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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

x

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2009

 

or

 

o

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from             to            

 

Commission file number 000-51995

 


 

ETELOS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

77-0407364

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

26828 Maple Valley Highway-#297
Maple Valley, WA

 

98038

(Address of principal executive offices)

 

(Zip Code)

 

(425) 458-4510

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

As of September 30, 2009, 24,826,360 shares of the issuer’s common stock, par value $0.01 per share, were outstanding.

 

 

 



Table of Contents

 

EXPLANATORY NOTE

 

On February 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issued an order confirming approval of the Plan of Reorganization, including the merger and the transfer of all of Tripath’s existing assets into a separate bankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplated the merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) with Tripath.   The overall impact of the confirmed Plan of Reorganization was for Tripath to emerge from the bankruptcy proceeding with no assets and no liabilities as a shell corporation and for all issued and outstanding securities of and interests in Tripath, including debentures, stock options (including, but not limited to, all stock options granted to employees), warrants, and other shares of common stock to be canceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Report on Form 8-K announcing, among other things, that Etelos-WA merged with and into Tripath, and that the surviving corporation changed its name to Etelos, Inc. and its fiscal year end to December 31.  The effective date of the merger was April 22, 2008, and Etelos, Inc., as the surviving corporation, will conduct the business and operations previously conducted by Etelos-WA.  In connection with the merger, all outstanding shares of Etelos-WA common stock were converted into shares of Etelos, Inc. common stock on a three for one ratio: one share of Etelos, Inc. common stock for every three shares of common stock of Etelos-WA.  Also in connection with the merger, (i) all outstanding shares of preferred stock of Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc. issued an aggregate of 5,010,000 shares of its common stock to the secured and unsecured creditors of Tripath and (iii) all the shares of Tripath were cancelled.  Prior to the merger, Tripath was a shell corporation and in accordance with the Plan of Reorganization had no assets or liabilities.  While Tripath acquired all the outstanding preferred and common stock of Etelos-WA, for accounting purposes, the acquisition has been treated as a recapitalization of Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22, 2008, are those of Etelos-WA and the description of the business contained in this report as well as the one contained in the financial statements reflect the operations of Etelos-WA for the quarterly and twelve month periods ended December 31, 2008 and 2007.

 

Also, on April 23, 2008, Etelos, Inc., formerly Tripath, amended its certificate of incorporation with the state of Delaware to change its total authorized shares of stock to 300,000,000 shares, of which 250,000,000 shares are designated “common stock” with a par value of $0.01 per share and 50,000,000 shares are designated “preferred stock” with a par value of $0.01 per share.  The preferred stock may be issued from time to time in one or more series, each of such series to consist of such number of shares and to have such terms, rights, powers and preferences, and the qualifications and limitations with respect thereto, as stated in the resolutions providing for the issue of such series adopted by the board of directors.

 

Information concerning number of shares outstanding for Etelos, Inc. including the conversion prices and number of shares issuable upon conversion of convertible securities and exercise prices of warrants and stock options and the number of shares issuable upon exercise of such options and warrants, has been adjusted to reflect the three for one conversion ratio effected in connection with the merger as if it had occurred for all periods presented.

 

i



Table of Contents

 

Etelos, Inc.

 

Quarterly Report on Form 10-Q

 

For the Quarterly Period Ended September 30, 2009

 

TABLE OF CONTENTS

 

 

 

Page

 

 

 

FORWARD LOOKING STATEMENTS

 

1

 

 

 

PART I —FINANCIAL INFORMATION

 

2

 

 

 

Item 1.

FINANCIAL STATEMENTS (UNAUDITED)

 

2

 

 

 

 

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

25

 

 

 

 

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

34

 

 

 

 

Item 4.

CONTROLS AND PROCEDURES

 

34

 

 

 

PART II —OTHER INFORMATION

 

34

 

 

 

Item 1.

LEGAL PROCEEDINGS

 

34

 

 

 

 

Item 1A.

RISK FACTORS

 

36

 

 

 

 

Item 6.

EXHIBITS

 

48

 

 

 

SIGNATURES

 

49

 

 

 

EXHIBIT INDEX

 

50

 

ii



Table of Contents

 

FORWARD LOOKING STATEMENTS

 

In this report, unless the context indicates otherwise, the terms “Etelos,” “Company,” “we,” “us,” and “our” refer to Etelos, Inc., a Delaware corporation.

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, or the “Securities Act,” and Section 21E of the Securities Exchange Act of 1934 or the “Exchange Act.”  These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or anticipated results, including those set forth under the heading “Risk Factors” and elsewhere in, or incorporated by reference into, this report.

 

In some cases, you can identify forward looking statements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,” or the negative of these terms.  These terms and similar expressions are intended to identify forward-looking statements.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected.  The forward-looking statements in this report are based upon management’s current expectations and belief, which management believes are reasonable.  In addition, we cannot assess the impact of each factor on our business or the extent to which any factor or combination of factors, or factors we are aware of, may cause actual results to differ materially from those contained in any forward looking statements.  You are cautioned not to place undue reliance on any forward-looking statements.  These statements represent our estimates and assumptions only as of the date of this report.  Except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including:

 

·                                          our ability to obtain future financing or funds when needed;

·                                          new competitors are likely to emerge and new technologies may further increase competition;

·                                          our operating costs may increase beyond our current expectations and we may be unable to fully implement our current business plan;

·                                          our ability to successfully obtain a diverse customer base;

·                                          our ability to protect our intellectual property through patents, trademarks, copyrights and confidentiality agreements;

·                                          our ability to attract and retain a qualified employee base;

·                                          our ability to respond to new developments in technology and new applications of existing technology before our competitors;

·                                          acquisitions, business combinations, strategic partnerships, divestures, and other significant transactions may involve additional uncertainties;

·                                          our ability to maintain and execute a successful business strategy; and

·                                          we face other risks described from time to time in periodic and current reports we file with the United States Securities and Exchange Commission, or the “SEC.”

 

Other risks and uncertainties include such factors as market acceptance and market demand for our products and services, pricing, the changing regulatory environment, the effect of our accounting policies, potential seasonality, industry trends, adequacy of our financial resources to execute our business plan, our ability to attract, retain and motivate key technical, marketing and management personnel, possible disruption in commercial activities occasioned by terrorist activity and armed conflict, and other risk factors detailed in this report and our other SEC filings.  You should consider carefully the statements under “Item 1A. Risk Factors” in Part II and other sections of this report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition.  All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements.

 

1



Table of Contents

 

PART I—FINANCIAL INFORMATION

 

ITEM 1. - FINANCIAL STATEMENTS (UNAUDITED)

 

ETELOS, INC.

CONDENSED BALANCE SHEETS

(in thousands, except share data)

(Unaudited)

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

287

 

$

7

 

Accounts receivable, net

 

4

 

60

 

Other receivable

 

500

 

 

Prepaid expenses and other current assets

 

9

 

46

 

Accreting interest on convertible notes payable

 

332

 

 

Total current assets

 

1,132

 

113

 

 

 

 

 

 

 

Property and equipment, net

 

54

 

82

 

Debt issuance costs

 

33

 

 

Other assets

 

2

 

10

 

 

 

 

 

 

 

Total assets

 

$

1,221

 

$

205

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ DEFICIT

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

1,125

 

$

983

 

Accounts payable related parties

 

25

 

42

 

Accrued payroll and related expenses

 

987

 

399

 

Other accrued expenses

 

1,312

 

1,381

 

Deferred revenue

 

4

 

64

 

Current portion convertible notes payable, net of discounts

 

1,764

 

7,264

 

Current portion other notes payable

 

152

 

89

 

Current portion notes payable to related parties, net of discounts

 

220

 

132

 

Current portion capital leases

 

9

 

9

 

Warrant and derivative liability

 

293

 

108

 

Total current liabilities

 

5,891

 

10,471

 

 

 

 

 

 

 

Long-term convertible notes payable, net of premiums and discounts, less current portion

 

6,711

 

 

Long-term notes payable to related parties, less current portion

 

552

 

552

 

Long-term capital leases, less current portion

 

13

 

24

 

 

 

 

 

 

 

Total liabilities

 

13,167

 

11,047

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ deficit:

 

 

 

 

 

Preferred stock, $0.01 par value: 50,000,000 shares authorized with liquidation preferences:

 

 

 

 

 

New Series A: 3,333,333 shares authorized; issued and outstanding: 843,333 shares at September 30, 2009 and 833,333 shares at December 31, 2008

 

8

 

8

 

Common stock, $0.01 par value: 250,000,000 shares authorized; issued and outstanding - 24,826,360 shares at September 30, 2009 and 23,027,624 shares at December 31, 2008

 

249

 

231

 

Additional paid-in capital

 

22,325

 

18,722

 

Accumulated deficit

 

(34,528

)

(29,803

)

Total stockholders’ deficit

 

(11,946

)

(10,842

)

 

 

 

 

 

 

Total liabilities and stockholders’ deficit

 

$

1,221

 

$

205

 

 

The accompanying notes are an integral part of these condensed interim financial statements.

 

2



Table of Contents

 

ETELOS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

 

 

 

Three
Months
Ended
September 30,
2009

 

Three
Months
Ended
September 30,
2008

 

Nine
Months
Ended
September 30,
2009

 

Nine
Months
Ended
September 30,
2008

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

5

 

$

10

 

$

131

 

$

55

 

Cost of revenue

 

74

 

211

 

246

 

459

 

Gross loss

 

(69

)

(201

)

(115

)

(404

)

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

209

 

844

 

1,397

 

3,320

 

Sales and marketing

 

132

 

514

 

877

 

1,315

 

General and administrative

 

312

 

529

 

1,377

 

1,629

 

Change in valuation of liability related to warrants from settlement, financing, and consulting services

 

 

 

(299

)

 

Total operating expenses

 

653

 

1,887

 

3,352

 

6,264

 

 

 

 

 

 

 

 

 

 

 

Loss from Operations

 

(722

)

(2,088

)

(3,467

)

(6,668

)

 

 

 

 

 

 

 

 

 

 

Other income (expense)

 

 

 

 

 

 

 

 

 

Merger costs

 

 

 

 

(13,444

)

Other income (expense)

 

15

 

 

15

 

(15

)

Loss on extinguishment of debt

 

(288

)

 

(587

)

 

Total other expense

 

(273

)

 

(572

)

(13,459

)

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

(154

)

(103

)

(427

)

(420

)

Amortization of notes discount premiums and debt issuance costs

 

(67

)

(358

)

(139

)

(783

)

Change in valuation of liability relating to embedded derivatives and warrants

 

16

 

4,200

 

(120

)

168

 

Beneficial conversion of interest conversion

 

 

 

 

(991

)

Total interest income (expense)

 

(205

)

3,739

 

(686

)

(2,026

)

 

 

 

 

 

 

 

 

 

 

Income (Loss) before taxes

 

(1,200

)

1,651

 

(4,725

)

(22,153

)

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(1,200

)

$

1,651

 

$

(4,725

)

$

(22,153

)

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

$

(0.05

)

$

0.07

 

$

(0.20

)

$

(1.34

)

Diluted net income (loss) per share

 

$

(0.05

)

$

0.06

 

$

(0.20

)

$

(1.34

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares used in computing basic net income (loss) per share

 

24,074

 

23,036

 

23,839

 

16,522

 

Weighted average number of common shares used in computing diluted net income (loss) per share

 

24,074

 

26,418

 

23,839

 

16,522

 

 

The accompanying notes are an integral part of these condensed interim financial statements.

 

3



Table of Contents

 

ETELOS, INC.

CONDENSED STATEMENTS OF STOCKHOLDERS’ DEFICIT

(in thousands, except share data)

(Unaudited)

 

 

 

Preferred Stock

 

 

 

 

 

 

 

 

 

Total

 

 

 

New Series A

 

Common Stock

 

Additional Paid

 

Accumulated

 

Stockholders’

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

in Capital

 

Deficit

 

Deficit

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2008

 

833,333

 

$

8

 

23,027,624

 

$

231

 

$

18,722

 

$

(29,803

)

$

(10,842

)

Issuance of Preferred New Series A Stock

 

10,000

 

 

 

 

6

 

 

6

 

Issuance of common stock upon exercise of options

 

 

 

48,736

 

 

2

 

 

2

 

Issuance of common stock to consultant

 

 

 

1,000,000

 

10

 

500

 

 

510

 

Issuance of common stock warrants with promissory notes

 

 

 

 

 

110

 

 

110

 

Issuance of common stock with senior secured debentures.

 

 

 

750,000

 

8

 

183

 

 

191

 

Issuance of Series I Warrants with senior secured debentures

 

 

 

 

 

424

 

 

424

 

Issuance of Series II Warrants with senior secured debentures

 

 

 

 

 

565

 

 

565

 

Beneficial conversion on issuance of senior secured debentures

 

 

 

 

 

776

 

 

776

 

Stock based compensation

 

 

 

 

 

106

 

 

106

 

Reclass warrant and derivative liability

 

 

 

 

 

931

 

 

931

 

Net loss

 

 

 

 

 

 

(4,725

)

(4,725

)

Balance at September 30, 2009

 

843,333

 

$

8

 

24,826,360

 

$

249

 

$

22,325

 

$

(34,528

)

$

(11,946

)

 

The accompanying notes are an integral part of these condensed interim financial statements.

 

4



Table of Contents

 

ETELOS, INCORPORATED

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

 

 

Nine Months
Ended
September 30,
2009

 

Nine Months
Ended
September 30,
2008

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(4,725

)

$

(22,153

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

28

 

13

 

Amortization (accretion) of notes discount (premium)

 

138

 

201

 

Amortization of financing fees and debt issuance costs

 

1

 

63

 

Accretion of interest

 

81

 

 

Stock based compensation

 

106

 

73

 

Interest expense paid in common stock

 

 

77

 

Consulting expenses paid through issuance of common stock and warrants

 

1,511

 

 

Beneficial conversion of interest conversion

 

 

991

 

Change in valuation of embedded derivatives and warrant liabilities

 

(180

)

636

 

Loss on extinguishment of restructured debentures and promissory notes

 

587

 

 

Merger costs paid in common stock

 

 

13,177

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

56

 

(6

)

Prepaid expenses and other current assets

 

37

 

(2

)

Other assets

 

(26

)

 

Accounts payable

 

229

 

651

 

Accounts payables related parties

 

(17

)

(50

)

Accrued payroll and related expenses

 

588

 

(366

)

Other accrued expenses

 

388

 

92

 

Other current liabilities

 

 

200

 

Deferred revenues

 

(60

)

5

 

Deferred rent

 

 

9

 

Net cash used in operating activities

 

(1,258

)

(6,389

)

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

 

(55

)

Net cash used in investing activities

 

 

(55

)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from notes payable

 

1,485

 

5,489

 

Proceeds from notes payable to related parties

 

100

 

 

Payments of notes payable

 

(44

)

 

Payment on capital lease

 

(11

)

(10

)

Proceeds from issuance of preferred stock

 

6

 

 

Proceeds from issuance of common stock

 

2

 

459

 

Payment of fees for financing transactions

 

 

(284

)

Payments of notes payable to related parties

 

 

(132

)

Net cash provided by financing activities

 

1,538

 

5,522

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

280

 

(922

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of year

 

7

 

928

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

287

 

$

6

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

 

 

Cash paid for interest

 

 

126

 

 

 

 

 

 

 

Supplemental disclosures of non-cash financing activities:

 

 

 

 

 

Reclass of warrants from liability to equity

 

799

 

 

Issuance of detachable warrants

 

989

 

73

 

Increase in convertible notes principal

 

413

 

 

Issuance of common stock for convertible debt

 

191

 

2,463

 

Reclass of derivatives from liability to equity

 

132

 

 

Record warrants and embedded derivatives as liabilities

 

45

 

6,489

 

Issuance of common stock for interest conversion

 

 

199

 

Discount on convertible notes

 

 

68

 

Issuance of common stock for anti-dilution

 

 

55

 

Repurchase of common stock

 

 

 

36

 

Conversion of preferred stock to common stock

 

 

15

 

 

The accompanying notes are an integral part of these condensed interim financial statements.

 

5



Table of Contents

 

NOTES TO FINANCIAL STATEMENTS

 

1. Organization

 

On February 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issued an order confirming approval of the Plan of Reorganization, including the merger and the transfer of all of Tripath’s existing assets into a separate bankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplated the merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) with Tripath.  The overall impact of the confirmed Plan of Reorganization was for Tripath to emerge from the bankruptcy proceeding with no assets and no liabilities as a shell corporation and for all issued and outstanding securities of and interests in Tripath, including debentures, stock options (including, but not limited to, all stock options granted to employees), warrants, and other shares of common stock to be canceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Report on Form 8-K announcing, among other things, that Etelos-WA merged with and into Tripath (the “Merger”), and that the surviving corporation changed its name to Etelos, Inc. and its fiscal year end to December 31.  The effective date of the Merger was April 22, 2008, and Etelos, Inc., as the surviving corporation, will conduct the business and operations previously conducted by Etelos-WA.  In connection with the Merger, all outstanding shares of Etelos-WA common stock were converted into shares of Etelos, Inc. common stock on a three for one ratio: one share of Etelos Inc. common stock for every three shares of common stock of Etelos-WA.  Also in connection with the Merger, (i) all outstanding shares of preferred stock of Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc. issued an aggregate of 5,010,000 shares of its common stock to the secured and unsecured creditors of Tripath and (iii) all the shares of Tripath Technology were cancelled. Also on April 23, 2008, Etelos, Inc., formerly Tripath, amended its articles of incorporation with the state of Delaware to change its total authorized shares of stock to 300,000,000 shares, of which 250,000,000 shares are designated “Common Stock” with a par value of $0.01 per share and 50,000,000 shares are designated “Preferred Stock” with a par value of $0.01 per share.  The Preferred Stock may be issued from time to time in one or more series, each of such series to consist of such number of shares and to have such terms, rights, powers and preferences, and the qualifications and limitations with respect thereto, as stated in the resolutions providing for the issue of such series adopted by the board of directors.

 

Prior to the Merger, Tripath was a shell corporation and in accordance with the Plan of Reorganization had no assets or liabilities.  While Tripath acquired all the outstanding preferred and common stock of Etelos-WA, for accounting purposes, the acquisition has been treated as a recapitalization of Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22, 2008, are those of Etelos-WA.

 

The 5,010,000 shares of Etelos, Inc. common stock were valued at $2.63 per share, the estimated fair value of the common stock on the date of the Merger, which resulted in a charge to operations of $13.2 million included in the caption Merger Related Costs in the accompanying Statement of Operations.  Etelos, Inc. believes that these shares were issued primarily for past services provided to Etelos-WA by the secured creditors and the release of the secured and unsecured creditors claims against Tripath.

 

Information concerning number of shares outstanding for Etelos, Inc. including the conversion prices and number of shares issuable upon conversion of convertible securities and exercise prices of warrants and stock options and the number of shares issuable upon exercise of the options and warrants, has been adjusted to reflect this stock split for all periods presented.  Also, the stockholders’ deficit section of the accompanying balance sheet has been adjusted to reflect the legal capital structure of Tripath adjusted for the change in authorized shares of common and preferred stock.

 

2.  The Company

 

As used herein, unless the context requires otherwise, the terms the “Company” or “Etelos” refers to Etelos, Inc., the corporation that survived the Merger.

 

Etelos has a Web Application distribution platform delivering Web Applications for businesses.  Etelos provides a Software-as-a-Service (SaaS) ecosystem for building, distributing, and using Web Applications, including a marketplace to deploy and support them.  Unlike other cloud computing and Platform-as-a-Service (PaaS) solutions, Etelos enables software manufacturers to migrate existing applications or create new applications, then package, distribute, host, bill, market and support their SaaS enabled applications through multiple private label applications marketplaces.

 

Etelos has developed products for Web Applications, which include open standards-based tools for Web developers, businesses and individual users such as the Etelos Application ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programming languages and also support the English Application Scripting Engine (EASETM), a simple-to-use open standards-based scripting language developed by the Company.  In order to support broader adoption of its products,

 

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EASE and other components of the EDE are made available to developers at market appropriate pricing.  This is done to support the development of new Web Applications and the migration of existing Web Applications into the Etelos ecosystem where there are tools and other support mechanisms for the marketing, distribution, and support of these applications.  Etelos generally receives a transaction fee or subscription fee for transactions that occur within the Etelos ecosystem either via the Etelos Marketplace™ pursuant to Storefront Operating Agreements, or in third-party branded Marketplaces operated by Etelos pursuant to Marketplace Partner Agreements (sometimes referred to as “an Etelos Marketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay a subscription fee, which revenue Etelos shares with Syndication Partners and Marketplace Partners; this revenue share is calculated as a percentage of gross revenues from the sale of subscriptions to customers of Syndication Partner products and service in the Etelos Marketplaces.

 

3. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying condensed financial statements include our accounts as of September 30, 2009, and December 31, 2008, and for the nine months ended September 30, 2009 and 2008. The accompanying condensed balance sheet as of December 31, 2008, has been derived from the audited balance sheet in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2008. These condensed financial statements have been prepared by management, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The Company has performed an evaluation of subsequent events through the date of filing of the financial statements.

 

In the opinion of management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present the financial position, results of operations and cash flows for the interim periods presented have been included. The results of operations for the quarter ended September 30, 2009, and the nine months ended September 30, 2009, are not necessarily indicative of the results to be expected for the full year or for any future periods.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods and such differences could be material.  These financial statements should be read in conjunction with the audited financial statements and accompanying notes included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2008.  Certain prior period amounts have been reclassified to conform to the present period presentation.

 

During the third quarter of 2009, the Company adopted the new Accounting Standards Codification (“ASC”) as issued by FASB.  The ASC has become the authoritative source of US GAAP recognized by FASB to be applied by non-governmental entities.  The ASC is not intended to amend or change US GAAP.  The adoption of the ASC did not have a material impact on the Company’s financial statements.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash, cash equivalents, and accounts receivable.  Cash and cash equivalents are maintained in federally-insured banks in the United States of America.  Deposits in such banks may exceed US federally-insured limits and be subject to the current risks and uncertainties of dealing with such US banks. Etelos maintains the majority of cash balances and all short-term investments with one financial institution.

 

The Company’s accounts receivables are derived primarily from customers.  For the nine months ended September 30, 2009, three customers accounted for 88% of the Company’s revenue in the period. One customer accounted for 100% of the Company’s accounts receivable as of September 30, 2009.

 

Allowance for Doubtful Accounts

 

The Company provides, when appropriate, an allowance for doubtful accounts to ensure trade receivables are not overstated due to un-collectability. The collectability of the Company’s receivables is evaluated based on a variety of factors, including the length of time receivables are past due, indication of the customer’s willingness to pay, significant one-time events, and historical experience. As of September 30, 2009, and December 31, 2008, the Company determined that an allowance for doubtful accounts was not necessary or warranted.

 

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Deferred Revenue

 

Deferred revenue represents money received or promised but not recognized as revenue because the work has not been completed or the software subscription has been fully delivered, and therefore is deferred until the work is completed or the software subscription is fully delivered when it is then transferred to the appropriate revenue account.

 

Property and Equipment

 

Property, furniture, and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed on a straight-line basis over the estimated useful lives of the assets, which the Company currently believes are three to five years.

 

Fair Value of Financial Instruments

 

The Company’s balance sheet includes the following financial instruments: cash, accounts receivable, accounts payable, and accrued liabilities. The Company considers the carrying amount of working capital items to approximate the fair value for these financial instruments because of the relatively short period of time between origination of the instruments and their expected realization.

 

Research and Development and Software Development Costs

 

Research and development expenses consist primarily of salaries, payroll taxes, benefits, and related expenditures for technology, software development, project management, and support personnel. Costs related to the research and development of new products, services and enhancements to existing products are expensed as provided for by ASC 985-20 “Costs of Software to be Sold, Leased, or Marketed” (ASC 985-20). Under ASC 985-20, costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Research and development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers. Technological feasibility is reached when the product reaches the working model stage. To date, products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time and all research and development costs have been expensed.

 

ASC 350-40 “Internal-Use Software” (ASC 350-40), which applies to SaaS business model, are met for the capitalization of software development cost.  Under ASC 350-40, software development costs, including costs incurred to purchase third party software, are capitalized beginning when the Company has determined certain factors are present, including, among others, that technology exists to achieve the performance requirements, buy versus internal development decisions have been made, and the Company’s management has authorized the funding for the project. Capitalization of software development costs ceases when the software is substantially complete and is ready for its intended use.  To date, no software development costs incurred have met the criteria set forth in ASC 350-40 for capitalization.

 

Revenue Recognition

 

Etelos distributes Web Applications and it Marketplace Platform as a subscription service using the SaaS or software-on-demand business model and allow third parties to offer their products or services through storefronts in an Etelos Marketplace, and to advertise on its web site or in its magazine for a fee.  It also license certain of its software products under perpetual and term licenses.  Revenues are recognized on these service and licensing transactions using the criteria in ASC 605-10, “Revenue Recognition”, (ASC 605-10) and ASC 985-605, “Software Revenue Recognition” (ASC 985-605), respectively, which both provide that revenue may be recognized when all of the following are met:

 

·                                          persuasive evidence of an arrangement exists,

·                                          the product or service has been delivered,

·                                          the fee is fixed or determinable, and

·                                          collection of the resulting receivable is reasonably assured or probable.

 

For the SaaS business model, persuasive evidence is generally an acceptance by the customer of a binding agreement and authorization by the customer to charge a credit card; delivery generally occurs over the term of the subscription agreement related to the SaaS; and the fee is fixed and collection reasonably assured when the customer’s credit card is charged.  Accordingly, revenue is recognized over the period the SaaS is provided.

 

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For software licensed under term or perpetual agreements, persuasive evidence of an arrangement is evidenced by a binding agreement signed by the customer and delivery generally occurs upon delivery of the software to a common carrier. If a significant portion of a fee is due after our normal payment terms of typically 30 days, then we recognize revenue as the fees become due. If the Company determines that collection of a fee is not reasonably assured, then it defers the fees and recognizes revenue upon cash receipt, provided that all other revenue recognition criteria are met.

 

Advertising on the Company’s web site is recognized as revenue over the period the advertisement appears on its web site and advertising presented in its magazine is recognized upon publication of the magazine provided the other criteria for revenue recognition set forth above have been met.

 

Arrangements for which the fees are not deemed reasonably assured for collection are recognized upon cash collection.

 

Stock Based Compensation

 

The Company, under ASC 718-10, “Compensation — Stock Compensation” (ASC 718-10) is applying the “modified prospective method” and used the Black-Scholes Merton model to value all new stock based compensation awards granted starting January 1, 2007, and for any modification, cancellation, or repurchase of awards granted prior to January 1, 2007.  As a result, the Company has recorded compensation cost in the statement of operations based on the fair value of the award for the requisite service period. ASC 718-10 also requires the Company to estimate forfeitures in calculating the expense relating to share-based compensation as opposed to only recognizing these forfeitures and the corresponding reduction in expense as they occur. This resulted in $106 thousand and $73 thousand of expense for the nine months ended September 30, 2009 and 2008, respectively.

 

ASC 718-10 requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. Due to its loss position, there were no such tax benefits during the nine months ended September 30, 2009 and 2008. Prior to the adoption of ASC 718-10, those benefits would have been reported as operating cash flows had we received any tax benefits related to stock option exercises.

 

Income Taxes

 

The Company accounts for income taxes in accordance with ASC 740-10, “Income Taxes” (ASC 740-10) which utilizes the liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

 

The Company has adopted the provisions of ASC 740-10-25, “Income Taxes — Overall — Recognition” (ASC 740-10-25). The Company did not have any unrecognized tax benefits and there was no effect on its financial condition or results of operations as a result of implementing ASC 740-10-25.

 

The Company files income tax returns in the United States of America federal jurisdiction and various state jurisdictions in the United States of America.  The Company does not believe that there will be any material changes in its unrecognized tax positions over the next twelve months.  The Company believes that its income tax filing positions and deductions would be sustained on audit and does not anticipate any adjustments that will result in a material adverse effect on the Company’s financial position, results of operations, or cash flow.  Therefore, no reserves for uncertain income tax positions have been recorded pursuant to ASC 740-10-25.  In addition, the Company did not record a cumulative effect adjustment related to the adoption of ASC 740-10-25.

 

The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of ASC 740-10-25, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any such interest expense recognized during the nine months ended September 30, 2009 and 2008, or the year ended December 31, 2008.  The Company’s effective tax rate differs from the federal statutory rate primarily due to increases in its deferred income tax valuation allowance.

 

Net Income (Loss) per Share

 

Basic net income (loss) per share is computed by dividing the net loss available to common stockholders for the period by the weighted average number of shares of common stock outstanding during the period, excluding any unvested restricted stock that is subject to repurchase. Diluted net income per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares consist of unvested restricted stock (using

 

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the treasury stock method), the incremental common shares issuable upon the exercise of stock options and warrants (using the treasury stock method) and the conversion of the Company’s convertible notes and debentures (using the if-converted method).  As their effect is antidilutive, 108,731 and 4,480,911 shares of common stock exercisable under outstanding employee stock options, 9,864,444 and 611,111 shares of common stock exercisable under outstanding warrants, 11,191,424 and 6,426,074 shares of common stock issuable upon conversion of the outstanding convertible notes payable and debentures, as of, and for the nine months ended September 30, 2009 and 2008, respectively, have been excluded from this calculation.  The average exercise price of outstanding employee stock options to purchase the Company’s common stock is $0.22 and $0.23, respectively, at September 30, 2009 and 2008. The average exercise price of outstanding warrants to purchase the Company’s common stock is $0.45 and $1.80, respectively, at September 30, 2009 and 2008.

 

The following table sets forth the computation of basic and diluted net loss per share for the periods presented (in thousands, except per share amounts):

 

 

 

For the Three Months
Ended September 30,

 

For the Nine Months
Ended September 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(1,200

)

$

1,651

 

$

(4,725

)

$

(22,153

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) - diluted

 

$

(1,200

)

$

1,651

 

$

(4,725

)

$

(22,153

)

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common stock

 

24,074

 

23,036

 

23,839

 

16,522

 

 

 

 

 

 

 

 

 

 

 

Convertible notes payable

 

 

3,382

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common stock - diluted

 

24,074

 

26,418

 

23,839

 

16,522

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.05

)

$

0.07

 

$

(0.20

)

$

(1.34

)

Diluted

 

$

(0.05

)

$

0.06

 

$

(0.20

)

$

(1.34

)

 

Use of Estimates

 

The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Segment Reporting

 

The Company has one operating segment because the Company is not organized into multiple segments for the purpose of making operating decisions or for assessing performance. The chief operating decision maker evaluates performance, makes operating decisions, and allocates resources based on financial data consistent with the presentation in the accompanying financial statements.

 

4. Going Concern

 

The financial statements have been prepared with the assumption that the Company will continue as a going concern.  The Company has experienced net losses of $4.7 million and $22.2 million for the nine months ended September 30, 2009 and 2008, respectively, and has a total stockholders’ deficit of $11.9 million and $10.8 million, as of September 30, 2009, and December 31, 2008, respectively, all of which raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might arise should it be unable to continue as a going concern.

 

Management has supported current operations by raising additional operating cash through the private sale of convertible debentures and notes payable and preferred stock. This has provided the cash inflows to continue the Company’s business plan, but has not resulted in significant improvement in its financial position or results of operations.  Management also has substantially reduced

 

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operating expenses by termination of employees and other reductions in operating expenses.  Alternatives being pursued to improve the Company’s cash flow used in operations include (1) raising additional working capital through additional sale of preferred stock, common stock and/or debt and (2) reducing cash operating expenses to levels that are in line with current revenues.  The first alternative could result in substantial dilution to existing shareholders. There can be no assurance that the Company’s current financial position can be improved, that it can raise additional working capital, or that it can achieve positive cash flows from operations. The Company’s long-term viability as a going concern is dependent upon its ability to (1) locate sources of debt or equity funding to meet current commitments and near-term future working capital requirements and (2) achieve profitability and ultimately generate sufficient cash flow from operations to sustain its continuing operations.

 

The Company’s cash balance including proceeds from its recent debt financings and preferred stock financing may not be sufficient to fund operations beyond June 2010.  If cash reserves are not sufficient to sustain operations, then management plans to further reduce operating expenses and/or raise additional capital by selling shares of capital stock or other securities that could result in substantial dilution to existing shareholders.  However, there are no commitments or arrangements for future financings in place at this time and the Company can give no assurance that such capital will be available on favorable terms, or at all.  The Company may need additional financing thereafter until it can achieve profitability.  If it cannot, then it will be forced to further curtail operations or possibly be forced to evaluate a sale or liquidation of assets.  Even if it is successful in raising additional funds, there is no assurance regarding the terms of any additional investment.

 

On September 30, 2009, the Company issued convertible debentures (the “10% Senior Secured Debentures”) with a principal amount of $2.0 million, warrants to purchase 5,250,000 shares of the Company’s common stock, and 750,000 shares of common stock in exchange for $0.8 million in cash and the cancellation of $1.2 million in promissory notes and accrued interest.  Seventy-five percent of the 10% Senior Secured Debentures are held by Enable Capital Management LLC or its affiliates (“Enable Capital”).  Enable Capital beneficially owns more than 10% of the Company’s common stock. Under the terms of the securities purchase agreement pursuant to which the 10% Senior Secured Debentures were issued, subject to the satisfaction of certain covenants and conditions, the Company has the right, at any time after December 15, 2009 and before January 15, 2010, to require the purchasers of the 10% Senior Secured Debentures to purchase an aggregate of $1.0 million in additional principal amount of 10% Senior Secured Debentures.  At September 30, 2009, the purchasers of the 10% Senior Secured Debentures executed and delivered all documents in the transaction except for funding of $500,000 which was paid in full subsequent to the period end. The $500,000 of funding was recorded as an Other Receivable in the accompanying condensed balance sheet as of September 30, 2009.

 

5.  Recently Issued Accounting Standards

 

In October 2009, the FASB issued new accounting guidance related to the revenue recognition of multiple element arrangements. The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective for the Company during the first quarter of fiscal 2011. Early adoption is allowed. The Company is currently evaluating the impact of this accounting guidance on its financial statements.

 

6. Convertible Notes and Debentures and Embedded Derivative and Warrant Liability

 

Convertible notes and debentures comprise (in thousands):

 

 

 

September 30,
2009

 

December 31,
2008

 

 

 

 

 

 

 

6% Convertible Notes

 

$

1,764

 

$

1,764

 

January 2008 Debentures

 

2,320

 

2,000

 

April 2008 Debentures

 

4,012

 

3,500

 

10% Senior Secured Debentures

 

2,000

 

 

 

 

10,096

 

7,264

 

 

 

 

 

 

 

Plus (less) premium (discount) on notes payable

 

(1,621

)

(—

)

 

 

8,475

 

7,264

 

Less current portion of notes payable

 

(1,764

)

(7,264

)

 

 

 

 

 

 

Long term notes payable, net of premium (discount), less current portion

 

$

6,711

 

$

 

 

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6% Convertible Notes

 

During the period August 2007 to October 2007, the Company issued 6% convertible notes (the “6% Convertible Notes”) with a face value of $3,326 thousand at an original issue discount of 10 percent with detachable warrants to purchase shares of its common stock in exchange for $3,024 thousand.  These notes matured on March 31, 2009, with interest due and payable on February 1, 2008, and on the last day of each calendar quarter thereafter. The Company was required to make payments on the outstanding principal balance beginning September 1, 2008, and on the 1st day of each calendar quarter thereafter. The default interest rate was 8 percent. The notes and unpaid interest are convertible into shares of the Company’s common stock at the option of the holder or involuntarily upon the occurrence of certain financing events. As of December 31, 2008, and September 30, 2009, $1,562 thousand of the face value of the 6% Convertible Notes had been converted to 2,083 thousand shares of the Company’s common stock and $1,764 thousand remain outstanding. The Company failed to make required interest and principal payments as of December 31, 2008, and through September 30, 2009. Accordingly, the Company was and remains in default under the terms of the notes, which resulted in all principal and interest related to the notes becoming due and payable to the holders. As a result, the Company classified all amounts due related to the 6% Convertible Notes as current liabilities as at December 31, 2008, and September 30, 2009.

 

In addition, the purchasers of the 6% Convertible Notes received warrants to purchase 1,080,000 shares of the Company’s common stock at an exercise price of $0.12. At December 31, 2008, all of these warrants had been exercised or expired and none are outstanding.

 

January 2008 Debentures — Prior to Restructuring on June 30, 2009 (see below)

 

On January 31, 2008, the Company issued convertible debentures (the “January 2008 Debentures”) with a principal amount of $2 million and detachable warrants to purchase 222,222 shares of its common stock in exchange for $1.9 million.  The January 2008 Debentures are all held by Enable Capital. Enable Capital beneficially owns more than 10% of the Company’s common stock.  The January 2008 Debentures are due on January 31, 2010, and bear interest at 6 percent per annum payable semiannually on January 1 and July 1, commencing July 1, 2008.  Monthly principal payments equal to 1/18th of the principal amount were to begin on September 1, 2008.  The Company had the right to pay interest and monthly principal payments in cash, or upon notice to the holders and compliance with certain equity conditions, it can pay all or a portion of any such payment in common stock valued at a price equal to the lesser of the then effective conversion price or 85 percent of the average of the volume weighted average price per share for its common stock for the 10 consecutive trading days immediately prior to the applicable payment date.  The equity conditions that it must meet include having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debenture, and having the daily dollar trading volume for its common stock exceed $250,000 for each of the 20 consecutive trading days before the date in question.  The January 2008 Debentures and any accrued interest are convertible at anytime at the discretion of the holder at a conversion price per share of $1.35, subject to a cap on the beneficial ownership of its shares of common stock by the holder and its affiliates following such conversion. The conversion price is adjusted upon a stock split, reverse stock split, or upon issuance of stock dividends, whereby the conversion price would be adjusted to ensure that the holder would be receiving the same number of shares, as though the conversion right had been exercised prior to the triggering event.  Further, the conversion price is adjusted if common stock or equivalents are subsequently sold or re-priced at a price below the conversion price or rights, options or warrants are issued to holders of its common stock entitling them to purchase common stock at prices lower than the volume weighted average price on the date issued.

 

The Company has the option to redeem the January 2008 Debentures before their maturity by payment in cash of an amount equal to 120 percent of the then outstanding principal amount, plus accrued interest and other charges, and the right to force conversion of the debentures if the average of the volume weighted average price of its common stock exceeds $3.39 for 20 trading days out of a consecutive 30 trading day period.  This redemption option and forced conversion right are subject to the Company meeting certain equity conditions, including having the daily dollar trading volume for its common stock exceed $250 thousand for each of the 20 consecutive trading days before the date in question and having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debentures and the forced conversion option, subject to the applicable cap on the beneficial ownership of its shares of common stock by the holder and its affiliates following such conversion.  The January 2008 Debentures are collateralized by substantially all the assets of the Company.

 

The January 2008 Debentures impose certain covenants on the Company, including restrictions against incurring additional indebtedness, creating any liens on its property, amending its certificate of incorporation or bylaws, redeeming or paying dividends on shares of our outstanding common stock, and entering into certain related party transactions.  The January 2008 Debentures also define certain events of default, including, without limitation, failure to make a payment obligation, failure to observe other covenants of the debenture or related agreements (subject to applicable cure periods), breach of representation or warranty, bankruptcy, default under another significant contract or credit obligation, delisting of its common stock, a change in control, failure to secure and maintain an effective registration statement covering the resale of the common stock underlying the debentures and the warrants, or failure to deliver share certificates in a timely manner.  In the event of default, the holders of the January 2008 Debentures have the

 

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right to accelerate all amounts outstanding under the debentures and demand payment of a mandatory default amount equal to 130 percent of the amount outstanding plus accrued interest and expenses. The Company failed to make required interest and principal payments on the January 2008 Debentures beginning with the payment due on September 30, 2008 and through June 30, 2009. Accordingly, the Company is in default under the terms of the January 2008 Debentures, and the holders have the right to demand that the default amount equal to 130% of the amount outstanding plus accrued interest be paid to the holders. As of December 31, 2008 and June 30, 2009, the Company classified all amounts due related to the January 2008 Debentures as current liabilities, and the holders had not elected to exercise their rights arising from the Company’s default.

 

The detachable warrants, which are fully exercisable, to purchase 222,222 shares of our common stock, expire in January 2011 and are exercisable at a price of $1.80 per share, subject to adjustment.  As of September 30, 2009, none of these warrants had been exercised.

 

Restructuring of January 2008 Debentures

 

On June 30, 2009, the Company executed an agreement to restructure the January 2008 Debentures. Under the terms of the agreement, the maturity of the debentures was extended to December 31, 2012; the outstanding interest as of June 30, 2009, and interest that would have been earned under the original terms of the Debentures was added to principal as of June 30, 2009; the interest rate was reduced to 0% until September 30, 2010; the monthly amortizing redemption payment schedule was eliminated and replaced with a requirement to pay interest only on a semi-annual basis beginning January 1, 2011, and to pay principal at maturity; the option to make principal and interest payments in shares of common stock instead of cash was removed; the anti-dilution provisions were modified so that the conversion price cannot be reduced below $0.10 as a result of subsequent equity sales; the registration rights agreement entered into in conjunction with the debentures was terminated; the optional redemption amount was reduced to 100% of the then outstanding principal amount plus accrued but unpaid interest and plus all liquidated damages and other amounts due; and all past defaults were waived. Additionally, the warrants issued in conjunction with the debentures were modified so that the warrant may be exchanged for a share of common stock on a 1:1 basis, and were modified to eliminate the anti-dilution provisions afforded for subsequent equity sales at a price lower than the original conversion price. No direct fees were either charged by or received from the debenture holders for the restructuring.

 

The Company evaluated the restructuring of the January 2008 Debentures, under the guidance in ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30, 2009. The Company concluded that the restructuring of the January 2008 Debentures met the definition of an extinguishment of debt as the terms of the modified debentures were substantially different from the original terms. Accordingly, the Company recorded the difference between the fair value and carrying value of the January 2008 Debentures as a loss on extinguishment of debt of $300 thousand in earnings for the six months ended June 30, 2009.

 

Additionally, as part of the restructuring of the January 2008 Debentures, the outstanding accrued interest of $170 thousand as of June 30, 2009, was reclassified to outstanding principal, and the interest that was to have been earned under the original terms of the debentures from July 1, 2009, through September 30, 2010, of $150 thousand was recorded as an increase to outstanding principal with the corresponding debit amount being recorded as Accreting Interest on Convertible Notes Payable. This interest amount will be accreted to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

 

The Company recorded a debt premium of $300 thousand related to the difference between the fair value and the revised principal amount of the January 2008 Debentures, along with the increase in the fair value of the embedded conversion option of $50 thousand as a debt discount, and debt issuance costs related to fees incurred by the Company from service providers related to the restructuring of the January 2008 Debentures of $9 thousand were capitalized as Debt Issuance Costs. These items will be accreted or amortized to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

 

April 2008 Debentures — Prior to Restructuring on June 30, 2009 (see below)

 

On April 22, 2008, the Company issued convertible debentures (the “April 2008 Debentures”) with a principal amount of $3.5 million and detachable warrants to purchase 388,889 shares of our common stock in exchange for $3.4 million.  The April 2008 Debentures are all held by Enable Capital.  Enable Capital beneficially owns more than 10% of the Company’s common stock.  The April 2008 Debentures are due on April 30, 2010, and have identical terms and conditions to the January 2008 Debentures described above. The Company failed to make required interest and principal payments on the April 2008 Debentures beginning with the payment due on September 30, 2008, and through June 30, 2009. Accordingly, the Company is in default under the terms of the April 2008 Debentures, and the holders have the right to demand that the default amount equal to 130% of the amount outstanding plus accrued interest be paid to the holders. As of December 31, 2008 and June 30, 2009, the Company classified all amounts due related to the April 2008 Debentures as current liabilities, and the holders had not elected to exercise their rights arising from the Company’s default.

 

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The detachable warrants, which are fully exercisable, to purchase 388,889 shares of our common stock, expire in April 2011 and are exercisable at a price of $1.80 per share, subject to adjustment.  As of September 30, 2009, none of these warrants had been exercised.

 

In connection with the January 2008 Debentures and the April 2008 Debentures, the Company also entered into a registration rights agreement with the investors, pursuant to which it agreed to file a registration statement covering the resale of the shares of common stock that may be issued to such investors upon the conversion of the debentures, payment in kind, and the exercise of the related warrants.  The Company agreed to maintain the effectiveness of the registration statement (subject to certain limitations) for a period of time until the holders can sell the underlying common stock without volume restrictions under Rule 144 of the Securities Act of 1933, or the Securities Act. If the registration statement is not declared effective by an agreed to date, or if the Company fail to maintain the effectiveness of the registration statement, then the Company is required to pay to each investor, as partial liquidated damages, cash equal to 1.0 percent of the aggregate purchase price paid by such investor for the securities purchased in the financing and then held by such investor, and must pay to such investor 1 percent for each subsequent 30-day period that the default remains uncured, up to a maximum aggregate liquidated damages amount of 10 percent of the aggregate purchase price paid by the holders of the debentures.

 

The Company’s registration statement was effective July 31, 2008, which was eight days after the deadline in the registration rights agreements. However, the penalties for this delay were waived in the agreement to restructure the January 2008 and April 2008 Debentures on June 30, 2009.

 

Restructuring of January 2008 and April 2008 Debentures

 

On June 30, 2009, the Company executed an agreement to restructure the January 2008 and April 2008 Debentures. Under the terms of the agreement, the maturity of these debentures was extended to December 31, 2012; the outstanding interest as of June 30, 2009, and interest that would have been earned under the original terms of the debentures was added to principal as of June 30, 2009; the interest rate was reduced to 0% until September 30, 2010; the monthly amortizing redemption payment schedule was eliminated and replaced with a requirement to pay interest only on a semi-annual basis beginning January 1, 2011, and to pay principal at maturity; the option to make principal and interest payments in shares of common stock instead of cash was removed; the anti-dilution provisions were modified so that the conversion price cannot be reduced below $0.10 as a result of subsequent equity sales; the registration rights agreement entered into in conjunction with these debentures was terminated; the optional redemption amount was reduced to 100% of the then outstanding principal amount plus accrued but unpaid interest and plus all liquidated damages and other amounts due; and all past defaults were waived. Additionally, the warrants issued in conjunction with these debentures were modified so that the warrant may be exchanged for a share of common stock on a 1:1 basis, and were modified to eliminate the anti-dilution provisions afforded for subsequent equity sales at a price lower than the original exercise price. No direct fees were either charged by or received from the debenture holders for the restructuring.

 

The Company evaluated the restructuring of these debentures under the guidance of ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30, 2009.  The Company concluded that the restructuring of the January 2008 Debentures met the definition of an extinguishment of debt, as the terms of the modified debentures were substantially different from the original terms.  Accordingly, the Company recorded the difference between the fair value and carrying value of the January 2008 Debentures as a loss on extinguishment of debt of $300 thousand in earnings for the six months ended June 30, 2009.

 

The Company concluded that the restructuring of the April 2008 Debentures did not meet the definition of an extinguishment of debt as the terms of the modified debentures were not substantially different from the original terms. However, as the April 2008 Debentures included an embedded conversion feature, the Company is required to account for any increase in the fair value of the embedded conversion option immediately prior to and immediately after the transaction as a debt discount with the credit being recorded as additional paid in capital. Accordingly, the Company recorded the increase in the fair value of the embedded conversion option of $80 thousand as a debt discount that will be amortized over the revised maturity date of the April 2008 Debentures using the effective interest method.

 

The Company recorded a debt premium of $300 thousand related to the difference between the fair value and the revised principal amount of the January 2008 Debentures, along with the increase in the fair value of the embedded conversion option of $50 thousand as a debt discount, and debt issuance costs related to fees incurred by the Company from service providers related to the restructuring of the January 2008 Debentures of $9 thousand were capitalized as Debt Issuance Costs. These items will be accreted or amortized to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

 

Additionally, as part of the restructuring of the April 2008 Debentures, the outstanding accrued interest of $420 thousand as of June 30, 2009, was reclassified to outstanding principal, and the aggregate interest that would have accrued under the original terms of the debentures from July 1, 2009, through September 30, 2010, of $413 thousand was recorded as an increase to outstanding principal with the corresponding debit amount being recorded as Accreting Interest on Convertible Notes Payable. This interest amount will be accreted to earnings over the revised maturity date of these Debentures using the effective interest method.

 

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10% Senior Secured Debentures

 

On September 30, 2009, the Company issued 10% Senior Secured Debentures with a principal amount of $2.0 million, warrants to purchase 5,250,000 shares of our common stock, and 750,000 shares of our common stock in exchange for $0.8 million in cash and the cancellation of $1.2 million in promissory notes and accrued interest.  Seventy-five percent of the 10% Senior Secured Debentures are held by Enable Capital.  Enable Capital beneficially owns more than 10% of the Company’s common stock.  The 10% Senior Secured Debentures are due on September 30, 2011, and bear interest at 10 percent per annum payable quarterly on January 1, April 1, July 1, and October 1, commencing January 1, 2010.  The principal amount is due on maturity.  The 10% Senior Secured Debentures are convertible at anytime at the discretion of the holder at a conversion price per share of $0.50, subject to a cap on the beneficial ownership of its shares of common stock by the holders and their affiliates following such conversion. The conversion price is adjusted upon a stock split, reverse stock split, or upon issuance of stock dividends, whereby the conversion price would be adjusted to ensure that the holder would be receiving the same number of shares, as though the conversion right had been exercised prior to the triggering event.  Further, the conversion price is adjusted if common stock or equivalents are subsequently sold or re-priced at a price below the conversion price, or rights, options or warrants are issued to holders of its common stock entitling them to purchase common stock at prices lower than the volume weighted average price on the date issued, with a floor for the conversion price of $0.10 per share.

 

The Company has the option to redeem the 10% Senior Secured Debentures before their maturity by payment in cash of an amount equal to 100 percent of the then outstanding principal amount, plus outstanding accrued interest and other charges, and all interest that would have accrued if the outstanding principal amount had remained outstanding through maturity.  This redemption option is subject to the Company meeting certain equity conditions, including having the daily dollar trading volume for its common stock exceed $250 thousand for each of the 20 consecutive trading days before the date in question and having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debentures, subject to the applicable cap on the beneficial ownership of its shares of common stock by the holders and their affiliates following such conversion.  The 10% Senior Secured Debentures are collateralized by substantially all the assets of the Company.

 

The 10% Senior Secured Debentures impose certain covenants on the Company, including restrictions against incurring additional indebtedness, creating any liens on its property, amending its certificate of incorporation or bylaws, redeeming or paying dividends on shares of our outstanding common stock, and entering into certain related party transactions.  The 10% Senior Secured Debentures also define certain events of default, including, without limitation, failure to make a payment obligation, failure to observe other covenants of the debenture or related agreements (subject to applicable cure periods), breach of representation or warranty, bankruptcy, default under another significant contract or credit obligation, delisting of its common stock, a change in control, failure to secure and maintain an effective registration statement covering the resale of the common stock underlying the debentures and the warrants, or failure to deliver share certificates in a timely manner.  In the event of default, the holders of the 10% Senior Secured Debentures have the right to accelerate all amounts outstanding under the debentures and demand payment of a mandatory default amount equal to the greater of (i) the outstanding principal amount plus all accrued and unpaid interest divided by the conversion price multiplied by the volume weighted average price or (ii) 120 percent of the amount outstanding, plus accrued interest and expenses, and all interest that would have accrued if the then outstanding principal amount had remained outstanding through maturity. Additionally the mandatory default amount would also include all other amounts, costs, expenses and liquidated damages due in respect of the debentures.

 

The detachable warrants, which are fully exercisable, to purchase 3,000,000 and 2,250,000 shares of our common stock, expire in September 2014 and September 2016, respectively, and are exercisable at a price of $0.60 and $0.01 per share, respectively, subject to adjustment.  The warrants may be exchanged for a share of common stock on a 1:1 basis, and the warrants that expire in September 2014 include a floor on the exercise price of $0.10 per share.  As of September 30, 2009, none of these warrants had been exercised.

 

As part of the issuance of the 10% Senior Secured Debentures, the Company exchanged existing promissory notes with an aggregate principal amount of $1,150 thousand, including the $250 thousand promissory note issued in July 2009, for a like portion of 10% Senior Secured Debentures. The Company evaluated the restructuring of these promissory notes under the guidance in ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of September 30, 2009. The Company concluded that the restructuring of the various promissory notes met the definition of an extinguishment of debt as the terms of the 10% Senior Secured Debentures were substantially different from the original terms of the promissory notes due to the insertion of a conversion feature. Accordingly, the Company recorded the difference between the fair value of the 10% Senior Secured Debentures and carrying value of the promissory notes as a loss on extinguishment of debt of $288 thousand in earnings for the nine months ended September 30, 2009, including the remaining unamortized debt discount recorded on the July 2009 promissory note of $68 thousand.

 

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The Company recorded a debt premium of $220 thousand related to the difference between the fair value and the principal amount of the 10% Senior Secured Debentures, and debt issuance costs related to fees incurred by the Company of $25 thousand were capitalized as Debt Issuance Costs. Additionally, the Company recognized a further debt discount due to a beneficial conversion feature on the issuance of the 10% Senior Secured Debentures of $776 thousand.  These items will be accreted or amortized to earnings over the maturity date of the 10% Senior Secured Debentures using the interest method.

 

At September 30, 2009, the purchasers of the 10% Senior Secured Debentures executed and delivered all documents in the transaction except for funding of $500,000 which was paid subsequent to the end of the period. The $500,000 of funding was recorded as an Other Receivable in the accompanying condensed balance sheet as of September 30, 2009.

 

Embedded Derivatives

 

The Company has evaluated the embedded derivatives included in the 6% Convertible Notes, the January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures, consisting of the conversion features and certain put and call features described above, under the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on the issuance date of the Convertible Notes, the January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures, and on each subsequent reporting date.  The purpose of the evaluation is to determine whether the embedded derivatives need to be bifurcated from the debt host and accounted for as a derivative at their estimated fair value as a liability at the date of issuance and thereafter, adjusted to estimated fair value with a charge or credit to the Company’s statement of operations.  ASC 815-10 generally indicates that if the conversion features are (i) indexed to the Company’s capital stock under the guidance in ASC 815-40-15, “Derivatives and Hedging — Contracts in Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15), and (ii) would be classified as equity if a freestanding derivative under the guidance in ASC 815-40-25 “Derivatives and Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25) then the embedded derivatives need not be bifurcated from the debt host.  ASC 815-40-25 generally requires, among other factors, that (i) the Company can settle the derivative in cash or its own stock, at its option, (ii) settlement can be made in unregistered shares, and (iii) the Company has sufficient authorized shares to issue shares of its common stock for all equity instruments convertible to or which can be exercised for its capital stock.  ASC 815-10 also provides guidance on when put and call features included in a debt host agreement are not clearly and closely related to the debt host must be bifurcated and recorded as a liability.  The January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures include put and call features.

 

Embedded Derivatives — 6% Convertible Notes

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the 6% Convertible Notes met the criteria in ASC 815-10 at issuance and through April 21, 2008, the day prior to the merger with Tripath, because the conversion to the Company’s common stock could only be settled in its capital stock, the capital stock could be unregistered and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock and recorded the conversion features embedded in the 6% Convertible Notes with an estimated fair value of $3,674 thousand and recorded the amount as Warrant and Derivative Liability. At December 31, 2008, and June 30, 2009, the estimated fair value of the conversion features was subsequently revalued to $2 thousand and $0 thousand, with the related credit of $3,672 and $2 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the conversion features on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 0.95, 0.25, and 0 years, respectively; risk free interest rates of 1.82%, 0.11% and 0.0%, respectively; and volatility of 47.16%, 73.59%, and 0.0%, respectively. Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

 

Upon the restructuring of the Company’s January and April Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the 6% Convertible Notes met the criteria in ASC 815-10 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock, as the modified anti-dilution provisions relating to the January 2008 and April 2008 Debentures include a floor on the conversion price adjustment as a result of any subsequent equity sales. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $0 thousand. As of September 30, 2009, the Company continues to conclude that the conversion features embedded in the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

 

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Embedded Derivatives — January 2008 and April 2008 Debentures

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the January 2008 Debentures met the criteria in ASC 815-10 at issuance and through April 21, 2008, the day prior to the merger with Tripath, and therefore, were not bifurcated from the debt host because the conversion to the Company’s common stock could only be settled in its common stock, the common stock could be unregistered and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the conversion feature in unregistered shares. Therefore, the Company recorded the conversion features embedded in the January 2008 Debentures with an estimated fair value of $896 thousand and recorded the amount as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the conversion feature was subsequently revalued to $5 thousand and $2 thousand, respectively, with the related credit of $891 thousand and $3 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009. The Company determined the estimated fair value of the conversion options on April 22 and December 31, 2008, and June 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 1.75 years, 1.08 years, and 0.58 years, respectively; risk free interest rates of 1.84%, 0.40%, and 0.39%, respectively; and volatility of 47.16% 65.48%, and 48.84%, respectively.  Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the April 2008 Debentures should be bifurcated from the debt host and recorded as liabilities because the conversion features must be settled in registered shares and that due to the Merger with Tripath the Company no longer had control over a shareholder vote to ensure the sufficiency of its authorized shares of common stock. The estimated fair value of the embedded conversion features was $1,507 thousand at April 22, 2008, and recorded in the line entitled “Warrant and derivative liability” in the accompanying Balance Sheet. At December 31, 2008, and June 30, 2009, the estimated fair value of the embedded conversion features was subsequently revalued to $10 thousand and $2 thousand, respectively, with the related credit of $1,497 thousand and $8 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the conversion options on April 22 and December 31, 2008, and June 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 2, 1.33, and 0.83 years, respectively; risk free interest rates of 1.87%, 2.24%, and 0.49%, respectively; and volatility of 49.00%, 61.48%, and 58.72%, respectively.  Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the January 2008 and April 2008 Debentures met the criteria in ASC 815-10 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock, as the modified anti-dilution provisions relating to the January 2008 and April 2008 Debentures include a floor on the conversion price adjustment as a result of any subsequent equity sales, and because the conversion features no longer are required to be settled in registered shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value of the conversion features embedded in the January 2008 and April 2008 Debentures as of June 30, 2009, to additional paid in capital of $0 thousand and $2 thousand, respectively. As of September 30, 2009, the Company continues to conclude that the conversion features embedded in the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

 

The Company also concluded that the put and call in the January 2008 and April 2008 Debentures were embedded derivatives that were not clearly and closely related to the debt host and therefore should be bifurcated from the debt host along with the conversion features and recorded as a liability at their estimated fair value at issuance.  The Company determined the net fair value of the put and call embedded in the January 2008 and April 2008 Debentures on April 22 and December 31, 2008 to be de minimus.

 

As of September 30, 2009, the Company concluded that the put and call features embedded in the January 2008 and April 2008 Debentures continue to be not clearly and closely related to the debt host and therefore should be bifurcated from the debt host and recorded as a liability at their estimated fair value. The Company determined the net fair value of the put and call to be $91 thousand and $157 thousand for the January 2008 and April 2008 Debentures, respectively, with the related debit of $91 thousand and $157 thousand, respectively, included in the Company’s statement of operations in interest expense for the nine months ended September 30, 2009. The Company determined the estimated fair value of the put on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the put embedded in the January 2008 and April 2008 Debentures equivalent to 130% of the outstanding principal and accrued interest of $3,015,858 and $5,216,312, respectively; term of 3.25 years to the maturity date of December 31, 2012; risk free interest rate of 1.56%; and volatility of 14.91% which was determined using the volatility of the Bank Prime Lending Rate. The Company determined the estimated fair value of the call on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise

 

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price of the call embedded in the January 2008 and April 2008 Debentures equivalent to 100% of the outstanding principal and accrued interest of $2,319,890 and $4,012,548, respectively; term of 3.25 years to the maturity date of December 31, 2012; risk free interest rate of 1.56%; and volatility of 14.91% which was determined using the volatility of the Bank Prime Lending Rate.

 

Embedded Derivatives — 10% Senior Secured Debentures

 

Upon the issuance of the 10% Senior Secured Debentures on September 30, 2009, the Company concluded that the conversion features embedded in the 10% Senior Secured Debentures met the criteria in ASC 815-10 to be accounted for as an equity instrument even though the 10% Senior Secured Debentures include a reset provision on the conversion price and is considered non-conventional debt, because the Company has control to ensure the sufficiency of its authorized shares of common stock, as the debentures include a floor on the conversion price adjustment, and because the conversion features are not required to be settled in registered shares.

 

The Company also concluded that the put and call in the 10% Senior Secured Debentures were embedded derivatives that were not clearly and closely related to the debt host and therefore should be bifurcated from the debt host and recorded as a liability at their estimated fair value at issuance.  The Company determined the net fair value of the put and call embedded in the 10% Senior Secured Debentures on September 31, 2009 to be $45 thousand, and recorded a discount on the debentures that will be amortized as interest expense over the life of the debentures using the interest method.

 

The Company determined the estimated fair value of the put on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the put embedded in the 10% Senior Secured Debentures equivalent to 120% of the outstanding principal and accrued interest expected to be earned to maturity of $2,800,000; term of 2.0 years to the maturity date of September 30, 2011; risk free interest rate of 0.95%; and volatility of 18.31% which was determined using the volatility of the Bank Prime Lending Rate. The Company determined the estimated fair value of the call on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the call embedded in the 10% Senior Secured Debentures equivalent to 100% of the outstanding principal and accrued interest expected to be earned to maturity of $2,400,000; term of 2.0 years to the maturity date of September 30, 2011; risk free interest rate of 0.95%; and volatility of 18.31% which was determined using the volatility of the Bank Prime Lending Rate.

 

Warrants Issued in Connection with January 2008 and April 2008 Debentures

 

Effective with the issuance of the January 2008 and April 2008 Debentures, the Company issued warrants to purchase 222,222 and 388,889 shares, respectively, of the Company’s common stock at an exercise price of $1.80 per share, subject to adjustment, which warrants have a term of three years.

 

The Company evaluated the terms and conditions of the warrants issued with the January 2008 and April 2008 Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the January 2008 Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance and through April 22, 2008, and therefore, were accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the warrants in unregistered shares and therefore, recorded the estimated value fair value of the warrants of $320 thousand asWarrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the warrants was revalued to $1 thousand and $1 thousand, respectively, with the related credit of $319 thousand and $0 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 2.5, 2.08 and 1.58 years, respectively; risk free interest rates of 2.54%, 0.78%, and 0.88%, respectively; and volatility of 47.81%, 56.98%, and 59.34%, respectively.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the April 2008 Debentures did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the warrants in unregistered shares and therefore, recorded the estimated value fair value of the warrants of $590 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the warrants was revalued to $4 thousand and $2 thousand with the related credit of $586 thousand and $2 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of

 

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the warrants on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 3, 2.33, and 1.83 years, respectively; risk free interest rates of 2.43%, 0.84%, and 1.02%, respectively; and volatility of 49.17%, 62.44%, and 57.08%, respectively.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the January 2008 and April 2008 Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as equity because the Company had control to ensure the sufficiency of its authorized shares of common stock,.  The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009, to additional paid in capital of $1 thousand and $2 thousand, respectively. As of September 30, 2009, the Company continues to conclude that the warrants issued with the January 2008 and April 2008 Debentures meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

 

Warrants Issued in Connection with 10% Senior Secured Debentures

 

Effective with the issuance of the 10% Senior Secured Debentures, the Company issued Series I and Series II warrants to purchase 3,000,000 and 2,250,000 shares, respectively, of the Company’s common stock at exercise prices of $0.60 and $0.01 per share, respectively, subject to adjustment, and with terms of five and seven years, respectively.

 

The Company evaluated the terms and conditions of the warrants issued with the 10% Senior Secured Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the detachable warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

 

On September 30, 2009, the Company concluded that the Series I and Series II warrants issued with the 10% Senior Secured Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, were accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control. The Company determined the fair value of the Series I and Series II warrants on September 31, 2009 to be $424 thousand and $565 thousand, respectively, and recorded a discount on the debentures that will be amortized as interest expense over the life of the debentures using the interest method.

 

The Company determined the estimated fair value of the Series I warrants on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.78; exercise price of $0.60; term of 5.0 years; risk free interest rate of 2.31%; and volatility of 54.11%. The Company determined the estimated fair value of the Series II warrants on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.78; exercise price of $0.01; term of 7.0 years; risk free interest rate of 2.93%; and volatility of 57.83%.

 

Warrants Issued in Connection with Other Notes Payable and Notes Payable to Related Parties

 

Effective with the issuance of promissory notes on February 23, March 31, and July 9, 2009, the Company issued warrants to purchase 26,667, 133,333, and 500,000 shares, respectively, of the Company’s common stock at an exercise price of $0.75 per share, which warrants have a term of three, three, and five years, respectively.

 

The Company evaluated the terms and conditions of these warrants under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued with the promissory note in February 2009, did not meet the criteria in ASC 815-10 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrant of $36 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrant was revalued to $1 thousand with the related credit of $35 thousand included in the Company’s statement of operations in interest expense for the six months ended June 30, 2009. The Company determined the estimated fair value of the warrant on February 23 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.01 and $0.36, respectively, per share; terms of 3 and 2.67 years, respectively; risk free interest rates of 1.34% and 1.46%, respectively; and volatility of 53.63% and 52.58%, respectively.

 

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The fair value of the warrant recorded upon issuance was treated as a discount on other notes payable, and was amortized over the life of the promissory note, which matured on May 31, 2009, using the interest method. During the six months ended June 30, 2009, $36 thousand of the discount was amortized to interest expense.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the promissory note in February 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as equity because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $1 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the promissory note in February 2009 should be accounted for as equity. The February 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued with the promissory note in March 2009, did not meet the criteria in ASC 815-10 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrant of $83 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrant was revalued to $7 thousand with the related credit of $76 thousand included in the Company’s statement of operations in interest expense for the six months ended June 30, 2009.  The Company determined the estimated fair value of the warrant on March 31 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $1.20 and $0.36 per share, respectively; term of 3 and 2.75 years, respectively; risk free interest rate of 1.15% and 1.51%, respectively; and volatility of 53.28% and 51.87%, respectively.

 

The fair value of the warrant recorded upon issuance was treated as a discount on notes payable to related parties, and will be amortized over the life of the promissory note, which is due to mature on October 31, 2009, using the interest method. During the six months ended June 30, 2009, $35 thousand of the discount was amortized to interest expense.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the promissory note in March 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $7 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the promissory note in March 2009 should be accounted for as equity. The March 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures.

 

The Company concluded that the warrant issued with the promissory note in July 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, was accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control. The Company determined the fair value of the warrant on issuance to be $110 thousand and recorded a discount on the promissory note that will be amortized as interest expense over the life of the promissory note using the interest method. During the nine months ended September 30, 2009, the Company amortized $42 thousand in the Company’s statement of operations as interest expense. The July 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures. As a result, the remaining unamortized debt discount of $68 thousand was written off as part of the loss on extinguishment of debt,

 

The Company determined the estimated fair value of the warrant on issuance, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.55; exercise price of $0.75; term of 5.0 years; risk free interest rate of 2.34%; and volatility of 53.68%.

 

Warrants issued with New Series A Preferred Stock

 

In October 2008 and as amended in December 2008, the Board of Directors authorized the designation and issuance of up to 3,333,333 shares of New Series A Convertible Preferred Stock (the “New Series A Preferred Stock”), and the offering of up to $2,500,000 of New Series A Preferred Stock and a number of warrants with an exercise price of $0.75 equal to 100% of the number of

 

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shares purchased by each purchaser. Through the nine months ended September 30, 2009, and the period ending December 31, 2008, respectively, the Company closed a round of financing for the sale of 10,000 and 833,333 shares, respectively, of its New Series A Preferred Stock at $0.75 per share, for an aggregate purchase price of $7.5 thousand and $625 thousand, respectively, and warrants to purchase 10,000 and 833,333 shares of common stock of the Company, respectively, at an exercise price of $0.75 per share, and a three year term. The lead investor of this financing was Daniel J.A. Kolke, the Company’s founder, chairman, chief executive officer, acting chief financial officer, and chief technology officer, with participation from two of the Company’s directors and other prior investors. The holders of the January 2008 Debentures and the April 2008 Debentures consented to this financing, but did not participate.

 

The Company concluded at the date of issuance and through the reporting date that the embedded conversion features in the New Series A Preferred Stock should not be bifurcated from the equity host as they were clearly and closely related to the equity host. Also during the year ended December 31, 2008, the Company recorded a beneficial conversion feature related to the New Series A Preferred Stock, which could have been converted to the Company’s common stock, through the date the conversion feature was recorded, as a dividend expense of $22 thousand.

 

The Company evaluated the terms and conditions of the warrants issued with the New Series A Preferred Stock under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the New Series A Preferred Stock did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock. Therefore, the Company recorded the estimated value fair value of the warrants of $148 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, respectively, the estimated fair value of the warrants was revalued to $40 thousand and $40 thousand, respectively, with the related credit of $108 thousand and $0 thousand included in the Company’s statement of operations in financing expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on December 3 and 31, 2008 and June 30, 2009, and February 27 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.60, $0.33 and $0.36, and $0.51 and $0.36, respectively, per share; terms of 3, 2.92 and 2.42, and 3.0 and 2.67 years, respectively; risk free interest rates of 1.07%, 0.98% and 1.33%, and 1.4% and 1.46%, respectively; and volatility of 53.07%, 54.96% and 54.25%, and 53.63% and 52.58%, respectively.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the New Series A Preferred Stock met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $40 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the New Series A Preferred Stock should be accounted for as equity.

 

Warrants Issued in Connection with Litigation Settlement

 

Effective December 5, 2008, the Company entered into a settlement agreement with Kaufman Bros., pursuant to which the Company issued to Kaufman Bros. a warrant to purchase 500,000 shares of the Company’s common stock at an exercise price of $0.75 per share, which warrant has a term of five years. See discussion infra Note 12.

 

The Company evaluated the terms and conditions of the warrants issued in the settlement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to its respective estimated fair value at each reporting date.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in the settlement did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrants of $130 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, respectively, the estimated fair value of the warrants was revalued to $46 thousand and $47 thousand with the related (credit) debit of ($84) thousand and $1 thousand included in the Company’s statement of operations in settlement expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on December 5 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.60, $0.33, and $0.36, respectively, per share; terms of 5 years, 4.92, and 4.42 years, respectively; risk free interest rates of 1.67%, 1.53%, and 2.28%, respectively; and volatility of 56.16%, 56.74%, and 54.68%, respectively.

 

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Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the litigation settlement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009, to additional paid in capital of $47 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the litigation settlement should be accounted for as equity.

 

Warrants Issued in Connection with Consulting Agreement

 

Effective March 2, 2009, the Company entered into a consulting agreement with Salzwedel Financial Communications, Inc., pursuant to which the Company issued a warrant to purchase 2,000,000 shares of the Company’s common stock at an exercise price of $0.01 per share, which warrant has a term of five years.

 

The Company evaluated the terms and conditions of the warrants issued in relation to the consulting agreement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to its respective estimated fair value at each reporting date.

 

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued in relation to the consulting agreement did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrants of $1,001 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrants was revalued to $702 thousand with the related credit of $299 thousand included in the Company’s statement of operations in investor relations expense for the six months ended June 30, 2009. The Company determined the estimated fair value of the warrants on March 2 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.51 and $0.36, respectively, per share; terms of 5 years and 4.67 years, respectively; risk free interest rates of 1.86% and 2.39%, respectively; and volatility of 56.68% and 54.64%, respectively.

 

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the consulting agreement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $702 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the consulting agreement should be accounted for as equity.

 

The following is a summary of the movement related to embedded derivatives and warrant liabilities during the nine months ended September 30, 2009 (in thousands):

 

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Embedded
derivatives

 

Warrant
liabilities

 

Total

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2008

 

$

16

 

$

92

 

$

108

 

 

 

 

 

 

 

 

 

Fair value of warrant liabilities issued with Other Notes Payable and Notes Payable to Related Parties

 

 

 

120

 

120

 

Fair value of warrant liabilities issued with New Series A Preferred warrants

 

 

 

1

 

1

 

Fair value of warrant liabilities issued with consulting agreement

 

 

 

1,001

 

1,001

 

Fair value of embedded derivatives issued with 10% Senior Secured Debentures

 

45

 

 

 

45

 

Change in marked-to-market value of 6% convertible notes payable

 

(2

)

 

 

(2

)

Change in marked-to-market value of January 2008 Debentures

 

86

 

 

 

86

 

Change in marked-to-market value of April 2008 Debentures

 

150

 

 

 

150

 

Change in marked-to-market value of January 2008 warrants

 

 

 

(—

)

(—

)

Change in marked-to-market value of April 2008 warrants

 

 

 

(3

)

(3

)

Change in marked-to-market value of Other Notes Payable and Notes Payable to Related Parties warrants

 

 

 

(112

)

(112

)

Change in marked-to-market value of New Series A Preferred warrants

 

 

 

(2

)

(2

)

Change in marked-to-market value of litigation settlement warrants

 

 

 

1

 

1

 

Change in marked-to-market value of consulting agreement warrants

 

 

 

(299

)

(299

)

Reclassification to additional paid in capital upon restructuring of January and April Debentures

 

(2

)

(799

)

(801

)

 

 

 

 

 

 

 

 

Balance as of September 30, 2009

 

$

293

 

$

 

$

293

 

 

7. Notes Payable to Related Parties

 

The Company previously entered into a series of unsecured loan transactions with relatives of Daniel J.A. Kolke, its executive chairman, chief executive officer, acting chief financial officer, and chief technology officer.  On December 30, 2007, in connection with settlement of these loans, the Company entered into three unsecured promissory notes with an aggregate original principal amount of $816 thousand, each of which will become collateralized by certain presently unidentified assets of the Company if and when Daniel J.A. Kolke is no longer an employee of the Company nor a member of its board of directors.  Such security interest, if granted, would be subordinated to any and all bank debt or convertible corporate debt.  These three notes are outstanding and in default in an aggregate balance of $685 thousand as of September 30, 2009.  No demands for payment have been made as of the date of this report and the default has been waived through the nine months ended September 30, 2009.

 

During the quarter ended March 31, 2009, the Company issued an unsecured promissory note with one of its directors, in the principal amount of $100,000, with a maturity date of October 31, 2009, and an interest rate of ten percent per annum.  In connection with this promissory note, the Company also issued to that director warrants to purchase 133,333 shares of common stock of the Company with an exercise price of $0.75 per share and a term of three years.

 

8. Notes Payable

 

On March 19, 2009, the Company issued an unsecured note of $88 thousand for an accounts payable balance. The note bears interest of 11% and is due on April 1, 2010, with payment terms of $15 thousand on issuance of the note, and monthly payments of $6 thousand beginning May 1, 2009 with a final payment on March 20, 2010. Interest expense was $3 thousand for the nine months ended September 30, 2009.

 

9. Equity

 

Preferred Stock

 

During the nine months ended September 30, 2009, the Company sold 10,000 shares of its New Series A Preferred Stock at $0.75 per share, for an aggregate purchase price of $7.5 thousand, and warrants to purchase 10,000 shares of common stock of the Company, at an exercise price of $0.75 per share, and a three year term.

 

Common Stock

 

The Company has issued 24,826,360 shares of common stock from a total of 250,000,000 authorized shares with a par value of $0.01 per share.

 

On March 2, 2009, the Company entered into a consulting agreement with Salzwedel Financial Communications, Inc. to provide services to the Company for a period of one year.  Compensation payable under that agreement included 1,000,000 shares of the Company’s common stock and a warrant to purchase 2,000,000 shares of the Company’s common stock at a price of $0.01 per share, exercisable through March 14, 2014.

 

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In connection with the issuance of the 10% Senior Secured Debentures, the Company also issued 750,000 shares of common stock.  The Company determined the fair value of these shares of common stock on the date of issuance to be $191 thousand, and recorded a discount on the 10% Senior Secured Debentures that will be amortized as interest expense over the life of the debentures using the interest method.

 

10. Accounting for Share-Based Compensation

 

The following table summarizes stock option activity under the Company’s stock option plans (in thousands, except share and per share data):

 

Options

 

Shares

 

Weighted Average
Exercise Price Per
Share

 

Weighted Average
Remaining
Contractual Life

 

Aggregate
Intrinsic Value

 

Outstanding at December 31, 2008

 

4,086,497

 

$

0.24

 

8.6

 

$

3,971

 

Granted

 

750,000

 

$

0.10

 

 

 

 

 

Exercised

 

(48,736

)

$

0.05

 

 

 

 

 

Canceled

 

(241,179

)

$

0.67

 

 

 

 

 

Outstanding at September 30, 2009

 

4,546,582

 

$

0.22

 

8.07

 

$

3,101

 

Exercisable at September 30, 2009

 

1,121,189

 

$

0.31

 

7.84

 

$

738

 

Unvested at September 30, 2009

 

3,425,393

 

$

0.18

 

8.15

 

$

2,363

 

 

Aggregate intrinsic value was determined based upon the closing price of the Company’s common stock price on September 30, 2009, of $0.78 per share.

 

The amount of cash received as a result of options exercised during the nine months ended September 30, 2009, was $2 thousand. There were no equity instruments granted under share-based payment arrangements and therefore there was no cash used to settle any equity instrument. The Company does not plan to repurchase any shares during the upcoming annual period.

 

11. Restructuring

 

As part of its reduction of monthly cash operating expenses during the quarter ended September 30, 2008, and continuing during the year ended December 31, 2008, and the nine months ended September 30, 2009, the Company placed all remaining employees on partial deferrals of salary, ranging from 10% to 100% of base salary and accrued these deferrals.  At September 30, 2009, and as of the date of filing this report, this deferral amount remains unpaid, including amounts due to employees in the Company’s California office who were terminated during the period.

 

12. Commitments and Contingencies

 

In June 2008, Kaufman Bros. L.P. filed suit against the Company in the United States District Court for the Southern District of New York (Case No. 80 CV 5716) and sought a temporary restraining order and other extraordinary relief.  The complaint arises out of an advisory services agreement, pursuant to which Kaufman Bros. was to provide to the Company advisory services in connection with financings and strategic transactions. The Company notified Kaufman Bros. that it believed Kaufman Bros. had failed to provide the required services under the agreement, and that it were therefore entitled to terminate the agreement for cause. In the suit, Kaufman Bros. was seeking (i) monetary damages of $400,000 for anticipatory breach of the agreement; (ii) $73,800 in fees allegedly owed in connection with a previously closed financing transaction; (iii) and injunction prohibiting us from cancelling any shares issued to Kaufman Bros. as compensation, (iv) a declaration from the court that the Company are not entitled to a refund of any fees previously paid to Kaufman Bros., and (v) a declaration that the Company are obligated to pay Kaufman Bros. a commission on any financing or transaction that we enter into within 18 months following the termination of the agreement.  On July 15, 2008, Kaufman Bros. voluntarily filed a notice of dismissal without prejudice.  Settlement discussions were unsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantially the same claims in the Supreme Court of New York - County of New York (Index No. 08-602239). Effective on December 5, 2008, the Company entered into a settlement agreement with Kaufman Bros., pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) the Company issued to Kaufman Bros. warrants to purchase 500,000 shares of the Company’s common stock at an exercise price of $0.75 per share, which warrants have a term of five years; (iii) the Company and Kaufman Bros. agreed immediately to terminate all provisions, terms and conditions of the advisory services agreement and exchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss the pending lawsuit in the Supreme Court of New York, without prejudice. Subsequent to entering into the settlement agreement, the Company has not fully complied with its payment obligations under the settlement agreement but, through the date of filing of these financial statements, Kaufman Bros. has not exercised any of its remedies for default under the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo, California.  The landlord for these premises filed a complaint claiming damages of $659 thousand and other amounts against the Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”) in the Superior Court of San Mateo County, California (Case No. CIV 479535).  A default judgment was entered for the landlord but the default was set aside because the landlord failed to properly serve either the Company or Etelos-WA. The Company is continuing to defend its position.

 

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On September 18, 2008, the employment of Jeffrey L. Garon as president and chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garon resigned from the Board of Directors.  Mr. Garon and the Company entered into an Employment Agreement dated August 11, 2007, which provided certain benefits to Mr. Garon in the event of termination of his employment, and granted to the Company certain rights to repurchase shares issued on behalf of Mr. Garon pursuant to his employment agreement, in accordance with a Stock Purchase Agreement dated February 29,2008. On June 22, 2009, the Company filed a demand for Arbitration with the American Arbitration Association [Case No. 74 166 00535 09 LMT] seeking injunctive and other relief, including rescission of the Employment Agreement and the Stock Purchase Agreement that it entered into with Mr. Garon.  The demand includes assertions that Mr. Garon misrepresented his employment qualifications and, inter alia, seeks to recover from Mr. Garon 2,383,333 shares of the Company’s common stock that were issued in connection with his employment.  Mr. Garon has filed a counter-demand against the Company, certain employees of the Company, and members of its Board of Directors seeking declaratory relief, a preliminary injunction, and damages in an amount to be proved at the arbitration.  The Hearing in this matter is scheduled to begin on November 16, 2009.

 

As part of the reduction of monthly cash operating expenses beginning in the quarter ending September 30, 2008, and continuing after the end of the quarter, the Company placed all employees on partial deferrals of salary, ranging from 10% to 100% of base salary. As of September 30, 2009, and until the filing date of this report, a substantial part of this deferral amount remains unpaid, including amounts due to employees who subsequently were terminated. The $987 thousand of these unpaid salaries were accrued under accrued payroll and related expenses payable as of September 30, 2009. Two former employees have asserted claims with the California Labor Commission for payment of these unpaid amounts and the assertion of other such claims or demands by such employees, or by governmental authorities, is foreseeable.

 

On September 9, 2009, the Company entered into a Master Agreement with Renovatix Solutions, LLC to market private label marketplaces directly and through resellers.  As part of that Agreement, the Company agreed to issue up to 1 million shares of the Company’s common stock to Renovatix Solutions LLC as bonus compensation for achievement of mutually agreed sales goals, which have not yet been established.

 

13. Subsequent Events

 

Under the terms of the securities purchase agreement pursuant to which the 10% Senior Secured Debentures were issued, the parties were obligated to fund their purchases on the Closing Date.  However two purchasers failed to make such payments before September 30, 2009, in the aggregate amount of $500 thousand and that amount was recorded as an other current asset on the accompanying condensed balance sheet.  Subsequent to September 30, 2009, both purchasers have made their payments, in the amounts of $250 thousand each.

 

On September 4, 2009, the Board of Directors adopted the 2009 Equity Incentive Plan (the “Plan”) and reserved 6 million shares for issuance under the Plan.  On that date the Board also amended certain outstanding Stock Options to reduce the exercise price to the closing price of the Company’s shares on October 2, 2009, and authorized the issuance of 4.725 million options with an exercise price to be set at the closing price of the Company’s shares on October 2, 2009.  The closing price of the Company’s shares on October 2, 2009, was $0.51.  Since the exercise price of the Options was not known until after September 30, 2009, these Options were not repriced or granted until after the end of the quarter.

 

Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

The following discussion of our financial condition and results of operations should be read in conjunction with our condensed financial statements and the related notes and other financial information appearing elsewhere in this report. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation, the disclosures made under “Item 1A. Risk Factors” included in Part II of this report.

 

Business

 

We have a Web Application distribution platform delivering Web Applications for businesses.  We provide a Software-as-a-Service (SaaS) ecosystem for building, distributing, and using Web Applications, including a marketplace to deploy and support them.  Unlike other cloud computing and Platform-as-a-Service (PaaS) solutions, we enable software manufacturers to migrate existing applications or create new applications, then package, distribute, host, bill, market and support their SaaS enabled applications through multiple private label applications marketplaces.

 

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We have developed products for Web Applications, which include open standards-based tools for Web developers, businesses and individual users such as the Etelos Application ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programming languages and also support the English Application Scripting Engine (EASETM), a simple-to-use open standards-based scripting language developed by us.  In order to support broader adoption of our products, EASE and other components of the EDE are made available to developers at market appropriate pricing.  This is done to support the development of new Web Applications and the migration of existing Web Applications into the Etelos ecosystem where there are tools and other support mechanisms for the marketing, distribution, and support of these applications.

 

We generally receive a transaction fee or subscription fee for transactions that occur within the Etelos ecosystem either via the Etelos Marketplace™ pursuant to Storefront Operating Agreements, or in third-party branded Marketplaces operated by us pursuant to Marketplace Partner Agreements (sometimes referred to as “an Etelos Marketplace” or, collectively, as “Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay a subscription fee, which we share with Syndication Partners and Marketplace Partners; this revenue share is calculated as a percentage of gross revenues from the sale of subscriptions to Syndication Partner offerings in the Etelos Marketplaces.

 

Etelos Marketplaces support and encourage communities of developers, distributors, and consumers to expand their offerings, collaborate on new ideas and improvements, and provide scalable solutions using Web Applications available to others.

 

History

 

We were originally organized as Etelos, Incorporated, a Washington corporation on May 5, 1999. We have been engaged in the business of web application development and services since our inception.

 

On February 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issued an order confirming approval of the Plan of Reorganization, including the merger and the transfer of all of Tripath’s existing assets into a separate bankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplated the merger of Etelos, Incorporated with and into Tripath.

 

On April 22, 2008, we completed the merger with and into Tripath, changed the name of the surviving entity to Etelos, Inc. and changed its fiscal year end to December 31.

 

Recent Developments

 

On November 6, 2008, we announced changes to our business model to focus on the sales and operation of private label Web application marketplaces, including provision of the professional services required to develop, deploy and operate such marketplaces, and the launch of offerings of the Etelos Platform SuiteTM.  The Etelos Platform Suite focuses on enabling Independent Software Vendors (ISVs) to implement SaaS delivery of their existing applications, whether or not those applications are already Web Applications, and syndicating the offering of those applications through multiple private label marketplaces. In these difficult economic times, we believe that a variety of ISVs will have applications that they need to move to the Web for lower cost implementation, easier, simpler scalability, and broader distribution.  The Etelos Platform Suite also enables Marketplace Partners, including non-technology businesses, to have their own private label marketplaces and tools to offer SaaS Web Applications to better serve their customers in multiple distribution channels.

 

Although we have long enabled applications to be distributed via the Web, we believe this shift away from a core direct marketing focus of offering multiple products through a single portal in the Etelos Marketplace will have four major benefits for our business. First, this offering will expose the core platform to more ISVs for greater benefit to their end users and the creation of a larger pool of applications for syndication. Second, the development and operation of third party-branded marketplaces shifts the financial expense and operational burdens of sales and marketing to end users to Marketplace Partners that better know their customers and are better capitalized to support necessary sales and marketing activities.  Third, because this two-pronged go-to-market strategy is offered on a revenue-sharing basis, it fundamentally reduces barriers to acceptance by eliminating up front costs for Syndication Partners to offer their products through multiple Marketplace Partners, and by charging Marketplace Partners only for sales success.  Finally, this shift allows us to focus on our core competency in development and operation of online marketplaces, while better managing limited financial and other resources.

 

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During the period ended December 31, 2008, we began to implement this shift and, during the periods up to the date of this report, we have entered into new Syndication Partner agreements with ISVs to deliver SaaS-enabled versions of their products and to syndicate those apps for distribution through a number of third party-branded SaaS marketplaces.  In the interim periods, we have launched third party private labeled marketplaces and we have announced agreements to market and launch additional third party private label marketplaces, including to third parties not traditionally regarded as technology providers.  We expect to make further such announcements reflecting this shift during the coming months but we do not have an estimate or projection of how, or when, or if, the benefits, if any, of this shift will be reflected in our operating results.

 

On September 30, 2009, we issued convertible debentures (the “10% Senior Secured Debentures”) with a principal amount of $2.0 million, warrants to purchase 5,250,000 shares of our common stock, and 750,000 shares of common stock in exchange for $0.8 million in cash and the cancellation of $1.2 million in promissory notes and accrued interest.  Seventy-five percent of the 10% Senior Secured Debentures are held by Enable Capital Management LLC or its affiliates (“Enable Capital”).  Enable Capital beneficially owns more than 10% of the Company’s common stock. Under the terms of the securities purchase agreement pursuant to which the 10% Senior Secured Debentures were issued, subject to the satisfaction of certain covenants and conditions, we have has the right, at any time after December 15, 2009 and before January 15, 2010, to require the purchasers of the 10% Senior Secured Debentures to purchase an aggregate of $1.0 million in additional principal amount of 10% Senior Secured Debentures.  At September 30, 2009, the purchasers of the 10% Senior Secured Debentures executed and delivered all documents in the transaction except for funding of $500,000 which was received subsequent to the period end.

 

Critical Accounting Policies Involving Management Estimates and Assumptions

 

Our discussion and analysis of our financial condition and results of operations is based on our financial statements.  In preparing our financial statements in conformity with accounting principles generally accepted in the United States, we must make a variety of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of revenues and expenses.  We have identified the following accounting policies that we believe require application of management’s most subjective judgments, often requiring the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.

 

Allowance for Doubtful Accounts

 

We provide, when appropriate, an allowance for doubtful accounts to ensure that our trade receivables are not overstated due to un-collectability. The collectability of our accounts receivables is evaluated based on a variety of factors, including the length of time receivables are past due, indication of the customer’s willingness to pay, significant one-time events and historical experience.  We have not recorded an allowance for doubtful accounts at this time as we believe all our accounts receivable will be collected.

 

Revenue Recognition

 

We provide Web Applications as a subscription service using the Software-as-a-Service (SaaS) or software-on-demand business model and allow third parties to offer their products and service through Storefronts in an Etelos Marketplace, and to advertise on our web site or in our annual magazine for a fee.  We also license our software under perpetual and term licenses.  Revenues are recognized on these service and licensing transactions using the criteria in ASC 605-10, “Revenue Recognition” (ASC 605-10) and ASC 985-605, “Software Revenue Recognition”, (ASC 985-605) respectively, which both provide that revenue may be recognized when all of the following criteria are met:

 

·      Persuasive evidence of an arrangement exists,

·      The product or service has been delivered,

·      The fee is fixed or determinable, and

·      Collection of the resulting receivable is reasonably assured or probable.

 

We must first determine whether ASC 605-10 or ASC 985-605 applies to our revenue transactions.  We than determine if the criteria above have been met by assessing the ASC 605-10 and ASC 985-605 and their various interpretations in view of the agreements and other documentation related to the revenue transactions.  The interpretation of the agreements often requires considerable judgment as well as determining what accounting literature is appropriate and how that literature should be applied.  If our standard agreements are used to establish evidence of the arrangement, then our revenue is generally recognized as follows:

 

For SaaS revenue transactions, persuasive evidence of an arrangement exists upon acceptance by the customer of a binding agreement and authorization by the customer to charge a credit card; delivery generally occurs over the term of the subscription agreement related to the SaaS; and the fee is fixed and collection reasonably assured when the customer’s credit card is charged.  Accordingly, revenue is recognized over the period the SaaS is provided.

 

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For software licensed under term or perpetual agreements, persuasive evidence of the arrangement is evidenced by a binding agreement signed by the customer and delivery generally occurs upon delivery of the software to a common carrier. If a significant portion of a fee is due after our normal payment terms of typically 30 days, we recognize revenue as the fees become due. If we determine that collection of a fee is not reasonably assured, we defer the fees and recognize revenue upon cash receipt, provided that all other revenue recognition criteria are met.

 

However, if the terms and conditions of an agreement are nonstandard, then significant contract interpretation is sometimes required to determine the appropriate accounting for these transactions including: (1) whether an arrangement exists; (2) how the arrangement consideration should be allocated among potential multiple elements; (3) when to recognize revenue on the deliverables; (4) whether all elements of the arrangement have been delivered; (5) whether the arrangement should be reported gross as a principal versus net as an agent; (6) whether we receive a separately identifiable benefit from the purchase arrangements with our customer for which we can reasonably estimate fair value; and (7) whether the arrangement should be characterized as revenue or a reimbursement of costs incurred. In addition, our revenue recognition policy requires an assessment as to whether collection is reasonably assured, which inherently requires us to evaluate the creditworthiness of our customers. Changes in judgments on these assumptions and estimates could materially impact the timing or amount of revenue recognition.

 

Internal Use Software

 

Under ASC 985-20 “Costs of Software to be Sold, Leased, or Marketed” (ASC 985-20), costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established.  Alternatively, ASC 350-40 “Internal Use Software” (ASC 350-40), applies to software development costs that are not related to software to be sold, licensed, leased or otherwise marketed as a separate product or as part of a product or process and are within the scope of ASC 985-20.  Under ASC 350-40, software development costs incurred for software that is only used internally, including costs incurred to purchase third party software, are capitalized beginning when the Company has determined certain factors are present, including among others, that technology exists to achieve the performance requirements, buy versus internal development decisions have been made, and the Company’s management has authorized the funding for the project.  We must determine whether ASC 985-20 or ASC 350-40 is applicable to our software development costs.  We then must determine when software capitalization should begin and cease and what costs under the applicable standard can be capitalized.  Both of these tasks involves considerable judgment and can result in material different amounts of software being capitalized and have a significant impact on our reported results of operations.  To date, because we plan to license all our software products, we have determined that the provisions of ASC 985-20 should be applied to the cost of our product development.  As products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time, all research and development costs have been expensed.

 

Stock-Based Compensation Expense

 

We have adopted ASC 718-10 using the modified prospective method and therefore have not restated prior periods’ results. Under the fair value recognition provisions of ASC 718-10, we recognize stock-based compensation expense net of an estimated forfeiture rate and therefore only recognize compensation cost for those shares expected to vest over the service period of the award.  Calculating stock-based compensation expense requires the input of highly subjective assumptions, including the expected term of the stock-based awards, stock price volatility, and the pre-vesting option forfeiture rate. We estimate the expected life of options granted based on historical exercise patterns, which we believe are representative of future behavior. We estimate the volatility of our common stock on the date of grant based on the historical volatility of other publicly traded companies in our industry. The assumptions used in calculating the fair value of stock-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate, as well as the probability that performance conditions that affect the vesting of certain awards will be achieved, and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience of our stock-based awards that are granted, exercised, and cancelled. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. Beginning in the quarter ended December 31, 2008, and continuing in the quarter ended September 30, 2009, the global economy has been highly volatile and, during this period, the Company found it necessary to take drastic measures to reduce operating expenses, but the likelihood of success of these efforts cannot be predicted.  Therefore the forfeiture rate in the quarter ended December 31, 2008, was very high.  The forfeiture rate declined substantially during the nine months ended September 30, 2009, but it is not known whether this forfeiture rate will be maintained in the future; management will continue to monitor its estimates.

 

Accounting for Convertible Notes and Debentures, Embedded Derivatives and Warrants

 

We evaluate the embedded derivatives included in the debt instruments we issue under the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on the issuance date of the debt and on each subsequent reporting date to determine whether such embedded derivatives are clearly and closely related to the debt host.  The purpose of the evaluation is to determine whether the

 

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embedded derivatives, which are not clearly and closely related to the debt host, need to be bifurcated from the debt host and accounted for as a derivative at their estimated fair value as a liability or asset at the date of issuance and thereafter, adjusted to estimated fair value with a charge or credit to our statement of operations. ASC 815-10 generally indicates that if the conversion features are (i) indexed to the Company’s capital stock under the guidance in ASC 815-40-15 “Derivatives and Hedging — Contracts in Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15) and (ii) would be classified as equity if a freestanding derivative under the guidance in ASC 815-40-25 “Derivatives and Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25), then the embedded derivatives need not be bifurcated from the debt host.  We also evaluate the warrants issued with the debt under ASC 815-40-25 to determine whether the proceeds allocated to the warrants or the fair value of the warrants should be recorded as equity or a liability, respectively, and if a liability adjusted to fair value with a charge or credit to our statement of operations. ASC 815-40-25 generally requires, among other factors, that (i) the Company can settle the derivative in cash or its own stock, at its option, (ii) settlement can be made in unregistered shares, and (iii) the Company has sufficient authorized shares to issue shares of its common stock for all equity instruments convertible to or which can be exercised for its capital stock. ASC 815-10 also provides guidance on when put and call features included in a debt host agreement are not clearly and closely related to the debt host and must be bifurcated and recorded as liability.  The guidance in ASC 815-10 is complex and it has many interpretations.  Accordingly, we must use judgment to apply and interpret this guidance as well as ensure we have applied the correct guidance.

 

If the embedded derivatives or warrants must be recorded as a liability, then we must make certain assumptions to value the embedded derivative.  This includes computing the discounted net present value of the debt and making assumptions about interest rates, probabilities of outcomes, volatility, fair value of the Company’s stock prior to its merger with Tripath, and discount rates.  The discount factor is the Company’s estimate of the appropriate rate of return that an investor would expect from a similar debenture not taking into consideration the conversion feature or warrants.  All of these assumptions have a material impact on the value attributed to the derivative or warrant.

 

Our analysis and judgment may vary from quarter to quarter and changes in estimates may result in significant increases or decreases in expenses.  Moreover, because of the relative size of our operations and the number of stock options and derivative instruments we have issued, income and expenses associated with changes in the value of outstanding derivative securities historically have had an overshadowing impact on our financial results.  Consequently, our net income or loss for any particular period may not be indicative of the Company’s performance for that period as a result of the application of such accounting rules, and therefore should not be relied upon by any person as an accurate depiction of the true financial condition of the Company.

 

Results of Operations

 

Three Months Ended September 30, 2009, Compared with Three Months Ended September 30, 2008

 

Revenues

 

Revenues were $5 thousand and $10 thousand for the quarters ended September 30, 2009 and 2008, respectively. Revenues decreased by $5 thousand, or 50 percent, in the three months ended September 30, 2009, compared to the same period in 2008.  This decrease was due to our focus on the implementation of longer-term projects without immediate cash flow.  In the year ended December 31, 2008, and to the date of this report, we also experienced a significant decline in sales of our customer resource management product, which had been introduced in mid-2007.

 

Cost of Revenue

 

Cost of revenue includes our costs of hardware, software and other resources used in delivery of our products and services. Cost of revenue was $74 thousand and $211 thousand for the quarters ended September 30, 2009 and 2008, respectively. Cost of revenue for the three months ended September 30, 2009, decreased by $137 thousand, or by 65 percent.  The decrease in cost of revenue from 2008 to 2009 was primarily attributable to the decreased costs of hosting and Internet bandwidth associated with the deployment of our products and services. Stated as a percentage of revenues, cost of revenue for the three months ended September 30, 2009, was 1480 percent and for the corresponding period of 2008 was 2110 percent.

 

Operating Expenses

 

Research and Development.  Research and development expenses include primarily employee and employee related expenses. Research and development expenses were $209 thousand and $844 thousand for the quarters ended September 30, 2009 and 2008, respectively. Stated as a percentage of revenues, research and development expenses for the corresponding periods were 4,180 percent and 8,440 percent, respectively. Research and development expenses decreased by $635 thousand or by 75 percent, in the three months ended September 30, 2009, compared to the same period in 2008.  This decrease was primarily due to decreased salary and benefits expenses for fewer engineers engaged in research and development.

 

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Sales and Marketing Expenses.  Sales and marketing expenses include payroll, employee benefits, and other headcount-related costs associated with sales and marketing personnel and travel, advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses were $132 thousand and $514 thousand for the quarters ended September 30, 2009 and 2008, respectively. The $382 thousand, or 74 percent decrease in sales and marketing expenses was due to reduced headcount and decreased activities of sales and marketing following the restructuring begun in the quarter ended December 31, 2008.  Stated as a percentage of revenues, sales and marketing expenses for the corresponding periods was 2,640 percent and 5,140 percent, respectively.

 

General and Administrative.  General and administrative expenses include payroll and related employee benefits, and other headcount-related costs associated with finance, facilities, legal and other administrative expenses. General and administrative expenses were $312 thousand and $529 thousand for the quarters ended September 30, 2009 and 2008, respectively. The $217 thousand, or 41 percent, decrease in general and administrative expense was primarily attributable to decreased hiring of accounting, administrative, legal, and compliance personnel and much less use of consultants and temporary personnel.  Stated as a percentage of revenues, general and administrative expense for the corresponding periods was 6,240 percent and 5,290 percent, respectively.

 

Interest Income (Expense)

 

Interest expense was $(205) thousand for the three months ended September 30, 2009, compared to income of $3,739 thousand for the comparable period of 2008, and consists primarily of interest expense on convertible notes and debentures, amortization of discounts on convertible notes and debentures, and the change in mark to market valuation of derivative and warrant liabilities. The decrease of $3.9 million in interest expense from 2008 to 2009 related to the $4.2 million change in the mark to market valuation of derivative and warrant liabilities primarily due to the decrease in the Company’s stock price at September 30, 2008 from June 30, 2008, while there was no comparable significant movement in the Company’s stock price at September 30, 2009 from June 30, 2009.

 

Net Income (Loss)

 

Our net loss was $(1.2) million for the quarter ending September 30, 2009, compared to net income of $1.7 million for the quarter ending September 30, 2008, a decrease in net income of $2.9 million.  The decrease in net income from 2008 to 2009 was primarily due to the $4.2 million change in the mark to market valuation of derivative and warrant liabilities primarily due to the decrease in the Company’s stock price at September 30, 2008 from June 30, 2008, offset by a loss on the cancellation of promissory notes in exchange for 10% Senior Secured Debentures on September 30, 2009 of $0.3 million, and a decrease in operating expenses of $1.2 million as noted above.

 

Nine Months Ended September 30, 2009, Compared with Nine Months Ended September 30, 2008

 

Revenues

 

Revenues were $131 thousand and $55 thousand for the periods ended September 30, 2009 and 2008, respectively. Revenues increased by $76 thousand, or 138 percent, in the nine months ended September 30, 2009, compared to the same period in 2008. This increase was due to our temporary focus on short term consulting projects with immediate cash flow.  In the year ended December 31, 2008, and to the date of this report, we also experienced a significant decline in sales of our customer resource management product, which had been introduced in mid-2007.

 

Cost of Revenue

 

Cost of revenue includes our costs of hardware, software and other resources used in delivery of our products and services. Cost of revenue was $246 thousand and $459 thousand for the periods ended September 30, 2009 and 2008, respectively. Cost of revenue for the nine months ended September 30, 2009, decreased by $213 thousand, or by 46 percent.  The decrease in cost of revenue from 2008 to 2009 was primarily attributable to the decreased costs of hosting and Internet bandwidth associated with the deployment of our products and services. Stated as a percentage of revenues, cost of revenue for the nine months ended September 30, 2009, was 188 percent and for the corresponding period of 2008 was 835 percent.

 

Operating Expenses

 

Research and Development.  Research and development expenses include primarily employee and employee related expenses. Research and development expenses were $1.4 million and $3.3 million for the nine months periods ended September 30, 2009 and 2008, respectively. Stated as a percentage of revenues, research and development expenses for the corresponding periods were 1,066 percent and 6,036 percent, respectively. Research and development expenses decreased by $1.9 million or 58 percent, in the nine months ended September 30, 2009, compared to the same period in 2008.  This decrease was primarily due to decreased salary and benefits expenses for fewer engineers engaged in research and development.

 

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Sales and Marketing Expenses.  Sales and marketing expenses include payroll, employee benefits, and other headcount-related costs associated with sales and marketing personnel and travel, advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses were $877 thousand and $1,315 thousand for the nine months periods ended September 30, 2009 and 2008, respectively. The $438 thousand, or 33 percent, decrease in sales and marketing expenses was due to reduced headcount and decreased sales and marketing activities following the restructuring begun in the quarter ended December 31, 2008. Stated as a percentage of revenues, sales and marketing expenses for the corresponding periods are 669 percent and 2,391 percent, respectively.

 

General and Administrative.  General and administrative expenses include payroll and related employee benefits, and other headcount-related costs associated with finance, facilities, legal and other administrative expenses. General and administrative expenses were $1377 thousand and $1629 thousand for the periods ended September 30, 2009 and 2008, respectively. The $252 thousand, or 15 percent, decrease in general and administrative expense was primarily attributable to decreased hiring of accounting, administrative, legal, and compliance personnel and less use of consultants and temporary personnel.  Stated as a percentage of revenues, general and administrative expenses for the corresponding periods were 1,051 percent and 2,962 percent, respectively.

 

Interest Expense

 

Interest expense was $686 thousand for the nine months ended September 30, 2009, compared to $2,026 thousand for the comparable period of 2008, and consists primarily of interest expense on convertible notes and debentures, amortization of discounts on convertible notes and debentures, and changes in the mark to market valuation of derivative and warrant liabilities. The decrease of $1.3 million in interest expense from 2008 to 2009 related primarily to a non recurring expense in April 2008 of $1.0 million related to the beneficial conversion of interest conversion.

 

Net Loss

 

Our net loss was $4.7 million and $22.2 million for the nine months periods ended September 30, 2009 and 2008, respectively, a decrease of $17.5 million, or 79 percent.  The decrease in net loss from 2008 to 2009 was primarily due to non recurring merger related costs of $13.4 million that occurred in the quarter ended June 30, 2008, to the decrease in operating expenses of $2.9 million as noted above, and to a non recurring expense in 2008 of $1.0 million related to the beneficial conversion of interest conversion.

 

Liquidity and Capital Resources

 

On September 30, 2009, we had $287 thousand in cash and cash equivalents, net accounts receivable of $4 thousand, and prepaid expenses and other current assets and other receivables of $509 thousand.  Our working capital deficit at September 30, 2009, was $4.8 million, compared to a deficit of $10.3 million at December 31, 2008. The decrease in working capital deficit was due to the reclassification of the January 2008 and April 2008 Debentures from short term to long term debt due to the restructuring of the debentures on June 30, 2009, and further discussed in “Note 6 Convertible Notes and Debentures and Embedded Derivative and Warrant Liability” in our financial statements included in this report.

 

Net cash used by operating activities during the nine months ended September 30, 2009, was $1,258 thousand, compared to $6.4 million during the nine months ended September 30, 2008. The primary use of cash from operating activities during the nine months ended September 30, 2009, was related to payment of expenses relating to accounting and compliance.

 

Investing activities did not provide any cash during the nine months ended September 30, 2009.  At that date we did not have any significant commitments for capital expenditures.

 

Net cash provided by financing activities during the nine months ended September 30, 2009, was $1,538 thousand, primarily from the issuance of various promissory notes and the 10% Senior Secured Debentures. See “ — Recent Developments” above.

 

At September 30, 2009, we had an other receivable of $500 thousand related to the sale of our 10% Senior Secured Debentures, which was collected subsequent to the end of the quarter.  We also have a right to require purchasers of our 10% Senior Secured Debentures to purchase up to $1 million of additional debentures, subject to certain conditions.

 

We need immediate and substantial cash to continue our operations. Management has projected that the combination of cash on hand and proceeds from our other receivable of $500 thousand and further investment of $1 million will be sufficient to allow us to continue our operations only through June 2010. If cash reserves are not sufficient to sustain operations, then we plan to raise additional capital by selling shares of our capital stock or other securities.  However, there are no commitments or arrangements for future financings in place at this time and we can give no assurance that such capital will be available on favorable terms, or at all.  We may need additional financing thereafter until we can achieve profitability. We are considering alternatives to address our cash flow situation that include: (1) raising capital through additional sale of our common stock and/or debentures and (2) reducing cash operating expenses to levels that are in line with current revenues.  If we cannot obtain additional financing, then we may be forced to curtail our operations, cease voluntarily filing reports with the SEC, or possibly be forced to evaluate a sale or liquidation of our assets or consider other strategic alternatives such as bankruptcy.  Even if we are successful in raising additional funds, there is no assurance regarding the terms of any additional investment and any such investment or other strategic alternative would likely substantially dilute or eliminate the interests of our stockholders.

 

September 2007 Notes

 

Our September 2007 notes were issued as part of a private placement that was completed during August and September 2007.  In that private placement we issued a total of approximately $3.3 million of 6% convertible notes at an original issue discount of 10% with

 

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warrants to purchase 1,080,000 shares of common stock with an exercise price of $1.20 per share. In connection with the merger that closed on April 22, 2008, $1.5 million of these notes were converted at $0.75 per share. At the time of the merger, all of the warrants had been exercised or expired by their terms upon closing the Merger.

 

Under the terms of the remaining $1.8 million of the notes that were not converted, periodic principal payments were payable beginning on September 1, 2008.  On June 15, 2008, the holders of these notes agreed to either convert the then-accrued interest to shares of common stock at a rate of one share for each $1.35 of interest owed or to add the then-accrued interest to the principal, and to waive any default arising out of our failure to pay the accrued and unpaid interest through June 15, 2008.

 

As of the filing date of this report, none of the required principal payments have not been made and the Company does not have, or expect to have, cash on hand to make the payments in the near future; no interest payments have been made for interest accrued since June 15, 2008.  We are in regular communication with the holders of the September 2007 notes and none of the holders have demanded payment or exercised other remedies due to our non-payments, but no assurances can be given that the holders will not exercise their remedies in the future.

 

January 2008 Debentures

 

In January 2008, we issued our January 2008 Debentures with an aggregate principal amount of $2.0 million. Under the terms of these debentures, we were to begin making monthly redemption payments on September 1, 2008, through the maturity date of January 31, 2010.

 

On March 2, 2009, Enable Growth Partners LP, the holder — with its affiliates - of the substantial majority of the January 2008 and April 2008 Debentures, purchased the remainder of the January 2008 Debentures from Hudson Bay Fund LTD and its affiliate; price terms were not disclosed.  As a result of this transaction, Enable Growth Partners LP and its affiliates own 100% of the January 2008 Debentures.

 

On June 30, 2009, we executed an agreement to restructure our January 2008 and April 2008 Convertible 6% Secured Debentures with a principal amount of $5.5 Million.  Under the terms of the agreement, the term of the debentures is extended to December 31, 2012, interest accrual will be at 0% from the date of the agreement until October 1, 2010, and all accrued interest as of October 1, 2010, has been added to principal to be paid at maturity. Our obligation to make monthly amortizing redemption payments has been terminated; we are required to make semi-annual interest payments only, beginning January 1, 2011. The registration rights agreement entered into in conjunction with the debentures has been terminated and the warrants issued in conjunction with the debentures will be exchanged for Etelos common stock on 1:1 basis.

 

April 2008 Debentures

 

In April 2008, we issued our April 2008 Debentures with an aggregate principal amount of $3.5 million. Under the terms of these debentures, we are to begin making monthly redemption payments on November 1, 2008, through the maturity date of April 30, 2010.

 

On March 2, 2009, Enable Growth Partners LP, the holder — with its affiliates - of the substantial majority of the April 2008 Debentures, purchased the remainder of the April 2008 Debentures from Hudson Bay Overseas Fund LTD; price terms were not disclosed.  As a result of this transaction, Enable Growth Partners LP owns 100% of the April 2008 Debentures.

 

On June 30, 2009, we executed an agreement to restructure our January 2008 and April 2008 Convertible 6% Secured Debentures with a principal amount of $5.5 Million.  Under the terms of the agreement, the terms of the debentures are extended to December 31, 2012, interest accrual will be at 0% from the date of the agreement until October 1, 2010, and all accrued interest as of October 1, 2010, has been added to principal to be paid at maturity. Our obligations to make monthly amortizing redemption payments has been terminated; we are required to make semi-annual interest payments only, beginning January 1, 2011. The registration rights agreement entered into in conjunction with the debentures has been terminated and the warrants issued in conjunction with the debentures will be exchanged for Etelos common stock on 1:1 basis.

 

10% Senior Secured Debentures

 

See “ — Recent Developments” above.

 

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Operating and Capital Leases

 

We have non-cancelable leases for corporate facilities and equipment.  Rent expense under the leases totaled $10 thousand and $126 thousand for the nine months ended September 30, 2009 and 2008, respectively.  Future minimum rental payments required under non-cancelable leases are as follows for the twelve months ended December 31:

 

 

 

Operating
Leases

 

Capital
Leases

 

 

 

 

 

 

 

2010

 

 

13

 

2011

 

 

13

 

2012

 

 

2

 

Total minimum lease payments

 

$

 

$

28

 

Less: amount representing interest

 

 

 

(6

)

Present value of minimum lease payments

 

 

 

22

 

Less: current portion of capital lease obligations

 

 

 

(9

)

Long-term capital lease obligations

 

 

 

$

13

 

 

On October 31, 2008, the Company closed its offices in San Mateo, California.  The landlord for these premises filed a complaint claiming damages of $659 thousand and other amounts against the Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”) in the Superior Court of San Mateo County, California (Case No. CIV 479535).  A default judgment was entered for the landlord but the default was set aside because the landlord failed to properly serve either the Company or Etelos-WA. The Company is continuing to defend its position.

 

The landlord for the Renton, Washington location has notified us that we are in default of the sublease but has not yet filed any claim against us, but the assertion of such a claim, and the need for us to defend such a claim, is foreseeable.

 

Off Balance Sheet Arrangements

 

We did not have any off-balance sheet arrangements as of the period ended September 30, 2009.

 

Going Concern Issue

 

We remain dependent on outside sources of funding until our results of operations provide positive cash flows.  Our independent auditors issued a going concern explanatory paragraph in their report dated April 24, 2009. With our current level of funding, substantial doubt exists about our ability to continue as a going concern.

 

During the quarter ended September 30, 2009, we have been unable to generate cash flows sufficient to support our operations and have been dependent on debt raised from qualified investors.

 

These factors raise substantial doubt about our ability to continue as a going concern.  The financial statements contained herein do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should we be unable to continue in existence.  Our ability to continue as a going concern is dependent upon our ability to generate sufficient cash flows to meet our obligations on a timely basis, to obtain additional financing as may be required, and ultimately to attain profitable operations.  However, there is no assurance that profitable operations or sufficient cash flows will occur in the future.

 

We have supported current operations by raising additional operating cash through bridge loans and the private sale of our convertible debentures and preferred stock.  This has provided us with the cash inflows to continue our business plan, but has not resulted in significant improvement in our financial position. We are considering alternatives to address our cash flow situation that include raising capital through additional sale of our common stock and/or debentures.

 

This could result in substantial dilution of existing stockholders. There can be no assurance that our current financial position can be improved, that we can raise additional working capital, or that we can achieve positive cash flows from operations. Our long-term viability as a going concern is dependent upon our ability to (i) locate sources of debt or equity funding to meet current commitments and near-term future requirements and (ii) achieve profitability and ultimately generate sufficient cash flow from operations to sustain our continuing operations.

 

Recent Accounting Pronouncements

 

During the third quarter of 2009, the Company adopted the new Accounting Standards Codification (“ASC”) as issued by FASB.  The ASC has become the authoritative source of US GAAP recognized by FASB to be applied by non-governmental entities.  The ASC is not intended to amend or change US GAAP.  The adoption of the ASC did not have a material impact on the Company’s financial statements.

 

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In October 2009, the FASB issued new accounting guidance related to the revenue recognition of multiple element arrangements. The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective for the Company during the first quarter of fiscal 2011. Early adoption is allowed. The Company is currently evaluating the impact of this accounting guidance on its financial statements.

 

Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Intentionally omitted pursuant to Item 305(e) of Regulation S-K.

 

Item 4.    CONTROLS AND PROCEDURES

 

Disclosure controls and procedures are controls and other procedures that are designed to ensure that the information required to be disclosed by a company in the reports that it files or submits under the Securities and Exchange Act of 1934, or the “Exchange Act,” is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that a company files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive officer and principal accounting officer, as appropriate to allow timely decisions regarding required disclosure.

 

We carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2009, the end of the period covered by this report. Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of September 30, 2009, because of certain material weaknesses in our internal control over financial reporting.

 

Because of these weaknesses, we cannot provide reasonable assurances that all information required to be disclosed in our reports filed with the SEC will be accumulated and communicated to our management to allow for timely decisions regarding required disclosure.  Please see the internal control over financial reporting discussion in our Form 10-K that we filed with the SEC on April 29, 2009 for more information regarding the weaknesses in our internal control over financial reporting.

 

Furthermore, due to the resignation of our vice president and chief financial officer, and the lack of a replacement at this time, we are unable to assure that we have adequate and appropriate controls in place, or that the controls that we do have in place are being managed appropriately.  We will attempt to engage additional appropriate professionals to evaluate and manage our controls as soon as financial resources permit, but there is no assurance when, or if, that will be possible in the foreseeable future.

 

Changes In Internal Controls Over Financial Reporting.

 

No changes were made in our internal control over financial reporting or disclosure controls or both, (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during our last fiscal quarter that has materially affected, or is likely to materially affect, our internal control over financial reporting.

 

Limitations On Disclosure Controls And Procedures.

 

Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. The design of any system of controls is based in part upon a cost-benefit analysis and certain assumptions about the likelihood of future events and any design may not succeed in achieving its stated goals under all potential future conditions. While our management does not believe that our controls will prevent all errors or all instances of fraud, our disclosure controls and procedures are designed to provide a reasonable assurance of achieving their objectives.

 

PART IIOTHER INFORMATION

 

Item 1.    LEGAL PROCEEDINGS.

 

From time to time, we become subject to various legal proceedings and claims, both asserted and unasserted, that arise in the ordinary course of business. Litigation in general, and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings are difficult to predict. An unfavorable resolution of one or more of these

 

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lawsuits would materially adversely affect our business, results of operations, or financial condition. We accrue legal costs when incurred.  The need to defend any such claims could require payments of legal fees and our limited financial resources could severely impact our ability to defend any such claims.

 

In June 2008, Kaufman Bros. L.P. filed suit against us in the United States District Court for the Southern District of New York (Case No. 80 CV 5716) and sought a temporary restraining order and other extraordinary relief.  The complaint arises out of an advisory services agreement, pursuant to which Kaufman Bros. was to provide us with advisory services in connection with financings and strategic transactions. We notified Kaufman Bros. that we believed it had failed to provide the required services under the agreement, and that we were therefore entitled to terminate the agreement for cause. In the suit, Kaufman Bros. was seeking (i) monetary damages of $400,000 for anticipatory breach of the agreement; (ii) $73,800 in fees allegedly owed in connection with a previously closed financing transaction; (iii) and injunction prohibiting us from cancelling any shares issued to Kaufman Bros. as compensation, (iv) a declaration from the court that we are not entitled to a refund of any fees previously paid to Kaufman Bros., and (v) a declaration that we are obligated to pay Kaufman Bros. a commission on any financing or transaction that we enter into within 18 months following the termination of the agreement.  On July 15, 2008, Kaufman Bros. voluntarily filed a notice of dismissal without prejudice.  Settlement discussions were unsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantially the same claims in the Supreme Court of New York - County of New York (Index No. 08-602239). Effective on December 5, 2008, the Company entered into a settlement agreement with Kaufman Bros., pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) the Company issued to Kaufman Bros. warrants to purchase 500,000 shares of the Company’s common stock at an exercise price of $0.75 per share, which warrants have a term of five years; (iii) the Company and Kaufman Bros. agreed immediately to terminate all provisions, terms and conditions of the advisory services agreement and exchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss the pending lawsuit in the Supreme Court of New York, without prejudice. Subsequent to entering into the settlement agreement, we have not fully complied with our payment obligations under the settlement agreement but, through the date of filing of this report, Kaufman Bros. has not exercised any of its remedies for default under the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo, California.  The landlord for these premises filed a complaint claiming damages of $659 thousand and other amounts against the Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”) in the Superior Court of San Mateo County, California (Case No. CIV 479535).  A default judgment was entered for the landlord but the default was set aside because the landlord failed to properly serve either the Company or Etelos-WA. The Company is continuing to defend its position.

 

On September 18, 2008, the employment of Jeffrey L. Garon as president and chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garon resigned from the Board of Directors.  Mr. Garon and the Company entered into an Employment Agreement dated August 11, 2007, which provided certain benefits to Mr. Garon in the event of termination of his employment, and granted to the Company certain rights to repurchase shares issued on behalf of Mr. Garon pursuant to his employment agreement, in accordance with a Stock Purchase Agreement dated February 29,2008. On June 22, 2009, the Company filed a demand for Arbitration with the American Arbitration Association [Case No. 74 166 00535 09 LMT] seeking injunctive and other relief, including rescission of the Employment Agreement and the Stock Purchase Agreement that it entered into with Mr. Garon.  The demand includes assertions that Mr. Garon misrepresented his employment qualifications and, inter alia, seeks to recover from Mr. Garon 2,383,333 shares of the Company’s common stock that were issued in connection with his employment.  Mr. Garon has filed a counter-demand against the Company, certain employees of the Company, and members of its Board of Directors seeking declaratory relief, a preliminary injunction, and damages in an amount to be proved at the arbitration.  The Hearing in this matter commenced on November 16, 2009.

 

As part of our reduction of monthly cash operating expenses during the quarter ending September 30, 2008, and continuing after the end of the quarter, we placed all employees on partial deferrals of salary, ranging from 10% to 100% of base salary.  At the end of the quarter, until the date of this filing, a substantial part of this deferral amount remains unpaid, including amounts due to employees who subsequently were terminated; the amount of accrued payroll and related expenses payable is $987 thousand, as of the nine months ended September 30, 2009.  Two former employees have asserted claims with the California Labor Commission for payment of these unpaid amounts and the assertion of other such claims or demands by such employees, or by governmental authorities, is foreseeable.

 

In connection with our reverse merger, multiple financings, and protection of our intellectual property, we have incurred substantial accounts payable to law firms that remain unpaid and overdue.  We have been in communication with these vendors and expect to enter into negotiated payment plans with these vendors, and others, but there is no assurance that we will be successful in these negotiations, or that we will be able to make payments under such plans if and when negotiated.  Therefore the assertion of claims by these vendors for these amounts due and owing could become the subject of claims in litigation.

 

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Item 1A.   RISK FACTORS.

 

Investment in our common stock involves a high degree of risk. You should carefully consider the risks described below together with all of the other information included in this report before making an investment decision. If any of the following risks actually occur, our business, financial condition or results of operations could suffer. In that case, the market price of our common stock could decline, and you may lose all or part of your investment.

 

Our current cash will fund our business as currently planned only through June 2010. We need additional funding or we will be forced to curtail or cease operations.

 

We need immediate and substantial cash to continue our operations. We currently have no funding commitments, beyond the additional $1 million that we have the right to call in the period from December 15, 2009 through January 15, 2010, under the terms of the securities purchase agreement pursuant to which the 10% Senior Secured Debentures were issued.  Based upon the $500 thousand subsequently received in the period after the nine months ended September 30, 2009, and the $1 million commitment, Management has projected that cash on hand will be sufficient to allow us to continue our operations only through June 2010.  Since August 2008, all remaining employees have been on deferred salary, ranging from 10% to 100% of base salary; although some payments have been made to these employees from time to time during this period, these employees are owed $987 thousand in accrued salary and related expenses as of the nine months ended September 30, 2009, and there is no assurance that any of these employees will be able to continue to work for us on this arrangement.  We also need to negotiate payment plans for certain trade payables and there is a risk that trade creditors will not accept deferred payment and exercise other remedies to collect balances due and owing. We therefore will need additional funding, either through equity or debt financings, or we will be forced to curtail or cease operations or consider other strategic alternatives such as bankruptcy.

 

If our business model is not successful, or if we are unable to generate sufficient revenue to offset our start-up expenditures, then we may not become profitable and you may lose your entire investment in our company.

 

We incurred a net loss of $4.7 million for the nine months ended September 30, 2009, and $22.2 million for the nine months ended September 30, 2008, and have an accumulated deficit of $34.5 million at September 30, 2009.  We cannot assure you that our future planned operations will be implemented successfully or that we will ever have profits.  Furthermore, we are experiencing the initial costs and uncertainties of a young operating company, including start-up expenditures, unforeseen costs and difficulties, complications, and delays, all of which must be resolved and/or paid without the benefit of a predictable revenue stream.  We cannot be sure that we will be successful in meeting these challenges and addressing these risks and uncertainties.  If we are unable to do so, then we may be required to scale back our business, sell or license some or all of our technology or assets, or curtail or cease operations.

 

Our limited operating history may not serve as an adequate basis to judge our future prospects and results of operations.

 

We began our operations in 1999 but we did not adopt the SaaS on-demand Web Application delivery model until 2005, and we have recently changed our basic business model. Our limited operating history in the SaaS industry may not provide a meaningful basis on which to evaluate our business. Since our inception our revenues have not always grown from year to year.  We cannot assure you that we will achieve our growth targets, or that we will achieve positive cash-flow or profitability, or that we will not incur negative cash flow or net losses in the future. We expect that our operating expenses will increase as we expand. Any significant failure to realize anticipated revenue growth could result in significant operating losses beyond our forecasts. We will continue to encounter risks and difficulties frequently experienced by companies at a similar stage of development, including our potential failure to:

 

·      maintain and improve our technology;

 

·      expand our product and service offerings and maintain the high quality of products and services offered;

 

·      sell subscriptions to our products and offerings by our Syndication Partners to sufficient, quality customers to produce revenues adequate to meet our operating needs;

 

·      manage our expanding operations, including the integration of any future acquisitions;

 

·      obtain sufficient working capital to support our expansion and to fill customers’ orders in time;

 

·      maintain adequate control of our expenses;

 

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·      implement our product development, marketing, sales, and acquisition strategies and adapt and modify them as needed; and/or

 

·      anticipate and adapt to changing conditions in the markets in which we operate as well as the impact of any changes in government regulation, mergers and acquisitions involving our competitors, technological developments, and other significant competitive and market dynamics.

 

If we are not successful in addressing any or all of these risks, then our business may be materially and adversely affected.

 

We may encounter substantial competition in our business and our failure to compete effectively may adversely affect our ability to generate revenue.

 

We believe that existing and new competitors will continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. We expect that we will be required to continue to invest in product development and productivity improvements to compete effectively in our markets. Our competitors could develop better technology or more efficient products or undertake more aggressive and costly marketing campaigns than ours, which may adversely affect our marketing strategies and could have a material adverse effect on our business, results of operations, and financial condition.

 

Our major competitors may be better able than us to successfully endure downturns in our markets. In periods of reduced demand for our products, we can either choose to maintain market share by reducing our subscription prices to meet competition or maintain subscription prices, which likely would result in sacrifice of our market share. Sales and overall profitability would be reduced and sustained losses may continue in either case. In addition, we cannot be assured that additional competitors will not enter our existing markets, or that we will be able to compete successfully against existing or new competition.

 

We have a history of operating losses and we may not achieve profitability in the future.

 

Although we have periodically shown profits due to mark-to-market accounting anomalies related to warrant liability and embedded derivatives, we have never been profitable from operations on a quarterly or annual basis since our formation. Our operations resulted in a net loss of $4.7 million for the nine months ended September 30, 2009, and $22.2 million for the nine months ended September 30, 2008. As of September 30, 2009, our accumulated deficit was $34.5 million.  We expect to make significant future expenditures related to the development and expansion of our business. In addition, as a public company, we incur significant legal, accounting, and other expenses that we did not incur as a private company. As a result of these increased expenditures, we will have to generate and sustain increased revenue to achieve and maintain future profitability.  While our revenue has grown somewhat in recent periods, that growth has not been significant and future revenue growth may not be sustainable and we may not achieve sufficient revenue to achieve or maintain profitability. We have incurred and may continue to incur significant losses in the future for a number of reasons, including due to the other risks described in this report, and we may encounter unforeseen expenses, difficulties, complications, delays, and other unknown factors. Accordingly, we may not be able to achieve or maintain profitability and we may continue to incur significant losses for the foreseeable future.

 

The market for on-demand Web Applications may develop more slowly than we expect.

 

Our success will depend, to a large extent, on the willingness of individuals and SMBs to accept on-demand services for Web Applications that they view as critical to the success of their business. Many businesses have invested substantial effort and financial resources to integrate traditional enterprise software into their businesses and may be reluctant or unwilling to switch to a different application or to migrate these applications to on-demand Web Applications.

 

Other factors that may affect market acceptance of our Web Applications include our ability to:

 

·      minimize the time and resources required to implement products distributed through an Etelos Marketplace;

 

·      maintain high levels of customer satisfaction;

 

·      implement upgrades and other changes to our products without disrupting our service; and/or

 

·      provide rapid response time during periods of intense activity on customer websites.

 

In addition, market acceptance of our Web Applications may be affected by:

 

·      the security capabilities, reliability, and availability of on-demand services;

 

·      customer concerns with entrusting a third party to store and manage their data, especially confidential or sensitive data;

 

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·      the level of customization or configuration we offer; and/or

 

·      the price, performance, and availability of competing products and services.

 

The market for our products may not develop further, or it may develop more slowly than we expect, either of which would harm our business.

 

The market in which we participate is intensely competitive, and if we do not compete effectively, then our operating results may be harmed.  The market for SaaS on-demand Web Applications for business is highly competitive and rapidly changing with relatively low barriers to entry. With the introduction of new technologies and new market entrants, we expect competition to intensify in the future. In addition, pricing pressures and increased competition generally could result in reduced sales, reduced margins, or the failure of our products to achieve or maintain more widespread market acceptance. Often we offer products in an Etelos Marketplace that compete against existing systems that our potential customers have already made significant expenditures to install. Competition in our market is based principally upon service breadth and functionality; service performance, security and reliability; ability to tailor and customize services for a specific company, vertical or industry; ease of use of the service, speed and ease of deployment, integration and configuration; total cost of ownership, including price and implementation and support costs; professional services implementation; and financial resources of the vendor.

 

We face competition from both traditional software vendors and other SaaS providers. Many of our actual and potential competitors enjoy substantial competitive advantages over us, such as greater name recognition, longer operating histories, more varied products and services, and larger marketing budgets, as well as substantially greater financial, technical, and other resources. In addition, many of our competitors have established marketing relationships and access to larger customer bases, and have major distribution agreements with consultants, system integrators, and resellers. If we are not able to compete effectively, then our operating results will be harmed.

 

Our inability to fund our capital to meet our expenditure requirements may adversely affect our growth and profitability.

 

Our continued growth is dependent upon our ability to raise capital from outside sources. Our ability to obtain financing will depend upon a number of factors, including our financial condition and results of operations, the condition of the economy, and conditions in relevant financial markets.  If we are unable to obtain financing, as needed, on a timely basis and on acceptable terms, our financial position, competitive position, growth, and profitability may be adversely affected.  The current state of the US and global economy raises substantial doubts, especially about our ability to raise the additional capital that we will need to sustain our business operations.

 

We have reduced our employment force and have challenges meeting our operating demands.

 

We have decreased our number of full-time employees from 32 at September 30, 2008, to 11 as of September 30, 2009.  All of these remaining employees are on deferred salary, ranging from 10% to 100% of base salary, and there is no assurance that any of these personnel will be able to continue to work on this payment arrangement. As of the nine months ended September 30, 2009, accrued salary and related expenses owed to employees was $987 thousand.  Our operating plan has placed, and our anticipated growth plan is expected to continue to place, a significant strain on our very limited managerial, administrative, operational, financial, and other resources, compounded by these recent reductions in headcount. Although we will be required to continue to improve our operational, financial, and management controls and our reporting procedures it is clear that we may not be able to do so effectively and may not be able to recruit or retain adequate, qualified personnel to meet our operating demands. As such, we may be unable to manage our expenses effectively in the future, which may negatively impact our gross margins or operating expenses in any particular quarter.

 

Our customers are individuals, small and medium-sized businesses, and divisions of large companies, which may increase our costs to reach, acquire and retain customers.

 

We market and distribute our products and services and other offerings in Etelos Marketplaces to individuals, SMBs, and divisions of large companies. To grow our revenue quickly, we must add new customers, sell additional services to existing customers, and encourage existing customers to renew their subscriptions. However, selling to and retaining individuals and SMBs can be more difficult than selling to and retaining large enterprises because SMB customers tend to be more price sensitive and more difficult to reach with broad marketing campaigns.  In addition, individuals and SMBs have high churn rates in part because of the nature of their businesses and often lack the staffing to benefit fully from our products.  Further, individuals and SMBs often require higher sales, marketing, and support expenditures by vendors that sell to them per revenue dollar generated for those vendors.

 

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Many of our customers are price sensitive, and if the prices that we or our Syndication Partners charge for subscriptions to products or services offered in an Etelos Marketplace are unacceptable to our customers, then our operating results will be harmed.

 

Many of our customers are price sensitive, and we have limited experience with respect to determining the appropriate prices for our products or services. In addition, we have no control over prices charged by our Syndication Partners for their products or services offered in an Etelos Marketplace. As the market for our products or services matures, or as new competitors introduce new products or services that compete with ours, we may be unable to renew agreements with existing customers or attract new customers at the same price or based on the same pricing model as previously used. As a result, it is possible that competitive dynamics in our market may require us to change pricing models or reduce prices, which could harm our revenue, gross margin, and operating results.

 

We may not be able to prevent others from unauthorized use of our patents and other intellectual property, which could harm our business and competitive position.

 

Our success depends, in part, on our ability to protect our proprietary technologies. We own multiple filed United States and foreign patent applications covering our technology and we expect to file more U.S. and foreign patent applications in the future. We have filed to protect most of those patents in many foreign countries. But the process of seeking patent protection can be lengthy and expensive and we cannot assure that our patent applications will result in patents being issued, or that our existing or future issued patents will be sufficient to provide us with meaningful protection or commercial advantages.  We also cannot assure that our current or potential competitors do not have, and will not obtain, patents that will prevent, limit or interfere with our ability to make, use or sell our technology or operate an Etelos Marketplace.

 

Our success depends in large part on our ability to protect and enforce our intellectual property rights.

 

We rely on a combination of patent, copyright, service mark, trademark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights on a global basis, all of which provide only limited protection. We cannot assure you that any patent will issue from our currently pending patent applications in a manner that gives us the protection that we seek, if at all, or that any future patents issued to us will not be challenged, invalidated, or circumvented. Since the filing of some of these patent applications may have been, or will be, made after the date of first sale or disclosure of the subject inventions, patent protection may not be available for these inventions outside the United States.  Any patents that may issue in the future may not provide sufficiently broad protection or they may not prove to be enforceable in actions against alleged infringers. Also, we cannot assure you that any future service mark or trademark registrations will be issued for pending or future applications or that any registered service marks or trademarks will be enforceable or provide adequate protection of our domestic and foreign proprietary rights.

 

We have not maintained operating controls or logs, or initiated or conducted any forensic, code history, ‘genealogy’ or other forms of audit, analysis, processes, training, or code review of software code incorporated into any Etelos product or in other products offered by Syndication Partners in an Etelos Marketplace. We do not review the intellectual property rights related to products or services offered by Syndication Partners in an Etelos Marketplace. These products may include code subject to various forms of ‘open source’, ‘copyleft’, or similar licenses that require as a condition of modification or distribution of software subject to such license(s) that (i) such software or other software combined or distributed with such software be disclosed or distributed in source code form, or (ii) such software or other software combined or distributed with such software, and any related intellectual property, be licensed on a royalty-free basis, including for the purposes of making additional copies or derivative works of such software.  This may adversely affect our ability to patent certain inventions or to license or distribute certain products - whether by open source license or other form of license or right - and may result in liability to unknown parties for infringement of their patents or other intellectual property rights.

 

We require our Syndication Partners to indemnify us for intellectual property claims but we cannot assure that these agreements will be enforceable.

 

We endeavor to enter into agreements with our employees and contractors and agreements with parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are competitive to ours or infringe our intellectual property. Enforcement of our intellectual property rights also depends on our successful legal actions against these infringers, but these actions may not be successful, even when our rights have been infringed.  In addition, the legal standards relating to the validity, enforceability, and scope of protection of intellectual property rights in Internet-related industries are uncertain and still evolving.

 

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Assertions by third parties that we infringe their intellectual property, whether successful or not, could subject us to costly and time-consuming litigation or expensive licenses.

 

The software and technology industries are characterized by the existence of a large number of patents, copyrights, trademarks, and trade secrets and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. As we face increasing competition, the possibility of intellectual property rights claims against us may grow; the costs of defending against such claims can be very large. Our technologies may not be able to withstand any third-party claims or rights against their use. Additionally, many of our partner and product agreements require us to indemnify our customers for certain third-party intellectual property infringement claims, which could increase our costs as a result of defending such claims and may require that we pay damages or purchase expensive licenses, if there were an adverse ruling related to any such claims. These types of claims could harm our relationships with our customers, may deter future customers from subscribing to our services, or could expose us to litigation for these claims. Even if we are not a party to any litigation between a customer and a third party, an adverse outcome in any such litigation could make it more difficult for us to defend our intellectual property in any subsequent litigation in which we are a named party.

 

Any intellectual property rights claim against our customers, or us, with or without merit, could be time-consuming, expensive to litigate or settle, and could divert management attention and financial resources. An adverse determination also could prevent us from offering our products to our customers and may require that we procure or develop substitute services that do not infringe.

 

For any intellectual property rights claim against us or against our Marketplace Partners or customers, we may have substantial direct and indirect costs.  Direct costs can include a requirement to pay damages or stop using technology found to be in violation of a third party’s rights. We may have to purchase a license for the technology, which may not be available on reasonable terms, if at all, may significantly increase our operating expenses, or may require us to restrict our business activities in one or more respects. As a result, we may also be required to develop alternative non-infringing technology, which could require significant effort and expense.  Substantial indirect costs also may be expected in the form of diversion of development and management resources in strategic planning for legal, technology, and business defenses to such claims.

 

We rely on our management team and need additional personnel to grow our business, and the loss of one or more key employees or our inability to attract and retain qualified personnel could harm our business.

 

Our success and future growth depends to a significant degree on the skills and continued services of our management team, especially Daniel J.A. Kolke, our interim Chief Executive Officer, Acting Chief Financial Officer, and Chairman of the Board. The loss of the services of any member of our management team for any reason may have a material adverse effect on our business and prospects.  We do not maintain key man insurance on any members of our management team, including Mr. Kolke.

 

Subsequent to the termination of our former Chief Executive Officer, we significantly and materially reduced our management team and have not hired replacements for the management team in the positions of Vice President and Chief Financial Officer, Vice President — Marketing, Vice President Corporate Development, and Vice President — Human Resources, as well as several other Director-level positions, primarily in non-technical positions throughout the Company.  We did not fill these positions in the period ending September 30, 2009, and we have not filled any of these positions to the date of this report.

 

Our future success also depends on our ability to attract, retain and motivate highly skilled technical, managerial, sales, marketing and service and support personnel, including members of our management team. Competition for sales, marketing, and technology development personnel is particularly intense in the software and technology industries. As a result, we may be unable to successfully attract or retain qualified personnel. Our inability to attract and retain the necessary personnel could harm our business.

 

If we do not effectively expand and train our sales force and our services and support teams, then we may be unable to add new customers and retain existing customers.

 

We plan to expand our sales force and our services and support teams to increase our customer base and revenue. We believe that there is significant competition for sales, service, and support personnel with the skills and technical knowledge that we require. Our ability to achieve significant revenue growth will depend, in part, on our success in recruiting, training, and retaining sufficient numbers of personnel to support our growth. New hires require significant training and, in most cases, take significant time before they achieve full productivity. Our recent hires and planned hires may not become as productive as we expect and we may be unable to hire or retain sufficient numbers of qualified individuals in the markets where we do business. If these expansion efforts are not successful or do not generate a corresponding increase in revenue, then our business will be harmed.

 

If we are unable to cost-effectively market and distribute our products to our target customers, then our ability to grow our revenue quickly and become profitable will be harmed.

 

Our quarterly operating results may fluctuate in the future. As a result, we may fail to meet or exceed the expectations of research analysts or investors, which could cause our stock price to decline. Also period-to-period comparisons of our operating results may not be meaningful. You should not rely on the results of one quarter as an indication of future performance.

 

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Fluctuations in our quarterly operating results may be due to a number of factors, including the risks and uncertainties discussed elsewhere in this report. Fluctuations in our quarterly operating results could cause our stock price to decline rapidly, may lead analysts to change their long-term model for valuing our common stock, could cause us to face short-term liquidity issues, may impact our ability to retain or attract key personnel, or cause other unanticipated issues. If our quarterly operating results fall below the expectations of research analysts or investors, then the price of our common stock could decline substantially.

 

We use third-party data centers to support our services. Any disruption of service at these facilities could interrupt or delay our ability to deliver our service to our customers.

 

We host many of our services and serve a significant number of our customers from third-party data center facilities with Network OS, located in the greater Seattle Washington area. We do not control the operation of these facilities. These facilities may be vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, terrorist attacks, power losses, telecommunications failures, and similar events. These facilities also could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. The occurrence of a natural disaster or an act of terrorism, a decision to close the facilities without adequate notice, or other unanticipated problems could result in lengthy interruptions in our services.

 

We owe substantial amounts to our data center facility providers and they have no obligation to continue their services or renew their agreements with us on commercially reasonable terms, or at all. If we are unable to renew our agreements with any facility provider on commercially reasonable terms, then we may experience increased costs or downtime in connection with the transfer to a new data center facility.

 

Any errors, defects, disruptions, or other performance problems with our services could harm our reputation and may damage our customers’ businesses. Interruptions in our services might reduce our revenue, cause us to issue credits to customers, subject us to potential liability, cause customers to terminate their subscriptions, and harm our renewal rates.

 

Any significant fluctuation in price of servers or related support may have a material adverse effect on the cost of our products and services.

 

The prices of servers and related support are subject to market conditions and generally we do not, and do not expect to, have long-term contracts with our suppliers for those items. While these items are generally available and we have not experienced any shortage in the past, we cannot assure you that the necessary servers or support will continue to be available to us at prices currently in effect or acceptable to us. The prices for these items have varied significantly in the past and may vary significantly in the future. Numerous factors, most of which are beyond our control, influence prices of servers and related support. These factors include general economic conditions, industry capacity utilization, vendor backlogs and delays and other uncertainties.

 

We may not be able to adjust our product prices, especially in the short-term, to recover cost increases in these items. Our future profitability may be adversely affected to the extent we are unable to pass on higher server and support related costs to our customers.

 

We may become liable to our customers and lose customers if we have defects or disruptions in our products and services or if we provide poor service.

 

Because we deliver products as a service through an Etelos Marketplace, errors or defects in the Web Applications underlying the service, or a failure of our hosting infrastructure may make the service unavailable to our customers. Because our customers use the products to manage critical aspects of their business, any errors, defects, disruptions in service, or other performance problems with the products, whether in connection with the day-to-day operation of the products, upgrades or otherwise, could damage our customers’ businesses. If we have any errors, defects, disruptions in service, or other performance problems with the products, then customers could elect not to renew their subscriptions or delay or withhold payment to us. As a result, we could lose future sales or customers may make warranty claims against us or our Syndication Partners, which could result in an increase in our provision for doubtful accounts, an increase in collection cycles for accounts receivable, or costly litigation.

 

If our security measures are breached and unauthorized access is obtained to a customer’s data, then we may incur significant liabilities, our service may be perceived as not being secure, and customers may curtail or stop using our products.

 

The products and services we offer in an Etelos Marketplace involve the storage of large amounts of our customers’ sensitive and proprietary business information. If our security measures are breached as a result of third-party action, employee error, malfeasance, or otherwise, and someone obtains unauthorized access to our customers’ data, then we could incur significant liability to our Syndication and Marketplace Partners, our customers, and to individuals or businesses whose information was being stored by our customers, our business may suffer and our reputation may be damaged. Because techniques used to obtain unauthorized access to, or to sabotage, systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventive measures. If an actual or perceived breach of our security occurs, then the market perception of the effectiveness of our security measures could be harmed and we could lose sales and customers.

 

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If we are unable to develop new products or services, distribute our products or services into new markets, or add Syndication Partners to offer their products or services for distribution in an Etelos Marketplace, then our revenue growth will be harmed and we may not be able to achieve profitability.

 

Our ability to attract new customers and to increase revenue from existing customers will depend in large part on our ability to enhance and improve our existing products and to add new Marketplace Partners and new Syndication Partners to offer their products and services and distribute into new markets. The success of any enhancement or new Syndication Partner offering depends on several factors, including the timely completion, introduction, and market acceptance of the enhancement, product or service. Any new product or service offered by a Syndication Partner or that we develop or acquire may not be introduced in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to generate significant revenue. Any new markets into which we attempt to distribute our products or services may not be receptive. If we are unable to successfully develop or acquire new products or services, enhance our existing products and services to meet customer requirements, or distribute our products and services into new markets, then our revenue will not grow as expected and we may not be able to achieve profitability.

 

If we fail to maintain proper and effective internal controls or are unable to remediate the material weakness in our internal controls, then our ability to produce accurate and timely financial statements could be impaired and investors’ views of us could be harmed.

 

Ensuring that we have adequate internal financial and accounting controls and procedures in place so that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.

 

During our audit for the year ended December 31, 2008, we identified material weaknesses in our internal controls. The material weaknesses relate to the absence of specific policies and procedures for some accounting functions and the need for accounting personnel who possess the skill sets necessary to operate and report as a public company, and specifically the skills necessary to ensure that adequate review of critical account reconciliations is performed and that supporting documentation is complete, accurate, and in accordance with generally accepted accounting principles. Our financial position and limited resources make it difficult for us to address these weaknesses.  If we fail to address these material weaknesses or if additional material weaknesses in our internal controls are discovered in the future, then we may fail to meet our future reporting obligations, our financial statements may contain material misstatements and the price of our common stock may decline.

 

Implementing any appropriate changes to our internal controls may distract our officers and employees, entail substantial costs to modify our existing processes, and add personnel and take significant time to complete. These changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and harm our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements on a timely basis may harm our stock price and make it more difficult for us to effectively market and distribute our products and services to new and existing customers.

 

Material defects or errors in the software we use to deliver our products and services and the offerings by our Marketplace and Syndication Partners could harm our reputation, result in significant costs to us, and impair our ability to distribute our services.

 

The Web Applications underlying the offerings in an Etelos Marketplace are inherently complex and may contain material defects or errors, particularly when first introduced or when new versions or enhancements are released. We have, from time to time, found defects in our products and services, and new errors in our existing software and services may be detected in the future. We have no actual knowledge, but we reasonably expect that the products and services offered by our Syndication Partners may have similar errors and/or defects. Any errors or defects that cause interruptions to the availability of our services and the services for our Marketplace Partners could result in:

 

·      a reduction in sales or delay in market acceptance of services from us or our Marketplace Partners;

 

·      sales credits or refunds to our customers and customers of our Marketplace Partners;

 

·      loss of existing customers and difficulty in attracting new customers;

 

·      diversion of development resources;

 

·      harm to our reputation, or the reputation of our Marketplace Partners; and/or

 

·      increased warranty and insurance costs.

 

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After the release of our services, defects or errors may also be identified from time to time by our internal team, our Marketplace and Syndication Partners, and by our customers. The costs incurred in correcting any material defects or errors in such products or services may be substantial and could harm our operating results.

 

Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or our failure to comply with regulations could harm our operating results.

 

As Internet commerce continues to evolve, increasing regulation by super-national, federal, state or local government agencies becomes more likely. Increased regulation in the area of data privacy, and laws and regulations applying to the solicitation, collection, processing, or use of personal or consumer information could affect our customers’ ability to use and share data, potentially reducing demand for Web-based applications and restricting our ability to store, process, and share our customers’ data. In addition, taxation of services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet access or use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Web-based services, which could harm our business and operating results.

 

Privacy concerns and laws or other regulations may reduce the effectiveness of our products and services and harm our business.

 

Our customers can use the products and services offered in an Etelos Marketplace to store personal or identifying information regarding their customers and contacts. Super-national, federal, state and other government bodies and agencies have adopted or are considering adoption of laws and regulations regarding the collection, use, and disclosure of personal information obtained from consumers and other individuals. The costs of compliance with, and other burdens imposed by, such laws and regulations that are applicable to the businesses of our customers may limit the use and adoption of our products and services and reduce overall demand.

 

In addition to government activity, privacy advocacy groups and the technology and other industries are considering various new, additional, or different self-regulatory standards that may place additional burdens on us and our Marketplace and Syndication Partners. If the gathering of personal information were to be curtailed, then Web-based applications would be less effective, which may reduce demand for the products and services offered in an Etelos Marketplace and harm our business.

 

Our operating results may be harmed if we are required to collect taxes for our subscription services in jurisdictions where we have not historically done so.

 

We have not collected any sales or other taxes from our customers or remitted any such taxes to any taxing jurisdiction where we may be required to do so. We have begun an analysis of this issue but to date have not made any accrual for any potential liability.  In addition, additional taxing jurisdictions at various local, national and super-national levels may seek to impose sales or other tax collection obligations on us.  We have not recorded sales or other tax liabilities for the quarters ended June 30, 2009 or 2008, in respect of sales or other tax liabilities in any jurisdiction. A successful assertion that we should be collecting sales or other taxes on our service could result in substantial tax liabilities for past sales, discourage customers from purchasing our products, or otherwise harm our business and operating results.

 

Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations, and harm our operating results.

 

A change in accounting standards or practices could harm our operating results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may harm our operating results or the way we conduct our business.

 

We may expand by acquiring or investing in other companies, which may divert management’s attention, result in additional dilution to our stockholders, and consume resources that are necessary to operate and sustain our business.

 

Although we have no ongoing negotiations or current agreements or commitments for any acquisitions, our business strategy may include acquiring complementary products, services, technologies, or businesses. We also may enter into relationships with other businesses to expand our product or service offerings or our ability to provide service in foreign jurisdictions, which could involve preferred or exclusive licenses, additional channels of distribution, discount pricing, investments in other companies, or other

 

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strategies. Negotiating these transactions can be time-consuming, difficult, and expensive, and our ability to close these transactions may often be subject to approvals that are beyond our control. Consequently, these transactions, even if undertaken and announced, may not close.

 

An acquisition, investment, or business relationship may result in unforeseen operating difficulties and expenditures. In particular, we may encounter difficulties assimilating or integrating the businesses, technologies, products, services offerings, personnel, or operations of the acquired companies, particularly if the key personnel of the acquired company choose not to work for us, the target’s software is not easily adapted to work with ours, or we are unable to retain the customers of any acquired business due to changes in management or otherwise. Acquisitions may also disrupt our business, divert our resources, and require significant management attention that would otherwise be available for operation and development of our business. Moreover, the anticipated benefits of any acquisition, investment, or business relationship may not be realized or we may be exposed to unknown liabilities. For one or more of those transactions, we may:

 

·      issue additional equity securities that would dilute our stockholders;

 

·      use cash that we may need in the future to operate our business;

 

·      incur debt on terms unfavorable to us or that we are unable to repay;

 

·      incur large charges or substantial liabilities;

 

·      encounter difficulties retaining key employees of the acquired company or integrating diverse software codes or business cultures; and/or

 

·      become subject to adverse tax consequences, substantial depreciation, or deferred compensation charges.

 

Any of these risks could harm our business and operating results.

 

We may be subject to other legal claims.

 

In June 2008, Kaufman Bros. L.P. filed suit against us in the United States District Court for the Southern District of New York (Case No. 80 CV 5716) and sought a temporary restraining order and other extraordinary relief.  The complaint arose out of an advisory services agreement, pursuant to which Kaufman Bros. was to provide us with advisory services in connection with financings and strategic transactions. We notified Kaufman Bros. that we believed it had failed to provide the required services under the agreement, and that we were therefore entitled to terminate the agreement for cause. In the suit, Kaufman Bros. was seeking (i) monetary damages of $400,000 for anticipatory breach of the agreement; (ii) $73,800 in fees allegedly owed in connection with a previously closed financing transaction; (iii) and injunction prohibiting us from cancelling any shares issued to Kaufman Bros. as compensation, (iv) a declaration from the court that we are not entitled to a refund of any fees previously paid to Kaufman Bros., and (v) a declaration that we are obligated to pay Kaufman Bros. a commission on any financing or transaction that we enter into within 18 months following the termination of the agreement.  On July 15, 2008, Kaufman Bros. voluntarily filed a notice of dismissal without prejudice.  Settlement discussions were unsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantially the same claims in the Supreme Court of New York - County of New York (Index No. 08-602239). Effective on December 5, 2008, the Company entered into a settlement agreement with Kaufman Bros., pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) the Company issued to Kaufman Bros. warrants to purchase 500,000 shares of the Company’s common stock at an exercise price of $0.75 per share, which warrants have a term of five years; (iii) the Company and Kaufman Bros. agreed immediately to terminate all provisions, terms and conditions of the advisory services agreement and exchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss the pending lawsuit in the Supreme Court of New York, without prejudice. Subsequent to entering into the settlement agreement, we have not fully complied with our payment obligations under the settlement agreement but, through the date of filing of this report, Kaufman Bros. has not exercised any of its remedies for default under the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo, California.  The landlord for these premises filed a complaint claiming damages of $659 thousand and other amounts against the Company’s predecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”) in the Superior Court of San Mateo County, California (Case No. CIV 479535).  A default judgment was entered for the landlord but the default was set aside because the landlord failed to properly serve either the Company or Etelos-WA. The Company is continuing to defend its position.

 

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On September 18, 2008, the employment of Jeffrey L. Garon as president and chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garon resigned from the Board of Directors.  Mr. Garon and the Company entered into an Employment Agreement dated August 11, 2007, which provided certain benefits to Mr. Garon in the event of termination of his employment, and granted to the Company certain rights to repurchase shares issued on behalf of Mr. Garon pursuant to his employment agreement, in accordance with a Stock Purchase Agreement dated February 29,2008. On June 22, 2009, the Company filed a demand for Arbitration with the American Arbitration Association [Case No. 74 166 00535 09 LMT] seeking injunctive and other relief, including rescission of the Employment Agreement and the Stock Purchase Agreement that it entered into with Mr. Garon.  The demand includes assertions that Mr. Garon misrepresented his employment qualifications and, inter alia, seeks to recover from Mr. Garon 2,383,333 shares of the Company’s common stock that were issued in connection with his employment.  Mr. Garon has filed a counter-demand against the Company, certain employees of the Company, and members of its Board of Directors seeking declaratory relief, a preliminary injunction, and damages in an amount to be proved at the arbitration.  The Hearing in this matter is scheduled to begin on November 16, 2009.

 

On October 1, 2008, we relocated our headquarters from San Mateo, California to Renton, Washington, and terminated eight employees based in California. In October 2008, we terminated eight more employees employed in both our California and Washington offices.  Two former employees have asserted claims with the California Labor Commission for payment of these unpaid amounts and the assertion of other such claims or demands by such employees, or by governmental authorities, is foreseeable.

 

As part of our reduction of monthly cash operating expenses during the quarter ended December 31, 2008, and continuing after the end of the quarter ended September 30, 2009, and to the filing date of this report, we placed all employees on partial deferrals of salary, ranging from 10% to 100% of base salary.  At the end of the quarter, until the filing date of this report, this deferral amount remains unpaid, including amounts due to employees who subsequently were terminated. Two former employees have asserted claims with the California Labor Commission for payment of these unpaid amounts and the assertion of such claims or demands by such employees, or by other governmental authorities, is foreseeable.

 

In connection with our reverse merger, multiple financings, and protection of our intellectual property, we have incurred substantial accounts payable to law firms that remain unpaid and overdue.  We have been in communication with these vendors and expect to enter into negotiated payment plans with these vendors, and others, but there is no assurance that we will be successful in these negotiations, or that we will be able to make payments under such plans if and when negotiated.  Therefore the assertion of claims by these vendors for these amounts due and owing could become the subject of claims in litigation.

 

Our officers, directors, and affiliates control us through their positions and stock ownership and their interests may differ from other stockholders.

 

As of September 30, 2009, our officers, directors, and affiliates beneficially own approximately 72 percent of our common stock and 60 percent of our preferred stock. As a result, if they act together, they are able to influence the outcome of stockholder votes on various matters, including the election of directors and extraordinary corporate transactions, including business combinations. This concentration could also have the effect of delaying or preventing a change in control that could otherwise be beneficial to our stockholders. The interests of our officers, directors, and affiliates may differ from other stockholders. Furthermore, the current ratios of ownership of our common stock reduce the public float and liquidity of our common stock, which can in turn affect the market price of our common stock.

 

We are responsible for the indemnification of our officers and directors.

 

Our articles of incorporation and bylaws provide for the indemnification of our directors, officers, employees, and agents, and, under certain circumstances, against costs and expenses incurred by them in any litigation to which they become a party arising from their association with or activities on our behalf. Consequently, we may be required to expend substantial funds to satisfy these indemnity obligations.

 

The market price of our securities could be adversely affected by sales of registered and restricted securities.

 

Actual sales or the prospect of future sales of shares of our common stock pursuant to a prospectus or under Rule 144 may have a depressive effect upon the price of, and market for, our common stock.  As of September 30, 2009, 24,826,360 shares of our common stock were issued and outstanding, of which 18,017,624 are “restricted securities” and under some circumstances may, in the future, be under a registration under the Securities Act or in compliance with Rule 144 adopted under the Securities Act.  In general, under Rule 144, subject to the satisfaction of other conditions, a person who has beneficially owned restricted shares of common stock for at least one year is entitled to sell, within any three month period, a number of shares that does not exceed the greater of 1 percent of the total number of outstanding shares of the same class; or if the common stock is quoted on NASDAQ or a stock exchange, the average weekly trading volume during the four calendar weeks immediately preceding the sale.  We cannot predict what effect, if any, that sales of shares of common stock, or the availability of these shares for sale, will have on the market prices prevailing from time to time.  Nevertheless, the possibility that substantial amounts of common stock may be sold in the public market may adversely effect prevailing prices for our common stock and could impair our ability to raise capital in the future through the sale of equity securities.

 

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The sale of the shares of our common stock acquired in private placements could cause the price of our common stock to decline.

 

The purchasers of our January 2008 and April 2008 Debentures and related warrants, as well as the holders of our other outstanding convertible notes, may, subject to compliance with Rule 144, rely on the provisions of Rule 144 to resell the shares of our common stock acquired upon the conversion and exercise of such securities.  We have no way of knowing whether or when such shares may be sold.  Depending upon market liquidity at the time, a sale of shares by such investors at any given time could cause the trading price of our common stock to decline.  The sale of substantial number of shares of our common stock, or anticipation of such sales, could make it more difficult for us to sell equity or equity-related securities in the future at a time and at a price that we might otherwise wish to effect sales.

 

In addition, in connection with our January 2008 and April 2008 Debentures and 10% Senior Secured Debentures, in the aggregate, we owe a total of $8.3 million principal amount of these convertible debentures, convertible into 8,690,695 shares of our common stock, and warrants to purchase an additional 5,861,111 shares of our common stock. The conversion or exercise into our common stock could result in a substantial increase in the number of shares in our public float.  Depending upon market liquidity at the time a resale of our common stock is made by the investors in such private placements, such sale could cause the trading price of our common stock to decline.  In addition, the sale of a substantial number of shares of our common stock, or anticipation of such sales, could make it more difficult for us to sell equity or equity-related securities in the future at a time and at a price that we might otherwise wish to effect sales.

 

We have significant indebtedness and agreed to certain restrictions in connection with the debentures may impair our ability to issue additional debt or equity.

 

We have incurred $8.3 million of long term convertible debt, including $6.3 million in principal amount of indebtedness as a result of the issuance of our January 2008 and April 2008 Debentures, and $2.0 million in principal amount of indebtedness as a result of the issuance of our 10% Senior Secured Debentures. Our January 2008 and April 2008 Debentures and 10% Senior Secured Debentures impose significant covenants on us, some of which may impair our ability to issue additional debt or equity, if necessary.

 

Our ability to comply with these provisions may be affected by changes in our business condition or results of our operations, or other events beyond our control.  We have breached certain of these covenants and are in a default under the debentures, which permits the holders thereof to accelerate the maturity of the debentures and demand repayment in full.  Such actions by such holders could impair our ability to operate or cause us to seek bankruptcy protection.

 

If we need additional financing in the future and are required to issue securities which are priced at less than the conversion price of our debentures or the exercise price of warrants sold in our recent private placements, it will result in additional dilution.

 

Our January 2008 and April 2008 Debentures and 10% Senior Secured Debentures and the related warrants contain provisions that will require us to reduce the conversion price and exercise price, as the case may be, if we issue additional securities while such debentures or warrants are outstanding which contain purchase prices, conversion prices or exercise prices less than the conversion price of our January 2008 or April 2008 Debentures or 10% Senior Secured Debentures and or the exercise price of the warrants.  If this were to occur, current investors, other than the investors in our recent private placements, would sustain material dilution in their ownership interest.

 

Anti-takeover provisions contained in our amended and restated certificate of incorporation and amended and restated bylaws, as well as provisions of Delaware law, could impair a takeover attempt.

 

Our amended and restated certificate of incorporation, amended and restated bylaws and Delaware law contain provisions that could have the effect of rendering more difficult or discouraging an acquisition deemed undesirable by our board of directors. Our corporate governance documents include provisions:

 

·      authorizing blank check preferred stock, which could be issued with voting, liquidation, dividend, and other rights superior to our common stock;

 

·      limiting the liability of, and providing indemnification to, our directors and officers;

 

·      limiting the ability of our stockholders to call and bring business before special meetings;

 

·      requiring advance notice of stockholder proposals for business to be conducted at meetings of our stockholders and for nominations of candidates for election to our board of directors;

 

·      controlling the procedures for the conduct and scheduling of board and stockholder meetings; and

 

·      limiting, generally, the filling of vacancies or newly created seats on the board to our board of directors then in office.

 

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These provisions, alone or together, could delay hostile takeovers and changes in control or changes in our management.

 

Any provision of our amended and restated certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock.

 

We may issue additional shares of our capital stock, including through convertible debt securities, to finance future operations or complete a business combination, which would reduce the equity interest of our stockholders and could cause a change in control of our ownership.

 

Although we have no commitments as of the date of this report to issue any additional securities, we may issue a substantial number of additional shares of our common stock or preferred stock, or a combination of both, including through convertible debt securities, to finance future operations.  We may not be able to obtain additional debt or equity financing on favorable terms, if at all.  If we engage in debt financing, then we may be required to accept terms that restrict our ability to incur additional indebtedness and force us to maintain specified liquidity or other ratios.

 

Further, the issuance of additional shares of our common stock or any number of shares of preferred stock, including upon conversion of any debt securities, may:

 

·      significantly reduce the equity interest of our current stockholders;

 

·      cause a change in control if a substantial number of our shares of common stock or voting preferred stock are issued, which may affect, among other things, our ability to use our net operating loss carry-forwards, if any, and could also result in a change in management; and/or

 

·      adversely affect prevailing market prices for our common stock.

 

If we need additional capital and cannot raise it on acceptable terms, we may not be able to, among other things:

 

·      develop or enhance our products and services;

 

·      continue to expand our development, sales and marketing organizations;

 

·      acquire complementary technologies, products or businesses;

 

·      expand operations;

 

·      hire, train and retain employees; and/or

 

·      respond to competitive pressures or unanticipated working capital requirements.

 

Although we have no commitments as of the date hereof to issue any additional securities, we may issue a substantial number of additional shares of our common stock or preferred stock, or a combination of both, including through convertible debt securities, to finance future operations or complete a business combination.  The issuance of additional shares of our common stock or any number of shares of preferred stock, including upon conversion of any debt securities:

 

·      may significantly reduce the equity interest of our current stockholders; and

 

·      will likely cause a change in control if a substantial number of our shares of common stock or voting preferred stock are issued and could also result in a change in management; and/or may adversely affect prevailing market prices for our common stock.

 

The 2007 Stock Incentive Plan and all options issued under the 2007 Stock Incentive Plan contain provisions for acceleration of all unvested options in the event of a change of control, which might be a disincentive to acquisition of the Company as a liquidation strategy.

 

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The 2007 Stock Incentive Plan and all options currently issued thereunder and options granted outside such plan provides for accelerated vesting of all unvested options in the event of a change of control, which is defined as an acquisition by a single person of more than 50 percent of the total combined voting power of all of our outstanding securities. This may be regarded as a barrier to retention of key employees following a change-of-control acquisition and therefore make such an acquisition more costly or difficult, and therefore an unattractive strategic option, for a prospective acquiror.

 

We have never paid dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future.

 

We have paid no cash dividends on any of our classes of capital stock to date and we currently intend to retain our future earnings, if any, to fund the development and growth of our business.  In addition, the terms of the Notes prohibit us from making any dividend payment or distribution to holders of our common stock while any portion of the Notes remain outstanding.  As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.

 

Our securities may be thinly traded on the Over-the-Counter Bulletin Board, which may not provide liquidity for our investors.

 

Our common stock is quoted on the Over-the-Counter Bulletin Board. The Over-the-Counter Bulletin Board is an inter-dealer, over-the-counter market that provides significantly less liquidity than the NASDAQ Stock Market or other national or regional exchanges. Securities traded on the Over-the-Counter Bulletin Board are usually thinly traded, highly volatile, have fewer market makers, and are not followed by analysts.

 

The SEC’s order handling rules, which apply to NASDAQ-listed securities, do not apply to securities quoted on the Over-the-Counter Bulletin Board. Quotes for stocks included on the Over-the-Counter Bulletin Board may not be listed in newspapers. Therefore, prices for securities traded solely on the Over-the-Counter Bulletin Board may be difficult to obtain and holders of our securities may be unable to resell their securities at or near their original acquisition price, or at any price.

 

Investors must contact a broker-dealer to trade Over-the-Counter Bulletin Board securities. As a result, you may not be able to buy or sell our common stock at the times that you may wish.

 

Even though our common stock is quoted on the Over-the-Counter Bulletin Board, the Over-the-Counter Bulletin Board may not permit our investors to sell securities when and in the manner that they wish. Because there are no automated systems for negotiating trades on the Over-the-Counter Bulletin Board, they are conducted via telephone. In times of heavy market volume, the limitations of this process may result in a significant increase in the time it takes to execute investor orders. Therefore, when investors place market orders to buy or sell a specific number of shares at the current market price it is possible for the price of a stock to go up or down significantly during the lapse of time between placing a market order and its execution.

 

Our stock price may be volatile and you may not be able to sell your shares for more than what you paid.

 

Our stock price is likely to be subject to significant volatility and you may not be able to sell shares of common stock at or above the price you paid for them. The market price of the common stock could continue to fluctuate in the future in response to various factors including, but not limited to: quarterly variations in operating results; our ability to control costs and improve cash flow; announcements of technological innovations or new products by us or our competitors; changes in investor perceptions; and new products or produce enhancements by us or our competitors. The stock market in general has continued to experience volatility, which may further affect our stock price. As such, you may not be able to resell your shares of common stock at or above the price you paid for them.

 

Our common stock is likely to be subject to penny stock rules

 

Our common stock is subject to Rule 15g-1 through 15g-9 under the Exchange Act, which imposes certain sales practice requirements on broker-dealers which sell our common stock to persons other than established customers and “accredited investors” (generally, individuals with net worths in excess of $1 million or annual incomes exceeding $200 thousand (or $300 thousand together with their spouses)).  For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to the sale.  This rule adversely affects the ability of broker-dealers to sell our common stock and purchasers of our common stock to sell their shares of such common stock.  Additionally, our common stock is likely to be subject to the SEC regulations for “penny stock.”  Penny stock includes any equity security that is not listed on a national exchange and has a market price of less than $5.00 per share, subject to certain exceptions.  The regulations require that prior to any non-exempt buy/sell transaction in a penny stock, a disclosure schedule set forth by the SEC relating to the penny stock market must be delivered to the purchaser of such penny stock.  This disclosure must include the amount of commissions payable to both the broker-dealer and the registered representative and current price quotations for the common stock.  The regulations also require that monthly statements be sent to holders of penny stock which disclose recent price information for the penny stock and information of the limited market for penny stocks.  These requirements adversely affect the market liquidity of our common stock.

 

Item 6.   EXHIBITS

 

See the exhibit index immediately following the signature page of this report.

 

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SIGNATURES