;
-- develop customer support systems;
-- develop expanded internal management and financial controls adequate
to keep pace with growth in personnel and sales, if they occur;
-- manage the use of third-party manufacturers and suppliers; and
-- successfully leverage the potential for sales of products and services
of each business segment to customers of the other segment.
If we are able to grow our business but do not manage our growth successfully,
we may experience increased operating expenses, loss of end users, distributors
or suppliers and declining or slowed growth of revenues.
Our ability to compete may be damaged and our revenues may be reduced if we are
unable to protect our intellectual property rights adequately.
Our success depends upon maintaining the confidentiality and proprietary nature
of our software and other intellectual property rights, particularly in relation
to our Internet security solutions business. To protect these rights, we rely
principally on a combination of:
-- contractual arrangements providing for non-disclosure and prohibitions
on use;
-- patents and pending patent applications;
13
-- trade secret, copyright and trademark laws; and
-- certain technical measures.
Our policy is to enter into confidentiality, technology ownership and/or license
agreements, as applicable, with our technical employees, as well as with
distributors and customers, and to limit access to and distribution of our
software, documentation and other proprietary information. In addition, we do
not license or release our source code, except in connection with source code
escrow arrangements and applicable restricted source code license agreements for
any source code appropriately released from escrow.
Patent, trade secret, copyright and trademark laws provide limited protection.
Because patent applications in the United States are not publicly disclosed
until the relevant patent is issued, applications may have been filed, which, if
issued as patents, could relate to our services and products as currently
designed or as we may modify them in the future to meet the market's
requirements. Trade secret, copyright and trademark laws, in combination with
the steps we take to protect our proprietary rights, may not adequately prevent
misappropriation of those rights. We may be required to bring proceedings in the
United States Patent and Trademark office or other legal action to enforce our
patents, trademarks or copyrights. We may find it necessary to litigate to
protect our trade secrets and know-how. Any legal actions would be costly,
timing consuming, and would divert the attention of management and technical
personnel.
The protections provided by laws protecting intellectual property rights do not
prevent our competitors from developing, independently, products similar or
superior to our products and technologies. In addition, effective protection of
copyrights, trade secrets, trademarks, and other proprietary rights may be
unavailable or limited in certain foreign countries.
Our inability or failure to protect our proprietary technology could damage our
ability to compete, particularly in the Internet security solutions business,
reduce our revenues and damage our prospects for achieving growth and
profitability.
If our products incorporate technology that infringes the proprietary rights of
third parties and we do not secure licenses from them, we could be liable for
substantial damages that would cause a material reduction in revenues and impair
our prospects for achieving growth and profitability.
In furtherance of the development of our services or products, we may need to
acquire licenses for intellectual property to avoid infringement of third party
rights or claims of infringement. These licenses may not be available on
commercially reasonable terms, if at all. Claims for infringement if made, could
damage our business prospects, our results of operations and financial
condition, whether or not the claims have merit, by:
-- consuming substantial time and financial resources required to defend
against them;
-- diverting the attention of management from growing our business and
managing operations;
-- resulting in costly litigation; and
-- disrupting product sales and shipments.
If any third party prevails in an action against us for infringement of its
proprietary rights, we could be required to pay damages and either enter into
costly licensing arrangements or redesign our products so as to exclude the
infringing technology. As a result, we would incur substantial costs, delays in
the product development, sales and shipments of our products and our revenues
may decline substantially and we may never be able to achieve the growth
required for us to achieve profitability.
Potential acquisitions may involve financial and operational risks to our
business.
In the normal course of our business, we evaluate prospective acquisitions of
businesses, products and technologies that could complement or expand our
business. In connection with any acquisition, we cannot predict whether we will:
-- identify suitable acquisition candidates;
-- negotiate successfully the terms of the acquisition;
-- secure adequate financing;
14
-- obtain a proper and adequate valuation of the business or assets
to be acquired;
-- integrate an acquired business, product or technology
successfully into our existing business or products; or
-- retain key personnel previously associated with the acquired
businesses.
In addition, we may compete for acquisitions with companies that have
significantly greater resources than we do. Negotiating potential acquisitions
and integrating acquired businesses could divert the time and resources of
management and skilled technical personnel.
We may finance future mergers or acquisitions with cash from operations,
significant additional indebtedness or additional equity financings involving
issuance of a significant number of shares of common or preferred stock. We
cannot assure you that we will be able to generate cash from operations or
obtain additional financing from external sources or that such financing, if
available, will be on terms acceptable to us. If we incur substantial debt to
finance an acquisition it could significantly increase our leverage and involve
restrictive covenants which may limit our operations. The issuance of additional
stock to finance acquisitions may dilute our earnings and result in substantial
dilution to our shareholders.
Our success may depend upon successful integration of acquisitions.
Our success may depend, in part, on our ability to manage the combined
operations of our Internet security solutions business and the business of NNSI
and to integrate their operations into a single organization. In addition, part
of our strategy for growing the two businesses is to sell the products and
services of our Internet security business to the established customers of NNSI.
We cannot assure you that our cross-selling efforts will be successful or that
we will otherwise succeed in integrating the operations of the two businesses.
The need to integrate these businesses could place additional demands on
management and other personnel. If we do not succeed in integrating the two
businesses as planned, our financial results and business prospects could suffer
materially.
Failure to attract and retain management and other personnel may damage our
operations and financial results and cause our stock price to decline.
We depend to a significant degree on the skills, experience and efforts of our
executive officers and other key management, technical, finance, sales and other
personnel. Our failure to attract, integrate, motivate and retain existing or
additional personnel could disrupt or otherwise harm our operations and
financial results. Although we have employment agreements with each of Walter M.
Groteke, our Chairman and Chief Executive Officer, Walter R. Groteke, our
Executive Vice President and Peter C. Castle, our Vice President - Finance,
securing their employment for varying terms, we do not carry key man life
insurance policies covering any employees. The loss of services of any of our
key employees, an inability to attract or retain qualified personnel in the
future, or delays in hiring additional personnel could delay the development of
our business and have a negative impact on our operating results and financial
condition.
Risks Related to Our Industry
Slower growth in demand for Internet security solutions and related products and
services may harm our revenues and prospects for achieving growth and
profitability.
The markets for our products and services depend on economic conditions
affecting the broader network security, telecommunications services and related
markets. Downturns in any of these markets may cause end users to delay or
cancel orders for our products and services. Customers may experience financial
difficulties, cease or scale back operations, or reverse prior decisions to
budget for orders of our products and services. As a result, we could experience
longer sales cycles, delays in payment and collection, and pressures from our
markets to reduce our prices. Any reduction in prices would cause us to realize
lower revenues and margins. The rate of capital spending in the information
technology and telecommunications sectors have generally decreased in the past
12 to 24 months, and many potential customers have experienced declining
revenues. Although we believe the terrorist attacks of September 11, 2001 have
caused some contraction in business generally, the attacks and ensuing events
have also heightened awareness of the need for security, including security of
Information Technology. If capital spending in our markets nevertheless
declines, we may not be able to increase revenues or achieve profitability
without increasing market share from competitors. See "If we are unable to
15
compete successfully in the markets for Internet security solutions and
telecommunications services, we may not increase revenues or achieve
profitability."
If we are unable to compete successfully in the markets for Internet security
solutions and telecommunications services, we may not increase revenues or
achieve profitability.
The markets for Internet security products are highly competitive, and
management expects competition to intensify in the future. Many of our
competitors have:
-- longer operating and product installation histories;
-- significantly greater financial and technical, marketing and product
development resources;
-- greater name recognition;
-- greater range of products and services, particularly in relation to
our Internet security solutions business;
-- a larger installed base of customers; and
-- greater ability to cross-sell products and services.
Each of these factors represents a significant competitive advantage over us.
Companies with greater resources have significant competitive advantages as to
pricing and the ability to offer enhanced products and services. Competitors
with greater financial and other resources to devote to research, development
and marketing are able to respond more quickly to new or emerging technologies
and changes in customer requirements, including demand for products and services
incorporating the most current technology and value-added features. In addition,
there are few substantial barriers to entry, so that we anticipate growing
competition from new market entrants as well as existing competitors.
Our competitors in the Internet security solutions business include:
-- developers and distributors of firewall and virtual private network
("VPN") software, such as Check Point Software Technologies;
-- network equipment manufacturers such as Cisco Systems, Inc., Lucent
Technologies Inc., Nortel Networks Corporation, Intel Corporation and
Nokia Corporation;
-- security appliance suppliers such as SonicWALL, Inc., WatchGuard
Technologies, Inc. and NetScreen Technologies;
-- manufacturers of encryption processing equipment such as nCipher and
Rainbow Technologies;
-- computer and network component manufacturers; and
-- low-cost Internet hardware suppliers whose products incorporate
network security features
Our competitors in the markets for telecommunications services include:
-- carriers such as MCI Worldcom, AT&T and Sprint.
If we are unable to compete successfully in either business segment, our
revenues may diminish and we may never achieve profitability.
Continuing changes in technology and industry standards could render our
Internet security solutions unmarketable or obsolete.
The markets for our Internet security solutions change rapidly because of
technological innovation, changes in customer requirements, declining prices,
and evolving industry standards. New products and technology often render
existing technology products, services or infrastructure obsolete, too costly or
otherwise unmarketable. Our success depends on our ability to introduce
innovations in our products and services, integrate new technologies into
current products, and to develop new products and services, all on a timely
basis. We cannot assure you that we will be successful in doing so, or do so in
a sufficiently timely manner that we are able to compete successfully for
customers and market share. In addition, if we fail to incorporate the features,
16
performance criteria and security standards in our products and services that
our customers require, market acceptance of our products may not materialize or
be significantly delayed and our revenues will fail to grow or decline.
Technological advances also require us, on a continuing basis, to commit
substantial resources to acquiring and applying new technologies for use in the
products and services. Product development for Internet security appliances
requires substantial lead time for engineering and testing. If we do not commit
resources to developing and selling products incorporating new technologies at
the rate demanded by our markets, our products and services may be rendered
obsolete, our revenues will suffer, and we may not achieve profitability. Even
if we do develop new or enhanced products and services, we cannot assure you
that they will gain acceptance in the marketplace. Failure of any of these
products and services could adversely affect our revenues and prevent us from
achieving profitability.
Government regulations affecting Internet security could have a negative effect
on our revenues.
Any additional government regulation of imports or exports could adversely
affect our international and domestic sales. The United States and various
foreign governments have imposed controls, export license requirements and
restrictions on the import or export of some technologies, especially encryption
technology. From time to time, government agencies have proposed further
regulation of encryption technology. Additional regulation of encryption
technology could add to the expense of product development and enhancements.
Because foreign competitors are subject to less stringent controls on the export
of encryption technology, they may have a competitive advantage over us in both
foreign and domestic Internet security markets.
Other Risks
Continued volatility in our stock price could adversely affect your investment.
The market price of our common stock, like the price of shares of technology
companies generally, has been and may continue to be volatile. From January 1,
2001 through September 24, 2003, the closing bid price of our common stock has
varied from a high of $6.00 to a low of $.50 per share, as reported on the
Nasdaq SmallCap Market (the "SmallCap Market"). The closing price of our common
stock on September 24, 2003 was $2.43. If our future operating results are below
the expectations of stock market analysts and investors, our stock price may
decline. Public announcement of our financial results and business developments
may have a significant impact on the market price of our common stock. For
example, each of the following could have the effect of temporarily or
permanently reducing the market price of our common stock:
-- shortfalls in revenues or cash flows from operations;
-- conversions of preferred stock into common stock;
-- delays in development or roll-out of any of our product and services;
and
-- announcements by one or more competitors of new product introductions,
acquisitions or technological innovations.
In addition, the stock market experiences extreme fluctuations in price and
volume that particularly affect the market prices of shares of emerging and
technology companies, such as ours. These price and volume fluctuations are
often unrelated or disproportionate to the operating performance of the affected
companies. Because of this volatility, we may fail to meet the expectations of
our shareholders or of securities analysts, and our stock price could decline as
a result. Declines in our stock price for any reason, as well as broad-based
market fluctuations or fluctuations related to our financial results or other
developments, may adversely affect your ability to sell your shares at a price
equal to or above the price at which you purchased them. Decreases in the price
of our common stock may also lead to de-listing of our common stock.
If our common stock is de-listed from the SmallCap Market, our stock price may
decline, we may find it more difficult to raise additional capital, and you may
have greater difficulty disposing of your shares.
In October 2002, Nasdaq informed us that we did not comply with its continuing
listing requirements of three independent directors and $2,500,000 in net worth.
Since then, we have appointed two additional independent directors, as required,
and have met this financial requirement.
17
In November 2002, Nasdaq informed us that our common stock would be de-listed if
we did not comply with Nasdaq's minimum bid price requirement by May 19, 2003.
In order to comply, the closing bid price of our common stock had to equal or
exceed $1.00 per share for at least ten consecutive trading days prior to that
date. Since January 2003, the closing bid price of our common stock has exceeded
$1.00 per share for well in excess of ten consecutive trading days and we were
notified on May 5, 2003, that we are in compliance with Nasdaq's minimum bid
price requirements. Our stock price has been volatile, and may again fail to
meet Nasdaq's minimum bid price requirements.
If we do not comply with this requirement, Nasdaq will determine whether we meet
the initial listing criteria for its SmallCap Market. These criteria require
shareholders' equity of $5 million and $50 million in market value of listed
securities or $750,000 in net income from continuing operations in the most
recently completed fiscal year or in two of the last three most recently
completed fiscal years.
If our stock is delisted from the SmallCap Market, it will be listed for
quotation on the Over-the-Counter Bulletin Board or quoted in the "Pink Sheets."
In such event, you may find it more difficult to obtain accurate quotations of
the market value of our common stock and to dispose of shares of our common
stock in the secondary market. De-listing of our common stock could also impair
our future ability to raise capital for a significant period of time.
If our common stock is delisted from the SmallCap Market, it could be treated as
a "penny stock" and it would be more difficult for shareholders to sell their
shares.
If our common stock is de-listed from the SmallCap Market, it could become
subject to the SEC's "penny stock" rules. Penny stocks generally are equity
securities that are not registered on certain national securities exchanges or
quoted by Nasdaq and have a price per share of less than $5.00. Penny stocks are
subject to "penny stock rules" that impose additional sales practice
requirements on broker-dealers who sell the stocks to persons other than
established customers and accredited investors. For transactions covered by
these rules, the broker-dealer must make a special suitability determination for
the purchase of such securities and obtain the purchaser's written consent to
the transaction prior to the sale. Prior to the sale, broker-dealers must also
deliver to the potential purchaser a disclosure schedule prescribed by the SEC
describing the penny stock market and disclose the commissions payable to both
the broker-dealer and the registered representative and current quotations for
the securities. Finally, broker-dealers must deliver to penny stock investors
monthly statements disclosing recent price information for penny stocks held in
the account and information on the limited market in penny stocks. These
additional requirements may restrict the ability of broker-dealers to sell our
common stock and may make it more difficult for investors to dispose of our
common stock in the secondary market.
Future sales of a large number of shares of our common stock may cause our stock
price to decline.
At September 15, 2003, 15,867,571 shares of our common stock were outstanding
and approximately 14,581,893 shares are issuable upon conversion of outstanding
preferred stock. Of these shares, approximately 10,507,613 are transferable
without restriction under the Securities Act of 1933. Another approximately
16,884,585 shares are eligible for resale subject to the restrictions on volume,
manner of sale and other conditions of Rule 144 promulgated under the Securities
Act. A total of approximately 14,581,893 shares, including some of the shares
eligible for resale under Rule 144, are subject to registration pursuant to
currently exercisable registration rights. Approximately 13,000,000 shares are
issuable upon exercise of outstanding stock options and warrants. Sales of large
amounts of these shares in the public market could depress the market price of
the common stock and impair our ability to raise capital through offerings of
our equity securities. Resale of shares of common stock that may be received by
holders of outstanding options and warrants or convertible preferred stock may
also dilute substantially the net tangible book value of your shares of common
stock.
The absence of Arthur Andersen's consent to the use of its opinion may limit the
remedies available to purchasers of common stock.
Our inability to obtain Arthur Andersen's consent to the use of its opinion for
our financial statements for the 2001 year and the absence of a signed opinion
may limit the remedies available to you since your claims against Arthur
18
Andersen LLP under the Securities Act based on these financial statements may be
limited. Moreover, even if claims against Arthur Andersen LLP are permitted,
Arthur Andersen LLP may not have the financial resources to satisfy any
judgment. In addition, notwithstanding that we have not filed the written
consent of Arthur Andersen, LLP, our directors and officers may still be able to
establish a due diligence defense to any claim relating to those financial
statements on the basis that they were made on the authority of our expert which
could limit your ability to assess a claim against them.
Provisions of New York law, our certificate of incorporation and bylaws, and
employment agreements with management may deter or prevent a takeover, even in
situations where you could sell your shares at a premium over the market price.
Some provisions of New York law, our certificate of incorporation and bylaws,
and employment agreements with certain executive officers may discourage
attempts to acquire control of us through a merger, tender offer or proxy
contest targeting us, including transactions in which shareholders might be
offered a premium for their shares. These provisions may limit your ability as a
shareholder to approve a transaction that you may believe to be in your best
interest. These provisions include:
-- Classified Board of Directors. Our certificate of incorporation
provides for a board which is divided into three classes so not all of
the directors are subject to election at the same time. As a result,
someone who wishes to take control of our company by electing a
majority of the board of directors must do so over a two-year period.
-- Employment Contracts. The employment agreements between us and each of
Walter M. Groteke, Walter R. Groteke and Peter C. Castle provide that
in the event there is a change in control of NetWolves, the employee
has the option to terminate his employment agreement. Upon such
termination, each employee has the right to receive a lump sum payment
equal to his compensation, including any incentive payment, for the
remainder of the term of his contract and the immediate vesting of all
unvested options. Change of control for this purpose is defined as the
acquisition of 30% or more of our voting power or consummation of a
merger, consolidation, reorganization or sale of all or substantially
all of our assets without board approval; or the change in a majority
of our directors without approval by the incumbent board. Termination
for change of control under these agreements will result in the
acceleration of compensation payments through the term of the
agreements and the immediate vesting of all unvested options.
-- New York anti-takeover statute. New York law restricts business
combinations with shareholders who acquire 15% or more of a company's
common stock without the consent of our board of directors.
ITEM 2. PROPERTIES
The Company currently maintains leased facilities in the locations listed
below.
Current
annual
Square Term of lease
Function Location Feet Lease costs
- ------------------------ -------------------------------- ------------ --------------- -----------------
NetWolves Corporation - 4002 Eisenhower Blvd. 20,520 12/20/05 $ 467,000
Corporate Headquarters Tampa, FL 33634
ComputerCOP Corp. - One Corporate Drive 4,318 06/30/05 $ 102,000
Corporate Headquarters Bohemia, NY 11716
Norstan Network Services, 5101 Shady Oak Road 6,700 Month to $ 92,000
Inc. - Corporate Minnetonka, MN 55343 month
Headquarters
19
The Company believes that its present facilities are adequate to meet its
current business requirements and that suitable facilities for expansion will be
available, if necessary, to accommodate further physical expansion of corporate
operations and for additional sales and support offices.
ITEM 3. LEGAL PROCEEDINGS
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A. We held our Annual Meeting of Shareholders on June 9, 2003.
B. One director was elected at the Annual Meeting to serve in Class III
until the Annual Meeting of Shareholders in 2005. The name of this
director and votes cast in favor of his election and shares withheld
are as follows:
Name Votes For Votes Withheld
---------------------------------------------------------------
Carlos Campbell 10,290,483 34,460
The other directors are Walter M. Groteke, Walter R. Groteke, Fassil
Gabremariam and Myron Levy.
C. In addition to the election of directors, the shareholders approved
proposals to:
(i) ratify and approve a 2003 Stock Option/Stock Issuance Plan -
3,774,409 shares were voted in favor of this proposal, 173,485
shares against and 31,250 abstained; and
(ii) ratify the appointment by the board of directors of Ernst & Young
LLP, as the Company's independent certified public accountants
for the year ending June 30, 2003 - 10,251,020 shares were voted
in favor of this proposal, 45,848 shares against and 850
abstained.
20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock has been traded on the Nasdaq SmallCap Market under the symbol
"WOLV." since April 2000. The following table sets forth, for the calendar
periods indicated, the high and low closing sales prices for the common stock as
reported by the Nasdaq SmallCap Market for the fiscal quarters indicated:
Fiscal 2003 Fiscal 2002
----------- -----------
Quarter High Low High Low
--------------- --------------- --------------- ---------------
First $ 1.650 $ 1.100 $ 3.800 $ 1.890
Second 1.100 0.500 4.050 2.190
Third 1.500 0.900 4.150 2.000
Fourth 1.650 1.050 2.450 1.120
As of September 24, 2003, there were approximately 152 holders of record of the
common stock. On September 24, 2003, the closing sales price of NetWolves common
stock was $2.43 per share.
NetWolves has not paid any cash dividends on its Common Stock and does not
presently intend to do so. Future dividend policy will be determined by its
Board of Directors on the basis of NetWolves' earnings, capital requirements,
financial condition and other factors deemed relevant.
The transfer agent and registrar of NetWolves' Common Stock is American Stock
Transfer and Trust Co., 40 Wall Street, New York, New York 10005.
Recent Sales of Unregistered Securities The Company sold the following
unregistered restricted securities in reliance on the exemption provided by
Section 4(2) and Regulation D of the Securities Act as transactions not
involving public offerings.
From July to September 2002, approximately 30 accredited investors acquired
269,462 shares of the Company's Series A Preferred Stock for total cash
consideration of $4,041,972.
From December to March 2003, approximately 60 accredited investors acquired
290,663 shares of the Company's Series B Preferred Stock for a total cash
consideration of $4,650,500.
From July to September 2003, approximately 80 accredited investors acquired
approximately 75,000 shares of the Company's Series C Preferred Stock for total
cash consideration of approximately $4,500,000.
ITEM 6. SELECTED FINANCIAL DATA
The following consolidated financial data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our consolidated financial statements and notes
thereto. The selected consolidated statement of operations data for the years
ended June 30, 2003, 2002 and 2001 and the selected consolidated balance sheet
data as of June 30, 2003 and 2002 are derived from, and are qualified by
reference to, the audited consolidated financial statements included elsewhere
in this annual report on Form 10-K. The selected consolidated statements of
operations data for the years ended June 30, 2000 and 1999 and the selected
21
consolidated balance sheet data as of June 30, 2001, 2000 and 1999 are derived
from our audited consolidated financial statements that are not included in this
annual report on Form 10-K. The historical results presented below are not
necessarily indicative of future results.
Year ended June 30,
----------------------------------------------------------------------------------
2003 2002 2001 2000 1999
--------------- -------------- --------------- --------------- ---------------
Consolidated Statements of Operations
Data:
Revenue $ 21,159,459 $ 738,748 $ 1,425,138 $ 1,423,690 $ 1,789,144
Cost of revenue 14,036,044 757,697 1,345,120 959,039 582,724
--------------- -------------- -------------- --------------- ---------------
Gross profit 7,123,415 (18,949) 80,018 464,651 1,206,420
Operating expenses 13,695,570 10,647,123 15,982,067 24,281,166 8,666,381
--------------- -------------- -------------- --------------- ---------------
Loss before other income (expense)
and income taxes (6,572,155) (10,666,072) (15,902,049) (23,816,515) (7,459,961)
Investment expense, net 189,634 79,576 650,003 611,746 58,884
Gain on extinguishment of debt (716,014) - - - -
Other expense (income) 118,402 9,160 (3,545) 68,012 478,063
--------------- -------------- -------------- --------------- ---------------
Loss before income taxes (6,164,177) (10,577,336) (15,255,591) (23,136,757) (6,923,014)
(Provision for) benefit from income
taxes 129,300 - - (25,000) -
--------------- -------------- -------------- --------------- ---------------
Net loss from continuing operations (6,293,477) (10,577,336) (15,255,591) (23,161,757) (6,923,014)
Discontinued business
Loss from discontinued operations - - (4,725,901) (1,165,191) -
Loss on disposal of discontinued
operations (117,097) (1,053,274) (650,000) - -
--------------- -------------- -------------- --------------- ---------------
Net loss $ (6,410,574) $ (11,630,610) $ (20,631,492) $ (24,326,948) $ (6,923,014)
================ =============== =============== ================ ================
Basic and diluted net loss per share
Beneficial conversion on preferred
stock (138,882) - - - -
Dividends on preferred stock (453,179) - - - -
--------------- -------------- -------------- --------------- ---------------
Net loss from continuing operations $ (7,002,635) $ (11,630,610) $ (20,631,492) $ (24,326,948) $ (6,923,014)
================ =============== =============== ================ ================
Basic and diluted net loss per share
Loss from continuing operations $ (.53) $ (0.90 $ (1.74) $ (3.29) $ (1.48)
Loss from discontinued operations (.01) (0.09) (.61) (.17) -
--------------- -------------- -------------- --------------- ---------------
$ (.54) $ (0.99 $ (2.35) $ (3.46) $ (1.48)
================ =============== =============== ================ ================
Weighted average common shares
Outstanding, basic and diluted 12,929,559 11,756,220 8,776,928 7,034,994 4,691,651
================ =============== =============== ================ ================
June 30,
----------------------------------------------------------------------------------
2003 2002 2001 2000 1999
--------------- -------------- -------------- --------------- ---------------
Consolidated Balance Sheet Data:
Cash and cash equivalents $ 1,336,191 $ 656,880 $ 4,087,767 $ 20,204,309 $ 5,585,981
Marketable securities, available for
sale - 82,250 71,000 99,500 606,000
Working capital (1,256,993) 1,110,257 3,794,438 19,459,099 5,799,246
Total assets 11,328,337 3,224,454 6,860,444 25,543,130 12,811,934
Long-term debt, net of current
maturities - - 80,000 418,102 266,537
Minority interest 275,734 272,533 281,693 305,761 704,500
Total shareholders' equity 5,457,201 1,493,868 4,662,230 22,807,629 11,099,802
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-looking Statements
Certain statements in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations" are forward looking statements. These
statements relate to future events or our future financial performance and
involve known and unknown risks, uncertainties and other factors that may cause
our or our industry's actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by the
forward-looking statements. In some cases, you can identify forward-looking
statements by terminology such as "may", "will", "should", "expects", "plans",
"anticipates", "believes", "estimates", "predicts", "potential", "continue" or
the negative of these terms or other comparable terminology. These statements
are only predictions. Actual events or results may differ materially. In
evaluating these statements, you should specifically consider various factors,
including the risks included in this annual report on Form 10-K. These factors
may cause our actual results to differ materially from any forward- looking
statement.
Overview
We operate primarily in three distinct segments. The first is the technology
segment, consisting of NetWolves Technologies Corp. (NWT), which is engaged in
network and security infrastructure. The second segment is the
telecommunications segment, consisting of Norstan Network Services, Inc. (NNSI),
a managed communication services provider. The third segment is the management
and consulting segment in the automotive industry through our subsidiary, TSG
Global Web, Inc. Because its operations will not be material to us on a going
forward basis, we are not providing any additional business information on this
segment.
We have achieved an offering of managed products and services that meet the
necessary requirements for organizations to move off of expensive private data
networks while attaining the benefits and flexibility of public data network.
Additionally, our proprietary technology provides a high level of security
through its integrated approach to management, monitoring and interoperability
for small and medium remote enterprise locations (locations with less than 300
network users). We offer products and services that provide complete system
solutions to organizations needing cost effective network security features
(firewall, virtual private networking, routing, intrusion detection, content
filtering, email, etc.) delivered on low cost commodity hardware with
Internet-based expansion capabilities. Our patent pending system technology
enables organizations to achieve corporate Information Technology (IT) and
e-business initiatives through the deployment of easily installable perimeter
office security platforms, coupled with secure remote monitoring and management
("SRM2 TM") system. SRM2 TM provides centralized management capabilities for
hundreds or thousands of remote locations without risking networking integrity
by opening an administrative port on the remote device through which outsiders
can gain access to information on the system. We also provide cost-effective,
value-added expansion technologies such as intelligent fail-over, which means
that if one circuit for gaining access to information fails, the system would
automatically switch to an alternative circuit.
Acquisition of Norstan Network Services, Inc.
On July 9, 2002, the Company acquired all of the outstanding capital stock of
Norstan Network Services, Inc. ("NNSI"). Consideration was $7,500,000,
$3,750,000 of which was paid in cash on or prior to closing and $3,750,000 that
was payable under the term of a non-interest bearing promissory note due July 9,
2003. Subsequently, the Company negotiated an early payoff of the note for $2.9
23
million in cash and issued 300,000 shares of its common stock. This note
repayment and share issuance resulted in recognition of a gain on extinguishment
of debt, which is reflected in the accompanying condensed consolidated balance
statements of operations and comprehensive loss.
NNSI provides multiple source data and voice services to approximately 400
customers throughout the United States. NNSI's products include voice services
consisting of switched and dedicated inbound/outbound long distance, travel
cards, conference calling and local services, and data services consisting of IP
dedicated and dial up services, broadband services, frame relay and private
line.
NNSI's selling methodology includes completing a thorough needs assessment to
understand the current infrastructure and future requirements of the prospective
customer. Upon completion of the assessment, NNSI designs a custom, unique and
flexible solution utilizing multi-carrier alternatives under one contract, one
invoice and support structure. Its account teams, strategic industry
relationships and consolidated information and billing platform allow NNSI to
deliver a single source solution utilizing the best of what is available to
solve the customer's communication and network needs.
As a result of the acquisition, the Company expects to increase its security
solution revenues within its Technology segment by leveraging NNSI's existing
customer base. In addition, the Company expects the acquisition will enable it
to expand the range of services it can offer its existing customers as well as
future customers.
Agreement with General Electric
On September 26, 2002, the Company entered into a three year agreement with
General Electric Consumer Finance, the consumer financing arm of the General
Electric Company. The agreement covers the use of the Company's technology by
General Electric Consumer Finance in all of its offices worldwide, encompassing
36 countries. The first rollouts of our products have been completed in Germany,
are underway in Japan and are being scheduled for Australia.
Results of Operations
The Company currently operates in three business segments, the technology
segment ("Technology"), the telecommunications segment ("Telecommunications")
and the management and consulting segment ("Management and Consulting"). During
June 2001, the Company formally adopted a plan to discontinue its ComputerCOP
software operations, eliminating the computer software segment. Effective August
31, 2002, the Company ceased all operations of ComputerCOP, terminated all
remaining employees of ComputerCOP and subleased a majority of the space
previously occupied by ComputerCOP.
The year ended June 30, 2003 ("Fiscal 2003") compared to the year ended June 30,
2002 ("Fiscal 2002") is as follows:
Revenue
Revenue from continuing operations increased to $21,159,459 in Fiscal 2003 from
$738,748 in Fiscal 2002. The increase in revenue was primarily the result of the
inclusion of the results of Norstan Network Services, Inc., commencing July 9,
2002, which resulted in revenue from the Telecommunications segment of
$20,349,748. Revenues from the Company's Technology and Management and
Consulting segments did not experience significant change for the year ended
June 30, 2003 compared to the year ended June 30, 2002.
Cost of revenue and gross profit
Cost of revenue in connection with the Telecommunications segment includes costs
of multiple source data and voice service providers. Cost of revenue in
connection with the Technology segment include costs associated with the sale of
24
the Company's Internet products and services and include manufacturing,
packaging and shipping costs, amortization of capitalized software costs, and
warranty expenses. Cost of revenue in connection with the Management and
Consulting segment include direct expenses of consultants utilized in the
generation of management and consulting revenue and software licensing costs.
Cost of revenue increased to $14,036,044 for Fiscal 2003, compared to $700,398
for Fiscal 2002. The increase in cost of revenue was primarily the result of the
inclusion of the results of Norstan Network Services, Inc., commencing July 9,
2002, which resulted in cost of revenue from the Telecommunications segment of
$13,506,072. Cost of revenue within the Technology segment decreased to $279,611
in Fiscal 2003 compared to $425,223 Fiscal 2002. This decrease was primarily the
result of a writedown of inventory due to obsolescence in Fiscal 2002 of
$193,000. Cost of revenue within the Management and Consulting segment decreased
to $250,361 compared to $275,175 for Fiscal 2002. This decrease was the result
of the consolidation of consulting services.
Overall gross profit was at 34% for Fiscal 2003, compared to (3)% for Fiscal
2002. The increase in gross profit was primarily the result of the inclusion of
the results of Norstan Network Services, Inc., commencing July 9, 2002, which
resulted in gross profit from the Telecommunications segment of 34%.
General and administrative
General and administrative expenses consist primarily of salaries and related
expenses for executive, finance, facilities and human resources personnel,
recruiting expenses and professional fees. General and administrative expenses
increased to $8,847,462 in Fiscal 2003 compared to $6,442,954 in Fiscal 2002.
The increase was primarily the result of the inclusion of the results of Norstan
Network Services, Inc., totaling $2,846,529 for the period commencing July 9,
2002 through June 30, 2003 and a net increase in equity compensation of
consultants and executive management of approximately $727,000. This was
partially offset by a reduction of costs related to a settlement expense and
staff reductions of approximately $487,500 and $325,000 respectively, compared
to the prior period. Included in general and administrative expense for fiscal
2003 and 2002 was non-cash compensation of approximately $2,115,000 and
$1,388,000 Respectively. We expect general and administrative costs to increase
in absolute dollars in the future.
Engineering and development
Engineering and development expenses, which are expensed as incurred, consist
primarily of salaries and related expenses for personnel utilized in designing,
maintaining and enhancing our products as well as material costs for test units
and prototypes. Costs associated with the development of software products are
generally capitalized once technological feasibility is reached. Engineering and
development expenses decreased to $1,595,882 in Fiscal 2003 from $1,703,376 in
Fiscal 2002. The decrease in engineering and development costs was primarily the
result of a limited reduction of engineering and development personnel, which
resulted in reduced salary of $207,105 in Fiscal 2003 compared to Fiscal 2002.
This was partially offset by Company having no capitalized software development
costs in Fiscal 2003 compared to approximately $73,000 during Fiscal 2002. We
expect to incur engineering and development costs in the future as we continue
to maintain our existing product line as well as develop new products and
features, as evidenced by the development of our intelligent Failover and
continued development of our SRM2 TM technology.
Sales and marketing
Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and customer support
functions, as well as costs associated with trade shows, promotional activities,
advertising and public relations. Sales and marketing expenses increased to
$3,252,226 in Fiscal 2003 from $2,500,793 in Fiscal 2002. The increase in sales
and marketing expenses was primarily the result of the inclusion of the results
of Norstan Network Services, Inc., totaling $1,899,236 for the period commencing
July 9, 2002 through June 30, 2003. This was partially offset by a reduction in
the number of sales personnel and associated salaries in the Company's
Technology segment totaling $835,731. Additionally, the Company has been
changing its marketing efforts to focus primarily on direct sales to Fortune
1000 customers. The Company intends to continue to aggressively promote its
current and future products and, therefore, expects sales and marketing costs to
increase in absolute dollars in the future.
25
Other income (expenses)
Other income (expenses) consists primarily of realized gains and losses on
marketable securities, interest expense and investment portfolio income and
increased to $407,978 in Fiscal 2003, compared to $88,736 in Fiscal 2002. The
increase was primarily due to an increase in interest expense on the note
payable to Norstan, Inc. of $184,378 and a loss on the sale of marketable
securities of $115,201 offset by a gain on extinguishment of debt within the
Management and Consulting segment of $296,786 and the Telecommunications segment
of $419,228.
The year ended June 30, 2002 ("Fiscal 2002") compared to the year ended June 30,
2001 ("Fiscal 2001") is as follows:
Revenue
Revenue from continuing operations decreased to $738,748 in Fiscal 2002 from
$1,425,138 in Fiscal 2001. The decrease was primarily the result of a decrease
in revenue from the Management and Consulting segment of approximately $552,000
due to the termination of a contract with BP Amoco in December 2000. Service
revenue from the TSG subsidiary has been substantially reduced as a result of
the reduction in its operations and the recently settled dispute between the
parties. The decrease in sales of the Company's Internet products and services
(Technology segment) was primarily due to reduced shipments to the Company's
major customer resulting in decreased revenues of approximately $42,000. Sales
to this major customer were delayed largely as a result of requests by this
customer that the Company develop and add new Failover technology to be utilized
in future large-scale deployments. The Company believes this additional feature
will result in substantial additional benefits, since the feature added to its
core products should assist the Company in facilitating sales to other Fortune
1000 companies. The Company intends to generate continuing revenue from the sale
of its Internet products and services in the coming year, including continuing
revenue from this customer, including sales under its September 2002 agreement
with General Electric Consumer Finance.
Revenue from discontinued operations increased to $220,267 compared to $102,525
in the prior year. The increase was due to an increased effort to sell as much
product as possible preceding the discontinuance of operations.
Cost of revenue and gross profit
Cost of revenue for sale of the Company's Internet products and services include
manufacturing costs, which to date have been outsourced, packaging and shipping
costs and warranty expenses. Cost of revenue in connection with management and
consulting services include direct expenses of employees and consultants
utilized in the generation of management and consulting revenue. Cost of revenue
from continuing operations decreased to $757,697 for Fiscal 2002 as compared to
$1,345,120 for Fiscal 2001. The decrease in the Management and Consulting
segment of approximately $491,000 was primarily due to the termination of a
contract with BP Amoco in December 2000.
Overall gross profit percentage from continuing operations was at (3)% for
Fiscal 2002 as compared to 6% for Fiscal 2001. Negative gross profit resulted
from a writedown of inventory approximating $193,000 in the technology segment,
caused by the substantial upgrades and improvements made by the Company to its
core products by discontinuing its FoxBox line of 4U products with the
introduction of its WolfPac Security Platform 2U product line as compared to a
writedown of $243,000 in the prior period. The gross profit percentage in the
Management and Consulting segment remained constant and the Company does not
anticipate a significant change in such percentage in the near future.
Cost of revenue from discontinued operations increased to $37,970 compared to
$8,356 in Fiscal 2001. The increase is consistent with an increase in sales of
ComputerCOP software during the year end June 30, 2002.
General and administrative
General and administrative expenses consist primarily of salaries and related
expenses for executive, finance, facilities and human resources personnel,
recruiting expenses and professional fees. General and administrative expenses
from continuing operations decreased to $6,442,954 in Fiscal 2002 compared to
$7,714,047 in Fiscal 2001. The decrease was primarily due to a reduction in
equity compensation given to various financial consultants and staff reductions.
We expect general and administrative costs to increase in absolute dollars in
the future.
General and administrative expenses from discontinued operations decreased to
$671,540 in Fiscal 2002 compared to $1,551,384 in Fiscal 2001. The decrease was
primarily due to no amortization expense on the acquired ComputerCOP software
technology in the current year and a reduction of administrative personnel in
accordance with the cessation of operations.
Engineering and development
Engineering and development expenses, which are expensed as incurred, consist
primarily of salaries and related expenses for personnel utilized in designing,
maintaining and enhancing our products as well as material costs for test units
and prototypes. Costs associated with the development of software products are
generally capitalized once technological feasibility is reached. Engineering and
development expenses from continuing operations decreased to $1,703,376 in
26
Fiscal 2002 from $1,893,372 in Fiscal 2001. The decrease in was primarily the
result of the Company capitalizing approximately $73,000 in software development
costs during Fiscal 2002 as compared to approximately $116,000 in Fiscal 2001 in
the Technology segment. We expect to incur engineering and development costs in
the future as we continue to maintain our existing product line as well as
develop new products and features, as evidenced by the development of our
intelligent Failover and continued development of our SRM2 TM technology.
Engineering and development expenses from discontinued operations decreased to
$83,007 in Fiscal 2002 compared to $478,068 in Fiscal 2001. The decrease was
primarily due a reduction of engineering personnel in accordance with the
cessation of operations.
Sales and marketing
Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and customer support
functions, as well as costs associated with trade shows, promotional activities,
advertising and public relations. Sales and marketing expenses from continuing
operations decreased to $2,500,793 in Fiscal 2002 from $4,958,719 in Fiscal
2001. The decrease in sales and marketing expenses was primarily in the
Technology segment and was the result of a reduction in the number of sales
personnel, totaling approximately $673,000 and a decrease in marketing efforts
of approximately $1,499,000, to focus primarily on direct sales to Fortune 1000
customers. Sales and marketing expense from the Company's Management and
Consulting segment did not experience significant change for the year ended June
30, 2002 compared to the year ended June 30, 2001.The Company intends to
continue to aggressively promote its current and future products and, therefore,
expects sales and marketing costs to increase in absolute dollars in the future.
Sales and marketing expenses from discontinued operations decreased to $381,024
in Fiscal 2002 compared to $681,636 in Fiscal 2001. The decrease was primarily
due a reduction in the number of sales and marketing personnel in accordance
with the cessation of operations.
Impairment charges
There were no impairment charges from continuing operations in Fiscal 2002
compared to $1,415,929 in Fiscal 2001. In June 2001, the Company determined that
the remaining unamortized value of a warrant previously issued to Comdisco,
Inc., was impaired and, accordingly, recorded a charge to operations of
approximately $1,245,000 during fiscal 2001.
Impairment charges from discontinued operations decreased to $100,000 in Fiscal
2002 compared to $2,108,982 in Fiscal 2001. On December 31, 2000, the Company
recorded a writedown of its ComputerCOP technology in the amount of $2,000,000,
reducing the carrying value of the asset to $202,395 at December 31, 2000.
Additionally, in June 2001 the Company recorded an impairment of the remaining
carrying value of the ComputerCOP technology totaling $108,982. The asset was
determined to be impaired because of the inability of the software technology to
generate future operating income without substantial sales volume increases,
which are uncertain. Fair value was based on discounted future cash flows.
27
Other income (expenses)
Other income (expenses) from continuing operations consists primarily of
investment portfolio income which decreased to $88,736 in Fiscal 2002 from
$646,458 in Fiscal 2001. The decrease was primarily due to a reduction in
interest income due to a decrease in the average cash balances during the
current year.
Quarterly Results
The following table presents certain unaudited quarterly results for the last
eight quarters:
Three months ended
------------------------------------------------------------------------------------------------------------
Sep 30, Dec 31, Mar 31, Jun 30, Sep 30, Dec 31, Mar 31, Jun 30,
2001 2001 2002 2002 2002 2002 2003 2003
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Revenue $ 187,425 $ 188,234 $ 183,556 $ 179,533 $ 4,824,750 $ 5,260,237 $5,510,443 $5,564,029
Cost of revenue 158,018 137,481 125,260 279,639 3,215,665 3,514,786 3,625,610 3,679,983
----------- ------------ ------------ ------------ ------------ ----------- ---------- ----------
Gross profit (1) 29,407 50,753 58,296 (100,106) 1,609,085 1,745,451 1,884,833 1,884,046
Operating expenses 3,155,942 2,430,376 2,689,172 2,428,932 2,839,598 3,123,646 2,747,237 4,985,089
Other income
(expense), net 44,896 19,289 12,741 11,810 (175,194) (61,674) 630,342 (114,796)
----------- ------------ ------------ ------------ ------------ ----------- ---------- ----------
operations (3,081,639) (2,360,334) (2,618,135) (2,517,228) (1,405,707) (1,439,869) (232,062) (3,215,839)
Loss on disposal of
discontinued
operations - (470,000) (265,534) (317,740) (117,097) - - -
----------- ------------ ------------ ------------ ------------ ----------- ---------- ----------
Net loss(2) $(3,081,639) $(2,830,334) $(2,883,669) $(2,834,968) $(1,522,804) $(1,439,869) $ (232,062) $(3,215,839)
=========== ============ ============ ============ ============ =========== ========== ==========
Basic and diluted
loss per share:
Net loss $(3,081,639) $(2,830,334) $(2,883,669) $(2,834,968) $(1,522,804) $(1,439,869) $(232,062) $(3,215,839)
Beneficial conversion
on preferred stock - - - - - (35,379) (103,293) (210)
Dividends on
preferred stock - - - - (57,133) (85,689) (134,858) (175,499)
Net loss available to ----------- ------------ ------------ ------------ ------------ ----------- ---------- -----------
common shareholders$(3,081,639) $(2,830,334) $(2,883,669) $(2,834,968) $(1,579,937) $(1,560,937) $(470,213) $(3,391,548)
Loss from continuing =========== ============ ============ ============ ============ ============ ========== ===========
operations $ (.30) $ (.20) $ (.21) $ (.20) $ (.12) $ (.12) $ (.04) $ (.25)
Loss from =========== ============ ============ ============ ============ ============ ========== ===========
discontinued
operations $ - $ (.04) $ (.02) $ (.03) $ (.01) $ - $ - $ -
Weighted average =========== ============ ============ ============ ============ ============ ========== ===========
common shares
outstanding, basic
and diluted 10,439,135 11,520,765 12,490,132 12,599,976 12,607,119 12,607,119 12,662,202 13,446,838
(1) Negative gross profit for the quarter June 30, 2002 is primarily due to
writedowns of inventory due to obsolescence in such quarter.
(2) Net loss for the quarter March 31, 2003 includes a gain on extinguishment
of debt of $716,014 relating to the promissory note due to Norstan, Inc.
for the acquisition of NNSI and the notes payable to Duffy-Vinet Institute,
Inc., which were assumed by TSG in connection with its acquisition of Sales
and Management Consulting, Inc.
Liquidity and Capital Resources
The year ended June 30, 2003 ("Fiscal 2003") compared to the year ended June 30,
2002 ("Fiscal 2002") is as follows:
Our operating activities used cash of $1.2 million during the year ended June
30, 2003, as compared to $8.5 million during the prior year. Cash used for the
year ended June 30, 2003 was primarily attributable to a net loss of $6.4
million, partially offset by non-cash expenses including equity compensation of
$2.2 million. Cash used for the year ended June 30, 2002 was primarily
attributable to a net loss of $11.6 million, partially offset by non-cash
expenses including equity compensation of $2.3 million.
Our investing activities used cash of $3.5 million during the year ended June
30, 2003, as compared to using cash of $.9 million during the prior year. Cash
used in investing activities for the year ended June 30, 2003 was primarily
attributable to a payment of $3.4 million, exclusive of acquisition costs paid
of $.1 million, to acquire NNSI. Cash used in investing activities for the year
28
ended June 30, 2002 was primarily attributable to a finders fee and purchase
deposit of $.35 million and $.4 million, respectively, related to the purchase
of NNSI.
Our financing activities provided cash of $5.4 million during the year ended
June 30, 2003, as compared to providing cash of $6.0 million during the prior
year. Cash provided by financing activities for the year ended June 30, 2003 was
primarily attributable to the private sale of the Company's preferred stock and
warrants aggregating $8.9 million, exclusive of $.8m of financing costs,
partially offset by the repayment of the note payable to Norstan, Inc. totaling
$2.9 million. Cash provided by financing activities for the year ended June 30,
2002 was primarily attributable to the private sale of the Company's common
stock for $6.3 million, exclusive of financing costs paid of $.3 million.
The year ended June 30, 2002 ("Fiscal 2002") compared to the year ended June 30,
2001 ("Fiscal 2001") is as follows:
Our operating activities used cash of $8.5 million during the year ended June
30, 2002, as compared to $13.7 million during the prior year. Cash used for the
year ended June 30, 2002 was primarily attributable to a net loss of $11.6
million, partially offset by non-cash expenses including equity compensation of
$2.3 million. Cash used for the year ended June 30, 2001 was primarily
attributable to a net loss of $20.6 million and a decrease in accounts payable
and accrued expenses of $.9 million, partially offset by non-cash expenses
including amortization, equity compensation and an impairment provision totaling
$1.2 million, $2.0 million and $3.5 million, respectively. Cash used in
operating activities included above relating to discontinued operations totaled
$1.0 and $1.5 million for the years ended June 30, 2002 and 2001, respectively.
Our investing activities used cash of $.9 million during the year ended June 30,
2002, as compared to using cash of $1.1 million during the prior year. Cash used
in investing activities for the year ended June 30, 2002 was primarily
attributable to a finders fee and purchase deposit of $.35 million and $.4
million, respectively, related to the purchase of NNSI. Cash used in investing
activities for the year ended June 30, 2001 was primarily attributable to the
Company's purchases of property and equipment totaling $.7 million. There were
no cash flows from investing activities related to discontinued operations for
the year ended June 30, 2002. Cash used in investing activities included above
relating to discontinued operations totaled $.1 million for the year ended June
30, 2001.
Our financing activities provided cash of $6.0 million during the year ended
June 30, 2002, as compared to using cash of $1.0 million during the prior year.
Cash provided by financing activities for the year ended June 30, 2002 was
primarily attributable to the private sale of the Company's common stock for
$6.3 million, exclusive of financing costs paid of $.3 million. Cash used in
financing activities for the year ended June 30, 2001 was primarily attributable
to the Company's repurchases of warrants relating to the Anicom settlement
totaling $.7 million. There were no cash flows from financing activities related
to discontinued operations for the years ended June 30, 2002 and 2001.
Post June 30, 2003 transactions
Through September 25, 2003, the Company has issued approximately 75,000
additional shares of its Series C Preferred Stock for total cash consideration
of approximately $4,500,000 and approximately 1,200,000 shares of unregistered
common stock for total cash consideration of approximately $1,200,000.
Summary
Historically, the Company has experienced significant reoccurring net operating
losses as well as negative cash flows from operations. The Company's main source
of liquidity has been equity financing which is used to fund losses from
operating activities. For the year ended June 30, 2003, the Company has raised,
exclusive of commissions, approximately $9.0 million from the sale of its
preferred and common stock. While approximately $6 million of the proceeds was
utilized to purchase the outstanding capital stock of NNSI and repay a note
payable due to Norstan, Inc., the remainder of the proceeds has been and will
continue to be utilized to fund ongoing operations.
The Company will continue to utilize cash generated from its Telecommunications
segment to fund the operations of its other segments and currently has
29
sufficient cash to meet its funding needs for at least the next 12 months.
Additionally, management has instituted cost saving measures over the past 12
months intended to reduce its overhead expenses, most notably, a reduction of
staffing within its Technology segment and its discontinued ComputerCOP
operations, aggregating approximately $2.5 million in annual salaries and
related benefits. The Company anticipates that negative cash flow from
operations will average less than $150,000 per month for the quarter ended
September 30, 2003.
Contractual obligations, commitments, contingent liabilities and off-balance
sheet items
The following table presents, at June 30, 2003, the Company's significant fixed
and determinable contractual obligations by payment date.
Payments Due by Period
Contractual Total Less than 1 year 1-3 years 4-5 years After 5 years
Obligations
Long Term Debt $120,000 $120,000
Operating Leases $1,534,617 $634,767 $893,973 $5,877 $ -
Telecommunication
Purchase
Commitments $19,250,000 $8,850,000 $10,400,000 $ - $ -
Critical accounting policies
The Company's discussion and analysis of its financial condition and results of
operations is based upon the consolidated financial statements, which have been
prepared in accordance with U.S. generally accepted accounting principles. The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, the disclosure of
contingent assets and liabilities as of the date of the financial statements,
and the reported amounts of revenue and expenses during the periods. Estimates
have been made by management in several areas, including, but not limited to,
revenue recognition, allowance for doubtful accounts, the realizability of
deferred tax assets, goodwill and other intangible assets and stock based
compensation. We base our estimates on historical experience and on various
other assumptions that we believe to be reasonable under the circumstances.
Actual results may differ materially from these estimates under different
assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements.
Revenue recognition
The Company records revenue in accordance with Statement of Position 97-2
"Software Revenue Recognition" ("SOP 97-2"), issued by the American Institute of
Certified Public Accountants (as modified by Statement of Position 98-9) and SEC
Staff Accounting Bulletin 101 "Revenue Recognition in Financial Statements"
("SAB 101") regarding revenue recognition in financial statements. SOP 97-2
provides additional guidance with respect to multiple element arrangements;
returns, exchanges, and platform transfer rights; resellers; services; funded
software development arrangements; and contract accounting. Accordingly, revenue
from the sale of hardware is recognized within product revenue at the time of
delivery and acceptance of hardware products by the customer, when the fee is
fixed and determinable and collectibility is probable. Maintenance or monitoring
revenue that is bundled with an initial license fee is deferred and recognized
ratably within service revenue over the maintenance or monitoring period in the
accompanying consolidated statements of operations and comprehensive loss.
Amounts deferred for maintenance or monitoring are based on the fair value of
equivalent maintenance or monitoring services sold separately. The Company has
established vendor specific objective evidence ("VSOE") on all undelivered
elements of its software arrangements, which consists of maintenance, monitoring
and, at times, training and consulting. The Company uses the residual method for
delivered elements.
The Company's consulting and training projects are short-term in nature and are
recorded as revenue when the services have been rendered.
30
Revenues from NNSI generated from the resale of long distance services are
recognized as services are provided. Revenues from NNSI primarily consist of
monthly fees, which are recognized over the monthly period and long distance
charges, which are recognized as incurred. These revenues are included within
product revenue in the accompanying consolidated statements of operations and
comprehensive loss.
Revenue for shipping and handling are included within products revenue and the
related costs are included in cost of revenue in the accompanying consolidated
statements of operations and comprehensive loss.
Allowance for doubtful accounts
The Company provides allowances for doubtful accounts for estimated losses from
the inability of customers to satisfy their accounts as originally contemplated
at the time of sale and charges actual losses to the allowance when incurred.
The calculation for these allowances is based on the detailed review of certain
individual customer accounts, historical satisfaction rates and the Company's
estimation of the overall economic conditions affecting the Company's customer
base. If the financial condition of the Company's customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required.
Income taxes
As part of the process of preparing our consolidated financial statements we are
required to prepare our income taxes in each of the jurisdictions in which we
operate. This process involves estimating our actual current tax exposure
together with assessing temporary differences resulting from differing treatment
of items for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within our consolidated balance
sheet. We must then assess the likelihood that our deferred tax assets will be
recovered from future taxable income and to the extent we believe that recovery
is not likely, we must establish a valuation allowance. We have fully reserved
our deferred tax assets at June 30, 2003 and 2002.
Goodwill and other intangible assets
We evaluate the recoverability of goodwill and other intangibles of each of our
reporting units as required under SFAS 142 by comparing the fair value of each
reporting unit with its carrying value. The fair values of our reporting units
are determined using a combination of a discounted cash flow analysis and market
multiples based upon historical and projected financial information. We apply
our best judgment when assessing the reasonableness of the financial projections
used to determine the fair value of each reporting unit.
Stock-based compensation
The Company applies the intrinsic value-based method of accounting prescribed by
Accounting Principles Board ("APB") Opinion 25, Accounting for Stock Issued to
Employees, and related interpretations, to account for stock-based employee
compensation plans and reports pro forma disclosures by estimating the fair
value of options issued and the related expense in accordance with SFAS 123.
Under this method, compensation cost is recognized for awards of shares of
common stock or stock options to directors, officers and employees of the
Company only if the quoted market price of the stock at the grant date (or other
measurement date, if later) is greater than the amount the grantee must pay to
acquire the stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Management does not believe that there is any material market risk exposure
with respect to derivative or other financial instruments that would require
disclosure under this item.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and its subsidiaries are included
herein:
31
-- Reports of Independent Certified Public Accountants
-- Consolidated Balance Sheets at June 30, 2003 and 2002
-- Consolidated Statements of operations and comprehensive loss, Cash
Flows and Shareholders' Equity for the years ended June 30, 2003, 2002
and 2001
-- Notes to Consolidated Financial Statements
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Previously disclosed in Report on Form 8-K dated July 9, 2002.
ITEM 9A. CONTROLS AND PROCEDURES
Within 90 days prior to the filing date of this report, under the supervision of
our Chief Executive Officer and Chief Financial Officer, we evaluated our
disclosure controls and procedures (as defined in rules 13a-14(c) and 15d-14(c)
under the Securities Exchange Act of 1934). Based on that evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures were sufficient to provide reasonable assurances that
the information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission's rules and forms.
In the fall of 2002 and during the transition period of the Company's newly
acquired subsidiary, NNSI, the Company was the target of a theft of
telecommunications services. The Company is currently working with one of its
major providers to resolve this issue and currently believes this obligation to
the provider approximates $205,000 as of June 30, 2003. Accordingly, the Company
has accrued such amount and included it in general and administrative expenses
within the condensed consolidated statements of operations and comprehensive
loss.
As a result of this theft of telecommunications services, management has since
enacted new internal controls at the subsidiary level in order to deter future
occurrences of this nature. It is the opinion of management that the outcome of
this matter will not have a material adverse effect on the Company's operations
or financial condition.
Other than the event listed above, there have been no significant changes in our
internal controls or in other factors that could significantly affect those
internal controls subsequent to the date of our evaluation thereof.
32
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) See Index to Financial Statements at beginning of attached financial
statements.
(b) Reports on Form 8-K
-------------------
Current Report on Form 8-K dated September 15, 2003.
(c) Exhibits
--------
3.1 Certificate of Incorporation, as amended ******
3.2 By-Laws. *
4.1 Specimen common stock certificate.*
4.2 Form of warrant to investment banking firm. *
4.3 Form of warrant to employees.*
10.1 Agreement between The Sullivan Group and NetWolves Corporation dated
January 5, 1999.*
10.2 Warrant Agreement between NetWolves Corporation and Walter M.Groteke dated
June 17, 1998.*
10.3 1998 Stock Option Plan*
10.4 2000 Stock Option Plan **
10.5 2001 Stock Option Plan ***
10.6 2002 Stock Option Plan *****
10.7 2003 Stock Option/Stock Issuance Plan.
10.8 Form of Indemnification Agreement*
10.9 Employment Agreement between NetWolves Corporation and Walter M. Groteke
dated October 1, 2000. ***
10.10 Employment Agreement between NetWolves Corporation and Walter R. Groteke
dated October 1, 2000. ****
10.11 Employment Agreement between NetWolves Corporation and Peter C. Castle
dated October 1, 2000. ****
10.12 Agreement of Lease between Registrant and Fortunato Development, Inc.
dated April 18, 2000.******
10.13 Office Lease Agreement between Registrant and BRST Fountain Square L.L.C.
dated September 29, 2000. ******
22 Subsidiaries of the Registrant
Name State of Incorporation Percentage owned by Company
---- ---------------------- ---------------------------
ComputerCOP Corp. New York 100%
NetWolves Technologies
Corporation New York 100%
NNS, Inc. Delaware 100%
Norstan Network Services, Inc. Minnesota 100%
TSG Global Education, Inc. Delaware 97%
23.1 Consent of Ernst & Young LLP
31 CEO and CFO Certifications Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32 CEO and CFO Certifications Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
__________________________________________________________________________
* Previously filed as exhibits to Report on Form 10, as amended.
** Previously filed as an exhibit to Report on Form 10-K for the fiscal
year ended June 30, 2000.
*** Previously filed as an exhibit to Report on Form 10-K for the fiscal
year ended June 30, 2001.
**** Previously filed as an exhibit to Report on Form 10-Q for the quarter
ended March 31, 2001.
***** Previously filed as an exhibit to Report on Form 10-K for the fiscal
year ended June 30, 2002.
****** Previously filed as an exhibit to Amendment No. 1 to Registration
Statement on Form S-3/A File No. 333-100734.
33
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized on the 29th day of September,
2003.
NetWolves Corporation
By: /s/ Walter M. Groteke
-----------------------------
Walter M. Groteke
Chairman of the Board, President
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below on September 29, 2003 by the following persons in the
capacities indicated:
/s/ Walter M. Groteke
- ----------------- Chairman of the Board and President
Walter M. Groteke Chief Executive Officer
/s/ Walter R. Groteke
- ----------------- Vice President - Sales and Marketing
Walter R. Groteke and Director
/s/ Peter C. Castle
- --------------- Secretary and Treasurer
Peter C. Castle Principal Financial Officer and
Principal Accounting Officer
/s/ Carlos Campbell
- --------------- Director
Carlos Campbell
/s/ Fassil Gabremariam
- --------------- Director
Fassil Gabremariam
/s/ Myron Levy
- --------------- Director
Myron Levy
CONTENTS
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ..........................F-1
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ..........................F-2
CONSOLIDATED BALANCE SHEETS
June 30, 2003 and 2002 ..................................................F-3
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
For the years ended June 30, 2003, 2002 and 2001.........................F-5
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
For the years ended June 30, 2001, 2002 and 2003 ..................F-6 - F-7
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended June 30, 2003, 2002 and 2001...................F-8 - F-9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ..........................F-10 - F-37
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES................F-39
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of
NetWolves Corporation:
We have audited the accompanying balance sheets of NetWolves Corporation (a New
York corporation) and subsidiaries as of June 30, 2003 and 2002, and the related
consolidated statements of operations and comprehensive loss, shareholders'
equity and cash flows for the years then ended. Our audit also included the
financial statement schedule for the years ended June 30, 2003 and 2002 listed
in the index at Item 14. These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of NetWolves
Corporation and subsidiaries at June 30, 2003 and 2002, and the consolidated
results of their operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule for the years
ended June 30, 2003 and 2002, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
/s/ Ernst & Young LLP
Tampa, Florida
September 25, 2003
F-1
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of
NetWolves Corporation:
We have audited the accompanying consolidated balance sheet of NetWolves
Corporation (a New York corporation) and subsidiaries as of June 30, 2001, and
the related consolidated statements of operations and comprehensive loss,
shareholders' equity and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of NetWolves Corporation and
subsidiaries as of June 30, 2001, and the results of their operations and their
cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States.
Our audit was made for the purpose of forming an opinion on the basic financial
statements taken as a whole. Schedule II listed in the index of financial
statements is presented for purposes of complying with the Securities and
Exchange Commission's rules and is not part of the basic financial statements.
Schedule II has been subjected to the auditing procedures applied in the audit
of the basic financial statements and, in our opinion, fairly states in all
material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP
Tampa, Florida
August 17, 2001 (except with respect to
the matters discussed in Note 17, as to
which the date is October 11, 2001)
The report is a copy of the previously issued Arthur Andersen accountants'
report and such report has not been reissued by Arthur Andersen.
F-2
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30,
--------------------------------------
2003 2002
------------------ ------------------
ASSETS
Current assets
Cash and cash equivalents $ 1,336,191 $ 656,880
Restricted cash 297,701 366,276
Marketable securities, available for sale - 82,250
Accounts receivable, net of allowance for doubtful accounts of
$179,859 and $191,164 at June 30, 2003 and 2002, respectively 2,254,790 107,178
Inventories 89,598 136,930
Prepaid expenses 172,002 129,293
Purchase deposits - 841,000
Other current assets 8,241 13,491
------------------ ------------------
Total current assets 4,158,523 2,333,298
Property and equipment, net 578,192 682,395
Internally developed software, net 50,572 104,874
Identifiable intangible assets
Patent 47,649 45,394
Licenses 203,000 -
Contractual customer relationships, net 1,959,277 -
Computer billing software, net 756,043 -
------------------ ------------------
Total identifiable intangible assets 2,965,969 45,394
Goodwill 3,515,698 -
Other assets 59,383 58,493
------------------ ------------------
$ 11,328,337 $ 3,224,454
LIABILITIES AND SHAREHOLDERS' EQUITY ================== ==================
Current liabilities
Accounts payable and accrued expenses $ 4,613,252 $ 675,321
Accrued losses of discontinued operations 108,639 137,958
Deferred revenue 423,625 46,780
Advances from related parties 150,000 -
Current maturities of long-term debt 120,000 362,982
------------------ ------------------
Total current liabilities 5,415,516 1,223,041
Deferred revenue 51,000 -
Accrued losses of discontinued operations 128,886 235,012
------------------ ------------------
Total liabilities 5,595,402 1,458,053
------------------ ------------------
Minority interest 275,734 272,533
------------------ ------------------
Commitments and contingencies
Shareholders' equity
Series A Preferred stock, $.0033 par value; $8,682,886 liquidation
preference; 1,000,000 and no shares authorized on June 30, 2003 and
June 30, 2002, respectively; 269,462 and no shares issued and
outstanding on June 30, 2003 and June 30, 2002, respectively 2,819,876 -
The accompanying notes to the financial statements
are an integral part of these consolidated
balance sheets.
F-3
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
Series B Preferred stock, $.0033 par value; $9,615,038 liquidation
preference; 500,000 and no shares authorized on June 30, 2003 and
June 30, 2002, respectively; 290,963 and no shares issued and
outstanding on June 30, 2003 and June 30, 2002, respectively 3,055,770 -
Series C Preferred stock, $.0033 par value; $172,555 liquidation
preference; 100,000 and no shares authorized on June 30, 2003 and
June 30, 2002, respectively; 2,850 and no shares issued and
outstanding on June 30, 2003 and June 30, 2002, respectively 135,701 -
Preferred stock, $.0033 par value; 400,000 and 2,000,000 authorized on
June 30, 2003 and 2002, respectively; no shares issued and
outstanding on June 30, 2003 and 2002 - -
Common stock, $.0033 par value; 50,000,000 shares authorized on June 30,
2003 and 2002; 15,847,119 and 12,607,119 shares issued and
outstanding on June 30, 2003 and 2002, respectively 52,296 41,604
Additional paid-in capital 69,520,368 65,176,647
Unamortized value of equity compensation (104,758) -
Accumulated deficit (70,022,052) (63,611,478)
Accumulated other comprehensive loss - (112,905)
------------------ ------------------
Total shareholders' equity 5,457,201 1,493,868
------------------ ------------------
$ 11,328,337 $ 3,224,454
================= ==================
The accompanying notes to the financial statements
are an integral part of these consolidated
balance sheets.
F-4
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
For the year ended June 30,
-----------------------------------------------------------
2003 2002 2001
----------------- ----------------- -----------------
Revenue
Products $ 214,675 $ 246,016 $ 341,203
Services 20,944,784 492,732 1,083,935
----------------- ----------------- -----------------
21,159,459 738,748 1,425,138
----------------- ----------------- -----------------
Cost of revenue
Products 193,138 304,809 439,799
Services 13,842,906 452,888 905,321
----------------- ----------------- -----------------
14,036,044 757,697 1,345,120
----------------- ----------------- -----------------
Gross profit 7,123,415 (18,949) 80,018
----------------- ----------------- -----------------
Operating expenses
General and administrative 8,847,462 6,442,954 7,714,047
Engineering and development 1,595,882 1,703,376 1,893,372
Sales and marketing 3,252,226 2,500,793 4,958,719
Impairment charges - - 1,415,929
----------------- ----------------- -----------------
13,695,570 10,647,123 15,982,067
----------------- ----------------- -----------------
Loss before other income (expense)
and income taxes (6,572,155) (10,666,072) (15,902,049)
Other income (expense)
Investment income 13,351 117,147 650,003
Gain on extinguishment of debt 716,014 - -
Realized loss on sale of marketable securities (115,201) - -
Minority interest (3,201) 9,160 24,068
Interest expense (202,985) (37,571) (27,613)
----------------- ----------------- -----------------
Loss before income taxes (6,164,177) (10,577,336) (15,255,591)
Provision for income taxes 129,300 - -
----------------- ----------------- -----------------
Net loss from continuing operations (6,293,477) (10,577,336) (15,255,591)
Discontinued business
Loss from discontinued operations - - (4,725,901)
Loss on disposal of discontinued operations,
including $117,097, $525,204 and none for
operating losses for the year ended June 30,
2003, 2002 and 2001, respectively. (117,097) (1,053,274) (650,000)
----------------- ----------------- -----------------
Net loss $ (6,410,574) $ (11,630,610) $ (20,631,492)
================= ================= =================
The accompanying notes to the financial statements
are an integral part of these consolidated
balance sheets.
F-5
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
For the year ended June 30,
-----------------------------------------------------------
2003 2002 2001
----------------- ----------------- -----------------
Other comprehensive income (loss)
Marketable securities valuation adjustment (2,296) 11,250 (28,500)
----------------- ----------------- -----------------
Comprehensive loss $ (6,412,870) $ (11,619,360) $ (20,659,992)
================= ================= =================
Basic and diluted net loss per share
Net loss $ (6,410,574) $ (11,630,610) $ (20,631,492)
================= ================= =================
Beneficial conversion on preferred stock (138,882) - -
Dividends on preferred stock (453,179) - -
----------------- ----------------- -----------------
Net loss available to common shareholders $ (7,002,635) $ (11,630,610) $ (20,631,492)
================= ================= =================
Basic and diluted net loss per share
Loss from continuing operations $ (0.53) $ (0.90) $ (1.74)
Loss from discontinued operations (0.01) (0.09) (.61)
----------------- ----------------- -----------------
$ (0.54) $ (0.99) $ (2.35)
================= ================= =================
Weighted average common shares
outstanding, basic and diluted 12,929,559 11,756,220 8,776,928
================= ================= =================
The accompanying notes to the financial statements
are an integral part of these consolidated
balance sheets.
F-5
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED JUNE 30, 2001, 2002 AND 2003
Common stock Series A Preferred Series B Preferred Series C Preferred Accumulated
Stock stock Stock Additional other
paid-in Accumulated comprehensive
Shares Amount Shares Amount Shares Amount Shares Amount capital deficit income(loss)
------ ------ ------ ------ ------ ------ ------ ------ ---------- ----------- -------------
Balance, June 30, 2000 8,592,613 $ 28,356 - $ - - $ - - $ - $56,076,197 $(31,349,376) $ (95,655)
Common stock, options
and warrants
issued for services 575,000 1,898 2,377,302 - -
Marketable securities
valuation adjustment - - - - (28,500)
Repurchase of warrant - - (705,000) - -
Net loss, year ended
June 30, 2001 - - - (20,631,492) -
---------- ------- ---------- ------------ ---------
Total comprehensive
loss
Balance, June 30, 2001 9,167,613 $ 30,254 - - - - - - $57,748,499 $(51,980,868) $(124,155)
Common stock, options
and warrants issued
for services 130,000 429 466,569 - -
Amortization of warrants - - - - -
Common stock issued in
settlement of employment
agreements 350,000 1,155 956,345 - -
Common stock issued in
private placement, net
of expenses of
$310,000 2,830,000 9,339 6,005,661 - -
Common stock issued
upon exercise of
warrants 129,506 427 (427) - -
Marketable securities
valuation adjustment - - - - 11,250
Net loss, year ended
June 30, 2002 - - - (11,630,610) -
---------- ------- ---------- ------------ ---------
Total comprehensive
loss
Balance, June 30, 2002 12,607,119 $41,604 - - - - - - $65,176,647 $(63,611,478) $(112,905)
========== ======= ========== ============ =========
The accompanying notes to the financial statements
are an integral part of these consolidated
statements.
F-6
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED JUNE 30, 2001, 2002 AND 2003
Unamortized Total
value of equity Shareholders' Comprehensive
compensation Equity Income (loss)
--------------- ------------- -------------
Balance, June 30, 2000 $(1,851,893) $22,807,629
Common stock, options
and warrants
issued for services 840,393 3,219,593
Marketable securities
valuation adjustment - (28,500) $ (28,500)
Repurchase of warrant - (705,000)
Net loss, year ended
June 30, 2001 - (20,631,492) (20,631,492)
----------- ----------- ------------
Total comprehensive
loss $(20,659,992)
============
Balance, June 30, 2001 $(1,011,500) $ 4,662,230
Common stock, options
and warrants issued
for services - 466,998
Amortization of warrants 1,011,500 1,011,500
Common stock issued in
settlement of employment
agreements 957,500
Common stock issued in
private placement, net
of expenses of
$310,000 - 6,015,000
Common stock issued
upon exercise of
warrants - -
Marketable securities
valuation adjustment - 11,250 $ 11,250
Net loss, year ended
June 30, 2002 (11,630,610) (11,630,610)
----------- ----------- ------------
Total comprehensive
loss $(11,619,360)
============
Balance, June 30, 2002 - $ 1,493,868
=========== ============
The accompanying notes to the financial statements
are an integral part of these consolidated
statements.
F-6
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED JUNE 30, 2001, 2002 AND 2003
Common stock Series A Preferred Series B Preferred Series C Preferred
Stock stock Stock Additional
paid-in Accumulated
Shares Amount Shares Amount Shares Amount Shares Amount capital deficit
------ ------ ------ ------ ------ ------ ------ ------ ---------- -----------
Balance, June 30, 2002 12,607,119 $ 41,604 - $ - - $ - - $ - $65,176,647 $(63,611,478)
========== ======== ======= ======== ========= ========== ======== ====== =========== ============
Common stock, options
and warrants
issued for services 2,840,000 9,372 2,322,523
Amortization of warrants
Preferred stock with
beneficial conversion
feature issued in
private placement,
net of expenses of
$821,558 269,462 2,819,876 290,963 3,055,770 2,850 135,701 2,035,367
Preferred stock dividends (453,179)
Common stock issued
to settle note
payable to Norstan, Inc. 300,000 990 344,010
Common stock issued in
private placement,
net of expenses of
$5,000 100,000 330 95,000
Marketable securities
valuation adjustment
Loss on sale of
marketable securities
Net loss, year ended
June 30, 2003 - - - - - - - - - (6,410,574)
---------- -------- ------- -------- --------- ---------- -------- ------ ----------- ------------
Total comprehensive
loss
Balance, June 30,
2003 15,847,119 52,296 $269,462 $2,819,876 290,963 $3,055,770 2,850 $135,701 $69,520,368 $(70,022,052)
========== ======== ======= ======== ========= ========== ======== ====== =========== ============
The accompanying notes to the financial statements
are an integral part of these consolidated
statements.
F-7
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED JUNE 30, 2001, 2002 AND 2003
Accumulated
other Unamortized Total
comprehensive value of equity shareholders' Comprehensive
income(loss) compensation equity income (loss)
------------- --------------- ------------- -------------
Balance, June 30, 2002 $(112,905) $ - $ 1,493,868
========= =========== ===========
Common stock, options
and warrants
issued for services (128,000) 2,203,895
Amortization of warrants 23,242 23,242
Preferred stock with
beneficial conversion
feature issued in
private placement,
net of expenses of
$821,558 8,046,714
Preferred stock dividends (453,179)
Common stock issued
to settle note
payable to Norstan, Inc. 345,000
Common stock issued in
private placement,
net of expenses of
$5,000 95,330
Marketable securities (2,296) (2,296) (2,296)
valuation adjustment
Loss on sale of
marketable securities 115,201 115,201
Net loss, year ended - - (6,410,574) (6,410,574)
June 30, 2003
--------- ----------- ----------- ----------
Total comprehensive
loss $(6,412,870)
===========
Balance, June 30,
2003 $ - $(104,758) $ 5,457,201
========= =========== ===========
The accompanying notes to the financial statements
are an integral part of these consolidated
statements.
F-7
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the year ended June 30,
-----------------------------------------------------------
2003 2002 2001
------------------ ----------------- ----------------
Cash flows from operating activities
Net loss $ (6,410,574) $ (11,630,610) $ (20,631,492)
Adjustments to reconcile net loss to net cash used
in operating activities
Depreciation 236,982 243,715 231,029
Amortization 714,982 42,390 1,190,223
Realized loss on sale of marketable securities 115,201 - -
Provision for impairment - 100,000 3,524,911
Provision for inventory obsolescence - 193,086 243,222
Loss on disposal of property and equipment 5,207 91,723 64,435
Provision for other assets - 56,000 -
Gain on extinguishment of debt (716,014) - -
Non-cash charge to operations with respect to
common stock, options and warrants issued for
services 2,227,137 2,344,998 1,974,799
Amortization of imputed interest 184,378 - -
Minority interest 3,201 (9,160) (24,068)
Changes in operating assets and liabilities
Restricted cash 68,575 (42,386) (323,890)
Accounts receivable (277,526) 259,690 (84,418)
Inventories 47,332 15,021 86,484
Prepaid expenses (42,709) 105,355 (83,304)
Other current assets 70,769 165,639 14,551
Accounts payable and accrued expenses 1,827,615 (251,313) (865,396)
Accrued loss on disposal of discontinued operations (135,445) (123,957) 496,927
Deferred revenue 13,889 (83,198) 118,805
Due to Norstan, Inc. 846,474 - -
------------------ ----------------- ----------------
Net cash used in operating activities (1,220,526) (8,523,007) (14,067,182)
------------------ ----------------- ----------------
Cash flows from investing activities
Proceeds from sale of marketable securities 79,954 - -
Payment to purchase Norstan Network Services, Inc.
(3,350,000) - -
Finders fee paid in connection with acquisition of
Norstan Network Services, Inc. - (350,000) -
Deposit paid to Norstan, Inc. in connection with
acquisition of Norstan Network Services, Inc. - (400,000) -
License fees paid - - (150,000)
Acquisition costs paid (129,500) - -
Patent costs paid (2,255) (13,293) (32,101)
Purchases of property and equipment (81,686) (104,456) (745,215)
Capitalized software costs, net of funding - (72,852) (116,066)
Return of (payments for) security deposits (890) 17,721 (37,423)
------------------ ----------------- ----------------
Net cash used in investing activities
(3,484,377) (922,880) (1,080,805)
------------------ ----------------- ----------------
F-8
NETWOLVES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the year ended June 30,
-----------------------------------------------------------
2003 2002 2001
------------------ ----------------- ----------------
Cash flows from financing activities
Cash proceeds from issuance of preferred stock and
warrants 8,868,272 - -
Repayment of notes payable (2,907,500) - (263,555)
Repurchase of warrant - (705,000)
Cash proceeds from issuance of common stock 100,000 6,325,000 -
Financing costs paid (826,558) (310,000) -
Advances from related parties 600,000 - -
Repayment of advances from related parties (450,000) - -
------------------ ----------------- ----------------
Net cash provided by (used in) financing
activities 5,384,214 6,015,000 (968,555)
------------------ ----------------- ----------------
Net (decrease) increase in cash and cash equivalents 679,311 (3,430,887) (16,116,542)
Cash and cash equivalents, beginning of year 656,880 4,087,767 20,204,309
------------------ ----------------- ----------------
Cash and cash equivalents, end of year $ 1,336,191 $ 656,880 $ 4,087,767
================== ================= ===============
Cash paid for interest $ 6,682 $ 16,250 $ 27,613
================== ================= ===============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Issuance of non-interest bearing promissory note to
Norstan, Inc. (Note 4) $ 3,479,850 $ - $ -
================== ================= ===============
Common stock issued in partial repayment of
non-interest bearing promissory note to Norstan,
Inc. (Note 4) $ 345,000 $ - $ -
================== ================= ===============
Common stock issued for services related to purchase
of Norstan Network Services, Inc. $ - $ 91,000 $ -
================== ================= ===============
The accompanying notes to the financial statements
are an integral part of these consolidated
statements.
F-9
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1 The Company
The consolidated financial statements include the accounts of NetWolves
Corporation and its subsidiaries, NetWolves Technologies Corporation
("NWT"), Norstan Network Services, Inc. (NNSI), ComputerCOP Corporation
("Computer Cop") and its majority owned TSG Global Education Web, Inc.
("TSG") (collectively "NetWolves" or the Company").
NWT designs, develops, assembles and sells Internet infrastructure security
platforms, coupled with network based management services, designed to
significantly reduce the up-front and ongoing costs associated with small,
medium and remote offices' global Internet access. NNSI provides multiple
source data and voice services and related consulting and professional
services throughout the United States. TSG provides management and
consulting services to the automotive industry. Effective August 31, 2002,
the Company ceased all operations of ComputerCOP and terminated all
remaining employees of ComputerCOP.
2 Significant accounting policies
Use of estimates
In preparing consolidated financial statements in conformity with
accounting principles generally accepted in the United States, management
makes estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities at the
date of the consolidated financial statements, as well as the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates.
Principles of consolidation
The consolidated financial statements include the accounts of the Company
and its subsidiaries. All significant intercompany transactions and
balances have been eliminated in consolidation. The separate ownership of
TSG is reflected in the Company's consolidated financial statements as
minority interest. The minority interest includes common stock representing
1.7% of the outstanding shares of the subsidiary.
Prepaid expenses
Prepaid expenses consist primarily of prepaid insurance and are being
amortized over their respective lives using the straight-line method.
F-10
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Business combinations and goodwill
In June 2001, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Standards ("SFAS") 141, "Business Combinations"
("SFAS 141") and SFAS 142, "Goodwill and Other Intangible Assets" ("SFAS
142"). SFAS 141 addresses financial accounting and reporting for business
combinations while SFAS 142 addresses financial accounting and reporting
for acquired goodwill and other intangible assets. SFAS 141 applies to all
business combinations initiated after June 30, 2001, while SFAS 142 is
required to be applied in fiscal years beginning after December 15, 2001.
Identifiable intangible assets with other than indefinite lives will
continue to be amortized in the financial statements, however, goodwill and
identifiable intangible assets with indefinite lives will no longer be
amortized. In connection with the acquisition of NNSI, the adoption of SFAS
141 has had a material impact on the Company's financial statements. The
adoption of SFAS 142 has not had material impact on the Company's financial
statements although the Company is required to review its intangibles and
goodwill annually for indicators of impairment and this review could result
in recognition of impairment losses. SFAS 142 requires that the Company
test all goodwill for impairment within six months of implementation. The
Company has performed testing for impairment by utilizing the discounted
cash flow method and did not find any impairment of goodwill.
Long lived assets
In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment
and Disposal of Long-Lived Assets." SFAS 144 supersedes SFAS 121,
"Accounting for the Impairment of Long- Lived Assets and for Long-Lived
Assets to Be Disposed Of" and also supersedes the provisions of APB Opinion
30, "Reporting the Results of Operations-Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual, and Infrequently
Occurring Events and Transactions." SFAS 144 retains the requirements of
SFAS 121 to (a) recognize an impairment loss only if the carrying amount of
a long-lived asset is not recoverable from its undiscounted cash flow and
(b) measure an impairment loss as the difference between the carrying
amount and the fair value of the asset. SFAS 144 establishes a single model
for accounting for long-lived assets to be disposed of by sale. As
required, we have adopted the provisions of SFAS 144 effective July 1,
2002, and the effect of adoption was not material to our financial position
or results of operations.
Basic and diluted net loss per share
The Company displays loss per share in accordance with SFAS 128, "Earnings
Per Share" ("SFAS 128"). SFAS 128 requires dual presentation of basic and
diluted earnings per share. Basic earnings per share includes no dilution
and is computed by dividing net income (loss) available to common
shareholders by the weighted average number of common shares outstanding
for the period. The diluted loss per share does not include the impact of
potential shares to be issued upon exercise of convertible preferred stock,
options and warrants aggregating approximately 13,123,000, 7,474,000 and
7,135,000 at June 30, 2003, 2002 and 2001, respectively, because the
Company had a net loss from operations and, therefore, the effect would be
antidilutive.
F-11
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Revenue recognition
The Company records revenue in accordance with Statement of Position 97-2
"Software Revenue Recognition" ("SOP 97-2"), issued by the American
Institute of Certified Public Accountants (as modified by Statement of
Position 98-9) and SEC Staff Accounting Bulletin 101 "Revenue Recognition
in Financial Statements" ("SAB 101") regarding revenue recognition in
financial statements. SOP 97-2 provides additional guidance with respect to
multiple element arrangements; returns, exchanges, and platform transfer
rights; resellers; services; funded software development arrangements; and
contract accounting. Accordingly, revenue from the sale of hardware is
recognized within product revenue at the time of delivery and acceptance of
hardware and software products by the customer, when the fee is fixed and
determinable and collectibility is probable. Maintenance or monitoring
revenue that is bundled with an initial license fee is deferred and
recognized ratably within service revenue over the maintenance or
monitoring period in the accompanying consolidated statements of operations
and comprehensive loss. Amounts deferred for maintenance or monitoring are
based on the fair value of equivalent maintenance or monitoring services
sold separately. The Company has established vendor specific objective
evidence ("VSOE") on all undelivered elements of its software arrangements,
which consists of maintenance, monitoring and, at times, training and
consulting. The Company uses the residual method for delivered elements.
The Company's consulting and training projects are short-term in nature and
are recorded as revenue when the services have been rendered.
Revenues from NNSI generated from the resale of long distance services are
recognized as services are provided. Revenues from NNSI primarily consist
of monthly fees, which are recognized over the monthly period and long
distance charges, which are recognized as incurred. These revenues are
included within service revenue in the accompanying consolidated statements
of operations and comprehensive loss.
Revenue for shipping and handling are included within products revenue and
the related costs are included in cost of revenue in the accompanying
consolidated statements of operations and comprehensive loss.
Inventories
Inventories consist of raw materials and finished goods. Inventories are
valued at the lower of cost or net realizable value using the first-in,
first-out method. During the year ended June 30, 2001, the Company recorded
a writedown of inventory approximating $243,000. Additionally, raw material
and finished goods amounted to $69,649 and $19,949, respectively, at June
30, 2003 and $108,079 and $28,851, respectively, at June 30, 2002.
Property and equipment
Property and equipment are stated at cost. Costs assigned to property and
equipment of the acquired businesses (Note 3) were based on estimated fair
value at acquisition. Depreciation is provided on furniture and fixtures
and machinery and equipment over their estimated lives, ranging from 5 to 7
years, using the straight-line method. Leasehold improvements are amortized
over the lesser of the term of the respective lease or the useful lives of
the related assets. Expenditures for maintenance and repairs are charged
directly to the appropriate operating accounts at the time the expense is
incurred. Expenditures determined to represent additions and betterments
are capitalized and amortized over the lesser of their useful lives or the
useful lives of the related assets. Depreciation and amortization is
included in general and administrative expenses in the accompanying
consolidated statements of operations and comprehensive loss.
F-12
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Internally developed software
Costs associated with the development of software products are generally
capitalized once technological feasibility is established in accordance
with SFAS 86, "Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed". Software costs are amortized using the
greater of the ratio of current revenue to total projected revenue for a
product or the straight-line method over its estimated useful life and
amortization begins when products become available for general customer
release. The Company recorded approximately $54,000, $41,000 and $43,000 in
amortization expense for the years ended June 30, 2003, 2002 and 2001,
respectively, relating to internally developed software costs. Costs
incurred prior to establishment of technological feasibility are expensed
as incurred and reflected as engineering and development costs in the
accompanying consolidated statements of operations and comprehensive loss.
The Company capitalized internally developed software development costs of
approximately $0, $73,000 and $116,000 and incurred approximately
$1,596,000, $1,703,000 and $1,893,000 in research and development costs for
the years ended June 30, 2003, 2002 and 2001, respectively. Accumulated
amortization at June 30, 2003 was approximately $138,000.
Product warranties
The Company offers warranties on the sales of certain of its products and
records an accrual for estimated future claims. Such accruals are based
upon historical experience and management's estimate of the level of future
claims.
Income taxes
In accordance with SFAS 109 "Accounting for Income Taxes", the Company
accounts for income taxes using the liability method which requires the
determination of deferred tax assets and liabilities based on the
differences between the financial and tax bases of assets and liabilities
using enacted tax rates in effect for the year in which differences are
expected to reverse. The net deferred tax asset is adjusted by a valuation
allowance, if, based on the weight of available evidence, it is more likely
than not that some portion or all of the net deferred tax asset will not be
realized. The Company and its subsidiaries file a consolidated Federal
income tax return.
Stock-based compensation
SFAS 123, "Accounting for Stock-Based Compensation" ("SFAS 123")
establishes a fair value- based method of accounting for stock based
compensation plans. The Company has chosen to adopt the disclosure
requirements of SFAS 123 and SFAS 148, "Accounting for Stock-Based
Compensation Transition and Disclosure" ("SFAS 148") and continue to record
stock compensation for its employees and outside directors using the
intrinsic value method prescribed in Accounting Principles Board Opinion
25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB 25,
charges are made to operations in accounting for stock options granted to
employees and outside directors when the option exercise prices are below
the fair market value of the common stock at the measurement date.
If the Company had elected to recognize compensation expense based upon the
fair value at the date of grant consistent with the methodology prescribed
by SFAS 123 and SFAS 148, the effect on the Company's net loss and net loss
per share would be as follows:
F-13
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended June 30,
---------------------------------------------------------------
2003 2002 2001
------------------- ------------------- ------------------
Net loss available to common
shareholders, as reported $ (7,002,635) $ (11,630,610) $ (20,631,492)
Add: Total stock-based
employee compensation
expense included in
reported net loss, net of
related tax effects - - -
Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effects (544,699) (664,478) (12,271,972)
----------------- ----------------- -----------------
Pro forma net loss $ (7,547,334) $ (12,295,088) $ (32,903,464)
================= ================= =================
Basic and diluted net loss per
share
As reported $ (.54) $ (.99) $ (2.35)
Pro forma $ (.58) $ (1.05) $ (3.74)
Equity issuances to non-employees in exchange for services are charged to
operations over the period the services are provided using the fair value
method on the measurement date. The costs associated with issuances of
fixed awards with pro rata vesting are revalued at the respective vesting
dates and expensed in the respective consolidated statement of operations
and comprehensive loss as the services are provided.
The weighted average fair value per share of common stock, options and
warrants granted to employees during the years ended June 30, 2003, 2002
and 2001, approximated $.74, $1.38 and $2.73, respectively, are estimated
on the date of grant using the Black-Scholes option-pricing model with the
following assumptions: no dividend yield, expected volatility ranging from
75% to 85%, risk-free interest rates ranging from 2.48% to 6.68%, and
expected lives ranging from 5 to 10 years.
Cash and cash equivalents
The Company considers highly liquid investments in debt securities with
original maturities of three months or less to be cash equivalents. At June
30, 2003, approximately $298,000 of the Company's cash is being utilized to
secure various letters of credit.
Allowance for doubtful accounts
The Company provides allowances for doubtful accounts for estimated losses
from the inability of customers to satisfy their accounts as originally
contemplated at the time of sale and charges actual losses to the allowance
when incurred. The calculation for these allowances is based on the
detailed review of certain individual customer accounts, historical
satisfaction rates and the Company's estimation of the overall economic
conditions affecting the Company's customer base. If the financial
condition of the Company's customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.
F-14
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Concentrations and fair value of financial instruments
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash investments and
marketable securities. At June 30, 2003, the Company's cash investments are
held at primarily one financial institution. The fair value of financial
instruments approximates their recorded values.
Comprehensive income (loss)
The Company presents comprehensive income (loss) in accordance with SFAS
130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes
standards for reporting and display of comprehensive income (loss) and its
components. As this statement pertains to disclosure information
requirements, it has no impact on the Company's operating results or
financial position. The Company's adjustment to arrive at comprehensive
income (loss) consists of the marketable securities valuation adjustment
and is presented in the accompanying consolidated statements of
shareholders' equity and comprehensive income (loss).
Summary of recent accounting pronouncements
In January 2003, the FASB issued Interpretation 46, Consolidation of
Variable Interest Entities, an interpretation of ARB 51 ("FIN 46"). FIN 46
addresses the consolidation by business enterprises of variable interest
entities, as defined in the interpretation. FIN 46 expands existing
accounting guidance regarding when a company should include in its
financial statements the assets, liabilities and activities of another
entity. The consolidation requirements apply to variable interest entities
created after January 31, 2003. Certain of the disclosure requirements
apply in all financial statements after January 31, 2003. The consolidated
requirements of FIN 46 apply to any variable interest entity created before
February 1, 2003 in the first fiscal year or interim period beginning after
June 15, 2003. The Company will fully adopt FIN 46 on July 1, 2003. The
Company has one entity, TSG, which is not wholly-owned. Based on the
requirements of FIN 46, the Company believes that TSG will continue to be
consolidated in the same manner it is currently upon adoption of FIN 46.
The Company has not identified any other variable interest entities. The
application of FIN 46 is not expected to have a material effect on
the Company's financial position, results of operations or cash flows.
In May 2003, the FASB issued SFAS 150 "Accounting for Certain Financial
Instruments With Characteristics of Both Liabilities and Equity". This
standard requires issuers to classify as liabilities the following three
types of freestanding financial instruments: (1) mandatorily redeemable
financial instruments, (2) obligations to repurchase the issuer's equity
shares by transferring assets; and (3) certain obligations to issue a
variable number of shares. The Company will adopt the provisions of this
statement, as required, on July 1, 2003, and it is not expected to have a
material effect on the Company's financial position, results of operations
or cash flows.
Reclassifications
Certain reclassifications have been made to the 2002 consolidated financial
statements shown for the prior periods in order to have them conform to the
current period's classifications.
3 Business combination
On July 9, 2002, the Company acquired all of the outstanding capital stock
of NNSI pursuant to a Stock Purchase Agreement dated as of January 30,
2002, as amended, among Norstan, Inc. ("Seller") and NNSI, both Minnesota
corporations, and the Company. NNSI provides multiple source data and voice
services and related consulting and professional services throughout the
United States. The acquisition of NNSI provides the Company with a
competitive advantage of offering a complete program of internet security
and communication services when soliciting customers.
F-15
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Consideration was $7,500,000, $3,750,000 of which was paid in cash on or
prior to closing and $3,750,000 was payable under the terms of a
non-interest bearing promissory note due July 9, 2003. The $3,750,000 in
cash paid by the Company to the Seller was primarily obtained through
equity and debt financing and to a lesser extent from working capital.
On March 18, 2003, the Company agreed to pay Norstan, Inc. $2.9 million in
cash and issued 300,000 shares of its common stock in full settlement of
its outstanding $3.75 million non-interest bearing promissory note.
Management determined the fair value of the common shares issued based on
the quoted market price on such date to be $345,000. The Company recorded
the difference between the consideration given and the carrying value of
the note as of March 18, 2003 as a gain on extinguishment of debt in the
accompanying consolidated statements of operations and comprehensive loss.
The total purchase price, including acquisition costs, is summarized as
follows:
Cash paid to Norstan, Inc., on or prior to closing $ 3,750,000
Promissory note payable* 3,479,850
Finders fee 350,000
Professional fees 225,500
-----------------
$ 7,805,350
=================
*The non-interest bearing promissory note payable with a face value of
$3,750,000 was discounted using a rate of 7.5% and was due on July 9,
2003.
The results of NNSI's operations have been included in our consolidated
financial statements commencing July 9, 2002.
The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at the July 9, 2002 acquisition date.
Current assets $ 2,782,079
Equipment 56,300
Intangible assets not subject to amortization - licenses 203,000
Intangible assets subject to amortization (estimated 5 year
useful life) 3,376,000
Goodwill 3,515,698
-----------------
Total assets acquired 9,933,077
-----------------
Current liabilities (2,127,727)
-----------------
Total liabilities assumed (2,127,727)
-----------------
Net assets acquired $ 7,805,350
=================
F-16
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value of acquired intangible assets and goodwill was determined by
an independent appraiser. The fair value of acquired intangible assets
subject to amortization, as well as their respective estimated useful lives
and accumulated amortization at June 30, 2003, is as follows:
Estimated Accumulated
Amortization at
Useful Life Fair Value June 30, 2003
---------------- ----------------- ---------------
Contractual customer relationships 5 Years $ 2,436,000 $ 476,723
Computer billing software 5 Years 940,000 183,957
All of the goodwill arising from this acquisition is expected to be
deductible for income tax purposes over a period of 15 years and is
included in the Company's Telecommunications segment. Based on intangible
assets held at June 30, 2003, estimated amortization of the Company's
identifiable intangible assets will equal approximately $675,000 in each of
the four succeeding fiscal years. Total amortization expense for the year
ended June 30, 2003 on such intangibles was $660,680.
The following unaudited pro forma consolidated statements of operations and
comprehensive loss for the year ended June 30, 2003 and 2002, gives pro
forma effect to the completion of the acquisition of NNSI as if it had
occurred July 1, 2001. The Company has a fiscal year end of June 30, while
NNSI had a fiscal year end of April 30. The consolidated operations of the
Company for the year ended June 30, 2002 have been combined with NNSI's
operations for the year ended April 30, 2002. The consolidated operations
of the Company for the year ended June 30, 2003 have been combined with
NNSI's operations for the period of July 1, 2002 to July 9, 2002, the date
of the acquisition.
The pro forma adjustments are based on estimates, available information and
certain assumptions management deems appropriate. The pro forma financial
data do not purport to represent what our financial position would actually
have been if such transactions had occurred on those dates and are not
necessarily representative of our financial position or results of
operations for any future period.
Proforma
For the year ended
June 30, June 30,
2003 2002
------------------- ----------------
Revenue $ 21,511,459 $ 21,880,748
Net loss from continuing operations
available to common shareholders $ (6,847,538) $ (9,360,336)
Basic and diluted net loss per
share from continuing operations $ (.48) $ (.80)
Net loss available to common
shareholders (including
discontinued operations) $ (6,963,635) $ (10,413,610)
Basic and diluted net loss per
share (including discontinued
operations) $ (.54) $ (.89)
F-17
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4 Disposal of business segment
During June 2001, the Company formally adopted a plan to discontinue its
ComputerCOP software operations. At that time, this operation consisted
primarily of ComputerCOP software technology, inventory and property and
equipment. At June 30, 2001, the Company accrued a provision for estimated
losses during the phase out period of approximately $497,000. During the
year ended June 30, 2002, the Company recorded additional charges
aggregating $1,053,275, which primarily represented the cost of salaries
through an extended disposal date of August 31, 2002, and a revised
estimate of the total leased facility costs. Effective August 31, 2002, the
Company ceased all operations of ComputerCOP and terminated all remaining
employees of ComputerCOP. During the year ended June 30, 2003, the Company
recorded activity related to the cessation of operations and the lease
payments related to the facility. Accrued losses of discontinued operations
included within the accompanying consolidated balance sheet at June 30,
2003 represent lease payment obligations on the ComputerCOP facility. A
summary of the operating results of the discontinued operations follows:
For the year ended June 30,
----------------------------------------------------------
2003 2002 2001
------------------ ------------------ -----------------
Revenue $ - $ 220,267 $ 102,525
Cost of revenue - 37,970 8,356
Selling, general and administrative 117,097 1,135,571 2,213,295
Amortization - - 1,147,793
Impairment - 100,000 2,108,982
------------------ ------------------ -----------------
117,097 1,053,274 5,375,901
Loss on disposal of discontinued
operations (117,097) (1,053,274) (650,000)
------------------ ------------------ -----------------
Loss from discontinued operations $ - $ - $ (4,725,901)
================== ================== =================
5 Marketable securities, available for sale The following is a summary of
marketable securities, available for sale:
Gross
Amortized unrealized Fair
cost loss value
--------------- --------------- -----------------
June 30, 2003
Bonds $ - $ - $ -
=============== =============== =================
June 30, 2002
Bonds $ 195,155 $ (112,905) $ 82,250
=============== =============== =================
Proceeds from sales of marketable securities and realized losses on such
sales aggregated $79,954 and $115,201, respectively for the year ended June
30, 2003. There were no sales of marketable securities during the years
ended June 30, 2002 and 2001.
F-18
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6 Property and equipment, net
Property and equipment consist of the following:
June 30,
--------------------------------------
2003 2002
----------------- -----------------
Machinery and equipment $ 880,422 $ 755,045
Furniture and fixtures 218,497 218,497
Leasehold improvements 142,432 140,875
----------------- -----------------
1,241,351 1,114,417
Less: accumulated depreciation and amortization (663,159) (432,022)
----------------- -----------------
Property and equipment, net $ 578,192 $ 682,395
================= =================
7 Accounts payable and accrued expenses
Accounts payable and accrued expenses consist of the following:
June 30,
--------------------------------------
2003 2002
----------------- -----------------
Trade accounts payable and other accrued operating
expenses $ 2,648,242 $ 490,311
Sales, excise and universal services charges payable 518,120 -
Dividends payable 453,179 -
Compensated absences 388,272 182,671
Provider settlement obligation 205,000 -
Other liabilities 199,370 1,039
Bonuses and commissions payable 101,069 1,300
Accrued taxes 100,000 -
----------------- -----------------
$ 4,613,252 $ 675,321
================= =================
8 Current maturities of long-term debt
Current maturities of long-term debt consists of the following:
June 30,
--------------------------------------
2003 2002
----------------- -----------------
Notes payable to Duffy-Vinet Institute, Inc. $ - $ 242,982
Finders fee payable 120,000 120,000
----------------- -----------------
$ 120,000 $ 362,982
================= =================
F-19
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On March 26, 2003, the Company paid $7,500 in full settlement of notes
payable to the Duffy- Vinet Institute, Inc., which were assumed by TSG in
connection with its acquisition of Sales and Management Consulting, Inc. At
the time, the notes had a carrying value of approximately $304,000
representing unpaid principal and accrued interest. The settlement resulted
in a gain on extinguishments of debt of approximately $297,000, which is
included in the accompanying consolidated statements of operations and
comprehensive loss.
In connection with the Company's purchase of ComputerCOP Corporation, the
Company incurred finder fees of $960,000, $360,000 of which are payable at
$10,000 per month over 36 months commencing on March 1, 2000. The Company
has ceased making payments on the debt in the current fiscal year and has
classified all amounts due as current liabilities.
9 Shareholders' equity
Common stock issuances
Management determined the fair value of all common stock issuances based on
each respective issuance's quoted market price at the measurement date.
For the year ended June 30, 2001, the Company issued 575,000 shares of its
common stock as follows:
-- In August 2000, 150,000 unregistered shares were issued to a
consulting firm for services rendered, which resulted in a charge
to operations of $807,000 and is included in sales and marketing
in the consolidated statements of operations and comprehensive
loss. One of the Company's employees, who is also a shareholder,
has an ownership interest in this consulting firm.
-- On May 14, 2001 and in connection with the Company entering into
a one year agreement with its investment bankers, the Company
issued 400,000 unregistered shares. The fair value of the shares,
$1,156,000, was amortized over the life of the agreement and is
included in general and administrative in the consolidated
statements of operations and comprehensive loss. The investment
bankers have demand registration rights on the shares issued 90
days after the commencement of the agreement.
-- In June 2001, 25,000 unregistered shares were issued to a
consulting firm for services rendered, which resulted in a charge
to operations of $89,250 and is included in general and
administrative in the consolidated statements of operations and
comprehensive loss.
For the year ended June 30, 2002, the Company issued 3,439,506 shares of
its common stock as follows:
-- On July 9, 2001, the Company completed a private placement with
Pequot Partners Fund, L.P. and Pequot International Fund, Inc.,
two funds managed by Pequot Capital Management, Inc. The Company
sold 1,200,000 shares of unregistered common stock at $2.50 per
share (a total of $3,000,000).
-- In July 2001, the Company completed a private placement to
accredited investors for $325,000 through the sale of 130,000
shares of unregistered common stock at $2.50 per share.
-- In July 2001, and in consideration for the termination of a three
year employment agreement, the Company issued 150,000 shares of
unregistered common stock to such employee, which resulted in a
charge to fiscal 2002 operations of $487,500.
F-20
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
-- In November 2001, the Company completed private placements with
Credit Suisse Asset Management, LLC, and Whiffletree Partners,
LP, which is managed by Palisade Capital Management, LLC, whereby
the Company sold an aggregate of 1,500,000 shares of unregistered
common stock at $2.00 per share (a total of $3,000,000) exclusive
of commissions and professional services aggregating $310,000,
$300,000 of which was paid to a company in which an employee of
NetWolves has an ownership interest.
-- In November 2001, and in consideration for the termination of a
three year employment agreement, the Company issued 200,000
shares of unregistered common stock and a warrant to purchase
100,000 shares of unregistered common stock to such employee,
which resulted in a charge to loss from discontinued operations
of $320,000 (exclusive of $150,000 which had been previously
accrued).
-- In January 2002, the Company issued 100,000 shares of
unregistered common stock for professional and consulting
services relating to potential business acquisitions to a company
in which an employee of NetWolves has an ownership interest. A
portion of the cost of such issuance has been included in other
current assets in the consolidated balance sheets at June 30,
2002.
-- During the year the Company issued a total of 30,000 shares of
unregistered common stock to two consultants for professional
services, which resulted in a charge to fiscal 2002 operations of
$68,300.
-- A total of 129,506 shares of the Company's common stock were
issued to individuals upon the cashless exercise of warrants
previously issued to these individuals.
For the year ended June 30, 2003, the Company issued 3,240,000 shares of
its common stock as follows:
-- In January 2003, the Company entered into a three-year consulting
agreement. In return for services, the Company issued 100,000
shares of the Company's unregistered common stock. Additionally,
the Company granted an immediately exercisable five-year warrant
to purchase 350,000 shares of the Company's common stock at an
exercise price of $1.50 per share. The fair value of the 100,000
shares issued is being revalued monthly and the aggregate value
of the unearned shares at June 30, 2003, totaling $104,758, is
included in unamortized value of equity compensation in the
accompanying consolidated balance sheets. During May 2003, the
agreement was revised to increase the amount of unregistered
common stock issued to the consultant by 150,000 shares and the
period for which services are to be performed was shortened by 4
months. The 150,000 shares have been included in common stock in
the accompanying consolidated balance sheets but as of June 30,
2003 have not been released by the transfer agent due to
administrative reasons. These shares were issued shortly after
June 30, 2003. The aggregate fair value of the earned shares for
the year ended June 30, 2003, $38,305, is included in general and
administrative expense in the accompanying consolidated
statements of operations and comprehensive loss.
-- In March 2003, the Company issued 300,000 shares of unregistered
common stock to Norstan, Inc. in addition to cash paid of $2.9
million in full settlement of its outstanding $3.75 million
non-interest bearing promissory note.
-- On June 1, 2003 the Company entering into two 30 month agreements
with consultants. Each consultant will be issued 300,000
unregistered shares, which vest at the monthly rate of 10,000
shares. The aggregate fair value of the vested shares at June 30,
2003, $22,000, is included in general and administrative expense
in the accompanying consolidated statements of operations and
comprehensive loss. The shares have been included in common stock
in the accompanying consolidated balance sheets but as of June
30, 2003 have not been released by the transfer agent due to
administrative reasons. These shares were issued shortly after
June 30, 2003.
F-21
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
-- During June 2003, the Company issued a total of 465,000 shares of
unregistered common stock to three consultants for professional
services rendered, which resulted in a charge to general and
administrative expense of $492,900 in the accompanying
consolidated statements of operations and comprehensive loss. The
shares have been included in common stock in the accompanying
consolidated balance sheets but as of June 30, 2003 have not been
released by the transfer agent due to administrative reasons.
These shares were issued shortly after June 30, 2003.
-- During June 2003, the Company issued a total of 1,400,000 shares
of unregistered common stock to certain members of its executive
management team. The aggregate value of the shares, $1,484,000 is
included in general and administrative expense in the
consolidated statements of operations and comprehensive loss. The
shares have been included in common stock in the accompanying
consolidated balance sheets but as of June 30, 2003 have not been
released by the transfer agent due to administrative reasons.
These shares were issued shortly after June 30, 2003.
-- During June, 2003, the Company sold 100,000 shares of
unregistered common stock during the year to accredited investors
at $1 per share exclusive of commissions and fees of
approximately 5%. The shares have been included in common stock
in the accompanying consolidated balance sheets but as of June
30, 2003 have not been released by the transfer agent due to
administrative reasons.
-- During June, 2003, the Company issued 125,000 shares of
unregistered common stock to an employee/stockholder for legal
services related to the Series A, B and C preferred stock
offerings. The aggregate value of the shares, $132,500, was
recorded as a reduction of proceeds to additional paid in capital
in the accompanying consolidated balance sheet. The share have
been included in common stock in the accompanying consolidated
balance sheets but as of June 30, 2003 have not been released by
the transfer agent due to administrative reasons. These shares
were issued shortly after June 30, 2003.
Preferred Stock
On July 16, 2002 the Company amended its Certificate of Incorporation, as
authorized by its Board of Directors, by designating 1,000,000 shares of
its 2,000,000 shares of preferred stock as Series A Convertible Preferred
Stock, par value $.0033 per share ("Series A Preferred Stock").
Cumulative dividends on the Series A Preferred Stock accrue at a rate of 8%
per annum from the date of issuance through June 30, 2004 and thereafter at
a rate of 12% per annum and will be payable annually at the Company's
option in cash or Series A Preferred Stock. Cumulative preferred dividends
in arrears on the Series A Preferred Stock were $299,513 at June 30, 2003.
Each share of the Series A Preferred Stock was originally convertible at
the holders' option into 10 shares of common stock. Pursuant to the
antidilution provision of the Series A Preferred Stock, each share of
Series A Preferred Stock is now convertible into 18.75 shares of common
stock. Each share of Series A Preferred Stock will have ten votes and will
vote as a single class with holders of the Company's common stock.
Through June 30, 2003, the Company has issued 269,462 shares of its Series
A Preferred Stock for a total cash consideration of $4,041,972. The shares
were issued in connection with a private offering of the Company's
securities pursuant to which shareholders also received warrants to
purchase shares of the Company's common stock at an initial exercise price
equal to $1.65 per share. Five warrants were issued for each share of
Series A Preferred Stock. The warrants have an exercise price equal to
$1.65 per share and are exercisable for five years from the issuance date.
F-22
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Approximately $3,000,000 of the proceeds from the sale of the Series A
Preferred Stock was used to purchase the outstanding capital stock of NNSI.
On October 30, 2002, the Company amended its Certificate of Incorporation,
as authorized by its Board of Directors, by designating 500,000 shares of
its 2,000,000 shares of preferred stock as Series B Convertible Preferred
Stock, par value $.0033 per share ("Series B Preferred Stock").
Cumulative dividends on the Series B Preferred Stock accrue at a rate of 8%
per annum from the date of issuance through January 31, 2005 and thereafter
at a rate of 12% per annum and will be payable annually at the Company's
option in cash or Series B Preferred Stock. Cumulative preferred dividends
in arrears on the Series B Preferred Stock were $152,111 at June 30, 2003.
Each share of the Series B Preferred Stock is convertible at the holders'
option into 20 shares of common stock. Each share of Series B Preferred
Stock will have ten votes and will vote as a single class with holders of
the Company's common stock.
Through June 30, 2003, the Company has issued 290,963 shares of its Series
B Preferred Stock for a total cash consideration of $4,655,300. The shares
were issued in connection with a private offering of the Company's
securities pursuant to which shareholders also received warrants to
purchase shares of the Company's common stock at an initial exercise price
equal to $1.25 per share. Five warrants were issued for each share of
Series B Preferred Stock. The warrants have an exercise price equal to
$1.25 per share and are exercisable for five years from the issuance date.
The Company amended its Certificate of Incorporation, as authorized by its
Board of Directors, by designating 100,000 shares of its 2,000,000 shares
of preferred stock as Series C Convertible Preferred Stock, par value
$.0033 per share ("Series C Preferred Stock").
Cumulative dividends on the Series C Preferred Stock accrue at a rate of 7%
per annum from the date of issuance through April 30, 2005 and thereafter
at a rate of 9% per annum and will be payable annually at the Company's
option in cash or Series C Preferred Stock. Each share of the Series C
Preferred Stock is convertible at the holders' option into 60 shares of
common stock. Each share of Series C Preferred Stock will have fifteen
votes and will vote as a single class with holders of the Company's common
stock.
Through June 30, 2003, the Company has issued 2,850 shares of its Series C
Preferred Stock for a total cash consideration of $171,000. The shares were
issued in connection with a private offering of the Company's securities
pursuant to which shareholders also received warrants to purchase shares of
the Company's common stock at an initial exercise price equal to $1.50 per
share. Six warrants were issued for each share of Series C Preferred Stock.
The warrants have an exercise price equal to $1.50 per share and are
exercisable for five years from the issuance date.
Proceeds from the issuance of the preferred stock and warrants were
allocated to preferred stock and to additional paid-in capital based upon
their relative fair value. Additionally, after allocating the proceeds, the
Company determined that there was a beneficial conversion feature for the
Series A, B and C Preferred Stock, totaling $27,605, $111,277 and $0, for
the year ended June 30, 2003, respectively, which has been included in the
accompanying consolidated statements of operations and comprehensive loss.
As of June 30, 2003, approximately 11,043,000 shares of the Company's
common stock are issuable upon conversion of preferred stock.
F-23
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Stock option plans
The Company's Stock Option Plans (the "Plans"), authorize the Board of
Directors to grant nonstatutory stock options to employees and directors to
purchase up to a total of 8,932,500 shares of the Company's common stock.
Generally, options granted under the Plans vest ratably over three years.
If any award under the Plans terminates, expires unexercised, or is
canceled, the shares of common stock that would otherwise have been
issuable pursuant thereto will be available for issuance pursuant to the
grant of new awards.
Approximate
Maximum net cumulative
allowable issuances Maximum
Plans Date adopted issuances June 30, 2003 term in years
------------------- ------------------- ----------------- ----------------- -------------
1998 Plan June 1998 282,500 112,000 10
2000 Plan July 2000 1,500,000 1,206,700 10
2001 Plan February 2001 1,750,000 500,000 10
2002 Plan June 2002 3,000,000 2,092,500 10
2003 Plan June 2003 2,400,000 50,000 10
----------------- -----------------
8,932,500 3,961,200
================= =================
Warrants
For the year ended June 30, 2001, the Company granted warrants to purchase
its common stock as follows:
-- In May 2001, seven consultants were granted warrants to purchase
a total of 105,000 shares of common stock, at exercise prices
ranging from $4 to $5 per share. All of the warrants are
immediately exercisable and have terms ranging from 2 to 5 years.
The value of the warrants resulted in a charge to operations of
approximately $197,000 for the three months ended June 30, 2001,
portions of which have been included in general and
administrative and sales and marketing in the consolidated
statements of operations and comprehensive loss.
For the year ended June 30, 2002, the Company granted warrants to purchase
its common stock as follows:
-- In February 2002, a consultant was granted a warrant to purchase
a total of 100,000 shares of common stock, at an exercise price
of $2.94 per share. The warrant is immediately exercisable and
has a term of 3 years. The value of the warrant resulted in a
charge to operations of approximately $128,000 during the year
ended June 30, 2002, which has been included in general and
administrative in the consolidated statements of operations and
comprehensive loss.
For the year ended June 30, 2003, the Company granted warrants to purchase
its common stock as follows:
-- In November 2002, the Company entered into a renewable one-year
consulting agreement. In return for services, the Company granted
a five-year warrant to purchase 200,000 shares of the Company's
common stock at an exercise price of $1.00 per share. The
warrants vest at a rate of 10,000 per month and resulted in a
charge to operations of approximately $34,000 through June 30,
2003, at which time the remaining 130,000 unvested warrants were
cancelled due to termination of the consulting agreement.
F-24
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
-- In January 2003, a consultant was granted an immediately
exercisable four-year warrant to purchase 25,000 shares of common
stock at an exercise price of $1.00. The value of the warrant
resulted in a charge to operations of approximately $16,000
during the year ended June 30, 2003, which is included in general
and administrative expense in the accompanying consolidated
statements of operations and comprehensive loss.
-- In January 2003, the Company entered into a three-year consulting
agreement. In return for services, the Company issued 100,000
shares of unregistered common stock. Additionally, the Company
granted an immediately exercisable five-year warrant to purchase
350,000 shares of the Company's common stock at an exercise price
of $1.50 per share. During May 2003, the agreement was revised to
increase the amount of unregistered common stock issued to the
consultant by 150,000 shares and the period for which services
are to be performed was shortened by 4 months. The value of the
warrant is determined monthly as the warrants vest using the
Black-Scholes option-pricing model. The value of the warrants for
the year ended June 30, 2003, was $51,287 and is included in
general and administrative expense in the accompanying
consolidated statements of operations and comprehensive loss.
-- In April 2003, a consultant was granted a five-year warrant to
purchase a total of 750,000 shares of common stock, at an
exercise price of $1.00 per share. The warrants vest as follows:
250,000 in April 2003, 250,000 in October 2004 and 250,000 in
April 2006. The value of the warrant is determined at the
respective vesting dates using the Black-Scholes option-pricing
model. The value of the warrants for the year ended June 30,
2003, was $37,875 and is included in general and administrative
expense in the accompanying consolidated statements of operations
and comprehensive loss.
-- In June 2003, a consultant was granted an immediately exercisable
three-year warrant to purchase 60,000 shares of common stock at
an exercise price of $1.05 per share. The value of the warrant
resulted in a charge to operations of approximately $35,000
during the year ended June 30, 2003, which is included in general
and administrative expense in the accompanying consolidated
statements of operations and comprehensive loss.
-- During 2003, the Company granted 632,326 three-year warrants and
155,000 four-year warrants with exercise prices ranging from $.80
to $1.50 to investment bankers in conjunction with the Series A,
B and C preferred stock offerings. The value of the warrants
totaling approximately $510,000 was recorded as a reduction to
preferred stock in the accompanying consolidated balance sheets.
The value of the warrants were calculated using the Black-Scholes
option-pricing model with the following assumptions: no dividend yield,
expected volatility of 85%, 75% and 75% for fiscal 2003, 2002 and 2001,
respectively, risk-free interest rates ranging from 1.75% to 3.81%, and
expected life equaling the term of each respective warrant.
F-25
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Summary of options and warrants
The following is a summary of all of the Company's stock options and
warrants that were described in detail above.
Weighted
average
Number exercise
options and price per
warrants share
---------------- -----------
Outstanding at June 30, 2000 3,056,833 $ 6.29
Granted 4,830,250 $ 4.63
Exercised - $ -
Forfeited (752,583) $ 8.23
----------------
Outstanding at June 30, 2001 7,134,500 $ 4.96
Granted 719,700 $ 3.43
Exercised (129,506) $ 1.63
Forfeited (250,494) $ 5.29
----------------
Outstanding at June 30, 2002 7,474,200 $ 4.86
----------------
Granted 7,255,551 $ 1.11
Exercised - $
Forfeited (1,606,333) $ 1.67
----------------
Outstanding at June 30, 2003 13,123,418 $ 2.77
================
At June 30, 2003, there were approximately 4,971,300 options available for
future issuance.
The following table summarizes information about all of the Company's
options and warrants outstanding at June 30, 2003:
Options and warrants Options and warrants
outstanding at exercisable at
June 30, 2003 June 30, 2003
------------------------------------------ -------------------------
Weighted
average Weighted Weighted
remaining average average
Range of Number of contractual exercise Number of exercise
exercise prices shares life price Shares price
--------------- ------------ ------------- ------------ ------------ ----------
$ 0.80-$1.50 5,676,741 4.09 $ 1.05 3,184,241 $ 1.18
$ 1.63-$1.75 2,313,977 4.14 $ 1.66 2,313,977 $ 1.64
$ 2.94-$3.00 106,000 1.72 $ 2.94 104,000 $ 2.94
$ 4.00-$4.82 1,945,000 2.76 $ 4.02 1,945,000 $ 4.02
$ 5.00-$5.25 2,215,700 2.20 $ 5.11 2,201,234 $ 5.11
$ 6.00-$9.50 162,500 2.38 $ 6.03 108,334 $ 6.03
$ 10.00-$13.00 622,000 3.06 $ 10.93 616,000 $ 10.92
$ 15.00-$18.00 81,500 1.42 $ 17.91 81,500 $ 17.91
------------ ----------
13,123,418 10,554,286
============ ==========
Options exercisable as of June 30, 2002 and June 30, 2001 was 6,312,000 and
6,345,832, respectively.
F-26
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
All employee based stock compensation awards issued for the year ended June
30, 2003 had no intrinsic value and, accordingly, resulted in no charge to
operations in such period.
10 Segment information
The Company reports segments in accordance with SFAS 131 "Disclosures about
Segments of an Enterprise and Related Information". As of June 30, 2003,
the Company and its subsidiaries operate in three separate business
segments, the Technology segment, the Telecommunications segment and the
Management and Consulting segment. These operating segments are
representative of the Company's management approach to its evaluation of
its operations. The accounting policies of the reportable operating
segments are the same as those described in the summary of significant
accounting policies. The Technology segment, which operates worldwide, is
primarily engaged in the design, development, marketing and support of
information delivery hardware products and software. The Telecommunications
segment, which operates domestically, provides multiple source data and
voice services and related consulting and professional services. The
Management and Consulting segment, which operates domestically, provides
management and consulting services primarily to the automotive industry
throughout the United States.
For the year ended June 30,
------------------------------------------------------
2003 2002 2001
---------------- ---------------- ----------------
Revenue
Technology $ 488,315 $ 404,498 $ 487,588
Telecommunications 20,349,748 - -
Management and consulting 321,396 334,250 937,550
---------------- ---------------- ----------------
Total $ 21,159,459 $ 738,748 $ 1,425,138
================ ================ ================
Operating (loss) income
Technology $ (6,426,864) $ (10,127,644) $ (14,460,314)
Telecommunications 2,097,911 - -
Management and consulting (90,857) (538,428) (1,441,735)
Other (2,152,345) - -
---------------- ---------------- ----------------
Total $ (6,572,155) $ (10,666,072) $ (15,902,049)
================ ================ ================
F-27
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30,
----------------------------------
2003 2002
----------------- ---------------
Identifiable assets
Technology $ 1,250,289 $ 3,114,692
Telecommunications 10,047,700 -
Management and consulting 13,549 45,143
Other 574 -
----------------- ---------------
11,312,112 3,159,835
Net assets of discontinued operations 16,225 64,619
----------------- ---------------
Total $ 11,328,337 $ 3,224,454
================= ================
Net revenue by geographic area follows:
For the year ended June 30,
-----------------------------------------------------
2003 2002 2001
---------------- ---------------- ----------------
Revenue
United States $ 20,895,276 $ 686,882 $ 1,115,838
Foreign 264,183 51,866 309,300
---------------- ---------------- ----------------
Total $ 21,159,459 $ 738,748 $ 1,425,138
================ ================ ================
The Company incurred interest expense of $6,682, $184,378 and $11,925 in
the Technology, Telecommunications and the Management and Consulting
segments, respectively for the year ended June 30, 2003. Additionally, the
Company incurred depreciation expense of $201,997, $34,985 and $0 in the
Technology, Telecommunications and the Management and Consulting segments,
respectively, for the year ended June 30, 2003.
The Company had two major customers in the Telecommunication segment which
accounted for 32% (Swift Transportation) and 11% (Norstan, Inc.) of
consolidated revenue for the year ended June 30, 2003 and two customers in
the Telecommunication segment which accounted for 14% and 11%,
respectively, of consolidated accounts receivable at June 30, 2003. The
Company had one major customer in the Technology segment, which accounted
for 34% of consolidated revenue for the year ended June 30, 2002 and four
customers, one in the Technology segment and three in the Management and
Consulting segment that accounted for 29%, 10%, 13% and 21% of consolidated
accounts receivable, respectively, at June 30, 2002. The Company had two
major customers, one in the Technology segment and one in the Management
and Consulting segment, which accounted for 21% and 35%, respectively, of
consolidated revenue for the year ended June 30, 2001. Additionally, the
Technology segment was dependent upon one customer, who accounted for 80%,
62% and 60% of the segment's revenues for the year ended June 30, 2003,
2002 and 2001, respectively.
F-28
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11 Income taxes
The provision for income taxes consists of the following:
For the year ended June 30,
-------------------------------------------------
2003 2002 2001
--------------- ---------------- -------------
Current - Federal and States $ 129,300 $ - $ -
Deferred - Federal - - -
Deferred - States - - -
--------------- ---------------- -------------
Provision for income taxes $ 129,300 $ - $ -
=============== ================ =============
The following table summarizes the significant differences between the
Federal statutory tax rate and the Company's effective tax rate for
financial reporting purposes:
For the year ended June 30,
-----------------------------------------------
2003 2002 2001
--------------- --------------- ------------
Federal statutory tax rate (34.0)% (34.0)% (34.0)%
State and local taxes net of Federal
Tax effect (4.5) (6.0) (6.0)
Stock and option compensation - .4 .8
Other items - - (.1)
Loss on disposal - - 1.1
Depreciation & amortization - - .5
Impairment - - 5.8
Permanent differences .5 .2 .2
Valuation allowance on deferred tax
Asset 36.0 39.4 31.7
--------------- --------------- ------------
Effective tax rate (2.0)% 0.0% 0.0%
=============== =============== ============
The tax effects of temporary differences and carryforwards that give rise
to deferred tax assets or liabilities are summarized as follows:
June 30,
--------------------------------------
2003 2002
----------------- -----------------
Non deductible reserves and other $ 855,000 $ 216,000
Loss on disposal of discontinued operations 85,000 148,000
Net operating loss carryforward 21,263,000 16,246,000
Intangible assets 173,000 2,407,000
Valuation allowance on net deferred tax asset (22,376,000) (19,017,000)
----------------- -----------------
Deferred tax asset, net $ - $ -
================= =================
F-29
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Due to the history of net operating losses for income tax purposes, the
Company has provided for full valuation allowances on the net deferred tax
asset due to it being more likely than not that the deferred tax asset will
not be utilized.
At June 30, 2003, the Company has net tax operating loss carryforwards of
approximately $53.0 million. A portion or all of these losses may be
subject to Section 382 of the Internal Revenue Code and therefore not
available to offset future income tax liabilities. The carryforward losses
expire in the years 2013 through 2023 and have not been recognized in the
accompanying consolidated financial statements as a result of a valuation
allowance against the deferred tax asset.
12 Related party transactions
In August 2000, 150,000 unregistered shares were issued to a consulting
firm for services rendered (Note 9). One of the Company's employees, who is
also a shareholder, has an ownership interest in this consulting firm. In
December 2000, the Company reduced the exercise price of 300,000 warrants
previously issued to this consulting firm to $5 per share and shortened the
remaining term of the warrant to three years, which resulted in a charge to
operations of $468,000 that is included in general and administrative
expenses. The market price of the Company's common stock at the time of
this reduction was $4.188 per share.
In July 2001, the Company paid $300,000 for marketing services to a
consulting firm in which one of the Company's employees has an ownership
interest. This amount is included in sales and marketing in the
consolidated statements of operations and comprehensive loss for the year
ended June 30, 2001.
On July 10, 2002, the Company received advances from four individuals, one
of whom is an officer and director of the Company and another who is a
director of the Company, aggregating $600,000, of which, $450,000 was
subsequently repaid to three of those individuals. The advances are
non-interest bearing, due on demand and have no scheduled repayment terms.
On November 1, 2002, the Company entered into a consulting agreement with a
corporation whose majority owner is also a shareholder of the Company, for
marketing and new business development opportunities, as well as strategic
advisory services. The agreement commenced effective November 1, 2002 and
required payments of $20,000 per month, cancelable at the Company's option
upon 30 days notice. The agreement was superceded by a new agreement
effective June 1, 2003, which requires issuance of 300,000 shares of common
stock that vest at a rate of 10,000 shares monthly. The new agreement is
cancelable at the Company's option upon 90 days notice.
On June 1, 2003 the Company entering into a 30 month consulting agreement
with a corporation whose majority owner is also an employee of the Company,
for marketing and new business development opportunities, as well as
strategic advisory services. Under the terms of the agreement the Company
will issue 150,000 unregistered shares, which vest at the monthly rate of
10,000 shares. The agreement is cancelable at the Company's option upon 90
days notice.
During June 2003, the Company issued 250,000 shares of unregistered common
stock to a corporation whose majority owner is also an employee and
stockholder, which resulted in a charge to fiscal 2003 operations of
$265,000.
During June, 2003, the Company issued 125,000 shares of unregistered common
stock to an employee/stockholder for legal services related to the Series
A, B and C preferred stock offerings. The aggregate value of the shares,
$132,500, was recorded as a reduction of proceeds to additional paid in
capital in the accompanying consolidated balance sheet.
F-30
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During the year ended June 30, 2003, the Company paid approximately
$185,000 for legal services to law firms in which an employee/stockholder
is affiliated.
13 Major customers/significant agreements
Sprint Communications Company L.P.
During August 2002, the Company entered into two agreements with Sprint
Communications Company L.P. ("Sprint") to provide telecommunication
services to the Company's customers. The agreement for switched services
has a term of 28 months and the agreement for the data and private line
services has a term of 24 months. The Company made purchases from Sprint
that aggregated approximately 84% of the total cost of revenue for the year
ended June 30, 2003. The Company has a commitment to purchase a minimum of
$1,000,000 of telecommunication services monthly from Sprint.
General Electric Company
On June 29, 2000, NetWolves and General Electric Company ("GE") signed a
contract for the master purchase, license and support services of
NetWolves' security, remote monitoring and configuration management system.
GE is using the Company's products for interconnectivity of its worldwide
offices.
The contract is for a term of six years and can be extended for four
additional one-year periods unless prior notice of non-renewal is given by
either party as defined in the agreement. The contract provides for the
Company to receive a fee upon shipment of each unit, and an additional
one-time configuration and installation fee. Additionally, upon shipment of
each unit, GE has the right to purchase from the Company support service
and annual monitoring and management service on an annual basis ("Annual
Services"). The Annual Services shall continue at the same rate per annum,
at GE's discretion, provided that GE requests such services at any time
during a subsequent year. GE is required to pay fees for Annual Services in
full from the expiration date of the prior year period and revenue
generated from the Annual Services is recognized over the service period.
14 Provider liabilities
During the transition period of the Company's newly acquired subsidiary,
NNSI, the Company was the target of a theft of telecommunications services.
The Company is currently working with one of its major providers to resolve
this issue and currently believes its obligation to approximate $205,000.
Accordingly, the Company has accrued such amount in the accompanying
consolidated balance sheet as of June 30, 2003.
As a result of this theft of telecommunications services, management has
since enacted new internal controls at the subsidiary level in order to
deter future occurrences of this nature. It is the opinion of management
that the outcome of this matter will not have a material adverse effect on
the Company's operations or financial condition.
F-31
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14 Commitments and contingencies
Leases
The Company has entered into several leases for office space, office
equipment and vehicles. At June 30, 2003, the approximate future minimum
annual lease payments, are summarized as follows:
Fiscal year ending June 30,
2004 $ 635,000
2005 616,000
2006 278,000
2007 6,000
----------------
$ 1,535,000
================
The above future minimum annual lease payments include approximately
$235,000 in payments for discontinued operations.
Total rent expense (excluding discontinued operations) for the years ended
June 30, 2003, 2002 and 2001 was $648,784, $590,508, and $576,914,
respectively.
Employment agreements
In August 2000 the Company entered into an employment agreement for a
period of three years and grants the employee/stockholder, who is
affiliated with a law firm who provided legal services to the Company,
warrants to purchase 275,000 shares of common stock of the Company at a
purchase price of $5.125 per share, subject to a vesting schedule as
specified in such agreement.
During October 2000, the Company entered into employment agreements with
certain members of its executive management team. All of the employment
agreements provide for certain payments following death or disability, for
certain fringe benefits such as reimbursement for reasonable expenses and
participation in medical plans, and for accelerated payments in the event
of change of control of the Company. The specific terms are as follows:
-- The agreement with the Chief Executive Officer is for a term of
five years at an annual salary of $275,000 subject to cost of
living increments.
-- The agreement with the Senior Vice President is for a term of
three years, subject to two additional one-year extensions, at an
annual salary of $175,000.
-- The agreement with the Vice President of Finance is for a term of
three years, subject to two additional one-year extensions, at an
annual salary of $150,000.
Benefit plans
The Company has established a 401(k) defined contribution plan. Employees
21 years or older with at least six months of service are eligible to
participate in the plan. Participants may elect to contribute, on a
F-32
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
tax-deferred basis, up to 15% of their compensation, not to exceed $12,000,
in 2003. The Company did not make any contributions to the plan for the
years ended June 30, 2003, 2002 and 2001.
15 Legal matters
Anicom Inc.
On April 19, 2000, Anicom, Inc. commenced an action against the Company in
the U.S. District Court for the Northern District of Illinois. The action
was based upon NetWolves' alleged failure to deliver approximately 74,842
shares of its common stock to Anicom, upon exercise by Anicom of the
Company's warrants. The action sought specific performance as well as any
damages that may have resulted from a diminution in value of NetWolves
common stock.
On November 16, 2000, and in connection with the litigation, the Company
and Anicom reached a settlement (the "Settlement Agreement"). Under the
Settlement Agreement the allegations for the breach of the warrant
agreement by the Company and unasserted claims for the breach of the
distribution agreement by Anicom and the Company were settled. The Company
paid $1,150,000 to Anicom pursuant to the Settlement Agreement, which
included the repurchase of all unvested warrants. As of September 30, 2000,
the Company reduced additional paid-in capital in the amount of $705,000,
representing the fair value of the warrants, calculated using the Black-
Scholes option pricing model with the following assumptions: dividend yield
of none, expected volatility of 65%, risk free interest rate of 5.85% and
an expected term of 3.17 years the remaining life to the maturity date. The
remaining portion of the settlement, in the amount of $445,000, has been
charged to operations and included in general and administrative expenses
for the year ended June 30, 2001.
16 Liquidity
Historically, the Company has experienced significant reoccurring net
operating losses as well as negative cash flows from operations. The
Company's main source of liquidity has been equity financing which is used
to fund losses from operating activities. For the year ended June 30, 2003,
the Company has raised, exclusive of commissions, approximately $9.0
million from the sale of its preferred and common stock. While
approximately $6 million of the proceeds was utilized to purchase the
outstanding capital stock of NNSI and repay a note payable due to Norstan,
Inc., the remainder of the proceeds has been and will continue to be
utilized to fund ongoing operations. Additionally, management has
F-33
NETWOLVES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
instituted cost saving measures over the past 12 months intended to reduce
its overhead expenses, most notably, a reduction of staffing within its
Technology segment and its discontinued ComputerCOP operations, aggregating
approximately $2.5 million in annual salaries and related benefits.
17 Subsequent events
Through September 25, 2003, the Company has issued approximately 75,000
additional shares of its Series C Preferred Stock for total cash
consideration of approximately $4,500,000 and approximately 1,200,000
shares of unregistered common stock for total cash consideration of
approximately $1,200,000.
F-34
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Additions Balance
Balance at charged to Deductions from at
beginning costs and allowances end
of period expenses of period
--------------- --------------- --------------- ---------------
Year ended June 30, 2003:
Allowance for doubtful notes and accounts
receivable $ 191,164 $ 188,550 $ 199,855 $ 179,859
Allowance for other assets $ 89,589 $ - $ 89,589 $ -
Accrued losses of discontinued operations $ 372,970 $ 117,097 $ 252,542 $ 237,525
Year ended June 30, 2002:
Allowance for doubtful notes and accounts
receivable $ 152,259 $ 38,905 $ - $ 191,164
Allowance for other assets $ 33,589 $ 56,000 $ - $ 89,589
Accrued losses of discontinued operations $ 496,927 $ - $ 123,957 $ 372,970
Year ended June 30, 2001:
Allowance for doubtful accounts receivable $ 44,747 $ 107,512 $ - $ 152,259
Allowance for other assets $ - $ 33,589 $ - $ 33,589
Accrued losses of discontinued operations $ - $ 496,927 $ - $ 496,927