NEW CENTURY COMPANIES, INC.

AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2009 AND 2008

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Reports of Independent Registered Public Accounting Firms		F-1
Consolidated Balance Sheets		F-3
Consolidated Statements of Operations		F-4
Consolidated Statements of Stockholders’ Deficit		F-5
Consolidated Statements of Cash Flows		F-6
Notes to Consolidated Financial Statements		F-7

 

 

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

New Century Companies, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheet of New Century Companies, Inc. and Subsidiaries (the "Company") as of December 31, 2009, and the related consolidated statements of operations, stockholders’ deficit and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company was not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of New Century Companies, Inc. and Subsidiaries as of December 31, 2009 and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1 to the consolidated financial statements, as of December 31, 2009, the Company has an operating loss of $2,441,821, an accumulated deficit of approximately $26,839,000, a working capital deficit of approximately $9,491,000 and also incurred events of default on its CAMOFI and CAMHZN debt.  These factors raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans regarding these matters are also described in Note 1.  The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

/s/ KMJ Corbin & Company LLP

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April 15, 2010

Costa Mesa, California

 

 

F-1

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

New Century Companies, Inc. and Subsidiary

We have audited the accompanying consolidated balance sheets of New Century Companies, Inc. and Subsidiary (the "Company") as of December 31, 2008, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for the year ended December 31, 2008. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company was not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of New Century Companies, Inc. and Subsidiary as of December 31, 2008, and the results of their operations and their cash flows for the year ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, as of December 31, 2008, the Company has an operating loss of $3,192,887, an accumulated deficit of approximately $12,880,000, working capital deficit of approximately $4,750,000 and was also in default on its CAMOFI and CAMHZN debt.  These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans regarding these matters are also described in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.  The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

As discussed in Note 14 to the accompanying consolidated financial statements, subsequent to May 15, 2008, and after the Company had filed its Annual Report  on  Form  10-KSB  for  the  years  ended December 31, 2007 and 2006, management determined that the accounting for the 2006 CAMOFI convertible notes incorrectly did not record separate derivative liabilities for the conversion option and warrants issued. These corrections resulted in changes to net income (loss) available to shareholders, total liabilities, and stockholders’ deficit (equity) as more fully described in Note 14.

 

/s/ SQUAR, MILNER, PETERSON, MIRANDA & WILLIAMSON, LLP

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May 20, 2009

Newport Beach, California

 

 

F-2

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NEW CENTURY COMPANIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2009 and December 31, 2008

		December 31, 2009				December 31, 2008
ASSETS
Current assets:
Cash		$	157,633			$	31,889
Contract receivables, net of allowance of $24,000 and $0 for December 31, 2009 and 2008, respectively			71,120				237,787
Inventories			284,339				564,022
Costs and estimated earnings in excess of billings on uncompleted contracts			5,725				416,664
Deferred financing costs, current portion			150,251				252,305
Prepaid expenses and other current assets			7,738				168,668
Total current assets			676,806				1,671,335
Property and equipment, net			716,864				186,906
Goodwill			2,359,121				-
Intangible assets, net			1,446,429				-
Deferred financing costs, long-term portion			92,338				233,702
Other assets			151,790				-
		$	5,443,348			$	2,091,943
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Bank overdraft		$	7,515			$	15,329
Accounts payable and accrued liabilities			3,856,316				1,417,464
Derivative liability			48,378				1,975,298
Dividends payable			204,600				459,275
Billings in excess of costs and estimated earnings on uncompleted contracts			149,849				1,388,348
Current portion of capital lease obligations			752,957				27,874
Loan payable and accrued interest, net of discount of $10,003			145,563				-
Notes payable and accrued interest			115,544				-
Notes payable to related parties and accrued interest			545,356				-
12% Convertible notes payable and accrued interest, net of discount of $753,619 and $2,089,443 at December 31, 2009 and 2008, respectively			2,514,582				737,838
15% Convertible notes payable and accrued interest, net of discount of $596,545 and $350,090 at December 31, 2009 and 2008, respectively			1,827,031				399,910
Total current liabilities			10,167,691				6,421,336
Long-term liabilities:
Capital lease obligation, net of current portion			-				9,804
Total liabilities			10,167,691				6,431,140
Commitments and contingencies
Stockholders’ deficit:
Cumulative, convertible, Series B preferred stock, $1 par value, 15,000,000 shares authorized, no shares issued and outstanding (liquidation preference of $25 per share)			-				-
Cumulative, convertible, Series C preferred stock, $1 par value, 75,000 shares authorized, 26,880 shares issued and outstanding (liquidation preference of $672,000 and $925,000 at December 31, 2009 and 2008, respectively)			26,880				26,880
Cumulative, convertible, Series D preferred stock, $25 par value, 75,000 shares authorized, 11,640 shares issued and outstanding (liquidation preference of $495,600 and $456,000 at December 31, 2009 and 2008, respectively)			291,000				291,000
Common stock, $0.10 par value, 250,000,000 shares authorized; issued and outstanding 22,430,211 and 15,344,654 shares at December 31, 2009 and 2008, respectively			2,243,022				1,534,466

Deferred equity compensation			(29,169	)			(101,667	)
Notes receivable from stockholders			(584,691	)			(564,928	)
Additional paid-in capital			20,167,283				7,355,007
Accumulated deficit			(26,838,668	)			(12,879,955	)
Total stockholders’ deficit			(4,724,343	)			(4,339,197	)
		$	5,443,348			$	2,091,943

 

See accompanying notes to the consolidated financial statements

F-3

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NEW CENTURY COMPANIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

For The Years Ended December 31, 2009 and 2008

		2009				2008
Contract revenues		$	3,726,431			$	4,822,026
Cost of sales			3,794,136				5,498,196
Gross loss			(67,705	)			(676,170	)
Operating expenses:
Consulting and other compensation			886,722				601,440
Salaries and related			538,483				837,147
Selling, general and administrative			948,911				1,078,130
Total operating expenses			2,374,116				2,516,717
Operating loss			(2,441,821	)			(3,192,887	)
Other income (expenses):
Gain on write-off of accounts payable			21,899				66,194
Gain on forgiveness of debt			-				2,872,133
Loss on disposal of assets			(253,303	)			-
(Loss) gain on valuation of derivative liabilities			(7,426,840	)			4,168,415
Interest income			19,763				19,763
Interest expense			(4,834,631	)			(1,749,026	)
Total other income (expenses)			(12,473,112	)			5,377,479
(Loss) income before provision for income taxes			(14,914,933	)			2,184,592
Provision for income taxes			(5,929	)			(3,200	)
Net (loss) income		$	(14,920,862	)		$	2,181,392
Preferred stock dividends			254,675				(82,550	)
Net (loss) income applicable to common stockholders		$	(14,666,187	)		$	2,098,842
Basic net (loss) income available to common stockholders per common share		$	(0.87	)		$	0.14
Diluted net (loss) income available to common stockholders per common share		$	(0.87	)		$	0.05
Basic weighted average common shares outstanding			16,767,495				14,696,227
Diluted weighted average common shares outstanding			16,767,495				62,101,547

 

See accompanying notes to the consolidated financial statements

F-4

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NEW CENTURY COMPANIES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT

For The Years Ended December 31, 2009 and 2008

		Preferred Stock, Series C							Preferred Stock, Series D							Common Stock							Additional Paid-in				Notes Receivable From				Deferred				Subscriptions				Accumulated				Total Stockholders’
		Shares			Amount				Shares			Amount				Shares			Amount				Capital				Stockholders				Compensation				Receivable				Deficit				Deficit
Balance, December 31, 2007 (restated)		26,880			$	26,880			11,640			$	291,000			13,744,654			$	1,374,466			$	7,743,743			$	(545,165	)		$	(334,921	)		$	(462,500	)		$	(14,978,797	)		$	(6,885,294	)
Issuance of common stock for consulting services		-				-			-				-			875,000				87,500				41,500				-				(93,000	)			-				-				36,000
Issuance of stock for penalties due on convertible notes		-				-			-				-			725,000				72,500				7,250				-				-				-				-				79,750
Change in fair value of deferred compensation		-				-			-				-			-				-				(10,000	)			-				-				-				-				(10,000	)
Deferred comp – ISOP granted 10/8/08 and vested 50% 12/08		-				-			-				-			-				-				35,014				-				-				-				-				35,014
Amortization of deferred compensation		-				-			-				-			-				-				-				-				326,254				-				-				326,254
Cumulated preferred dividends		-				-			-				-			-				-				-				-				-				-				(82,550	)			(82,550	)
Write off of uncollectible receivable		-				-			-				-			-				-				(462,500	)			-				-				462,500				-				-
Interest on notes receivable		-				-			-				-			-				-				-				(19,763	)			-				-				-				(19,763	)
Net income																																								2,181,392				2,181,392
Balance, December 31, 2008		26,880				26,880			11,640				291,000			15,344,654				1,534,466				7,355,007				(564,928	)			(101,667	)			-				(12,879,955	)			(4,339,197	)
Issuance of common stock for consulting services		-				-			-				-			900,000				90,000				72,000				-				-				-				-				162,000
Issuance of common stock in connection with acquisition		-				-			-				-			5,000,000				500,000				400,000				-				-				-				-				900,000
Issuance of warrant in connection with acquisition		-				-			-				-			-				-				540,000				-				-				-				-				540,000
Cashless exercise of options and warrants		-				-			-				-			1,280,619				128,062				(35,662	)			-				-				-				-				92,400
Reclassification of non-employee options and warrants to derivative liabilities		-				-			-				-			-				-				(836,998	)			-				-				-				707,474				(129,524	)
Reclassification of non-employee options and warrants to equity		-				-			-				-			-				-				147,556				-				-				-				-				147,556
Reconciliation of outstanding common stock		-				-			-				-			(95,062	)			(9,506	)			9,506				-				-				-				-				-
Reclassification of derivative liabilities upon exercise of warrants		-				-			-				-			-				-				212,069				-				-				-				-				212,069
Reclassification of derivative liabilities to equity upon effectively fixing conversion feature and warrant price		-				-			-				-			-				-				11,938,285				-				-				-				-				11,938,285
Stock based compensation		-				-			-				-			-				-				365,520				-				-				-				-				365,520
Amortization of deferred compensation		-				-			-				-			-				-				-				-				72,498				-				-				72,498
Cumulative preferred dividends		-				-			-				-			-				-				-				-				-				-				254,675				254,675
Interest on notes receivable		-				-			-				-			-				-				-				(19,763	)			-				-				-				(19,763	)
Net loss		-				-			-				-			-				-				-				-				-				-				(14,920,862	)			(14,920,862	)
Balance, December 31, 2009		26,880			$	26,880			11,640			$	291,000			22,430,211			$	2,243,022			$	20,167,283			$	(584,691	)		$	(29,169	)		$	-			$	(26,838,668	)		$	(4,724,343	)

 

See accompanying notes to the consolidated financial statements

F-5

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NEW CENTURY COMPANIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For The Years Ended December 31, 2009 and 2008

		2009				2008
Cash flows from operating activities:
Net (loss) income		$	(14,920,862	)		$	2,181,392
Adjustments to reconcile net (loss) income to net cash used in by operating activities:
Depreciation and amortization			208,068				82,186
Bad debt recovery			-				(2,741	)
Gain on write-off of accounts payable			(21,899	)			(66,194	)
Gain on forgiveness of debt			-				(2,872,133	)
Loss on disposal of assets			253,303				-
Amortization of deferred financing cost			398,638				296,268
Amortization of stock-based consulting fees and employee compensation			72,498				233,254
Amortization of debt discount			3,763,992				1,280,067
Estimated fair value of common stock issued for consulting services and exercise of warrants			254,400				162,355
Estimated fair value of options issued to employees and consultants			365,520				35,014
Loss (gain) on valuation of derivative liabilities			7,426,840				(4,168,415	)
Interest accrued on notes receivable from stockholders			(19,763	)			(19,763	)
Warrants issued in connection with debt extension			80,000				-
Changes in operating assets and liabilities, net of acquisition:
Contracts receivable			211,273				203,830
Inventories			279,683				322,085
Costs and estimated earnings in excess of billings on uncompleted contracts			410,939				154,133
Prepaid expenses and other current assets			161,380				(154,485	)
Other assets			(151,790	)			-
Accounts payable and accrued liabilities			1,188,469				334,932
Billings in excess of costs and estimated earnings on uncompleted contracts			(1,238,499	)			1,300,323
Net cash used in operating activities			(1,277,810	)			(697,892	)
Cash flows from investing activities:
Purchases of property and equipment			(6,698	)			-
Proceeds received from acquisition			772				-
Net cash used in investing activities			(5,926	)			-
Cash flows from financing activities:
Bank overdraft			(7,814	)			(3,633	)
Proceeds from issuance of convertible notes payable			1,353,000				600,000
Proceeds from issuance of loan payable			150,000				-
Principal payments on notes payable to related parties			(10,679	)			-
Principal payments on notes payable and capital leases			(75,027	)			(148,315	)
Net cash provided by financing activities			1,409,480				448,052
Net increase (decrease) in cash			125,744				(249,840	)
Cash at beginning of year			31,889				281,729
Cash at end of year		$	157,633			$	31,889
Supplemental schedule of cash flow information:
Interest paid		$	10,443			$	-
Income taxes paid		$	5,929			$	-

Supplemental disclosure of non-cash financing and investing activities:
Accrued cumulative dividends on preferred stock		$	54,575			$	82,550
Reversal of accrued dividends on preferred stock		$	(309,250	)		$	-
Reclassification of accrued interest and penalties to notes payable		$	-			$	1,178,806
Reclassification of derivative liabilities to additional paid-in capital upon exercise of warrants		$	212,069			$	-
Cumulative effect to accumulated deficit due to reclassification of non-employee options and warrants to derivative liability		$	707,474			$	-
Reclassification of the estimated fair value of non-employee options and warrants to derivative liability		$	129,524			$	-
Reclassification of the estimated fair value of non-employee options and warrants from derivative liability to additional paid-in capital		$	147,556			$	-
Reclassification of the estimated fair value of embedded conversion feature and warrants from derivative liability to additional paid-in capital		$	11,938,285			$	-
Cashless exercise of stock options and warrants		$	70,138			$	-
Debt discount recorded on convertible notes payable, net of financing costs		$	1,088,695			$	-
Debt discount recorded on notes payable		$	108,101			$	-
Reconciliation of outstanding common stock		$	9,506			$	-
Estimated fair value of common stock issued in connection with acquisition		$	900,000			$	-
Estimated fair value of warrant issued in connection with acquisition		$	540,000			$	-
Note payable to related party issued in connection with acquisition		$	500,000			$	-
Stock and warrants issued for financing costs		$	-			$	36,000
CAMHZN non-cash debt modification		$	-			$	150,000
Derivative liabilities from 15% CAMHZN note		$	-			$	442,219
Derivative liabilities from amended 12% CAMOFI note		$	-			$	2,773,598

 

See accompanying notes to the consolidated financial statements

 

F-6

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1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Nature of Operations

New Century Companies, Inc., a Delaware corporation (“New Century”), was incorporated in Delaware on August 1, 1980. Its wholly owned subsidiary, New Century Remanufacturing Inc., a California corporation, was incorporated in March 1996 and is located in Southern California. On October 9, 2009, New Century entered into a share exchange agreement with Precision Aerostructures, Inc. (“PAI”) pursuant to which the sole shareholder of PAI agreed to transfer all capital stock of PAI to New Century (see Note 4).  Collectively, New Century and its wholly owned subsidiaries are referred to as the “Company”.  The Company provides after-market services, including rebuilding, retrofitting and remanufacturing of metal cutting machinery.  Once completed, a remanufactured machine is “like new” with state-of-the-art computers and the cost to the Company’s customer is substantially less than the price of a new machine.  Through PAI, the Company is also a world class supplier of complex structural airframe machined components and assemblies for commercial and military aircraft builders in the United States and around the world. PAI specializes in engineering and manufacturing of precision computerized numerical control (“CNC”) machined multiaxis structural aircraft components.

New Century currently sells its services by direct sales and through a network of machinery dealers across the United States.  Its customers are generally medium to large sized manufacturing companies in various industries where metal cutting is an integral part of their business.  New Century grants credit to its customers who are predominantly located in the western United States.

New Century trades on the Over-the-Counter Bulletin Board under the symbol “NCNC.”

Principles of Consolidation

The consolidated financial statements include the accounts of New Century Companies, Inc. and its wholly owned subsidiaries, New Century Remanufacturing, Inc. and PAI.  All significant intercompany accounts and transactions have been eliminated in consolidation.

Segments of an Enterprise and Related Information

The Company has adopted the authoritative guidance for disclosures about segments of an enterprise and related information. The guidance requires the Company to report information about segments of its business in annual financial statements and requires it to report selected segment information in its quarterly reports issued to stockholders.  The guidance also requires entity-wide disclosures about the products and services an entity provides, the material countries in which it holds assets and reports revenues and its major customers. The Company’s two reportable segments are managed separately based on fundamental differences in their operations.  At December 31, 2009, the Company operated in the following two reportable segments (see Note 13):

(a) CNC machine tool remanufacturing and

 

(b) Multiaxis structural aircraft components.

The Company evaluates performance and allocates resources based upon operating income. The accounting policies of the reportable segments are the same as those described in this summary of significant accounting policies.

Going Concern

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. As of December 31, 2009, the Company has an operating loss of $2,441,821, an accumulated deficit of approximately $26,839,000, working capital deficit of approximately $9,491,000 and had events of default on its CAMOFI and CAMHZN debt (see Note 6).   These factors raise substantial doubt about the Company's ability to continue as a going concern. The Company intends to fund operations through anticipated increased sales which management believes may be insufficient to fund its capital expenditures, working capital and other cash requirements for the year ending December 31, 2009. Therefore, the Company will be required to seek additional funds to finance its long-term operations in the form of debt and equity financing which the Company believes is available to it.  The successful outcome of future activities cannot be determined at this time and there is no assurance that if achieved, the Company will have sufficient funds to execute its intended business plan or generate positive operating results.

 

In response to these problems, management has taken the following actions:

 

	·	continued its aggressive program for selling its products;
	·	continued to implement plans to further reduce operating costs; and
	·	is seeking investment capital through the public and private markets.

The consolidated financial statements do not include any adjustments to the carrying amounts related to recoverability and classification of assets or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern.

Basis of Presentation

The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

 

F-7

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Use of Estimates

In the opinion of management, the accompanying consolidated balance sheets and related consolidated statements of operations, cash flows and stockholders’ deficit include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with GAAP.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting periods.  Significant estimates made by management are, among others, deferred tax asset valuation allowances, realization of inventories, collectibility of receivables, recoverability of long-lived assets, accrued warranty costs, payroll and income tax penalties, the valuation of conversion options, stock options and warrants and the estimation of costs for long-term construction contracts.  Actual results could differ from those estimates.

Concentrations of Credit Risks

Cash is maintained at various financial institutions. The Federal Deposit Insurance Corporation (“FDIC”) insures accounts at each financial institution for up to $250,000.  At times, cash may be in excess of the FDIC insured limit.  The Company did not have any uninsured bank balances at December 31, 2009 and 2008.  The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risks on cash.

The Company sells products to customers throughout the United States. The Company’s ability to collect receivables is affected by economic fluctuations in the geographic areas served by the Company.  Although the Company does not obtain collateral with which to secure its contract receivable, management periodically reviews contracts receivable and assesses the financial strength of its customers and, as a consequence, believes that the receivable credit risk exposure could, at times, be material to the consolidated financial statements.

 

The Company maintains an allowance for doubtful accounts for balances that appear to have specific collection issues. The collection process is based on the age of the invoice and requires attempted contacts with the customer at specified intervals. If, after a specified number of days, the Company has been unsuccessful in its collection efforts, a bad debt allowance is recorded for the balance in question. Delinquent accounts receivable are charged against the allowance for doubtful accounts once uncollectibility has been determined. The factors considered in reaching this determination are the apparent financial condition of the customer and the Company’s success in contacting and negotiating with the customer. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of ability to make payments, additional allowances may be required.

 

During the year ended December 31, 2009, sales to five customers approximated 65% of net sales.  Further, there were three customers that accounted for 77% of receivables.  

During the year ended December 31, 2008, sales to three customers accounted for approximately 38% of net sales, 16%, 14% and 8% respectively.  Further, there were two customers that accounted for 76% of receivables, the customer that accounted for 16% of sales also accounted for 40% of the receivables at December 31, 2008. Another customer accounted for 36% of receivables but was not in the top three largest customers for the year. No other single customer had net sales of more than 10% of total net sales for the year ended December 31, 2008.

Management reviews the collectibility of receivables periodically and believes that the allowance for doubtful accounts for year ended December 31, 2009 and 2008 is adequate. The allowance for doubtful accounts was $0 and $24,000 for the years ended December 31, 2009 and 2008, respectively.

F-8

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Risks and Uncertainties

The Company operates in industries that are subject to intense competition.  The Company's operations are subject to significant risks and uncertainties including financial, operational, technological and other risks associated with operating a business including the potential risk of business failure.

Cash and Cash Equivalents

The Company considers all highly liquid fixed income investments with maturities of three months or less at the time of purchase, to be cash equivalents. The Company had no cash equivalents at December 31, 2009 and 2008.

Inventories

At		Inventory Cost (thousands)				Direct Labor (thousands)				Direct Material (thousands)				Subcontractors (thousands)				Allocation or Indirect Overhead (thousands)
12/31/2008		$	1,097			$	107			$	568			$	45			$	377

Property and Equipment

Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful lives of the related assets ranging from three to five years.  Equipment under capital leases are depreciated over the shorter of the estimated useful life or the term of the lease.  Maintenance and repairs are charged to expense as incurred.  Significant renewals and betterments are capitalized. At the time of retirement or other disposition of property and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in the consolidated statement of operations. For the years ended December 31, 2009 and 2008, the Company incurred depreciation expense of approximately $155,000 and $82,000, respectively.

F-9

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Business Combinations and Intangible Assets Including Goodwill

Business combinations are accounted for using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entities are recorded at their estimated fair values at the acquisition date.  Goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets.  Obtaining information needed to finalize the fair value of the acquired assets and liabilities takes time and frequently occurs over several quarters.  Accordingly, it is common for initial fair value estimates to be subsequently revised.  The results of operations of acquired businesses are included in the Company’s consolidated financial statements from the acquisition date.

Identifiable intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives.  They are reviewed for impairment if indicators of potential impairment exist.  Goodwill is tested for impairment on an annual basis.

Impairment of Other Long-Lived Assets

The Company evaluates other long-lived assets held and used by the Company for impairment whenever events or changes in circumstances indicate that their net book value may not be recoverable.  When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. The Company's management believes there is no impairment of long-lived assets as of December 31, 2009. There can be no assurance, however, that market conditions will not change or demand for the Company's products will continue, which could result in future impairment of long-lived assets.

Revenue Recognition

 

The Company's revenues consist primarily of contracts with customers. The Company uses the percentage-of-completion method of accounting to account for long-term contracts pursuant to U.S. accounting standards, and, therefore, takes into account the cost, estimated earnings and revenue to date on fixed-fee contracts not yet completed. The percentage-of-completion method is used because management considers total cost to be the best available measure of progress on the contracts. Because of inherent uncertainties in estimating costs, it is at least reasonably possible that the estimates used will change within the near term.

 

F-10

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For contracts, the amount of revenue recognized at the consolidated financial statement date is the portion of the total contract price that the cost expended to date bears to the anticipated final cost, based on current estimates of cost to complete. Contract costs include all materials, direct labor, machinery, subcontract costs and allocations of indirect overhead.

Because contracts may extend over a period of time, changes in job performance, changes in job conditions and revisions of estimates of cost and earnings during the course of the work are reflected in the accounting period in which the facts that require the revision become known. At the time a loss on a contract becomes known, the entire amount of the estimated ultimate loss is recognized in the consolidated financial statements.

Contracts that are substantially complete are considered closed for financial statement purposes. Costs incurred and revenue earned on contracts in progress in excess of billings (under billings) are classified as a current asset. Amounts billed in excess of costs and revenue earned (over billings) are classified as a current liability.

For revenues from stock inventory the Company follows U.S accounting standards, which outline the basic criteria that must be met to recognize revenue other than revenue on contacts, and provides guidance for presentation of this revenue and for disclosure related to these revenue recognition policies in financial statements filed with the Securities and Exchange Commission (“SEC”).

The Company accounts for shipping and handling fees and costs in accordance with U.S accounting standards. Shipping and handling fees and costs incurred by the Company are immaterial to the operations of the Company and are included in cost of sales.

In accordance with U.S. accounting standards, revenue is recorded net of an estimate for markdowns and price concessions. Such reserve is based on management's evaluation of historical experience, current industry trends and estimated costs. As of December 31, 2009, the Company estimated the markdowns and price concessions and concluded amounts are immaterial and did not record any adjustment to revenues.

F-11

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Warranty

The Company provides a warranty on certain products sold.  Estimated future warranty obligations related to certain products and services are provided by charges to operations in the period in which the related revenue is recognized.  At December 31, 2009 and 2008, the warranty obligation balance was approximately $137,000 and $50,000, respectively.  Amounts charged to warranty expense in the accompanying consolidated statements of operations was approximately $153,000 and $147,000 for the years ended December 31, 2009 and 2008, respectively.

Advertising

The Company expenses the cost of advertising when incurred as selling expense in the accompanying consolidated statements of operations.  Advertising expenses were approximately $3,000 and $0 for the years ended December 31, 2009 and 2008, respectively.

Research and Development Costs

Research and development costs are expensed as incurred.  During the years ended December 31, 2009 and 2008, the Company did not incur any research and development costs.

Income Taxes

 

The Company records deferred tax assets and liabilities on its consolidated balance sheets to reflect the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and tax bases of the Company’s assets and liabilities result in a deferred tax asset,.  The Company is required to perform an evaluation of the probability of being able to realize the future benefits indicated by such assets. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. A full valuation allowance for deferred tax assets has been provided at December 31, 2009 and 2008. The valuation allowance approximates $13,540,000 and $6,929,000 as of December 31, 2009 and 2008, respectively. See Note 8 for additional information.

Basic and Diluted Loss (Income) Per Common Share

Basic net (loss) income per share is computed by dividing net (loss) income by the weighted average number of common shares outstanding for the period. Diluted net (loss) income per share is computed by dividing net (loss) income by the weighted average number of common shares and dilutive common stock equivalents outstanding for each respective year.

Common stock equivalents, representing convertible Preferred Stock, convertible debt, options and warrants totaling approximately 141,347,000 shares at December 31, 2009 are not included in the diluted loss per share as they would be anti-dilutive.

Common stock equivalents, representing convertible Preferred Stock, convertible debt, options and warrants totaling approximately 62,101,548 shares at December 31, 2008 are included in the diluted income per share (see Note 10).

 

F-12

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Stock Based Compensation

 

The Company uses the fair value method of accounting for employee stock compensation cost. Share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period. The Company had no equity incentive awards granted prior to January 1, 2006 that were not yet vested.  For the years ended December 31, 2009 and 2008, share-based compensation expense of $365,520 and $35,014 was recognized in consulting and other compensation in the accompanying consolidated statements of operations.

From time to time, the Company's Board of Directors grants common share purchase options or warrants to selected directors, officers, employees, consultants and advisors in payment of goods or services provided by such persons on a stand-alone basis outside of any of the Company's formal stock plans. The terms of these grants are individually negotiated and generally expire within five years from the grant date.

Under the terms of the Company's 2000 Stock Option Plan, options to purchase an aggregate of 5,000,000 shares of common stock may be issued to officers, key employees and consultants of the Company. The exercise price of any option generally may not be less than the fair market value of the shares on the date of grant. The term of each option generally may not be more than five years.

 

F-13

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In accordance with U.S. accounting standards, the Company’s policy is to adjust share-based compensation on a quarterly basis for changes to the estimate of expected award forfeitures based on actual forfeiture experience.

The fair value of stock-based awards to employees and directors is calculated using the Black-Scholes option pricing model, even though the model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restriction, which differ significantly from the Company's stock options. The Black-Scholes model also requires subjective assumptions regarding future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. The expected volatility is based on the historical volatility of the Company’s common stock. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.

 

The Company accounts for transactions involving services provided by third parties where the Company issues equity instruments as part of the total consideration using the fair value of the consideration received (i.e. the value of the goods or services) or the fair value of the equity instruments issued, whichever is more reliably measurable. In transactions when the value of the goods and/or services are not readily determinable, the fair value of the equity instruments is more reliably measurable and the counterparty receives equity instruments in full or partial settlement of the transactions, the Company uses the following methodology:

a) For transactions where goods have already been delivered or services rendered, the equity instruments are issued on or about the date the performance is complete (and valued on the date of issuance).

b) For transactions where the instruments are issued on a fully vested, non-forfeitable basis, the equity instruments are valued on or about the date of the contract.

c) For any transactions not meeting the criteria in (a) or (b) above, the Company re-measures the consideration at each reporting date based on its then current stock value.

From time to time, the Company issues warrants to employees and to third parties pursuant to various agreements, which are not approved by the shareholders.

 

Deferred Financing Costs

 

Direct costs of securing debt financing are capitalized and amortized over the term of the related debt. When a loan is paid in full, any unamortized financing costs are removed from the related accounts and charged to operations. During the years ended December 31, 2009 and 2008, the Company amortized approximately $399,000 and $296,000, respectively, of deferred financing costs to interest expense.

F-14

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Fair Value Measurements

U.S. accounting standards require disclosure of a fair-value hierarchy of inputs the Company uses to value an asset or a liability. The three levels of the fair-value hierarchy are described as follows:

Level 1: Quoted prices (unadjusted) in active markets for identical assets and liabilities. For the Company, Level 1 inputs include quoted prices on the Company’s securities that are actively traded.

Level 2: Inputs other than Level 1 that are observable, either directly or indirectly. For the Company, Level 2 inputs include assumptions such as estimated life, risk free rate and volatility estimates used in determining the fair values of the Company’s option and warrant securities issued.

Level 3: Unobservable inputs for the asset or liability. Beginning January 1, 2009, Level 3 inputs may be required for the determination of fair value associated with certain nonrecurring measurements of nonfinancial assets and liabilities. The Company does not currently present any nonfinancial assets or liabilities at fair value.

Determining which category an asset or liability falls within the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter.  Liabilities measured at fair value on a recurring basis are summarized as follows:

		Level 1				Level 2				Level 3				December 31, 2009
Fair value of derivative liability		$	-			$	-			$	48,378			$	48,378
Total		$	-			$	-			$	48,378			$	48,378

 

The Company has no assets that are measured at fair value on a recurring basis. There were no assets or liabilities measured at fair value on a non-recurring basis during the year ended December 31, 2009.

Accounting for Derivative Instruments

In connection with the issuance of certain convertible notes payable (see Note 6), the notes had conversion features that the Company determined were embedded derivative instruments. The accounting treatment of derivative financial instruments requires that the Company record the derivatives and related warrants at their fair values as of the inception date of the note agreements and at fair value as of each subsequent balance sheet date. During the third quarter of 2009, as a result of entering into the 2009 debenture agreements and subsequent 2009 amendments, the Company did not have a sufficient number of authorized shares to settle outstanding and exercisable options, warrants, and convertible instruments. Therefore, the Company was required to reclassify all non-employee options and warrants as derivative liabilities and record them at their fair values.  The non-employee warrants and stock options were initially valued at $836,998 and recorded as additional paid-in capital.  The $707,474 difference between the derivative liability of $129,524 and the $836,998 amount recorded in additional paid-in capital was recorded as a cumulative retained earnings adjustment.  On December 22, 2009, the Company amended Article IV of their Certificate of Incorporation, to increase the shares of common stock that are authorized for issuance by 200,000,000 shares, bringing the total number of common shares authorized for issuance to 250,000,000 (see Note 9).  The Company reclassified all non-employee options and fixed-price warrants recorded as derivative liabilities to equity at their then fair values because there were sufficient authorized shares to settle outstanding options, warrants and convertible instruments.  Upon valuation at December 22, 2009, the fair value of the non-employee options and fixed-price warrants was $147,556 which was recorded as additional paid-in capital.  The change from the initial derivative liability valuation of $104,395 was recorded as a loss on valuation of derivative liabilities in the accompanying consolidated statement of operations.

For all of the derivative instruments, any change in fair value is recorded as non-operating, non-cash income or expense at each balance sheet date. If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company recorded a non-operating, non-cash charge. If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company recorded non-operating, non-cash income.

As discussed in Note 6, effective December 31, 2009, CAMOFI and CAMHZN removed the variability of the conversion feature of their notes, fixing the conversion price at the then conversion price of $0.04 per share.  In addition, CAMOFI and CAMHZN also removed the variability of the exercise price of their outstanding warrants.  As a result, the fair values of the variable conversion feature ($11,190,904) of the notes and the related warrants ($747,381) were reclassified to additional paid-in capital on December 31, 2009.

During the years ended December 31, 2009 and 2008, the Company recognized other income (expense) of $(7,426,840) and $4,168,415, respectively, related to recording derivative liabilities at fair value.  At December 31, 2009 and 2008, the derivative liability balance was $48,378 and $1,975,298, respectively.

F-15

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Warrant-related and conversion-related derivatives were valued using the Black-Scholes Option Pricing Model with the following assumptions during the year ended December 31, 2009: dividend yield of 0%; volatility ranging from 177% to 669% and risk free interest rates ranging from 0.16% to 3.39%.

The following table summarizes the activity related to the derivative liability during the year ended December 31, 2009:

 

Derivative liability – December 31, 2008		$	1,975,298
Derivative liability added for reclassification from accrued liabilities			50,000
Derivative liability added for warrants issued in connection with debt modification			80,000
Derivative liability added for convertible debt issued			2,684,626
Derivative liability added for reclassification of warrants from equity			129,524
Derivative liability reduced for reclassification of warrants to equity			(147,556	)
Derivative liability reduced for warrants exercised and reclassified to additional paid-in capital			(212,069	)
Derivative liability reduced for reclassification of conversion feature of notes and related
warrants to equity			(11,938,285	)
Change in fair value of derivative liability			7,426,840
Total derivative liability – December 31, 2009		$	48,378

 

F-16

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Subsequent Events

The Company has evaluated subsequent events through the filing date of this Form 10-K, and determined that no subsequent events have occurred that would require recognition in the consolidated financial statements or disclosure in the notes thereto other than as discussed in the accompanying notes.

Significant Recent Accounting Pronouncements

In the third quarter of 2009, the Financial Accounting Standards Board (“FASB”) issued the FASB Accounting Standards Codification (the “Codification”). The Codification is the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in preparation of financial statements in conformity with GAAP. All accounting guidance that is not included in the Codification will be considered to be non-authoritative. The FASB will issue Accounting Standard Updates (“ASUs”), which will serve only to update the Codification, provide background information about the guidance and provide the basis for conclusions on changes in the Codification. ASUs are not authoritative in their own right. The Codification does not change GAAP and did not have an effect on the Company’s financial position or results of operations.

In January 2010, the FASB issued an update to its accounting guidance regarding fair value measurement and disclosure. The guidance affects the disclosures made about recurring and non-recurring fair value measurements. This guidance is effective for annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010. Early adoption is permitted. The Company is currently evaluating the impact that this guidance will have on its consolidated financial statements.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not or are not believed by management to have a material impact on the Company’s present or future consolidated financial statements.

2. CONTRACTS IN PROGRESS

Contracts in progress which include completed contracts not completely billed approximate the following as of December 31, 2009 and 2008:

 

		December 31,				December 31,
		2009				2008
Cumulative costs to date		$	3,166,000			$	6,756,000
Cumulative gross profit to date			2,611,000				5,768,000
Cumulative revenue earned			5,777,000				12,524,000
Less progress billings to date			(5,921,000	)			(13,495,000	)
Net (over)/under billings		$	(144,000	)		$	(971,000	)

 

The following approximate amounts are included in the accompanying consolidated balance sheets under these captions as of December 31, 2009 and 2008:

		December 31,				December 31,
		2009				2008
Costs and estimated earnings in excess of billings on uncompleted contracts		$	6,000			$	417,000
Billings in excess of costs and estimated earnings on uncompleted contracts			(150,000	)			(1,388,000	)
Net over billings		$	(144,000	)		$	(971,000	)

 

F-17

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3. PROPERTY AND EQUIPMENT

Property and equipment approximate the following at December 31, 2009 and 2008:

 

		December 31,				December 31,
		2009				2008
Machinery and equipment		$	1,265,000			$	907,000
Leased vehicles			181,000				109,000
Computer equipment			36,000				20,000
Furniture and fixtures			5,000				4,000
			1,487,000				1,040,000
Less accumulated depreciation and amortization			(770,000	)			(853,000	)
		$	717,000			$	187,000

 

Assets under capital leases are comprised of equipment purchases aggregating to $834,000 and $109,000 at December 31, 2009 and 2008, respectively.  Depreciation expense recorded for these assets under capital leases amounted to $81,670 and $21,835 for the years ended December 31, 2009 and 2008, respectively.

 

F-18

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4. ACQUISITION OF PRECISION AEROSTRUCTURES, INC

On October 9, 2009, the Company entered into a Share Exchange Agreement (the “Share Exchange Agreement”) with PAI and Michael Cabral (“Cabral”) pursuant to which Cabral, as the sole shareholder of PAI, agreed to transfer to the Company, and the Company agreed to acquire from Cabral, all of the capital stock of PAI (the “PAI Shares”) in exchange for 5,000,000 shares of the Company’s common stock (the “NCCI shares”) with an acquisition-date fair value of $900,000 and the delivery of promissory note of the Company (the “Note”) in the principal amount of $500,000 payable from the proceeds of any equity financing with gross proceeds of at least $2,000,000 provided that the investors in such financing permit the proceeds thereof  to be used for such purpose (see Note 12).

Additionally, at such time (the “Vesting Date”) as the cumulative net income of PAI is at least $3,000,000 for the period commencing on January 1, 2010 and ending on October 9, 2012 the Company will issue to Cabral warrants (“Warrants”) to purchase 3,000,000 shares of Company common stock.  The Warrants will be for a term of the earlier of three years from the Vesting Date or January 1, 2014, and shall have an exercise price of $0.10 per share.  The Warrant vests immediately on the Vesting Date and the estimated acquisition-date fair value of the Warrants was $540,000 (based on the Black-Scholes option pricing model).

The Company acquired PAI to position itself for growth in the aerospace business, which is projected to grow at a 5% compounded annual rate for the next 20 years.  PAI complements the Company’s machining capabilities in an industry that shows more growth in comparison to machine tooling.

The terms of the purchase were the result of arms-length negotiations.  There is no material relationship between the Company, on the one hand, and PAI or Cabral, on the other hand. 

The purchase price has been determined as follows:

 

Common stock		$	900,000
Promissory note			500,000
Warrants to purchase 3,000,000 shares at $0.10 per share			540,000
		$	1,940,000

 

The following represents an allocation of the purchase price over the acquisition-date fair value of the acquired assets and liabilities of PAI as of October 1, 2009, the effective date of the acquisition:

 

Cash		$	772
Accounts receivable			44,606
Prepaid expenses and other current assets			450
Deferred financing costs			10,220
Property and equipment			931,060
Accounts payable and accrued expenses			(1,961,453	)
Capital lease obligations			(772,380	)
Notes payable to related parties			(49,785	)
Notes payable and accrued interest			(122,611	)
Net tangible liabilities assumed			(1,919,121	)
Identifiable intangibles:
Customer relationships			1,500,000
Deferred tax liability			-
Goodwill			2,359,121
		$	1,940,000

 

F-19

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The Company recorded approximately $5,000 in acquisition-related costs which was included in selling, general and administrative in the accompanying consolidated statements of operations.   The fair values assigned to identifiable intangible assets acquired were based on estimates and assumptions determined by management.  The fair values of the customer relationships were determined using an income approach.  The amount of goodwill deductible for income tax purposes approximates $0.  Following the acquisition, the Company is reporting PAI's results of operations as a new segment.

The pro forma combined historical results, as if PAI had been acquired as of January 1, 2009 and 2008, are estimated as follows (unaudited):

 

		Year Ended
		December 31,				December 31,
		2009				2008
Net sales		$	4,431,291			$	8,225,099
Net loss		$	(15,101,622	)		$	(463,861	)
Weighted average common share outstanding:
Basic and diluted			20,630,509				19,696,227
Loss per share:
Basic and diluted		$	(0.73	)		$	(0.02	)

 

The pro forma information has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisition actually been made at such date, nor is it necessarily indicative of future operating results.

 

5.  GOODWILL AND OTHER INTANGIBLE ASSETS

 

Goodwill represents the excess of acquisition cost over the net assets acquired in a business combination and is not amortized.  The Company allocates its goodwill to its various reporting units, determines the carrying value of those businesses, and estimates the fair value of the reporting units so that a two-step goodwill impairment test can be performed.  In the first step of the goodwill impairment test, the fair value of each reporting unit is compared to its carrying value.  Management reviews, on an annual basis, the carrying value of goodwill in order to determine whether impairment has occurred.  Impairment is based on several factors including the Company's projection of future undiscounted operating cash flows. If an impairment of the carrying value were to be indicated by this review, the Company would perform the second step of the goodwill impairment test in order to determine the amount of goodwill impairment, if any.

 

The changes in the carrying amount of goodwill for the year ended December 31, 2009 are as follows:

 

Balance, January 1, 2009		$	-
Goodwill of PAI acquired (see Note 4)			2,359,121
Balance, December 31, 2009		$	2,359,121

 

The Company performed an impairment test on goodwill as of December 31, 2009.  Based on its analysis as of December 31, 2009, the Company's management believes there is no impairment of its goodwill.  There can be no assurance, however, that market conditions will not change or demand for the Company's products or services will continue, which could result in impairment of goodwill in the future.

 

Identifiable intangibles acquired in connection with business acquisitions are recorded at their respective fair values.  Deferred income taxes have been recorded to the extent of differences between the fair value and the tax basis of the assets acquired and liabilities assumed. 

 

Other intangible assets consist of the following as of December 31, 2009: 

 

		Estimated Useful Life (Years)		Gross Carrying Amount				Accumulated Amortization				Net Carrying Amount
Customer relationships		Seven		$	1,500,000			$	(53,571	)		$	1,446,429

 

Amortization of other intangible assets was $53,571 for the year ended December 31, 2009.

 

 The estimated amortization expense for the next five years approximates:

 

For The Years Ending December 31,
2010		$	214,000
2011			214,000
2012			214,000
2013			214,000
2014			214,000
Thereafter			376,000
		$	1,446,000

 

F-20

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6. CONVERTIBLE NOTES PAYABLE

CAMOFI and CAMHZN 12% and 15% Senior Secured Convertible Debt

On February 28, 2006, the Company issued a 12% Senior Secured Convertible Promissory Note (“CAMOFI Note”) to CAMOFI Master LDC (“CAMOFI”) in the amount of $3,500,000 and was due February 20, 2009.  The CAMOFI Note contained an anti-dilution provision concerning convertibility that reduces the conversion price for any and all equity or convertible equity instruments issued that have a conversion price less than the CAMOFI Note (“anti-dilution provision”). Consequently the variable conversion feature does not allow the CAMOFI Note to be considered conventional convertible debt.  In accordance with the FASB Accounting Standards Codification ("ASC") Topic 815, Derivatives & Hedging (“ASC Topic 815”), the embedded conversion option is required to be treated as a derivative and separated from the contract. Further, the CAMOFI Note also contains a buy-in provision for conversion shares which could require a net cash settlement. The convertibility and buy-in provisions required that the conversion option be classified as a liability. The conversion option was valued at $3,502,664 on February 26, 2006 and recorded as a liability.

The conversion option was marked-to-market on a quarterly basis and the resulting change in fair value of the liability was recorded as a gain or loss upon valuation in the consolidated statement of operations.  For the period ended June 26, 2008, the Company recorded on the valuation a gain of $1,667,074 which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statement of operations. The initial conversion option fair value is also treated as a discount to the CAMOFI Note and is amortized over the life of the Note. As of June 26, 2008, $1,094,311 was amortized to interest expense in the accompanying consolidated statements of operations.

Amendment to CAMOFI Notes

As of June 26, 2008 an aggregate of $3,800,890 principal, interest and penalties were due under the note.

 

Pursuant to a letter agreement dated June 26, 2008 (the “Letter Agreement”) between the Company and CAMOFI, CAMOFI agreed to waive certain penalties and default interest which had been accrued under the transaction documents previously entered into with CAMOFI, including the CAMOFI Note in the original principal amount of $3,500,000, Security Agreement, an Amended and Restated Registration Rights Agreement, and a Subsidiary Guaranty. The waiver is subject to the Company’s performance of its obligations under the Letter Agreement and the execution of further documentation to be prepared in connection with the Letter Agreement. Pursuant to the Letter Agreement, the Company issued an amended and restated Note (the “CAMOFI Amended Note”) in the principal amount of $2,950,000 with a new maturity date of August 1, 2010. The note is secured by all of the assets of the Company.

Additionally, under the Letter Agreement, the Company issued 725,000 shares of common stock and 725,000 five year warrants with an exercise price of $0.10 per share and 725,000 five year warrants with an exercise price of $0.20 share (See “Stock Purchase Warrants Issued and Cancelled in Connection with the CAMOFI Note” below). Commencing on August 1, 2008, and continuing thereafter on the first business day of every month for the next twenty-four months, the Company has the obligation to pay to CAMOFI the amount of $70,000, allocated first to the payment of interest and second to the payment of principal on the CAMOFI Amended Note. On or before August 1, 2010, the Company shall pay to CAMOFI all amounts still outstanding under the Amended Note, whether of principal, interest or otherwise.

F-21

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The transaction for the exchange of the CAMOFI Amended Note for the original CAMOFI Note is treated as an extinguishment of debt.  ASC Topic 470, Debt (“ASC Topic 470”), requires that an exchange of debt with substantially different terms is an extinguishment of debt and should be accounted for in accordance with ASC Topic 860, Transfers and Servicing (“ASC Topic 860”).  ASC Topic 860 permits derecognition of the liability if and only if it has been extinguished if the debtor pays the creditor and is relieved of its obligation or the debtor is legally released from being the primary obligor under the liability either judicially or by the creditor.  Per the Amended CAMOFI Note and the Letter Agreement dated June 26, 2008, the Company has been released from its obligation under the original 12% Convertible Note Agreement. In accordance with ASC Topic 470, the Company evaluated the change in cash flows and determined there was a greater than 10% change and therefore treatment as debt extinguishment was applicable.  A gain on extinguishment of $2,872,133 was recorded on June 26, 2008 primarily due to the extinguishment of accrued penalties and interest of $850,000 and extinguishment of the warrant and conversion option derivative liabilities of $347,460.

The CAMOFI Amended Note contained the same anti-dilution provision and buy-in features which were present in the CAMOFI Note and therefore the embedded conversion option is treated as a derivative liability and separated from the contract. The liability was valued at $2,535,393 on June 26, 2008. The Black Scholes model was used and the assumptions were: $0.11 closing stock price, $0.10 exercise price, 2.21% risk free rate, 163.91% volatility and no dividends.

As discussed in Note 1, CAMOFI removed the anti-dilution provision effective December 31, 2009.  Prior to removing the feature, the conversion price decreased to $0.04 and $0.07 at December 31, 2009 and 2008, respectively.  As of December 31, 2009 and 2008, the fair value of the conversion option derivative liability was determined to be $6,242,938 and $1,515,634, respectively.  As a result of the removal of the anti-dilution provision, the fair value of the conversion option was reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the derivative liability that resulted in a loss of $4,727,304, which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations. The initial conversion option value is also treated as a discount to the CAMOFI Amended Note and is amortized over the life of the Note. For the year ended December 31, 2009 and period June 26, 2008 to December 31, 2008, $1,216,989 and $625,397, respectively, was amortized to interest expense in the accompanying consolidated statements of operations. As of December 31, 2009, the unamortized balance of debt discount for the conversion option is approximately $693,000.

Stock Purchase Warrants Issued and Cancelled in Connection with the CAMOFI Note

 

In February 2006, the Company granted warrants in connection with the issuance of the CAMOFI Note.  The warrants have an exercise feature that is the same as the anti-dilution provision in the CAMOFI Note and also has the buy-in feature (See, “CAMOFI Master LDC (“CAMOFI”) Debt”). Consequently, the warrants are also treated as derivative liabilities. The fair value of the warrants in February 2006 was $2,190,000.

For the period ended June 26, 2008, the Company recorded on the valuation a gain of $1,043,112 which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statement of operations. The initial warrant liability fair value is also treated as a discount to the CAMOFI Note and is amortized over the life of the Note. As of June 26, 2008, $503,784 was amortized to interest expense in the accompanying consolidated statements of operations.

Amendment to CAMOFI Note and Warrants

As part of the June 26, 2008 amendment to the CAMOFI Note, CAMOFI cancelled 3,476,190 warrants with a term of five years, which were issued on February 28, 2006 with an exercise price at issuance of $0.63 per share and 1,500,000 warrants dated December 19, 2006 with an exercise price at issuance of $0.35 per share. The fair value of such warrants on June 26, 2008 was approximately $530,000, based on the Black-Scholes pricing model and was recorded as gain on forgiveness of debt in the accompanying consolidated statement of operations.  Further, the Company issued 725,000 warrants exercisable at $0.10 per share and 725,000 warrants exercisable at $0.20 per share. The new warrants contained the anti-dilution and buy-in provisions of the original warrants and thus were also derivative liabilities. The value of the warrants on June 26, 2008 was $158,455. The Black Scholes model was used and the assumptions were: $0.11 closing stock price, $0.10 exercise price, 2.21% risk free rate, 187.01% volatility and no dividends.

 

F-22

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As discussed in Note 1, CAMOFI removed the anti-dilution provision effective December 31, 2009.  Prior to removing the feature, the exercise price decreased to $0.04 and $0.07 at December 31, 2009 and 2008, respectively.  The decrease in the exercise price adjusted the total warrants to 5,625,000 and 3,214,286 at December 31, 2009 and 2008, respectively.  As of December 31, 2009 and 2008, the fair value of the warrant derivative liability was determined to be $493,780 and $151,400, respectively.  As a result of the removal of the anti-dilution provision, the fair value of the warrants was reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the derivative liability that resulted in a loss of $437,686, which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations. The initial warrant liability fair value was also treated as a discount to the CAMOFI Amended Note and was amortized over the life of the Note. For the years ended December 31, 2009 and December 31, 2008, $80,555 and $39,086, respectively, was amortized to interest expense in the accompanying consolidated statements of operations. As of December 31, 2009, the unamortized balance of debt discount for the warrants issued is approximately $39,000.

Stock Issued in Connection with the restructuring of CAMOFI Note

In connection with the Letter Agreement dated June 26, 2008, the Company issued to CAMOFI 725,000 shares of common stock. The common shares were valued at $79,750 at issuance date, when the closing price was of $0.11 per share. This has been accounted for as a discount to the note and an increase in common stock and APIC. The discount amount from the shares is amortized to interest expense over the remaining life of the Notes.  Approximately $38,000 and $20,000 of debt discount was amortized during the years ended December 31, 2009 and 2008, respectively. As of December 31, 2009, the unamortized balance of debt discount for the stock issued is approximately $22,000.

For the year ended December 31, 2008, $122,719 of principal payments were made on the CAMOFI Note. As of December 31, 2009 and 2008, the principal balance is approximately $2,834,000 and $2,827,000, respectively, which is presented in the accompanying consolidated balances net of unamortized debt discounts totaling approximately $754,000 and $2,089,443, respectively.

CAMHZN Master LDC (“CAMHZN”) Convertible Debt

 

On August 8, 2008, the Company issued a 15% Senior Secured Convertible Promissory Note (“CAMHZN Note”) to CAMHZN Master LDC (“CAMHZN”) in the principal amount of $600,000, with a maturity date of August 1, 2010, and a conversion price of $0.07. The note is secured by all of the assets of the Company.

Additionally, the Company granted 1,000,000 seven year warrants with an exercise price of $0.07 to CAMHZN Master LDC (“CAMHZN Warrants”). 

The CAMHZN Note contains the same anti-dilution provision and buy-in features which are present in the CAMOFI Note and therefore the embedded conversion option is treated as a derivative liability and separated from the contract.  The liability was valued at $380,463 on August 8, 2008. The Black Scholes model was used and the assumptions were: $0.062 closing stock price, $0.07 exercise price, 4.04% risk free rate, 216% volatility and no dividends.

As discussed in Note 1, CAMHZN removed the anti-dilution provision effective December 31, 2009.  Prior to removing the feature, the conversion price decreased to $0.04 at December 31, 2009.  As of December 31, 2009, the fair value of the conversion option derivative liability was determined to be $1,656,080.  As a result of the removal of the anti-dilution provision, the fair value of the conversion option was reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the derivative liability that resulted in a loss of $1,347,816, which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations. The initial conversion option value was also treated as a discount to the CAMHZN Amended Note and is amortized over the life of the Note.  For the years ended December 31, 2009 and 2008, $190,232 and $79,263, respectively, was amortized to interest expense in the accompanying consolidated statements of operations.

 

F-23

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Stock Purchase Warrants Issued in connection with CAMHZN Convertible Note Payable

 

The CAMHZN Warrants have an exercise feature that is the same as the anti-dilution provision in the CAMOFI Warrants and CAMOFI Note and also has the buy-in feature (See, “CAMOFI Master LDC (“CAMOFI”) Debt”). Consequently, the warrants are also treated as derivative liabilities. The fair value of the warrants as of August 8, 2008 was $61,756.  The fair value of the warrants was determined based on the Black-Scholes pricing model using the following assumptions:  closing stock price $0.07 per share, exercise price of $0.07 estimated life 7 years, risk free rate 4.04% and volatility 216%.

As discussed in Note 1, CAMHZN removed the anti-dilution provision effective December 31, 2009.  Prior to removing the feature, the exercise price decreased to $0.04 at December 31, 2009.  The decrease in the exercise price adjusted the total warrants to 1,750,000 at December 31, 2009.  The Company reclassified the fair value of the warrant at December 31, 2008 from accrued liabilities to derivative liability during the current year.  As of December 31, 2009, the fair value of the warrant derivative liability was determined to be $153,601.  As a result of the removal of the anti-dilution provision, the fair value of the warrants was reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the derivative liability that resulted in a loss of $134,001, which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations. 

The initial CAMHZN Warrants derivative liability represents a discount from the face amount of the notes payable. Such discounts are amortized to interest expense over the term of the note. During the years ended December 31, 2009 and 2008, the Company amortized approximately $33,000 and $13,000, respectively, to interest expense in the accompanying consolidated statements of operations.

Amendment to the Warrant Agreement

On December 30, 2008, the Company entered into an amended agreement with the warrant holder, CAMHZN Master LDC, whereby the warrant holder agreed to waive its Registration Rights for a fee of $150,000. Such fee was added to the outstanding balance of the 15% Convertible Promissory Note. The Company recorded the $150,000 as deferred financing fees and is amortizing it over the remaining maturity of the CAMHZN Note.  During the year ended December 31, 2009 and 2008, the Company amortized $94,737 and $0, respectively to interest expense in the accompanying consolidated statements of operations.

As of December 31, 2009, the principal balance of the CAMHZN Note is $750,000, which is presented in the accompanying consolidated balances sheets net of unamortized debt discount of approximately $127,000.

As of December 31, 2008, the principal balance of the CAMHZN Note is $701,000, which is presented net of unamortized debt discount of approximately $49,000, respectively.

During the year ended December 31, 2009, the Company amortized $46,151 in deferred financing fees related to the CAMOFI and CAMHZN notes to interest expense in the accompanying consolidated statements of operations.

The last monthly contractual payment on the CAMOFI note was made in October 2008 and no payments have made on the CAMHZN Note which were scheduled to begin on September 1, 2008.  As a result, these are events of default under the terms of the agreement. Under the terms of the agreement, if any event of default occurs, the full principal amount of the note, together with interest and other amounts owing in respect thereof, to the date of acceleration shall become, at the note holder’s election, immediately due and payable in cash. The note holders have yet to elect to exercise the following provision.

 

F-24

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CAMOFI AND CAMHZN Senior Secured Convertible Debt 83.42857% of face amount.

On February 18, 2009, the Company entered into an agreement with CAMOFI for the issuance of a Senior Secured Convertible Note for $701,200 (the “February CAMOFI Note”), maturing on August 18, 2009. The Note can be converted at $0.07 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

On February 18, 2009, the Company entered into an agreement with CAMHZN for the issuance of a Senior Secured Convertible Note for $173,800 (the “February CAMHZN Note”) maturing on August 18, 2009. The Note can be converted at $0.07 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

Per ASC Topic 815, the conversion option is a derivative liability. The Company recorded at issuance a $384,460 derivative liability for the February CAMOFI Note, and a $95,292 derivative liability for the February CAMHZN Note.

The Company recorded deferred financing costs at issuance of $116,200 on the February CAMOFI Note and $28,800 on the February CAMHZN Note for the difference between the face amount of the notes and the net proceeds received. In addition, the discounts resulting from the conversion options of $384,460 on the February CAMOFI Note and $95,292 on the February CAMHZN Note were amortized to interest expense ratably over the life of the Notes.

For the year ended December 31, 2009, the Company recorded amortization expense on the conversion option and issuance costs of $384,460 and $116,200, respectively, on the February CAMOFI Note and $95,292 and $28,800, respectively, on the February CAMHZN Note.

 

On August 18, 2009, The Company entered into an amendment (the "2009 Amendment") of the February CAMOFI Note and February CAMZHN Note. Pursuant to the 2009 Amendment, the notes were amended as follows:

 

(a) The maturity dates were extended to August 1, 2010.

 

(b) The conversion price of the notes was reset to $0.04 per share.

 

In consideration for the 2009 Amendment, the Company issued 800,000 and 200,000 seven year warrants with an exercise price of $0.000001 per share to CAMOFI and CAMZHN, respectively.  This issuance was not considered an anti-dilution event, therefore no conversion or exercise price adjustments were effected.  The Company recorded on August 18, 2009 a derivative liability of $64,000 for the CAMOFI warrants and $16,000 for the CAMZHN warrants and recorded an equivalent amount of expense, which is recorded in the accompanying consolidated statements of operations.  At December 31, 2009 the fair value was $80,000 for the CAMOFI warrants and $20,000 for the CAMZHN warrants.  

At December 31, 2009 the fair values of the conversion features were $1,535,618 for the February CAMOFI Note and $380,619 for the February CAMHZN Note.  

As discussed in Note 1, CAMOFI and CAMHZN removed the anti-dilution provisions of the conversion option of the notes and the exercise price of the warrants effective December 31, 2009.  As a result of the removal of the anti-dilution provisions, the fair values of the conversion options and warrants were reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the warrants derivative liability that resulted in a loss of $16,000 and $4,000 for the CAMOFI and CAMZHN warrants, respectively.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the conversion options derivative liability that resulted in a loss of $1,151,158 and $285,327 for the February CAMOFI and CAMHZN notes, respectively.

The change in fair values of the derivative instruments are included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations.

F-25

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July 17, 2009 CAMOFI AND CAMHZN 15% Senior Secured Convertible Debt

On July 17, 2009, the Company entered into an agreement with CAMOFI for the issuance of a Senior Secured Convertible Note for $50,400 (the “July CAMOFI Note”), maturing on August 1, 2010. The July CAMOFI Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

 

On July 17, 2009, the Company entered into an agreement with CAMHZN for the issuance of a Senior Secured Convertible Note for $12,600 (the “July CAMZHN Note”) maturing on August 1, 2010. The July CAMZHN Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments.

 

Per ASC Topic 815, the conversion options of the July CAMOFI and CAMZHN notes were derivative liabilities. The Company recorded at issuance a $39,154 derivative liability for the July CAMOFI Note, and a $9,789 derivative liability for the July CAMHZN Note and corresponding debt discounts of $39,154 and $9,789, respectively.  At December 31, 2009 the fair value of the conversion features were $111,289 and $27,822 for the July CAMOFI Note and CAMHZN Note, respectively.  

As discussed in Note 1, CAMOFI and CAMHZN removed the anti-dilution provisions of the conversion option of the notes effective December 31, 2009.  As a result of the removal of the anti-dilution provisions, the fair values of the conversion options were reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the conversion options derivative liability that resulted in a loss of $72,135 and $18,033 for the July CAMOFI and CAMHZN notes, respectively. The change in fair values of the derivative instruments are included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations.

 

The discounts are amortized into interest expense ratably over the life of the Notes. For the year ended December 31, 2009, the Company recorded amortization expense on the conversion option of $17,219 and $4,307 on the July CAMOFI Note and CAMHZN Note, respectively.

September 25, 2009 CAMOFI AND CAMHZN 15% Senior Secured Convertible Debt

On September 25, 2009, the Company entered into an agreement with CAMOFI for the issuance of a Senior Secured Convertible Note for $48,000 (the “September CAMOFI Note”), maturing on August 1, 2010. The September CAMOFI Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

 

On September 25, 2009, the Company entered into an agreement with CAMHZN for the issuance of a Senior Secured Convertible Note for $12,000 (the “September CAMZHN Note”) maturing on August 1, 2010. The September CAMZHN Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments.

 

Per ASC Topic 815, the conversion options of the September CAMOFI and CAMZHN notes were derivative liabilities. The Company recorded at issuance a $245,736 derivative liability for the September CAMOFI Note, and a $61,434 derivative liability for the September CAMHZN Note and debt discounts of $48,000 and $12,000, respectively, and the remaining $241,170 recorded as interest expense upon issuance. At December 31, 2009 the fair value of the conversion features were $105,989 and $26,497 for the September CAMOFI Note and CAMHZN Note, respectively.  

As discussed in Note 1, CAMOFI and CAMHZN removed the anti-dilution provisions of the conversion option of the notes effective December 31, 2009.  As a result of the removal of the anti-dilution provisions, the fair values of the conversion options were reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the conversion options derivative liability that resulted in a gain of $139,747 and $34,937 for the September CAMOFI and CAMHZN notes, respectively. The change in fair values of the derivative instruments are included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations.

The discounts will be amortized into interest expense ratably over the life of the Notes. For the year ended December 31, 2009, the Company recorded amortization expense on the conversion option of $14,400 and $3,600 on the September CAMOFI Note and CAMHZN Note, respectively.

F-26

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October 9, 2009 CAMOFI AND CAMHZN 15% Senior Secured Convertible Debt

On October 9, 2009, the Company entered into an agreement with CAMOFI for the issuance of a Senior Secured Convertible Note for $200,000 (the “October CAMOFI Note”), maturing on August 1, 2010. The October CAMOFI Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

 

On October 9, 2009, the Company entered into an agreement with CAMHZN for the issuance of a Senior Secured Convertible Note for $50,000 (the “October CAMZHN Note”) maturing on August 1, 2010. The October CAMZHN Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments.

 

Per ASC Topic 815, the conversion options of the October CAMOFI and CAMZHN notes were derivative liabilities. The Company recorded at issuance a $848,934 derivative liability for the October CAMOFI Note, and a $212,233 derivative liability for the October CAMHZN Note, and debt discounts of $200,000 and $50,000, respectively, and the remaining $811,167 recorded as interest expense upon issuance. At December 31, 2009 the fair value of the conversion features were $441,621 and $110,405 for the October CAMOFI Note and CAMHZN Note, respectively.  

As discussed in Note 1, CAMOFI and CAMHZN removed the anti-dilution provisions of the conversion option of the notes effective December 31, 2009.  As a result of the removal of the anti-dilution provisions, the fair values of the conversion options were reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the conversion options derivative liability that resulted in a gain of $407,313 and $101,828 for the October CAMOFI and CAMHZN notes, respectively. The change in fair values of the derivative instruments are included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations.

The discounts will be amortized into interest expense ratably over the life of the Notes. For the year ended December 31, 2009, the Company recorded amortization expense on the conversion option of $60,000 and $15,000 on the October CAMOFI Note and CAMHZN Note, respectively.

December 22, 2009 CAMOFI AND CAMHZN 15% Senior Secured Convertible Debt

On December 22, 2009, the Company entered into an agreement with CAMOFI for the issuance of a Senior Secured Convertible Note for $200,000 (the “December CAMOFI Note”), maturing on August 1, 2010. The December CAMOFI Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments. The note is secured by all of the assets of the Company.

 

On December 22, 2009, the Company entered into an agreement with CAMHZN for the issuance of a Senior Secured Convertible Note for $50,000 (the “December CAMZHN Note”) maturing on August 1, 2010. The December CAMZHN Note can be converted at $0.04 per share at any time during the term of the convertible note, subject to certain anti-dilution adjustments.

 

Per ASC Topic 815, the conversion options of the December CAMOFI and CAMZHN notes were derivative liabilities. The Company recorded at issuance a $546,613 derivative liability for the December CAMOFI Note, and a $132,880 derivative liability for the December CAMHZN Note, and debt discounts of $200,000 and $50,000, respectively, and the remaining $429,493 recorded as interest expense upon issuance. At December 31, 2009 the fair value of the conversion features were $441,621 and $110,405 for the December CAMOFI Note and CAMHZN Note, respectively.  

As discussed in Note 1, CAMOFI and CAMHZN removed the anti-dilution provisions of the conversion option of the notes effective December 31, 2009.  As a result of the removal of the anti-dilution provisions, the fair values of the conversion options were reclassified from derivative liability to additional paid-in capital.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the conversion options derivative liability that resulted in a gain of $104,992 and $22,475 for the December CAMOFI and CAMHZN notes, respectively. The change in fair values of the derivative instruments are included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statements of operations.

The discounts will be amortized into interest expense ratably over the life of the Notes. For the year ended December 31, 2009, the Company recorded amortization expense on the conversion option of $20,000 and $5,000 on the December CAMOFI Note and CAMHZN Note, respectively.

 

F-27

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Convertible notes payable, net of debt discounts, consist of the following at December 31, 2009:

Amended 12% CAMOFI note, net of discount of $753,619		$	2,080,662
Accrued interest			433,920
		$	2,514,582
15% CAMZHN note, net of discount of $127,128			622,872
February 2009 CAMOFI note			701,200
February 2009 CAMZHN note			173,800
July 2009 CAMOFI note, net of discount of $21,935			28,465
July 2009 CAMZHN note, net of discount of $5,482			7,118
September 2009 CAMOFI note, net of discount of $33,600			14,400
September 2009 CAMZHN note, net of discount of $8,400			3,600
October 2009 CAMOFI note, net of discount of $140,000			60,000
October 2009 CAMZHN note, net of discount of $35,000			15,000
December 2009 CAMOFI note, net of discount of $180,000			20,000
December 2009 CAMZHN note, net of discount of $45,000			5,000
Accrued interest			175,576
		$	1,827,031

7. LOAN AND NOTES PAYABLE

On November 12, 2009, the Company entered into an agreement with Micro Pipe Fund I, LLC for the receipt of a Secured Loan of $150,000 (the “Micro Pipe Loan”).  The loan accrued interest at a rate of 2% per month and matured on January 5, 2010.  On maturity date, all principal and interest was due in addition to a payment equal to 10% of the principal balance.  The loan was not repaid at maturity and is now due on demand.  The loan is secured by a secondary interest in all of the assets of the Company.

 

In connection with the Micro Pipe Loan, the Company granted 400,000 immediately vested five year warrants with an exercise price of $0.20 (“Micro Pipe Warrants”).

The Micro Pipe Warrants have an exercise feature that is the same as the anti-dilution provision in the CAMOFI Warrants (See, “CAMOFI Master LDC (“CAMOFI”) Debt”). Consequently, the warrants are also treated as a derivative liability. The fair value of the warrants as of November 12, 2009 was $108,101.  The fair value of the warrants was determined based on the Black-Scholes pricing model using the following assumptions:  closing stock price $0.07 per share, exercise price of $0.07 estimated life 7 years, risk free rate 4.04% and volatility 216%.

As of December 31, 2009, the fair value of the warrant derivative liability was determined to be $48,378.

For the year ended December 31, 2009, the Company recorded a change in the fair value of the warrant derivative liability that resulted in a gain of $59,723, which is included in (loss) / gain on valuation of derivative liabilities in the accompanying consolidated statement of operations.

The initial Micro Pipe Warrants derivative liability of $108,101 represents a discount from the face amount of the note payable. Such discount is amortized to interest expense over the term of the note. During the year ended December 31, 2009, the Company amortized approximately $98,098 to interest expense in the accompanying consolidated statements of operations.

 

F-28

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Notes Payable

 

The notes payable are in default and are classified as current on the accompanying consolidated balance sheets.

 

The Company’s notes payable consist of the following at December 31, 2009:

 

Mercedes-Benz Financial, secured with an auto, entered into in February 2007, bearing interest at 9.5% per annum, payable in principal and interest monthly installments of $1,839, maturing in January 2012, includes accrued interest of $4,814. The Company is in default on the note and the balance is due on demand.		$	60,831
GE Money Bank, secured with equipment, entered into in July 2007, bearing interest at 17.9% per annum, payable in monthly principal and interest installments of $1,156, maturing in June 2012, includes accrued interest of $5,807. The Company is in default on the note and the balance is due on demand.			35,061
Capital One Finance, secured with an auto, entered into in April 2008, bearing interest at 7.9% per annum, payable in monthly principal and interest installments of $530, maturing in March 2013, includes accrued interest of $678. The Company is in default on the note and the balance is due on demand.			19,652
			115,544
Less current portion			(115,544	)
		$	-

 

8. INCOME TAXES

During 2009 and 2008, the provision for income taxes differs from the amounts computed by applying the U.S. Federal income tax rate of 34% to income before provision for income taxes as a result of the following:

 

		2009				2008
Computed “expected” tax (benefit) expense		$	(5,071,000	)		$	(1,349,000	)
Addition to (reduction in) income taxes resulting from: State income taxes, net of federal benefit			(895,000	)			(240,000	)
Other			(591,000	)			-
Change in deferred tax asset valuation allowance			6,562,929				1,592,200
		$	5,929			$	3,200

 

The effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31, 2009 and 2008 are presented below:

 

		2009				2008
Deferred tax assets:
Tax net operating loss carryforwards		$	10,580,000			$	7,022,000
Warrant liability			2,377,000				(593,000	)
Depreciation			(323,000	)			27,000
Accrued inventory reserve			410,000				213,000
Accrued expenses			496,000				308,000
Total gross deferred tax asset			13,540,000				6,977,000
Less valuation allowance			(13,540,000	)			(6,977,000	)
Total net deferred tax asset		$	-			$	-

 

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Based upon the Company’s history of continued operating losses, realization of its deferred tax assets does not meet the “more likely than not” criteria and, accordingly, a valuation allowance for the entire deferred tax asset amount has been recorded.

The valuation allowance increased by $6,563,000 and $1,592,000 during the years ended December 31, 2009 and 2008, respectively. The current provision for income taxes for the years ended December 31, 2009 and 2008 is due primarily to certain state taxes.

At December 31, 2009, the Company had net tax operating loss carryforwards for federal and state income tax purposes of approximately $27.6 million and $19.9 million, respectively, available to offset future taxable federal and state income. If not utilized to offset future taxable income, the federal and state carryforwards will expire in various years through 2029. Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to ownership change limitations that have occurred previously or that could occur in the future as provided by Section 382 of the Internal Revenue Code of 1986, as amended, as well as similar state provisions. These ownership changes may limit the amount of the net operating loss and tax credit carryforwards that can be utilized annually to offset future taxable income. Since the Company’s formation, the Company has raised capital through the issuance of capital stock and convertible debt on several occasions which may have resulted in a change of control, as defined by Section 382, or could result in a change of control in the future. The Company has not completed a study to assess whether a change of control has occurred or whether there have been multiple changes of control since the Company’s formation due to the significant complexity and cost associated with such study and that there could be additional changes in control in the future. If the Company has experienced a change of control at any time since Company formation, utilization of the Company’s net operating loss carryforwards would be subject to an annual limitation under Section 382. Any limitation may result in expiration of a portion of the carryforwards before utilization. Further, once a study is completed and any limitation known, the amounts currently presented as an uncertain tax position may change. Any carryforwards that will expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding reduction of the valuation allowance.

 On January 1, 2007, the Company adopted the provisions of ASC Topic 740, Income Taxes (“ASC Topic 740”) regarding the accounting for uncertainty in income taxes recognized in the entity’s financial statements. The adoption did not result in a cumulative effect adjustment to the Company’s retained earnings. As of the date of adoption, the Company had no unrecognized income tax benefits. Accordingly, the annual effective tax rate was not affected by the adoption of ASC Topic 740. Should the Company incur interest and penalties relating to tax uncertainties, such amounts would be classified as a component of interest expense and operating expense, respectively.

 

At December 31, 2009 and 2008, the Company had no increase or decrease in unrecognized income tax benefits for the year. There was no accrued interest or penalties relating to tax uncertainties at December 31, 2009 and 2008.

The Company expects resolution of unrecognized tax benefits, if created, would occur while the full valuation allowance of deferred tax assets is maintained, therefore, the Company does not expect to have any unrecognized tax benefits that, if recognized, that would affect the effective tax rate.

 

The Company is subject to income tax in the U.S. federal and California state jurisdictions and has identified its federal and California tax returns below as “major” tax filings. These jurisdictions, along with the years still open to audit under the applicable statutes of limitation, are as follows:

Jurisdiction		Tax Years
Federal		2006 - 2008
California		2005 – 2008

However, because the Company had net operating losses carried forward in both of the jurisdictions, certain items attributable to closed tax years are still subject to adjustment by applicable taxing authorities through an adjustment to tax attributes carried forward to open years.

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9. EQUITY TRANSACTIONS

On November 5, 2009, the Company’s Board of Directors approved an amendment to Article IV of the Company’s Certificate of Incorporation, to increase the shares of common stock that are authorized for issuance by 200,000,000 shares, bringing the total number of common shares authorized for issuance to 250,000,000. The amendment was submitted for approval by the Company’s stockholders as required by Delaware corporations’ law.  The Company received valid consents from the holders of a majority of the shares entitled to act on the proposal and on December 22, 2009 the Company executed a certification of amendment and amended Article IV of their Certificate of Incorporation to increase the shares of common stock that are authorized to 250,000,000.

 

 No change was made to the number of shares of preferred stock that are authorized for issuance, and no change was made to the other provisions of the Company’s Certificate of Incorporation that pertain to the rights and preferences of the authorized common stock or preferred stock.

Preferred Stock

The Company has authorized 15,000,000 shares of cumulative, convertible Series B Preferred Stock (“Series B”) with a par value of $1 per share.  The Series B has a mandatory cumulative dividend of $1.25 per share, which is payable on a semi-annual basis, and convertible into 1.67 shares of the Company’s common stock, does not have any voting rights, and has liquidation preference equal to $25 per share before any payment or distribution shall be made on common stock.

In March 2002, the Board of Directors authorized 75,000 shares of 5% cumulative, convertible Series C Preferred Stock (“Series C”) with a par value of $1 per share.  As and if declared by the Company’s Board of Directors, the Series C has a mandatory cumulative dividend of $1.25 per share, which is payable on a semi-annual basis in June and December each year to holders of record on November 30 and May 31.  The Series C does not have any voting rights and has liquidation preferences, as defined.  Each share of Series C is convertible at the option of the holder into 16.667 shares of the Company’s common stock.

During the year ended December 31, 2004, the Company issued a Private Placement Memorandum (“PPM”) in which the Company offered to eligible investors, as defined, a maximum of 75,000 shares of Series D Preferred Stock (“Series D”), with a required minimum offering of 1,000 shares of Series D to be sold at $25 per share.  The Series D has a mandatory cumulative dividend of $1.25 per share, which is payable on a semi-annual basis in June and December each year to holders of record on November 30 and May 31. The Series D does not have any voting rights and has liquidation preferences, as defined.  Each share of Series D is convertible at the option of the holder into 50 shares of the Company’s common stock, subject to adjustment.

At December 31, 2009 and 2008, the Company had a total of 26,880 preferred shares Series C and 11,640 preferred shares Series D issued and outstanding.

The Company determined that a reversal of $309,250 in cumulative dividends payable for Series C preferred stockholders was to be recorded as the dividends were not legally required to be paid or accrued by the Company since no dividends were declared or authorized by the Company’s Board of Directors.  The Company recorded the reversal at December 31, 2009 and has included such amount in the accompanying consolidated statements of stockholders’ deficit.

At December 31, 2009 and 2008, the Company’s accumulated dividends payable were $204,600 and $459,275, respectively.

 

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Common Stock, Warrants and Options

Acquisition of PAI

As part of the Share Exchange Agreement with PAI and Cabral (see Note 4), the Company issued 5,000,000 shares of the Company’s common stock with an acquisition-date fair value of $900,000 to Cabral.  In addition, the Company granted to Cabral a warrant to purchase 3,000,000 shares of the Company’s common stock.  The warrant will be for a term of the earlier of three years from the Vesting Date or January 1, 2014, and shall have an exercise price of $0.10 per share.  The warrant vests immediately on the Vesting Date and the acquisition-date fair value of the warrant was $540,000 or $0.18 per share.

Related to CAMOFI and CAMHZN Note

In connection with the initial issuance of the CAMOFI Note on February 28, 2006, the Company issued 250,000 shares of common stock to the placement agent. The common stock was recorded at the estimated fair value of the common stock on the date of the transaction totaling $157,500, which was recorded as deferred financing cost. During 2009 and 2008, the Company amortized to interest expense $8,750 and $52,500, respectively.

The Company issued an aggregate of 722,539 warrants to the placement agent and its assignee.  The warrants are exercisable at an exercise price of $0.63 per share and expire on February 28, 2013.  The estimated fair value of the warrants of $847,700 was recorded as deferred financing cost on the date of grant.  During 2009, the Company amortized to interest expense $90,420.

In connection with the issuance of the CAMOFI Note, CAMOFI Amended Note and CAMHZN note, the Company issued common stock and various warrants to the note holders.  See Note 6 to the consolidated financial statements for details.

 

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Stock Option and Warrant Exercise

On September 15, 2009, an employee exercised options to purchase shares of common stock on a cashless basis.  The holder exercised a total of 100,000 options at an exercise price of $0.075 for 65,908 shares of the Company’s common stock.

On October 19, 2009, a consultant exercised options to purchase shares of common stock on a cashless basis.  The holder exercised a total of 700,000 options at an exercise price of $0.15 for 116,667 shares of the Company’s common stock. The Company issued the consultant an additional 513,333 shares of common stock valued at $92,400.  The additional shares were expensed entirely at the time of issuance and are included in consulting and other compensation in the accompanying consolidated statements of operations.  At the time of exercise, the option was classified as a derivative liability.  In connection with the following exercise, the Company reclassified $86,363 from derivative liabilities to additional paid-in capital to record the fair value of the warrants exercised.

On October 26, 2009, CAMOFI and CAMHZN exercised warrants to purchase shares of common stock on a cashless basis.  The holders exercised a total of 750,000 warrants at an exercise price of $0.04 for 584,711 shares of the Company’s common stock.  In connection with the following exercise, the Company reclassified $125,706 from derivative liabilities to additional paid-in capital to record the fair value of the warrants exercised.

Issuance of Common Stock For Services

In October 2009, the Company issued 100,000 shares of common stock to a consultant in consideration for investor relation consulting services rendered valued at $19,000. The consulting fees were expensed entirely at the time of issuance and are included in consulting and other compensation in the accompanying consolidated statements of operations.

In November 2009, the Company issued 300,000 shares of common stock to a consultant in consideration for investor relation consulting services rendered valued at $75,000. The consulting fees were expensed entirely at the time of issuance and are included in consulting and other compensation in the accompanying consolidated statements of operations.

In November 2009, the Company issued 100,000 shares of common stock to a consultant in consideration for investor relation consulting services rendered valued at $20,000. The consulting fees were expensed entirely at the time of issuance and are included in consulting and other compensation in the accompanying consolidated statements of operations.

In November 2009, the Company issued 400,000 shares of common stock to a consultant in consideration for investor relation consulting services rendered valued at $48,000. The consulting fees were expensed entirely at the time of issuance and are included in consulting and other compensation in the accompanying consolidated statements of operations.

In June 2008, the Company entered into a three month contract with a third party for public and financial communication services valued at $18,000. The fee was paid in the form of 200,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was amortized to consulting and other compensation in the accompanying consolidated statements of operations.

 

In March 2008, the Company entered into a one month contract with a third party for public and financial communication services valued at $25,000. The fee was paid in the form of 125,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was amortized to operating expense over the life of the agreement. The consulting fees under this contract were amortized to consulting and other compensation in the accompanying consolidated statements of operations.

In February 2008, the Company entered into a three month contract with a third party for public and financial communication services valued at $20,000. The fee was paid in the form of 100,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was being amortized consulting and other compensation in the accompanying consolidated statements of operations.

F-33

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In February 2008, the Company entered into a one year contract with a third party for corporate consulting and marketing services valued at $30,000. The fee was paid in the form of 150,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was amortized to operating expense over the life of the agreement. During the years ended December 31, 2009 and 2008, consulting fees under this contract of $2,500 and $27,500, respectively, were amortized to consulting and other compensation in the accompanying consolidated statements of operations.

In December 2007, the Company entered into a three month contract with a third party for corporate consulting and marketing services valued at $180,000. The fee was paid as follows: $30,000 in cash, 300,000 shares of the Company’s common stock valued at $45,000 based on the stock market price of the shares at the contract date, and 700,000 options valued at $105,000 using the Black-Scholes option-pricing model to purchase the Company’s common shares. The value of the common stock and options issued on the date of the transaction were recorded as a deferred charge and were amortized to operating expense over the life of the agreement.

In June 2007, the Company entered into a three year contract with a third party for Internet public investor relations services valued at $210,000. The fee was paid in the form of 300,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and during the years ended December 31, 2009 and 2008, $69,998 and $105,000, respectively, was amortized to consulting and other compensation in the accompanying consolidated statements of operations.  At December 31, 2009, the remaining deferred consulting fees totaled $29,169.

In June 2007, the Company entered into a ninety day contract with a third party for public investor relations services valued at $10,500. The fee was paid in the form of 15,000 shares of the Company’s common stock and valued based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was amortized to consulting and other compensation in the accompanying consolidated statements of operations.   During the year ended December 31, 2008, $7,000 was amortized to expense.

In June 2007, the Company entered into a six month contract with a third party for corporate consulting and marketing services valued at $52,500. The fee was paid in the form of 75,000 shares of the Company’s common stock based on the stock market price of the shares at the contract date. The value of the common stock on the date of the transaction was recorded as a deferred charge and was amortized to consulting and other compensation in the accompanying consolidated statements of operations.  During the year ended December 31, 2008, $43,750 was amortized to expense.

In May 2007, the Company issued 100,000 shares of common stock valued at $70,000 to a third party for public investor relations services under a one year contract. The common stock was recorded at the estimated fair value of the common stock on the date of the transaction as a deferred charge and is amortized to consulting and other compensation in the accompanying statements of operations. In accordance with ASC Topic 505, Equity, the value of the services are not readily determinable and the fair value of the equity instruments is more reliably measurable. Under this arrangement, the performance criteria required for a measurement date is not reached until the service period has been completed. As a result, the Company is required to re-measure the consideration at each reporting date based on its then current stock value. During the year ended December 31, 2008, the Company recorded a net decrease to the fair value of such equity based compensation arrangement of approximately $48,000. The consulting fees under this contract were amortized to expense and $13,750 was recorded during 2008.

 

STOCK OPTIONS

Under the terms of the Company's Incentive Stock Option Plan ("ISOP"), options to purchase an aggregate of 5,000,000 shares of common stock may be issued to key employees, as defined. The exercise price of any option may not be less than the fair market value of the shares on the date of grant. No options granted may be exercisable more than 10 years after the date of grant.

Under the terms of the ISOP, on October 8, 2008, the Company granted 1,300,000 incentive stock options to its key employees. The options have exercise prices ranging from $0.075 to $0.0825, vest 50% on December 31, 2008, and 50% on April 8, 2009, and expire on April 6, 2010. Accordingly, $70,028 of share-based compensation will be recognized in the consolidated financial statements based on vesting periods, as follows: $35,014 for the each of the years ended December 31, 2009 and 2008.

The Company did not grant any incentive stock options under the plan during 2009.  During the year ended December 31, 2009, a cashless exercise of 100,000 options was completed under the plan.

At December 31, 2009, the Company had 1,700,000 options available for future issuance under their ISOP equity compensation plan.

Under the terms of the Company's non-statutory stock option plan ("NSSO"), options to purchase an aggregate of 1,350,000 shares of common stock may be issued to non-employees for services rendered. These options are non-assignable and non-transferable, are exercisable over a five-year period from the date of grant, and vest on the date of grant.

During year ended December 31, 2009, a cashless exercise of 700,000 options was completed and 100,000 options expired under the plan.

As of December 31, 2009, the Company had 650,000 options available for future issuance under their non-statutory stock option plans.

F-34

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All options outstanding have vested as of December 31, 2009 and are as follows:

		Number of Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term in Years				Aggregate Intrinsic Value (1)
Vested			7,400,000			$	0.12				2.06			$	26,250

(1)	Represents the difference between the exercise price and the closing market price of the Company’s common stock at the end of the reporting period (as of December 31, 2009 the market price of the Company’s common stock was $0.10.

		Outstanding Options
		Number of Shares				Weighted Average Exercise Price				Aggregate Intrinsic Value (1)
January 1, 2009			4,100,000			$	0.15			$	-
Grants (2)			4,200,000			$	0.10			$	-
Exercises			(182,575	)		$	0.12			$	1,650
Forfeited / Cancelled			(717,425	)		$	0.15			$	-
December 31, 2009			7,400,000			$	0.12			$	26,250

 

(1)	Represents the difference between the exercise price and the closing market price of the Company's common stock at the end of the reporting period (as of December 31, 2009 the market price of the Company’s common stock was $0.10).

(2)	From time to time, the Company issues options and warrants to employees and to third parties pursuant to various agreements, which are not approved by the shareholders.

 

On September 1, 2009, the Company granted 4,200,000 options to key employees outside the Company’s stock option plans.  The options have an exercise price of $0.10 per share, vest immediately and expire on September 1, 2012.  The options had a grant date fair value of $330,506 which was recorded as consulting and other compensation in the accompanying consolidated statements of operations.

F-35

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The weighted average grant-date fair value of the options granted during 2009 was $0.08. The fair value of each share-based award is estimated on the grant date using the Black Scholes option-pricing formula.   The options granted were valued with the following assumptions: dividend yield of 0%; volatility of 178%, expected term of 3.00 years and risk free interest rate of 0.19%.

From time to time, the Company issues warrants to employees and to third parties pursuant to various agreements, which are not approved by the stockholders.  The CAMOFI Warrants and CAMHZN Warrants contained an anti-dilution provision which reduced the exercise price whenever other securities were issued with a lower price.  The anti-dilution feature of the CAMOFI and CAMHZN Warrants lowered the exercise prices and increased the number of shares issuable under the warrants from the price and shares as originally issued (see Note 6).  Effective December 31, 2009, CAMOFI and CAMHZN removed anti-dilution provisions (see Note 6).

 

The following represents a summary of all warrant activity for the year ended December 31, 2009:

		Outstanding Warrants
		Number of Shares				Weighted Average Exercise Price				Aggregate Intrinsic Value (1)
Outstanding and exercisable at January 1, 2009			5,586,824			$	0.21			$	-
Grants (2)			7,660,714			$	0.09			$	-
Exercise			(584,711	)		$	0.04			$	35,080
Cancelled			(165,289	)		$	0.04			$	-
Outstanding at December 31, 2009 (3)			12,497,538			$	0.12			$	542,500
Exercisable at December 31, 2009 (3)			9,497,538			$	0.13			$	542,500

 

(1)	Represents the added value as difference between the exercise price and the closing market price of the Company's common stock at the end of the reporting period (as of December 31, 2009, the market price of the Company's common stock was $0.10).

(2)	4,660,714 of the warrants issued are exercisable at December 31, 2009.   The 3,000,000 warrants not exercisable at December 31, 2009 were issued in connection with the acquisition of PAI.  See Note 4 for a description of the vesting terms of the warrant.

(3)	The warrants outstanding and exercisable at December 31, 2009 have a weighted-average contractual remaining life of 4.02 years and 5.29 years, respectively.

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10. EARNINGS (LOSS) PER SHARE

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per share computations for the years ended December 31, 2009 and 2008:

		2009												2008
		Income (Loss)				Shares				Per Share Amount				Income (Loss)				Shares				Per Share Amount
Net (loss) income		$	(14,920,862	)										$	2,181,392
Add (less): preferred stock dividends adjustment			254,675												(82,550	)
Basic (loss) income available to common stockholders			(14,666,187	)			16,767,495			$	(0.87	)			2,098,842				14,696,227			$	0.14
Add: preferred dividends															82,550
Add: interest on convertible debt															940,439
Add: dilutive impact of convertible preferred stock																			1,026,676
Add: dilutive impact of convertible debt																			45,500,978
Add: dilutive impact of options and warrants																			877,666
Diluted (loss) income available to common stockholders
		$	(14,666,187	)			16,767,495			$	(0.87	)		$	3,121,831				62,101,547			$	0.05

 

11. COMMITMENTS AND CONTINGENCIES

Service Agreements

Periodically, the Company enters into various agreements for services including, but not limited to, public relations, financial consulting and manufacturing consulting. Generally, the agreements are ongoing until such time they are terminated, as defined. Compensation for services is paid either at a fixed monthly rate or based on a percentage, as specified, and may be payable in shares of the Company’s common stock.  The Company's policy is that expenses related to these types of agreements are valued at the fair market value of the services or the shares granted, whichever is more realistically determinable.  Such expenses are amortized over the period of service.

Leases

The Company leases various office facilities and equipment under non-cancelable operating and capital lease arrangements.  The Company’s monthly lease payment for its office and warehouse facilities in Santa Fe Springs, CA is $36,000.  The lease expires on March 31, 2018.  Pursuant to the lease, the Company incurred a brokerage fee of approximately $72,500. This cost has been deferred and amortized over the term of the lease. During the year ended December 31, 2009 and December 31, 2008, the Company amortized approximately $7,200 and $5,400, respectively, to rent expense. At December 31, 2009, the unamortized portion of deferred brokerage fees for the lease is approximately $60,000.

 

As of September 19, 2008, the Company entered into an Amendment to its lease, at a cost of $50,000.  This cost has been deferred and is being amortized over the term of the lease. During the year ended December 31, 2009 and 2008, the Company amortized approximately $5,000 and $3,800, respectively, to rent expense. At December 31, 2009, the unamortized portion of the Amendment fee is approximately $41,000.

The Company’s monthly lease payment for one of its facilities in Rancho Cucamonga, CA is approximately $6,000 and expires on December 31, 2012.  The monthly lease payment for another facility is $4,800 and the lease expires on January 31, 2013.

The equipment under non-cancelable operating leases expire through January 2010 and require monthly payments ranging from $47 to $6,254.

The equipment under non-cancelable capital leases expire through March 2013 and require monthly payments ranging from $2,029 to $10,273 and accrue interest ranging from 7.42% to 11.99% per annum.  All capital leases are in default and are currently classified as current on the accompanying consolidated balance sheets.  The capital leases are secured by the equipment.

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Rental expense for operating leases approximated $557,000 and $464,000 for the years ended December 31, 2009 and 2008, respectively.

The following are approximate aggregate future minimum lease payments due under operating and capital leases as of December 31, 2009:

Years Ending December 31,		Operating Leases				Capital Leases				Total
2010		$	521,000			$	858,000			$	1,379,000
2011			524,000				-				524,000
2012			536,000				-				536,000
2013			436,000				-				436,000
Thereafter			1,836,000				-				1,836,000
		$	3,853,000				858,000			$	4,711,000
Less amounts representing interest (ranging from 7.42% to 11.99%)							(105,043	)
Present value of net minimum lease payments							752,957
Less current portion							(752,957	)
Long-term portion						$	-

 

Legal

From time to time, the Company may be involved in various claims, lawsuits, and disputes with third parties, actions involving allegations or discrimination or breach of contract actions incidental to the normal operations of the business.   

Delinquent Income Taxes

At December 31, 2009, the Company has approximately $352,000 accrued related to penalties and interest in connection with delinquent income taxes related to PAI’s Federal and State income tax returns for the years ended December 31, 2007 and 2006.  The Company has included the accrued amounts in accounts payable and accrued liabilities and recorded approximately $21,000 of penalties and interest during the year ended December 31, 2009 in selling, general and administrative expenses in the accompanying consolidated balance sheets and statements of operations.  The related returns were filed in April 2009.

Delinquent Payroll Taxes

At December 31, 2009 and 2008, the Company has accrued approximately $1,187,000 and $204,000, respectively, for payroll taxes not yet remitted for employee compensation and estimated penalties and interest in connection with payroll taxes incurred but not remitted related to executive compensation for the years ended December 31, 2009 and 2008.  The Company has included the accrued amounts in accounts payable and accrued liabilities in the accompanying consolidated balance sheets and the related expense in salaries and related expenses in the accompanying consolidated statements of operations.

Tax Lien

On August 25, 2009, PAI received notice from the IRS of a federal tax lien filing for amounts totaling $30,340. The lien attaches to all property owned by PAI and any property to be acquired in the future.

Backlog

The following schedule approximates a reconciliation of the backlog representing signed contracts:

Balance, January 1, 2009		$	2,491,000
New contracts, January 1, 2009 through December 31, 2009			1,415,000
			3,906,000
Less: contract revenue earned – January 1, 2009 through December 31, 2009			(3,505,000	)
Balance, December 31, 2009		$	401,000

 

Indemnities and Guarantees

The Company has made certain indemnities and guarantees, under which it may be required to make payments to a guaranteed or indemnified party, in relation to certain actions or transactions.  The Company indemnifies its directors, officers, employees and agents, as permitted under the laws of the State of California.  In connection with its facility leases, the Company has indemnified its lessors for certain claims arising from the use of the facilities.  The duration of the guarantees and indemnities varies, and is generally tied to the life of the agreement. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make.  Historically, the Company has not been obligated nor incurred any payments for these obligations and, therefore, no liabilities have been recorded for these indemnities and guarantees in the accompanying consolidated balance sheets.

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12. RELATED PARTY TRANSACTIONS

At December 31, 2009 and 2008, the Company had loans to two stockholders approximating $565,000, including accrued interest.  These loans were originated in 1999 and no additional amounts have been loaned to the stockholders.  The loans accrue interest at 5% and are due on demand.  The Company has included the notes receivable from stockholders in stockholders’ deficit as such amounts have not been repaid during 2009 or 2008.  For the years ended December 31, 2009 and 2008, total interest income accrued for notes receivable from stockholders approximated $20,000.

At December 31, 2009, the Company has loans to various employees totaling $39,106 included in notes payable to related parties in the consolidated balance sheet.  The loans are non-interest bearing and are due on demand.

In connection with the acquisition of PAI (see Note 4), the Company issued a promissory note to Cabral in the amount of $500,000.  Interest on the note accrues at 5% per annum and all principal and interest is due only on and paid from the proceeds of any equity financing of the Company with gross proceeds of  at $2,000,000 provided that the investors in such financing permit the proceeds thereof to be used for such purpose.

13. SEGMENT REPORTING

 

The Company’s operations are classified into two principal reportable segments that provide different products or services. Separate management of each segment is required because each business unit is subject to different marketing, production, and technology strategies. The Company operates in the following two reportable segments:

	(a)	CNC machine tool remanufacturing and
	(b)	Multiaxis structural aircraft components.

The Company evaluates performance and allocates resources based upon operating income. The accounting policies of the reportable segments are the same as those described in the summary of accounting policies. Inter-segment sales are eliminated upon consolidation.

The following table summarizes segment asset and operating balances by reportable segment, has been prepared in accordance with the internal accounting policies, and may not be presented in accordance with GAAP:

		Year Ended/ As of December 31 2009				Year Ended/ As of December 31 2008
Net revenue from external customers:
CNC machine tool remanufacturing		$	3,504,669			$	4,822,026
Multiaxis structural aircraft components			221,762				-
Total net revenue from external customers:			3,726,431				4,822,026
Operating loss:
CNC machine tool remanufacturing			(2,078,909	)			(3,192,887	)
Multiaxis structural aircraft components			(362,912	)			-
Total operating loss:			(2,441,821	)			(3,192,887	)
Depreciation and amortization from operations:
CNC machine tool remanufacturing			82,683				82,186
Multiaxis structural aircraft components			125,385				-
Total depreciation and amortization expense:			208,068				82,186
Interest expense:
CNC machine tool remanufacturing			4,803,831				1,749,026
Multiaxis structural aircraft components			30,800				-
Total interest expense:			4,834,631				1,749,026
Net (loss) income:
CNC machine tool remanufacturing			(14,273,847	)			2,181,392
Multiaxis structural aircraft components			(647,015	)			-
Total loss from continuing operations:			(14,920,862	)			2,181,392
Identifiable assets:
CNC machine tool remanufacturing			902,226				2,091,943
Multiaxis structural aircraft components			4,541,122				-
Total identifiable assets:			5,443,348				2,091,943
Capital expenditures:
CNC machine tool remanufacturing			6,698				-
Multiaxis structural aircraft components			-				-
Total capital expenditures:			6,698				-

14. RESTATEMENTS

The original accounting for the CAMOFI Note failed to appropriately record separate derivative treatment for the conversion option and the warrants issued with the CAMOFI Note. The requirements of ASC Topic 815 were not met and thus the conversion option and the warrants are derivative liabilities and must be accounted for separately and marked-to-market quarterly.

Additionally, the CAMOFI Amended Note was originally treated as a troubled debt restructuring, but upon further review was properly corrected as an extinguishment of debt. ASC Topic 420 requires that an exchange of debt with substantially different terms is an extinguishment of debt and should be accounted for in accordance with ASC Topic 860. ASC Topic 860 permits derecognition of the liability if and only if it has been extinguished if the debtor pays the creditor and is relieved of its obligation or the debtor is legally released from being the primary obligor under the liability either judicially or by the creditor. Per the Amended 12% Convertible Note Agreement and the Letter Agreement dated June 26, 2008, the Company has been released from its obligation under the original 12% Convertible Note Agreement.

F-39

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The effect of these changes impacted the consolidated balance sheet and the consolidated statement of operations from February 2006 through December 31, 2008. The consolidated balance sheet effect is due to the recording of the conversion option and warrant liabilities and the statement of operatons effect is due to the gains and losses from the marked-to-market adjustments and an increase in interest expense. Accordingly, the consolidated balance sheets and statements of operations for the periods described in the preceding sentence have been retroactively adjusted as summarized below:

 

Effect of Correction		As Previously Reported				Adjustment				As Restated
Balance Sheet as of  March 31, 2006
Conversion Option Liability		$	0			$	4,411,900			$	4,411,900
Warrant Liability			2,954,765				(194,174	)			2,760,591
Accumulated Deficit			7,883,952				2,907,726				10,791,678
Total Stockholders’ Deficit			66,598				2,907,726				2,974,324
Statement of Operations for the three months ended March 31, 2006
Marked-to-Market Gain (Loss)			(764,762	)			(1,165,062	)			(1,929,824	)
Net Income (Loss)			(1,212,380	)			(2,907,726	)			(4,120,106	)
Net Income (Loss) Available to common shareholders			(924,505	)			(2,907,726	)			(3,832,231	)
EPS, Basic and Diluted			(0.09	)			(0.26	)			(0.35	)
Balance Sheet as of June 30,2006
Conversion Option Liability			0				3,131,349				3,131,349
Warrant Liability			2,155,238				(195,909	)			1,959,329
Accumulated Deficit			7,579,559				1,625,440				9,204,999
Total Stockholders’ Deficit (Equity)			(334,838	)			1,722,483				1,387,645
Statement of Operations for the three months ended June 30, 2006
Marked-to-Market Gain (Loss)			799,524				1,282,286				2,081,810
Net Income (Loss)			346,793				1,282,286				1,629,079
Net Income (Loss) Available to common shareholders			304,793				1,282,286				1,587,079
EPS – Basic			0.03				0.11				0.14
EPS – Diluted			0.02				0.10				0.12
Statement of Operations for the six months ended June 30, 2006
Marked-to-Market Gain (Loss)			34,762				117,224				151,986
Net Income (Loss)			(865,587	)			(1,625,440	)			(2,491,027	)
Net Income (Loss) Available to common shareholders			(620,112	)			(1,625,440	)			(2,245,552	)
EPS – Basic			(0.06	)			(0.14	)			(0.20	)
EPS – Diluted			(0.06	)			(0.14	)			(0.20	)
Balance Sheet as of  September 30, 2006
Conversion Option Liability			0				2,814,867				2,814,867
Warrant Liability			1,320,952				440,350				1,761,302
Accumulated Deficit			7,704,934				1,945,217				9,650,151
Total Stockholders’ Deficit (Equity)			(256,440	)			2,089,237				1,832,797
Statement of Operations for the three months ended September 30, 2006
Marked-to-Market Gain (Loss)			834,286				(319,777	)			514,509
Net Income (Loss)			(125,375	)			(319,777	)			(445,152	)
Net Income (Loss) Available to common shareholders			(125,375	)			(319,777	)			(445,152	)
EPS, Basic and Diluted			(0.01	)			(0.03	)			(0.04	)
Statement of Operations for the nine months ended September 30, 2006
Marked-to-Market Gain (Loss)			869,048				(202,553	)			666,495
Net Income (Loss)			(990,962	)			(1,945,217	)			869,048
Net Income (Loss) Available to common shareholders			(745,487	)			(1,945,217	)			(2,690,704	)
EPS, Basic and Diluted			(0.11	)			(0.10	)			(0.21	)
Balance Sheet as of December 31, 2006
Conversion Option Liability			0				3,282,851				3,282,851
Warrant Liability			486,666				1,567,467				2,054,133
Accumulated Deficit			7,808,116				3,331,740				11,139,856
Total Stockholders’ Deficit (Equity)			(1,163,723	)			5,336,978				4,173,255
Statement of Operations for the three months ended December 31, 2006
Interest Expense			802,447				1,742,664				2,545,111
Marked-to-Market Gain (Loss)			625,714				(1,386,523	)			(760,809	)
Net Income (Loss)			(60,782	)			(1,386,523	)			(1,447,305	)
Net Income (Loss) Available to common shareholders			(103,182	)			(1,386,523	)			(1,489,705	)
EPS, Basic and Diluted			(0.01	)			(0.12	)			(0.13	)
Statement of Operations for the year ended December 31, 2006
Interest Expense			2,363,187				1,742,664				4,105,851
Marked-to-Market Gain (Loss)			1,494,762				(1,589,076	)			(94,314	)
Net Income (Loss)			(1,051,744	)			(3,331,740	)			(4,383,484	)
Net Income (Loss) Available to common shareholders			(848,669	)			(3,331,740	)			(4,180,409	)
EPS, Basic and Diluted			(0.09	)			(0.30	)			(0.39	)
Balance Sheet as of March 31, 2007
Conversion Option Liability			0				4,752,369				4,752,369
Warrant Liability			0				2,973,625				2,973,625
Accumulated Deficit			7,819,079				5,720,576				13,539,655
Total Stockholders’ Deficit (equity)			(1,492,237	)			8,065,471				6,573,234
Statement of Operations for the three months ended March 31, 2007
Marked-to-Market Gain (Loss)			0				(2,389,016	)			(2,389,016	)
Net Income (Loss)			(10,963	)			(2,389,016	)			(2,399,979	)
Net Income (Loss) Available to common shareholders			(10,963	)			(2,389,016	)			(2,399,979	)
EPS, Basic and Diluted			0.00				(0.20	)			(0.20	)
Balance Sheet as of June 30,2007
Conversion Option Liability			0				11,525,628				11,525,628
Warrant Liability			0				7,211,749				7,211,749
Accumulated Deficit			8,316,657				16,732,139				25,048,796
Total Stockholders’ Deficit (Equity)			(1,545,317	)			19,627,512				18,082,195
Statement of Operations for the three months ended June 30, 2007
Marked-to-Market Gain (Loss)			0				(11,011,383	)			(11,011,383	)
Net Income (Loss)			(524,928	)			(11,011,383	)			(11,536,311	)
Net Income (Loss) Available to common shareholders			(497,578	)			(11,011,383	)			(11,508,961	)
EPS – Basic and Diluted			(0.04	)			(0.87	)			(0.91	)
Statement of Operations for the six months ended June 30, 2007
Marked-to-Market Gain (Loss)			0				(13,400,399	)			(13,400,399	)
Net Income (Loss)			(535,891	)			(13,400,399	)			(13,936,290	)
Net Income (Loss) Available to common shareholders			(508,541	)			(13,400,399	)			(13,908,940	)
EPS – Basic and Diluted			(0.06	)			(1.07	)			(1.13	)
Balance Sheet as of September 30, 2007
Conversion Option Liability			0				5,049,714				5,049,714
Warrant Liability			0				3,159,678				3,159,678
Accumulated Deficit			9,243,040				7,597,661				16,840,701
Total Stockholders’ Deficit (Equity)			(746,915	)			9,200,158				8,453,243
Statement of Operations for the three months ended September 30, 2007
Marked-to-Market Gain (Loss)			0				10,527,985				10,527,985
Net Income (Loss)			(926,383	)			10,527,985				9,601,602
Net Income (Loss) Available to common shareholders			(899,033	)			10,527,985				9,628,952
EPS – Basic			(0.07	)			0.79				0.72
EPS – Diluted			(0.07	)			0.30				0.23
Statement of Operations for the nine months ended September 30, 2007
Marked-to-Market Gain (Loss)			0				(2,872,414	)			(2,872,414	)
Net Income (Loss)			(1,462,274	)			(2,872,414	)			(4,334,688	)
Net Income (Loss) Available to common shareholders			(1,434,924	)			(2,845,064	)			(4,279,988	)
EPS – Basic			(0.11	)			(0.23	)			(0.34	)
EPS – Diluted			(0.11	)			(0.23	)			(0.34	)
Balance Sheet as of December 31, 2007
Conversion Option Liability			0				3,537,826				3,537,826
Warrant Liability			0				2,213,668				2,213,668
Accumulated Deficit			11,232,567				3,746,456				14,979,023
Total Stockholders’ Deficit (Equity)			1,134,026				5,751,494				6,885,520
Statement of Operations for the three months ended December 31, 2007
Marked-to-Market Gain (Loss)			0				2,457,898				2,457,898
Net Income (Loss)			(1,948,252	)			2,457,898				509,646
Net Income (Loss) Available to common shareholders			(1,989,527	)			2,457,898				468,371
EPS – Basic			(0.15	)			0.19				0.04
EPS – Diluted			(0.15	)			0.17				0.02
Statement of Operations for the year ended December 31, 2007
Marked-to-Market Gain (Loss)			0				(414,516	)			(414,516	)
Net Income (Loss)			(3,410,526	)			(414,516	)			(3,825,042	)
Net Income (Loss) Available to common shareholders			(3,424,451	)			(414,516	)			(3,838,967	)
EPS, Basic and Diluted			(0.27	)			(0.03	)			(0.30	)
Balance Sheet as of  March 31, 2008
Conversion Option Liability			0				2,737,709				2,737,709
Warrant Liability			0				1,713,023				1,713,023
Accumulated Deficit			12,207,494				2,445,694				14,653,188
Total Stockholders’ Deficit (equity)			1,908,610				4,651,075				6,559,685
Statement of Operations for the three months ended March 31, 2008
Marked-to-Market Gain (Loss)			0				1,300,762				1,300,762
Net Income (Loss)			(974,927	)			1,300,762				325,835
Net Income (Loss) Available to common shareholders			(974,927	)			1,300,762				325,835
EPS - Basic			(0.07	)			0.09				0.02
EPS - Diluted			(0.07	)			0.08				0.01
Balance Sheet as of June 30,2008
Conversion Option Liability			0				3,021,989				3,021,989
Warrant Liability			0				186,916				186,916
Accumulated Deficit			13,098,072				1,203,869				14,301,941
Total Stockholders’ Deficit (Equity)			3,022,952				3,185,486				6,208,438
Statement of Operations for the three months ended June 30, 2008
Marked-to-Market Gain (Loss)			0				(515,057	)			(515,057	)
Net Income (Loss)			(849,305	)			1,241,827				392,522
Net Income (Loss) Available to common shareholders			(890,580	)			1,241,827				351,247
EPS – Basic			(0.06	)			0.08				0.02
EPS – Diluted			(0.06	)			0.08				0.02
Statement of Operations for the six months ended June 30, 2008
Marked-to-Market Gain (Loss)			0				785,705				785,705
Net Income (Loss)			(1,824,232	)			2,542,589				718,357
Net Income (Loss) Available to common shareholders			(1,865,507	)			2,542,589				677,082
EPS – Basic			(0.13	)			0.18				0.05
EPS – Diluted			(0.13	)			0.18				0.05
Balance Sheet as of September 30, 2008
Conversion Option Liability			0				4,032,781				4,032,781
Warrant Liability			0				310,389				310,389
Convertible Note Payable			543,390				(348,758	)			194,632
Accumulated Deficit			13,860,275				1,697,812				15,558,087
Total Stockholders’ Deficit (Equity)			3,604,689				3,859,895				7,464,584
Statement of Operations for the three months ended September 30, 2008
Marked-to-Market Gain (Loss)			0				(753,802	)			(753,802	)
Interest Expense			57,387				31,705				89,092
Net Income (Loss)			(762,203	)			(785,507	)			(1,547,710	)
Net Income (Loss) Available to common shareholders			(803,478	)			(785,507	)			(1,588,985	)
EPS – Basic and Diluted			(0.05	)			(0.05	)			(0.10	)
Statement of Operations for the nine months ended September 30, 2008
Marked-to-Market Gain (Loss)			0				260,838				260,838
Interest Expense			1,041,538				79,263				1,120,801
Net Income (Loss)			(2,586,435	)			2,096,985				(489,450	)
Net Income (Loss) Available to common shareholders			(2,627,710	)			2,096,985				(530,725	)
EPS – Basic and Diluted			(0.18	)			0.14				(0.04	)

 

F-40

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