Attached files

file filename
EX-31.2 - EXHIBIT 31.2 - NET TALK.COM, INC.v222283_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - NET TALK.COM, INC.v222283_ex31-1.htm
EX-32.1 - EXHIBIT 32.2 - NET TALK.COM, INC.v222283_ex32-2.htm
EX-32.1 - EXHIBIT 32.1 - NET TALK.COM, INC.v222283_ex32-1.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q
(Mark One)

þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarter ended March 31, 2011

OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to ______

Commission file number: 000-53668

NET TALK.COM, INC.
(Exact name of Registrant as specified in its charter)

Florida
20-4830633
(State or other jurisdiction of incorporation or organization)
(I.R.S. employer identification no.)
   
1100 NW 163 Drive, Miami, FL
33169
(Address of principal executive offices)
(Zip code)

Registrant's telephone number, including area code:  (305) 621-1200

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

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

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

Large accelerated filer  ¨       Accelerated Filer  ¨       Non-accelerated filer   ¨       Smaller reporting company   þ

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

The Registrant had 13,179,300 shares of Common Stock, par value $0.001 per share, outstanding as of May 16, 2011.
 
 
 

 

Net Talk.com, Inc

INDEX

 
 
Page No.
     
Part I
Financial Information
 
     
Item 1
Financial Statements
 
     
 
Balance Sheets at March  31, 2011 (Unaudited) and September 30, 2010
3
     
 
Statement of Operations for the Three and Six Months Ended
 
 
March 31, 2011and 2010 (Unaudited)
4
     
 
Statement of Cash Flows for the Six Months Ended March 31, 2011 and
 
 
2010 (Unaudited)
5
     
 
Notes to Financial Statements
6
     
Item 2
Management’s Discussion and Analysis of Financial Conditions and
 
 
Results of Operations
20
     
Item 3
Quantitative and Qualitative Disclosures About Market Risks
32
     
Item 4
Controls and Procedures
32
     
Part II
Other Information
 
     
Item 1
Legal Proceedings
33
     
Item 1A
Risk Factors
33
     
Item 2
Unregistered Sales of Equity Securities and Use of Proceeds
33
     
Item 3
Defaults Upon Senior Securities
33
     
Item 4
Submission of Matters to a Vote of Security Holders
33
     
Item 5
Other information
33
     
Item 6
Exhibits
34
     
Signatures
34

 
2

 

Part I

Item 1.   Financial statements

Net Talk.com, Inc.
Balance Sheets

   
March 31,
   
September 30,
 
   
2011
   
2010
 
   
(unaudited)
       
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 1,869,136     $ 1,021,684  
Restricted cash
    74,094       2,017,655  
Accounts receivables, net of allowance for bad debts of $0 and $22,749
    108,489       39  
Inventory
    1,856,917       568,560  
Prepaid expenses
    467       238,651  
Total current assets
    3,909,103       3,846,589  
                 
Telecommunication equipment and other property, net
    560,247       578,618  
Intangible assets, net
    250,925       366,361  
Deferred financing costs and other assets
    22,000       23,000  
                 
Total assets
  $ 4,742,275     $ 4,814,568  
                 
Liabilities, redeemable preferred stock and stockholders' deficit
               
Current liabilities:
               
Accounts payable
  $ 946,877     $ 534,725  
Accrued dividends
    -       93,000  
Accrued expenses
    92,328       58,515  
Deferred revenue
    364,464       92,906  
Notes payables - Demand notes
    2,500,000       -  
Current portion of senior secured convertible debentures
    4,998,773       4,998,773  
Current portion of derivative liabilities
    29,373,649       5,905,622  
Total current liabilities
    38,276,091       11,683,541  
                 
Redeemable preferred stock $.001 par value, 10,000,000 shares authorized, 300 issued and outstanding
    2,557,314       224,968  
                 
Stockholders' deficit:
               
Common stock, $.001 par value, 300,000,000 shares authorized, 13,179,300 issued and outstanding, as of March 31, 2011.
    13,179       13,430  
Preferred stock to be issued at future dates
    -       2,000,000  
Additional paid in capital
    1,711,424       3,314,488  
Accumulated deficit
    (37,815,733 )     (12,421,859 )
Total stockholders' deficit
    (36,091,130 )     (7,093,941 )
                 
Total liabilities, redeemable preferred stock and stockholders' deficit
  $ 4,742,275     $ 4,814,568  

The accompanying notes are an integral part of the financial statements

 
3

 

Net Talk.com, Inc.
Statements of Operations

   
Three months ended
   
Six months ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Revenues
  $ 611,779     $ 245,636     $ 1,082,153     $ 429,829  
Cost of sales
    972,577       326,467       1,697,565       658,783  
Gross margin
    (360,798 )     (80,831 )     (615,412 )     (228,954 )
                                 
Advertising
    373,701       91,108       483,697       164,038  
Compensation and benefits
    104,917       91,771       209,667       193,834  
Professional fees
    77,642       91,495       145,736       141,604  
Depreciation and amortization
    90,914       90,618       180,947       181,208  
Research and development
    149,119       78,179       334,677       124,464  
General and administrative expenses
    232,686       128,838       416,217       253,490  
Total operating expenses
    1,028,979       572,009       1,770,941       1,058,638  
                                 
Loss from operations
    (1,389,777 )     (652,840 )     (2,386,353 )     (1,287,592 )
                                 
Other income (expenses):
                               
Interest expense
    (149,964 )     (858,172 )     (275,964 )     (1,184,363 )
Derivative expense
    (22,260,451 )     (4,163,525 )     (22,366,227 )     (5,347,297 )
Debt extinguished
    -       (3,617,983 )     -       (3,617,983 )
Settlement expense
    (367,500 )     -       (367,500 )     -  
Interest income
    615       2,406       2,170       5,981  
      (22,777,300 )     (8,637,274 )     (23,007,521 )     (10,143,662 )
                                 
Net loss
    (24,167,077 )     (9,290,114 )     (25,393,874 )     (11,431,254 )
                                 
Reconciliation of net loss to loss applicable to common stockholders:
                               
Accretion of preferred stock
            (40,006 )             (40,006 )
Preferred stock dividends in arrears
    -       (35,000 )     -       (35,000 )
                                 
Loss applicable to common stockholders
  $ (24,167,077 )   $ (9,365,120 )   $ (25,393,874 )   $ (11,506,260 )
                                 
Loss per common shares:                                
Basic and diluted earnings per common share
  $ (1.83 )   $ (0.96 )   $ (1.93 )   $ (1.18 )
                                 
Weighted average shares:                                
Basic and diluted
    13,179,300       9,719,800       13,179,300       9,719,800  

The accompanying notes are an integral part of the financial statements

 
4

 

Net Talk.com, Inc.
Statements of Cash Flows

   
Six months ended March 31,
 
   
2011
   
2010
 
             
Cash flow from operating activities:
           
             
Net loss
  $ (25,393,874 )   $ (11,431,254 )
Adjustments to reconcile net loss to net cash used in operations:
               
Depreciation
    65,511       61,542  
Amortization
    115,436       119,666  
Amortization of finance costs
    -       72,341  
Amortization of debt discount
    -       479,404  
Bad debt expense
    (22,749 )     10,232  
Warrant liabilities
    1       2,538  
Derivative fair value adjustments
    22,079,560       5,347,297  
Debt extinguished
    -       3,617,983  
Changes in assets and liabilities:
               
Accounts receivables
    (85,701 )     (11,992 )
Prepaid expenses and other assets
    238,184       4,267  
Inventories
    (1,288,357 )     (21,447 )
Deferred revenues
    271,558       -  
Accounts payables
    412,153       169,227  
Accrued expenses
    (59,192 )     617,929  
Net cash (used) in operating activities
    (3,667,470 )     (962,267 )
Cash flow used in investing activities:
               
Restricted cash
    (74,094 )     (2,021,206 )
Acquisition of fixed assets
    (47,140 )     (6,544 )
Decrease in deposits
    1,000       10,497  
Net cash (used) in investing activities
    (120,234 )     (2,017,253 )
Cash flow used in financing activities:
               
Notes payables - Demand notes
    2,500,000       -  
Issuance of preferred stock and warrants
    -       5,000,000  
Issuance of common stock (net)
    117,500          
Loans from officers
    -       (27,775 )
Net cash provided by financing activities
    2,617,500       4,972,225  
Net (decrease) increase ein cash
    (1,170,204 )     1,992,705  
Cash and equivalents, beginning
    3,039,340       1,010,698  
Cash and equivalents, ending
  $ 1,869,136     $ 3,003,403  
                 
Supplemtal disclosures:
               
                 
Non - cash changes:
               
                 
Cash paid for interest
  $ 149,953     $ -  
Cash paid for income taxes
  $ -     $ -  
Cash paid for dividends
  $ 289,667     $ -  

The accompanying notes are an integral part of the financial statements
 
5

 

NET TALK.COM, INC.
Notes to Unaudited Financial Statements

Note 1 – Nature of Operations and Basis of Presentation

Basis of presentation:

The accompanying unaudited condensed financial statements as of and for the three and six months ended March 31, 2011 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. Accordingly, they do not include all the information and footnotes required for complete financial statements. However, the unaudited condensed financial information includes all adjustments which are, in the opinion of management, necessary to fairly present the financial position and the results of operations for the interim periods presented. The operations for the three and six months ended March 31, 2011 and 2010 are not necessarily indicative of the results for the year ending September 30, 2011.
The unaudited condensed financial statements included in this report should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2010, filed with the Securities and Exchange Commission.

Nature of operations:

Net Talk.com, Inc. (“NetTalk” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida. We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main products are the TK 6000 and the DUO, an analog telephone adapters that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). Our TK 6000 and DUO and their related services are a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  Our TK 6000 and DUO provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our TK 6000 and DUO are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

Note 2 - Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes. Significant estimates inherent in the preparation of our financial statements include developing fair value measurements upon which to base our accounting for acquisitions of intangible assets and issuances of financial instruments, including our common stock. Our estimates also include developing useful lives for our tangible and intangible assets and cash flow projections upon which we determine the existence of, or the measurements for, impairments. In all instances, estimates are made by competent employees under the supervision of management, based upon the current circumstances and the best information available.

Risk and Uncertainties

Our future results of operations and financial condition will be impacted by the following factors, among others: dependence on the worldwide telecommunication markets characterized by intense competition and rapidly changing technology, on third-party manufacturers and subcontractors, on third-party distributors in certain markets, on the successful development and marketing of new products in new and existing markets. Generally, we are unable to predict the future status of these areas of risk and uncertainty.

 
6

 
 
Revenue Recognition
 
Operating revenue consist of customer equipment sales of our main product TK6000, telecommunication service revenues, shipping and handling revenues.
 
Our operating revenues are generated from the sale of customer equipment of our main products, our TK6000 and DUO. We also derive service revenues from per minute fees for international calls. Revenue from the sale of our TK6000 is fully recognized at the time of our customer equipment sale.  Our TK6000 provides for life time service (over the life of the device/equipment). Our TK6000 is able to operate within our network/platform or over any other network/platform.  There is no need for income allocation between our TK6000 and life time service provided.  The full intrinsic value of the sale is allocated to the device.  Therefore, we recognized 100% of revenue at time of customer equipment sale and do no allocate any income to life time service provided. Shipping and handling is also recognized at time of sale.
 
On July 14, 2010 we revealed our newest product the net TALK DUO (“DUO”).  Our DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates. It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required. The DUO is flexible enough to connect directly to your Internet connection through the router/modem, there is also a convenient option with our DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.

The DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services. The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other Nettalk customers are always free.
 
Our DUO provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO is fully recognized at the time of our customer equipment sale, the one year telephone service is amortized over 12 month cycle.  Subsequent renewals of the annual telephone service is amortized over the corresponding 12 months cycle.
 
International calls are billed as earned from our customers.  International calls are prepaid and customers account is debited as minutes are used and earned.
 
Cash and Cash Equivalents

We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which currently exceed federally insured limits.

Inventory

Inventories are recorded at cost or market, whichever is lower.
   
March 31, 2011
   
September 30, 2010
 
             
Productive material, work in process and supplies
  $ 1,465,975     $ 454,231  
Finished products
    390,942       114,329  
Total
  $ 1,856,917     $ 568,560  

During the six months ended March 31, 2011, in accordance with our lower of cost or market analyses we did not record lower of cost or market adjustments to our finished goods inventories.

Telecommunications Equipment and Other Property
 
Property, equipment and telecommunication equipment includes acquired assets which consist of network equipment, computer hardware, furniture and software. All of our equipment is stated at cost with depreciation calculated using the straight line method over the estimated useful lives of related assets, which ranges from three to five years.  The cost associated with  major improvements are capitalized while the cost of maintenance and repairs is charged to operating expenses.
 
 
7

 
 
Intangible Assets

Our intangible assets were recorded at our acquisition cost, which encompassed estimates of their respective and their relative fair values, as well as estimates of the fair value of consideration that we issued. We amortize our intangible assets using the straight-line method over lives that are predicated on contractual terms or over periods we believe the assets will have utility.

Impairments and Disposals

We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values. In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment. For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates for intangible assets.

Research and Development and Software Costs

We expense research and development costs, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software production costs shall be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product.   At this time our main products the TK6000 and DUO are being sold in the market place. Therefore, research and development cost reported in our financial statements relates to  pre – marketing costs and are expensed accordingly.

   
Three months ended
   
Six months ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
Components of research and development:
                       
Product development and engineering
  $ 31,325     $ 21,924     $ 118,860     $ 25,495  
Payroll and benefits
    117,794       56,255       215,817       98,969  
Total
  $ 149,119     $ 78,179     $ 334,677     $ 124,464  

Reclassification

Certain reclassifications have been made to prior years financial statements in order to conform to the current year’s presentation.   The reclassification had no impact on net earnings previously reported.

Share-Based Payment Arrangements
 
In June 2008, the FASB issued authoritative guidance on the treatment of participating securities in the calculation of earnings per shares (“EPS”).  This guidance addresses whether instruments granted in share – based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two - class method.  This guidance was effective for fiscal years beginning on or after December 15, 2008.  Adoption of this guidance did not have a material impact on our results of operations and financial position, or on basic or diluted EPS.

We apply the grant date fair value method to our share – based payment arrangements with employees and consultants. Share – based compensation cost to employees is measured at the grant date fair value based on the value of the award and is recognized over the service period.  Share – based payments to non – employees are recorded at fair value on the measurement date and reflected in expense over the service period.

 
8

 

2010 Stock Option Plan
 
On November 15, 2009, Net Talk.com, Inc. (the “Company”) adopted the 2010 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 10,000,000 shares of the Company’s common stock.
 
On July 26, 2010, we issued 3,709,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.03 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

We are planning to issue more shares under our 2010 Stock Option Plan in the near future.

2013 Stock Option Plan

We are working on our 2013 Stock Option Plan which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan.

Financial Instruments

Financial instruments, as defined in the Accounting Standards Codification (“ASC”) 825 Financial Instruments, consist of cash, evidence of ownership in an entity, and contracts that both (i) impose on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange other financial instruments on potentially unfavorable terms with the second entity, and (ii) conveys to that second entity a contractual right (a) to receive cash or another financial instrument from the first entity, or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Accordingly, our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, secured convertible debentures, and derivative financial instruments.

We carry cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities at historical costs since their respective estimated fair values approximate carrying values due to their current nature. We also carry convertible debentures and redeemable preferred stock at historical cost.

Derivative financial instruments, as defined in ASC 815-10-15-83 Derivatives and Hedging, consist of financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets.

We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain other financial instruments and contracts, such as our secured convertible debenture and warrant financing arrangements that are either (i) not afforded equity classification, (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty. As required by ASC 815, these instruments are required to be carried as derivative liabilities, at fair value, in our financial statements. See Note 7 for additional information about derivative financial instruments.

 
9

 
Recent Accounting Pronouncements

Accounting Changes

Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the cumulative effect, which amounted to $872,320, as a charge to our opening additional paid in capital on October 1, 2009.

Redeemable Preferred Stock

Redeemable preferred stock (and other redeemable financial instrument we may enter into) is initially evaluated for possible classification as liabilities under Statements of Financial Accounting Standards No. 150 Financial Instruments with Characteristics of Both Liabilities and Equity. Redeemable preferred stock classified as liabilities is recorded and carried at fair value. Redeemable preferred stock that does not, in its entirety, require liability classification is evaluated for embedded features that may require bifurcation and separate classification as derivative liabilities under Statement 133. In all instances, the classification of the redeemable preferred stock host contract that does not require liability classification is evaluated for equity classification or mezzanine classification based upon the nature of the redemption features. Generally, any feature that could require cash redemption for matters not within our control, irrespective of probability of the event occurring, requires classification outside of stockholders’ equity. See Note 6 for further disclosures about our redeemable preferred stock.

Loss Per Common Share

Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.

Income Taxes

We record our income taxes using the asset and liability method. Under this method, the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis are reflected as tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences reverse. Changes in these deferred tax assets and liabilities are reflected in the provision for income taxes. However, we are required to evaluate the recoverability of net deferred tax assets. If it is more likely than not that some portion of a net deferred tax asset will not be realized, a valuation allowance is recognized with a charge to the provision for income taxes.
 
Our net loss reflects permanent tax differences which are not deductible for tax purposes.  Therefore, our tax net operating loss would be reduced accordingly.  Our major permanent differences for the three and six months ended March 31, 2011, are as follows:

Permanent differences:
 
Three months
   
Six months
 
   
2011
   
2010
   
2011
   
2010
 
Derivative expense
  $ 22,260,451     $ 4,163,525     $ 22,366,227     $ 5,347,297  
Debt extinguished
    0       3,617,983       0       3,617,983  
Total
  $ 22,260,451     $ 7,781,508     $ 22,366,227     $ 8,965,280  

Effective January 1, 2010, the Company adopted the provisions in ASU 2009-17, “Consolidation (ASC Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”, which changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The adoption of the provisions in ASU 2009-17 did not have an impact on the Company’s financial statements.

 
10

 

Effective January 1, 2010, the Company adopted ASU 2010-01, “Equity (ASC Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash”, which clarifies that the stock portion of a distribution to shareholders that allow them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected prospectively in earnings per share and is not considered a stock dividend for purposes of ASC Topic 505 and ASC Topic 260. The adoption of the provisions in ASU 2010-01 did not have an impact on the Company’s consolidated financial statements.
 
Effective January 1, 2010, the Company adopted the provisions in ASU 2010-06, “Fair Value Measurements and Disclosures (ASC Topic 820): Improving Disclosures about Fair Value Measurements, which requires new disclosures related to transfers in and out of levels 1 and 2 and activity in level 3 fair value measurements, as well as amends existing disclosure requirements on level of disaggregation and inputs and valuation techniques. The adoption of the provisions in ASU 2010-06 did not have an impact on the Company’s financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s Financial Statements upon adoption.

Note 3 - Telecommunications Equipment and Other Property

Telecommunications equipment and other property consist of the following:

   
Life
   
March 31, 2011
   
September 30, 2010
 
                   
Telecommunication equipment
    7     $ 706,900     $ 674,362  
Computer equipment
    5       113,775       107,092  
Office equipment and furnishing
    7       28,574       23,760  
Purchased software
    3       23,759       20,655  
Sub – total
            873,008       825,869  
Less: accumulated depreciation
            (312,761 )     (247,251 )
Total
          $ 560,247     $ 578,618  

Our telecommunications equipment is deployed in our Network Operations Center (“NOC”) as is most of the computer equipment. Other computer and office equipment and furnishings are deployed at our corporate offices, which we lease under an operating lease.

Depreciation of the above assets was as follows:
   
Three Months Ended
   
Six Months Ended
 
    March 31,    
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
Depreciation expense
  $ 33,196     $ 30,785     $ 65,511     $ 61,542  

Note 4 - Intangible Assets:

Intangible assets consist of following:
   
Life
   
March 31, 2011
   
September 30, 2010
 
                   
Trademarks National and International
    5     $ 332,708     $ 332,708  
Employment agreements
    3       225,084       225,084  
Knowhow and specialty skills
    3       212,254       212,254  
Workforce
    3       54,000       54,000  
Telephony licenses
    2       9,195       9,195  
Patents
    20       11,024       11,024  
Domain names
    2       7,723       7,723  
              851,988       851,988  
Less accumulated amortization
            (601,063 )     (485,627 )
            $ 250,925     $ 366,361  

Amortization of the above assets was as follows:
 
Three months ended
   
Six Month Ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Amortization expense
  $ 57,718     $ 59,833     $ 115,436     $ 119,666  
 
 
11

 
 
The weighted average amortization period for the amortizable intangible assets is 2.4 years.
 
Estimated future amortization of intangible assets is as follows:

March 31,
     
       
2011
  $ 118,681  
2012
    70,238  
2013
    62,006  
Total
  $   250,925  

Note 5 - Secured Convertible Debentures

The carrying values of our 12% secured convertible debentures consist of the following as of March 31, 2011 and September 30, 2010:

   
March 31,
2011
   
September 30
2010
 
             
$3,146,000 face value convertible debenture, due June 30, 2011
  $ 3,146,000     $ 3,146,000  
$587,166 face value convertible debenture, due July 20, 2011
    587,161       587,161  
$1,265,607 face value convertible debenture, due September 25, 2011
    1,265,607       1,265,607  
Total
  $ 4,998,768     $ 4,998,768  

Our convertible debentures as of March 31, 2011 and September 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.

Our accounting for the aforementioned exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances, our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both. As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures at fair value, with the difference reflected in our expenses.

The following table reflects the components of our extinguishment calculation on February 24, 2010:

   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
Debentures
    1,713,124       152,755       267,000       2,132,879  
Accrued Interest
    546,000       87,166       165,607       798,773  
Compound embedded derivative
    3,723,200       750,000       1,632,400       6,105,600  
Deferred finance costs
    (85,372 )     (23,933 )     (92,122 )     (201,427 )
      5,896,952       965,988       1,972,885       8,835,825  
                                 
Extinguishment loss
  $ 1,870,498     $ 524,268     $ 1,223,217     $ 3,617,983  
 
12

 

The fair values of the Secured Convertible Debentures were determined based upon their respective discounted cash flow, using observable market rates, plus the fair value of the embedded conversion options. Observable market rates on the exchange date ranged from 7.91% for one-year and 8.47% for two years and were derived from publicly available surveys of corporate bond curves for issuers with similar risk characteristics as ours. The fair value of our compound embedded derivatives were determined using the Monte Carlo Simulations model. See Note 7. The compound embedded derivatives were adjusted to fair value on the exchange date, immediately before the exchange transaction, which amount is included in our derivative expense.

The fair value of the new convertible debentures was allocated to the debt balance, the compound embedded derivative and paid-in capital. Paid-in capital arises in this transaction, because the allocation resulted in premiums which, under accounting principles, are considered equity components. The following table summarizes the allocation on the exchange date:

   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30
2011
   
Total
 
Convertible debentures
  $ 3,146,000     $ 587,166     $ 1,265,607     $ 4,998,773  
Compound embedded derivative
    4,505,072       880,749       1,878,161       7,263,982  
Paid-in capital
    116,378       22,341       52,334       191,053  
    $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  

Our accounting for the original debenture financings was as follows:

2008 Convertible Debenture Financing

On September 10, 2008, we issued a $1,000,000 face value, 12% secured convertible debenture (T-1), due September 10, 2010 and Series B warrants indexed to 4,000,000 shares of our common stock in exchange for the Interlink Asset Group, discussed in Note 3. Also on September 30, 2008, we issued a $500,000 face value 12% secured convertible debenture (T-2), due September 10, 2010 and Series B warrants indexed to 2,000,000 shares of our common stock for net cash proceeds of $472,800. The warrants have a term of five years. These financial instruments were issued to the same creditor under contracts that are substantially similar, unless otherwise mentioned in the following discussion.

The principal amount of the debentures was initially payable on September 10, 2010 and the interest is payable quarterly, on a calendar quarter basis. While the debenture is outstanding, the investor has the option to convert the principal balance, and not the interest, into shares of our common stock at a conversion price of $0.25 per common share. The terms of the conversion option provide for anti-dilution protections for traditional restructurings of our equity, such as stock-splits and reorganizations, if any, and for sales of our common stock, or issuances of common-indexed financial instruments, at amounts below the otherwise fixed conversion price. Further, the terms of the convertible debenture provide for certain redemption features. If, in the event of certain defaults on the terms of the debentures, some of which are indexed to equity risks, we are required at the investors option to pay the higher of (i) 110% of the principal balance, plus accrued interest or (ii) the if-converted value of the underlying common stock, using the 110% default amount, plus accrued interest. If this default redemption is not exercised by the investor, we would incur a default interest rate of 18% and the investor would have rights to our assets under the related Security Agreement. We may redeem the convertible debentures at anytime at 110% of the principal amount, plus accrued interest.

Because the two hybrid debt contracts were issued as compensation for the Interlink Asset Group and as further discussed in Note 3 we concluded that they should be combined for accounting purposes, the accounting resulted in no beneficial conversion feature.

2009 Convertible Debenture Financings

We entered into several Securities Purchase Agreements with Debt Opportunity Fund, LLP (“DOF”) during the year ended September 30, 2009.

 
-
On January 30, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $600,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,400,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $507,900. The warrants have a term of five years.

 
-
On February 6, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $443,250. The warrants have a term of five years.

 
13

 

 
-
On July 20, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $446,250. The warrants have a term of five years.

 
-
On September 25, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $1,100,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 4,400,000 shares of our common stock at an exercise price of $0.25 for net cash proceeds of $1,000,000.  The warrants have a term of five years.

Each debenture bears interest at a rate of 12% per annum from the date of issuance until paid in full. Interest is calculated on the basis of a 360-day year and paid for the actual number of days elapsed, and accrues and is payable quarterly or upon conversion (as to the principal amount then being converted). The debentures convert into shares of our common stock at the option of the holder at $0.25 per share (which conversion price is subject to adjustment under certain circumstances). The debentures are secured by a lien in all of the assets of the Company. Further, the terms of the convertible debentures provide for default redemption features similar to those described above.

Midtown Partners & Co., LLC (“Midtown Partners”), an NASD registered broker dealer, acted as the placement agent for the Company in connection with the January 30, July 20, and September 25, 2009 Convertible Debt Offerings (“2009 Convertible Debt Offerings”). We paid Midtown Partners cash commissions equal to $198,000 and we issued Series BD Common Stock Purchase Warrants to Midtown Partners entitling Midtown Partners to purchase 1,720,000 shares of the Company’s common stock at an initial exercise price of $0.50 per share and 440,000 shares of the Company’s common stock at an initial exercise price $0.25 per share. Since the Series BD warrants offered full ratchet anti-dilution protection, any previously issued and outstanding warrants with a conversion price greater than $0.25 automatically had their conversion price ratchet down to $0.25 as subsequent issuances were made with a conversion price of $0.25.

On September 22, 2009 we voided and reissued warrants in connection with our financing transactions. The cancellation and reissuance of warrants was treated as a modification under ASC 470-50 Modifications and Extinguishments although the change in cash flow was <10% so extinguishment accounting was not applicable.
 
Cancelled and re-issued warrants were as follows:
 
Original Warrants
 
Indexed
Shares
   
Strike
Price
 
Reissued
Warrants
 
Indexed
Shares
   
Strike
Price
 
C-1 warrants
    2,400,000     $ 0.50  
C-3 warrants
    2,400,000     $ 0.50  
C-2 warrants
    2,000,000     $ 0.50  
C-4 warrants
    2,000,000     $ 0.50  
BD-1 warrants
    480,000     $ 0.50  
BD-4 warrants
    240,000     $ 0.25  
                 
BD-5 warrants
    240,000     $ 0.50  
BD-2 warrants
    400,000     $ 0.50  
BD-6 warrants
    200,000     $ 0.25  
                 
BD-7 warrants
    200,000     $ 0.50  
BD-3 warrants
    200,000     $ 0.50  
BD-8 warrants
    200,000     $ 0.25  
BD-4 warrants
    200,000     $ 0.50  
BD-9 warrants
    200,000     $ 0.50  

Accounting for the Financing Arrangements

We have evaluated the terms and conditions of the secured convertible debentures under the guidance of ASC 815, Derivatives and Hedging. We have determined that, while the anti-dilution protections preclude treatment of the embedded conversion option as conventional, the conversion option is exempt from classification as a derivative because it otherwise achieves the conditions for equity classification (if freestanding) provided in ASC 815. We have further determined that the default redemption features described above are not exempt for treatment as derivative financial instruments, because they are not clearly and closely related in terms of risk to the host debt agreement. On the inception date of the arrangements through June 30, 2010, we determined that the fair value of these compound derivatives is de minus. However, we are required to re-evaluate this value at each reporting date and record changes in its fair value, if any, in income. For purposes of determining the fair value of the compound derivative, we have evaluated multiple, probability-weighted cash flow scenarios. These cash flow scenarios include, and will continue to include fair value information about our common stock. Accordingly, fluctuations in our common stock value will significantly influence the future outcomes from applying this technique.

 
14

 


Since, as discussed above, the embedded conversion options did not require treatment as derivative financial instruments; however, we were required to evaluate the feature as embodying a beneficial conversion feature under ASC 470-20, Debt with Conversion and Other Options. A beneficial conversion feature (“BCF”) is present when the fair value of the underlying common share exceeds the effective conversion price of the conversion option. The effective conversion price is calculated as the basis in the financing arrangement allocated to the hybrid convertible debt agreement, divided by the number of shares into which the instrument is indexed.  Because the two hybrid debt contracts dated September 10, 2008 were issued as compensation for the Interlink Asset Group, we concluded that they should be combined for accounting purposes and the accounting resulted in no beneficial conversion feature. The financings issued in 2009 were found to have a BCF which gives effect to the (i) the trading market price on the contract dates and (ii) the effective conversion price of each issuance after allocation of proceeds to all financial instruments sold based upon their relative fair values. Notwithstanding, the BCF was limited to the value ascribed to the remaining hybrid contract (using the relative fair value approach). Accordingly, the BCF allocated to paid-in capital from the 2009 financings amounted to $872,320 for the year ended September 30, 2009.

We evaluated the terms and conditions of the Series B, Series C and Series BD warrants under the guidance of ASC 480, Distinguishing Liabilities from Equity (“ASC 480”). The warrants embody a fundamental change-in-control redemption privilege wherein the holder may redeem the warrants in the event of a change in control for a share of assets or consideration received in such a contingent event. This redemption feature places the warrants within the scope of ASC 480-10, as put warrants and, accordingly, they are classified in liabilities and measured at inception and on an ongoing basis at fair value. Fair value of the warrants was measured using the Black-Scholes-Merton valuation technique and in applying this technique we were required to develop certain subjective assumptions which are listed in more detail below.

Premiums on the secured convertible debentures arose from initial recognition at fair value, which is higher than face value. Discounts arose from initial recognition at fair value, which is lower than face value. Premiums and discounts are amortized through credits and debits to interest expense over the term of the debt agreement.

Direct financing costs were allocated to the financial instruments issued (hybrid debt and warrants) based upon their relative fair values. Amounts related to the hybrid debt are recorded as deferred finance costs and amortized through charges to interest expense over the term of the arrangement using the effective interest method. Amounts related to the warrants were charged directly to income because the warrants were classified in liabilities, rather than equity, as described above. Direct financing costs are amortized through charges to interest expense over the term of the debt agreement.

On September 24, 2009, we obtained an extension of the interest payments due June 30, 2009 and September 30, 2009 to June 30, 2010 and September 30, 2010, respectively. The change in cash flow from this modification was analyzed to determine if it was greater than 10% which would give rise to extinguishment accounting. In each case, the change in cash flows was less than 10% so extinguishment accounting was not applicable.

On February 24, 2010, we exchanged the convertible debentures for newly issued convertible debentures as discussed in the beginning of this footnote.

Note 6 – Redeemable Preferred Stock

Redeemable preferred stock consists of the following as of March 31, 2011 and September 30, 2010:

   
March 31,
2011
   
September 30,
2010
 
Series A Convertible Preferred Stock, par value $0.001 per share, stated value $10,000 per share; 500 shares issued and outstanding at March 31, 2011; redemption value $5,000,000, and 300 shares issued and outstanding at September 30, 2010; redemption value $3,000,000.
           
Initial carrying value
  $ 624,000     $  
Accumulated accretion
    1,933,314       224,968  
Carrying values
  $ 2,557,314     $ 224,968  

On February 24, 2010, we designated 500 shares of our authorized preferred stock as Series A Convertible Preferred Stock; par value $0.001 per share, stated value $10,000 per share (“Preferred Stock”). The Preferred Stock is redeemable for cash on June 30, 2011 at the stated value, plus accrued and unpaid dividends. Dividends accrue, whether or not declared, at a rate of 12% of the stated value.
 
15

 

The Preferred Stock is convertible into common stock at the holder’s option at $0.25 based upon the stated value (20,000,000 linked common shares). Such conversion rate is subject to adjustment for traditional reorganizations and recapitalization and in the event that we sell common stock or other equity-linked instruments below the conversion price. Holders of the Preferred Stock are entitled to a preference equal to the stated value, plus accrued and unpaid dividends. While the Preferred Stock is outstanding, holders vote the number of indexed common shares.

We sold 300 shares of Series A Preferred on February 24, 2010, with warrants to purchase 12,000,000 shares of our common stock for proceeds of $3,000,000. We sold 200 shares of Series A Preferred on October 25, 2010, with warrants to purchase 8,000,000 shares of our common stock for proceeds of $2,000,000.

Our accounting for the Preferred Stock and warrant financing transaction required us to evaluate the classification of the embedded conversion feature and the warrants. As a prerequisite to establishing the classification of the embedded conversion option, we were required to determine the nature of the hybrid Preferred Stock contract based upon its risks as either a debt-type or equity-type contract. The presence of the mandatory cash redemption and the requirement to accrue dividends were persuasive evidence that the Preferred Stock was more akin to a debt than an equity contract, with insufficient evidence to the contrary (e.g. voting privilege).

Given that the embedded conversion feature, when evaluated as embodied in a debt-type contract, did not meet the definition for an instrument indexed to a company’s own stock, the embedded conversion feature required bifurcation and classification in liabilities, at fair value. Similarly, the warrants did not meet the definition for an instrument indexed to a company’s own stock, resulting in their classification in liabilities, at fair value.

The following table reflects the allocation of the purchase price on the financing date:

Allocation:
 
October 25,
2010
   
February 24,
2010
 
Redeemable preferred Stock
  $ 624,000     $  
Warrants
    936,000       5,062,800  
Compound embedded derivative
    440,000       4,260,000  
Derivative loss, included in derivative income (expense)
          (6,322,800 )
    $ 2,000,000     $ 3,000,000  

Warrants issued with the February 24, 2010 financing were valued on the financing date using the Black-Scholes-Merton valuation technique. Significant assumptions were as follows: Market value of underlying, using the trading market of $0.58; expected term, using the contractual term of 5.0 years; market volatility, using a peer group of 90.20%; and, risk free rate, using the yield on zero coupon government instruments of 2.40%. Warrants issued with the October 25, 2010 financing were valued on the financing date and subsequently using Binomial Lattice. Significant assumptions were as follows: Market value of the underlying, using the trading market of $0.26; market volatility, using a peer group ranged from 76.06% to 99.78% with an equivalent volatility of 89.40%; and risk free rate using the yield on zero coupon government instruments ranging from 0.12% to 2.01% with an equivalent rate of 0.66%. The implied expected life of the warrant is 4.7 years.

The compound embedded derivative was valued using the Monte Carlo Simulations (“MCS”) technique. The MSC technique is a generally accepted valuation technique for valuing embedded conversion features in hybrid convertible notes, because it is an open-ended valuation model that embodies all significant assumption types, and ranges of assumption inputs that management of the Company believe would likely be considered in connection with the arms-length negotiation related to the transference of the instrument by market participants. However, there may be other circumstances or considerations, other than those addressed herein, that relate to both internal and external factors that would be considered by market participants as it relates specifically to the Company and the subject financial instruments.

Given its redeemable nature, we are required to classify our Series A Preferred Stock outside of stockholders’ equity. Further, the inception date carrying value is subject to accretion to its ultimate redemption value over the term to redemption, using the effective method. During the period from its issuance to September 30, 2010, we accreted $224,969, which was reflected as a charge to paid-in capital in the absence of accumulated earnings. During the six months ended March 31, 2011, we accreted $1,708,346. We also accrued $286,667 and $136,667 during the same periods which amount represents the cumulative dividends that we are required to pay whether or not they are declared. All dividends have been paid as of March 31, 2011.

 
16

 

Note 7 – Derivative Financial Instruments

The components of our derivative liabilities consisted of the following at March 31, 2011 and September 30, 2010:

   
March 31, 2011
       
Derivative Financial Instrument
 
Indexed
Shares
   
Fair
Value
   
September 30
2010
 
                   
Compound Derivative Financial Instruments:
                 
February 24, 2010 Secured Convertible Debentures
    19,995,092     $ 11,312,049     $ 2,276,794  
February 24, 2010 Series A Convertible Preferred Stock
    12,000,000       6,780,000       1,404,000  
October 24, 2010 Series A Convertible Preferred Stock
    8,000,000       4,520,000        
                         
Warrants (dates correspond to financing):
                       
February 24, 2010 Series D warrants, issued with the preferred financing (Note 7)
    12,000,000       2,064,000       858,000  
February 24, 2010 Series D warrants, issued with the exchange (Note 8)
    16,800,000       2,889,600       1,201,200  
October 25, 2010 Series D warrants, issued with the financing (Note 7)
    8,000,000       1,808,000        
Financing warrants issued to brokers
    2,160,000             165,628  
Total
    78,955,092     $ 29,373,649     $ 5,905,622  

On January 11, 2011, certain warrants previously issued to brokers and that were linked to 2,160,000 shares of our common stock were modified to remove provisions that could result in adjustments to the exercise prices if we sold common shares or common share linked contracts at a per share price that was less than the exercise price of these warrants. As a result of this modification, these warrants no longer require liability classification and measurement at fair value. On the modification date we adjusted these warrants to their fair values with a charge to income and reclassified the balance, amounting to $274,200 to paid-in capital.

The following table reflects the activity in our derivative liability balances from October 1, 2009 to March 31, 2011:

   
Compound
   
Warrants
   
Total
 
Balances at October 1, 2010
  $ 3,680,794     $ 2,224,828     $ 5,905,622  
Issuances
    936,000       440,000       1,376,000  
Conversion and redemption
                 
Unrealized derivative (gains) losses
    618,764       (512,988 )     105,776  
Balances at December 31, 2010
    5,235,558       2,151,840       7,387,398  
Issuances
                 
Conversion and redemption
                 
Reclassifications
          (274,200 )     (274,200 )
Unrealized derivative (gains) losses
    17,376,491       4,883,960       22,260,451  
Balances at March 31, 2011
  $ 22,612,049     $ 6,761,600     $ 29,373,649  

Effective on January 1, 2011, we changed our method for valuing our derivative warrants from a Black-Scholes Merton Model, adjusted to give effect to the anti-dilution features (the Noreen Wolfson Model) to Binomial Lattice. Binomial Lattice was considered by our management to be more appropriate because it both provides for early exercise scenarios and incorporates the down-round anti-dilution protection possibilities that could arise in early exercise scenarios.
 
 
17

 

The following table reflects the activity in our derivative liability balances from October 1, 2008 to March 31, 2010:

   
Compound
   
Warrants
   
Total
 
Balances at October 1, 2009
  $     $ 1,327,272     $ 1,327,272  
Accounting change
    1,865,600             1,865,600  
Effect of exchange transaction
    1,158,382             1,158,382  
Issuances
    4,260,000       5,062,800       9,322,800  
Conversion and redemption
                 
Unrealized derivative (gains) losses
    (1,751,367 )     775,864       (975,503 )
Balances at March 31, 2010
  $ 5,532,615     $ 7,165,936     $ 12,698,551  

Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the derivative liability in the amount of $1,865,600 was established and the cumulative effect, which amounted to $872,319, was charged to our opening accumulated deficit on October 1, 2009.

As more fully discussed in Note 6, on February 24, 2010, we exchanged our convertible debentures for newly issued convertible debentures. This amount represents the change in the fair value of the compound embedded derivatives between the old and new debentures, which in part arose from the capitalization of accrued interest and in part arose from other changes to the debentures. As further noted in Note 6, the exchange transaction gave rise to the extinguishment of the old debentures, and therefore the compound derivative, due to the substantive nature of these changes. Since an extinguishment is recorded by replacing the carrying value of the old debentures with the fair value of the new debentures, with a charge to expense for the difference, this amount is included in the extinguishment loss that we recorded in connection with the exchange.

Fair Value Considerations

We adopted the provisions of ASC 820 Fair Value Measurements and Disclosures (“ASC 820”) with respect to our financial instruments. As required by of ASC 820, assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments which are required to be measured at fair value on a recurring basis under of ASC 815 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

We have selected the Monte Carlo Simulations valuation technique to fair value the compound embedded derivative because we believe that this technique is reflective of all significant assumption types, and ranges of assumption inputs, that market participants would likely consider in transactions involving such types of derivatives. Such assumptions include, among other inputs, interest risk assumptions, credit risk assumptions and redemption behaviors in addition to traditional inputs for option models such as market trading volatility and risk free rates.
 
   
March 31,
 
September 30,
 
March 31,
   
2011
 
2010
 
2010
Quoted market price of our common stock
 
$0.80
 
$0.25
 
$0.34
Contractual conversion rate
 
$0.25
 
$0.25
 
$0.25
Implied expected term (years)
 
0.10—0.15
 
0.59—0.92
 
1.10—1.30
Market volatility:
           
Range of volatilities
 
9%—49%
 
134%-160%
 
109%-127%
Equivalent volatility
 
31%—34%
 
145%—152%
 
115%-118%
Market-risk adjusted interest rate:
           
Range of rates
 
12.0%
 
12.0%
 
9.9%-12.0%
Equivalent market-risk adjusted interest rate
 
12.0%
 
12.0%
 
11.1%-12.0%
Credit-risk adjusted yield rate:
           
Range of rates
 
7.3%-8.0%
 
7.5%-8.0%
 
7.9%-8.9%
Equivalent credit-risk adjusted yield rate
 
7.6%
 
7.7%
 
8.3%
Risk-free rates using yields on zero coupon US Treasury Security rates:
           
Range of rates
 
0.30%-1.29%
 
0.27%-0.64%
 
0.41%-1.60%
 
 
18

 
 
The warrants are valued using the Binomial Lattice Valuation technique on March 31, 2011 and Black-Scholes-Merton (“BSM”) valuation methodology on September 30, 2010 and March 31, 2010, adjusted to give effect to the anti-dilution features, because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions were as follows as of March 31, 2011 and September 30, 2010:

   
Series D
Warrants
 
BD
Warrants
 
BD
Warrants
March 31, 2011 (Assumptions for BD Warrants are January 11, 2011)
           
Contractual strike price
 
$0.50
 
$0.25
 
$0.50
Adjusted strike price (for anti-dilution)
 
$0.46
 
$0.24
 
$0.43
Term to expiration
 
4.2-4.9
 
3.1-3.7
 
3.1-3.7
Implied expected life
 
3.9-4.6
 
3.0-3.7
 
3.0-3.7
Volatility range
 
74%-100%
 
75%-101%
 
75%—101%
Effective volatility
 
82%-85%
 
91%
 
91%
Risk-free rate ranges
 
0.09-2.24
 
0.12-2.01
 
0.12-2.01
Effective risk free rates
  
0.81-0.94
  
0.51-0.66
  
0.51-0.66

   
Series D
Warrants
 
BD
Warrants
 
BD
Warrants
September 30, 2010
           
Contractual strike price
 
$0.50
 
$0.25
 
$0.50
Adjusted strike price
 
$0.43
 
$0.23
 
$0.43
Volatility
 
107.9%
 
111.5%-116.7%
 
111.5%-116.7%
Term to expiration
 
4.40
 
3.33—4.00
 
3.33—4.00
Risk-free rate
 
1.27
 
0.64-1.27
 
0.64-1.27
Dividends
  
  
  

 
Note 8 - Commitment and Contingencies

Leases
 
Our principal executive offices are located at 1100 NW 163rd Drive, Miami, Florida 33169.  Our lease terminated on August 31, 2010 and we are presently under negotiations with our landlord to renew the lease agreement for additional term of 2 years.  This facility is suitable for our purposes and is expected to accommodate our needs for the foreseeable future.
   
Three months ended
   
Six months ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
Occupancy expense
  $ 66,779     $ 43,234     $ 120,995     $ 86,390  

Legal proceedings

Form 8 K was filed on January 28, 2011, as follows: Issuance of 750,000 shares of Nettalk.com, Inc. common stock.  The shares were issued in connection with the settlement of  litigation between the Company and Midtown Partners and Co., LLC  in the Circuit Court of Hillsborough County, Florida (Case No. 101981) .
 
Said settlement further provides that certain cashless warrants previously issued to Midtown Partners and Co., LLC be modified, reducing from  2,251,800 to 1,102,921 the number of shares of the Company’s common stock to be issued thereunder.
 
Subsequent event
 
On May 5, 2011 we filed Form 8 K, as follows:
 
On May 3, 2011 Vicis Capital Master Fund completed its commitment to loan to the Company $4,000,000 represented by a series of promissory notes ($1,000,000 funded January 2011, $1,500,000 funded March 2011 and $1,500,000 funded May, 2011) bearing interest at the rate of 5% per annum, principal and interest payable upon demand. Vicis is the holder of the Company's Senior Secured Debentures and Series A Preferred Stock.
 
 
19

 
 
Item 2 – Management Discussion and Analysis of Financial Conditions and Results of Operations
 
Our Management’s Discussion and Analysis should be read in conjunction with our financial statements included in this report.
 
Forward Looking Statements
 
Certain statements contained in this annual report on Form 10-K and other written material and oral statements made from time to time by us do not relate to historical or current facts.  As such, they are referred to as “forward-looking statements,” which are intended to convey our expectations or predictions regarding the occurrence of possible future events or the existence of trends and factors that may impact our future plans and operating results. These forward-looking statements are derived, in part, from various assumptions and analyses we have made in the context of our current business plan and information currently available to us and in light of our experience and perceptions of historical trends, current conditions and expected future developments and other factors we believe to be appropriate in the circumstances. You can generally identify forward-looking statements through words and phrases such as “ seek, ” “ anticipate, ” “ believe, ” “ estimate, ” “ expect, ” “ intend, ” “ plan, ” “ budget, ” “ project, ” “ may be, ” “ may continue, ” “ may likely result, ” and similar expressions. When reading any forward looking statement, you should remain mindful that actual results or developments may vary substantially from those expected as expressed in or implied by that statement for a number of reasons or factors, such as those relating to:
 
 
·
whether or not a market for our products and services develop and, if a market develops, the pace at which it develops;
 
·
our ability to successfully sell our products and services if a market develops;
 
·
our ability to attract the qualified personnel to implement our growth strategies;
 
·
our ability to develop sales and marketing capabilities;
 
·
the accuracy of our estimates and projections;
 
·
our ability to fund our short-term and long-term financing needs;
 
·
changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in the sections of this quarterly report, including the section captioned “Plan of Operation”.
 
Each forward-looking statement should be read in context with, and with an understanding of, the various other disclosures concerning our Company and our business made elsewhere in this prospectus, as well as other public reports filed with the SEC. You should not place undue reliance on any forward-looking statement as a prediction of actual results or developments. We are not obligated to update or revise any forward-looking statement contained in this report to reflect new events or circumstances unless and to the extent required by applicable law.
 
Background
 
Company and Business
 
We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main product is the TK 6000, an analog telephone adapter that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”).
 
Our TK 6000 and its related services is a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  The TK 6000 provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to the TK 6000 are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.
 
On July 14, 2010 we revealed our newest product the netTALK DUO (“DUO”).
The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

We are presently working on other new products and anticipate future deployment over the next year.
 
 
20

 
 
History and Overview
 
We are a Florida corporation, incorporated on May 1, 2006 under the name Discover Screens, Inc. (“Discover Screens”).
 
Prior to September 10, 2008, we were known as Discover Screens, a development-stage company, dedicated to providing advertising through interactive, audiovisual, information and advertising portals located in high-traffic indoor venues. Our name and business operations changed in a series of transactions beginning in December of 2007. Pursuant to an asset purchase agreement dated December 30, 2007, we sold all of the assets associated with the advertising business as a going concern to Robert H. Blank, who was then our President and Chief Operating Officer. Following that transaction, we ceased all existing operations, and from December 30, 2007 to September 9, 2008, we owned nominal assets and generated no revenue. In February of 2008, Mr. Blank resigned as officer and director.
 
On September 9, 2008, Robin C. Hoover, our sole remaining officer and director, appointed four new members to the Board of Directors, Anastasios Kyriakides, Kenneth Hosfeld, Guillermo Rodriguez and Leo Manzewitsch. Mr. Hoover then resigned as an officer and director. Mr. Richard Diamond was appointed by the Board of Directors to fill the vacancy left by Mr. Hoover’s resignation.  Mr. Diamond resigned as a director of the Company, effective November 23, 2009.
 
On September 10, 2008, we changed our name from Discover Screens, Inc. to NetTalk.com, Inc. On September 10, 2008, we entered into a Contribution Agreement with Vicis Capital Master Fund (“Vicis”) by which Vicis contributed certain operating assets to the Company in exchange for (a) a 12% Senior Secured Convertible Debenture in the principal amount of $1,000,000; and (b) a Series B Warrant to purchase 4,000,000 shares of common stock of the Company. Also on September 10, 2008, the Company entered into a Securities Purchase Agreement with Debt Opportunity Fund, LLP (“DOF”) by which DOF purchased (a) a 12% Senior Secured Convertible Debenture in the principal amount of $500,000; and (b) a Series B Warrant to purchase 2,000,000 shares of Common Stock of the Company.
 
On September 10, 2008, we acquired certain tangible and intangible assets, formerly owned by Interlink Global Corporation (“Interlink”), (the “Interlink Asset Group”) directly from Interlink’s creditor who had seized the assets pursuant to a Security and Collateral Agreement. Our purpose in acquiring these assets, which included employment rights to the executive management team of Interlink who now currently serve as our officers, was to advance the TK 6000 VoIP Technology Program, which Interlink launched in July 2008. Accordingly, these assets substantially comprise our current business assets and the infrastructure for our future operations. Contemporaneously with this purchase, we executed an assignment and intellectual property agreement with Interlink that served to perfect our ownership rights to the assets.
 
Consideration for the acquisition consisted of a face value $1,000,000 convertible debenture, plus warrants to purchase 4,000,000 shares of our common stock. On the date of the Interlink Asset Group acquisition, we also entered into a financing agreement with DOF (as described above) that provided for the issuance of a face value $500,000 convertible debenture, plus warrants to purchase 2,000,000 shares of our common stock for net cash consideration of $448,300. In connection with this acquisition, we issued 6,000,000 shares of common stock to our new management team in connection with the Interlink Asset Group acquisition.
 
We continue to improve and enhance the following factors in building and expanding our customer base:
 
 
·
Deployment and distribution of our  products TK 6000 and DUO devices.
 
 
·
Attractive and innovative value proposition.  We offer our customers an attractive and innovative value proposition: a portable telephone replacement with multiple and unique features that differentiates our services from the competition.
 
 
·
Innovative, high technology and low cost technology platform.  We believe our innovative software and network technology platform provides us with a competitive advantage over our competition and allows us to maintain a low cost infrastructure relative to our competitors.
 
Plan of Operation
 
We provide, sell and supply commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. We are developing our business infrastructure and new products and services.
 
 
21

 
 
Our Products
 
At this time, our main products are the TK 6000 and DUO. Our TK 6000 and DUO are designed to provide specifications unique to each customer’s existing equipment. It allows the customer full mobile flexibility by being able to take internet interface anywhere the customer has an internet connection. Our TK 6000 and DUO both have the following features:

A Universal Serial Bus (“USB”) connection allowing the interconnection of ourTK 6000 and  DUO to any host computer.
 
In addition to the USB power source option, our TK 6000 and DUO has  an external power supply allowing the phone to independently power itself when not connected to a host computer;

Unlike most VoIP telephone systems, our TK 6000 and DUO both have standalone feature allowing them to be plugged directly into a standard internet connection.

Our TK 6000 and DUO are compact, space-efficient products.
 
Our TK 6000 and DUO both have interface component so that the customer can purchase multiple units that can communicate with each other allowing simultaneous ringing from multiple locations.
 
Our products are portable and allows our customers to make and receive phone calls with a telephone anywhere  broadband internet connection is available without the need of a computer.  We transmit the calls using Voice over Internet Protocol “VOIP” technology, which converts voice signals into digital data transmissions over the internet.
 
Our Services
 
Our business is to provide products and services that utilize Voice Over Internet Protocol, which we refer to as “VoIP.” VoIP is a technology that allows the consumer to make telephone calls over a broadband internet connection instead of using a regular (or analog) telephone line. VoIP works by converting the user’s voice into a digital signal that travels over the internet until it reaches its destination. If the user is calling a regular telephone line number, the signal is converted back into a voice signal once it reaches the end user. Our business model is to develop and commercialize software technology solutions for cost effective, real-time communications over the internet and related services.
 
Services provided or to be provided
 
Text to phone reminder service. We are currently developing a service that will allow VoIP to synchronize  with the customer’s data base schedule management system (such as Microsoft Office Outlook © ).   Our goal is to develop a service that will call the customer at a pre-designated time to provide an audio  reminder of that day’s agenda to the customer. By offering this service at a low price point of less than five  dollars per month we hope to appeal to a broad customer base. This software is currently under development.

Free conference server. This product is currently available to all our customers.

Future Voice Message Delivery. This service allows the user to record a voice message which will be delivered to a recipient at a later date and time specified by the user.

Speech to text services for the hearing impaired. This is a standalone service that will allow the hearing impaired  to receive real time conversion of incoming voice signals into text displayed on an incorporated display panel.

 
22

 
 
Patents – Domestic and International
 
Our products are currently under US patent pending as well as International patent pending in over 123 countries.
 
Federal CALEA
 
On August 5, 2005, the Federal Communications Commission (the “FCC”) released an Order extending the obligations of the Communication Assistance for Law Enforcement Act (“CALEA”) to interconnected VoIP providers. Under CALEA, telecommunication carriers must assist law enforcement in executing electronic surveillance, which includes the capability of providing call content and call-identifying information to a local enforcement agency, or LEA, pursuant to a court order of other lawful authorization.
 
The FCC required all interconnected VoIP providers to become fully CALEA compliant by May 14, 2007.  To date, we have complied with all lawful CALEA requests.
 
Marketing
 
We have developed direct sales channels, as represented by web sites and toll free numbers.  Our direct sales channels are supported by highly integrated advertising campaigns across multiple media such as infomercials, television and other media channels.   Our website is www.nettalk.com, our telephone number is (305) 621-1200 and our fax number is (305) 621-1201.
 
Our primary source of revenue is the sale and distribution of our TK 6000 and DUO products.  We also generate revenue from the sale of accessories to our product and international long distance monthly charges that are billed to our customers.
 
Advertising
 
Our goal is to position ourselves as a premier supplier of choice for VoIP services. Our current business strategy is to focus our advertising dollars on our home market in South Florida.  Our advertising will consist of mass marketing campaigns focusing on television infomercials for the South Florida market and other states including cable television channels..

Customers
 
Our customers are made up of residential and small businesses. We anticipate that future services will appeal to our existing customers and hope that our additional phone products and services will provide a complete phone package experience to our customers.
 
Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications. We are also reaching a large audience with our websites. We hope that consumers will find our websites by doing an internet search for VoIP service providers. We also use other means of advertising such as direct to consumer sales, eCommerce and wholesale sales to retail stores.
 
Geographic Markets
 
Our primary geographic market is our home market of South Florida. Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications.  We also expect to reach a large audience with our websites. We hope that consumers will find our websites by doing an internet search for VoIP service providers. We will also use other means of advertising such as direct to consumer sales, ecommerce and  wholesale sales to retail stores.
 
We have been granted and or are applying for Competitive Local Exchange Carrier (“CLEC”) Licenses in thirty two states, as follows:

Alabama
Idaho
Massachusetts
New York
South Dakota
West Virginia
Arkansas
Illinois
Missouri
North Carolina
Texas
Wisconsin
California
Indiana
Montana
North Dakota
Utah
 
Connecticut
Iowa
Nebraska
Ohio
Vermont
 
Florida
Kansas
New Jersey
Oregon
Washington D.C.
 
Georgia
Kentucky
New Mexico
Pennsylvania
Washington
 
 
It is our intent to focus our expansion on the geographic markets in which we have been granted CLEC Licenses. We also intend to expand our market place to reach customers worldwide.
 
 
23

 
 
Results of Operations
 
Three months ended March 31, 2011 compared to three months ended March 31, 2010
 
Revenues: Our revenues amounted to $611,779 and $245,636 for the three months ended March 31, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.
 
Cost of sales: Our cost of sales amounted to $972,577 and $326,467 for the three months ended March 31, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.
 
Gross margin: Our gross margin amounted to $(360,798) and $(80,831) for the three months ended March 31, 2011 and 2010, respectively. The decrease in gross margin is negative due to allocating additional expenses to technical support and telecommunication expenses.
 
Advertising:  Our advertising expenses amounted to $373,701and $91,108for the three months ended March 31, 2011 and 2010, respectively.  The breakdown of our advertising expense is as follows:
 
   
March 31,
 
   
2011
   
2010
 
             
Infomercial/production time
  $ -     $ -  
Media and others
    373,701       91,108  
Total
  $ 373,701     $ 91,108  
 
Compensation and Benefits: Our compensation and benefits expense amounted to $104,917 and $91,771 for the three months ended March  31, 2011 and 2010, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.
 
Professional Fees: Our professional fees amounted to $77,642 and $91,495 for the three months ended March  31, 2011 and 2010, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services. Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company, we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act as well as other reporting requirements under the Exchange Act.
 
We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.
 
Depreciation and Amortization: Depreciation and amortization amounted to $90,914 and $90,618 for the three months ended March 31, 2011 and 2010, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the three months ended March 31, 2011, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.
 
Research and Development and Software Costs:  We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.

   
Three months ended
 
   
March 31,
 
Components of research and development:
 
2010
   
2011
 
Product development and engineering
  $ 31,325     $ 21,924  
Payroll and benefits
    117,794       56,255  
Total
  $ 149,119     $ 78,179  
 
 
24

 
 
General and Administrative Expenses: General and administrative expenses amounted to $232,686 and $128,838 for the three months ended March 31, 2011 and 2010, respectively, and consisted of general corporate expenses and certain other start up expenses. General corporate expenses included $66,779 in occupancy costs for the three months ended March 31, 2011 and $43,234 for comparable period ended March 31, 2010.  Our increased costs are associated with our efforts of being a public company.
 
Our general and administrative expenses are made up of the following accounts:
 
   
March 31,
 
   
2011
   
2010
 
                 
Bad debt expense
  $ (582 )   $ 2,039  
Rent and occupancy
    66,779       43,234  
Insurance
    25,190       17,044  
Software
    13,260       3,992  
Taxes and licenses
    17,482       5,643  
Telephone
    5,548       5,221  
Travel
    36,813       26,180  
Other
    68,196       25,485  
Total
  $ 232,686     $ 128,838  
 
Interest Expense: Interest expense amounted to $149,964 and $858,172 for the three months ended March 31, 2011 and 2010 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts and (iii) the amortization of deferred finance costs.  Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method.
 
In addition, our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, and included the capitalization of $798,773 of accrued interest. The capitalization of accrued interest was to include interest up to December 31, 2010.  Therefore, during quarter ended June 30, 2010 we recorded no interest expense.
 
Derivative expense : Derivative expense amounted to $22,260,451and $4,163,525 for the three months ended March 31, 2011 and 2010, respectively.  Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income.  In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.
 
Our convertible debentures as of March 31, 2011 and September 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.
 
 
25

 
 
Debt extinguished: Debt extinguished amounted to $0 and $3,617,983 for the three months ended March 31, 2011 and 2010, respectively.

The following table reflects the components of our extinguishment calculation on February 24, 2010:
   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
Debentures
    1,713,124       152,755       267,000       2,132,879  
Accrued Interest
    546,000       87,166       165,607       798,773  
Compound embedded derivative
    3,723,200       750,000       1,632,400       6,105,600  
Deferred finance costs
    (85,372 )     (23,933 )     (92,122 )     (201,427 )
      5,896,952       965,988       1,972,885       8,835,825  
                                 
Extinguishment loss
  $ 1,870,498     $ 524,268     $ 1,223,217     $ 3,617,983  
 
Net loss: The net loss amounted to $24,167,077and $9,290,114 for the three months ended March 31, 2011 and 2010, respectively.  The net loss includes derivative expense associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.

Net loss excluding derivative valuation:  Net loss excluding derivative valuation expenses amounted to $1,906,626 and $1,508,606 for the three months ended March 31, 2011 and 2010.  Derivative valuation expenses are “paper loss” and are not normal recurring operating expenses.

Net loss applicable to common stockholders: The net loss applicable to common stockholders amounted to $24,167,077 and $9,365,120 for the three months ended March 31, 2011 and 2010, respectively.  The net loss includes derivative valuation expenses associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.
 
Loss Per Common Share:  Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.
 
Results of Operations
 
Six months ended March 31, 2011 compared to six months ended March 31, 2010
 
Revenues: Our revenues amounted to $1,082,153 and $429,829 for the six months ended March 31, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.
 
Cost of sales: Our cost of sales amounted to $1,697,565 and $658,783 for the six months ended March 31, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.
 
Gross margin: Our gross margin amounted to $(615,412) and $(228,954) for the six months ended March 31, 2011 and 2010, respectively. The decrease in gross margin is negative due to allocating additional expenses to technical support and telecommunication expenses.
 
 
26

 
 
Advertising:  Our advertising expenses amounted to $483,697 and $164,038for the six months ended March 31, 2011 and 2010, respectively.  The breakdown of our advertising expense is as follows:
 
   
March 31,
 
   
2011
   
2010
 
                 
Infomercial/production time
  $ -     $ 18,400  
Media and others
    483,697       145,638  
Total
  $ 483,697     $ 164,038  
 
Compensation and Benefits: Our compensation and benefits expense amounted to $209,667 and $193,834 for the six months ended March 31, 2011 and 2010, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.
 
Professional Fees: Our professional fees amounted to $145,736 and $141,604 for the six months ended March 31, 2011 and 2010, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services. Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company, we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act as well as other reporting requirements under the Exchange Act.
 
We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability    and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.
 
Depreciation and Amortization: Depreciation and amortization amounted to $180,947 and $181,208 for the six months ended March 31, 2011 and 2010, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the six months ended March 31, 2011, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.
 
Research and Development and Software Costs:  We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.
 
Components of research and development:
 
March 31,
 
   
2011
   
2010
 
Product development and engineering
  $ 118,860     $ 25,495  
Payroll and benefits
    215,817       98,969  
Total
  $ 334,677     $ 124,464  
 
General and Administrative Expenses: General and administrative expenses amounted to $416,217 and $253,490 for the six months ended March 31, 2011 and 2010, respectively, and consisted of general corporate expenses and certain other start up expenses. General corporate expenses included $120,995 in occupancy costs for the six months ended March 31, 2011 and $86,390 for comparable period ended March 31, 2010.  Our increased costs are associated with our efforts of being a public company.
 
 
27

 
 
Our general and administrative expenses are made up of the following accounts:
 
   
March 31,
 
   
2011
   
2010
 
                 
Bad debt expense
  $ 408     $ 10,232  
Rent and occupancy
    120,994       86,390  
Insurance
    45,570       35,632  
Software
    24,485       4,949  
Taxes and licenses
    17,482       10,041  
Telephone
    11,144       8,111  
Travel
    88,963       54,719  
Other
    107,171       43,416  
Total
  $ 416,217     $ 253,490  
 
Interest Expense: Interest expense amounted to $275,964 and $1,184,363 for the six months ended March 31, 2011 and 2010 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts and (iii) the amortization of deferred finance costs.  Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method.
 
In addition, our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, and included the capitalization of $798,773 of accrued interest. The capitalization of accrued interest was to include interest up to December 31, 2010.  Therefore, during quarter ended June 30, 2010 we recorded no interest expense.
 
Derivative expense : Derivative expense amounted to $22,366,227and $5,347,297 for the six months ended March 31, 2011 and 2010, respectively.  Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income.  In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.
 
Our convertible debentures as of March 31, 2011 and September 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.
 
 
28

 
 
Debt extinguished: Debt extinguished amounted to $0 and $3,617,983 for the six months ended March 31, 2011 and 2010, respectively.

The following table reflects the components of our extinguishment calculation on February 24, 2010:
   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
Debentures
    1,713,124       152,755       267,000       2,132,879  
Accrued Interest
    546,000       87,166       165,607       798,773  
Compound embedded derivative
    3,723,200       750,000       1,632,400       6,105,600  
Deferred finance costs
    (85,372 )     (23,933 )     (92,122 )     (201,427 )
      5,896,952       965,988       1,972,885       8,835,825  
                                 
Extinguishment loss
  $ 1,870,498     $ 524,268     $ 1,223,217     $ 3,617,983  

 Net loss: The net loss amounted to $25,393,874 and $11,431,254 for the six months ended March 31, 2011 and 2010, respectively.  The net loss includes derivative expense associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.

Net loss excluding derivative valuation:  Net loss excluding derivative valuation expenses amounted to $3,027,647 and $2,465,974 for the six months ended March 31, 2011 and 2010.  Derivative valuation expenses are “paper loss” and are not normal recurring operating expenses.

Net loss applicable to common stockholders: The net loss applicable to common stockholders amounted to $25,393,874 and $11,506,260 for the six months ended March  31, 2011 and 2010, respectively.  The net loss includes derivative valuation expenses associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.
 
Loss Per Common Share:  Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.
 
Liquidity and Capital Resources
 
On May 5, 2011 we filed Form 8 K, as follows:
 
On May 3, 2011 Vicis Capital Master Fund completed its commitment to loan to the Company $4,000,000 represented by a series of promissory notes ($1,000,000 funded January 2011, $1,500,000 funded March 2011 and $1,500,000 funded May, 2011) bearing interest at the rate of 5% per annum, principal and interest payable upon demand. Vicis is the holder of the Company's Senior Secured Debentures and Series A Preferred Stock.
 
Statement of cash flow data:
 
March 31 , 2011
   
March 31,2010
 
Net cash provided (used) in operating activities
  $ (3,667,470 )   $ (962,267 )
Net cash provided (used) in investing activities
    (120,234 )     (2,017,253 )
Net cash provided (used) in financing activities
    2,617,500       4,972,225  
 
Net cash used by operating activities of $3,667,470 was primarily due to operating expenses including increase in marketing expenses.
 
Net cash used in investing activities of $120,234 was due to purchase of equipment.
 
 
29

 
 
Net cash of $2,617,500 used in financing activities was due to proceeds from Notes payable – Demand notes in the amount of $2,500,000.

On March 31, 2011, we had cash on hand of $1,869,136 and restricted cash on hand of $74,094.
 
Our largest operating expenditures currently consist of the following items: $27,500 per month on leasing our corporate office space and network operational center (NOC) and includes our base rent and associated utility expenses and $150,000 per month on payroll. We do not anticipate that our leasing costs will change during the next 12 months.
 
Our current long term business plan contemplates acquiring the ongoing business of related companies, either through asset acquisitions, consolidations or mergers.
 
Off-Balance Sheet Arrangements - NONE
 
Critical Accounting Policies and estimates
 
Our accounting policies are discussed and summarized in Note 2 to our financial statements.  The following describes our critical accounting policies and estimates.
 
Critical Accounting Policies
 
The financial information contained in our comparative results of operations and liquidity disclosures has been derived from our financial statements. The preparation of those financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes.        The following significant estimates were made in the preparation of our financial statements and should be considered when reading our Management’s Discussion and Analysis:
 
 
·
Impairment of Long-lived Assets: Our telecommunications equipment, other property and intangible assets are material to our financial statements. Further, they are subject to the potential negative effects arising from technological obsolescence. We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values.  In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment.  For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates, for intangible assets. These estimates are made by competent employees, using the best available information, under the direct supervision of our management.
 
·
Intangible assets: Our intangible assets require us to make subjective estimates about our future operations and cash flows so that we can evaluate the recoverability of such assets. These estimates consider available information and market indicators including our operational history, our expected contract performance, and changes in the industries that we serve.
 
·
Share-based payment arrangements: We currently intend to issue share-indexed payments in future periods to employees and non-employees. There are many valuation techniques, such as Black-Scholes-Merton valuation model that we may use to value share-indexed contracts, such as warrants and options.  All such techniques will require certain assumptions that require us to develop forward-looking information as well as historical trends. For purposes of historical trends, we may need to look to peer groups of companies and the selection of such groups of companies is highly subjective.
 
·
Common stock valuation: Estimating the fair value of our common stock is necessary in the preparation of computations related to acquisition, share-based payment and financing transactions.  We believe that the most appropriate and reliable basis for common stock value is trading market prices in an active market.
 
·
Derivative Financial Instruments: We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain other financial instruments and contracts, such as our secured convertible debenture and warrant financing arrangements that are either (i) not afforded equity classification,   (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty. We are required to carried as derivative liabilities, at fair value, in our financial statements.  The fair value of share-indexed derivatives will be significantly influenced by the fair value of our common stock (see Common Stock Valuation, above). Certain other elements of forward-type derivatives are significantly influenced by credit-adjusted interest rates used in cash-flow analysis. Since we are required to carry derivative financial instruments at fair value and make adjustments through earnings, our future profitability will reflect the influences arising from changes in our stock price, changes in interest rates,  and changes in our credit standing.
 
 
30

 
 
Revenue Recognition
 
Operating revenue consist of customer equipment sales of our main product TK6000, telecommunication service revenues, shipping and handling revenues.
 
Our operating revenues are generated from the sale of customer equipment of our main products, our TK6000 and DUO. We also derive service revenues from per minute fees for international calls. Revenue from the sale of our TK6000 is fully recognized at the time of our customer equipment sale.  Our TK6000 provides for life time service (over the life of the device/equipment). Our TK6000 is able to operate within our network/platform or over any other network/platform.  There is no need for income allocation between our TK6000 and life time service provided.  The full intrinsic value of the sale is allocated to the device.  Therefore, we recognized 100% of revenue at time of customer equipment sale and do no allocate any income to life time service provided. Shipping and handling is also recognized at time of sale.
 
On July 14, 2010 we revealed our newest product the net TALK DUO (“DUO”).  Our DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required. The DUO is flexible enough to connect directly to your Internet connection through the router/modem, there is also a convenient option with our DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.

Our DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services. The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other netTALK customers are always free.
 
Our DUO provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO is fully recognized at the time of our customer equipment sale, the one year telephone service is amortized over 12 month cycle.
 
Subsequent renewals of the annual telephone service is amortized over the corresponding 12 months cycle.
 
International calls are billed as earned from our customers.  International calls are prepaid and customers account is debited as minutes are used and earned.
 
Recent Accounting Pronouncements
 
Effective January 1, 2010, the Company adopted the provisions in ASU 2009-17, “Consolidation (ASC Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”, which changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The adoption of the provisions in ASU 2009-17 did not have an impact on the Company’s financial statements.

Effective January 1, 2010, the Company adopted ASU 2010-01, “Equity (ASC Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash”, which clarifies that the stock portion of a distribution to shareholders that allow them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected prospectively in earnings per share and is not considered a stock dividend for purposes of ASC Topic 505 and ASC Topic 260. The adoption of the provisions in ASU 2010-01 did not have an impact on the Company’s consolidated financial statements.
 
Effective January 1, 2010, the Company adopted the provisions in ASU 2010-06, “Fair Value Measurements and Disclosures (ASC Topic 820): Improving Disclosures about Fair Value Measurements, which requires new disclosures related to transfers in and out of levels 1 and 2 and activity in level 3 fair value measurements, as well as amends existing disclosure requirements on level of disaggregation and inputs and valuation techniques. The adoption of the provisions in ASU 2010-06 did not have an impact on the Company’s financial statements.
 
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s Financial Statements upon adoption.
 
 
31

 
 
Item 3 Quantitative and Qualitative Disclosures About Market Risk

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required   to provide the information under this item.
 
Item 4 Controls and Procedures
 
Disclosure Controls
 
We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

As of March 31, 2011, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective in ensuring that information required to be disclosed by us in our periodic reports is recorded, processed, summarized and reported, within the time periods specified for each report and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

In connection with the assessment described above, management identified the following control deficiencies that represent material weaknesses at March 31, 2011:

 
·
Due to the Company’s limited resources, the Company has insufficient personnel resources and technical accounting and reporting expertise to properly address all of the accounting matters inherent in the Company’s financial transactions.  The Company does not have a formal audit committee, and the Board does not have a financial expert, thus the Company lacks the board oversight role within the financial reporting process.
 
 
·
The Company’s small size and “one-person” office prohibits the segregation of duties and the timely review of accounts payable, expense reporting and inventory management and banking information.

Our Chief Executive Officer and Chief Financial Officer are in the process of determining how best to change our current system and implement a more effective system to insure that information required to be disclosed in our quarterly and annual reports has been recorded, processed, summarized and reported accurately.  Our management acknowledges the existence of this problem, and intends to develop procedures to address them to the extent possible given limitations in financial and manpower resources.   While management is working on a plan, no assurance can be made at this point that the implementation of such controls and procedures will be completed in a timely manner or that they will be adequate once implemented.  
 
Changes in Internal Controls.
 
During the three months ended March  31, 2011 , there were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (f) of Rule 13a-15 or Rule 15d-15 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
32

 
 
PART II                OTHER INFORMATION

Item 1.  Legal Proceedings

Form 8 K was filed on January 28, 2011, as follows: Issuance of 750,000 shares of Nettalk.com, Inc. common stock.  The shares were issued in connection with the settlement of litigation between the Company and Midtown Partners and Co., LLC in the Circuit Court of Hillsborough County, Florida (Case No. 101981) .

Said settlement further provides that certain cashless warrants previously issued to Midtown Partners and Co., LLC be modified, reducing from  2,251,800 to 1,102,921 the number of shares of the Company’s common stock to be issued thereunder.

Item 1A. Risk Factors

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required   to provide the information under this item.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

Form 8 K was filed on January 28, 2011, as follows: Issuance of 750,000 shares of Nettalk.com, Inc. common stock.  The shares were issued in connection with the settlement of litigation between the Company and Midtown Partners and Co., LLC in the Circuit Court of Hillsborough County, Florida (Case No. 101981) .

Said settlement further provides that certain cashless warrants previously issued to Midtown Partners and Co., LLC be modified, reducing from  2,251,800 to 1,102,921 the number of shares of the Company’s common stock to be issued thereunder.

Item 3. Defaults Upon Senior Securities

None.
 
Item 4.       Submission of Matters to a Vote of Security Holders

None.

Item 5.       Other Information

On May 5, 2011 we filed Form 8 K, as follows:On May 3, 2011 Vicis Capital Master Fund completed its commitment to loan to the Company $4,000,000 represented by a series of promissory notes ($1,000,000 funded January 2011, $1,500,000 funded March 2011 and $1,500,000 funded May, 2011) bearing interest at the rate of 5% per annum, principal and interest payable upon demand. Vicis is the holder of the Company's Senior Secured Debentures and Series A Preferred Stock.

2010 Stock Option Plan
 
On November 15, 2009, Net Talk.com, Inc. (the “Company”) adopted the 2010 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 10,000,000 shares of the Company’s common stock.
 
On July 26, 2010, we issued 3,709,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.03 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.

We are planning to issue more shares under our 2010 Stock Option Plan in the near future.

 
33

 

2013 Stock Option Plan

We are working on our 2013 Stock Option Plan which is intended to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan.

Item 6.
Exhibit
   
Exhibit No.
Description
   
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.
   
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.
   
32.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.
   
32.1
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.
   
99.1
Form 8 K was filed on May 5, 2011 –  previously submitted.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
NET TALK.COM, INC.
     
Date:  May 16, 2011
By
/s/ Anastasios Kyriakides
 
Anastasios Kyriakides
 
Chief Executive Officer (Principal Executive Officer)
   
Date:  May 16, 2011
By:
/s/ Guillermo Rodriguez