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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

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

For the quarterly period ended September 30, 2011

 

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

Commission File Number 001-15941

 

 

INNOVARO, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   59-3603677

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

2109 Palm Avenue

Tampa, FL 33605

(Address of principal executive offices)

(813) 754-4330

(Registrant’s telephone number)

(Former name, former address and former fiscal year, if changed since last report)

None

 

 

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

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

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   x

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

On October 28, 2011, there were 15,041,274 shares outstanding of registrant’s common stock, $0.01 par value.

 

 

 


Table of Contents

INNOVARO, INC.

FORM 10-Q TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

  

ITEM 1.

 

Financial Statements

     3   

Consolidated Balance Sheets as of September 30, 2011 (unaudited) and December  31, 2010

     3   

Consolidated Statements of Operations for the Three and Nine Months Ended September  30, 2011 and 2010 (unaudited)

     4   

Consolidated Statements of Cash Flows for the Nine Months Ended September  30, 2011 and 2010 (unaudited)

     5   

Notes to Consolidated Financial Statements (unaudited)

     7   

ITEM 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      15   

ITEM 3.

  Quantitative and Qualitative Disclosures about Market Risks      24   

ITEM 4.

  Controls and Procedures      24   

PART II. OTHER INFORMATION

  

ITEM 1.

  Legal Proceedings      25   

ITEM 1A.

  Risk Factors      25   

ITEM 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      25   

ITEM 3.

  Defaults Upon Senior Securities      25   

ITEM 4.

  Reserved      25   

ITEM 5.

  Other Information      25   

ITEM 6.

  Exhibits      25   

Signatures

     26   

Exhibits

  

 

Page 2 of 30


Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

INNOVARO, INC.

Consolidated Balance Sheets

 

     September 30,
2011
(Unaudited)
    December 31,
2010
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 1,545,942      $ 262,619   

Accounts receivable, net

     1,103,502        1,796,454   

Contracts in process

     131,276        214,734   

Available-for-sale securities

     110,744        171,139   

Prepaid expenses and other assets

     520,424        791,432   
  

 

 

   

 

 

 

Total current assets

     3,411,888        3,236,378   

Cost method investments

     95,589        95,589   

Equity method investments

     303,454        303,454   

Note receivable and accrued interest

     1,778,000        1,700,000   

Fixed assets, net

     6,582,665        6,736,567   

Goodwill

     6,412,538        6,407,640   

Intangible assets, net

     5,563,532        6,174,792   
  

 

 

   

 

 

 

Total assets

   $ 24,147,666      $ 24,654,420   
  

 

 

   

 

 

 
LIABILITIES     

Current liabilities:

    

Accounts payable

   $ 934,868      $ 1,078,088   

Accrued expenses

     551,513        420,707   

Accrued bonus

     2,198,530        —     

Deferred revenue

     987,285        987,624   

Current maturities of long-term debt

     109,344        433,964   
  

 

 

   

 

 

 

Total current liabilities

     4,781,540        2,920,383   

Long-term debt, less current maturities

     5,282,093        5,358,173   

Derivative liabilities

     760,368        1,140,005   

Deferred tax liability

     1,198,177        1,220,687   
  

 

 

   

 

 

 

Total liabilities

     12,022,178        10,639,248   
  

 

 

   

 

 

 
EQUITY     

Innovaro stockholders’ equity:

    

Preferred stock, $.01 par value, 1,000,000 shares authorized; none issued and outstanding

     —          —     

Common stock, $.01 par value, 29,000,000 shares authorized; 15,161,274 and 14,631,950 shares issued; 15,041,274 and 14,585,261 shares outstanding at September 30, 2011 and December 31, 2010, respectively

     150,413        145,853   

Additional paid-in capital

     86,718,619        85,024,704   

Accumulated deficit

     (75,362,144     (71,829,344

Accumulated other comprehensive income

     93,215        147,922   
  

 

 

   

 

 

 

Total Innovaro stockholders’ equity

     11,600,103        13,489,135   

Noncontrolling interest

     525,385        526,037   
  

 

 

   

 

 

 

Total equity

     12,125,488        14,015,172   
  

 

 

   

 

 

 

Total liabilities and equity

   $ 24,147,666      $ 24,654,420   
  

 

 

   

 

 

 

See accompanying notes

 

Page 3 of 30


Table of Contents

INNOVARO, INC.

Consolidated Statements of Operations

(Unaudited)

 

     Three Months Ended Sept. 30,     Nine Months Ended Sept. 30,  
     2011     2010     2011     2010  

Revenue:

        

Strategic services

   $ 2,899,131      $ 3,337,416      $ 10,482,237      $ 6,684,046   

Technology services

     521,120        868,998        1,766,225        2,593,574   
  

 

 

   

 

 

   

 

 

   

 

 

 
     3,420,251        4,206,414        12,248,462        9,277,620   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses:

        

Direct costs of revenue – Strategic services

     2,756,720        3,125,688        8,913,962        5,301,333   

Direct costs of revenue – Technology services

     301,729        363,305        1,000,184        1,237,063   

Salaries and wages

     437,195        648,118        1,247,130        2,117,273   

Professional fees

     102,025        142,494        287,174        509,591   

Research and development

     27,936        297,587        661,600        848,241   

Sales and marketing

     114,070        18,867        228,188        456,744   

General and administrative

     507,499        593,136        1,535,809        1,770,808   

Depreciation and amortization

     296,686        388,095        976,871        1,184,503   

Impairment loss

     —          11,620,708        —          11,620,708   
  

 

 

   

 

 

   

 

 

   

 

 

 
     4,543,860        17,197,998        14,850,918        25,046,264   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (income) and expense:

        

Other (income) expense

     (598,060     283,239        631,698        126,850   

Interest expense, net

     106,348        235,136        329,558        512,374   
  

 

 

   

 

 

   

 

 

   

 

 

 
     (491,712     518,375        961,256        639,224   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income taxes

     (631,897     (13,509,959     (3,563,712     (16,407,868

Provision for income tax benefit

     (7,547     (300,529     (23,674     (390,338
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

     (624,350     (13,209,430     (3,540,038     (16,017,530
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to the noncontrolling interest

     (2,835     (2,084     (7,238     (4,445
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to Innovaro stockholders

   $ (621,515   $ (13,207,346   $ (3,532,800   $ (16,013,085
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to Innovaro stockholders per share: Basic and diluted

   $ (0.04   $ (0.91   $ (0.24   $ (1.26

Weighted average shares outstanding: Basic and diluted

     15,024,970        14,536,396        15,003,871        12,745,278   

See accompanying notes

 

Page 4 of 30


Table of Contents

INNOVARO, INC.

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended September 30,  
     2011     2010  

Operating Activities:

    

Net loss attributable to Innovaro stockholders

   $ (3,532,800   $ (16,013,085

Adjustments to reconcile net loss attributable to Innovaro stockholders to net cash flows from operating activities:

    

Goodwill and intangible asset impairment

     —          10,332,628   

Fixed asset impairment

     —          1,288,080   

Net loss attributable to noncontrolling interest

     (7,238     (4,445

Depreciation and amortization

     976,871        1,184,503   

Amortization of debt discount from investor warrants

     98,832        247,252   

Loss on sale and impairment of available-for-sale securities

     201        1,136,865   

Loss (gain) on derivative liabilities

     911,193        (817,609

Stock-based compensation

     407,645        213,360   

Deferred income taxes

     (23,674     (390,338

Other

     13,740        (24,974

Changes in operating assets and liabilities:

    

Accounts receivable and contracts in process

     775,343        (1,318,457

Prepaid expenses and other assets

     218,942        103,604   

Deferred revenue

     (339     (599,461

Accounts payable, accrued expenses and accrued bonus

     2,192,701        1,802,353   
  

 

 

   

 

 

 

Net cash flows from operating activities

     2,031,417        (2,859,724
  

 

 

   

 

 

 

Investing Activities:

    

Capital expenditures

     (34,693     (39,546

Capitalization of software development costs

     (185,272     —     

Proceeds from sale of available-for-sale securities

     —          311,997   

Proceeds from redemption of certificates of deposit

     —          492,246   
  

 

 

   

 

 

 

Net cash flows from investing activities

     (219,965     764,697   
  

 

 

   

 

 

 

Financing Activities:

    

Net repayments on bank line of credit

     —          (250,000

Payments on long-term debt

     (525,466     (791,758

Gross proceeds from private equity securities offering

     —          3,799,999   

Offering costs paid from private equity securities offering

     —          (593,440
  

 

 

   

 

 

 

Net cash flows from financing activities

     (525,466     2,164,801   
  

 

 

   

 

 

 

Effect of foreign exchange rates

     (2,663     19,600   
  

 

 

   

 

 

 

Increase in cash and cash equivalents

     1,283,323        89,374   

Cash and cash equivalents at beginning of period

     262,619        2,118,970   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 1,545,942      $ 2,208,344   
  

 

 

   

 

 

 

See accompanying notes

 

Page 5 of 30


Table of Contents

INNOVARO, INC.

Consolidated Statements of Cash Flows (continued)

(Unaudited)

 

     Nine Months Ended September 30,  
     2011     2010  

Supplemental Disclosures of Non-Cash Investing and Financing Activities

    

Unrealized gain (loss) from available-for-sale securities, net

   $ (60,195   $ 171,047   
  

 

 

   

 

 

 

Derivative liability extinguished in connection with exercise of investor warrants

   $ 1,290,830     
  

 

 

   

The Company issued 23,484 shares of common stock in connection with certain acquisition earnout contingencies

     $ 43,680   
    

 

 

 

The Company transferred certain equity interests in a subsidiary to satisfy a severance obligation resulting in the following:

    

Noncontrolling interest

     $ 532,132   

Increase to additional paid-in capital

       17,868   
    

 

 

 
     $ 550,000   
    

 

 

 

The Company issued 243,933 shares of common stock in connection with its investment in Verdant Ventures Advisors, LLC

     $ 1,000,125   
    

 

 

 

Warrants issued as direct offering costs in connection with private equity securities offering

     $ (661,236
    

 

 

 

Supplemental Disclosures of Cash Flow Information

    
    

Cash paid for taxes

   $ —        $ —     
  

 

 

   

 

 

 

Cash paid for interest

   $ 324,774      $ 367,748   
  

 

 

   

 

 

 

See accompanying notes

 

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Table of Contents

INNOVARO, INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

1. Basis of Presentation

Interim Financial Information

The financial information for Innovaro, Inc. (the “Company”, “we”, “us” or “Innovaro”) as of September 30, 2011 and for the three and nine month periods ended September 30, 2011 and 2010 is unaudited, but includes all adjustments (consisting only of normal recurring accruals), which, in the opinion of management are necessary in order to make the consolidated financial statements not misleading at such dates and for those periods. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and, therefore, do not include all information and notes required by GAAP for complete consolidated financial statements. These consolidated financial statements should be read in conjunction with the consolidated audited financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the entire year.

Organization

We commenced operations in 1997 and were originally incorporated under the laws of the State of Florida, and subsequently under the laws of the State of Delaware in July 1999.

The Company

Innovaro is The Innovation Solutions Company. The focus of the business is to help clients innovate and grow. Innovaro offers a comprehensive set of services and software to assure the success of any innovation project, regardless of the size or intent. The Company’s unique combination of consulting services provide innovation expertise, its new LaunchPad software product provides an integrated innovation environment, and technology services provide any business with the innovation support they need to drive success. These services are provided internationally from offices in the United States and the United Kingdom.

Principles of Consolidation

The consolidated financial statements include the accounts of Innovaro and its wholly owned subsidiaries: Innovaro Europe, Ltd. (formerly UTEK Europe, Ltd.) and UTEK Real Estate Holdings, Inc. and its subsidiaries: Ybor City Group, Inc., 22nd Street of Ybor City, Inc., ABM of Tampa Bay, Inc., and Cortez 114, LLC (collectively “UTEK Real Estate”). All intercompany transactions and balances are eliminated in consolidation.

Reclassifications

Certain reclassifications have been made to the 2010 balances to conform to the 2011 financial statement presentation. In particular, reclassifications were made to the revenue line items in the consolidated statements of operations for the three and nine months ended September 30, 2010 to conform to the Company’s new business segments. Reclassifications were also made to the expense line items in the consolidated statements of operations for the three and nine months ended September 30, 2010 to move the direct costs associated with these business lines into two separately captioned line items: direct costs of revenue – strategic services and direct costs of revenue – technology services.

In addition, reclassifications were made to the equity section of the December 31, 2010 consolidated balance sheet to conform to the September 30, 2011 presentation. Reclassifications were made to combine the total accumulated loss under investment company accounting of $(52,073,915) with the accumulated deficit under operating company accounting of $(19,755,429) into one accumulated deficit line item with a balance of $(71,829,344) as of December 31, 2010.

 

2. Significant Accounting Policies

Accounts Receivable

The Company records an allowance for losses on trade receivables based on a review of the current status of existing receivables and management’s evaluation of periodic aging of accounts. The Company charges off accounts receivable against the allowance for losses when an account is deemed to be uncollectible. The Company determines the allowance based on historical

 

Page 7 of 30


Table of Contents

bad debt experience, current receivables aging, expected future write-offs, as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible. It is not the Company’s policy to accrue interest on past due receivables. The expense associated with the allowance for doubtful accounts is recognized as a component of general and administrative expense in the consolidated statements of operations. The allowance for doubtful accounts and notes was approximately $14,000 and $15,000 as of September 30, 2011 and December 31, 2010, respectively.

Cost Method Investments

Cost method investments were not evaluated for impairment as of September 30, 2011. The Company does not estimate the fair value of a cost method investment, before its annual impairment evaluation date of December 31, if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value because it is not practicable to estimate fair value on a quarterly basis.

Software Development Costs

Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 985-20 Costs of Software to Be Sold, Leased or Marketed, requires companies to expense all software development costs incurred until technological feasibility has been established, at which time those costs are capitalized until the product is available for general release to customers. In addition, costs incurred to enhance existing software products or after the general release of the product are required to be expensed as incurred as research and development costs.

In accordance with ASC Subtopic 985-20, the Company has expensed all costs incurred to establish the technological feasibility of Version 1.0 of the Innovaro LaunchPad software (“LaunchPad”) as research and development costs. As of June 29, 2011, LaunchPad Version 1.0 reached technological feasibility with the introduction of a working model. The Company is now incurring costs related to the refinement of Version 1.0, which will be capitalized until the product is available for general release to market. The Company capitalized $185,000 in software development costs for each of the three and nine months ended September 30, 2011.

The Company has begun development of the next components of LaunchPad with Version 2.0. Costs related to the development of this and other versions of the software will continue to be expensed until they too reach technological feasibility.

Earnings per Share (EPS)

Basic earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding plus the potential dilutive effect of outstanding stock options, warrants and unvested shares of restricted stock.

Components of basic and diluted per share data are as follows:

 

     Three Months  Ended
September 30,
     Nine Months Ended
September 30,
 
     2011      2010      2011      2010  

Weighted-average outstanding shares of common stock

     15,024,970         14,536,396         15,003,871         12,745,278   

Dilutive effect of stock options, warrants and unvested shares of restricted stock

     —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Common stock and common stock equivalents

     15,024,970         14,536,396         15,003,871         12,745,278   
  

 

 

    

 

 

    

 

 

    

 

 

 

Shares excluded from calculation of diluted EPS (1)

     2,939,898         2,584,483         2,939,898         2,584,483   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) 

These shares attributable to outstanding stock options, warrants and unvested restricted stock were excluded from the calculation of diluted EPS because their inclusion would have been anti-dilutive, primarily as a result of having incurred a net loss during the periods presented.

Financial Instruments and Concentrations of Credit Risk

The Company’s financial instruments consist of investments, cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, long-term debt and derivative liabilities. The fair value of accounts receivable, accounts payable and certain accrued expenses approximate their carrying amounts in the financial statements due to the short-term nature of such instruments. The estimated fair value of the Company’s long-term debt as of September 30, 2011 and December 31, 2010 is not materially different from its carrying values at such dates. The fair value of available-for-sale securities and derivative liabilities are determined as described in Note 6.

 

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Financial instruments with significant credit risk include investments and cash and cash equivalents. The Company maintains its cash and cash equivalents with high credit quality financial institutions in the United States and, at times, balances may exceed federally insured limits. The Company has not experienced any losses related to these balances.

The Company had four major customers during each of the three months ended September 30, 2011 and 2010 and two major customers during each of the nine months ended September 30, 2011 and 2010, all of which were customers of the strategic services line of business. Major customers, those generating greater than 10% of total revenue, accounted for approximately 80% and 62% of the Company’s revenue during the three months ended September 30, 2011 and 2010, respectively. Major customers accounted for approximately 54% and 26% of the Company’s revenue during the nine months ended September 30, 2011 and 2010, respectively. In addition, two customers accounted for approximately 65% of accounts receivable as of September 30, 2011.

Use of Estimates

The preparation of the Company’s consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that could affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The Company’s most significant estimates relate to revenue recognition, the valuation and impairment of certain investments, stock-based compensation, the valuation and impairment of goodwill and intangible assets, and the valuation of derivative liabilities. Actual results could differ from these estimates.

Recently Issued Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-04 Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The ASU expands ASC Topic 820’s existing disclosure requirements for fair value measurements and makes other amendments that could change how the fair value measurement guidance in ASC Topic 820 is applied. The ASU is effective for the Company with the reporting period beginning January 1, 2012. The adoption of this ASU is not expected to have a significant impact on the Company’s financial statements or disclosures.

In June 2011, the FASB issued ASU 2011-05 Presentation of Comprehensive Income, which revises the manner in which entities present comprehensive income in their financial statements. The new guidance requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. The ASU is effective for the Company with the reporting period beginning January 1, 2012. The adoption of this ASU will change the way the Company presents comprehensive income in its financial statements.

In September 2011, the FASB issued ASU 2011-08 Testing Goodwill for Impairment. Under the revised guidance, entities testing goodwill for impairment have the option of performing a qualitative assessment before calculating the fair value of a reporting unit in step 1 of the goodwill impairment test. If entities determine, on the basis of qualitative factors, that the fair value of the reporting unit is more likely than not greater than the carrying amount, a quantitative calculation is not needed. The ASU is effective for the Company’s annual and interim goodwill impairment tests performed with the reporting period beginning January 1, 2012 with early adoption permitted. The adoption of this ASU is not expected to have a significant impact on the Company’s financial statements.

 

3. Accounts Receivable

Accounts receivable consist of the following as of September 30, 2011 and December 31, 2010:

 

     September 30,
2011
    December 31,
2010
 

Trade accounts receivable

   $ 1,012,118      $ 1,408,047   

Allowance for doubtful accounts

     (14,488     (14,926

Unbilled client costs

     105,872        403,333   
  

 

 

   

 

 

 

Total accounts receivable

   $ 1,103,502      $ 1,796,454   
  

 

 

   

 

 

 

 

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4. Contracts in Process

Contracts in process consist of the following as of September 30, 2011 and December 31, 2010:

 

     September 30,
2011
     December 31,
2010
 

Contract costs and estimated earnings on uncompleted contracts

   $ 2,625,132       $ 3,712,143   

Less: advances and progress payments

     2,493,856         3,497,409   
  

 

 

    

 

 

 

Total contracts in process

   $ 131,276       $ 214,734   
  

 

 

    

 

 

 

Components of contracts in process consist of the following as of September 30, 2011 and December 31, 2010:

 

     September 30,
2011
    December 31,
2010
 

Billings in excess of costs and estimated earnings on uncompleted contracts

   $ 193,880      $ 634,541   

Costs and estimated earnings in excess of billings on uncompleted contracts

     (62,604     (419,807
  

 

 

   

 

 

 

Total contracts in process

   $ 131,276      $ 214,734   
  

 

 

   

 

 

 

 

5. Available-for-Sale Securities

The Company classifies its investments in freely tradable equity securities as available-for-sale in accordance with FASB ASC Topic 320 Investments – Debt and Equity Securities and its intentions regarding these instruments. A summary of the estimated fair value of available-for-sale securities as of September 30, 2011 and December 31, 2010 is presented below.

 

            Unrealized (1)     Realized        
     Cost      Gain      Loss     Loss     Fair Value  

As of September 30, 2011

   $ 42,100       $ 68,845       $ —        $ (201   $ 110,744   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

As of December 31, 2010

   $ 225,400       $ 129,132       $ (93   $ (183,300   $ 171,139   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

(1) 

The net unrealized gain (loss) is included in equity as a component of accumulated other comprehensive income in the consolidated balance sheets.

As of September 30, 2011, none of our five available-for-sale securities were in an unrealized loss position. The Company had no sales of available-for-sale securities during the three and nine months ended September 30, 2011. Proceeds from the sale of available-for-sale securities were approximately $63,000 and $312,000 for the three and nine months ended September 30, 2010, respectively. The Company recognized an impairment loss of $201 on available-for-sale securities during the nine months ended September 30, 2011. Gross realized gain (loss) as a result of the sale of available-for-sale securities was approximately $(57,000) and $54,000 for the three and nine months ended September 30, 2010, respectively. In addition, the Company recognized an impairment loss to available-for-sale securities of approximately $146,000 during the nine months ended September 30, 2010. The realized gain (loss) related to available-for-sale securities is included as a component of other (income) expense in the consolidated statements of operations.

 

6. Fair Value Measurements

The Company performs fair value measurements in accordance with the guidance provided by FASB ASC Topic 820 Fair Value Measurements and Disclosures. ASC Topic 820 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, management considers the principal or most advantageous market in which the Company would transact and considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.

ASC Topic 820 establishes a fair value hierarchy that encourages and is based on the use of observable inputs, but allows for unobservable inputs when observable inputs do not exist. When there are multiple inputs for determining the fair value of an investment, the Company classifies the investment in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. Inputs are classified into one of three categories:

 

   

Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities.

 

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Level 2—Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.

 

   

Level 3—Unobservable inputs for the asset or liability.

Assets and liabilities measured at fair value on a recurring basis by level within the fair value hierarchy as of September 30, 2011 and December 31, 2010 are as follows:

 

     Fair Value Measurements  at
September 30, 2011 (1)
    Fair Value Measurements at
December 31, 2010 (1)
 
     Using Level 2     Total     Using Level 2     Total  

Assets:

        

Available-for-sale securities

   $ 110,744      $ 110,744      $ 171,139      $ 171,139   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

   $ 110,744      $ 110,744      $ 171,139      $ 171,139   
  

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities:

        

Derivative liabilities

   $ (760,368   $ (760,368   $ (1,140,005   $ (1,140,005
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

   $ (760,368   $ (760,368   $ (1,140,005   $ (1,140,005
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) 

The Company did not have any assets or liabilities measured at fair value using Level 1 or Level 3 of the fair value hierarchy as of September 30, 2011 or December 31, 2010.

The Company’s investments in available-for-sale securities are classified within Level 2 of the fair value hierarchy. Our equity interests in companies for which there is no liquid public market are valued using quoted market prices for identical or similar instruments in markets that are not active. The determined values are generally discounted to account for the illiquid nature of the investment and minority ownership positions. The value of our equity interests in public companies for which market quotations are readily available is based on quoted market prices for similar instruments in an active market. These securities are generally thinly traded and/or carry discounts from the public market value for certain restrictions on resale. The Company utilizes the market approach in determining the fair value of these securities.

The Company’s derivative liabilities are classified within Level 2 of the fair value hierarchy. The Company utilizes the Black-Scholes Model to value the derivative liabilities utilizing observable inputs such as the Company’s common stock price, the exercise price of the warrants, and expected volatility, which is based on historical volatility. The Company considered the use of a binomial model, but determined that the probability of the exercise price adjusting downward was remote. The Black-Scholes Model employs the market approach in determining fair value.

 

7. Derivative Liabilities

In accordance with FASB ASC Topic 815 Derivatives and Hedging, the Company has recorded derivative liabilities for certain stock warrants with variable exercise prices. Derivative liabilities are recorded at fair value at inception and then are adjusted to reflect fair value at the end of each reporting period, with any increase or decrease in the fair value being recorded as a component of other (income) expense in the consolidated statements of operations. The Company recognized a gain (loss) related to the adjustment of these derivatives to fair value of approximately $513,000 and $776,000 for the three months ended September 30, 2011 and 2010, respectively, and $(911,000) and $818,000 for the nine months ended September 30, 2011 and 2010, respectively.

The Company uses the Black-Scholes Model to estimate the fair value of the derivative instrument. The Company employed the following assumptions for the Black-Scholes Model at September 30, 2011 and December 31, 2010:

 

     September 30,
2011
    December 31,
2010
 

Expected dividend yield

     0     0

Expected volatility

     66     53-54

Risk-free interest rate

     0.96     2.01

Expected life

     4.3 years        3.8 - 5.0 years   

Fair value

   $ 0.51      $ 0.35 - $1.42   

 

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Warrant Exercise

Effective April 6, 2011, 437,500 of the Company’s $0.01 fully vested common stock warrants were exercised. The derivative liability related to the warrants was adjusted to fair value of approximately $1.3 million on the date of exercise. The derivative liability related to the warrants was effectively extinguished through the adjustment of the $1.3 million from derivative liabilities to additional paid-in capital at the above exercise date.

 

8. Equity

Accumulated Other Comprehensive Income

Components comprising accumulated other comprehensive income as of and for the nine months ended September 30, 2011 are as follows:

 

     Unrealized gain
(loss) from
available-for-

sale securities
    Foreign currency
translation
adjustment
     Accumulated
other
comprehensive
income
 

Balances at December 31, 2010

   $ 129,040      $ 18,882       $ 147,922   

Gain (loss) for the period

     (60,195     5,488         (54,707
  

 

 

   

 

 

    

 

 

 

Balances at September 30, 2011

   $ 68,845      $ 24,370       $ 93,215   
  

 

 

   

 

 

    

 

 

 

 

9. Other (Income) Expense

Components comprising other (income) expense for the three and nine months ended September 30, 2011 and 2010 are as follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2011     2010     2011     2010  

Loss (gain) on sale and impairment of investments

   $ —        $ 1,102,064      $ 201      $ 1,136,865   

Loss (gain) on derivative liabilities

     (513,103     (775,659     911,193        (817,609

Rental income

     (86,415     (42,065     (224,084     (125,745

Other

     1,458        (1,101     (55,612     (66,661
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (income) expense

   $ (598,060   $ 283,239      $ 631,698      $ 126,850   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

10. Comprehensive Income (Loss)

Comprehensive income (loss) for the nine months ended September 30, 2011 and 2010 is as follows:

 

     Nine Months Ended September 30,  
     2011     2010  

Net loss attributable to Innovaro stockholders

   $ (3,532,800   $ (16,013,085

Other comprehensive income (loss):

    

Unrealized gain (loss) from available-for-sale securities

     (60,195     171,047   

Foreign currency translation adjustment

     5,488        (198,659
  

 

 

   

 

 

 

Other comprehensive income (loss)

     (54,707     (27,612
  

 

 

   

 

 

 

Comprehensive loss

   $ (3,587,507   $ (16,040,697
  

 

 

   

 

 

 

 

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11. Segment Reporting

FASB ASC Topic 280 Segment Reporting establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company is organized geographically and by line of business. The line of business management structure is the primary basis for which the allocation of resources and financial results are assessed.

A summary of revenue and other financial information by reportable geographic operating segment is shown below:

 

0000000000000, 0000000000000, 0000000000000,
     For the Three Months Ended September 30, 2011  
     United
Kingdom
    United States     Total  

Revenue

   $ 106,574      $ 3,313,677      $ 3,420,251   

Loss before income taxes

     (33,563     (598,334     (631,897

Depreciation and amortization

     831,818        (535,132     296,686   

 

000000000000 000000000000 000000000000
     For the Three Months Ended September 30, 2010  
     United
Kingdom
    United States     Total  

Revenue

   $ 136,130      $ 4,070,284      $ 4,206,414   

Loss before income taxes

     (3,056,991 )(1)      (10,452,968 )(2)      (13,509,959

Depreciation and amortization

     106,620        281,475        388,095   

 

000000000000,, 000000000000,, 000000000000,,
     For the Nine Months Ended September 30, 2011  
     United
Kingdom
    United States     Total  

Revenue

   $ 360,183      $ 11,888,279      $ 12,248,462   

Loss before income taxes

     (76,281     (3,487,431     (3,563,712

Depreciation and amortization

     889,921        86,950        976,871   

 

0000000000000 0000000000000 0000000000000
     For the Nine Months Ended September 30, 2010  
     United
Kingdom
    United States     Total  

Revenue

   $ 527,007      $ 8,750,613      $ 9,277,620   

Loss before income taxes

     (3,444,986 )(1)      (12,962,882 )(2)      (16,407,868

Depreciation and amortization

     317,137        867,366        1,184,503   

 

(1)

Loss before income taxes for the United Kingdom segment included impairment charges of approximately $2.9 million for each of the three and nine months ended September 30, 2010.

(2) 

Loss before income taxes for the United States segment included impairment charges of approximately $8.7 million for each of the three and nine months ended September 30, 2010.

From time to time, the Company will reorganize its internal organizational structure to better align its service offerings. In 2011, we reorganized into two new lines of business: Strategic Services and Technology Services. As a result, line of business segment information for the three and nine months ended September 30, 2010 has been restated to reflect these new segments.

 

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A summary of revenue and other financial information by reportable line of business segment is shown below:

 

0000000000000, 0000000000000, 0000000000000, 0000000000000,
     For the Three Months Ended September 30, 2011  
     Strategic
Services
    Technology
Services
     Administrative
and Other
    Total  

Revenue

   $ 2,899,131      $ 521,120       $ —        $ 3,420,251   

Income (loss) before income taxes

     (54,164     117,109         (694,842     (631,897

 

00000000000000000 00000000000000000 00000000000000000 00000000000000000
     For the Three Months Ended September 30, 2010  
     Strategic
Services
    Technology
Services
    Administrative
and Other
    Total  

Revenue

   $ 3,337,416      $ 868,998      $ —        $ 4,206,414   

Loss before income taxes

     (4,828,711 )(1)      (5,317,600 )(2)      (3,363,648 )(3)      (13,509,959

 

00000000000000 00000000000000 00000000000000 00000000000000
     For the Nine Months Ended September 30, 2011  
     Strategic
Services
     Technology
Services
     Administrative
and Other
    Total  

Revenue

   $ 10,482,237       $ 1,766,225       $ —        $ 12,248,462   

Income (loss) before income taxes

     1,075,151         339,418         (4,978,281     (3,563,712

 

Administrative00, Administrative00, Administrative00, Administrative00,
     For the Nine Months Ended September 30, 2010  
     Strategic
Services
    Technology
Services
    Administrative
and Other
    Total  

Revenue

   $ 6,684,046      $ 2,593,574      $ —        $ 9,277,620   

Loss before income taxes

     (3,966,183 )(1)      (5,428,473 )(2)      (7,013,212 )(3)      (16,407,868

 

(1) 

Loss before income taxes for the strategic services segment included impairment charges of approximately $4.9 million for each of the three and nine months ended September 30, 2010.

(2) 

Loss before income taxes for the technology services segment included impairment charges of approximately $5.5 million for each of the three and nine months ended September 30, 2010.

(3) 

Loss before income taxes for administrative and other included impairment charges of approximately $1.3 million for each of the three and nine months ended September 30, 2010.

 

12. Stock Compensation Plans

In June 2011, the Company’s stockholders approved an amendment and restatement of the Company’s three existing equity compensation plans as one plan, the Innovaro, Inc. Equity Compensation Plan (the “Equity Compensation Plan”). The maximum number of shares available for issuance under the Equity Compensation Plan is 4,626,274, which is the total number of shares available under the existing Non-Qualified Option Plan, Employee Option Plan and Restricted Stock Plan. The options and restricted stock previously granted under the three existing equity compensation plans are counted in determining the shares that remain available for issuance under the Equity Compensation Plan. The Compensation Committee of the Company’s Board of Directors determines those officers, employees, directors and consultants of the Company who are eligible to participate in the Equity Compensation Plan.

 

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements regarding the plans and objectives of management for future operations. These forward-looking statements may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by any forward-looking statements. Forward-looking statements, which involve assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words "may," "will," "should," "expect," "anticipate," "estimate," "believe," "intend" or "project" or the negative of these words or other variations on these words or comparable terminology. These forward-looking statements are based on assumptions that may be incorrect, and we cannot assure you that the projections included in these forward-looking statements will come to pass. Our actual results could differ materially from those expressed or implied by the forward-looking statements as a result of various factors.

Business Overview

Innovaro is The Innovation Solutions Company. The focus of our business is to help clients innovate and grow. Innovaro offers a comprehensive set of services and software to assure the success of any innovation project, regardless of the size or intent. Our unique combination of consulting services provide innovation expertise, our new LaunchPad software product provides an integrated innovation environment, and technology services provide any business with the innovation support they need to drive success. These services are provided internationally from our offices in the United States and the United Kingdom.

People are the key to providing innovation expertise though our consulting services. Our people have defined and refined our methodology for over 15 years with more than 250 clients in over 750 engagements, which has created a proven effective process to get a company through the innovation cycle. This process has served to develop our Leading Edge Innovation Practices (“LEIPs”) contained within our methodology.

We provide strategic services to enable our clients to become more efficient by finding new avenues to grow, fighting commoditization, improving return on investment, transforming the organization, and removing barriers to innovation. Business value is delivered to clients through working with a team of seasoned and experienced professionals capable of unlocking an organization’s capacity by:

 

   

Identifying and developing new segments and markets;

 

   

Creating and acting on game-changing strategies;

 

   

Building an enterprise-wide capability for innovation;

 

   

Accelerating and improving new product development processes; and

 

   

Assessing a company’s innovation capability.

Our technology services business provides information to assist clients in gaining insights and making decisions. We offer expansive networks, experts in scouting, partner sourcing and licensing expertise, and world leading online marketplaces. We also provide an important foundation to successful licensing—understanding the true potential value of our clients’ intellectual property “IP” and IP portfolio. We access that value and build a roadmap for our clients’ use, and uncover opportunities and options to realize any latent value.

We have an online information service, purpose-built for those who need it most—technology transfer, business development, intellectual property, competitive intelligence, and marketing professionals across the physical and life sciences.

We also provide the insight and intelligence our clients require, applied to their markets today and into the future. From current market research to predictive intelligence, we help our clients find insights at the intersections affecting their business. Our research identifies and explains key consumer trends—including emerging trends not covered by other sources—and delivers insights about how these trends will shape the future operating environment.

Our LaunchPad software product provides an integrated innovation environment which embodies our LEIPs to offer a process that is repeatable, reliable and scalable. LaunchPad helps innovation teams by making their jobs better, faster and easier.

 

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Innovaro LaunchPad

We are continuing the development of our innovation management software platform, Innovaro LaunchPad (“LaunchPad”), which is designed to enhance and complement our innovation service offerings to clients. Previously in 2011, we introduced a working model of Version 1.0 of the LaunchPad software to certain customers. We will continue to incur costs related to the refinement of Version 1.0 while proceeding with the development of the next components of LaunchPad with Version 2.0. The next components of LaunchPad are designed to take the outputs from the current product and extend them further into the organization’s product delivery process.

Recent Developments

On April 18, 2011, our Board of the Directors increased its size from four to five directors and, upon the recommendation of the Nominating and Corporate Governance Committee, elected Asa Lanum as a new director. In addition, our Board of Directors appointed Mr. Lanum, who has served as our interim Chief Executive Officer since August 2010, as our permanent Chief Executive Officer. In connection with such appointment, we agreed to pay Mr. Lanum an annual base salary of $325,000 and awarded him options to purchase 250,000 shares of the Company’s common stock.

Effective April 22, 2011, Peter C. Skarzynski resigned from his position as Managing Director of the strategic services division. In accordance with the terms of his employment agreement, Mr. Skarzynski remains bound by a covenant regarding the protection of our confidential information and a one-year covenant not to solicit our clients or employees. Mr. Skarzynski continues to act as a consultant for us.

On April 22, 2011, we appointed Gary Getz as Managing Director of the strategic services division. Mr. Getz has held a management position at Innovaro since its acquisition of Strategos in 2008, and held a management position at Strategos since that company’s founding.

In June 2011, our stockholders approved an amendment and restatement of our three existing equity compensation plans as one plan, the Innovaro, Inc. Equity Compensation Plan (the “Equity Compensation Plan”). The maximum number of shares available for issuance under the Equity Compensation Plan is 4,626,274, which is the total number of shares available under the existing Non-Qualified Option Plan, Employee Option Plan and Restricted Stock Plan. The options and restricted stock previously granted under the three existing equity compensation plans are counted in determining the shares that remain available for issuance under the Equity Compensation Plan. The Compensation Committee of the Company’s Board of Directors determines those officers, employees, directors and consultants who are eligible to participate in the Equity Compensation Plan. The amendment and restatement of the three existing plans as the Equity Compensation Plan did not increase the number of shares of common stock authorized for issuance as stock-based incentive compensation, but gives the Compensation Committee greater flexibility to make grants of non-qualified options, incentive stock options or restricted stock as it deems appropriate, since one maximum limit will apply to all three types of stock-based incentive compensation.

Financial Condition

Our total assets were $24.1 million as of September 30, 2011 and $24.7 million as of December 31, 2010. As of September 30, 2011, we had $1.5 million in cash and cash equivalents, $1.2 million in accounts receivable and contracts in process, $3.7 million in accounts payable, accrued expenses and accrued bonus and $5.4 million in total debt outstanding. As of December 31, 2010, we had $263,000 in cash and cash equivalents, $2.0 million in accounts receivable and contracts in process, $1.5 million in accounts payable and accrued expenses and $5.8 million in total debt outstanding. As of September 30, 2011, we had a working capital deficit of $1.4 million and an accumulated deficit of $75.4 million.

 

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Results of Operations

Revenue

 

     Three Months
Ended
Sept. 30,
     Percentage
Change
    Nine Months
Ended
Sept. 30,
     Percentage
Change
 

(in thousands, except percentages)

   2011      2010            2011      2010         

Strategic services

   $ 2,899       $ 3,337         (13 )%    $ 10,482       $ 6,684         57

Technology services

     521         869         (40 )%      1,766         2,594         (32 )% 
  

 

 

    

 

 

      

 

 

    

 

 

    

Total revenue

   $ 3,420       $ 4,206         (19 )%    $ 12,248       $ 9,278         32
  

 

 

    

 

 

      

 

 

    

 

 

    

Strategic Services

Our strategic services revenue is derived from consulting services we provide to our clients. Our strategic services revenue decreased by $438,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decrease is the result of this division having a 40% decline in the value of contracts in process during the three months ended September 30, 2011 in comparison to the same period of 2010. However, certain of the current year contracts have required the work of a specialist consultant who bills out at a significantly higher rate than that of the other consultants, which partially offset the decrease in revenue by approximately $225,000 for the three months ended September 30, 2011 over the same period of 2010.

Our strategic services revenue increased by $3.8 million for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The increase is the result of this division having a significant number of new contracts with a higher average value during the nine months ended September 30, 2011 in comparison to the same period of 2010. We attribute the increased contract level in 2011 to a renewed interest in innovation efficiency and new product development in the U.S. and abroad. In addition, certain of the current year contracts have required the work of a specialist consultant who bills out at a significantly higher rate than that of the other consultants, which contributed to an increase in revenue of approximately $574,000 for nine months ended September 30, 2011 over the same period of 2010. An increase in billable expenses related to overseas travel and lodging contributed to an increase in revenue of approximately $714,000 for the nine months ended September 30, 2011 over the same period of 2010.

Our strategic services revenue in recent years has largely been dependent on the efforts of certain key consulting professionals whose employment contracts with us expired in April 2011. We were able to retain the majority of these consulting professionals under new employment contracts or consulting contracts in order to maintain the level of strategic services revenue we have generated in recent years.

We expect that our strategic services revenue will decrease from that of the three months ended September 30, 2011 for the remainder of 2011.

Technology Services

Our technology services revenue is derived from a combination of global technology licensing services, online marketplace fees, foresight and trend research revenue and intellectual property (“IP”) consulting revenue. Our technology services revenue decreased by $348,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decreased revenue is primarily a result of a reduction of $27,000 in monthly fees for our global technology licensing services, a reduction of $26,000 in online marketplace fees, and a reduction of $342,000 in foresight and trend research revenue, partially offset by an increase of $44,000 in intellectual property consulting revenue.

Our technology services revenue decreased by $828,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decreased revenue is primarily a result of a reduction of $75,000 in monthly fees for our global technology licensing services, a reduction of $110,000 in online marketplace fees, a reduction of $530,000 in foresight and trend research revenue, and a reduction of $103,000 in intellectual property consulting revenue. The decreased revenue throughout this division for the three and nine months ended September 30, 2011 in comparison to the same periods of 2010 results from a reduction in the number of personnel selling and fulfilling projects, as well as budget cuts for a large group of our customers. This has had a significant, direct impact on new sales and renewals for this line of business.

We expect that our technology services revenue will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

 

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Direct Costs of Revenue

 

(in thousands, except percentages)    Three
Months
Ended
September 30,
2011
     Gross
Margin
    Three
Months
Ended
September 30,
2010
     Gross
Margin
    Nine
Months
Ended
September 30,
2011
     Gross
Margin
    Nine
Months
Ended
September 30,
2010
     Gross
Margin
 

Direct costs of revenue - strategic services

   $ 2,757        5   $ 3,126        6   $ 8,914         15   $ 5,301         21

Direct costs of revenue - technology services

     302         42     363         58     1,000         43     1,237         52

Direct Costs of Revenue - Strategic Services

Direct costs of revenue - strategic services are comprised of salaries and related taxes, bonuses, certain outside services and other business development costs related to our strategic services business. The most significant portion of direct costs of revenue - strategic services is comprised of consulting personnel compensation, which includes bonuses. Direct costs of revenue - strategic services included a bonus accrual of $805,000 and $2.3 million for the three and nine months ended September 30, 2011, respectively. In comparison, direct costs of revenue - strategic services included a bonus accrual of $1.8 million for each of the three and nine months ended September 30, 2010.

In connection with the expiration of the employment contracts for the management team of the strategic services division in the second quarter of 2011, we have retained certain of these former professionals as consultants. The pay rate these consultants receive is higher than the pay rate of most other consultants we use due to their experience and relationship with the customers. In addition, certain of the contracts have required the work of a specialist consultant whose cost is much higher than that of the other consultants. We also needed to hire more consultants during 2011 as a result of the high number of contracts in process and a reduction in the number of employees.

Direct costs of revenue - strategic services decreased by $369,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decrease is primarily related to a $1.0 million decrease in the bonus accrual and a $250,000 decrease in salaries, partially offset by an $859,000 increase in outside consultant expenditures as discussed above.

The gross margin for the strategic services business decreased to 5% for the three months ended September 30, 2011 in comparison to 6% for the three months ended September 30, 2010. This gross margin level for the three months ended September 30, 2011 and 2010 is a direct result of the bonus accrual during these periods.

Direct costs of revenue - strategic services increased by $3.6 million for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The increase is primarily related to a $533,000 increase in the bonus accrual, a $2.5 million increase in outside consultant expenditures as discussed above, and a $714,000 increase in overseas travel and lodging, partially offset by a $135,000 decrease in salaries.

The gross margin for the strategic services business decreased to 15% for the nine months ended September 30, 2011 in comparison to 21% for the nine months ended September 30, 2010. The decrease is primarily related to the bonus accrual and utilization of consultants at higher than normal rates.

We expect that our direct costs of revenue - strategic services will decrease from that of the three months ended September 30, 2011 for the remainder of 2011.

Direct Costs of Revenue - Technology Services

Direct costs of revenue - technology services are comprised of certain salaries and related taxes, commissions, certain outside services and other direct costs related to technology services. Direct costs of revenue - technology services decreased by $61,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. In addition, direct costs of revenue - technology services decreased by $237,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decreases primarily relate to a reduction in sales and project management personnel, as well as the reduced utilization of outside contractors, related to the decline in revenue.

The gross margin for the technology services business decreased to 42% for the three months ended September 30, 2011 in comparison to 58% for the three months ended September 30, 2010. In addition, the gross margin for the technology services

 

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business decreased to 43% for the nine months ended September 30, 2011 in comparison to 52% for the nine months ended September 30, 2010. These decreases are related to the aforementioned reduction in sales personnel and certain customer budgets having had a more negative impact on new sales and renewals for this business as compared to the impact on the direct costs of revenue for this business.

We expect that our direct costs of revenue - technology services will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Salaries and Wages

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

Salaries and wages

   $ 437      $ 648        (33 )%    $ 1,247      $ 2,117        (41 )% 

As a percent of revenue

     13     15     (2 )ppt      10     23     (13 )ppt 

 

* The abbreviation “ppt” denotes percentage points.

Salaries and wages include non-sales employee and officer salaries and related benefits, including bonuses and stock-based compensation that are not otherwise allocated to direct costs of revenue. Salaries and wages decreased by $211,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decrease relates to a $209,000 reduction in officers’ salaries as a result of severance expense related to our former CEO in the third quarter of 2010 and a $130,000 reduction in administrative staff, partially offset by an increase of $226,000 in stock compensation expense that resulted from a change in estimate related to stock options in the third quarter of 2010.

Salaries and wages decreased by $870,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decrease relates to a $342,000 reduction in officers’ salaries as a result of a CEO change and a $407,000 reduction in administrative staff, partially offset by an increase of $194,000 in stock compensation expense that resulted from a change in estimate related to stock options in the third quarter of 2010.

We expect that our salaries and wages will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Professional Fees

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

Professional fees

   $ 102      $ 142        (28 )%    $ 287      $ 510        (44 )% 

As a percent of revenue

     3     3       ppt      2     5     (3 )ppt 

Professional fees include accounting fees, legal fees and valuation expenses for our investments. Professional fees decreased by $40,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The majority of the decrease is related to a $53,000 reduction in accounting fees as a result of our having become a smaller reporting company (a designation under the federal securities laws that impacts the level of our disclosure requirement thereunder) during 2010. As a smaller reporting company, we are subject to a more streamlined reporting regime than the reporting regime for larger companies, including the elimination of the requirement to have our auditors audit our internal control over financial reporting.

Professional fees decreased by $223,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. Valuation expenses were reduced by $38,000 because our investments no longer require outside valuations on a quarterly basis. Accounting fees were reduced by $132,000 as a result of our having become a smaller reporting company during 2010. Legal fees were reduced by $52,000 because of costs incurred during the nine months ended September 30, 2010 related to the preparation of our restricted stock plan and the settlement of a severance liability related to our former CEO that were not repeated during the nine months ended September 30, 2011.

 

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We expect that our professional fees will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Research and Development

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

Research and development

   $ 28      $ 298        (91 )%    $ 662      $ 848        (22 )% 

As a percent of revenue

     1     7     (6 )ppt      5     9     (4 )ppt 

Research and development costs include salaries, outside services, travel and other costs related to the development of our LaunchPad software platform, which is designed to enhance and complement our innovation services offerings to clients. Research and development costs decreased by $270,000 and $187,000 for the three and nine months ended September 30, 2011 in comparison to the three and nine months ended September 30, 2010, respectively. The decreases are primarily related to the capitalization of $185,000 in software costs in the third quarter of 2011 rather than the allocation of such costs to research and development expense. In addition, we scaled back the amount of resources allocated to the development of LaunchPad to approximately $200,000 in the third quarter of 2011.

In accordance with accounting guidance, we expense all costs incurred to establish the technological feasibility of our LaunchPad software platform as research and development expenses. Having established a working model of LaunchPad Version 1.0, all costs related to the refinement of this product will be capitalized until general release of the product to customers. We will continue to incur costs related to the refinement of Version 1.0 while proceeding with the development of the next components of LaunchPad with Version 2.0. The costs related to the development of Version 2.0 will be expensed as research and development until we have completed a working model. We expect to incur an additional $150,000 in product development of Version 2.0 and refinement of Version 1.0 during the fourth quarter of 2011. Since a portion of these costs will be capitalized, we expect that research and development expense will remain relatively consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Sales and Marketing

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

Sales and marketing

   $ 114      $ 19        505   $ 228      $ 457        (50 )% 

As a percent of revenue

     3     0     3 ppt      2     5     (3 )ppt 

Sales and marketing expenses include advertising, marketing, commissions paid to outside service providers, certain travel and other business development expenses. Sales and marketing expenses increased by $95,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The increase relates primarily to $86,000 in marketing costs incurred during the three months ended September 30, 2011 in connection with an increase in marketing efforts. In addition, we received a $45,000 credit against previously paid marketing costs during the three months ended September 30, 2010, which reduced the expense in that period.

Sales and marketing expenses decreased by $229,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decrease relates primarily to certain marketing costs incurred during the nine months ended September 30, 2010, including $89,000 in rebranding costs and $150,000 for partnering with external search partners, which were not repeated during the nine months ended September 30, 2011. This decrease in costs was partially offset by $86,000 in marketing costs incurred during the nine months ended September 30, 2011 in connection with an increase in marketing efforts.

We expect that our sales and marketing costs for the remainder of 2011 will remain consistent with that of the three months ended September 30, 2011.

 

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General and Administrative

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

General and administrative

   $ 507      $ 593        (14 )%    $ 1,536      $ 1,771        (13 )% 

As a percent of revenue

     15     14     1 ppt      13     19     (6 )Ppt 

General and administrative expenses decreased by $86,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decrease relates to a $17,000 reduction in insurance and other employee related costs due to having fewer employees; a $28,000 reduction in investor relations costs; a $56,000 decrease in outside services as a result of having hired our CEO in the second quarter of 2011 as opposed to paying him as a consultant; as well as a continued overall company plan to reduce all aspects of overhead; partially offset by a $28,000 increase in real estate taxes.

General and administrative expenses decreased by $235,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decrease relates to a $148,000 reduction in insurance and other employee related costs due to having fewer employees; a $31,000 reduction in printing costs related to the proxy and annual report; a $46,000 reduction in investor relations costs; an $81,000 decrease in outside services as a result of having hired our CEO in the second quarter of 2011 as opposed to paying him as a consultant; as well as a continued overall company plan to reduce all aspects of overhead; partially offset by a $38,000 increase in real estate taxes and a $25,000 increase related to moving and relocation expenses for our new CEO and Senior VP of Sales.

We expect that our general and administrative costs will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Depreciation and Amortization

 

     Three Months
Ended
Sept. 30,
    Percentage
Change
    Nine Months
Ended
Sept. 30,
    Percentage
Change
 

(In thousands, except percentages)

   2011     2010           2011     2010        

Depreciation and amortization

   $ 297      $ 388        (24 )%    $ 977      $ 1,185        (18 )% 

As a percent of revenue

     9     9      ppt      8     13     (5 )ppt 

Depreciation and amortization decreased by $91,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. Amortization expense decreased by $77,000 as a result of impairment charges related to our intangible assets that were incurred in 2010. Depreciation expense decreased by $14,000 as a result of impairment charges related to our fixed assets that were incurred in 2010.

Depreciation and amortization decreased by $208,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. Amortization expense decreased by $172,000 as a result of impairment charges related to our intangible assets that were incurred in 2010. Depreciation expense decreased by $36,000 as a result of impairment charges related to our fixed assets that were incurred in 2010.

We expect that our depreciation and amortization will remain consistent with that of the three months ended September 30, 2011 for the remainder of 2011.

Impairment Loss

 

     Three Months
Ended
Sept. 30,
     Percentage
Change
    Nine Months
Ended
Sept. 30,
     Percentage
Change
 

(In thousands, except percentages)

   2011      2010            2011      2010         

Impairment loss

   $ —         $ 11,621         (100 )%    $ —         $ 11,621         (100 )% 

 

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At the end of the third quarter of 2010, management concluded that the significant decline in our stock price subsequent to June 30, 2010 was other than short-term in nature. This conclusion, coupled with the severity of the decline, triggered a review for impairment outside of our next scheduled annual impairment evaluation date of December 31, 2010. A decline in stock price may be an indicator of an adverse change in business climate and it affects market capitalization and may affect fair value measurements for reporting units. Due to the reduction in our market capitalization, third party valuations were obtained to assist in the determination of fair value for our reporting units. As a result of a reduction in fair value of our reporting units, management determined that the implied fair value of our goodwill and intangible assets was less than their respective carrying values by approximately $10.3 million. We recognized impairment of approximately $9.4 million to our goodwill and impairment of approximately $971,000 to our intangible assets in the three and nine months ended September 30, 2010.

We also recorded impairment of approximately $1.3 million to our fixed assets during the three and nine months ended September 31, 2010. The commercial real estate market for certain of our properties had taken a significant downturn that was not expected to reverse in the near future. As a result, management determined that the decrease in fair value of the property was other-than-temporary. The impairment loss was determined based on third party valuations of the respective property.

We did not have any events occur during the nine months ended September 30, 2011 that would trigger a review for impairment outside of our next scheduled annual impairment evaluation date of December 31, 2011.

Other (Income) Expense

 

     Three Months
Ended
Sept. 30,
     Percentage
Change
    Nine Months
Ended
Sept. 30,
     Percentage
Change
 

(In thousands, except percentages)

   2011     2010            2011      2010         

Other (income) expense

   $ (598   $ 283         (311 )%    $ 632       $ 127         398

Other (income) expense includes rental income, gains and losses related to adjusting our derivative liabilities to fair value each reporting period, capital gains and losses and other miscellaneous income. Other (income) expense changed by $(881,000) for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The variance is primarily attributable to a $44,000 increase in rental income and a $1.1 million decrease in net capital loss, partially offset by a $263,000 decrease in net gain on adjustment of our derivative liabilities.

Other (income) expense changed by $505,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The variance is attributable to a $1.7 million decrease in net gain on adjustment of our derivative liabilities, partially offset by a $98,000 increase in rental income and a $1.1 million decrease in net capital loss.

Other (income) expense may continue to fluctuate significantly as the value of our derivative liability increases or decreases in connection with changes in our stock price.

Interest Expense, Net

 

     Three Months
Ended
Sept. 30,
     Percentage
Change
    Nine Months
Ended
Sept. 30,
     Percentage
Change
 

(In thousands, except percentages)

   2011      2010            2011      2010         

Interest expense, net

   $ 106       $ 235         (55 )%    $ 330       $ 512         (36 )% 

Interest expense, net decreased by $129,000 for the three months ended September 30, 2011 in comparison to the three months ended September 30, 2010. The decrease is primarily attributable to lower interest expense from the amortization of our debt discount of $122,000.

Interest expense, net decreased by $182,000 for the nine months ended September 30, 2011 in comparison to the nine months ended September 30, 2010. The decrease is primarily attributable to lower interest expense on long-term debt of $42,000 and lower interest expense from the amortization of our debt discount of $148,000.

 

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Liquidity and Capital Resources

Cash Flows

Cash flows from operating activities of $2,031,000 for the nine months ended September 30, 2011 increased $4,891,000 from $(2,860,000) for the nine months ended September 30, 2010. Total cash flows from operations of $2,031,000 in this period are primarily attributable to:

 

   

$1.1 million in non-cash depreciation and amortization;

 

   

$911,000 non-cash loss on derivative liabilities;

 

   

$408,000 in non-cash stock-based compensation expense related to vesting options and restricted stock;

 

   

$775,000 decrease in accounts receivable and contracts in process;

 

   

$219,000 decrease in prepaid expenses and other assets; and

 

   

$2.2 million increase in accounts payable, accrued expenses and accrued bonus;

partially offset by a $3.5 million net loss.

Cash flows from investing activities of $(220,000) for the nine months ended September 30, 2011 decreased $985,000 from $765,000 for the nine months ended September 30, 2010. Total cash flows from investing activities of $(220,000) in this period are primarily related to the capitalization of software development costs.

Cash flows from financing activities of $(525,000) for the nine months ended September 30, 2011 decreased $2,690,000 from $2,165,000 for the nine months ended September 30, 2010. Total cash flows from financing activities of $(525,000) in this period are related to principal payments on long-term debt.

Software Development Costs

We are continuing the development of our LaunchPad software, which is designed to enhance and complement our innovation service offerings to clients. We will continue to incur costs related to the refinement of Version 1.0 while proceeding with the development of the next components of LaunchPad with Version 2.0. As of September 30, 2011, we had invested $2.1 million in this software platform. We expect to incur approximately $150,000 in additional expenditures for product development of Version 2.0 and refinement of Version 1.0 during the fourth quarter of 2011.

Liquidity

Our primary cash requirements include working capital, research and development expenditures, principal and interest payments on indebtedness, and employee bonuses. Our primary sources of funds are cash received from customers in connection with operations and, to a lesser extent, proceeds from the sale from time to time of our investments. As of September 30, 2011, we had $1.5 million in cash and cash equivalents, $1.2 million in accounts receivable and contracts in process, $510,000 in investments, and a working capital deficit of $1.4 million.

We currently intend to fund our liquidity needs, including our software development costs, with existing cash and cash equivalent balances, cash generated from operations, collections of our existing receivables and the potential sales of our investments. We expect that our recent reductions in costs, coupled with our expected revenue, will be sufficient to fund our scheduled debt service payments of $109,000 and our operating requirements for the next twelve months. However, we are also exploring opportunities for obtaining a credit facility with certain financial institutions. Should we face a more restricted cash flow scenario than projected during the next twelve months, we have the capability to delay all cash intensive activities, including our software development costs, and will look to reduce costs further. However, if such measures prove inadequate, we could face liquidity problems and might be required to reduce or delay planned capital expenditures and other initiatives, sell assets, restructure or refinance our debt or seek additional equity capital, and we may be unable to take any of these actions on satisfactory terms or in a timely manner. Further, any of these actions may not be sufficient to allow us to service our debt obligations or may have an adverse impact on our business. Our failure to generate sufficient cash from our operations could have a material adverse effect on us.

 

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Critical Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make assessments, estimates and assumptions that affect the amounts reported in the financial statements. We evaluate the accounting policies and estimates used to prepare the financial statements on an ongoing basis. Critical accounting estimates are those that require management’s most difficult, complex, or subjective judgments and have the most potential to impact our financial position and operating results. For a detailed discussion of our critical accounting estimates, see our Annual Report on Form 10-K for the year ended December 31, 2010.

Recently Issued Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued new guidance that expands existing disclosure requirements for fair value measurements and makes other amendments that could change how the fair value measurement guidance is applied. The guidance is effective for us with the reporting period beginning in January 1, 2012. The adoption of this guidance is not expected to have an impact on our operations.

In June 2011, the FASB issued new guidance that revises the manner in which entities present comprehensive income in their financial statements. The new guidance requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. The guidance is effective for us with the reporting period beginning in January 1, 2012. The adoption of this guidance will change the way we present comprehensive income in our financial statements.

In September 2011, the FASB issued new guidance for goodwill impairment testing. Under the revised guidance, entities testing goodwill for impairment have the option of performing a qualitative assessment before calculating the fair value of a reporting unit in step 1 of the goodwill impairment test. If entities determine, on the basis of qualitative factors, that the fair value of the reporting unit is more likely than not greater than the carrying amount, a quantitative calculation is not needed. The guidance is effective for us with the reporting period beginning in January 1, 2012 with early adoption permitted. The adoption of this guidance is not expected to have an impact on our operations.

 

ITEM 3. Quantitative and Qualitative Disclosures about Market Risks

Not applicable.

 

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as is defined in Rules 13a-15(e) under the Securities Exchange Act of 1934). Based on their evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective such that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and such that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 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.

Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting (as defined in Rule13a-15(f) of the Securities Exchange Act of 1934) that occurred during the most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1. Legal Proceedings

Although we may from time to time be involved in litigation and claims arising out of our operations in the normal course of our business, as of September 30, 2011, we were not a party to any material pending legal proceedings.

 

ITEM 1A. Risk Factors

There have been no material changes to the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

 

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

None.

 

ITEM 3. Defaults upon Senior Securities

None.

 

ITEM 4. Reserved

 

ITEM 5. Other Information

None.

 

ITEM 6. Exhibits

Exhibit Index

 

  31.1*         Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
  31.2*         Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
  32.1*         Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.
  32.2*         Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.
101.INS**         XBRL Instance Document
101.SCH**         XBRL Taxonomy Extension Schema
101.CAL**         XBRL Taxonomy Extension Calculation Linkbase
101.DEF**         XBRL Taxonomy Extension Definition Linkbase
101.LAB**         XBRL Taxonomy Extension Label Linkbase
101.PRE**         XBRL Taxonomy Extension Presentation Linkbase

 

* Filed herewith.
** Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability.

 

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SIGNATURES

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.

 

    INNOVARO, INC.
              (Registrant)
Date: November 9, 2011    

/s/ Asa Lanum

    Asa Lanum
    Chief Executive Officer
Date: November 9, 2011    

/s/ Carole R. Wright

    Carole R. Wright, CPA
    Chief Financial Officer

 

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