As filed with the U.S. Securities and Exchange Commission on August 20, 2010

Registration No. 333-163046

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Amendment No. 9

to

 

Form S-1

 

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

 

XStream Systems, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

 

 

10305 102nd Terrace

Suite 101

Sebastian, FL 32958

Tel: (772) 646-6201

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

 

 

James J. Lowrey

Chairman and Co-Chief Executive Officer

XStream Systems, Inc.

10305 102nd Terrace

Suite 101

Sebastian, FL 32958

Tel: (772) 646-6201

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

 

Copies to:

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

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

(Do not check if a smaller reporting company)

 

CALCULATION OF REGISTRATION FEE

 

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

Subject to Completion, Dated August 20, 2010

 

 

PROSPECTUS

 

A Minimum of 3,333,334 shares

A Maximum of 5,000,000 shares

 

 

 

This is our initial public offering. No public market currently exists for our common stock. We are offering shares of our common stock on a best efforts basis as to a minimum offering of 3,333,334 shares generating gross proceeds of $20,000,000 and as to a maximum offering of 5,000,000 shares generating gross proceeds of $30,000,000. We have assumed a midpoint of $6.00 for the per share offering price in this prospectus. No closing will occur unless we raise at least $20,000,000 in gross proceeds. We expect that the offering price will be between $4.00 and $8.00 per share of common stock. All funds received from investors will be deposited into a non-interest bearing escrow account with our escrow agent, JPMorgan Chase Bank, N.A. We have applied for the listing of our common stock on the NYSE Amex. The listing of our common stock on the NYSE Amex is a condition to the completion of the offering. If the conditions to closing are met, this offering will price and close on a T+3 basis (three trading days after pricing) on or about          , 2010.

 

Proposed NYSE Amex Symbol:     XTRM

 

OpenIPO^® and Best Efforts Offering: The method of distribution being used by the underwriter in this offering differs somewhat from that traditionally employed in firm commitment underwritten public offerings. In particular, the public offering price and allocation of shares were determined primarily by an auction process conducted by the underwriter and other securities dealers participating in this offering. The minimum size for any bid in the auction is 100 shares. The underwriter is required to use its best efforts to sell a minimum of 3,333,334 in shares of common stock and to sell 5,000,000 shares, the maximum number of securities offered hereby so long as $20,000,000 in gross proceeds are raised.

 

 

 

 

This offering involves a high degree of risk. You should purchase shares only if you can afford a complete loss of your investment. See “Risk Factors” beginning on page 8.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed on the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

The date of this prospectus is          , 2010

 

You should rely only on the information contained in this prospectus. We have not authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. We are not making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information appearing in this prospectus is accurate as of the date on the front cover of this prospectus only. Our business, financial condition, results of operations and prospects may have changed since that date.

 

TABLE OF CONTENTS

 

 

PROSPECTUS SUMMARY

	•	service agreements for placement of our XT250tm system on-site with our customers. These generate usage-based income from an arrangement which minimizes our customer’s up-front capital expenditures;
	•	service agreements for customized authentication solutions utilizing the EDXRD technology developed to meet the specific requirements of a customer including multi-layer anti-counterfeiting solutions which incorporate molecular screening, pedigree, serialization and sealant;

	•	PILOT programs whereby potential customers will host our system for use on a trial basis, providing our potential customers with an option to enter into a multi-year service agreement following PILOT testing.

	•	the increase in counterfeiting and adulteration in the drug and pharmaceutical industry;
	•	indicators of growing corporate demand for counterfeit drug identification solutions;
	•	the proliferation of pharmaceutical product sales from internet sources;
	•	indications of demand for diagnostic detection solutions in the medical industry;
	•	terrorist activities around the globe;
	•	indications of demand for quality control in the cosmetics industry;
	•	industry indicators for demand in raw ore, mineral, and metal detection;
	•	indications of demand for quality control in the cement industry; and
	•	indications of demand for quality control in the veterinarian industry.

	•	scale the technology, in terms of speed and test volume size, to produce products that meet varying customer applications, including real-time testing, as well as large volume screening;
	•	expand our recognition and branding in our industry in identification of counterfeit and adulterated drugs and pharmaceuticals;
	•	pursue new customers and territories — we are aggressively targeting potential customers, primarily through our direct sales force, and believe that there are substantial market opportunities for our solutions in the Americas, Asia, Africa, and Europe;
	•	strategic PILOT programs whereby third parties host our XT250tm system;
	•	enhance our product offering — we intend to further develop our XT250tm platform’s capabilities and features;
	•	expand our product offering — we intend to customize other products to meet customer demands beyond the XT250tm platform;
	•	expand our target markets — we intend to leverage our products by offering them to new markets; and
	•	build and leverage awareness of the XStream molecular screening brand.

	•	Swisslog Healthcare Solutions, a global provider of integrated logistics solutions for warehouses, distribution centers and hospitals has executed a Letter of Intent with us to jointly collaborate and investigate the development of customized screening solutions; and
	•	Eastman Kodak, a corporation utilizing technology to combine imaging and information, has agreed in a Letter of Intent to explore with us strategic opportunities for joint design, development, cross-licensing, and co-marketing of security solutions. We believe that some of Kodak’s technologies would be complementary to our customized authentication solutions.

Common stock offered
Minimum offering		3,333,334 on a best efforts basis
Maximum offering		5,000,000 on a best efforts basis
		Our minimum offering requires us to raise at least $20,000,000 in gross proceeds, which would require either the price per share or the number of shares sold to be above their respective minimum thresholds. The sale of the minimum of 3,333,334 shares at the bottom of our price range, or $4.00, will not generate sufficient proceeds to close the offering.
Proposed NYSE Amex Symbol for the common stock		XTRM
Common stock outstanding prior to this offering		2,865,044 shares
Common stock to be outstanding after this offering(1)

Minimum offering		10,388,545 shares

Maximum offering		12,055,211 shares

OpenIPO Process		This offering will be made through the OpenIPO process, in which the allocation of shares and the public offering price are primarily based on an auction in which prospective purchasers are required to bid for the shares. The OpenIPO process is described in full under “Plan of Distribution” beginning on page 92.

Use of proceeds		In the event of either of the minimum offering or the maximum offering, we will use a portion of the net proceeds of this offering, first, in the repayment of our indebtedness through August 15, 2010, in the aggregate amount of $7,357,222 as follows:

		• $2,560,278 to discharge the Kimball judgment against us, plus accounts payable;

		• $287,260 to repay principal and accrued interest due to our two debenture holders;

		• $1,103,350 to discharge amounts we are in arrears under our license agreement with Rutgers University;

		• $741,472 to be paid to affiliates for deferred salary; and

		• $366,589 to repay principal and accrued interest due to officers, directors and shareholders for promissory notes

		• $2,298,272 in professional fees and miscellaneous expenses.

		The amount to be repaid to Kimball above was derived by deducting $39,722 in funds which are subject to a writ of garnishment from the filed judgment of $2,600,000. We will use the remainder of the net proceeds following repayment of our indebtedness for research and product development and general corporate purposes including salaries, professional fees, public reporting costs and office-related expenses.

		See “Use of Proceeds.”

Proposed Listing		We have applied for the listing of our common stock on the NYSE Amex. Assuming that we raise at least $20,000,000 in gross proceeds, we believe that we will be accepted for listing on the NYSE Amex at the time of the offering. The listing of our common stock on the NYSE Amex is a condition to the completion of the offering. The sale of the minimum of 3,333,334 shares at the bottom of our price range, or $4.00, will not generate sufficient proceeds to permit our initial listing on the NYSE Amex. In the event that we were to price the offering below the price range after the auction is closed, we would file a post-effective amendment to reflect the lower price and a higher number of shares. However, in no event would the actual offering price be less than $3.00 as that is the minimum price required to satisfy NYSE Amex listing requirements.
Escrow account		All payments for shares under this prospectus should be made payable to “JPMorgan Chase Bank, N.A.” as escrow agent for the escrow account. If at least an aggregate of $20,000,000 in funds are not received in the escrow account or the NYSE Amex does not confirm the listing of the shares on the exchange within three business days following the closing of the auction and pricing, the offering will terminate and funds deposited with the escrow agent will be returned to investors promptly without interest.

Ownership after this offering		Our executive officers and directors will beneficially own approximately 29.3% of our outstanding common stock if the minimum offering is completed and 25.5% if the maximum offering is completed.

(1)		Based on 2,865,044 shares outstanding on August 15, 2010, and assuming the conversion of shares of our Series A, B, C, and D preferred stock and accrued dividends through August 15, 2010 into 4,190,167 shares of our common stock on the effective date of the registration statement for this offering. The number of shares to be outstanding after this offering excludes the following:

	•	2,033,117 shares of common stock reserved for issuance upon the exercise of outstanding stock options under our Amended and Restated 2004 Stock Option Plan and 2009 Long Term Incentive Compensation Plan;
	•	13,078,685 shares of common stock reserved for issuance upon the exercise of outstanding warrants (for which cash would need to be remitted to us for exercise) at a weighted average exercise price of $2.99 and 5,203,480 shares of which are held by executive officers and directors and their affiliates; and
	•	3,848,769 additional shares of common stock reserved for issuance under the 2009 Long Term Incentive Compensation Plan.

	•	assumes the sale of shares of our common stock at the $6.00 midpoint of our estimated price range set forth on the cover of our prospectus.

	•	our history of annual net losses which may continue and which may negatively affect our ability to achieve our business objectives, and the going concern qualification in our 2008 and 2009 audits;

	•	we are currently a defendant in a lawsuit with the manufacturer of the XT250tm system, Kimball Electronics, Inc., in connection with funds we currently owe to its parent corporation, Kimball International, Inc., under a promissory note and, on February 8, 2010, Kimball entered an Agreed Judgment against us for $3,200,000;
	•	on June 11, 2010, Kimball issued writs of garnishment to SunTrust Bank and Wachovia Bank to locate assets to satisfy the outstanding judgment, which resulted in a freeze on those bank accounts; we do not have access to the cash funds deposited with the two banks subject to the writs, and Kimball may request an order from the court at any time entitling Kimball to the transfer of $39,722.33 in funds from those accounts in partial satisfaction of the outstanding $2,600,000 judgment;

	•	we can provide no assurances that Kimball will not file writs of garnishment against our escrow agent seeking to attach the $2,600,000 balance due; in the event that Kimball serves a writ of garnishment on our escrow agent, the offering may not close and, in that case, we and the underwriter will instruct the escrow agent to return your escrowed funds to you by the end of the T + 3 period (the third trading day after pricing);

	•	until such time as we repay Kimball the $2.6 million of indebtedness under the settlement agreement and we reach a new agreement with Kimball for the manufacturing of our product, we have uncertainty as to whether Kimball will continue to manufacture our XT250tm system or whether we will be required to identify a new manufacturer to build our system, which would likely lead to significant timing delays in the production of our system;
	•	we do not own the patented technology which we utilize in connection with our XT250tm system, which patent rights are licensed from Rutgers and furthermore, we are currently in default under our agreement with Rutgers; if we are unable to maintain this license, our operations and financial condition will be negatively affected;
	•	we have identified material weaknesses in our internal controls over financial reporting resulting in a restatement of our financial statements;
	•	an active trading market for our securities may not develop on the NYSE Amex or any other trading market or facility, and we expect that our stock price will be volatile and could decline following this offering, resulting in a substantial loss in your investment; and
	•	assuming we satisfy the eligibility criteria for listing our common stock on NYSE Amex, we can provide no assurances that if we are listed, we will continue to meet the continued listing standards.

										Six Months
		Year Ended December 31,								Ended June 30,
		2008				2009				2009				2010
										(Unaudited)
Statement of Operations Data:
Revenue		$	439,000			$	271,520			$	179,000			$	—
Gross profit (loss)			309,964				137,677				112,435				—
Total general and administrative expenses(1)			3,430,966				6,019,668				1,500,520				1,948,159
Research and development			635,531				581,547				288,186				280,084
Loss from operations			(3,756,533	)			(6,463,538	)			(1,676,271	)			(2,228,243	)
Net (loss) available to common stockholders			(8,430,795	)			(12,900,440	)			(5,352,126	)			(31,018,793	)
Net (loss) per share:
Basic and diluted		$	(4.95	)		$	(6.73	)		$	(3.12	)		$	(11.01	)
Weighted average number of shares outstanding:
Basic and diluted			1,702,156				1,917,157				1,714,725				2,817,688

		As of
		June 30, 2010
		Actual
		(Unaudited)
Balance Sheet Data:
Cash and cash equivalents		$	159
Working capital (deficiency)			(6,701,288	)
Total assets			1,386,443
Total liabilities			47,985,000
Total stockholders’ deficit			(59,849,576	)

(1)		Total general and administrative expenses, represents total operating expenses less research and development.

 

A purchase of our securities involves a high degree of risk. You should consider carefully the following risk factors, in addition to the other information contained in this prospectus and the documents incorporated by reference into this prospectus, before purchasing any securities in this offering.

 

Risks Related to Our Business

 

We have a history of annual net losses which may continue and which may negatively affect our ability to achieve our business objectives, and we received a going concern qualification in our 2009 audit.

 

For the year ended December 31, 2009 and the six months ended June 30, 2010, we had revenue of $271,520 and $-0- and a net loss of $(9,395,261) and $(30,581,149). At December 31, 2009, we had a stockholders’ deficit of $(29,006,573), as compared with $(11,852,015) from December 31, 2008. Our stockholders’ deficit was $(59,849,576) as of June 30, 2010. For the year ended December 31, 2008, we had revenue of $439,000 and a net loss of $(3,889,806). We had a net loss of $(30,581,149) for the six months ended June 30, 2010 compared to a net loss of $(4,386,692) for the comparable 2009 period. Our independent auditors, in their report dated March 12, 2010 for the related audit of our financial statements for the years ended December 31, 2009 and December 31, 2008, expressed doubt about our ability to continue as a going concern. There can be no assurance that our future operations will result in net income. Our failure to increase our revenues or improve our gross margins will harm our business. We may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, our gross margins fail to improve, or our operating expenses exceed our expectations, our operating results will suffer. The prices we charge for our XT250^tm system may decrease, which would potentially reduce our revenues. If we are unable to sell our solutions at acceptable prices relative to our costs, or if we fail to develop and introduce on a timely basis new products from which we can derive additional revenues, our financial results will suffer.

 

We currently are experiencing uncertain economic conditions, which makes it difficult to estimate growth in our markets and, as a result, future income and expenditures.

 

Current conditions in the domestic and global economies are extremely uncertain. As a result, it is difficult to estimate the level of growth for the economy as a whole. It is even more difficult to estimate growth in various parts of the economy, including some of the markets in which we participate. Because all components of our budgeting and forecasting are dependent upon estimates of growth in the markets we serve, the prevailing economic uncertainty renders estimates of future income and expenditures even more difficult than usual. As a result, we may make significant investments and expenditures but never realize the anticipated benefits, which could adversely affect our results of operations. The future direction of the overall domestic and global economies will have a significant impact on our overall performance.

 

Our resources may not be sufficient to manage our expected growth; failure to properly manage our potential growth would be detrimental to our business.

 

We may fail to adequately manage our anticipated future growth. Any growth in our operations will place a significant strain on our administrative, financial and operational resources, and increase demands on our management and on our operational and administrative systems, controls and other resources. We cannot assure you that our existing personnel, systems, procedures or controls will be adequate to support our operations in the future or that we will be able to successfully implement appropriate measures consistent with our growth strategy. As part of this growth, we may have to implement new operational and financial systems, procedures and controls to expand, train and manage our employee base, and maintain close coordination among our technical, accounting, finance, marketing, and sales staff. We cannot guarantee that we will be able to do so, or that if we are able to do so, we will be able to effectively integrate them into our existing staff and systems. If we are unable to manage growth effectively, such as if our sales and marketing efforts exceed our capacity to manufacture our XT250^tm systems or if new employees are unable to achieve performance levels, our business, operating results and financial condition could be materially and adversely affected.

We are currently a defendant in a lawsuit with the manufacturer of the XT250 system, Kimball Electronics, Inc. in connection with funds we currently owe to its parent corporation, Kimball International, Inc., under a promissory note and on February 8, 2010, Kimball entered an Agreed Judgment against us for $3,200,000.

 

We face significant risk relating to a lawsuit in which we are the defendant with the manufacturer of the XT250, Kimball International, Inc. and Kimball Electronics, Inc. (“Kimball”). There is significant uncertainty whether we will reach a compromise with Kimball to continue to manufacture our XT250 units. During September 2008, Kimball filed suit against us, including claims alleging we defaulted on a $2,000,000 loan provided by Kimball in favor of us, breach of a reserve capacity agreement and breach of a supplier agreement. We asserted counterclaims against Kimball for conversion, breach of contract and tortious interference with business relationship. On June 30, 2009, the District Court granted partial judgment in favor of Kimball in the amount of $2,000,000 against us. On December 23, 2009, we and Kimball entered into a settlement agreement (the “Agreement”). In connection with the Agreement we provided to Kimball an executed Agreed Judgment in favor of Kimball in the amount of $3,200,000 (the “Agreed Judgment”). We agreed to make payments to Kimball via wire transfer or certified funds as follows: (i) one payment of $600,000 to be made on or before December 31, 2009; and (ii) one final payment of $2,600,000 to be made on or before January 31, 2010. On December 29, 2009, we made the initial payment of $600,000 to Kimball under the Agreement. Because we failed to make the $2,600,000 payment to Kimball according to the terms of the Agreement, Kimball entered the Agreed Judgment against us in the amount of $3,200,000. On February 10, 2010, Kimball filed a motion for proceedings supplemental to collect the remaining $2,600,000 balance due on the $3,200,000 judgment. On June 11, 2010, Kimball issued writs of garnishment to SunTrust Bank and Wachovia Bank to locate assets to satisfy the outstanding judgment, which resulted in a freeze on those bank accounts. On June 23, 2010, Kimball filed notice of the writs in the United States District Court for the Southern District of Florida (Case No. 10-MC-14066-JEM). The deadline to dissolve the writs was July 13, 2010, and Kimball chose not to attempt to dissolve the writs. We do not have access to the cash funds deposited with the two banks subject to the writs. Kimball may request an order from the court at any time entitling Kimball to the transfer of $39,722.33 in funds from those accounts in partial satisfaction of the outstanding $2,600,000 Agreed Judgment. As of the date of this prospectus, a motion requesting a court order to transfer these funds to Kimball has not been filed. We anticipate that if this offering does not close for any reason, Kimball will move forward in its collection efforts to transfer our cash funds under the writs of garnishment. A portion of the proceeds of the offering will be utilized to discharge the $2,600,000 balance due on the Agreed Judgment. We can provide no assurances that Kimball will not file writs of garnishment against our offering escrow agent seeking to attach the $2,600,000 balance due. In the event that Kimball serves a writ of garnishment on our escrow agent, the initial public offering may not close, and in that case we and the underwriter will instruct the escrow agent to return your escrowed funds to you by the end of the T + 3 period (the third trading day after pricing).

 

We may be required to identify a new manufacturer for the XT250^tm system.

 

Until such time as we repay Kimball the $2.6 million of indebtedness under the settlement agreement and we reach a new agreement with Kimball for the manufacturing of our product, we have uncertainty as to whether Kimball will continue to manufacture our XT250^tm system or whether we will be required to identify a new manufacturer, which would likely lead to significant timing delays in the production of our system. Although we currently have four XT250^tm systems at our facility available for immediate sale, to the extent we receive purchase orders for additional units now, we believe two months would be required to train any new manufacturer of the XT250^tm system and it would likely take a new manufacturer six months to acquire all the needed materials to produce the XT250^tm system. These timing delays would adversely affect our ability to provide new units to our customers and could adversely affect our result of operations.

 

Although we believe that other manufacturers may be able to acquire the expertise to assemble and produce the hardware a significant investment in parts and scientific labor would likely be required on the part of the manufacturer and us to engage in a new manufacturing relationship. Since it appears unlikely that Kimball will voluntarily release the inventory to us, if we work with a new manufacturer, we will be required to replace these parts and components in the manufacture of our units. These additional capital expenditures to purchase parts and manufacture new units will additionally adversely affect our results of operations and financial performance.

We have identified material weaknesses in our internal controls over financial reporting.

 

We identified control deficiencies that have been classified as material weaknesses in our internal controls over financial reporting. A material weakness is a control deficiency that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. The control deficiencies identified include inadequate segregation of duties over financial reporting as well as improper reporting of certain financial instruments, income taxes, loss contingencies and share-based compensation which resulted in restatement of our financial statements for 2009, 2008 and 2007. The identification of these material weaknesses may cause investors to lose confidence in us and our stock may be negatively affected.

 

To address the control deficiencies, we have hired a new member of management with experience in complex accounting and we plan to hire additional accounting staff in order to implement an appropriate level of segregation of duties. In addition, we plan to hire additional qualified financial reporting personnel and engage outside consultants to assist in accurate financial reporting to ensure our financial statements are in accordance with generally accepted accounting principles.

 

The standards that must be met for management to assess the internal control over financial reporting are relatively new and complex, and require significant documentation, testing and possible remediation to meet the detailed standards. We may encounter problems or delays in completing the activities necessary to make future assessments of our internal control over financial reporting and completing the implementation of any necessary improvements. Future assessments may require us to incur substantial costs and may require a significant amount of time and attention of management, which could seriously harm our business, financial condition and results of operations. If we are unable to assess our internal control over financial reporting as effective in the future, investors may lose confidence in us and our stock may be negatively affected.

 

If we do not successfully develop new products and solutions, our business may be harmed.

 

Our business and operating results may be harmed if we fail to expand our products (either through internal product or capability development initiatives or through partnerships and acquisitions) beyond our current XT250^tm system in such a way that achieves market acceptance or that generates significant revenue and gross profits to offset our operating and other costs. We may not successfully identify, develop and market new product and service opportunities in a timely manner. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenue or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies or in new strategic partnerships, and we may not have sufficient resources to make these investments. Because the markets for our solutions are subject to rapid change, we may need to expand and/or evolve our product and service offerings quickly. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements and harm our business and operating results.

 

We do not own the technology which we utilize in connection with our XT250^tm system which patent rights are licensed from Rutgers University. We are currently in default under our agreement with Rutgers and if we are unable to maintain this license, we anticipate our operations and financial condition will be negatively affected.

 

We do not own all of the software, other technologies and content used in our products and services. We license the technology utilized in connection with our XT250^tm system from Rutgers, The State University of New Jersey (“Rutgers”) pursuant to an exclusive license agreement for the patent rights to registered patent U.S. Patent No. 6,118,850 and U.S. Patent application Serial No. 60/352,952 (WO 03/065077). A disagreement between Rutgers and us could have a very negative effect on our ability to operate our business effectively. In addition, we could learn that the technologies we have licensed from Rutgers do not perform as purported, are not effective, or are not the property of Rutgers, or some similar problem with the license any of which would have an immediate and negative effect on our business. The technology is licensed under the agreement from the effective date of December 13, 2004 and remains in effect in each country of the world until the later of (i) expiration in a country of the last-to-expire of issued patents within the Rutgers patent rights licensed under the agreement, or (ii) 15 years from the first commercial sale of the licensed products in that country. As of August 15, 2010, we are currently in arrears with respect to payment of $1,103,350, which equals the minimum annual royalty payment due under the

agreement and accrued interest. The licensing agreement provides that if either party breaches or fails to perform any provision of the agreement, the other party may give written notice of the default to the breaching party. The agreement further provides if we fail to cure the default within sixty days of receipt of the notice of default, Rutgers has the right to terminate the agreement and the license by sending a notice of termination to us. The agreement will automatically terminate on the effective date of the notice of termination. Representatives of the company have recently met with Rutgers to discuss the licensing agreement between the university and the company. The parties have mutually agreed and acknowledged verbally that we will require capital financing to repay Rutgers amounts due under the licensing agreement and that the agreement requires restructuring in connection with royalty fees owed in the future. The parties have verbally agreed to postpone restructuring of the license agreement until subsequent to the public offering. We believe that we and Rutgers are both using good faith efforts to maintain the business relationship and restructure the parties’ contractual obligations going forward. The loss of, or our inability to maintain, this license could result in our inability to sell our products including the XT250^tm systems without liability exposure including claims of infringement from other parties.

 

If we do not adequately protect our intellectual property rights, we may experience a loss of revenue and our operations may be materially harmed.

 

We have not received registered patents or copyrights on any of the software or technology we have developed and are relying on the patented technology owned by Rutgers which we license to produce the XT250^tm units. We additionally rely upon confidentiality agreements signed by our employees, consultants and third parties, and trade secret laws of general applicability, to safeguard our software and technology. We cannot assure you that we can adequately protect our intellectual property or successfully prosecute potential infringement of our intellectual property rights. Also, we cannot assure you that others will not assert rights in, or ownership of, trademarks and other proprietary rights of ours or that we will be able to successfully resolve these types of conflicts to our satisfaction. Our failure to protect our intellectual property rights may result in a loss of revenue and could materially harm our operations and financial condition.

 

Our lengthy sales cycle may increase our exposure to customer cancellations and other risks.

 

Our product sales cycle has been and is expected to continue to be lengthy and variable. We generally expect the need to educate our potential customers about the use and benefits of the XT250^tm system, which can require the investment of significant time and resources. This lengthy sales cycle creates risks related to customer decisions to cancel or change product plans, which could result in the loss of anticipated sales. We may incur significant research and development, selling and general and administrative expenses as part of this process before it generates the related revenues from any such customer.

 

We may not be able to secure all rights to our intellectual property; our rights may be subject to claims of infringement by others, and other issues affecting production.

 

We are relying on a combination of our patent licensing rights, as well as employee and third party non-disclosure agreements to protect intellectual property rights pertaining to our products and technologies. There can be no assurance, however, that these measures will provide meaningful protection of the technology, trade secrets, know-how, or other intellectual property in the event of any unauthorized use, misappropriation, or disclosure. There can also be no assurance that others will not independently develop similar technologies or duplicate any technology we develop or have developed without violating our intellectual property rights. In addition, there can be no assurance our intellectual property rights will be held to be valid, will not be successfully challenged or will otherwise be of value.

 

Our patent applications which may be submitted in the future may be subject to a charging and retaining lien held by our counsel that prepare and file such applications. Failure to repay outstanding debts to such counsel could prevent us from fully commercially exploiting the technology. In addition to developing and seeking patent and other intellectual property protection for the technology, we do not currently, but may in the future, rely on licenses from third parties for material components of the technology embodied in our products. A dispute with a licensor of such products, or claims for infringement against the licensor by third parties with respect to the technology licensed to us, could materially adversely affect our business.

Any of our future patent applications may not be approved or may be successfully challenged by others or invalidated through administrative processes or litigation. If our applications are not approved, we may not be able to enter into arrangements to allow us to continue to use our technology on commercially reasonable terms.

 

While we do not believe that our licensed technology infringes on any existing patents or intellectual property rights of third parties, there can be no assurance that such infringement has not occurred or will not occur. The costs of defending an intellectual property claim could be substantial and could adversely affect our business, even if we were ultimately successful in defending any such claims. If our licensed technology were found to infringe the rights of a third party, we would be required to pay significant damages or license fees or cease production, any of which could have a material adverse effect on our business.

 

We depend on the patent we license from Rutgers and other means to protect our intellectual property which may not be adequate.

 

The law of patents and trade secrets is constantly evolving and often involves complex legal and factual questions. The coverage under the Rutgers patent and any additional coverage we may seek in our patent applications can either be denied or significantly reduced before or after a patent is issued. Consequently, we cannot be sure that any particular patent we apply for will be issued, that the scope of the patent protection will exclude our competitors, that interference proceedings regarding any of our patent applications will not be filed, or that a patent will provide any other competitive advantage to us. In addition, we cannot be sure that the patented technology we license from Rutgers will be held valid if challenged or that others will not claim rights in or ownership of the patents and other proprietary rights held by us.

 

Because patent applications may be secret until patents are filed with the USPTO and the publication of discoveries in the scientific or patent literature lags behind actual discoveries, we cannot be certain if our patent application was the first application filed covering a particular invention. If another party’s rights to an invention are superior to ours, we may not be able to obtain a license to use that party’s invention on commercially reasonable terms, if at all. In addition, our competitors, many of which have greater resources than we do, could seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make use of our inventions either in the U.S. or in international markets. Further, the laws of some foreign countries do not always protect intellectual property rights to the same extent as do the laws of the U.S. Litigation or regulatory proceedings in the U.S. or foreign countries also may be necessary to enforce our patent or other intellectual property rights or to determine the scope and validity of our competitors’ proprietary rights. These proceedings can be costly, result in product development delays, and divert our management’s attention from our business.

 

We may also rely upon unpatented proprietary technology, and we cannot assure you that others will not independently develop substantially equivalent technology or otherwise gain access to or disclose our proprietary technology. We may not be able to meaningfully protect our rights in this proprietary technology, which would reduce our ability to compete in the market.

 

Although we have confidentiality agreements in place with our employees, these agreements may not adequately prevent disclosure of proprietary information.

 

Our policy is to execute confidentiality agreements with our employees and consultants upon the commencement of their employment or consulting arrangement with us. These agreements generally require that all confidential information developed by an individual or to which the individual is exposed during the course of his or her relationship with us must be kept confidential even after the individual has left our employment. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot be sure that these agreements will provide meaningful protection of our proprietary and other confidential information. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees or consultants have prior employment or consulting relationships. We may be forced to engage in costly and time-consuming litigation to determine the scope of and to enforce our proprietary rights. Even if successful, any litigation could divert our management’s attention from our business.

We have been subject to informal questioning and an informal inquiry from federal and state regulatory agencies recently related to an unidentified investigation and you should be aware that if we become a target or defendant in an investigation, litigation or other governmental proceeding our business prospects may potentially be adversely affected.

 

On August 6, 2009, the company was unexpectedly visited by special agents from the Office of Criminal Investigations of the federal Food and Drug Administration (“FDA”) and the Florida Department of Law Enforcement who informed our management that there was an investigation being conducted into two of our customers. The agents proceeded to ask a series of general questions based on which our management believes that the investigation involves the diversion of drugs. The agents made an inquiry as to the capabilities of our XT250^tm machine and whether it can be used to aid in diverting drugs. Our management explained that our equipment cannot be used in such a fashion as to aid in the diversion of drugs and that the company has at no time had any part in the diversion of drugs. Diversion of drugs most frequently occurs when a patient receives a legitimate prescription for an actual or feigned illness and sells the procured drugs on the black market. The black market may then distribute or divert the prescription drugs, which are likely not counterfeit drugs, into the legal supply chain. Our system as currently designed does not identify that these were diverted (or not diverted) drugs but rather is used to determine whether molecular structures of drugs are valid. At this time, we have no reasonable basis to believe that we are a target of the investigation against our customers and will fully cooperate with the investigation. To date, we have not received any formal or informal written correspondence from either regulatory agency relating to the investigation nor are we a party to any legal and/or regulatory proceeding related to this matter.

 

We will need to operate without infringing the proprietary rights of others.

 

We cannot be certain that U.S. or foreign patents or patent applications of other companies do not exist or will not be issued that would materially and adversely affect our ability to commercialize our products. We may be sued for infringing or misappropriating the patent or other intellectual property rights of others. Intellectual property litigation is costly and, even if we prevail, the cost of this litigation could negatively affect our business. If we do not prevail in litigation, in addition to any damages we might have to pay, we could be required to stop the infringing activity or obtain a license requiring us to make royalty payments. Any license we are required to obtain may not be available to us on commercially acceptable terms, if at all. In addition, any license we are required to obtain may be non-exclusive, and therefore our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around another company’s patent, we may be unable to make use of some of our technologies or distribute our products.

 

We may be liable for use of information we provide to third party customers.

 

Incorrect information that results from the use of our systems could cause the end-user either to take an action or fail to take an action which could have a detrimental effect, and we could be liable for the damages resulting from the incorrect information. While we maintain product liability insurance coverage in an amount that we currently believe is sufficient for our business, we cannot assure you that this coverage will prove to be adequate or will continue to be available on acceptable terms, if at all. A claim brought against us regarding injuries related to the use of our system that is uninsured or under-insured could materially harm our business, financial condition, results of operations and prospects in the future. A claim could also result in negative publicity.

 

Our failure to comply with certain local, state and federal government regulations could negatively affect our operating results and future prospects.

 

Certain computer applications, software and systems, such as ours, involving the use of X-ray technologies are subject to regulation by numerous local, state and federal governments, including the Department of Defense, the Drug Enforcement Agency, and various other law enforcement agencies. As such, our products and operations are subject to various local, state and federal regulations and oversight. Compliance with such current and future regulations could have a material adverse effect on our business, results of operations, financial conditions and prospects in the future.

Our failure to comply with federal FDA regulations could negatively affect our operating results.

 

The FDA is responsible for, among other things, assuring the safety and effectiveness of medical devices. Certain computer applications, software and systems are considered medical devices, and therefore subject to regulation by the FDA. We do not believe that our system currently is subject to FDA oversight. Nevertheless, if the FDA were to determine that our system is subject to FDA jurisdiction, or in the event we expand our product line into medical diagnostics, we may become subject to FDA jurisdiction, as such compliance with FDA requirements could have a material adverse effect on our business, results of operations, financial conditions and prospects in the future.

 

Product liability claims may exceed our insurance coverage.

 

The manufacture and sale of our products carries the risk of product liability claims. Any error, no matter how unlikely, may cost lives and significant property damage. While we intend to maintain a prudent level of product liability insurance and errors and omissions coverage, there can be no assurance that our coverage limits will be adequate to protect us from any liabilities we might incur in connection with the sale of our products or that we will be able to maintain this level of coverage in the future. Because we plan to market and sell anti-terrorism technology to the U.S. government, however, damages paid resulting from lawsuits related to these activities may be limited or otherwise covered under the federal Support Anti-Terrorism by Fostering Effective Technologies (SAFETY) Act of 2002, a part of the Homeland Security Act of 2002.

 

In addition, in order to maintain our competitive position, we will likely need to maintain a steady pace of new products and updates or enhancements of our existing product, the XT250^tm system. Accordingly, we may require increased product liability coverage as additional products and updates come to the market place. Such insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful product liability claim or series of such claims in excess of our insurance coverage could have a material adverse effect on our business.

 

We depend on certain key executive officers and the loss of such key employees could materially adversely affect our business.

 

We are dependent on our executive officers, the loss of any one of whom could have an adverse effect on our business if we could not promptly secure a replacement with equivalent expertise and experience. We will rely on the management expertise and experience of, among others, Mr. James Lowery and Mr. Anthony Chidoni, our co-chief executive officers.

 

While we believe that our management possesses the necessary experience to successfully manage our operations, there can be no guarantee that they will perform adequately or that our operations will be successful. In addition, our future success may depend in large part upon our ability to attract and retain additional highly skilled managerial and other personnel. We may not be successful in hiring or retaining the personnel we need and this could have a material adverse effect our business.

 

Our ability to use net operating loss carryforwards in the U.S. may be limited.

 

As of December 31, 2009, we had net operating losses of approximately $18.6 million for federal income tax purposes, which expire at various dates through 2029. To the extent available and not otherwise utilized, we intend to use any net operating loss carryforwards to reduce the U.S. corporate income tax liability associated with our operations. Section 382 of the Internal Revenue Code of 1986, as amended, generally imposes an annual limitation on the amount of net operating loss carryforwards that may be used to offset taxable income when a corporation has undergone certain changes in stock ownership. Our ability to utilize net operating loss carryforwards may be limited, under this section or otherwise, by the issuance of common stock in this offering. To the extent our use of net operating loss carryforwards is significantly limited, our income could be subject to U.S. corporate income tax earlier than it would if we were able to use net operating loss carryforwards, which could result in lower profits.

Risks Related to the Auction Process for this Offering

 

Potential investors should not expect to sell our shares for a profit shortly after our common stock begins trading.

 

A principal factor in determining the initial public offering price for the shares sold in this offering will be the clearing price resulting from an auction conducted by us and our underwriter. The clearing price is the highest price at which all of the shares offered may be sold to potential investors. Although we and our underwriter may elect to set the initial public offering price below the clearing price, the public offering price may be at or near the clearing price. If there is little to no demand for our shares at or above the initial public offering price once trading begins, the price of our shares could decline following our initial public offering. If your objective is to make a short-term profit by selling the shares you purchase in the offering shortly after trading begins, you should not submit a bid in the auction.

 

Some bids made at or above the initial public offering price may not receive an allocation of shares.

 

Our underwriter may require that bidders confirm their bids before the auction for our initial public offering closes. If a bidder is requested to confirm a bid and fails to do so within a required time frame, that bid will be rejected and will not receive an allocation of shares even if the bid is at or above the initial public offering price. In addition, we, in consultation with our underwriter, may determine, in our sole discretion, that some bids that are at or above the initial public offering price are manipulative or disruptive to the bidding process or are not creditworthy, in which case such bids will be reduced or rejected.

 

Potential investors may receive a full allocation of the shares they bid for if their bids are successful and should not bid for more shares than they are prepared to purchase.

 

If the public offering price is at or near the clearing price for the shares offered in this offering, the number of shares represented by successful bids will equal or nearly equal the number of shares offered by this prospectus. As a result, successful bidders may be allocated all or nearly all of the shares that they bid for in the auction. Therefore, we caution investors against submitting a bid that does not accurately represent the number of shares of our common stock they are willing and prepared to purchase.

 

Risks Related to Our Securities and this Offering

 

Because of the structure of the minimum/maximum offering which requires us to raise at least $20,000,000 in the auction to consummate a closing, during the offering period investor funds will be placed in escrow and investors will not have use of their funds during this period.

 

We are offering shares of our common stock on a best efforts basis. Based on the minimum/maximum structure of this offering no commitment by anyone exists to purchase all or any part of the shares offered hereby. Consequently, there is no assurance that the shares being offered will be sold in the auction and an auction bidder’s funds may be escrowed for as long as three business days following pricing, and then returned without interest if within such time an aggregate of $20,000,000 of funds are not received in the escrow account or NYSE Amex has not confirmed that the shares offered hereby will be listed on NYSE Amex. Investors will not have use of any funds paid for the shares of common stock during the time the investor’s funds are held in the escrow account. Prior to the auction and during the bidding process the bidders will not know what amount of proceeds will be raised, the number of shares to be sold, the price of the shares or whether the transaction will close. Furthermore, during the period while a bidder’s funds are held in the escrow account, the bidder will not have use of its funds and will not definitively know whether the offering will close.

 

An active trading market for our securities may not develop and we expect that our stock price will be volatile and could decline following this offering, resulting in a substantial loss in your investment.

 

Prior to this offering, there has not been a public market for our securities. An active trading market for our securities may never develop or if it develops it may not be sustained, which could affect your ability to sell your securities and could depress the market price of your securities. In addition, the initial public offering price of the securities has been determined by the board of directors and management in conjunction with the underwriter and

may bear no relationship to the price at which the securities will trade upon completion of this offering. The offering price does not necessarily indicate the current value of the securities offered hereby and should not be regarded as an indicator of any future market performance or value thereof.

 

In addition, the stock market can be highly volatile. As a result, the market price of our securities can be similarly volatile, and investors in our securities may experience a decrease in the value of their securities, including decreases unrelated to our operating performance or prospects. The market price of our securities after the offering will likely vary from the initial offering price and is likely to be highly unpredictable and subject to wide fluctuations in response to various factors, many of which are beyond our control. These factors include:

 

 

You will experience immediate and substantial dilution when you purchase securities in this offering.

 

Upon the closing of this offering, investors will incur immediate and substantial dilution in the per share net tangible book value of their shares of common stock. At June 30, 2010, after giving pro forma effect to our receipt of the net proceeds of this offering, we would have had a pro forma net tangible book value of $6,208,200, or $0.60 per share in a minimum offering and $15,708,196 or $1.30 per share in a maximum offering per share. Net tangible book value is the amount of our total assets minus intangible assets and liabilities. This represents a gain in our net tangible book value of $6.51 in a minimum offering and $8.81 in a maximum offering per share for the benefit of our current stockholders, and dilution of $8,357,222 or 41.79% in a minimum offering and $8,857,222 or 29.52% in a maximum offering of the public offering price, for investors in this offering. Investors in this offering will be subject to increased dilution upon the exercise of existing outstanding stock options and warrants. These stock options and warrants, for which cash would need to be remitted to us for exercise, represent an additional 15,111,802 shares of common stock that could be issued in the future. However, each of our warrantholders has agreed not to exercise the warrants for three years subsequent to the effective date of the registration statement in this offering.

 

Shares of stock issuable pursuant to our stock options, warrants, and convertible preferred stock may adversely affect the market price of our common stock.

 

As of August 15, 2010, we have outstanding under our 2004 Stock Option Plan, stock options to purchase an aggregate of 1,879,386 shares of common stock at a weighted average exercise price of $2.13 per share and outstanding warrants to purchase 13,078,685 shares of common stock (for which cash would need to be remitted for us to exercise) at a weighted average exercise price of $2.99 per share. In addition, as of August 15, 2010, we have outstanding shares of preferred stock as follows: Series A preferred stock — 962,101 shares convertible at $3.80 per share; Series B preferred stock — 1,619,127 at $3.00 per share; and Series C preferred stock — 365,996 at $3.00 per share; and Series D preferred stock — 563,414 at $3.00 per share, all of which are immediately convertible into shares of our common stock on a one-for-one basis on the effective date of this registration statement. We are also obligated to issue approximately 679,529 shares of common stock upon conversion of accrued dividends on such preferred stock as of August 15, 2010. In addition, 1,153,731 share based incentive grants are outstanding, including stock options to purchase an aggregate of 153,731 shares of common stock at a weighted average exercise price of $0.69 per share, and 3,846,269 shares of our common stock are reserved for issuance under our 2009 Long Term Incentive Compensation Plan. The exercise of the stock options, preferred stock and warrants and the sales of stock issuable pursuant to them, would further reduce a stockholder’s percentage voting and ownership interest. However,

each of our warrantholders has agreed not to exercise the warrants for three years subsequent to the closing of this offering.

 

The stock options and warrants are likely to be exercised when our common stock is trading at a price that is higher than the exercise price of these options and warrants, and we would be able to obtain a higher price for our common stock than we will receive under such options and warrants. The exercise, or potential exercise, of these options and warrants could adversely affect the market price of our common stock and adversely affect the terms on which we could obtain additional financing.

 

The large number of shares eligible for future sale may adversely affect the market price of our common stock.

 

The sale, or availability for sale, of a substantial number of shares of common stock in the public market could materially adversely affect the market price of our common stock and could impair our ability to raise additional capital through the sale of our equity securities. At the completion of this offering, assuming the sale of 5,000,000 shares of common stock there will be approximately 12,055,211 shares of common stock issued and outstanding. Of these shares, approximately 5,000,000 will be freely transferable, and approximately 7,055,211 shares will be eligible for resale under Rule 144 following the expiration of our lock-up agreements on the one year anniversary of the effective date of this registration statement, subject to exceptions for holders of 2,500 shares or less who have six-month lock-up agreements with us. Our executive officers and directors beneficially own 3,227,604 shares of common stock and shares of common stock issuable upon conversion of preferred stock and accrued dividends and exercise of certain options and warrants, which would be eligible for resale subject to the volume and manner of sale limitations of Rule 144 of the Securities Act of 1933, as amended (“Securities Act”), following expiration of any applicable lock-ups. Upon the conversion of our outstanding preferred stock and accrued dividends through August 15, 2010 into shares of common stock, an additional 4,190,167 shares are “restricted securities,” as that term is defined in Rule 144, and will be eligible for sale under the provision of Rule 144 following expiration of any applicable lock-ups. For additional information, see “Shares Eligible for Future Sale.”

 

We have provisions in our certificate of incorporation that substantially eliminate the personal liability of members of our board of directors for violations of their fiduciary duty of care as a director and that allow us to indemnify our officers and directors.

 

Certain provisions in our certificate of incorporation could make it very difficult for you to bring any legal actions against our directors for such violations or could require us to pay any amounts incurred by our directors in any such actions. Pursuant to our certificate of incorporation and amended and restated by-laws, members of our board of directors will have no liability for violations of their fiduciary duty of care as a director, except in limited circumstances. This means that you may be unable to prevail in a legal action against our directors even if you believe they have breached their fiduciary duty of care. In addition, our certificate of incorporation and amended and restated by-laws allows us to indemnify our directors from and against any and all expenses or liabilities arising from or in connection with their serving in such capacities with us. This means that if you were able to enforce an action against our directors or officers, in all likelihood we would be required to pay any expenses they incurred in defending the lawsuit and any judgment or settlement they otherwise would be required to pay.

 

Our officers and directors have significant voting power and may take actions that may not be in the best interests of other stockholders.

 

Our executive officers and directors currently beneficially own or control 65.2% of our common stock. Upon the completion of this offering our executive officers and directors will beneficially own or control approximately 29.3% of our outstanding common stock if the minimum offering is completed and 25.5% if the maximum offering is completed. If these stockholders act together, they will be able to exert significant control over our management and affairs requiring stockholder approval, including approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. As a result, these stockholders could together influence all matters presented to our stockholders for approval, including election and removal of our directors and change of control transactions. The interests of these stockholders may not always coincide with the interests of the other holders of our common stock.

We are restricted from paying dividends under the terms of our preferred stock designations and you should not buy our stock if you expect dividends.

 

We currently intend to retain our future earnings to support operations and to finance expansion and, therefore, we do not anticipate paying any cash dividends on our capital stock in the foreseeable future. Furthermore, the terms of our preferred stock designations restrict the payment of dividends and provide that except for the ratable payment of dividends on the Series A, B, C and D preferred stock, we may not directly or indirectly declare or pay any cash or property dividends or make any cash or property distributions upon any of our capital stock or other equity securities. You should not buy our stock if you are expecting to receive cash dividends.

 

As a public company we will incur additional cost and face increased demands on our management and key employees.

 

We have never operated as a public company. As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as rules implemented by the Securities and Exchange Commission, or SEC, and the exchange where we propose to trade our securities, impose various requirements on public companies. Our management and other personnel will devote substantial amounts of time to these requirements. We expect these requirements to significantly increase our legal and financial compliance costs and to make some activities more time-consuming and costly. In addition, we will incur additional costs associated with our public company reporting requirements. These rules and regulations also make it more difficult and more expensive for us to obtain director and officer liability insurance. We cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. If our profitability is harmed by these additional costs, it could have a negative effect on the trading price of our common stock.

 

We will retain broad discretion in using the net proceeds from this offering and may spend a substantial portion in ways with which you do not agree.

 

Our management will retain broad discretion to allocate the net proceeds of this offering. The net proceeds may be applied in ways with which you and other investors in the offering may not agree, or which do not increase the value of your investment. We intend to use a portion of our net proceeds from this offering to repay the outstanding indebtedness, which was $7,357,222 as of August 15, 2010. After repayment of indebtedness, we anticipate that we will use the remainder of the net proceeds for working capital and other general corporate purposes, which may include the acquisition of other businesses, products or technologies. We have not allocated these remaining net proceeds for any specific purposes except that we intend to use approximately $2,000,000 of the proceeds allocated for working capital and general corporate purposes for the construction and installation of new XT250^TM systems. Our management might not be able to yield a significant return, if any, on any investment of these net proceeds.

 

We do not know whether a market will develop for our common stock or what the market price of our common stock will be and as a result it may be difficult for you to sell your shares of our common stock.

 

Before this offering, there was no public trading market for our common stock. If a market for our common stock does not develop or is not sustained, it may be difficult for you to sell your shares of common stock at an attractive price or at all. We cannot predict the prices at which our common stock will trade. The initial public offering price for our common stock was determined by the board of directors and management in conjunction with the underwriter and may not bear any relationship to the market price at which the common stock will trade after this offering or to any other established criteria regarding our value. It is possible that in one or more future periods our results of operations may be below the expectations of public market analysts and investors and, as a result of these and other factors, the price of our common stock may fall.

 

If securities analysts do not publish research or reports about our business or if they publish negative evaluations of our stock, the price of our stock could decline.

 

The trading market for our common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. We do not currently have and may never obtain research coverage by industry or financial analysts. If no or few analysts commence coverage of us, the trading price of our stock would

likely decrease. Even if we do obtain analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our stock could decline. If one or more of these analysts cease to cover our stock, we could lose visibility in the market for our stock, which in turn could cause our stock price to decline.

 

Provisions in our organizational documents and in the Delaware General Corporation Law may prevent takeover attempts that could be beneficial to our stockholders.

 

Provisions in our certificate of incorporation and amended and restated by-laws, both of which will be effective upon the closing of this offering, and in the Delaware General Corporation Law, may make it difficult and expensive for a third party to pursue a takeover attempt we oppose even if a change in control of our company would be beneficial to the interests of our stockholders. Any provision of our certificate of incorporation or amended and restated by-laws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock. Our board of directors has the authority to issue up to 6,000,000 shares of preferred stock in one or more series and to fix the powers, preferences and rights of each series without stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisition proposals or make it more difficult for a third party to gain control of our company, or otherwise could adversely affect the market price of our common stock. Further, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. This section generally prohibits us from engaging in mergers and other business combinations with stockholders that beneficially own 15% or more of our voting stock, or with their affiliates, unless our directors or stockholders approve the business combination in the prescribed manner.

 

State Blue Sky laws may limit resale of the shares of common stock.

 

Although we assume that, as part of this offering, we will raise $20.0 million in gross proceeds and that we will have a minimum of 400 round lot holders to be accepted for listing on the NYSE Amex, we cannot guarantee that we will maintain our listing on such market. As such, investors should consider the possibility that any secondary market for our securities could be a limited one including a trading market on the over-the-counter bulletin board. The holders of our shares of common stock and persons who desire to purchase them in any trading market that might develop in the future should be aware that there may be significant state law restrictions upon the ability of investors to resell our shares. If the securities are traded on the over-the-counter bulletin board, we intend to seek coverage and publication of information regarding the company in an accepted publication which permits a “manual exemption.” This manual exemption permits a security to be distributed in a particular state without being registered if the company issuing the security has a listing for that security in a securities manual recognized by the state. However, it is not enough for the security to be listed in a recognized manual. The listing entry must contain (i) the names of issuers, officers, and directors, (ii) an issuer’s balance sheet, and (iii) a profit and loss statement for either the fiscal year preceding the balance sheet or for the most recent fiscal year of operations. Furthermore, the manual exemption is a non-issuer exemption restricted to secondary trading transactions, making it unavailable for issuers selling newly-issued securities. Most of the accepted manuals are those published in Standard and Poor’s, Moody’s Investor Service, Fitch’s Investment Service, and Best’s Insurance Reports, and many states expressly recognize these manuals. A smaller number of states declare that they ‘recognize securities manuals’ but do not specify the recognized manuals. The following states do not have any provisions and therefore do not expressly recognize the manual exemption: Alabama, Georgia, Illinois, Kentucky, Louisiana, Montana, South Dakota, Tennessee, Vermont and Wisconsin.

 

We may not be able to maintain our anticipated listing on the NYSE Amex, which may limit the ability of purchasers in this offering to resell their common stock in the secondary market.

 

Assuming that we raise $20.0 million in proceeds and have a minimum of 400 round lot holders, we believe that we will be accepted for listing on the NYSE Amex at the time of the offering. If our anticipated offering size decreases such that we do not anticipate raising such $20.0 million in gross proceeds, we will be required to delay this offering. Furthermore, the sale of the minimum of 3,333,334 shares at the bottom of our price range, or $4.00, will not generate sufficient proceeds to permit our initial listing on the NYSE Amex. In the event that we were to price the offering below the price range after the auction is closed, we would file a post-effective amendment to reflect the lower price and a higher number of shares. In no event would the actual offering price be less than $3.00

as that is the minimum price required to satisfy NYSE Amex initial listing requirements. Following our initial listing, we might not meet the criteria for continued listing in the future. A company having a security listed on NYSE Amex must make all required filings on a timely basis with the Securities and Exchange Commission. If we are unable to meet the qualitative and quantitative continued listing criteria of the NYSE Amex and became delisted, quotations for trading of our securities could be conducted in the over-the-counter bulletin board, or the Pink Sheets, LLC (if we are not current in our reporting obligations with the SEC). In such case, an investor would likely find it more difficult to dispose of our securities or to obtain accurate market quotations for it. If our securities were delisted from the NYSE Amex, they could become subject to the Securities and Exchange Commission’s “penny stock rules,” which impose sales practice requirements on broker-dealers that sell securities to persons other than established customers and “accredited investors.” Application of this rule could make broker-dealers unable or unwilling to sell our securities and limit the ability of purchasers in this offering to resell their securities in the secondary market.

 

Included in this prospectus are “forward-looking” statements, as well as historical information. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we cannot assure you that the expectations reflected in these forward-looking statements will prove to be correct. Our actual results could differ materially from those anticipated in forward-looking statements as a result of certain factors, including matters described in the section titled “Risk Factors.” Forward-looking statements include those that use forward-looking terminology, such as the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “project,” “plan,” “will,” “shall,” “should” and similar expressions, including when used in the negative. Although we believe that the expectations reflected in these forward-looking statements are reasonable and achievable, these statements involve risks and uncertainties and no assurance can be given that actual results will be consistent with these forward-looking statements. Actual results may be materially different than those described herein. Important factors that could cause our actual results, performance or achievements to differ from these forward-looking statements include the factors described in the “Risk Factors” section and elsewhere in this prospectus.

 

All forward-looking statements attributable to us are expressly qualified in their entirety by these and other factors. We undertake no obligation to update or revise these forward-looking statements, whether to reflect events or circumstances after the date initially filed or published, to reflect the occurrence of unanticipated events or otherwise, except to the extent required by federal securities laws.

 

The net proceeds from the sale of the shares of common stock offered hereby are estimated to be approximately $18,950,003 if the minimum offering is sold and $28,450,000 if the maximum offering is sold based on an assumed public offering price of $6.00 per share which is the midpoint of the range included on the cover page of this prospectus, and after deducting our 5% underwriter commission and $50,000 expense allowance.

 

We intend to use the net proceeds from this offering for the following purposes and in the following order of priority:

 

 

We intend to use approximately $7,357,222 of the proceeds to discharge our indebtedness through August 15, 2010, in the following order of priority and amounts: $2,560,278 to discharge the Kimball judgment against us for manufacturing of XT250^tm units, repayment of promissory notes, plus accounts payable (derived from the judgment of $2,600,000 less $39,722 in funds which are subject to the writ of garnishment); $287,260 to repay principal and accrued interest due to our two debenture holders, John F. Huseman and the R. David Collin Trust, who are unrelated to the company other than through ownership of these debentures; $1,103,350 to discharge amounts we are in arrears under our license agreement with Rutgers University; $741,472 to be paid to affiliates for deferred salary; $366,589 to repay principal and accrued interest due to officers, directors and certain shareholders for non-convertible promissory notes; and $2,298,272 in professional fees incurred in the offering and miscellaneous expenses. Of the $741,472 to be paid to affiliates for deferred salary, $480,792 will be paid to Mr. Brian T. Mayo, our president and chief technology officer, $135,980 will be paid to Mr. Alan Clock, our senior vice president of sales and marketing, $62,856 will be paid to Ms. Patricia Ann Earl, our senior vice president of business development and $44,470 will be paid to Mr. Paul Micciche, our senior vice president of engineering. The balance of $17,373 will be paid to two former employees. Of the $366,589 to be repaid in promissory notes, $365,000 in aggregate principal amount, plus accrued interest, will be repaid to the following directors: James J. Lowrey - $35,000; Anthony R. Chidoni - $35,000; Simon Irish - $35,000; Joseph J. Melone - $25,000; Robert E. Kennedy - $25,000; and Philip A. Odeen - $25,000; our chief financial officer, Dennis K. Cummings -$35,000; and $25,000 to each of the following securityholders who have no affiliation with us except through their ownership of securities and loans to us under the promissory notes: Thomas Cook, Walter Lovejoy, Geoffrey Stringer, William Jennings, Robert Girling, and Michael Haley. We will use the remainder of the net proceeds for research and product development and general corporate purposes including salaries, professional fees, public reporting costs and office-related expenses. We intend to use approximately $2,000,000 of the proceeds allocated for working capital and general corporate purposes for the construction and installation of new XT250^tm systems.

 

Of the portion of the proceeds to be used to discharge indebtedness under our outstanding debt instruments, $325,000 in principal outstanding to certain lenders is accruing interest at a rate of 10% per annum and matures on the closing date of the initial public offering. Additionally, our loans totaling $40,000 in outstanding principal mature on the closing date of our initial public offering and bear interest at a fixed rate equal to the one-month LIBOR rate on the date of the loans, equal to thirty-five hundredths of one percent (0.35%), plus two percent (2%), until all sums due are paid in full. Further, $250,000 in aggregate principal outstanding to our two debenture holders accrues interest at a rate of 8% per annum and matured on December 31, 2009.

 

In the event the price range or offering size described above changes prior to the effectiveness of the registration statement of which this prospectus forms a part, we will file a pre-effective amendment to this registration statement to reflect a revised use of proceeds. See “Plan of Distribution — Changes in the Price Range or Offering Size Before the Auction is Closed.”

 

The initial public offering price of shares of our common stock will be determined by our board of directors and management in conjunction with the underwriter. Among the factors considered in determining the initial public offering price were our future prospects and those of our industry in general, and certain other financial and operating information in recent periods, and other financial and operating information of companies engaged in activities similar to ours. We cannot assure you, however, that the prices at which the shares will sell in the public market after this offering will not be lower than the initial public offering price or that an active trading market in our common stock will develop and continue after this offering.

 

This offering will be made through the OpenIPO process, in which the allocation of shares and the public offering price are primarily based on an auction in which prospective purchasers are required to bid for the shares. The OpenIPO process allows all qualified investors, whether individuals or institutions, to bid for shares. All successful bidders in the auction will pay the same price per share.

 

Potential investors in this offering may submit bids through the underwriter or participating dealers. Bids for the shares may be made at any price, including a price above or below the projected price range set forth on the cover of this prospectus. Once the auction closes, the underwriter will determine the highest price that will sell all of the shares offered. This is the clearing price and is the maximum price at which the shares will be sold. The company may choose to sell shares at the auction-set clearing price or it may choose to sell the shares at a lower offering price, taking into account additional factors. Bidders that submit valid bids at or above the offering price will receive, at a minimum, a pro-rated amount of shares for which they bid. See “Plan of Distribution — Determination of Initial Public Offering Price” below on page 96.

 

We have never paid any cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain any future earnings to fund the development and growth of our business. Furthermore, the terms of our preferred stock designations restrict the payment of dividends and provide that except for the ratable payment of dividends on the Series A, B, C and D preferred stock, we may not directly or indirectly declare or pay any cash or property dividends or make any cash or property distributions upon any of our capital stock or other equity securities. You should not buy our stock if you are expecting to receive cash dividends.

 

The following table summarizes our short-term debt and capitalization as of June 30, 2010, giving effect to either a minimum offering of 3,333,334 shares or a maximum offering of 5,000,000 shares (a) on an actual basis, and (b) on a pro forma basis after giving effect to the conversion of all outstanding shares of our Series A, B, C, and D preferred stock and accrued dividends through August 15, 2010 into 4,190,167 shares of our common stock which will occur automatically on the effective date of the registration statement for this offering, and (c) on a pro forma as adjusted basis to reflect the estimated net proceeds we will receive from the sale of the minimum and maximum shares of common stock offered by this prospectus at an assumed public offering price of $6.00 per share after deducting repayment of our indebtedness as of August 15, 2010, in the aggregate amount of $7,357,222 as follows: $2,560,278 to discharge the Kimball judgment against us, plus accounts payable (derived from the judgment of $2,600,000 less $39,722 in funds which are subject to the writ of garnishment); $287,260 to repay principal and accrued interest due to our two debenture holders; $1,103,350 to discharge amounts we are in arrears under our license agreement with Rutgers University; $741,472 to be paid to affiliates for deferred salary; $366,589 to repay principal and accrued interest due to officers, directors and stockholders for promissory notes; and $2,298,272 in professional fees and miscellaneous expenses.

 

If our anticipated offering size or price changes from the amounts described above, we will file a pre-effective amendment to this registration statement describing such changes.

 

 

 

 

Our common stock is not currently traded on any market or exchange. We have applied to list our common stock on the NYSE Amex under the symbol “XTRM”. There can be no assurance that we will continue to satisfy the eligibility criteria to be listed on NYSE Amex.

 

As of August 15, 2010, we had 59 stockholders of record of our common stock.

 

Purchasers of securities in this offering will be diluted to the extent of the difference between the public offering price per share and the net tangible book value per share of our common stock immediately after this offering. Net tangible book value dilution per share represents the difference between the amount per share paid by purchasers of common stock in this offering and the net tangible book value per share of common stock immediately after completion of this offering.

 

Our net tangible book value (deficit) as of June 30, 2010, was $(59,849,863) or $(20.89) per share of common stock. Net tangible book value (deficit) per share as of a specified date is determined by dividing our tangible book value (deficit) by the number of outstanding shares of common stock at such date.

 

After giving effect to our sale of common stock offered by this prospectus (based upon an assumed public offering price of $6.00 per share, the midpoint of the range set forth on the cover page of this prospectus) after deducting our estimated offering expenses, underwriting commissions and expenses, and following extinguishment of our indebtedness as described in the section “Use of Proceeds”, our pro forma net tangible book value as of June 30, 2010 would have been $6,208,200 or $0.60 per share, if the minimum offering is sold, and $15,708,196 or $1.30 per share, if the Maximum Offering is sold.

 

This means that if you buy stock in this offering at $6.00 per share, you will pay substantially more than our current common stockholders paid for their shares. The following represents your dilution:

 

 

 

The following table illustrates this per share dilution, based on the net tangible book value and the fully diluted number of common shares outstanding as of June 30, 2010.

 

 

The following table shows as of June 30, 2010, the difference between the number of shares of common stock purchased from us (including shares of preferred stock and accrued dividends through August 15, 2010 which will convert into approximately 4,190,167 common stock on the effective date of this registration statement), the total

consideration paid to us and the average price paid per share by our existing stockholders and by new investors purchasing common stock in this offering:

 

 

 

Investors in this offering will be subject to increased dilution upon the exercise of outstanding stock options and warrants. However, each of our Series B, C and D warrantholders has agreed not to exercise these warrants until the three year anniversary of the effective date of this registration statement. As of August 15, 2010, these stock options and warrants represent an additional 15,111,802 shares that could be issued (for which cash would need to be remitted to us for exercise) in the future, of which 2,033,117 are outstanding options with a weighted average exercise price of $2.13 and 13,078,685 are outstanding warrants with a weighted average exercise price of $2.99. Of our outstanding options and warrants, 965,285 options and 5,203,480 warrants are held by our executive officers, directors and their affiliates. The following table shows how the numbers and percentages for “shares purchased” and “total consideration” change, assuming exercise of all outstanding options and warrants by existing securityholders:

 

 

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus. The following discussion should be read in conjunction with our financial statements and related notes thereto included elsewhere in this prospectus.

 

Overview

 

We design and develop material authentication and verification solutions that allow molecular structure analysis on hidden materials. Our license of patented technology owned by Rutgers University combines penetrating X-rays, forensic analysis, and automated software algorithms that allow non-technical personnel to rapidly validate products even when sealed within their original packaging. The initial focus for our product, the XT250^tm Material Identification System, has been molecular screening to protect the distribution supply chain from counterfeits, adulterations, and contamination of pharmaceuticals.

 

XT250^tm System

 

The technology we license from Rutgers allows inventory that is packaged and sealed to be non-intrusively verified. Deviations, that may be harmful to the public, are identified by our XT250^tm system and removed from the supply chain. We believe our company has raised the level of awareness of the dangers of counterfeits via our advertising, speaking engagements, websites, and internet blog activities. We have educated our potential customers on our product offerings and worked with them to develop processes to better protect their inventories.

 

The XT250^tm system can be programmed for different materials. In addition to the pharmaceutical distribution market that is already established, management hopes to target other markets with the XT250^tm system. Some industries that perform visual inspections today, like customs inspections and cosmetics distribution, could enhance their verification process with the XT250^tm system. Field related industries that rely upon sending samples to forensic laboratories, such as mining and cement industries, could analyze samples themselves with the XT250^tm system. These are just some of the large markets that provide opportunity for our XT250^tm system to verify or identify materials. In markets where the XT250^tm system may not meet the needs for the particular application, the technology is scalable in terms of speed, portability, and test sample size so that future products may be developed to meet those needs.

 

Management has succeeded in developing strategic relationships in key market segments. PILOT programs with major pharmaceutical manufacturers have allowed us to program the XT250^tm system for their specific needs. PILOT programs with major distributors helped us to develop processes and procedures to maximize value for all of our customers. PILOT programs with major returns logistics companies provided exposure and insight into the dispensing segment of the pharmaceutical market, resulting in enhanced capabilities of the XT250^tm that were developed. Each of the PILOT programs provided us with an opportunity to further validate the technology and demonstrate value for a particular market segment. XT250^tm units were discounted to early adopters, who agreed to PILOT programs, to provide an additional incentive for the customer. As the PILOT programs complete, management expects to return to significantly reduced discounts off the retail purchase price for future sales of XT250^tm systems.

 

PILOT Programs

 

Our PILOT programs have occurred in several different pharmaceutical markets, at one U.S. government entity and in several university research settings as follows:

 

 

 

 

To date, we have sold one XT250^tm unit resulting from a PILOT program. Although most of our PILOT programs have been designed for eventual sales of the XT250^tm our PILOT programs in academic institutions and with the government were designed primarily for research purposes to test the operational limits and effectiveness of the technology and to gather molecular fingerprint data. Our PILOT programs designed solely for research purposes are not expected to generate revenues for the company. We have received feedback from some of our PILOT participants that the processing speed or the testing output of a single system is more limited than those participants would have desired. Additionally, we have received unfavorable feedback from our PILOT participants related to the pricing of the unit. We believe the PILOT programs with our pharmaceutical distributors have assisted us in proving the technology, increasing the development of the system and identifying multiple counterfeit or fraudulent medications. Additionally, we believe our PILOT program conducted with universities was beneficial in testing the validity of the technology and in its efficacy in forensic and defense related academic research. We currently have one PILOT program participant.

 

The energy dispersive X-ray diffraction (“EDXRD”) technology licensed by the company was developed and tested by Rutgers for detection of hidden explosives, under the guidance of the Federal Aviation Administration (and Transportation Security Laboratory/TSL). TSL also performed testing of the EDXRD technology for explosives detection. A university performed a PILOT program, which enabled them to analyze newly developed nanotechnology materials. The PILOT program was beneficial in providing researchers molecular level information, but their need was short lived and a lack of capital budget did not allow them to purchase the XT250^tm unit. A second university PILOT program was to determine whether the XT250^tm could be used for the detection of illicit drugs. The PILOT program showed a wide variation of formulations for street drugs, and therefore no standard molecular fingerprints could be effectively developed for the XT250^tm. A PILOT was performed at a local South Florida county sheriff’s office for the detection of illicit drugs. While detection of crack cocaine was highly successful, other drugs could not be properly tested due to lack of standards for street drugs. The PILOT program at Pfizer was to determine if the XT250^tm could be effectively deployed in a “Returns” area, where pharmaceuticals are returned from hospitals, pharmacies, and clinics. These returns may be expired drugs, partially opened bottles, or overstock items, each being returned for cash credits. The Pfizer PILOT was a stepping stone to further refine the company’s business model. The PILOT program at a pharmaceutical distribution services company was to determine if the XT250^tm could be used for screening returned pharmaceutical products. Pfizer discontinued using the system after a period of months as this company found the XT250^tm did not meet its business needs. Representatives of Pfizer relayed to us the project had worked well from a technical standpoint.

 

Secure Pharma Network

 

Management believes that our Secure Pharma Network (“SPN”) may provide significant growth opportunities. SPN is a software product that allows customers to access via the Internet all of their systems purchased from XStream Systems. Customers may remotely manage their systems, downloading new material fingerprints or software updates, uploading results, and operating their systems remotely. Detailed reports can be generated, as well as customized and aggregated reporting across multiple systems. The ability to collect test results from multiple systems from our customers, process that data, and provide meaningful information across the industry provides significant value to our customers, which management believes can produce revenue in the future. We believe that integrating SPN into our customers’ inventory management systems provides additional value to our customers. Since SPN is software based, revenues we anticipate to generate from SPN in the future are expected to increase our profit margins. To date, no revenues have been earned from SPN.

Sales

 

Our initial net sales consist of XT250^tm units sold to equipment distributors at a significant discount off the retail purchase price as well as direct retail sales to pharmaceutical distributors and manufacturers. We have sold one unit at the retail price of $179,000 and we are currently offering the XT250^tm at discounts below this retail price.

 

Sales to equipment distributors represented approximately 38% and 0% of our net sales during 2008 and 2009, respectively, with the remaining sales in 2008 and all sales in 2009 directly to pharmaceutical distributors. We sold two XT250^tm systems in each of the fiscal years ended December 31, 2008 and 2009. Gross profit consists of net sales less product, packaging and freight, field service, warranty, and financing costs. Selling and advertising costs consist of sales person expenses, advertising and marketing expenses, as well as royalty fees. Research and development expenses consist primarily of engineering personnel expenses, engineering consulting and prototype expenditures. General and administrative expenses include administrative salaries and payroll related expenses, stock-based compensation expenses, depreciation, rent and general overhead expenses.

 

Performance Indicators

 

The management team reviews our performance on a regular basis using a variety of financial and non-financial metrics. These metrics include, but are not limited to, net sales, gross margin, sales and marketing expenses, personnel costs, accounts receivable and accounts payable aging, liquidity and cash resources. Management compares actual results against goals and budgets to take appropriate actions in order to improve performance.

 

Employees

 

At August 15, 2010, we had 12 employees in our operations, two of whom were sales and business development executives. Nine members of our staff are employed at our corporate headquarters in Sebastian, Florida.

 

Critical Accounting Policies

 

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the U.S. These accounting principles require management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates, and revisions to estimates are included from the period in which the actual amounts become known.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in our preparation of our consolidated financial statements, and therefore should be read in conjunction with our summary of significant accounting policies (see Note 2 of our Notes to Consolidated Financial Statements). Our critical accounting policies are as follows:

 

Revenue Recognition

 

Our XT250^tm systems include software embedded in the tangible product that is essential to its functionality. The software does not require significant production, modification or customization.

 

Revenue from the sale of our XT250^tm systems is recognized when all of the following criteria have been met:

 

a. persuasive evidence of an arrangement exists,

 

b. delivery has occurred,

 

c. the vendor’s fee is fixed or determinable, and

 

d. collectibility is probable.

While we engage in strategic PILOT programs with pharmaceutical manufacturers and distributors, revenue is not recognized until the unit is sold, delivered, installed and accepted, and collection of the sales price is probable.

 

We have two pricing models including wholesale pricing for distributors who are authorized sales agents and retail pricing to third party end-users.

 

Prior to installation, deposits are ordinarily required from customers before manufacturing commences. These amounts are recorded as customer deposits in current liabilities on the accompanying balance sheets.

 

There are no post-installation obligations other than warranty of the equipment for one year after installation. Warranty expense is estimated based on historical results and is accrued at the time the revenue is recognized.

 

We also anticipate generating revenues in the future from the sale of our SPN software. The sale of SPN would be commensurate with the sale of one or more XT250^tm units as a separate and optional purchase of an annual software license. If the customer chooses to purchase SPN, revenue from the license would be recognized ratably over the term of the license in accordance with FASB guidance.

 

Inventories

 

We state inventories at the lower of cost, determined using the average cost method, or net realizable value. We review inventory for excess quantities and obsolescence based on our best estimates of future demand, product lifecycle status and product development plans. We use historical information along with these future estimates to reserve for obsolete and potentially obsolete inventory.

 

Share-based Payments

 

We record all stock-based awards, including employee stock option grants, at fair value as of the grant date and recognize these awards as expenses in our statement of operations over the vesting period of the award in accordance with FASB issued guidance on share-based payments.

 

We estimate the fair value of each option grant on the date of grant using the Black-Scholes option pricing model. The weighted average assumptions utilized for our valuation analysis, for the years ended December 31, 2008 and 2009 are as follows:

 

 

The risk-free interest rate is derived from the Daily U.S. Treasury Yield Curve Rate in effect as of the valuation date of each grant. The dividend yield of zero is based on the fact that our present intention is not to pay cash dividends.

 

Volatility

 

Since our common stock is not traded on any public market, we have used the historical volatility of select comparable publicly traded companies over a period equivalent to the expected life, which is the expected time from grant date until exercise. For purposes of identifying otherwise similar entities, we selected Schmitt Industries, Inc. (“Schmitt”) and Arrowhead Research Corp. (“Arrowhead”). We believe these companies are similar to us in terms of industry, stage of life cycle, and size in the following ways:

 

Schmitt designs, manufactures and markets computer-controlled vibration detection and balancing equipment primarily to the machine tool industry, as well as precision laser-based surface measurement products for the disk drive, silicon wafer and optics industries and laser-based distance measurement products for a wide variety of

industrial applications. Schmitt was founded in 1993 and has approximate market capitalization, annual revenues, and net loss of $11,320,000, $9,500,000 and ($2,100,000), respectively. These amounts are based on Schmitt’s most recent annual report for the fiscal year ended May 31, 2009.

 

Arrowhead is a development stage nanotechnology holding company whose subsidiaries commercialize nanotechnologies in the electronics and biotech industries. One of its subsidiaries is focused on the commercialization of carbon nanotube products for the electronics industry and another is focused on exploring nanotechnology-based energy storage devices for hybrid electric vehicles and other large format applications. Arrowhead was founded in 2003 and has approximate market capitalization, annual revenues, and net loss of $75,350,000, $3,700,000 and ($19,300,000), respectively. These amounts are based on Arrowhead’s most recent annual report for the fiscal year ended September 31, 2009.

 

Fair Value of Common Stock

 

We determined the fair value of our common stock through retrospective valuations on each of March 14, 2007, December 31, 2007, December 31, 2008, August 14, 2009, December 31, 2009 and April 30, 2010. We did not obtain contemporaneous valuations by an unrelated valuation specialist at the time of the issuance of the stock options and grants during these periods primarily because our efforts were focused on product and business development and the financial and managerial resources for doing so were limited.

 

Determining the fair value of our stock requires making complex and subjective judgments. In conducting our retrospective valuations, we considered numerous objective and subjective factors in valuing our common stock at each valuation date in accordance with the guidance in the AICPA Practice Aid “Valuation of Privately-Held-Company Equity Securities Issued as Compensation.” We, with the aid of an unrelated valuation specialist, determined the fair value of our common stock as of each of the valuation dates to be:

 

 

A key driver behind the decline in fair value for each of the valuation dates through December 31, 2009 was as a result of the additional dilution provided by each of the preferred stock financings conducted subsequent to March 14, 2007. One of the drivers behind the increase in fair value from December 31, 2009 and April 30, 2010 was due in part to the forecasted performance of the Company used in the April 30, 2010 valuation as a result of the improvements in the Company’s business plan and implementation of changes to our strategy, including deferring approximately $14.5 million in anticipated research and development expenditures on projects unrelated to the XT250^tm until such time as these projects can be financed by the Company at appropriate WACC levels. These expenditures had been included in the Company’s projections used for the December 31, 2009 valuation date. Improvements to our business plan and strategy have included (i) strengthening our management ranks through the addition of our co-chief executive officer and our chief financial officer, (ii) changes to our pricing model enabling our independent distributors to pay for the use of the XT250^tmin a variable manner and without significant upfront capital expenditures, and (iii) our incorporation of a pedigree-based inventory tracking system into our existing XT250^tmsystem capabilities.

 

We believe the continued increase in fair value of our common stock, as evidenced by the estimated midpoint price to the public of $6.00, is primarily attributable to improvements in the recent events and developments of our business, including, among others (i) we moved ahead in negotiations with a manufacturer looking to incorporate our technology into an automated module based at various dispensers around the world; (ii) we made further progress in our relations with our manufacturer, Kimball, who verbally agreed that following the closing of the offering and upon the repayment of indebtedness to Kimball under the settlement agreement, Kimball will submit bids to us to continue the manufacturing and servicing of our product in the future; (iii) on May 28, 2010, GenMark Diagnostics, Inc. commenced its initial public offering, which we believe demonstrates a significant improvement in the market for initial public offerings in the U.S. in the medical instruments industry. Our May 2010 discussions

with our underwriter took into account our and the underwriter’s perceptions of significantly increased optimism regarding the market for initial public offerings, and confirmed our and our underwriters’ expectations that we would complete our initial public offering. Finally, the retrospective valuation of our common stock on April 30, 2010 contained two scenarios with a 90% probability of successful completion of an IPO, as described in greater detail below. If we had considered a 100% probability that the IPO would be completed, the retrospective valuation would have resulted in a fair value determination of $5.16 per share.

 

Determination of Fair Value

 

In determining the fair value of our common stock, we used the option pricing method for the valuations through August 14, 2009 and the probability weighted expected returns method (“PWERM”) for the December 31, 2009 and April 30, 2010 valuations in order to distribute the enterprise value for each of those dates. At the time of the valuation dates prior to December 31, 2009, the type and timing of the potential exit events for the Company were uncertain. The AICPA Practice Aid “Valuation of Privately-Held-Company Equity Securities Issued as Compensation” (“AICPA Aid”) provides that the option-pricing method is appropriate to use when the range of possible future outcomes is difficult to predict such that forecasts would be highly speculative. Furthermore, retrospective valuations were performed for each of the valuation dates prior to December 31, 2009 as opposed to contemporaneous valuations. The AICPA Aid indicates that the assumptions and estimates underlying the valuation should reflect only the business conditions, enterprise developments, and expectations that existed as of the valuation date. We were not certain of when there would be a future liquidity event (such as an initial public offering of our common stock) on the valuation dates prior to December 31, 2009.

 

In addition, reliable cash flow projections as of each of the valuation dates prior to December 31, 2009 were not available at the time of the retrospective valuations due to the fact that the Company had been in an early stage of development and management had not prepared extensive projections as of those specific dates. Therefore, a discounted cash flow analysis would not have been reliable for use in determining the enterprise value for the valuation dates prior to December 31, 2009 since under the PWERM, share value is based upon the probability-weighted present value of expected future net cash flows (distributions to stockholders), considering each of the possible future events, as well as the rights and preferences of each share class. The PWERM estimates the value of an enterprise’s common stock based upon an analysis of future values for the Company assuming various possible future liquidity events (such as an IPO, strategic sale or merger, dissolution, and private enterprise (no liquidity event)). Therefore, since the range of possible future outcomes was difficult for us to predict prior to December 31, 2009 (thereby making any forecasts speculative) and the inherent lack of reliable projections as of those dates, we believe that the option pricing method was the most appropriate method to use in valuing the Company’s common stock prior to December 31, 2009.

 

We contemplated using either the guideline comparable company method or the guideline comparable transaction method for estimating the fair value of our common stock, however, we concluded that neither method would be useful given that we earned a negative EBITDA during each of the respective fiscal years and therefore using a comparable company’s EBITDA multiple and applying it to a negative EBITDA would result in a negative enterprise value.

 

Fair Value as of March 14, 2007, December 31, 2007, December 31, 2008, and August 14, 2009

 

We determined the fair value of our common stock on each of March 14, 2007, December 31, 2007, December 31, 2008, and August 14, 2009 by initially calculating the post-money indication implied by the Series A preferred stock financing for the March 14, 2007 valuation, the Series B preferred stock financing for the December 31, 2007 valuation and the pre-money indication implied by the Series C preferred stock financing for the December 31, 2008 valuation and the Series D preferred financing for the August 14, 2009 valuation. The in-the-money option cash proceeds were then added and the net debt and accumulated preferred dividend for each financing were then subtracted to find the total distributable equity value at each of the respective valuation dates. We then allocated the total equity value between the preferred and common equity classes using the option pricing method, where certain inputs were applied to the Black-Scholes model. The key inputs which affected the fair value included the life of the option and volatility. Finally, we applied a lack of control discount to determine the per share value of our common stock on a non-marketable, minority interest basis.

Fair Value as of December 31, 2009 and April 30, 2010

 

We determined the fair value of our common stock as of December 31, 2009 and April 30, 2010 through the income approach using the discounted cash flow (“DCF”) method and applying it to our management’s estimates of the annual cash flows that our business is anticipated to generate through a projection period ending in 2012 for the December 31, 2009 valuation date and through the period ending in 2014 for the April 30, 2010 valuation date. The significant variables utilized in the discounted cash flow method for each valuation date were:

 

 

We converted the estimated free cash flows for the period to their present value equivalent by applying a discount rate calculated using the weighted average cost of capital (“WACC”) for our company. We determined the WACC, in part, using the inputs and assumptions “Cost of Equity” and “Cost of Debt” as well as an examination of the returns of early-stage companies in general. We estimated the terminal value of the Company using the EBITDA Exit Method, where terminal value is calculated as the product of our EBITDA in the last year of the discrete projection period (2012 and 2014) and an EBITDA multiple based upon the EBITDA multiples observed in the comparable companies and taking into consideration other Company specific factors. The present value of the estimated cash flows were then added to the present value equivalent of the residual value of our business at the end of the projection period to arrive at an estimate of the fair value of the enterprise. Such an approach necessarily relies on estimations of future cash flows that are inherently uncertain, as well as a determination of an appropriate rate of return in order to derive present value equivalents of both the projected cash flows and the residual value of the business at the end of the period. The use of different estimations of future cash flows or a different rate of return could result in a different indication of fair value.

 

We next calculated a “weighted” enterprise value by considering two possible scenarios for the Company, either an initial public offering or bankruptcy. As of each of the valuation dates, our management was 90% confident that we would successfully execute an initial public offering. If we are not able to successfully complete our initial public offering, as an alternative we may be required to seek bankruptcy/dissolution in the future, so the remaining 10% was applied to the bankruptcy scenario. Additionally, because the enterprise values of certain exit events were calculated at the projected future dates in which these exit events were to occur, discount factors were added to derive the present value of the common stock as of the date of valuation.

 

Finally, the per share value under each scenario was probability weighted and the resulting weighted values per share were summed to determine the fair value per share of our common stock on each of December 31, 2009 and April 30, 2010. In the initial public offering scenario, the per share value was allocated taking into account the liquidation preferences and other rights of our convertible preferred stock. The resulting indication of value represents the estimated fair value of our common stock, on a per-share basis, as of December 31, 2009 and April 30, 2010, which included a lack of control discount.

 

Application of Valuation for Each Grant Date

 

In order to determine the fair value of our common stock on the date of grant for purposes of calculating the fair value of our grants of stock options and common stock during the fiscal years ended December 31, 2008 and 2009 and the six months ended June 30, 2010, we utilized the valuation most closely related to the common stock as a starting point for determining the grant date fair value. We then considered the factors described below for the relevant periods to determine whether the fair value on the date of the grant had changed from the fair value on the particular valuation date. Due to the various offsetting positive and negative factors occurring during the relevant periods our management determined that the fair value on the specific grant date falling during the periods described below remained unchanged from the valuation date fair value used.

 

(1) Period 1: For all stock options granted between January 1, 2007 and August 7, 2007, we used the March 14, 2007 estimated fair value of $3.16 per share of common stock due to the closing of the Series A

preferred stock financing. Our primary considerations in using this value for each grant date during the period included: the proximity in time between the valuation date and the grant date; and an improvement in financial performance during the period as a result of the recognition of revenues from the sale of one XT250^tm machine.

 

(2) Period 2: For all stock options granted between August 8, 2007 and June 30, 2008 (the closing of the Series B preferred stock financing), we used the December 31, 2007 estimated fair value of $2.15 per share of common stock. Our primary considerations in using this value for each grant date during the period included: the proximity in time between the valuation date and the grant date; an improvement in financial performance during the period as a result of the recognition of revenues from our contract with TSA for the production of simulants and the sale of two XT250^tm machines; our entry into agreements with our first authorized sales agents and field service representatives (Remetronix and Compass Engineering) to sell and service our products; and a decline in the general economic conditions and outlook over this period.

 

(3) Period 3: For all stock options granted between July 1, 2008 and April 22, 2009 (the closing of the Series C preferred stock financing), we used the December 31, 2008 estimated fair value of $2.03 per share of common stock. Our primary considerations in using this value for each grant date during the period included: we introduced our first network product, Secure Pharma Network, to provide an integrated system wide solution for purchasers of the XT250^tm; we developed a new management team headed by Messrs. James Lowrey and Anthony Chidoni; six new members were appointed to the board of directors who have extensive industry knowledge, backgrounds and qualifications necessary for us to continue developing our business; the lawsuit with our XT250^tm manufacturer; the general deterioration of the domestic and international economies during the second half of 2008 and into 2009; and a lessened demand by private equity investors for early stage capital investments.

 

(4) Period 4: For all stock options and common stock granted between April 23, 2009 and October 22, 2009, we used the August 14, 2009 estimated fair value of $2.22 per share of common stock. Our primary considerations in using this value for each grant date during the period included: the proximity in time between the valuation date and the grant date; we entered into a letter of intent with Swisslog Healthcare Solutions and entered into Pilot Program agreements with AmerisourceBergen and Pfizer, Inc.; continued business uncertainty, including the expectation that the full impact of the new leadership team and their business initiatives would take time to implement; the continuing lawsuit with our XT250^tm manufacturer; and the continued general economic crisis experienced both domestically and globally causing a decrease in various forms of spending by consumers.

 

(5) Period 5: For all stock options and common stock granted between October 23, 2009 and December 31, 2009, we used the December 31, 2009 estimated fair value of $1.34 per share of common stock due to the Series D preferred stock financing occurring on October 31, 2009. Our primary considerations in using this value for each grant date during the period included: the proximity in time between the valuation date and the grant date; we entered into a letter of intent with Eastman Kodak Company; we entered into a settlement agreement with our XT250^tm manufacturer; continued business uncertainty, including the expectation that the full impact of the new leadership team and their business initiatives would take time to implement; and the continued general economic crisis experienced both domestically and globally causing a decrease in various forms of spending by consumers.

 

We did not grant any stock options or common stock as share-based payments during the six months ended June 30, 2010.

 

Intangible Assets

 

Intangible assets are accounted for at cost and are amortized over the estimated useful life of the asset on a straight-line basis, which is generally three to 15 years. In 2005, we purchased a license from a university for the exclusive right to produce and sell products which utilize the university’s patented X-ray defraction technology. In exchange for this license, the university was issued 73,500 shares of our common stock and we agreed to pay royalty fees during the term of the agreement. The initial license fee is stated at cost and amortized using the straight-line method over 15 years beginning in the year it was acquired.

Income Taxes

 

We account for income taxes in accordance with FASB guidance, relating to determining our effective tax rate, provision for tax expense, deferred tax assets and liabilities and the related valuation allowance. Our provision for income taxes is determined using the asset and liability method, which involves significant judgments and estimates. Under this method, deferred income tax assets and liabilities are calculated based upon the temporary differences between the financial statement and income tax bases of assets and liabilities using the combined federal and state effective tax rates that are applicable to us in a given year.

 

The deferred income tax assets are recorded net of a valuation allowance when, based on the weight of available evidence; we believe it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. For the years ended December 31, 2008 and 2009, we have recorded a valuation allowance against the full amount of our net deferred tax asset, because in our opinion, it is more likely than not that these deferred tax assets will not be realized through future taxable earnings or implementation of tax planning strategies. A change in our estimate of future taxable income may require a change to the valuation allowance.

 

We adopted the FASB issued guidance surrounding uncertain tax positions on January 1, 2007. As a result of the implementation, we determined that no material adjustment was required; there were no tax benefits that should not have been recognized, and accordingly no associated penalties and interest were required to be accrued as of December 31, 2009 or 2008.

 

Contingent Liabilities and Off-Balance Sheet Arrangements

 

We are contingently liable for certain payments related to sales of our XT250^tm units. We signed recourse agreements whereby we guarantee the payment of the unamortized principle balance of certain capital lease agreements in the event the customer defaults on the payments for the units. As of December 31, 2008 and 2009, the unamortized principle balance of these leases was approximately $135,000 and $0, respectively. Other than these arrangements, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results in operations, liquidity, capital expenditures or capital resources that is material to investors.

 

Results of Operations

 

Results of Operations for the Years Ended December 31, 2009 and 2008

 

The following table summarizes certain selected items from the statement of operations for the year ended December 31, 2009 compared to the year ended December 31, 2008.

 

 

Comparison of Year Ended December 31, 2009 to Year Ended December 31, 2008

 

Revenues

 

Revenues for the year ended December 31, 2009 amounted to $271,520 as compared to $439,000 for the year ended December 31, 2008, a decrease of $167,480 or 38%. This decrease is primarily due to revenue of $150,000 during 2008 from a contract with the TSA for the production of explosive simulants to be used in testing commercial X-ray equipment not repeated in 2009. We sold two XT250^tm systems in each of the fiscal years ended December 31, 2008 and 2009.

Cost of Sales

 

Cost of sales for the year ended December 31, 2009 totaled $133,843 as compared to $129,036 for the year ended December 31, 2008, an increase of $4,807 or 4%. This increase is due primarily to commissions of $13,878 on units sold in 2009, there were no commissions paid in 2008, offset by cost reductions related to installing the machines.

 

Gross Profit

 

Gross profit for the year ended December 31, 2009 amounted to $137,677 as compared to $309,964 for the year ended December 31, 2008, a decrease of $172,287. Overall gross profit as a percentage of revenue decreased to 51% for the year ended December 31, 2009 from 71% during the year ended December 31, 2008. The decrease in gross profit is due to the aforementioned payment of commissions on sales and loss of revenues from a contract modification with the TSA for the production of explosive simulants which had no costs associated with it in 2008. Revenues from the TSA contract and the cost of performing the contract were recognized in previous years. While the company believed all requirements had been completed in the years the revenue and costs were recognized, the TSA indicated, that in their opinion, certain requirements had not been met. As a result, in 2006 the company wrote off a portion of the revenues previously recognized. In 2008, the company was able to renegotiate the contract terms to exclude the specific requirements which were not achievable. The revenue was originally recorded and recognized in 2005 when the work was performed. In 2006, the company wrote-off the disputed amount as a reversal of the income during 2005 due to the fact that the criteria for recognition had not been met in that period. Subsequently, in 2008, as a result of the contract modification, the criteria for recognition were met and accordingly the income was properly recorded in that period. The TSA decommissioned a portion of the contract and remitted the agreed upon balance of $150,000.

 

Expenses:

 

 

Salaries and wages

 

Salaries and wages for the year ended December 31, 2009 totaled $3,707,208 as compared to $2,061,731 for the year ended December 31, 2008, an increase of $1,645,477 or 80%. This increase is predominately due to the issuance of stock in lieu of compensation to a member of the board of directors for services rendered, offset by reductions in administrative personnel headcount and related cost saving measures.

General and administrative expenses

 

General and administrative expenses for the year ended December 31, 2009 amounted to $598,899 as compared to $455,996 for the year ended December 31, 2008, an increase of $142,903 or 31%. This increase is due primarily to increased professional fees.

 

Selling and advertising expenses

 

Selling and advertising expenses for the year ended December 31, 2009 totaled $432,371 as compared to $613,239 for the year ended December 31, 2008, a decrease of $180,868 or 29%. This decrease is due primarily to reductions in sales and marketing personnel headcount and related cost saving measures.

 

Research and development expenses

 

Research and development expenses for the year ended December 31, 2009 amounted to $581,547 as compared to $635,531 for the year ended December 31, 2008, a decrease of $53,984 or 8%. This decrease is due primarily to reductions in engineering headcount and related costs implemented as cost saving measures.

 

Royalty Fees

 

Royalty fees for the year ended December 31, 2009 totaled $500,000 as compared to $300,000 for the year ended December 31, 2008, an increase of $200,000 or 67%. This increase is due to a change in the royalty agreement.

 

Legal Settlement

 

Legal settlement for the year ended December 31, 2009 totaled $781,190 as compared to none for the year ended December 31, 2008, an increase of $781,190 or 100%. This increase is due to the agreed judgment in the lawsuit with Kimball Electronics, Inc.

 

Results of Operations for the Six Months Ended June 30, 2010 and 2009

 

The following table summarizes certain selected items from the statement of operations for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.

 

 

Comparison of Six Months Ended June 30, 2010 to Six Months Ended June 30, 2009

 

Revenues

 

Revenues for the six months ended June 30, 2009 amounted to $179,000 as compared to $0 for the six months ended June 30, 2010, a decrease of $179,000 or 100%. This decrease is primarily due to no sales during the six months ended June 30, 2010.

 

Cost of Sales

 

Cost of sales for the six months ended June 30, 2009 totaled $66,565 as compared to $0 for the six months ended June 30, 2010, a decrease of $66,565 or 100%. This decrease is due primarily to no sales during the six months ended June 30, 2010.

Gross Profit

 

Gross profit for the six months ended June 30, 2009 amounted to $112,435 as compared to $0 for the six months ended June 30, 2010, a decrease of $112,435. Overall gross profit as a percentage of revenue decreased to 0% for the six months ended June 30, 2010 from 62.81% during the six months ended June 30, 2009. The decrease in gross profit is due to no sales during the six months ended June 30, 2010.

 

Expenses:

 

 

Salaries and wages for the six months ended June 30, 2009 totaled $913,801 as compared to $398,614 for the six months ended June 30, 2010, a decrease of $515,187 or 56%. This decrease is predominately due to the reduction in stock compensation expenses for the six months ended June 30, 2010.

 

Selling, general and administrative expenses

 

Selling, general and administrative expenses for the six months ended June 30, 2009 amounted to $336,719 as compared to $1,299,545 for the six months ended June 30, 2010, an increase of $962,826 or 286%. This increase is due primarily to increased professional fees associated with our initial public offering.

 

Research and development expenses

 

Research and development expenses for the six months ended June 30, 2009 amounted to $288,186 as compared to $280,084 for the six months ended June 30, 2010, a decrease of $8,102 or 3%. This decrease is due primarily to decreased payments to outside contractors implemented as cost savings measures.

 

Royalty Fees

 

Royalty fees for the six months ended June 30, 2009 totaled $250,000 as compared to $250,000 for the six months ended June 30, 2010, an increase of $0 or 0.00%.

 

Warrant Expense

 

Warrant expense for the six months ended June 30, 2010 increased due to the increase in the warrant liability. The warrant liability increased primarily due to a $3.31 increase in the fair value of our common stock to $4.65 on June 30, 2010 (See discussion of the fair value of our common stock under Critical Accounting Policies). The increase in the fair value of the warrant liability at June 30, 2009 was primarily attributable to an increase in the number of warrants outstanding issued in connection with our Series C preferred stock.

Liquidity and Capital Resources

 

We incurred a net loss of $(9,395,261) including $842,892 of stock compensation expense, for the year ended December 31, 2009. Our accumulated deficit since inception amounted to $29,006,852 as of December 31, 2009, including $3,387,384 of cumulative stock-based compensation expense.

 

Our primary source of liquidity since inception has been cash generated from private equity and convertible debt transactions totaling approximately $15,400,000, net of offering costs, through August 15, 2010. Our primary operating cash requirements include the payment of salaries, employee benefits and other personnel-related costs, as well as costs of our sales and marketing efforts and our office facilities. We believe our existing cash on hand, the net proceeds from this offering, and cash generated from operating activities will be sufficient to service our existing debt, finance internal growth, and invest in research and development of the technology. If we do not complete the initial public offering to which this prospectus relates or raise the minimum amount of funds contemplated in this prospectus, we cannot provide assurances that we will be able to find alternative financing on terms favorable to us or at all.

 

We had cash of $159 as of June 30, 2010 which is being used to fund current operations. Until the closing of the offering, we are funding our operations through loans from our officers, directors and stockholder lenders.

 

On June 11, 2010, each of Messrs. James J. Lowrey, Anthony R. Chidoni, Simon Irish and Dennis K. Cummings loaned us $10,000, totaling $40,000 in aggregate principal amount. The loans mature on the closing date of our initial public offering and bear interest at a fixed rate equal to the one-month LIBOR rate on the date of the loans, equal to thirty-five hundredths of one percent (0.35%), plus two percent (2%), until all sums due are paid in full. The loans are represented by four non-convertible promissory notes executed by us in favor of each lender. Principal and interest due on the loans will be repaid from the proceeds of the offering.

 

On various dates during July 2010, 13 individuals including certain officers, directors and stockholders loaned us $25,000, totaling $325,000 in the aggregate principal amount. The loans mature on the closing date of our initial public offering and bear interest at a fixed rate equal to ten percent (10%) until all sums due are paid in full. The loans are represented by 13 non-convertible promissory notes executed by us in favor of each lender. Principal and interest due on the loans will be repaid from the proceeds of the offering.

 

We estimate that approximately $2,000,000 in proceeds from the offering will be utilized to meet our expected peak financing needs for the construction and installation of the XT250^tm systems to be placed with our customers pursuant to a service agreement. Each service agreement is expected to generate adequate monthly cash flow to allow the large majority of our forecasted XT250^tm capital expenditures to be financed organically.

 

We were unable to comply with the final payment terms of our settlement agreement with Kimball and Kimball entered the Agreed Judgment against us in the United States District Court of the Southern District of Indiana on February 8, 2010 in the amount of $3,200,000. On February 10, 2010, Kimball filed a motion for proceedings supplemental to collect the remaining $2.6 million balance due on the $3.2 million judgment. On June 11, 2010, Kimball issued writs of garnishment to SunTrust Bank and Wachovia Bank to locate assets to satisfy the outstanding judgment, which resulted in a freeze on those bank accounts. We do not have access to the cash funds deposited with the two banks subject to the writs. Kimball may request an order from the court at any time entitling Kimball to the transfer of $39,722.33 in funds from those accounts in partial satisfaction of the outstanding $2,600,000 judgment. We anticipate that if this offering does not close for any reason, Kimball will move forward in its collection efforts to transfer our cash funds under the writs of garnishment. Until such time as we repay Kimball the $2.6 million of indebtedness under the settlement agreement, there remains uncertainty whether Kimball will continue to manufacture the XT250^tm systems. At the same time, our management has continued discussions with representatives from Kimball concerning our business relationship with Kimball following the initial public offering. Although no written agreement or memorandum of understanding has been executed by the parties at this time, Kimball and the Company have verbally agreed that following the closing of the offering and upon the repayment of indebtedness to Kimball under the settlement agreement, Kimball will submit bids to us to continue the manufacturing and servicing of our product in the future.

 

We are currently in arrears with respect to payments required under our licensing agreement with Rutgers University totaling $797,871 as of December 31, 2009. The loss of, or our inability to maintain, this license could

result in our inability to sell our products including the XT250^tm systems without liability exposure including claims of infringement from other parties. The licensing agreement provides that if either party breaches or fails to perform any provision of the agreement, the other party may give written notice of the default to the breaching party. Representatives of the company have recently met with Rutgers to discuss the licensing agreement between Rutgers and the company. The parties have mutually agreed and acknowledged verbally that the company will require capital financing to repay Rutgers amounts due under the licensing agreement and that the agreement requires restructuring in connection with royalty fees owed in the future. The parties have verbally agreed to postpone restructuring of the license agreement until completion of the public offering. We believe that we and Rutgers are both using good faith efforts to maintain the business relationship and restructure the parties’ contractual obligations going forward.

 

In addition, as of August 15, 2010, we are currently in default with respect to $287,260 in principal amount of debentures and accrued interest with respect to two of our debenture holders. The debentures matured on December 31, 2009. We have not amended the terms of the debentures to provide for extended maturity dates for these instruments. We have verbally agreed with the holders that we will repay the principal and accrued interest due under the debentures from the proceeds of the offering.

 

Mr. Brian T. Mayo delivered a demand letter to our management, dated November 16, 2009, alleging the company’s breach of his executive employment agreement. Mr. Mayo claims in the demand letter his base salary was reduced in breach of his executive employment agreement from $255,000 per year to approximately $63,750. Mr. Mayo requested restoration of his salary to $255,000 per year and payment of his base salary since the date his salary was reduced. Mr. Mayo’s base salary was temporarily reduced to $63,750 from its previous $127,500 level during the fourth quarter of 2009 in connection with salary reductions implemented for certain executive officers and key employees. Previously during 2006, Mr. Mayo’s salary was reduced from a base salary agreed to in his executive employment of $255,000 to $127,500. We have accrued for the difference of Mr. Mayo’s $255,000 salary level and the salary reduction to $63,750. At present the accrual through June 30, 2010 is approximately $449,000. As of the date of this registration statement, a litigation proceeding has not been filed with respect to this matter. Mr. Mayo’s salary reduction was related to general salary reductions affecting four key employees of the company which reductions were implemented to address budgeting and cash flow concerns. As of January 1, 2010, Mr. Mayo’s annual base salary has been restored to $127, 500 and we paid Mr. Mayo a cash payment of $14,711 on January 14, 2010, which included all deferred amounts since the reduction of Mr. Mayo’s salary in October 2009. The company and Mr. Mayo have verbally agreed that Mr. Mayo will be paid all additional deferred amounts under Mr. Mayo’s agreement following completion of the offering. No written release of the demand letter claims has been executed by the parties at this time and the company and Mr. Mayo have been unable to amicably resolve the issues raised by Mr. Mayo in his demand letter. Accordingly, we notified Mr. Mayo on March 4, 2010 that we will not renew or otherwise extend the employment agreement with Mr. Mayo after it expires on October 31, 2010. We will continue to pay all sums due under Mr. Mayo’s employment agreement until the expiration date, in accordance with our current payroll practices.

 

We did not have material commitments for capital expenditures as of June 30, 2010. Until such time as we repay Kimball the amounts we owe under the settlement agreement and reach a new agreement with Kimball for supply and manufacturing of the XT250^tm systems there is uncertainty whether we will be required to incur capital expenditures for inventory to build new machines.

 

Recent Securities Offerings

 

On various dates from December 14, 2006 through February 14, 2007, we issued convertible promissory notes in the principal amount of $325,000, payable on demand at any time on or after February 28, 2007. In accordance with the terms of the notes, on March 14, 2007, all of the principal and interest due on the notes was converted into 87,094 shares of Series A preferred stock.

 

On various dates from August 31, 2005 to March 14, 2006, we sold debentures in the aggregate principal amount of $1,525,000 to accredited investors. In connection with such sale, each investor received a ten-year warrant to purchase 5,000 shares of common stock at a price of $2.34 per share for each $25,000 in principal amount of debentures. As a result, we issued warrants to purchase an aggregate of 305,000 shares of common stock. On

December 21, 2007, a portion of these debentures in the principal amount of $1,000,000 and the related accumulated interest on that date, was exchanged for 336,248 shares of Series B preferred stock.

 

On various dates from September 14, 2007 through December 4, 2007, we sold convertible debentures in the aggregate principal amount of $886,000 to accredited investors. On December 21, 2007, all of the principal and interest due on the debentures was converted into 298,116 shares of Series B preferred stock.

 

In connection with a secured, revolving, demand promissory note dated November 16, 2006, we issued the holder of the note a warrant to purchase an aggregate of 21,000 shares of common stock at an exercise price of $3.80 per share on January 25, 2008.

 

By stock purchase agreement dated March 14, 2007, as amended from time to time, we sold an aggregate of 962,101 shares of Series A preferred stock to accredited investors. Of those shares, 87,094 were issued in exchange for convertible promissory notes in the principal amount of $325,000 and the related accrued interest. The remaining 875,007 share of Series A preferred stock were issued at a purchase price of $3.80 per share, resulting in $3,325,000 of gross proceeds.

 

On various dates from December 2007 through June 2008, we sold an aggregate of 1,585,795 shares of Series B preferred stock to accredited investors. The shares of Series B preferred stock were issued at a purchase price of $3.00 per share, resulting in $4,757,385 of gross proceeds. In addition, during this time period, we issued 33,332 shares of Series B preferred stock to the interim chief executive officer as compensation for services performed. Each investor received for each share of Series B preferred stock purchased, one ten-year warrant to purchase five shares of our common stock at an exercise price of $3.00 per share.

 

On various dates from March 2009 through August 2009, we sold an aggregate of 365,996 shares of Series C preferred stock, to accredited investors. The shares of Series C preferred stock were issued at a purchase price of $3.00 per share, resulting in $1,097,988 of gross proceeds. In addition, each investor received for each share of Series C preferred stock purchased, one ten-year warrant to purchase five shares of our common stock at an exercise price of $3.00 per share.

 

During October 2009, we sold an aggregate of 563,414 shares of Series D preferred stock, to accredited investors. The shares of Series D preferred stock were sold at a price of $3.00 per share, resulting in $1,690,242 of gross proceeds. In addition, each investor received for each share of Series D preferred stock purchased, one ten-year warrant to purchase five shares of our common stock at an exercise price of $3.00 per share.

 

Impact of Inflation

 

We believe that inflation has not had a material impact on our results of operations for the years ended December 31, 2008 and 2009. We cannot assure you that future inflation will not have an adverse impact on our operating results and financial condition.

 

Recently-Issued Accounting Standards

 

In June 2008, the FASB issued guidance in determining whether an instrument (or an embedded feature) is indexed to an Entity’s Own Stock. This guidance provides that an entity should use a two step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions. It also clarifies on the impact of foreign currency denominated strike prices and market based employee stock option valuation instruments on the evaluation. The guidance is effective for fiscal years beginning after December 15, 2008. As of January 1, 2009, the adoption of this guidance resulted in a reclassification of the fair value of certain outstanding warrants from stockholders’ equity to liability. The fair value of the warrants was determined by using the Black-Scholes option pricing model. The initial value of the warrants at adoption was approximately $7,263,825. Additionally, we note that upon adoption of guidance, the warrants will be marked to market at each reporting period. For the year ended December 31, 2009, we recorded warrant expense of $2,769,083. (See Note 3, “Fair Value Measurements,” for additional disclosures.)

In October 2009, the FASB issued guidance on Certain Revenue Arrangements that include Software Elements. The amendments in the update clarify the applicability of the FASB guidance on Software Revenue Recognition that affect vendors that sell tangible products in an arrangement containing software that is more than incidental to the tangible product being sold, and clarifies what guidance should be used in allocating and measuring revenue. The update excludes tangible products containing software and non-software components that function together to deliver the tangible product’s essential functionality from FASB guidance on Software Revenue Recognition. The guidance is effective prospectively for fiscal years beginning on or after June 15, 2010. This guidance does not impact our current financial statements and is not expected to have an impact on our financial position, results of operations and cash flows.

 

Quantitative and Qualitative Disclosures about Market Risk

 

This disclosure is not required for smaller reporting companies.

 

Restatement of Historical Financial Statements

 

We restated our 2009, 2008 and 2007 financial statements and had previously restated our 2007 financial statements after certain accounting errors were identified that we determined to be material. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. We identified control deficiencies that have been classified as material weaknesses in our internal controls over financial reporting. The control deficiencies identified include inadequate segregation of duties over financial reporting as well as improper reporting of certain financial instruments, income taxes, loss contingencies and share-based compensation. To address the control deficiencies, we have hired a new member of management with experience in complex accounting and we plan to hire additional accounting staff in order to implement an appropriate level of segregation of duties. In addition, we plan to hire additional qualified financial reporting personnel and engage outside consultants to assist in accurate financial reporting to ensure our financial statements are in accordance with generally accepted accounting principles.

 

If we fail to fully remediate these material weaknesses or fail to maintain effective internal controls in the future, it could result in a material misstatement of our financial statements that would not be prevented or detected on a timely basis, which could cause investors to lose confidence in our financial information or cause our stock price to decline.

 

Company Overview

 

XStream Systems, Inc. designs and develops material authentication and verification solutions that allow molecular structure analysis on hidden materials. The patented technology which we license exclusively from Rutgers, the State University of New Jersey (“Rutgers”) combines penetrating x-rays, forensic analysis, and automated software algorithms that allow non-technical personnel to rapidly validate products even when sealed within their original packaging.

 

We are a direct seller of hardware and software products and services. Our XT250^tm unit is based upon Energy Dispersive X-Ray Diffraction technology (“EDXRD”), which combines the penetrating power of X-rays with forensic analysis of materials tested. Our customers may use our unit to identify the molecular composition and authenticity of products and materials tested with the unit. In pharmaceutical products, EDXRD technology allows our system to collect the molecular fingerprint of the medicine inside without ever breaking any seals or opening the packaging. The molecular fingerprint is compared against the standard for the medicine, and deviations such as contamination, dosage changes, counterfeiting, or adulterations can be discovered. We have licensed from Rutgers the worldwide exclusive rights for all applications of this patented technology. The XT250^tm product is currently our primary source of revenue.

 

Our customers place sales orders by calling one of our internal sales representatives via our toll-free phone number. We also sell indirectly through contracted authorized sales agents.

 

History of the Business

 

XStream Systems, Inc. was formed as a Delaware corporation in May, 2004. We first generated revenue through a contract in 2005 with the Transportation Security Administration, an agency under the Department of Homeland Security under which we created recipes and provided samples of Simulants for explosive testing. We launched our website and developed our first prototype system in 2006. Significant changes to the product design were incorporated and our first XT250^tm Material Identification System (“XT250^tm”) shipped in 2007. Some PILOT programs for the XT250^tm were held at Pfizer, McKesson, Massachusetts Institute of Technology, Pharmaceutical Dimensions, AmerisourceBergen, Henry Lee Institute of Forensic Science at University of New Haven, RX Reverse Distributors, and Stericycle. In 2006, we entered into Distributor Agreements and in 2008 we entered into sales agreements with our first authorized sales agents and field service representatives (Remetronix and Compass Engineering) to sell and service our products. In 2008, we focused exclusively on the pharmaceutical industry, hired an experienced sales force from that industry, and added Eastern Applied Research as an additional authorized sales agent and field service representative. We introduced our first network product, Secure Pharma Network (SPN), which is described more fully in this section, in 2008 to provide a truly integrated system wide solution.

 

During 2010 we adjusted our sales strategy to focus on deploying the XT250^tm to independent pharmaceutical distributors in the United States. This is in contrast to our efforts prior to December 31, 2009, which incorporated a significant focus on a limited number of wholesalers and manufacturers. Furthermore, our business strategy has changed during 2010 to offer customers the option of paying for the XT250^tm services on the basis of its use rather than as an upfront charge for the purchase of the actual machine.

 

Industry Background

 

According to IMS Health, Inc., pharmaceutical sales grew to $773.0 billion in 2008,¹ and sales in the

 

 

¹ Source: IMS Health Market Prognosis, March 2009. Total Unaudited and Audited Global Pharmaceutical Market by Region http://www.imshealth.com/deployedfiles/imshealth/Global/Content/StaticFile/Top_Line_Data/Global_Pharm_Mar-ket_by_Region.pdf accessed 6/10/09.

U.S. reached $291.0 billion,² while non-U.S. sales reached $482.0 billion.³ Although precise and detailed data on counterfeit pharmaceuticals is difficult to obtain, estimates range from 1% of sales in developed countries such as the U.S. to over 10% in developing countries, depending on the geographic area.⁴ Overall, counterfeit pharmaceuticals were estimated to exceed $40.0 billion in 2005, and the Center for Medicines in the Public Interest projects worldwide counterfeits to increase to over $75.0 billion by 2010.⁵

 

Our initial market focus has been on the pharmaceutical distribution industry. Until recently the pharmaceutical industry has focused a significant amount of its attention on good manufacturing practices.⁶ Various federal, state, and local government agencies have regulated the manufacturing process of pharmaceuticals as well. While there has been focus on the manufacturing side, we believe there remain opportunities for illegal and dangerous activities, such as counterfeiting, diversions, adulterations, and dosage substitutions.

 

Industry efforts to combat counterfeiting pharmaceuticals include the use of scales to weigh products, visual inspections, documentation of transfers, use of forensic laboratories, and tagging products. We believe that each of these methods has limited success. State legislation, in form of pedigree laws, has been adopted in a number of states; yet, the amount of counterfeiting continues to increase.⁷ Forensic laboratories have the analytical capabilities to verify pharmaceuticals, but take a significant amount of time to provide test results.⁸ The high volumes shipped

 

 

² Source: IMS National Sales Perspectives^tm 2008 U.S. Sales and Prescription Information. Top Therapeutic Classes by U.S. Sales. http://www.imshealth.com/deployedfiles/imshealth/Global/Content/StaticFile/Top_Line_Data/2008_TopTherapy_Classes_ by_U.S._Sales.pdf.

³ Figure derived from subtracting U.S. market from total global market. Source: IMS Health Market Prognosis, March 2009. Total Unaudited and Audited Global Pharmaceutical Market by Region.& Source: IMS National Sales Perspectives^tm. 2008 U.S. Sales and Prescription Information.

⁴ World Health Organization. Counterfeit Medicine Fact Sheet revised November 2006. http://www.who.int/medicines/services/counterfeit/impact/ImpactF_S/en/index.html Last accessed 6/10/09.

⁵ Center for Medicines in the Public Interest. 21st Century Healthcare Terrorism: The Perils of International Drug Counterfeiting. September 20, 2005 by Peter Pitts, page 3.

⁶ Food and Drug Administration (FDA). Facts About Current Good Manufacturing Practices (cGMPs), last updated July 10, 2009. http://www.fda.gov/Drugs/DevelopmentApprovalProcess/Manufacturing/ucm169105.htm; FDA Recall — Firm Press Release Barr Laboratories, Inc., Issues a Voluntary Nationwide Recall of Dextroamphetamine /Amphetamine 20mg Tablets, Lot Number 311756, August 13, 2009. http://www.fda.gov/Safety/Recalls/ucm177321.htm; FDA Recall — Firm Press Release Hi-Tech Pharmaceuticals, Inc., Issues Nationwide Recall of All Lots of Stamina-Rx Dietary Supplement Products, June 15, 2009. http://www.fda.gov/Safety/Recalls/ucm167139.htm; FDA Recall — Firm Press Release AS Medications Solution LLC Announces a Nationwide Recall of All Lots of Digoxin Tablets 0.25mg Due to Size Variability, May 11, 2009. http://www.fda.gov/Safety/Recalls/ArchiveRecalls/ucm150734.htm.

⁷ The American Council on Science and Health Presents, Counterfeit Drugs: Coming to a Pharmacy Near You, January 2009; CSO Security and Risk, Case Study, Drug Busters: Tracking Down Counterfeiters, November 1, 2005. http://www.csoonline.com/article/220663/Drug_Busters_Tracking_Down_Counterfeiters.

⁸ United States Pharmacopeia (“USP”) establishes standards for manufacturing testing using analytical procedures. These tests are reactive (created in relation to a specific problem observed with a particular element rather than a proactive screening overall). The recent increase in substandard drugs due to adulterated raw materials has prompted several updates to specific test of a material to include testing for that specific adulteration. In 2009 alone, USP has updated or is in the process of updating the following guidelines: “USP Propylene Glycol Identification Test,” “Heparin Sodium Monograph Testing,” and “USP Sorbitol Solution Identification Test.” “USP Propylene Glycol Identification Test” United States Pharmacopeia (USP) Draft of Propylene Glycol Proposed Method for Informal Public Comment due August 14, 2009. The FDA requested USP revise the monograph since diethylene glycol and ethylene glycol are considered unacceptable toxic substances and Propylene Glycol has been identified as a material which is at risk for diethylene glycol or ethylene glycol adulteration. Testing time is around 4 to 10 minutes per test plus the preparation time. Heparin Sodium Monograph Testing” United States Pharmacopeia (USP), Pharmacopeial Forum, Vol. 35(5) [Sept.-Oct. 2009], INTERIM REVISION ANNOUNCEMENT for Heparin Sodium. U.S. scientists proposed new standards for testing the blood-thinner heparin after hundreds of deaths last year were linked to tainted Chinese ingredients. The tests require destruction of the sample, multiple samples and or tests, and some require either multiple tests of the sample (Nuclear Magnetic Resonance Spectrum method) or multiple test samples at different dilutions (ANTI-FACTOR Xa TO ANTI-FACTOR IIa RATIO Anti-factor Xa activity pH 8.4 buffer method — which requires 5 solutions dilutions) and lengthy testing times (CHROMATOGRAPHIC IDENTITY Method — which requires hours of testing). “USP Sorbitol Solution Identification Test” United States Pharmacopeia (USP), Sorbitol Solution Proposed Method for Informal Public Comment. Informal comments are due on August 14, 2009. Because of the serious hazards associated with the use of diethylene glycol-contaminated materials, and in response to recommendations set forth by the FDA in communication with USP dated January 12, 2009, USP is proposing to revise the USP Sorbitol Solution identification test. Test uses gas chromatography procedure. Sample preparation time would be ›12 mins and testing time would be ›2-5 mins.

through pharmaceutical distribution points require rapid testing. Forensic testing at laboratories also requires destructive testing, where the product is removed from its packaging and the contents are destroyed while being tested. Combating counterfeiting of pharmaceuticals has become a major initiative for some manufacturing companies. These companies each have dedicated personnel and departments to try and eliminate counterfeits. When harm comes from counterfeits, not only are manufacturing companies affected, but distribution companies may be held liable and some litigation has moved in that direction. Therefore, we believe the entire pharmaceutical supply chain has significant risk of negative consequences that could result from counterfeiting of pharmaceuticals.

 

Key Target Markets

 

Within the pharmaceutical distribution market, management believes we can most effectively add value to our customers when serving pharmaceutical distributors, re-packagers, mail order companies, government agencies, and return logistics companies.

 

We believe there are a multitude of sites worldwide that could potentially utilize our technology. To date, we have focused on the U.S. segments of the market. Europe, Middle East, Africa, and Southeast Asia are the primary expansion areas outside the U.S. that management anticipates would be most effectively served by our products and services.

 

Business Strategy

 

Our business strategy is to become the primary source for technology, products, and services for applications requiring material analysis of hidden objects. Management’s intention is to brand XStream Systems as the leading industry expert in molecular screening, providing trusted solutions in counterfeit identification and material verification. We believe our experience and innovative technology should allow us to solve some of the industries’ most demanding problems.

 

We utilize a multi-pronged strategy to provide wide market exposure and capture early adaptors. We have a direct sales force, with extensive pharmaceutical experience, concentrating on early adaptors, market development, and large enterprise prospects. Meanwhile, authorized sales representatives promote sales to smaller local customers.

 

We believe technology spending will need to increase throughout the pharmaceutical distribution chain to block the increasing threat of counterfeits. We believe no single competitor is effectively meeting the counterfeit challenge. Management believes it is imperative to verify the contents inside the package to truly authenticate the product.

 

Growth Strategy

 

We plan to grow organically and externally through the pursuit of strategic relationships. We have and continue to provide PILOT programs with larger corporations, which over time could develop into significant growth opportunities as these corporations expand the PILOT program into other locations within their organization. We also signed group purchasing and marketing agreements with several major pharmaceutical purchasing organizations, including National Coalition of Pharmaceutical Distributors (“NCPD”), Armada Health Care, and PDM Healthcare. These agreements provide access to potential customers, market exposure for us on their web sites, and speaking opportunities at conferences. See section below entitled “Strategic Relationships.”

 

While past efforts have focused on the U.S. domestic markets, the non-U.S. markets represent a large growth opportunity for XStream Systems. We anticipate using some of the funds raised through this public offering to pursue non-U.S. opportunities.

 

Management believes that increased marketing efforts, including advertising, publications, speaking opportunities, and attending conferences are critical for growth. We also believe that increased networking through association membership and participation is critical for our growth. We believe that these increased marketing activities will lead to new customers for our products and services.

 

Management believes that our SPN may provide significant growth opportunities. The ability to collect test results from multiple customers, process that data, and provide meaningful information across the industry provides significant value to our customers. We believe that integrating SPN into our customers’ inventory management

systems provides additional value to our customers. Since SPN is software based, revenues we anticipate to generate from SPN in the future are expected to increase our profit margins.

 

Management believes that expansion into markets beyond the pharmaceutical industry should open new opportunities for XStream Systems. We hope to scale the technology we license and develop products that meet the varying needs of our customers. We expect to develop marketing processes and recruit marketing professionals with pertinent industry expertise to maximize customer value.

 

Strategic Relationships

 

We are working on specific projects with recognized companies and intend to develop applications for our molecular screening technology in connection with these relationships. Our initial target market has been the pharmaceutical distribution market, including major pharmaceutical manufacturers, drug distributors and automated drug dispensing logistics (assembly line efficiencies) companies. Our teaming relationships include the following:

 

 

Swisslog and Kodak have not purchased a XT250^tm system. Our strategic associations have not participated in our PILOT programs but have familiarity with the XT250^tm system technology through numerous interactions between both sales and engineering teams to demonstrate how our two organizations can work together.

 

We are negotiating strategic relationships with other pharmaceutical distributors, manufacturers and logistic companies. We are directing our specific strategic efforts to produce applications which require a combination of non-destructive penetrating capability with forensic analysis.

 

Sales and Marketing

 

In 2008 we created a new sales and marketing organization specializing in pharmaceutical distribution. We believe that our pharmaceutical based website (www.securepharmachain.com), anti-counterfeiting blog (www.securepharmachain.blogspot.com) and professional networking at major pharmaceutical events have raised the level of awareness throughout the industry. Additionally, we believe that we are viewed as an industry innovator in addressing pharmaceutical counterfeiting and have received free publicity via television, major publications, and on-line articles.

 

Within the pharmaceutical distribution market, there are a number of submarkets that XStream Systems is targeting. We market to pharmaceutical manufacturers, including brand, generic, and contract manufacturers. We also market our products and services to pharmaceutical distributors, including large international wholesalers, regional wholesalers, secondary distributors, specialty distributors, and reverse logistics companies. There is a wide range of pharmaceutical dispensers to which we market as well, including mail order pharmacies, central fill pharmacies, buying group cooperatives, and warehousing groups. There are government regulatory agencies, such as the Food and Drug Administration, and international ministries of health to which we also market. Our company is also engaging various non-government organizations, such as the Family Health International.

 

Our Technology, Products and Solutions

 

XT250^tm Product

 

We offer material identification solutions to our customers through our XT250^tm product. Utilizing technology we license from Rutgers, network expertise, material science experience, and software knowledge base, management believes the XT250^tm product offers unique end-to-end solutions to companies of all sizes. Our XT250^tm unit is based upon EDXRD, which combines the penetrating power of X-rays with forensic analysis of materials tested. Our customers may use our unit to identify the molecular composition and authenticity of products and materials tested with the unit.

With the addition of our automated software, any person, even non-technical personnel, can rapidly and easily identify, authenticate, and verify hidden materials. EDXRD penetrates through all pharmaceutical packaging, including plastics, glass, cardboard, and even aluminum foils. In pharmaceutical products, EDXRD technology allows our system to collect the molecular fingerprint of the medicine inside without ever breaking any seals or opening the packaging. The molecular fingerprint is compared against the standard for the medicine, and deviations such as contamination, dosage changes, counterfeiting, or adulterations can be discovered. All of our current customers use the XT250^tm for verification purposes only.

 

We have licensed from Rutgers the worldwide exclusive rights for all applications of this patented technology. The XT250^tm product is currently our primary source of revenue.

 

Manufacturing end users may use the XT250^tm as a high speed, laboratory grade testing device to test the quality of raw materials or end of production goods without sending samples to laboratories and expediting production. Distribution end users may utilize the XT250^tm unit to non-destructively verify and authenticate their inventories within their unit-of-sale packaging, in real time and on-site, ensuring quality and protecting the users supply chain partners from fraudulent transactions, adulteration and counterfeiting. End users of products may utilize the XT250^tm unit to verify the quality, safety, efficacy and accuracy of products by screening products prior to the administration to consumers and patients, protecting them from medication errors, adulterated or fraudulent materials or substandard or degraded products.

 

The XT250^tm system verifies materials for which the unit has been programmed. For “verification”, the XT250^tm machine is programmed for a standard molecular fingerprint, then tests samples for any deviation from it, due to contamination, counterfeit, or dosage changes. As of August 15, 2010, our molecular fingerprint library consists of 202 prescription and over-the-counter medications ranging from over-the-counter aspirin to prescription antidepressants, antipsychotics, anti-HIV and erectile dysfunction medications, among others.

 

The verification mode of the XT250^tm has been independently evaluated by the Florida Technical Division of the Midwest Research Institute (“MRI”), which conducted two studies to determine how well the XT250^tm verified pharmaceutical products. We paid MRI $3,394 for the phase 1 testing conducted in October 2006 and $5,785 for the phase 2 testing conducted in July 2007.

 

The phase 1 study performed by MRI tested the sensitivity and specificity of the XT250^tm in identifying known over-the-counter medicines. The evaluation consisted of 20 independent runs performed on each of eight samples, totaling 160 measurements. The results showed that the XT250^tm accurately identified 98% of the samples (n=60). Only one compound was misidentified in one out of 20 replicates. The XT250^tm accurately identified all negative samples (n=100), demonstrating a specificity of 100%. The overall efficiency (accuracy) of the diagnostic test, defined as the percentage of samples correctly classified, was 99.38%; 159 out of 160 samples.

 

The phase 2 study tested the sensitivity and specificity of the XT250^tm in identifying known prescription medicines. The evaluation consisted of 50 independent runs performed on each of the five samples used in the analysis with the XT250^tm programmed for positive identification and 50 independent runs on each of the five samples with the machine programmed for misidentification for a total of 500 measurements. The results showed that the XT250^tm accurately identified 97.2% of the positive samples (n=250). The instrument accurately identified 249 out of 250 negative samples, demonstrating a specificity of 99.6%. The overall efficiency (accuracy) of the diagnostic test, defined as the percentage of samples correctly classified, was 98.4%; 492 out of the 500 samples.

 

Product Development

 

The technology we license from Rutgers can scale to meet additional customer needs. Our goal is to develop a range of products that operate rapidly to match customer demand, as well as scale to test any sample size to meet customer requirements. Management also hopes to develop products that scale down and that are smaller, more portable, and more cost effective. Customer requirements will drive the directions that our future products take.

 

Multi-Layer Solution

 

We are currently developing a multi-layer or “quad-layer” anti-counterfeiting solution XStreamCheck^tm, which we anticipate will provide four layers of protection against pharmaceutical counterfeiting. The first layer is molecular screening, which is performed by our XT250^tm system to verify the contents of a bottle or package. The second layer is attachment of a sealant in order to be able to identify whether the package has been tampered with in the distribution chain. The third layer is serialization, whereby each product is provided a unique number, to identify

a particular product/package, and no other. The fourth layer is identification of the pedigree of the product, which contains the tracking history of the product, the attachment of a unique serial number, as well as any molecular screening results that may have been done on the product.

 

Custom Solutions

 

We expect to customize the EDXRD technology for specific use by our customers. The objectives of customization of the technology include applications for medication error protection, automation of the technology for new users and retrofitting for existing users. We anticipate that revenue would be generated in the form of direct sales to the end user.

 

Future Revenues

 

Our ability to develop the customized EDXRD products and the multi-layer solutions and generate revenues from these future generation products and services is dependent on our completion of the offering.

 

We have not generated sales of customized EDXRD products or the quad-layer solution to date. We anticipate finalizing the development of the multi-layer solution following the offering during the fourth quarter of 2010.

 

Prior Line of Business

 

Under our prior contract with the TSA, we were contracted to develop “Simulants” (described below) to ensure that the equipment used by TSA could detect explosives properly. Prior to this, TSA used actual explosives to determine if explosive detection equipment was functional. The equipment used by TSA in such tests was its own equipment and not our XT250^tm. Our method for testing the equipment, called “Simulants”, required our research to determine recipes of materials that would closely simulate explosive materials safely. We created recipes and provided samples of Simulants for 11 explosives under the contract with TSA. The TSA contract has terminated. We do not anticipate at this time additional revenues based on our prior relationship with TSA. Furthermore, we are not conducting business operations in the field of Simulants research at the present time and do not anticipate any recurring revenues related to our prior Simulants research.

 

Secure Pharma Network

 

Management believes that our Secure Pharma Network (“SPN”) may provide significant growth opportunities. SPN is a software product that allows customers to access via the Internet their XT250^tm system purchased from XStream Systems. Customers may remotely manage the system, downloading new material fingerprints or software updates, uploading results, and operating the system remotely. Detailed reports can be generated, as well as customized and aggregated reporting across multiple systems. The ability to collect test results from multiple XT250^tm units purchased by our customers, process that data, and provide meaningful information across the industry provides significant value to our customers, which management believes can produce revenue in the future. We believe that integrating SPN into our customers’ inventory management systems provides additional value to our customers. To date, we have not generated revenue from SPN.

 

Manufacturing

 

To date, our hardware products have been manufactured by a U.S. contract manufacturer. This allows us to scale as our demands change. It also allows us to leverage the purchasing power of a larger organization. We place orders for hardware products with our contract manufacturer and those products are shipped directly to our customer sites. We are currently a defendant in a lawsuit with our manufacturer Kimball Electronics, Inc. Until such time as we repay Kimball the amounts we owe under our settlement agreement with Kimball, there is uncertainty whether we will be required to identify a new manufacturer of our XT250^tm to build our system which would lead to significant timing delays in the production of our system. Our management has continued discussions with representatives from Kimball concerning our business relationship with Kimball following the initial public offering. Although no written agreement or memorandum of understanding has been executed by the parties at this time, Kimball and the Company have verbally agreed that following the closing of the offering and upon the repayment of indebtedness to Kimball under the settlement agreement, Kimball will submit bids to us to continue the manufacturing and servicing of our product in the future. Although we currently have four XT250^tm systems at our facility available for immediate sale, to the extent we receive purchase orders for additional units now, we believe two months would be required to train any new manufacturer of the XT250^tm system and it would likely take

a new manufacturer six months to acquire all the needed materials to produce the XT250^tm system. For more information, see “Legal Proceedings,” “Risk Factors — We are currently a defendant in a lawsuit with the manufacturer of the XT250^tm system, Kimball Electronics, Inc.” and —“We may be required to identify a new manufacturer for the XT250^tm system.”

 

Our company provides all software products and services. The operating system and library of materials are provided for each system. Customers can contract for customized configurations, which are developed by us.

 

Field Service

 

Hardware and software support services are provided by contracted field service companies. Each authorized field service company is trained and certified by our company. Each of our customers has a designated field service representative that provides support services. Our company also provides an escalation process to support those field service companies.

 

Customers

 

Our current customer base consists primarily of pharmaceutical distribution companies. These companies purchase pharmaceutical products from a variety of sources, and wish to authenticate their inventories to protect the public and their reputation. We have also sold systems to equipment distributors, who then resell the equipment as authorized sales agents on our behalf.

 

One XT250^tm sales transaction with one customer during the year ended December 31, 2008 accounted for more than 10% of our 2008 revenues. Two XT250^tm sales transactions with two customers during the period ended December 31, 2009 accounted for more than 10% of our 2009 revenues. Our customers purchasing units to date have included Altec Medical, Med-Health Pharmaceutical Products, Eastern Applied Research, Compass Engineering, Remetronix, RX Reverse Distributor, and Cumberland Distribution. Each of these customers have accounted for more than 10% of our sales during the respective year the sale was made.

 

Our target customers range in size from small, privately owned distributorships with estimated revenues of less than $50,000,000 to large multinational distribution corporations with estimated revenues of more than $10.0 billion. Management believes these organizations have a need for a material identification and authentication system in order to protect their brands in the marketplace and reduce risk and potential litigation should they distribute a counterfeit product.

 

A number of organizations set up PILOT programs before they commit to purchasing our product. We have generated one sale of an XT250^tm system as a result of the PILOT program. Some of our PILOT programs have been designed to test the capabilities of the technology, data collection, materal recognition software engine generation, process improvement, throughput, and concept/industry viability. In most cases, PILOT program feedback proved the technology was viable, could verify materials and allowed for system enhancements. Some negative feedback for the system was the initial pricing and cost of the unit and limitation of the testing output of a single system (i.e., number of samples that can be tested per hour/shift). Some of our PILOT participants found that the system did not fit their business needs or criteria. We believe that the PILOT program process has been valuable in assisting us in further refining our revenue model to incorporate usage-based service agreements for placement of our XT250^tm system on-site with our customers.

 

In furtherance of our refined strategy, we recently entered into two usage-based XT250^tm service agreements with pharmaceutical distributors, and we are currently negotiating agreements with additional customers which we expect to execute during the third and fourth quarters of 2010. We believe these agreements represent our progress in implementing our new strategy; however, revenues have not yet been generated under the agreements and these two agreements, by themselves, are not expected to generate material cash flows from revenues over the term of the agreements.

 

All our shipments to date have been to sites within the U.S. Management believes that shipments outside the U.S. will represent a significant portion of sales in the future. We believe non-U.S. shipments should begin in the fourth quarter of 2010.

Research and Development

 

We spent $581,547 and $635,531 in research and development during the fiscal years ended December 31, 2009 and 2008, respectively. This included hardware and software development and enhancements of the XT250^tm and SPN products. These funds were also used in the development of a molecular library generation laboratory. Multiple companies contributed pharmaceutical products to this facility to aid in the research and development of molecular fingerprints.

 

Following the offering, we anticipate incurring approximately $14.5 million in anticipated research and development expenditures on projects unrelated to the XT250^tm at such time as these expenditures can be funded from cash flows from revenues. We are currently developing a “quad-layer” anti-counterfeiting product XStreamCheck^tm which is intended to provide four layers of protection against pharmaceutical counterfeiting. The development of the product XStreamCheck^tm will not be complete nor available for distribution prior to the closing of the offering and will not become available prior to the fourth quarter of 2010. We cannot provide any assurances that this product under development will generate revenues for the company in the future.

 

Competition

 

We operate in an unusually competitive market. In many cases, our customers have non-technical personnel operating in a warehouse environment. Counterfeit identification is sometimes performed by weighing the product with a simple scale. Other times counterfeit identification is done by track and trace methods, which tracks the transfers of the drugs, and on rare occasions by visual inspection. Our research has shown that some counterfeit drugs have weighed the same as valid drugs, some even come with falsified tracking documents, and many have passed visual inspection. Track and trace methods, which include pedigree laws, radio frequency inventory devices, bar codes, and taggants, have been deployed for a number of years and in some cases legislated for pharmaceuticals. We face a competitive environment of selling into end users and are either competing against them for capital expense or in integrating with solutions for limited supply chain security budgets. As it relates to material screening, the XT250^tm competes against laboratory testing services such as Angular Dispersive X-Ray Diffraction (“ADXRD”) and other laboratory grade equipment and on-site testing processes technologies such as Raman, Spectroscopy and Near Infrared Technologies (“NIR”). If there is a reason to suspect a drug is counterfeit, the sample may be shipped to a forensic laboratory for analysis. Highly trained personnel typically open and destructively test the suspect drug with one or more analytical instruments.

 

Our XT250^tm unit relies on Energy Dispersive X-Ray Diffraction (“EDXRD”) technology. ADXRD and EDXRD both use a specific X-ray wavelength, and rotates that X-ray source through many different angles to analyze materials. EDXRD, which is rarely used in the industry, but is the core of our solutions, uses the entire X-ray range of wavelengths, and only one specific angle to analyze materials. ADXRD technology utilizes low energy X-rays, which means ADXRD does not penetrate very well compared to EDXRD. Penetration of the X-rays is critical for our applications.

 

Raman, Spectroscopy, and NIR technologies are competitor technologies which are not very penetrating and cannot penetrate a thin piece of paper, for example. Because the Raman, Spectroscopy, and Near Infrared (NIR) energies are absorbed they can affect materials, like drugs. We believe this is a negative effect of our competitor technologies.

 

In terms of limitations of the EDXRD technology utilized by us, this technology requires shielding of X-rays from humans. Other technologies such as Raman, Spectroscopy and NIR technology, do not require shielding because they do not penetrate. EDXRD technology is not suited for gases, which do not have a crystalline structure, while some of the competitive technologies, like RAMAN, Spectroscopy, and NIR, may be suitable for gases.

 

We are not aware of true competitors as it relates to the EDXRD technology we license from Rutgers which allows for the real time, on-site molecular screening of materials and the authentication of products inside a unit-of-sale packaging without destruction or degradation of the tested material, however, there is market competition as it relates to other technologies for material screening and anti-counterfeiting that prospective end users would utilize. Some of the companies that have employed these technologies include Siemens, Centice, Ahura and Valimed. These technologies either are limited to laboratories or do not utilize the penetration of EDXRD and are limited to visual inspection of the material and destroying the testing sample. Because these solutions require access to the materials, it limits their deployment to either the manufacturing or the product dispensing process and makes them inferior within a comprehensive supply chain setting.

As it relates to anti-counterfeiting technologies, the XT250^tm can in some cases compete against, end user budgets; RFID, material serialization, pedigree, marker or what is known as track and trace solutions. Some of the companies that market these solutions include Axway, SupplyScape and Aegate. These technologies basically are inventory management technologies that track products by overt or covert markers or transactional recording of the packaging on products. These technologies are very specific to a process and require all members of the supply chain to participate. There is usually high infrastructure, set up and ongoing supply costs to each member of the supply chain to remain effective. Track and trace solutions are primarily inventory management tools that do not assure material safety or fraudulent acts from occurring.

 

Regulation

 

In addition to federal, state, and local laws applicable to all corporations and employers in general, each state has its own requirements and registration process for X-ray equipment. Our organization is also governed by the FDA, Drug Enforcement Agency, Environmental Protection Agency, and Department of Homeland Security regulations for handling and disposing of special materials. Our facility received a facility security clearance from the Department of Defense. Our company possesses Drug Enforcement Agency Researcher licenses for Schedule I-V drugs. Our company has received exemption letters for drug research purposes from the Florida Department of Health. In addition, each country also has its own requirements for our type of equipment, which our company must abide by in order to ship into those countries.

 

The Federal Communications Commission, Underwriters Laboratories, and Canadian Standards Association have certified that the XT250^tm product meets safety, health, environmental, and radiated emissions requirements. The costs for these certifications were included in the research and development spending for 2007 and 2008. Management believes that the XT250^tm will be required to pass Restriction of Hazardous Substances (RoHS) directives required by the European Community before the XT250^tm is allowed to ship into those countries.

 

To date we have not incurred any costs associated with disposal of any hazardous materials. We continue to make efforts to recycle all hazardous materials and management hopes to continue this in the future. When and if disposal of hazardous materials is necessary, management anticipates that disposal companies specializing in the materials will be hired.

 

Employees

 

As of August 15, 2010, we had 12 full-time employees, nine of which are located at our Sebastian, Florida corporate office. Two employees in our sales and marketing department are located outside of Florida. We have five employees in management and six employees are in our operations and engineering departments. None of our employees is covered by a collective bargaining agreement. We believe we have a good relationship with our employees.

 

Property

 

Our operations are currently located at 10305 102nd Terrace, Suite 101, Sebastian, Florida 32958. We lease real property at this location, which is part of an industrial park, Liberty Office Park. Our lease commenced in 2007 and expires in 2012. We lease approximately 8,000 square feet, and currently utilize approximately 5,000 square feet. We share a 40,000 square foot facility with two other companies. We believe our current office space provides more than adequate space for our offices, engineering development area, demonstration area, and Drug Enforcement Agency secured laboratory. We believe our current 8,000 square feet is adequate for our current needs and provides expansion room for engineering to develop the next generation of systems. The adjacent 10,000 square feet will allow for long term expansion if we need additional engineering and operations space. Rent expense under our office lease for 2009 totaled $106,659.

 

Intellectual Property

 

XStream Systems has worldwide, exclusive licensing rights to U.S. Patent #6118850 (granted Sept. 12, 2000), “Analysis Methods for Energy Dispersive X-Ray Diffraction Patterns” pursuant to a licensing agreement with Rutgers.

 

Under the terms of the License Agreement, the minimum royalty payment for 2008 of $300,000 became due January 31, 2009. In addition, certain other payments became payable in 2009 under the License Agreement. We were unable to pay the required minimum royalty and have requested a modification to the License Agreement. While Rutgers has the right to terminate the License Agreement after certain notifications and cure periods have

expired, Rutgers has indicated an interest in modifying the License Agreement and continuing the licensing arrangement. Final terms of the contract modifications are under review by Rutgers and will be presented to our board of directors for approval. The total amount due under the License Agreement as of June 30, 2010 was approximately $1,103,350.

 

We conduct business with trademarks of our XStream Systems logo, XT250^tm Material Identification System, XStream Check^tm, SECUREPHARMACHAIN^tm, and Beyond Pedigree^tm. At this time, we have not applied for registration of these marks. Dr. William Mayo, the brother of our president Mr. Brian Mayo is a co-inventor of the patent. Dr. Mayo retired from a teaching position at Rutgers University in 2009.

 

Legal Proceedings

 

Other than as set forth below, we are not a party to any pending legal proceeding nor is our property the subject of a pending legal proceeding that is not in the ordinary course of business or otherwise material to the financial condition of our business.

 

On or about September 16, 2008, Kimball International, Inc. and Kimball Electronics, Inc. (“Kimball”) filed suit against us in U.S. District Court in Evansville, Indiana. Kimball filed three claims against us including a claim alleging we defaulted on a $2,000,000 loan provided by Kimball in favor of the company, breach of a reserve capacity agreement and breach of a supplier agreement. We asserted counterclaims against Kimball for conversion, breach of contract and tortious interference with business relationship. On June 30, 2009, the District Court granted partial judgment in favor of Kimball in the amount of $2,000,000 against us. On December 23, 2009, we and Kimball entered into a settlement agreement (the “Agreement”). In connection with the Agreement, we provided to Kimball an executed Agreed Judgment in favor of Kimball in the amount of $3,200,000 (the “Agreed Judgment”). We agreed to make payments to Kimball via wire transfer or certified funds as follows: (i) one (1) payment of $600,000 to be made on or before December 31, 2009; and (ii) one (1) final payment of $2,600,000 to be made on or before January 31, 2010. On or about the date of the Agreement, we provided to Kimball an executed Stipulation of Dismissal of our counterclaims against Kimball, with prejudice. In the event that we timely remitted payments as set forth in the Agreement, Kimball was required to destroy the Agreed Judgment. On December 29, 2009, we made the initial payment of $600,000 to Kimball under the Agreement. We were unable to comply with the final payment terms of the Agreement, and Kimball entered the Agreed Judgment against us in the United States District Court of the Southern District of Indiana on February 8, 2010 in the amount of $3,200,000. On February 10, 2010, Kimball filed a motion for proceedings supplemental to collect the remaining $2,600,000 balance due on the $3,200,000 judgment. On June 11, 2010, Kimball issued writs of garnishment to SunTrust Bank and Wachovia Bank to locate assets to satisfy the outstanding judgment, which resulted in a freeze on our bank accounts. On June 23, 2010, Kimball filed notice of the writs in the United States District Court for the Southern District of Florida (Case No. 10-MC-14066-JEM). The deadline to dissolve the writ was July 13, 2010, and Kimball chose not to attempt to dissolve the writ. We anticipate that if this offering does not close for any reason, Kimball will move forward in its collection efforts to transfer our cash funds under the writs of garnishment. As a result of the filing of the Agreed Judgment and writ of garnishment, we anticipate that our results of operations could be adversely affected. Until such time as we repay Kimball the $2.6 million of indebtedness under the settlement agreement, there is uncertainty whether we will reach a compromise with Kimball to continue to manufacture the XT250^tm units.

 

Directors and Executive Officers

 

The following table sets forth the names and ages of our directors and executive officers, and their positions with us, as of August 15, 2010:

 

 

 

 

The principal occupations for the past five years (and, in some instances, for prior years) of each of our directors and executive officers are as follows:

 

James J. Lowrey, Chairman of the Board and Co-Chief Executive Officer

 

Mr. James J. Lowrey has served as chairman of the board of directors and chief executive officer since August 2009. Since March 2010, Mr. Lowrey has managed us as co-chief executive officer with Mr. Anthony Chidoni. Mr. Lowrey served as the co-chairman of the board from March 2009 through August 2009 and as chairman of the finance committee from March 2009 to October 2009. He has been a significant investor in XStream since 2007. From 1964 to 1978, Mr. Lowrey was employed with Salomon Brothers in New York, New York where he served as the partner-in-charge of banking, sales and trading of government and corporate tax exempt securities, and as a general partner at the time of his retirement in October 1978. During March 1979 he formed James J. Lowrey & Company, Inc. a financial advisory firm to corporations, governments and governmental entities. In 1980, Mr. Lowrey initiated the independent power industry through his formation of Catalyst Energy (“Catalyst”). Mr. Lowrey was instrumental in leading Catalyst through a number of purchases of developing projects and non-

nuclear energy companies and served Catalyst as its chairman of the board and its chief executive officer. Catalyst became a public company in 1984, was listed on the New York Stock Exchange and later taken private in 1988. Mr. Lowrey retired again in 1989. In 1993 he co-founded Navarro Lowrey, Inc. a Palm Beach County, Florida based real estate development firm dealing in real estate in Colorado, Texas and Florida. The firm is managed by Mr. Frank Navarro and Ms. Jessica Lee Lowrey, Mr. Lowrey’s daughter. Ms. Lowrey earned her J.D./LL.M. and M.B.A. degrees from New York University and Columbia University, respectively. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Lowrey should serve as a member of the board of directors included his knowledge of the company, his investment banking background, and his previous executive management experience at Salomon Brothers and Catalyst.

 

Joseph J. Melone, Vice-Chairman

 

Mr. Joseph J. Melone has served on our board of directors since August 2009 and as our vice-chairman since October 2009. Mr. Melone has served as the chairman of our nominating and corporate governance committee since October 2009. He is the former president and chief executive officer of Equitable Companies (now part of the AXA Group) and served in those positions from February 1996 to September 1997. Additionally, he served as chairman and chief executive officer of its principal insurance subsidiary, The Equitable Life Assurance Society of the United States from September 1992 to July 1997. Mr. Melone joined The Equitable Life Assurance Society of the United States in November 1990 as president and chief operating officer and served in those positions until September 1992. Prior to that, he had been president of The Prudential Insurance Company of America from March 1984 to November 1990. Upon the formation of The Equitable Companies in 1992, Mr. Melone was elected president and chief operating officer and served in those positions until February 1996. Also, from September 1992 to July 1997, he served as chief executive officer of Equitable Life, and two years later he was elected chairman. In February 1996, Mr. Melone was named chief executive officer of The Equitable Companies and served in that position until July 1997. Mr. Melone co-authored the book Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches (Pension Planning) which is currently in its 10th edition of publication. He is a former Huebner Foundation Fellow and was an Associate Professor of Insurance at The Wharton School of the University of Pennsylvania. He also served as Research Director at The American College before joining The Prudential. He is a Chartered Life Underwriter (CLU) and Chartered Financial Consultant (ChFC) from The American College, as well as Chartered Property and Casualty Underwriter (CPCU) from the American Institute of Chartered Property and Liability Underwriters. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Melone should serve as a member of the board of directors included his knowledge of the company and his previous executive management experience while at Equitable Companies and The Prudential Insurance Company of America.

 

Ash K. Chawla, Director

 

Mr. Ash K. Chawla has served on our board of directors since August 2009. Mr. Chawla has served as the chairman of our global business development committee since October 2009. Mr. Chawla has served as the founder and chief executive officer of PDM Healthcare from 1991 to the present. PDM Healthcare is a resource management company providing group purchasing, supply chain management and delivery, business and clinical consulting, and educational services to healthcare facilities in the U.S. Under his leadership, PDM Healthcare has maintained its position as a major buying groups/supply chain management in the U.S. PDM Healthcare currently has business trading relationships with over multiple pharmaceutical, medical surgical supply, and ancillary product manufacturers that are listed in Fortune 1000. Additionally, from January 2004 to the present he has served as the chairman and chief executive officer of Avani International, which specializes in business development, product launches and marketing, consulting, distribution, and global conferencing for the bio-technology, life sciences, pharmaceutical, medical device, and cosmetic markets. Avani is instrumental in creating relations and distribution channels between manufacturers abroad with customers in the U.S. as well as introducing products from the U.S. to international markets, including India. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Chawla should serve as a member of the board of directors included his independence and his leadership experience at companies operating in a similar industry as ours where he is currently serving as chief executive officer of PDM Healthcare and as chairman and chief executive officer of Avani International as more fully detailed above.

Anthony Chidoni, Director, Co-Chief Executive Officer, Chief Operating Officer and Secretary

 

Mr. Anthony Chidoni has served on our board of directors since April 2009. He commenced service as a member of our audit committee, as chairman of our compensation committee and as our corporate secretary in August 2009 and as our chief operating officer in October 2009. In addition, since October 2009, he has served as chairman of our executive committee and as a member of our finance committee. Mr. Chidoni was elevated to co-chief executive officer in March 2010. Mr. Chidoni has been the principal and owner of Lorelle Capital, a private hedge fund, since January 2004. From January 1990 to January 2004, he was the Managing Director of Private Client Business in the Los Angeles office of investment bank Credit Suisse First Boston, and its predecessor Donaldson Lufkin & Jenrette, where he had served in various positions for 21 years. Mr. Chidoni has served as a director of the public company Guess?, Inc. since November 2002 for which he also currently serves as the chairman of the audit committee. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Chidoni should serve as a member of the board of directors included his finance background and leadership experience as managing director of private client business in the Los Angeles office of Credit Suisse First Boston and his experience serving as a director and chairman of the audit committee of the public company, Guess?, Inc.

 

Dennis H. Ferro, Director

 

Mr. Dennis H. Ferro has served on our board of directors since August 2009 and as chairman of our finance committee and co-chairman of our investor relations committee since October 2009. Mr. Ferro was president and chief executive officer of Evergreen Investment Management Company from September 2003 through December 2008. Mr. Ferro joined Evergreen Investments as its chief investment officer in 1999. Mr. Ferro has also served as a director of New York Marine & General Insurance Company and as chairman of their finance committee from March 2009 to the present. From 1999 through 2003, he also served as their chief investment officer. From 1994 through 1999, Mr. Ferro was executive vice president of Zurich Investment Management Ltd. and head of international equity investments based in London. In 1995, Mr. Ferro was named as one of the top 100 mutual fund portfolio managers by Barron’s magazine. From 1991 through 1994, he was senior managing director of CIGNA International Investments and also served as chief investment officer for all non-U.S. investments. From 1988 through 1991, he served as the managing director for Asia for CIGNA Corporation based in Tokyo, Japan. From 1985 through 1988, Mr. Ferro served as president and managing director of Japan Bankers Trust Company Ltd based in Tokyo, Japan. From 1978 to 1985, he served as a founding director, president and chief investment officer for Bankers Trust Company of Florida. From 1970 to 1978, he served as vice president and portfolio manager of Banker’s Trust Company based in New York. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Ferro should serve as a member of the board of directors included his independence and his previous leadership experience as president and chief executive officer of Evergreen Investment Management Company and finance experience as chief investment officer for the New York Marine & General Insurance Company.

 

Simon Irish, Director

 

Mr. Simon Irish has served on our board of directors since August 2009 and as a co-chairman of our investor relations committee since October 2009. Mr. Irish is the former head of Man Global Strategies (“MGS”) in North America, an investment division of Man Group PLC where he provided services from October 2002 through January 2009. Man Group PLC is an investment business headquartered in the United Kingdom. At MGS, Mr. Irish established and grew a strategic investment program in hedge funds, which he operated for over six years. From October 2001 through October 2002, he held the position of director of U.S. business with FRM (Research) LLC, New York and held the position of senior vice president of FRM London from September 1999 through September 2001. From October 1995 through April 1999, Mr. Irish was a vice president of Credit Suisse Financial Products in London where he served as a quantitative analyst and as a trader in their Equity Derivatives Structuring and Trading Group. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Irish should serve as a member of the board of directors included his independence, his finance background and his previous leadership experience as the former head of MGS and vice president of Credit Suisse Financial Products in London.

Robert E. Kennedy, Director

 

Mr. Robert E. Kennedy has served on our board of directors since April 2007 and as a member of our audit committee since May 2007 and co-chairman of our audit committee since October 2009. In addition, Mr. Kennedy has served as the co-chairman of our audit committee since October 2009. Mr. Kennedy is a retired advertising industry executive with 33 years of experience. At the time of his retirement, Mr. Kennedy was the president and chief operating officer of Saatchi and Saatchi Advertising worldwide. Mr. Kennedy directed all of the company’s communications operations, notably the advertising subsidiaries and marketing services groups. Mr. Kennedy was also a member of Saatchi and Saatchi, Inc.’s board of directors. Mr. Kennedy joined Dancer-Fitzgerald-Sample in 1961 and spent most of his career in agency finances. He served as controller and became chief financial officer in 1980. When Saatchi and Saatchi and DFS merged in 1987, Mr. Kennedy became its vice-chairman and chief financial officer. Mr. Kennedy served on numerous industry committees during his working career. In retirement, he has been active in community organizations, most notably the VNA/Hospice of Vero Beach, the Environmental Learning Center of Vero Beach and Habitat for Humanity. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Kennedy should serve as a member of the board of directors included his independence, his knowledge of the company, and his previous executive managerial experience as more fully detailed above.

 

John R. (Reg) Murphy, Director

 

Mr. John R. (Reg) Murphy has served on our board of directors since November 2009 and chairman of our communications committee since March 2010. Mr. Murphy is Vice Chairman of National Geographic Society, a position he has held since March 1998. From May 1996 until March 1998, Mr. Murphy was President and Chief Executive Officer of National Geographic Society. He is a trustee of Mercer University, a trustee and Chairman of the Board of the PNC Mutual Funds and Chairman of the Board of the PNC Alternative Fund. He currently serves as chairman of the audit committee of the Omnicom Group. Mr. Murphy is also a past president of the U.S. Golf Association. Mr. Murphy served as political editor and then editor of The Atlanta Constitution in 1960-75, and later joined The San Francisco Examiner as publisher and editor from 1975 to 1981. Mr. Murphy joined The Baltimore Sun as publisher and chief executive officer and served in these positions from 1981 to 1988 and later served as chairman from 1988 to 1991. Mr. Murphy has authored or co-authored a number of books including Uncommon Sense, The Accomplishments of Griffin Bell; The Southern Strategy; and The Greatest Game. He has been awarded honorary doctorates by several universities, including Mercer, Utah State, Towson State and Loyola College, among others. The particular experience, qualifications, attributes or skills that led the board to conclude that Mr. Murphy should serve as a member of the board of directors included his executive management experience as president and chief executive officer of the National Geographic Society, his knowledge of the mass communications industry, and his experience serving as a director and chairman of the audit committee of a public company.

 

Philip A. Odeen, Director

 

Mr. Philip A. Odeen has served on our board of directors since July 2008 and as the chairman or co-chairman of our audit committee since August 2009. Mr. Odeen served as the chairman of AES Corporation since January 2008 and as non-executive chairman of Convergys Corporation since December 2007. He served as chairman of AVAYA from October 2006 to October 2007. He was chairman and acting chief executive officer of the Reynolds and Reynolds Company from July 2004 to February 2005 at which time he became non-executive chairman serving in that role until October 2006. He was also named chief executive officer of QinetiQ North America in October 2005 serving until June 2006. Previously, he had served as non-employee chairman and a director of TRW Inc. from February 2002 until December 2002. From 1998 to 2002, he held various leadership positions at TRW. Mr. Odeen joined TRW in 1997 when it acquired BDM International, Inc. where he had served as president, chief executive officer and director since 1992. Previously, Mr. Odeen was vice chairman, Management Consulting Services at Coopers & Lybrand after serving 13 years as managing partner of the firm’s public sector practice. Mr. Odeen served as a director of Northrop Grumman from May 2003 and May 2008. Mr. Odeen was appointed a member of the Defense Business Board in 2008. The particular experience, qualifications, attributes or skills that led the board

to conclude that Mr. Odeen should serve as a member of the board of directors included his independence and his executive management experience as chairman and/or chief executive officer of various companies.

 

Dr. E. Darracott Vaughan, Jr., Director

 

Dr. E. Darracott Vaughan, Jr. has served on our board of directors since August 2009 and as co-chairman of our medical advisory committee since October 2009. Dr. Vaughan is a physician and surgeon specializing in urology. Since 2001, he has served as the James J. Colt Professor, Chairman Emeritus Weill Cornell University Medical Center in the Department of Urology. From 1993 through 2001, Dr. Vaughan served as the James J. Colt Professor of Urology, Chairman, at Cornell University Medical Center. He was the executive vice dean and senior associate dean for Clinical Affairs until 2009. He now holds the position of Emeritus Professor in the Department of Urology. Dr. Vaughan was president of the American Urological Association in 2001. Dr. Vaughan is the recipient of numerous academic awards and honors which includes most recently the 2008 John Coleman Award, Department of Urology Weill Cornell University Medical Center. Dr. Vaughan’s research interests include obstructive uropathy, prostaglandins, renal hemodynamics, benign prostatic hyperplasia, hypertension and adrenal disorders. Dr. Vaughan has authored and co-authored over 350 publications in the field of renal and urological medicine. The particular experience, qualifications, attributes or skills that led the board to conclude that Dr. Vaughan should serve as a member of the board of directors included his independence, as well as his knowledge of the health care and pharmaceutical industries as more fully detailed above.

 

Stuart L. Weinstein, M.D., Director

 

Dr. Stuart L. Weinstein, has served on our board of directors since August 2009 and as co-chairman of our medical advisory committee since October 2009. Dr. Weinstein is the Ignacio V. Ponseti Chair and Professor of Orthopedic Surgery at The University of Iowa. He served as the president of the American Orthopaedic Association from 1997 to 1998; the American Board of Orthopaedic Surgery from 2000-2001 and The American Academy of Orthpaedic Surgeons from 2005-2006. He is a National Institutes of Health funded researcher. He has published more than 180 scientific articles in peer review journals on a wide variety of pediatric orthopaedic conditions. His research work has focused on spinal deformity in children, children’s hip and foot problems, and the natural history and long-term outcome of pediatric musculoskeletal conditions. He has edited three major textbooks including The Pediatric Spine: Principles and Practice; Lovell and Winter’s Pediatric Orthopaedics and Turek’s Orthopaedics.  He has served as an Associate Editor and a member of the Board of Trustees of the Journal of Bone and Joint Surgery. Dr. Weinstein currently serves as chairman of doctors for Medical Liability Reform, a Washington, DC based advocacy group, and chairman of the American Association of Orthopaedic Surgeons Political Action Committee. After interning in Internal Medicine at The University of California San Francisco, he returned to the University of Iowa for a residency in Orthopaedic Surgery. In 1976 he joined the faculty of the Department of Orthopaedic Surgery at The University of Iowa. The particular experience, qualifications, attributes or skills that led the board to conclude that Dr. Weinstein should serve as a member of the board of directors included his independence, his knowledge of the health care and pharmaceutical industries, as well as his being a publisher of numerous scientific articles and the editor of various medical textbooks.

 

Executive Management

 

The following individuals serve as our executive officers.

 

Brian T. Mayo, President and Chief Technology Officer

 

Mr. Brian T. Mayo founded the company in 2004. He is currently our president. Since July 2009, Mr. Mayo has also served as our chief technology officer. He served as our chief executive officer from May 2004 to October 2007, as president from October 2007 to the present, and as our chief executive officer again from July 2008 to July 2009. Mr. Mayo was chairman of the board of directors from May 2004 to October 2007 and served as our director until November 2009. Mr. Mayo has 30 years experience in the electronics industry. Mr. Mayo was instrumental in several startup ventures including: Ardent Communications, which pioneered voice over the Internet and where he was the director of engineering from January 1997 to August 1997; and Ingenuity Designs, a company specializing in airport security solutions where he was founder, president and chief executive officer from September 2001 to

May 2004. During his career, he enjoyed technical and management success at the following companies: Cisco Systems, where he was the director of engineering from August 1997 to September 2001; Nortel Networks (formerly Bay Networks) where he was the engineering director from July 1995 to January 1997; Ungermann-Bass Networks, where he was a corporate consulting engineer from May 1993 to July 1995; Digital Equipment Corporation, where he was the engineering manager from July 1987 to May 1993; Gould-Modicon, where he was program manager from April 1985 to July 1987; Teradyne, where he was hardware engineer from September 1978 to December 1980 and operations manager from December 1980 to April 1985; and Texas Instruments, where he was hardware engineer June 1977 to September 1977. Mr. Mayo has had involvement in the development of the communications industry’s first data network switch. Mr. Mayo has authored and co-authored a number of patents.

 

Dennis K. Cummings, Chief Financial Officer, Executive Vice President and Treasurer

 

Mr. Dennis K. Cummings has served as our chief financial officer and treasurer since February 2010 and our executive vice president since March 2010. He is a Certified Public Accountant and the principal and owner of Cummings & Associates, a private accounting practice he founded in February 1992. He has over 30 years experience in all aspects of management, financial reporting and controls for both publicly and privately held companies. Mr. Cummings began his professional career in private business prior to serving ten years with the public accounting firm of KPMG Peat Marwick in New York. Mr. Cummings is an EMT-I and former Director of Emergency Medical Services — Post 53 for the town of Darien, Connecticut.

 

Alan Clock, Senior Vice President of Sales and Marketing

 

Mr. Alan Clock joined us in 2007 and has served as our senior vice president of sales and marketing since October 2007. Mr. Clock has 23 years experience in the healthcare and pharmaceuticals industry. Mr. Clock has held senior level sales positions at: Active Health Management, an early pioneer in evidenced based disease management programs where he was senior vice president of sales from July 2006 to August 2007; nuvado, LLC, a pharmaceutical software and consulting company where he was executive vice president of business development and sales from July 2005 to July 2006; and AmerisourceBergen, one of the world’s largest pharmaceutical services companies where he was the corporate vice president of alternate care from November 1998 to July 2005. During his career, he enjoyed sales, business development and management success at the following companies: McKesson Corporation, where he was the vice president of national accounts from October 1995 to November 1998 and Cardinal Health (formerly Whitmire Distribution/Amfac Healthcare) where he served and was promoted through a variety of local, regional and national sales positions, eventually becoming corporate director of Hospital Services from May 1987 to October 1995. Mr. Clock was instrumental in the creation, development and success of the pharmaceutical distribution and service industry’s first alternate care vertical.

 

Other Key Employees

 

The following individuals are our key employees.

 

Patricia Ann Earl, Senior Vice President of Business Development

 

Mrs. Patricia Ann Earl has served as our executive strategic consultant and vice president of business development since May 2008 and was elevated to senior vice president of business development during March 2010. Mrs. Earl is a long time pharmaceutical industry veteran and has been actively involved in the pharmaceutical wholesale distribution industry since joining AmerisourceBergen Corporation (“Bergen”), one of the nation’s largest pharmaceutical services companies serving the U.S., Canada and selected global markets in 1986. She held a variety of executive management positions at Bergen including vice president general manager from February 1998 to December 2000 and corporate vice president of strategic development from January 2001 to May 2005. While at Bergen, she directed the strategic and marketing initiatives for U.S. health systems, the largest Pharmacy Benefit Management organizations, and alternate care providers. She played a significant role in the acquisition, strategic positioning, and implementation of the company’s pharmacy technologies, packaging and service offerings that enhanced medication safety in the pharmaceutical supply chain. Mrs. Earl was one of the founding members and was elected the co-chairman of the first Healthcare Distribution Management Association (“HDMA”) Collaborative Commerce Committee that promoted the advancement of collaborative e-commerce business solutions

between the nation’s largest pharmaceutical distributors and manufacturers. HDMA is the national association representing primary, full-service healthcare distributors and is the vital link in the healthcare system, working to provide value, remove costs and develop innovative solutions. During her tenure, the technological solutions investigated by the group and recommended to the industry included various bar code track and trace technologies, radio-frequency identification devices in cooperation with the MIT Auto-ID center, and e-pedigree solutions that met the requirements of Prescription Drug Marketing Act of 1987. From May 2005 until March 2008, she was vice president institutional marketing at H.D. Smith. Prior to her career in pharmaceutical distribution, Mrs. Earl had a successful career as an owner/principal, member of board of directors and served as chief operating officer from April 1978 to December 1986 for TP Communications, a privately-held corporation that acquired several broadcast radio stations. Subsequently those stations were acquired by Clear Channel Broadcasting Network. As a board member and corporate officer, she provided executive leadership, management oversight, and strategic direction to the sales, operations and financial functional areas.

 

Paul J. Micciche, Senior Vice President of Engineering

 

Mr. Paul J. Micciche has served as our vice president of engineering since November 2004 and was elevated to our senior vice president of engineering during March 2010. Mr. Micciche has over 24 years of experience in the high technology industry. Prior to his position at XStream Systems he was principal member of Technical Staff at Lucent Technologies from June 2000 through October 2004 where he managed development teams in the architecture, design, development and deployment of high throughput multi-service IP edge router platforms. At Ascend Communications, from 1999 to 2000, Mr. Micciche served as technical manager where he oversaw the architecture, design and development teams for high performance central processing units, internet physical layer cards and high speed backplanes. Ascend Communications was acquired by Lucent Technologies for $22.0 billion in 1999. From 1996 to 1999, Mr. Micciche served as an engineering manager for BayNetworks Inc. and was responsible for the architecture and design for data compression cards, FPGA control units and overall Ethernet router systems. BayNetworks was acquired by Nortel Networks in 1998 for over $9.0 billion. As a Senior Engineering at UB Networks from 1993 to 1996, Mr. Micciche was part of the development team that architected and designed several products including one of the industry’s first Ethernet concentration platforms, ATM Universal Network Interfaces and desk top switch products. Prior to these roles, Mr. Micciche worked for Draper Laboratories from 1985 to 1993 on U.S. Navy related defense programs and held a secret security clearance.

 

Advisory Board

 

Our advisory board offers counsel to our management on an informal basis concerning development of new technology, and strategic planning and partnering. We have also specifically designated one member of the advisory board to act as advisor to the co-chief executive officers. We do not have contractual relationships with the members of our advisory board. Each member of our advisory board is eligible to receive an annual grant of 2,500 share-based incentive awards for advisory service.

 

Mark S. Butler.  Mr. Butler is the former executive vice president, chief administrative officer and general counsel to the public company Indevus Pharmaceuticals, Inc. which was acquired in March 2009 by Endo Pharmaceuticals, Inc.

 

Dr. Ronald B. Gaeta.  Dr. Gaeta is a veterinarian and a partner in Patterson Veterinary MRI an equine exclusive imaging center located in Patterson, New York and an owner of Dunbarton Equine, a three doctor equine exclusive sport horse medicine practice located in Brookfield, Connecticut. Dr. Gaeta serves as the equine consultant to the Bronx Zoo.

 

Dr. William Hamilton.  Dr. Hamilton is an orthopedic surgeon specializing in the foot and ankle related medical conditions of athletes and performing artists including ballet dancers. He has served as a clinical professor of orthopedic surgery at the College of Physicians & Surgeons, at Columbia University from July 1995 to the present.

 

Dr. James D. Henry.  Dr. Henry is a urologic surgeon and has served as the Chief of Urologic Surgery at Good Samaritan Hospital and Saint Mary’s Hospital in West Palm Beach, Florida. Dr. Henry is a co-founder of Jupiter Hospital in Jupiter, Florida.

John R. Kennedy.  Mr. Kennedy is the former president and chief executive officer of Federal Paper Board Company, Inc. He was employed with Federal Paper Board Company from 1952 in various management positions until his retirement in April 1996. Mr. Kennedy is past chairman of Georgetown University and is currently chairman emeritus. As past chairman for The East Hampton Healthcare Foundation, Inc., Mr. Kennedy now serves as one of its trustees. He is also vice chairman of the Indian River Memorial Hospital Foundation and a board member of the Riverside Theater.

 

Frank Navarro.  Mr. Navarro is the managing principal of Navarro Lowrey, Inc., an owner, developer and manager of commercial real estate founded in 1993. Mr. Navarro leads the company’s business ventures while also developing and executing new business strategies such as the creation and development of “EcoPlex^®”, the Company’s trademarked, sustainability brand. He began his career as an architect, spending 10 years leading projects and advising clients in Florida, Virginia and Colorado then went on to earn his MBA in Finance and Real Estate Finance from Columbia University. Upon graduation, Mr. Navarro co-founded Navarro Lowrey, Inc. along with Mr. James J. Lowrey. Mr. Navarro is a LEED — Accredited Professional.

 

James A. Wilcox.  Mr. Wilcox is the Lowrey Professor of Financial Institutions at the Haas School of Business at the University of California, Berkley where he teaches courses on macroeconomics, financial markets and institutions and risk management at financial institutions. Mr. Wilcox was the Chief Economist at the Office of the Comptroller of the Currency in Washington, D.C. from 1999 to 2001. He has also served as the senior economist for monetary policy and macroeconomics for the President’s council of economic advisors under first President Bush and as an economist for the Board of Governors of the Federal Reserve System.

 

Board of Directors and Corporate Governance

 

Our board of directors is responsible for establishing broad corporate policies and for overseeing our overall management. In addition to considering various matters which require board approval, the board provides advice and counsel to, and ultimately monitors the performance of, our senior management.

 

We established an Audit Committee and Compensation Committee in January 2005. In March 2009, we established a Finance Committee. In October 2009, we established a Nominating and Corporate Governance Committee. The charters for the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are available at our website, www.xstreamsystems.com. We believe Messrs. Kennedy, Murphy, Odeen, Chawla, Ferro, Irish, Vaughan, and Weinstein are independent members of our board of directors, under NYSE Amex’s independence standards. The Audit, Compensation and Nominating and Corporate Governance Committees are composed of at least one of these independent members. In accordance with NYSE Amex phase-in rules for initial public offerings, we anticipate that within one year of our expected listing on NYSE Amex, each of the directors on the committees will be determined by the board to be “independent.”

 

The board, its committees and our management strive to perform and fulfill their respective duties and obligations in a responsible and ethical manner. We have adopted a Code of Ethics for Senior Financial Officers that applies to our co-chief executive officers, president, and chief financial officer, as well as a chief accounting officer and controller if we employ persons in these positions in the future. In addition, we have adopted a Code of Conduct generally applicable to all of our employees. Upon request, we will provide to any person without charge a copy of our Code of Ethics or Code of Conduct. Any such request should be made to Dennis K. Cummings, Chief Financial Officer, XStream Systems, Inc., 10305 102nd Terrace, Suite 101, Sebastian, FL 32958.

 

Committees of the Board

 

Audit Committee.  The board has an Audit Committee comprised of three directors, Messrs. Philip A. Odeen (Co-Chairman), Anthony Chidoni and Robert E. Kennedy (Co-Chairman). Each member of the Audit Committee is independent as defined under NYSE Amex’s listing standards, other than Mr. Chidoni. The board of directors has determined that Mr. Kennedy and Mr. Chidoni each qualify as an “audit committee financial expert.” The Audit Committee functions pursuant to a written charter, under which the committee has such powers as may be assigned

to it by the board from time to time. The Audit Committee was established in January 2005. The Audit Committee is currently charged with, among other things:

 

 

Compensation Committee.  The board has a Compensation Committee comprised of two directors, Messrs. Anthony Chidoni (Chairman) and Robert E. Kennedy. Mr. Kennedy is independent as defined under NYSE Amex’s listing standards. The Compensation Committee functions pursuant to a written charter, under which the committee has such powers as may be assigned to it by the board from time to time. The Compensation Committee was established in January 2005. The Compensation Committee is currently charged with, among other things, assisting the board to:

 

 

 

In general, the Compensation Committee formulates and recommends compensation policies for board approval, oversees and implements these board-approved policies, and keeps the board apprised of its activities on a regular basis. In addition, the Compensation Committee develops criteria to assist the board’s assessment of the co-chief executive officers’ leadership of our company.

 

Nominating and Corporate Governance Committee.  The board has a Nominating and Corporate Governance Committee comprised of two directors, Messrs. Robert E. Kennedy (Chairman) and Mr. James J. Lowrey. Mr. Kennedy is independent as defined under NYSE Amex’s listing standards. The Nominating and Corporate Governance Committee functions pursuant to a written charter, under which the committee has such powers as may be assigned to it by the board from time to time. The Nominating and Corporate Governance Committee was established in October 2009. The Nominating and Corporate Governance Committee is currently charged with, among other things, assisting the board in:

 

 

 

Finance Committee.  The board has a Finance Committee comprised of Messrs. Dennis H. Ferro (Chairman) and James J. Lowrey. The Finance Committee does not have a written charter. The Finance Committee was established in March 2009. This committee is currently charged with, among other things, assisting the board in:

 

 

Additionally, the Finance Committee reports periodically to the full board on our insurance and risk management programs.

 

The board of directors has additional standing committees including the executive committee, the investor relations committee, the medical advisory committee, the communications committee and the global business development committee.

 

Director Compensation for the Year Ended December 31, 2009

 

All directors are entitled to receive compensation for their services. In February 2008, a resolution was passed by the Compensation Committee granting directors the following annual compensation package:

 

 

In addition, in October 2009, the board of directors determined that the chairs of each of the board committees would receive stock options to purchase 2,500 shares of our common stock for their service.

The following table summarizes the compensation of each member of our board of directors for their service in 2009.