ARTISTdirect, Inc. and
Subsidiaries
Condensed Consolidated
Balance Sheets
(amounts
in thousands, except for share data)
|
|
September
30,
2007
|
|
December
31,
2006
|
|
|
|
(Unaudited)
|
|
|
|
Assets
|
|
|
|
|
|
Current assets:
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
6,360
|
|
$
|
5,602
|
|
Restricted cash
|
|
278
|
|
364
|
|
Accounts receivable, net of allowance for doubtful accounts
of $393 at September 30, 2007 and $421 at December 31,
2006
|
|
6,640
|
|
6,928
|
|
Income taxes refundable
|
|
330
|
|
|
|
Finished goods inventory
|
|
|
|
281
|
|
Prepaid expenses and other current assets
|
|
627
|
|
204
|
|
Total current assets
|
|
14,235
|
|
13,379
|
|
|
|
|
|
|
|
Property and equipment
|
|
4,362
|
|
4,197
|
|
Less accumulated depreciation and amortization
|
|
(2,322
|
)
|
(1,729
|
)
|
Property and equipment, net
|
|
2,040
|
|
2,468
|
|
|
|
|
|
|
|
Other assets:
|
|
|
|
|
|
Intangible assets:
|
|
|
|
|
|
Customer relationships, net
|
|
629
|
|
1,195
|
|
Proprietary technology, net
|
|
2,112
|
|
4,012
|
|
Non-competition agreements, net
|
|
481
|
|
728
|
|
Goodwill
|
|
31,085
|
|
31,085
|
|
Total intangible assets, net
|
|
34,307
|
|
37,020
|
|
Deferred financing costs, net
|
|
1,455
|
|
2,084
|
|
Deposits
|
|
20
|
|
21
|
|
Total other assets
|
|
35,782
|
|
39,125
|
|
|
|
$
|
52,057
|
|
$
|
54,972
|
|
(continued)
3
ARTISTdirect, Inc. and
Subsidiaries
Condensed Consolidated
Balance Sheets (continued)
(amounts in thousands,
except for share data)
|
|
September
30,
2007
|
|
December
31,
2006
|
|
|
|
(Unaudited)
|
|
|
|
Liabilities and Stockholders Deficiency
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
Accounts payable
|
|
$
|
1,406
|
|
$
|
1,832
|
|
Accrued expenses
|
|
2,882
|
|
1,575
|
|
Accrued interest payable
|
|
2,323
|
|
67
|
|
Deferred revenue
|
|
298
|
|
39
|
|
Income taxes payable
|
|
147
|
|
495
|
|
Liquidated damages payable under registration rights
agreements, net of advance payments of $500
|
|
2,558
|
|
3,777
|
|
Warrant liability
|
|
3,073
|
|
4,715
|
|
Derivative liability
|
|
11,300
|
|
18,356
|
|
Senior secured notes payable, net of discount of $766
and $1,110 at September 30, 2007 and December 31,
2006, respectively (in default)
|
|
12,541
|
|
12,197
|
|
Subordinated convertible notes payable, net of discount
of $4,554 and $6,516 at September 30, 2007 and
December 31, 2006, respectively (in default)
|
|
23,104
|
|
21,142
|
|
Total current liabilities
|
|
59,632
|
|
64,195
|
|
|
|
|
|
|
|
Long-term liabilities:
|
|
|
|
|
|
Deferred rent
|
|
189
|
|
199
|
|
Deferred income taxes payable
|
|
264
|
|
264
|
|
Total long-term liabilities
|
|
453
|
|
463
|
|
|
|
|
|
|
|
Commitments and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders deficiency:
|
|
|
|
|
|
Common stock, $0.01 par value -
|
|
|
|
|
|
Authorized 60,000,000 shares
|
|
|
|
|
|
Issued and outstanding 10,333,127 shares and
10,188,445 shares at September 30, 2007 and
December 31, 2006, respectively
|
|
103
|
|
102
|
|
Additional paid-in-capital
|
|
234,988
|
|
233,197
|
|
Accumulated deficit
|
|
(243,119
|
)
|
(242,985
|
)
|
Total stockholders deficiency
|
|
(8,028
|
)
|
(9,686
|
)
|
|
|
$
|
52,057
|
|
$
|
54,972
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes to condensed consolidated financial statements.
4
ARTIST
direct, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
(amounts in thousands, except for share data)
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(Restated)
|
|
Net revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
337
|
|
$
|
663
|
|
$
|
1,340
|
|
$
|
1,917
|
|
Media
|
|
1,974
|
|
1,572
|
|
5,139
|
|
3,937
|
|
Anti-piracy and file-sharing marketing services
|
|
3,627
|
|
4,158
|
|
11,498
|
|
11,781
|
|
Total net revenue
|
|
5,938
|
|
6,393
|
|
17,977
|
|
17,635
|
|
Cost of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
353
|
|
612
|
|
1,378
|
|
1,799
|
|
Media
|
|
969
|
|
709
|
|
2,562
|
|
2,110
|
|
Anti-piracy and file-sharing marketing services
|
|
2,414
|
|
2,040
|
|
6,928
|
|
5,617
|
|
Total cost of revenue
|
|
3,736
|
|
3,361
|
|
10,868
|
|
9,526
|
|
Gross profit
|
|
2,202
|
|
3,032
|
|
7,109
|
|
8,109
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
Sales and marketing
|
|
553
|
|
296
|
|
1,439
|
|
839
|
|
General and administrative, including stock-based compensation of
$702 and $652 for the three months ended September 30, 2007 and 2006,
respectively, and $1,690 and $1,736 for the nine months ended September 30,
2007 and 2006, respectively
|
|
2,982
|
|
2,107
|
|
8,490
|
|
6,896
|
|
Development and engineering
|
|
106
|
|
|
|
419
|
|
|
|
Write-off of fixed assets
|
|
|
|
|
|
97
|
|
|
|
Total operating costs
|
|
3,641
|
|
2,403
|
|
10,445
|
|
7,735
|
|
Income (loss) from operations
|
|
(1,439
|
)
|
629
|
|
(3,336
|
)
|
374
|
|
Other income (expense):
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
59
|
|
45
|
|
160
|
|
76
|
|
Interest expense
|
|
(1,805
|
)
|
(1,472
|
)
|
(5,733
|
)
|
(4,411
|
)
|
Loss on foreign currency transactions
|
|
|
|
|
|
(14
|
)
|
|
|
Other income
|
|
|
|
10
|
|
|
|
63
|
|
Reduction in liquidated damages payable under registration rights
agreements
|
|
|
|
|
|
719
|
|
|
|
Change in fair value of warrant liability
|
|
512
|
|
1,139
|
|
1,643
|
|
(1,818
|
)
|
Change in fair value of derivative liability
|
|
2,702
|
|
1,236
|
|
7,056
|
|
(2,765
|
)
|
Reduction in exercise price of warrants
|
|
|
|
|
|
|
|
(641
|
)
|
Amortization of deferred financing costs
|
|
(212
|
)
|
(212
|
)
|
(629
|
)
|
(646
|
)
|
Write-off of unamortized discount on debt and deferred financing
costs resulting from principal payments on senior secured notes payable and
conversion of subordinated convertible notes payable
|
|
|
|
|
|
|
|
(1,580
|
)
|
Income (loss) before income taxes
|
|
(183
|
)
|
1,375
|
|
(134
|
)
|
(11,348
|
)
|
Provision for income taxes
|
|
|
|
536
|
|
|
|
797
|
|
Net income (loss)
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.02
|
)
|
$
|
0.03
|
|
$
|
(0.01
|
)
|
$
|
(1.46
|
)
|
Diluted
|
|
$
|
(0.02
|
)
|
$
|
0.03
|
|
$
|
(0.01
|
)
|
$
|
(1.46
|
)
|
|
|
|
|
|
|
|
|
|
|
Weighted average common shares outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
10,292,611
|
|
27,933,889
|
|
10,228,904
|
|
8,296,876
|
|
Diluted
|
|
10,292,611
|
|
30,543,558
|
|
10,228,904
|
|
8,296,876
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes to condensed consolidated financial statements.
5
ARTISTdirect, Inc. and Subsidiaries
Condensed Consolidated Statement of
Stockholders Deficiency (Unaudited)
(amounts in thousands, except for share data)
|
|
Common Stock
|
|
Additional
Paid-In
|
|
Accumulated
|
|
Total
Stockholders
|
|
|
|
Shares
|
|
Amount
|
|
Capital
|
|
Deficit
|
|
Deficiency
|
|
Balance at January 1, 2007
|
|
10,188,445
|
|
$
|
102
|
|
$
|
233,197
|
|
$
|
(242,985
|
)
|
$
|
(9,686
|
)
|
Fair value of stock options granted
|
|
|
|
|
|
1,633
|
|
|
|
1,633
|
|
Common stock issued for consulting services
|
|
17,307
|
|
|
|
57
|
|
|
|
57
|
|
Common stock issued upon exercise of stock options
|
|
127,375
|
|
1
|
|
101
|
|
|
|
102
|
|
Net loss
|
|
|
|
|
|
|
|
(134
|
)
|
(134
|
)
|
Balance at September 30, 2007
|
|
10,333,127
|
|
$
|
103
|
|
$
|
234,988
|
|
$
|
(243,119
|
)
|
$
|
(8,028
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes to condensed consolidated financial statements.
6
ARTISTdirect, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash
Flows (Unaudited)
(amounts in thousands)
|
|
Nine Months Ended
September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
Cash flows from operating activities:
|
|
|
|
|
|
Net loss
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
Adjustments to reconcile net loss to net cash provided by operating
activities:
|
|
|
|
|
|
Depreciation and amortization
|
|
6,371
|
|
6,229
|
|
Write-off of unamortized discount on debt and deferred financing
costs resulting from principal payments on senior secured notes payable and
conversion of subordinated convertible notes payable
|
|
|
|
1,580
|
|
Provision for doubtful accounts
|
|
10
|
|
(67
|
)
|
Stock-based compensation
|
|
1,690
|
|
1,736
|
|
Deferred income taxes
|
|
|
|
(1
|
)
|
Other
|
|
|
|
(88
|
)
|
Change in fair value of warrant liability
|
|
(1,643
|
)
|
1,818
|
|
Change in fair value of derivative liability
|
|
(7,056
|
)
|
2,765
|
|
Reduction in exercise price of warrants
|
|
|
|
641
|
|
Reduction in liquidated damages payable under registration rights
agreements
|
|
(719
|
)
|
|
|
Write-off of fixed assets
|
|
97
|
|
|
|
Sub-total
|
|
(1,384
|
)
|
2,468
|
|
Changes in operating assets and liabilities:
|
|
|
|
|
|
(Increase) decrease in -
|
|
|
|
|
|
Accounts receivable
|
|
278
|
|
(2,342
|
)
|
Finished goods inventory
|
|
281
|
|
(40
|
)
|
Prepaid expenses and other current assets
|
|
(423
|
)
|
(183
|
)
|
Income taxes refundable
|
|
(330
|
)
|
828
|
|
Deposits
|
|
1
|
|
4
|
|
Increase (decrease) in -
|
|
|
|
|
|
Accounts payable
|
|
(426
|
)
|
109
|
|
Accrued expenses
|
|
1,307
|
|
(32
|
)
|
Accrued interest payable
|
|
2,256
|
|
(545
|
)
|
Deferred revenue
|
|
259
|
|
(321
|
)
|
Deferred rent
|
|
(10
|
)
|
200
|
|
Income taxes payable
|
|
(348
|
)
|
|
|
Liquidated damages payable under registration rights agreements
|
|
(500
|
)
|
|
|
Net cash provided by operating activities
|
|
961
|
|
146
|
|
|
|
|
|
|
|
Cash flows from investing activities:
|
|
|
|
|
|
Purchases of property and equipment
|
|
(391
|
)
|
(955
|
)
|
Net cash used in investing activities
|
|
(391
|
)
|
(955
|
)
|
|
|
|
|
|
|
Cash flows from financing activities:
|
|
|
|
|
|
Proceeds from exercise of stock options
|
|
102
|
|
71
|
|
Proceeds from exercise of warrants
|
|
|
|
5,212
|
|
Principal payments on senior secured notes payable
|
|
|
|
(1,693
|
)
|
(Increase) decrease in restricted cash
|
|
86
|
|
(4
|
)
|
Net cash provided by financing activities
|
|
188
|
|
3,586
|
|
|
|
|
|
|
|
Cash and cash equivalents:
|
|
|
|
|
|
Net increase
|
|
758
|
|
2,777
|
|
Balance at beginning of period
|
|
5,602
|
|
3,102
|
|
Balance at end of period
|
|
$
|
6,360
|
|
$
|
5,879
|
|
(continued)
7
ARTISTdirect, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash
Flows (Unaudited) (continued)
(amounts in thousands)
|
|
Nine Months Ended
September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
Supplemental disclosure of cash flow information:
|
|
|
|
|
|
Cash paid for -
|
|
|
|
|
|
Interest
|
|
$
|
1,139
|
|
$
|
2,585
|
|
Income taxes
|
|
$
|
678
|
|
$
|
|
|
|
|
|
|
|
|
Non-cash investing and financing activities:
|
|
|
|
|
|
Warrant liability transferred to additional paid-in capital as a
result of exercise of warrants
|
|
$
|
|
|
$
|
9,311
|
|
Common stock issued upon conversion of subordinated convertible notes
payable
|
|
$
|
|
|
$
|
3,275
|
|
Derivative liability transferred to additional paid-in capital as a
result of conversions of subordinated convertible notes payable
|
|
$
|
|
|
$
|
3,915
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes to condensed consolidated financial statements.
8
ARTISTdirect,
Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
Three
Months and Nine Months Ended September 30, 2007 and 2006 (2006 restated)
1. ORGANIZATION AND BUSINESS ACTIVITIES
ARTISTdirect, Inc., a
Delaware corporation (ADI), was formed on October 6, 1999 upon its
merger with ARTISTdirect, LLC. ARTISTdirect, LLC was organized as a California
limited liability company and commenced operations on August 8, 1996. Unless
the context indicates otherwise, ADI and its subsidiaries are referred to
herein as the Company. The Company is headquartered in Santa Monica,
California.
On July 28, 2005, the
Company completed the acquisition of MediaDefender, Inc., a privately-held
Delaware corporation (MediaDefender) (see Note 3). This transaction was
accounted for as a purchase in accordance with SFAS No. 141, Business
Combinations, and the operations of the two companies have been consolidated
commencing August 1, 2005. MediaDefender is a leading provider of
anti-piracy solutions in the Internet-piracy-protection (IPP) industry. During
the year ended December 31, 2006, MediaDefender also began to offer
file-sharing marketing services, wherein MediaDefender redirects, for a fee,
specific peer-to-peer traffic on the Internet to designated client
destinations.
The Company is a digital
media entertainment company that is home to an online music network and,
through its MediaDefender subsidiary, is a leading provider of anti-piracy
solutions in the IPP industry. The ARTISTdirect Network (www.artistdirect.com)
is a network of web-sites appealing to music fans, artists and marketing
partners that offers multi-media content, music news and information,
communities organized around shared music interests, music-related specialty
commerce and digital music services.
Restatement
of Financial Statements:
On December 20, 2006, the
Company determined that it was necessary to restate the financial statements
contained in its previously-filed Annual Report on Form 10-KSB/A for the fiscal
year ended December 31, 2005 and Quarterly Reports on Form 10-QSB or Form
10-QSB/A for the quarterly periods ended September 30, 2005, March 31, 2006,
June 30, 2006 and September 30, 2006 (collectively, the Financial Statements).
The determination was made by the Companys Audit Committee following receipt
by the Company of comments from the staff (the Staff) of the Securities and
Exchange Commission (the SEC), and following consultation with the Companys
senior management, financial advisors and independent registered public
accounting firm.
The Staff advised the
Company to consider EITF 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Companys Own Stock (EITF
00-19), and, in light of the guidance set forth in EITF 00-19, to further
evaluate the accounting treatment of certain embedded derivatives contained in
the outstanding Sub-Debt Notes (as subsequently defined) issued by the Company
in July 2005, as well as the accounting treatment of certain warrants issued to
the Companys lenders in July 2005, in conjunction with the financing of the
acquisition of MediaDefender. The Company filed the restated Financial
Statements on April 19, 2007. On May 11, 2007, the Staff provided
additional comments to the Company regarding the Financial Statements, to which
the Company subsequently responded. On June 11, 2007, the Staff advised the
Company that it would have no further comments. The adjustments to the
Financial Statements with respect to the restatements were non-cash in nature
and were not caused by or related to any changes in the underlying operating
performance of the Companys business, including its revenues, operating costs
and expenses, operating income or loss, operating cash flows or adjusted
EBITDA. However, such restatements had a material negative impact on the
Companys previously reported results of operations and earnings per share,
current liabilities, net working capital and shareholders equity (deficiency).
Additionally, as a result of the restatements, the Company triggered various
events of default under its financing documents (see Note 4).
The Sub-Debt Notes
contain reset, anti-dilution and change-in-control provisions that the Company
has determined caused such debt instruments to be classified as non-conventional
debt. Upon evaluation of such debt instruments under Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133) and EITF 00-19, it was determined that the
Company was required to bifurcate and value certain rights embedded in the
Sub-Debt Notes on the date of issuance (including, specifically, the initial
$1.55 per share fixed conversion feature, which was in excess of the $1.43 per
share fair market value of the Companys common stock on the date of issuance)
and to classify such rights as either assets or liabilities. The fair value of
these bifurcated derivatives, as determined by an independent valuation firm as
of July 28, 2005, was calculated in accordance with SFAS No. 133 Implementation
Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple
Derivative Features Embedded in a Single Hybrid Instrument, using a binomial
lattice model, and utilized highly subjective and theoretical assumptions that
can materially affect fair values from period to period.
9
The recognition of these
derivative amounts did not have any impact on the Companys revenues, operating
expenses, income taxes or cash flows. The Company recorded an initial embedded
derivative liability of $10,534,000, which was recorded as a discount to the
$31,460,500 of convertible subordinated notes, and is being amortized over the
term of the debt. The carrying value of the embedded derivative liability is
being adjusted to reflect any material changes in such liability from the date
of issuance to the end of each subsequent reporting period, with any such
changes included in other income (expense) in the statement of operations. The
Company has accounted for the registration rights penalties (see Note 4) in
accordance with EITF 00-19-2, Accounting for Registration Payment Arrangements
(EITF 00-10-2), which the Company adopted as of December 31, 2006, and Statement
of Financial Accounting Standards No. 5, Accounting for Contingencies.
In
addition to the adjustment for the embedded derivatives associated with the
Sub-Debt Notes, the Company revised the initial valuation and subsequent
changes to fair value of the warrants issued in conjunction with the Senior
Financing and the Sub-Debt Financing (see Note 5).
A
summary of the significant adjustments recorded to restate the financial
statements as of and for the three months and nine months ended September 30, 2006
is presented below. The restatement did not have an impact on the Companys
cash flows for the three months and nine months ended September 30, 2006.
(a) The initial fair value of the derivative
liability was bifurcated from the Sub-Debt Notes and was recorded as a discount
to the Sub-Debt Notes, and was amortized to interest expense over the life of
the related debt.
(b) The derivative liability was revalued at each
quarter end, with the resulting change in fair value reflected in the statement
of operations.
(c) The initial fair value of the warrants issued
in the Senior Financing and the Sub-Debt Financing was restated, resulting in
revisions to deferred financing costs and debt discount amounts, and in the
related amortization of such amounts to operations.
(d) The warrants issued in conjunction with the
Senior Financing and the Sub-Debt Financing were revalued at each quarter end,
with the resulting change in fair value reflected in the statement of
operations.
(e) The pro rata portion of the restated warrant
liability and the derivative liability associated with the conversion of the
sub-debt into common stock was transferred to additional paid-in capital.
10
The
following table presents the impact of the restatement on the effected balance
sheet categories at September 30, 2006 (amounts in thousands):
|
|
As Previously
Reported
|
|
Restatement
Adjustments
|
|
Adjustment
Legend
|
|
As Restated
|
|
|
|
|
|
|
|
|
|
|
|
Deferred financing costs
|
|
$
|
2,139
|
|
$
|
166
|
|
(c)
|
|
$
|
2,305
|
|
Warrant liability
|
|
6,209
|
|
1,620
|
|
(c),
(d)
|
|
7,829
|
|
Derivative liability
|
|
|
|
29,052
|
|
(a),
(b)
|
|
29,052
|
|
Discount on senior secured notes payable
|
|
864
|
|
362
|
|
(c),
(d)
|
|
1,226
|
|
Discount on subordinated convertible notes payable
|
|
540
|
|
6,673
|
|
(a),
(b), (c)
|
|
7,213
|
|
Additional paid-in capital
|
|
225,348
|
|
6,724
|
|
(e)
|
|
232,072
|
|
Accumulated deficit
|
|
$
|
(220,045
|
)
|
$
|
(30,195
|
)
|
(a),
(b), (c), (d)
|
|
$
|
(250,240
|
)
|
The
following table presents the impact of the restatement on the statements of operations
for the three months and nine months ended September 30, 2006 (amounts in
thousands, except per share data):
|
|
|
|
Three Months Ended
September 30, 2006
|
|
Nine Months Ended
September 30, 2006
|
|
|
|
Adjustment
Legend
|
|
As Previously
Reported
|
|
Restatement
Adjustments
|
|
As Restated
|
|
As Previously
Reported
|
|
Restatement
Adjustments
|
|
As Restated
|
|
Income (loss)
from operations
|
|
|
|
$
|
629
|
|
$
|
|
|
$
|
629
|
|
$
|
374
|
|
$
|
|
|
$
|
374
|
|
Interest income
|
|
|
|
45
|
|
|
|
45
|
|
76
|
|
|
|
76
|
|
Other income
|
|
|
|
10
|
|
|
|
10
|
|
63
|
|
|
|
63
|
|
Interest expense
|
|
(a), (c)
|
|
(825
|
)
|
(647
|
)
|
(1,472
|
)
|
(2,449
|
)
|
(1,962
|
)
|
(4,411
|
)
|
Amortization of
deferred financing costs
|
|
(c)
|
|
(197
|
)
|
(15
|
)
|
(212
|
)
|
(600
|
)
|
(46
|
)
|
(646
|
)
|
Change in fair
value of warrant liability
|
|
(c), (d)
|
|
887
|
|
252
|
|
1,139
|
|
(9,452
|
)
|
7,634
|
|
(1,818
|
)
|
Change in value
of derivative liability
|
|
(a), (b)
|
|
|
|
1,236
|
|
1,236
|
|
|
|
(2,765
|
)
|
(2,765
|
)
|
Write-off of
unamortized discount on debt and deferred financing costs due to conversion
of subordinated convertible notes payable and principal payments on senior
secured notes payable
|
|
(a), (c)
|
|
|
|
|
|
|
|
(537
|
)
|
(1,043
|
)
|
(1,580
|
)
|
Reduction in
exercise price of warrants
|
|
(c), (d)
|
|
|
|
|
|
|
|
(797
|
)
|
156
|
|
(641
|
)
|
Income (loss)
before income taxes
|
|
|
|
549
|
|
826
|
|
1,375
|
|
(13,322
|
)
|
1,974
|
|
(11,348
|
)
|
Provision for
income taxes
|
|
|
|
(536
|
)
|
|
|
(536
|
)
|
(797
|
)
|
|
|
(797
|
)
|
Net income (loss)
|
|
|
|
$
|
13
|
|
$
|
826
|
|
$
|
839
|
|
$
|
(14,119
|
)
|
$
|
1,974
|
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss)
per share basic
|
|
|
|
$
|
0.00
|
|
|
|
$
|
0.03
|
|
$
|
(1.70
|
)
|
|
|
$
|
(1.46
|
)
|
Net income (loss)
per share - diluted
|
|
|
|
$
|
0.00
|
|
|
|
$
|
0.03
|
|
$
|
(1.70
|
)
|
|
|
$
|
(1.46
|
)
|
Going Concern:
The
accompanying consolidated financial statements have been prepared in conformity
with accounting principles generally accepted in the United States of America,
which contemplate continuation of the Company as a going concern. As a result
of the matters described herein, the Companys independent registered public
accounting firm, in its report on the Companys 2006 consolidated financial
statements, expressed substantial doubt about the Companys ability to continue
as a going concern. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amounts and classification of liabilities that could result from
the outcome of this uncertainty.
As
a result of communications with the Staff of the SEC in 2006, in particular
regarding the application of accounting rules and interpretations related to
embedded derivatives associated with the Companys subordinated convertible
notes payable issued in July 2005, the Company determined that it was necessary
to restate previously issued financial statements. As a result, in December
2006, the Company was required to suspend the use of its then effective
registration statement for the holders of its senior and subordinated
indebtedness, which then triggered an event of default with respect to its
registration rights agreements with the holders of such indebtedness. Accordingly,
beginning January 18, 2007, the Company began to incur liquidated damages under
its registration rights agreements aggregating approximately $540,000 per
month, and the interest rate on its subordinated convertible notes payable
increased from 4.0% per annum to 12.0% per annum, an increase of approximately
$183,000 per month.
11
The
adjustments to the financial statements with respect to the restatements were
non-cash in nature and were not caused by or related to any changes in the
underlying operating performance of the Companys business, including revenues,
operating costs and expenses, operating income or loss, income taxes, operating
cash flows or adjusted EBITDA. The fair value of these bifurcated derivatives
of $10,534,000, as determined by an independent valuation firm, was calculated
using a binomial lattice option-pricing model utilizing highly subjective and
theoretical assumptions that can materially affect fair values from period to
period. The recognition of these derivative amounts, initially recorded as a
reduction to the related debt and being amortized to interest expense through
the life of the debt, with the resulting changes in fair value of the liability
being included as other income (expense) in the statement of operations each
subsequent reporting period, did not have any impact on the Companys revenues,
operating expenses, income taxes or cash flows. However, such restatements had
a material negative impact on the Companys previously reported results of
operations and earnings per share, current liabilities, net working capital and
shareholders equity (deficiency).
During
2005 and 2006 and the nine months ended September 30, 2007, the Companys
consolidated operations generated sufficient cash flows from operations to
enable the Company to fund its operating requirements and its originally
scheduled (i.e., undefaulted) debt service obligations to both the senior and
subordinated debt holders, and management currently anticipates that cash flows
from operations will be adequate to fund operating and debt service
requirements (based on the original terms as contemplated in the senior and
subordinated loan agreements and excluding the registration penalty amounts)
for the remainder of 2007 and generate operating cash flows in excess of
pre-default amounts for at least the next twelve months.
Primarily
as a result of the requirement to restate previously issued financial
statements, which resulted in the recording of an embedded derivative liability,
the reclassification of the senior and subordinated indebtedness to current
liabilities, and the recording of estimated liquidated damages payable under
registration rights agreements, the Company was not in compliance with certain
of its financial covenants under both the Senior Financing and the Sub-Debt
Financing at September 30, 2007 and December 31, 2006. Notwithstanding such
developments, the Company believes that it would have been out of compliance
with certain of its financial covenants at September 30, 2007.
As
of September 30, 2007 and December 31, 2006, approximately $13,307,000
principal amount was outstanding with respect to the Senior Financing, and
approximately $27,658,000 principal amount was outstanding with respect to the
Sub-Debt Financing. In addition, at September 30, 2007, approximately
$775,000 and $1,783,000 was outstanding with respect to accrued registration
delay penalties to the holders of the Senior Financing and the Sub-Debt
Financing, respectively, and approximately $116,000 and $2,207,000 was
outstanding with respect to accrued interest payable to the holders of the
Senior Financing and the Sub-Debt Financing, respectively. The Company has not
paid the registration delay penalties to either the holders of the Senior Notes
or the Sub-Debt Notes, although it has made advance payments to the holders of
the Senior Notes aggregating $500,000. As a result of the registration failure,
the failure to pay the registration delay penalties and the various financial
covenant and other breaches of the terms of the Senior Financing and the
Sub-Debt Financing, multiple events of default exist under the Senior Financing
and the Sub-Debt Financing. The terms of the Subordination Agreement among the
Company and the creditor parties thereto (the Subordination Agreement)
prevent the Company from making any cash payments to the Sub-Debt Note holders
until the events of default under the Senior Financing are either cured or
waived. Furthermore, upon the occurrence of an event of default, holders of at
least 25% of the outstanding senior indebtedness may declare the outstanding
principal and accrued interest on all senior notes immediately due and payable
upon written notice to the Company, and each holder of outstanding subordinated
indebtedness may only demand redemption of all or any portion of their
respective notes under certain circumstances as described in the Subordination
Agreement.
On
October 16, 2007, the Company received an Event of Default Redemption Notice
from the holders of approximately $2,693,000 principal amount of Sub-Debt Notes
demanding that the Company redeem their Sub-Debt Notes. The Company believes
and has advised these Sub-Debt Note holders that redemption (including the
demand for redemption) is not permitted under the terms of the Subordination
Agreement. On November 1, 2007, the Company received a copy of a letter to the
Sub-Debt Note holders from Senior Note holders representing approximately 66%
of the Senior Notes. The letter advised the Sub-Debt Note holders that the
Subordination Agreement prohibits the Company from redeeming any Sub-Debt Notes
and prohibits any Sub-Debt Note holder from pursuing any remedies. The letter
further stated that the Senior Note holders were inclined to give the Company
until November 30, 2007 to either cure the existing events of default or to pay
off the obligations to the Senior Note holders in full, or the Senior Note
holders expect they will likely begin to exercise additional remedies to obtain
payment of their outstanding obligations. The Company does not have the capital
resources necessary to cure the existing events of default, or to repay any
accelerated indebtedness or redemption or penalty amounts.
All quarterly interest
payments due on the outstanding senior and subordinated indebtedness were
timely paid by the Company through December 2006. In addition, the quarterly
interest payments due on the outstanding senior indebtedness in March 2007,
June 2007 and September 2007 were timely paid.
12
Pursuant to the terms of
the Subordination Agreement, interest on the outstanding subordinated
convertible notes payable cannot be paid as a result of the existence of the
events of default described herein.
Pursuant to a Forbearance
and Consent Agreement with the investors in the Senior Financing, such
investors agreed to forbear from the exercise of their rights and remedies
under the Senior Financing documents as a result of the events of default with
respect to the unavailability of the Companys registration statement, as well
as certain other events of default that existed or that could come into
existence during the forbearance period, from April 17, 2007 through July 31,
2007, in exchange for aggregate cash payments of $500,000. The payments made by
the Company under the Forbearance and Consent Agreement may be credited against
the registration delay cash penalties or any other amounts ultimately
determined to be due the investors in the Senior Financing. On July 6, 2007,
the Companys registration statement was declared effective by the SEC, thus
making it available to the investors in the Senior Financing and Sub-Debt
Financing. Although the Company and its representatives and advisors are in
ongoing discussions with the investors in the Senior Financing and the
investors in the Sub-Debt Financing as to a comprehensive resolution of the
matters discussed herein, the Company cannot predict the ultimate outcome of
such discussions.
On
August 3, 2007, the Company entered into a Waiver and Forbearance Agreement
with the holders of the Sub-Debt Financing pursuant to which the holders agreed
to waive their right to charge the 12.0% default interest rate triggered by the
Companys defaults under the Subordinated Financing transaction documents and
instead charge the 4.0% standard interest rate on the Sub-Debt Notes for the
period from July 16, 2007 through August 31, 2007 (the Forbearance Period). The
holders of the Sub-Debt Financing also agreed to forbear from exercising any of
their other rights and remedies under the Sub-Debt Financing transaction
documents during the Forbearance Period, upon the terms and conditions in the
Waiver and Forbearance Agreement. Effective September 1, 2007, the interest
rate returned to the 12.0% default interest rate.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company and its representatives and advisors are in ongoing
discussions with the holders of its senior and subordinated debt obligations to
obtain a waiver of and amendment to certain of the financing documents with
respect to the events of default, the impact of the restatements, the payment
of cash penalties and default interest, and various related matters. The
Company is exploring various alternatives to resolve the defaults under its
senior and secured debt obligations, but is unable to predict the outcome of
such negotiations. To the extent that the Company is unable to restructure its
senior and subordinated debt obligations in a satisfactory manner and/or the
lenders begin to exercise additional remedies to enforce their rights, the
Company will not have sufficient cash resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the
United States Bankruptcy Code.
2. BASIS OF PRESENTATION
Principles of Consolidation:
The accompanying condensed
financial statements include the consolidated accounts of ADI and its
wholly-owned subsidiaries. All intercompany accounts and transactions have been
eliminated for all periods presented.
Interim Financial
Information:
The interim condensed
consolidated financial statements are unaudited, but in the opinion of
management of the Company, contain all adjustments, which include normal
recurring adjustments, necessary to present fairly the financial position at
September 30, 2007, the results of operations for the three months and nine
months ended September 30, 2007 and 2006, and the cash flows for the nine
months ended September 30, 2007 and 2006. The condensed consolidated balance
sheet as of December 31, 2006 is derived from the Companys audited financial
statements as of that date.
Certain information and
footnote disclosures normally included in financial statements that have been
presented in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to the rules and regulations of the Securities
and Exchange Commission with respect to interim financial statements, although
management of the Company believes that the disclosures contained in these
financial statements are adequate to make the information presented therein not
misleading. For further information, refer to the consolidated financial
statements and notes thereto included in the Companys Annual Report on Form
10-KSB for the fiscal year ended December 31, 2006, as filed with the Securities
and Exchange Commission.
13
The Companys results of
operations for the three months and nine months ended September 30, 2007 are
not necessarily indicative of the results of operations to be expected for the
full fiscal year ending December 31, 2007.
Estimates:
In preparing financial
statements in conformity with generally accepted accounting principles,
management is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities at the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting period. Some of the more
significant estimates include the allowance for bad debts, impairment of
intangible assets and long-lived assets, stock-based compensation, the
valuation allowance on deferred tax assets and the change in fair value of the
warrant liability and derivative liability. Actual results could differ
materially from those estimates.
Development and Engineering
Costs:
Development and engineering
costs, which are presented as a separate line item in the statement of
operations in 2007, consist primarily of third-party development costs and
payroll and related expenses for in-house development costs incurred in the
design and production of the Companys content and services, including
revisions to the Companys web-site. These costs are charged to operations as
incurred. During the three months and nine months ended September 30, 2006,
these costs, which were not material, were included in cost of revenue.
Reclassification:
Certain amounts have been
reclassified from their presentation in 2006 to conform to the current
years presentation. Such reclassifications did not have any effect on income
(loss) from operations, net income (loss), or operating cash flows.
Net Income (Loss) Per Common
Share:
The
Company calculates net income (loss) per common share in accordance with
Statement of Financial Accounting Standards No. 128, Earnings Per Share (SFAS
No. 128), and EITF 03-6, Participating Securities and the Two-Class Method
under FASB Statement No. 128 (EITF 03-6). EITF 03-6 clarifies the use of the
two-class method of calculating earnings per share as originally prescribed
in SFAS No. 128 and provides guidance on how to determine whether a security
should be considered a participating security.
The
Company has determined that the convertible subordinated notes payable are a
participating security, as each note holder is entitled to receive any
dividends paid and distributions made to the common stockholders as if the note
had been converted into common stock on the record date. The participatory
shares are included in the weighted average shares outstanding as of the
beginning of each period in calculating the basic weighted average shares
outstanding.
Under the two-class method, basic
income (loss) per common share is computed by dividing net income (loss)
applicable to common stockholders by the weighted-average number of common
shares outstanding for the reporting period. Diluted income (loss) per common
share is computed using the more dilutive of the two-class method or the if-converted
method. Net losses are not allocable to the holders of the subordinated
convertible notes payable. Diluted income (loss) per share gives effect to all
potentially dilutive securities, including stock options, senior and sub-debt
warrants, and convertible subordinated notes payable, unless their effect is
anti-dilutive.
The calculation of
diluted weighted average common shares outstanding for the three months and
nine months ended September 30, 2007 and 2006 is based on the average of the
closing price of the Companys common stock during each respective period. The
calculation of diluted income (loss) per share for the three months ended
September 30, 2007 and the nine months ended September 30, 2007 and 2006
excluded the effect from the conversion of subordinated convertible notes
payable and the exercise of stock options and senior and sub-debt warrants
since their effect would have been anti-dilutive. The calculation of diluted
income per share for the three months ended September 30, 2006 included the
impact from dilutive stock options and senior and sub-debt warrants, but
excluded the effect from the conversion of subordinated convertible notes
payable, as well as stock options and warrants representing 585,149 shares and
433,333 shares, respectively, since their effect would have been anti-dilutive.
Issued but
unvested shares of common stock are excluded from the calculation of basic
earnings per share, but are included in the calculation of diluted earnings per
share, to the extent that they are not anti-dilutive.
14
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(Restated)
|
|
|
|
|
|
|
|
|
|
|
|
Numerator:
|
|
|
|
|
|
|
|
|
|
Net income (loss), as reported
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Allocation of net income (loss), as reported:
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(183
|
)
|
$
|
300
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
Net income (loss) applicable to convertible sub-debt note holders
|
|
|
|
539
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss), as reported
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(183
|
)
|
$
|
347
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
Net income (loss) applicable to convertible sub-debt note holders
|
|
|
|
492
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss), as reported
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Denominator:
|
|
|
|
|
|
|
|
|
|
Weighted average common shares outstanding
|
|
10,292,611
|
|
9,998,869
|
|
10,228,904
|
|
8,296,876
|
|
Weighted average common shares attributable to subordinated notes
|
|
|
|
17,935,020
|
|
|
|
|
|
Weighted average common shares used in calculating basic net income
(loss) per common share
|
|
10,292,611
|
|
27,933,889
|
|
10,228,904
|
|
8,296,876
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average common shares issuable upon exercise of outstanding
stock options, based on the treasury stock method
|
|
|
|
2,609,669
|
|
|
|
|
|
Weighted average common shares issuable upon exercise of sub-debt
warrants, based on the treasury stock method
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average common shares used in computing diluted net income
(loss) per common share
|
|
10,292,611
|
|
30,543,558
|
|
10,228,904
|
|
8,296,876
|
|
|
|
|
|
|
|
|
|
|
|
Calculation of net income (loss) per common share:
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Weighted average common shares used in calculating basic net income
(loss) per common share
|
|
10,292,611
|
|
27,933,889
|
|
10,228,904
|
|
8,296,876
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(0.02
|
)
|
$
|
0.03
|
|
$
|
(0.01
|
)
|
$
|
(1.46
|
)
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
|
|
|
|
|
|
|
|
|
|
Weighted average common shares used in calculating diluted net income
(loss) per common share
|
|
10,292,611
|
|
30,543,558
|
|
10,228,904
|
|
8,296,876
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) applicable to common stockholders
|
|
$
|
(0.02
|
)
|
$
|
0.03
|
|
$
|
(0.01
|
)
|
$
|
(1.46
|
)
|
15
Stock-Based Compensation:
Effective
January 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), a
revision to SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No.
123R requires that the Company measure the cost of employee services received
in exchange for equity awards based on the grant date fair value of the awards,
with the cost to be recognized as compensation expense in the Companys
financial statements over the vesting period of the awards. Accordingly, the
Company recognizes compensation cost for equity-based compensation for all new
or modified grants issued after December 31, 2005. In addition, commencing
January 1, 2006, the Company recognized the unvested portion of the grant date
fair value of awards issued prior to adoption of SFAS No. 123R based on the
fair values previously calculated for disclosure purposes over the remaining
vesting period of the outstanding stock options and warrants.
The
Company accounts for stock option and warrant grants issued and vesting to
non-employees in accordance with EITF No. 96-18, Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services, and EITF 00-18, Accounting
Recognition for Certain Transactions involving Equity Instruments Granted to
Other Than Employees, whereas the value of the stock compensation is based
upon the measurement date as determined at either (a) the date at which a
performance commitment is reached or (b) at the date at which the necessary
performance to earn the equity instruments is complete.
During
the three months and nine months ended September 30, 2007, the Company recorded
$580,000 and $1,354,000, respectively, and during the three months and nine
months ended September 30, 2006, the Company recorded $587,000 and $1,616,000,
respectively, as a charge to operations to recognize the unvested portion of
the grant date fair value of awards issued prior to the adoption of SFAS No.
123R.
At
September 30, 2007, the unvested portion of the grant date fair value of awards
issued prior to adoption of SFAS No. 123R on January 1, 2006 (excluding
milestonevested options), based on the fair values previously calculated, will
be charged to operations over the remaining vesting period of the outstanding
options as follows (amounts are in thousands):
Years Ending December 31,
|
|
|
|
2007 (three months)
|
|
$
|
323
|
|
2008
|
|
883
|
|
2009
|
|
26
|
|
Total
|
|
$
|
1,232
|
|
For
the past several years and in accordance with established public company
accounting practice, the Company has consistently utilized the Black-Scholes
option-pricing model to calculate the fair value of stock options and warrants
issued as compensation, primarily to management, employees and directors. The
Black-Scholes option-pricing model is a widely-accepted method of valuation
that public companies typically utilize to calculate the fair value of options
and warrants that they issue in such circumstances.
In calculating the
Black-Scholes value of stock options and warrants issued, the Company uses the
full term of the option, an appropriate risk-free interest rate (generally from
4% to 5%), and a 0% dividend yield.
The Company utilizes the
daily closing stock prices of its common stock as quoted on the OTC Bulletin
Board to calculate the expected volatility used in the Black-Scholes
option-pricing model. Since the Companys business operations and capital
structure changed dramatically on July 28, 2005 as a result of the acquisition
of MediaDefender and the related financing transactions, the Company has
utilized daily closing stock prices from August 1, 2005 through each subsequent
quarter end to generate a volatility factor for use in calculating the fair
value of options and warrants issued during each respective period. By
utilizing daily trading data related to the period of time that reflects the
Companys current business operations, the Company believes that this
methodology generates volatility factors that more accurately reflect, as well
as adjust for, normal market fluctuations in the Companys common stock over an
extended period of time. This methodology has generated volatility factors
ranging from approximately 163% to 100% during 2005, 2006 and 2007. These
volatility factors have generally trended downward during 2006 and 2007.
Derivative Financial
Instruments:
Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133), requires all derivatives to be recorded
on the balance sheet at fair value. When multiple derivatives (both
assets and liabilities) exist within a financial instrument, they are bundled
together as a single hybrid compound instrument in accordance with SFAS No. 133
Implementation Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple Derivative
Features Embedded in a Single Hybrid Instrument.
16
The calculation of the
fair value of derivatives utilizes highly subjective and theoretical
assumptions that can materially affect fair values from period to period. The
change in the fair value of the derivatives from period to period is recorded
in other income (expense) in the statement of operations. As a result, the
Companys financial statements are impacted quarterly based on factors such as
the price of the Companys common stock and the principal amount of Sub-Debt
Notes converted into common stock. Consequently, the Companys results of
operations and financial position may vary from quarter to quarter based on
factors other than those directly associated with the Companys operating
revenues and expenses. The recognition of these derivative amounts does not
have any impact on cash flows.
EITF 00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Companys Own Stock (EITF 00-19), requires freestanding contracts that are
settled in a companys own stock, including common stock warrants, to be
designated as an equity instrument, an asset or a liability. When the
ability to physically or net-share settle a conversion option or the exercise
of freestanding options or warrants is deemed to be not within the control of
the Company, the embedded conversion option or freestanding options or warrants
may be required to be accounted for as a derivative liability. Under the
provisions of EITF 00-19, a contract designated as an asset or a liability must
be carried at fair value on a companys balance sheet, with any changes in fair
value recorded in a companys results of operations.
The Company has accounted
for registration rights penalties in accordance with EITF 00-19-2, Accounting
for Registration Payment Arrangements, which the Company adopted as of
December 31, 2006, and Statement of Financial Accounting Standards No. 5, Accounting
for Contingencies.
The Company accounts for
derivatives, including the embedded derivatives associated with the Sub-Debt
Notes and the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing, at fair value, adjusted at the end of each reporting period
to reflect any material changes, with any such changes included in other income
(expense) in the statement of operations.
At the date of the
conversion of Sub-Debt Notes into common stock or the principal repayment of
Senior Notes, the pro rata portion of the related unamortized discount on debt
and deferred financing costs is charged to operations and included in other
income (expense). At the date of exercise of any of the warrants, or the
conversion of Sub-Debt Notes into common stock, the pro rata portion of the
fair value of the related warrant liability and/or embedded derivative
liability is transferred to additional paid-in capital.
Foreign Currency
Transactions:
The Companys
reporting currency and functional currency is the United States dollar. The
Company periodically receives payments for services in Canadian dollars and
British pounds, which are translated into United States dollars using the
exchange rate in effect at the date of payment. Gains or losses resulting from
foreign currency transactions, to the extent material, are included in other
income (expense) in the statement of operations.
Change in Estimate:
At June 30, 2007,
the Company evaluated the useful life of certain of its computer equipment and
determined to reduce the depreciation period from 7 years to 5 years. The
effect of this change in estimate was to increase depreciation expense by
approximately $124,000 and $248,000 for the three months and nine months ended
September 30, 2007, respectively. The Company estimates that this change in
estimate will increase depreciation expense by a total of approximately
$371,000 in 2007 and $168,000 in 2008 in excess of the amounts that would have
been recorded as depreciation expense originally.
Adoption of New
Accounting Policies:
In
December 2006, the FASB issued FSP EITF 00-19-2,
Accounting for Registration Payment Arrangements (EITF
00-19-2), which
addresses an issuers accounting for
registration payment arrangements. EITF 00-19-2 specifies that the contingent
obligation to make future payments or otherwise transfer consideration under a
registration payment arrangement, whether issued as a separate agreement or
included as a provision of a financial instrument or other agreement, should be
separately recognized and measured in accordance with SFAS No. 5,
Accounting for
Contingencies
. EITF 00-19-2 further clarifies that a
financial instrument subject to a registration payment arrangement should be
accounted for in accordance with other applicable generally accepted accounting
principles without regard to the contingent obligation to transfer
consideration pursuant to the registration payment arrangement. EITF 00-19-2 is
effective immediately for registration payment arrangements and the financial
instruments subject to those arrangements that are entered into or modified
subsequent to the date of issuance of EITF 00-19-2.
17
For
registration payment arrangements and financial instruments subject to those
arrangements that were entered into prior to the issuance of EITF 00-19-2, EITF
00-19-2 is effective for financial statements issued for fiscal years beginning
after December 15, 2006, and interim periods within those fiscal years. Early
adoption of EITF 00-19-2 for interim or annual periods for which financial
statements or interim reports have not been issued is permitted. The Company
chose to early adopt EITF 00-19-2 effective December 31, 2006 (see Note 4).
In June 2006, the
Emerging Issues Task Force (EITF) reached a consensus on EITF Issue 06-3, How
Taxes Collected From Customers and Remitted to Governmental Authorities Should
Be Presented in the Income Statement (That Is, Gross versus Net Presentation)
(EITF 06-3). The scope of EITF 06-3 includes any tax assessed by a
governmental authority that is directly imposed on a revenue-producing
transaction between a seller and a customer, and provides that a company may
adopt a policy of presenting taxes either on a gross basis - that is, including
the taxes within revenue - or on a net basis. For any such taxes that are
reported on a gross basis, a company should disclose the amounts of those taxes
for each period for which an income statement is presented if those amounts are
significant. The Company collects various state sales taxes that fall under the
scope of EITF 06-3 on goods that it sells in its e-commerce business segment
and is accounting for and reporting such taxes on a net basis. EITF 06-3 is
effective for financial reports for interim periods and annual reporting
periods beginning after December 15, 2006. The Company adopted EITF 06-3
effective January 1, 2007. The adoption of EITF 06-3 did not have a material
effect on the Companys financial statements.
Effective January
1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
Accounting for Income Taxes (FIN 48). FIN 48 addresses the determination of
whether tax benefits claimed or expected to be claimed on a tax return should
be recorded in the financial statements. Under FIN 48, the Company may
recognize the tax benefit from an uncertain tax position only if it is more
likely than not that the tax position will be sustained on examination by the
taxing authorities, based on the technical merits of the position. The tax
benefits recognized in the financial statements from such a position should be
measured based on the largest benefit that has a greater than fifty percent
likelihood of being realized upon ultimate settlement. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties on income
taxes, accounting in interim periods and requires increased disclosures. The
adoption of the provisions of FIN 48 did not have a material effect on the
Companys financial statements. As of September 30, 2007, no liability for
unrecognized tax benefits was required to be recorded.
The Company files
income tax returns in the U.S. federal jurisdiction and various states. The
Company is subject to U.S. federal or state income tax examinations by tax
authorities for years after 2002 (see Note 9).
The Companys
policy is to record interest and penalties on uncertain tax provisions as
income tax expense.
Recent Accounting
Pronouncements:
In
February 2007, the FASB issued Statement of Financial Accounting Standards No. 159,
The Fair Value Option for Financial Assets and Financial Liabilities (SFAS
No. 159), which provides companies with an option to report selected financial
assets and liabilities at fair value. SFAS No. 159s objective is to
reduce both complexity in accounting for financial instruments and the
volatility in earnings caused by measuring related assets and liabilities
differently. Generally accepted accounting principles have required different
measurement attributes for different assets and liabilities that can create
artificial volatility in earnings. SFAS No. 159 helps to mitigate this type of
accounting-induced volatility by enabling companies to report related assets
and liabilities at fair value, which would likely reduce the need for companies
to comply with detailed rules for hedge accounting. SFAS No. 159 also
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities. SFAS No. 159 requires companies to
provide additional information that will help investors and other users of
financial statements to more easily understand the effect of the companys
choice to use fair value on its earnings. SFAS No. 159 also requires companies
to display the fair value of those assets and liabilities for which the company
has chosen to use fair value on the face of the balance sheet. SFAS No.
159 does not eliminate disclosure requirements included in other accounting standards,
including requirements for disclosures about fair value measurements included
in SFAS No. 157 and SFAS No. 107. SFAS No. 159 is effective as of the beginning
of a companys first fiscal year beginning after November 15, 2007. Early
adoption is permitted as of the beginning of the previous fiscal year provided
that the company makes that choice in the first 120 days of that fiscal year
and also elects to apply the provisions of SFAS No. 157. The Company is
currently assessing the potential effect of SFAS No. 159 on its financial
statements.
In September 2006,
the FASB issued Statement of Financial Accounting Standards No. 157, Fair
Value Measurements (SFAS No. 157), which establishes a formal framework for
measuring fair value under Generally Accepted Accounting Principles (GAAP). SFAS
No. 157 defines and codifies the many definitions of fair value included among
various other authoritative literature, clarifies and, in some instances,
expands on the guidance for implementing fair value measurements, and increases
the level of disclosure required for fair value measurements. Although SFAS No.
157 applies to and amends the provisions of existing FASB and American
Institute of Certified Public Accountants (AICPA) pronouncements, it does
not, of itself, require any new fair value measurements, nor does it establish
valuation standards.
18
SFAS No. 157 applies to
all other accounting pronouncements requiring or permitting fair value
measurements, except for: SFAS No. 123R,
share-based payment and related pronouncements, the practicability exceptions
to fair value determinations allowed by various other authoritative
pronouncements, and AICPA Statements of Position 97-2 and 98-9 that deal with
software revenue recognition. SFAS No. 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
to interim periods within those fiscal years. The Company is currently
assessing the potential effect of SFAS No. 157 on its financial
statements.
Other
than the foregoing, management does not believe that any other recently issued,
but not yet effective, accounting standards, if currently adopted, would have a
material effect on the Companys consolidated financial statements.
3.
ACQUISITION OF MEDIADEFENDER, INC.
On July 28, 2005, the
Company consummated the acquisition of MediaDefender, Inc., a
privately-held Delaware corporation (MediaDefender), pursuant to the terms of
an Agreement and Plan of Merger (the Merger Agreement) entered into by and
among the Company, ARTISTdirect Merger Sub, Inc., a Delaware corporation
and wholly-owned subsidiary of the Company (Merger Sub), and MediaDefender. Under
the terms of the Merger Agreement, Merger Sub merged with and into MediaDefender,
the separate corporate existence of Merger Sub ceased and MediaDefender
survived as a wholly-owned subsidiary of the Company. The stockholders of
MediaDefender received aggregate consideration of $42,500,000 in cash, subject
to certain holdbacks and adjustments described in the Merger Agreement
MediaDefender is a leading
provider of anti-piracy solutions in the Internet-piracy-protection (IPP)
industry. During the year ended December 31, 2006, MediaDefender also began to
offer file-sharing marketing services, wherein MediaDefender redirects, for a
fee, specific peer-to-peer traffic on the Internet to designated client
destinations.
In order to fund the
acquisition of MediaDefender, the Company completed a $15,000,000 senior
secured debt transaction and a $30,000,000 convertible subordinated debt
transaction, as described at Note 4.
In accordance with the
Merger Agreement, the Company acknowledged the terms of Employment Agreements
entered into on July 28, 2005 by MediaDefender with each of Randy Saaf and
Octavio Herrera, confirming the terms of their employment. Mr. Saaf and
Mr. Herrera each earn a base salary of no less than $350,000 per annum
during the initial term of the agreements, which continue until
December 31, 2008, and are also entitled to receive performance bonuses of
up to $350,000 if MediaDefender achieves operating earnings before interest,
taxes, depreciation and amortization (calculated using the same accounting
methods and policies as MediaDefender has historically used) exceeding
$7,000,000 and $7,500,000 in fiscal 2007 and 2008, respectively. Mr. Saaf
and Mr. Herrera are each entitled to receive twelve months of severance
pay at the rate of 100% of their monthly salary and the pro rata portion of the
performance bonus referenced above if they are terminated without cause. In
addition, the Company granted stock options to purchase 200,000 shares of
common stock to each of Mr. Saaf and Mr. Herrera, exercisable at
$3.00 per share for a period of five years and vesting quarterly over a period
of three and one-half years.
The Company also
acknowledged the terms of Non-Competition Agreements entered into on
July 28, 2005 by MediaDefender and Mr. Saaf and Mr. Herrera. The
Non-Competition Agreements prohibit Mr. Saaf and Mr. Herrera from
(i) engaging in certain competitive business activities,
(ii) soliciting customers of MediaDefender or the Company,
(iii) soliciting existing employees of MediaDefender or the Company and
(iv) disclosing any confidential information regarding MediaDefender or
the Company. Each agreement has a term of four years and shall continue to
remain in force and effect in the event the above-referenced Employment
Agreements are terminated prior to the end of the four-year term of the
Non-Competition Agreements. In consideration, Mr. Saaf and
Mr. Herrera were each entitled to a cash payment of $525,000 from
MediaDefender on December 31, 2006 (which payments were timely made). As a
result of these agreements, effective July 28, 2005, the Company recorded
an asset of $1,050,000 for the non-competition agreements and a related
liability of $1,050,000 for the guaranteed payments to MediaDefender management.
The $1,050,000 allocated to non-competition agreements is being amortized over
the life of the employment agreements.
Mr. Saaf and
Mr. Herrera each invested $2,250,000 in the convertible subordinated debt
transaction entered into to fund the acquisition of MediaDefender on the same
terms and conditions as the other investors in such financing (see Note 4).
Upon the closing of the transaction, the Company issued 1,109,032
shares of common stock and a seven-year warrant to purchase 114,985 shares of
common stock with an exercise price of $1.55 per share to WNT07 Holdings, LLC (WNT07).
19
The managers of WNT07 are Eric Pulier and Teymour Boutros-Ghali, both
of whom were at the time of the issuance of the consideration and currently are
members of the Companys Board of Directors. The shares and warrants were
issued as consideration for services provided by Mr. Pulier and
Mr. Boutros-Ghali as consultants to the Company in connection with the
acquisition of MediaDefender. The consideration issued to WNT07 was approved by
the disinterested members of the Companys Board of Directors. The shares and
warrants were issued in reliance upon exemptions from registration pursuant to
Section 4(2) under the Securities Act and Rule 506 promulgated
thereunder. The shares of common stock were valued at $1,585,916 ($1.43 per
share) and the warrants were valued at $83,939, based on a valuation report
prepared by an independent valuation firm. The aggregate value of $1,669,855
was allocated $333,971 (20%) to a covenant not to compete (as described below)
and $1,335,884 (80%) to the costs that the Company incurred to acquire
MediaDefender, based on managements estimate of the relative values, as
confirmed by the independent valuation firm.
On July 28,
2005, the Company entered into a Non-Competition Agreement with WNT07, Eric
Pulier and Teymour Boutros-Ghali (collectively, the Advisors). The
Non-Competition Agreement prohibits any of the Advisors (i) from engaging
in certain competitive business activities and (ii) from soliciting
existing employees of the Company or its subsidiaries. The covenants not to complete
or solicit expire on the earlier of April 1, 2007 or the date of
termination of Advisors services with the Company. The amount allocated to the
covenant not to compete was amortized in full through April 1, 2007.
4.
FINANCING
TRANSACTIONS WITH RESPECT TO MEDIADEFENDER, INC. ACQUISITION (CURRENTLY IN DEFAULT)
In conjunction
with the acquisition of MediaDefender on July 28, 2005 (see Note 3), the
Company completed a $15,000,000 senior secured debt transaction (the Senior
Financing) and a $30,000,000 convertible subordinated debt transaction (the Sub-Debt
Financing).
The Senior
Financing was completed in accordance with the terms set forth in the Note and
Warrant Purchase Agreement entered into on July 28, 2005 by the Company,
each of the investors indicated on the schedule of buyers attached thereto
and U.S. Bank National Association as Collateral Agent (the Note Purchase
Agreement). Pursuant to the terms of the Note Purchase Agreement, each
investor received a note with a term of three years and eleven months that
bears interest at the rate of 11.25% per annum (each a Senior Note), payable
quarterly, with any unpaid principal and accrued interest due and payable at
maturity. Termination and payment of the Senior Notes by the Company prior to maturity
does not result in a prepayment fee. As collateral for the $15,000,000 Senior
Financing, the investors received a first priority security interest in all
existing and future assets of the Company and its subsidiaries, tangible and
intangible, including, but not limited to, cash and cash equivalents, accounts
receivable, inventories, other current assets, furniture, fixtures and
equipment and intellectual property.
In addition, not later than ninety days after the close of each fiscal
year, the Company is obligated to apply 60% of its excess cash flow, as defined
in the Note Purchase Agreement (the Annual Cash Sweep), to prepay the
principal amount of the Senior Notes. At December 31, 2006, there was no amount
payable for the 2006 Annual Cash Sweep.
The Senior Financing
investors also received five-year warrants to purchase an aggregate of
3,250,000 shares of the Companys common stock at an exercise price of $2.00
per share (collectively, the Senior Warrants). The Senior Warrants were
valued at $1,982,500 based on a valuation report prepared by an independent
valuation firm utilizing the Black-Scholes option-pricing model, and were
recorded as a discount to the $15,000,000 of senior secured debt, and are being
amortized to interest expense over the term of the debt.
The Senior Warrants were
subject to certain anti-dilution and price reset provisions, as well certain
registration rights obligations requiring the Company to file and maintain
effective a registration statement with the SEC covering the shares of common
stock underlying such warrants, which, if not complied with, subjects the
Company to a cash penalty of 1.5% of the Senior Financing per thirty-day period.
Accordingly, in accordance with EITF 00-19, the fair value of the Senior
Warrants was recorded as warrant liability in the Companys balance sheet at
July 28, 2005, and is being adjusted to reflect any material changes in such
liability from the date of issuance to the end of each subsequent reporting
period, with any such changes included in other income (expense) in the
statement of operations.
The Sub-Debt Financing was completed in accordance with the terms set
forth in the Securities Purchase Agreement entered into on July 28, 2005
by the Company and each of the investors indicated on the schedule of
buyers attached thereto (the Securities Purchase Agreement). Pursuant to the
terms of the Securities Purchase Agreement, each investor received a
convertible subordinated note with a term of four years that bears
interest at the rate of 4.0% per annum (each a Sub-Debt Note), with any
unpaid principal and accrued interest due and payable at maturity.
20
The interest rate increases to 12.0% per annum during any period in
which the Company is in default of its obligations under the Sub-Debt Note. Commencing
September 30, 2006, interest is payable quarterly in cash or shares of common
stock, at the option of the Company. Each Sub-Debt Note had an initial
conversion price of $1.55 per share, and was subject to certain anti-dilution,
reset and change-of-control provisions. In addition, each Sub-Debt Note is
subject to mandatory conversion by the Company in the event certain trading
price targets for the Companys common stock are met.
The Sub-Debt Notes contain specific provisions that expressly prohibit
the Company from issuing shares to a Sub-Debt Note holder if, after the
conversion, such Sub-Debt Note holder would exceed the respective limit called
for in their Sub-Debt Note, either 4.99% or 9.99%, of the Companys outstanding
common shares.
Following effectiveness of a registration statement filed by the
Company for the securities issued in the Sub-Debt Financing, two times within
any twelve-month period, the Company has the right to require the holder of
each Sub-Debt Note to convert all or a portion equal to not less than 25% of
the note conversion amount (limited to 50% of the note conversion amount if
pursuant to clause (a) below) into shares of the Companys common stock in the
event that (a) the closing sale price of the Companys common stock equals or
exceeds $2.32 per share for each of any fifteen consecutive trading days, with
a minimum trading volume of 200,000 shares of common stock on each such trading
day, (b) the closing sale price of the Companys common stock equals or exceeds
$3.10 per share on each trading day during the fifteen consecutive trading day
period, with a minimum trading volume of 200,000 shares of common stock on each
such trading day, subject in both cases to appropriate adjustments for stock
splits, stock dividends, stock combinations and other similar transactions
after the issuance date, or (c) completion of an equity financing (including
the issuance of securities convertible into equity securities, or long-term
debt securities issued as a unit with equity securities, of the Company) at a
price per share of not less than $2.50 generating aggregate gross proceeds of
at least $20,000,000 from outside third party investors.
The holders of the Sub-Debt Notes are entitled to receive any dividends
paid or distributions made to the holders of common stock to the same extent as
if such holders had converted their Sub-Debt Notes into common stock (without
regard to any limitations on conversion) and had held such shares of common
stock on the record date for such dividend or distribution, with such payment
to be made concurrently with the payment of the dividend or distribution to the
holders of common stock.
The Sub-Debt Financing investors also received five-year warrants to
purchase an aggregate of 1,596,774 shares of common stock at an exercise price
of $1.55 per share, subject to certain anti-dilution and price reset provisions
(collectively, the Sub-Debt Warrants). The Sub-Debt Warrants were valued at $1,133,710
based on a valuation report prepared by an independent valuation firm utilizing
the Black-Scholes option-pricing model, and were recorded as a discount to the
$30,000,000 of convertible subordinated debt, and are being amortized to
interest expense over the term of the debt.
In conjunction with the aforementioned financing transactions, a
Subordination Agreement dated July 28, 2005 was entered into between the
Company, the Senior Financing investors, and the Sub-Debt Financing investors
pursuant to which the Sub-Debt Financing investors agreed to subordinate their
rights to the investors in the Senior Financing in the event of a default under
the Senior Financing transaction documents and on certain other terms and
conditions described therein.
Legal fees
paid or reimbursed by the Company for services provided by the respective legal
counsels for the lenders were recorded as a charge to deferred financing costs
and are being amortized over the terms of the related debt.
Pursuant to
the terms of the Note Purchase Agreement and the Securities Purchase Agreement,
the Company was required to amend its Certificate of Incorporation to increase
the number of authorized shares of common stock from 15,000,000 shares to
60,000,000 shares. The Company obtained the requisite approvals of the Board of
Directors and stockholders and filed a Certificate of Amendment to the
Certificate of Incorporation with the Delaware Secretary of State on November
7, 2005 to effect the increase in the authorized shares of common stock.
If all of the securities issued in the Senior Financing and the
Sub-Debt Financing are converted or exercised into shares of the Companys
common stock in accordance with their respective terms, it will result in
significant dilution to the Companys existing stockholders and a possible
change in control of the Company. If all of the Companys outstanding
equity-based instruments are converted or exercised into shares of the Companys
common stock in accordance with their respective terms, including those issued
in conjunction with the acquisition of MediaDefender, there would be a total of
approximately 38,000,000 shares of the Companys common stock issued and
outstanding.
The securities issued by the Company in the Senior Financing and the
Sub-Debt Financing were offered and sold in reliance upon exemptions from
registration pursuant to Section 4(2) under the Securities Act of
1933, as amended (the Securities Act), and Rule 506 promulgated
thereunder. Each of the investors qualified as an accredited investor, as
specified in Rule 501 under the Securities Act.
21
The Sub-Debt Notes and
the Sub-Debt Warrants were subject to certain registration rights obligations
requiring the Company to file and maintain effective a registration statement
with the SEC covering the shares of common stock underlying such warrants,
which, if not complied with, subjects the Company to a cash penalty of 1.0% of
the Sub-Debt Financing per thirty-day period. Accordingly, in accordance with
EITF 00-19, the fair value of the Sub-Debt Warrants was recorded as
warrant liability in the Companys balance sheet at July 28, 2005, and is being
adjusted to reflect any material changes in such liability from the date of
issuance to the end of each subsequent reporting period, with any such changes
included in other income (expense) in the statement of operations.
The Sub-Debt Notes
contain reset, anti-dilution and change-in-control provisions that the Company
has determined caused such debt instruments to be classified as non-conventional
debt. Upon evaluation of such debt instruments under SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities (SFAS No. 133), and EITF
00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Companys Own Stock (EITF 00-19), it was
determined that the Company was required to bifurcate and value certain rights
embedded in the Sub-Debt Notes on the date of issuance (including, specifically,
the initial $1.55 per share fixed conversion feature, which was in excess of
the $1.43 per share fair market value of the Companys common stock on the date
of issuance) and to classify such rights as either assets or liabilities. The
fair value of these bifurcated derivatives as of July 28, 2005, as determined
by an independent valuation firm, was calculated in accordance with SFAS No.
133 Implementation Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple Derivative
Features Embedded in a Single Hybrid Instrument, using a binomial lattice
model utilizing highly subjective and theoretical assumptions that can
materially affect fair values from period to period. The recognition of these
derivative amounts did not have any impact on the Companys revenues, operating
expenses or cash flows. The Company recorded an initial embedded derivative
liability of $10,534,000, which was recorded as a discount to the $31,460,500
of convertible subordinated notes, and is being amortized over the term of the
debt. The carrying value of the embedded derivative liability is being adjusted
to reflect any material changes in such liability from the date of issuance to
the end of each subsequent reporting period, with any such changes included in
other income (expense) in the statement of operations. The Company has
accounted for registration rights penalties in accordance with EITF 00-19-2, Accounting
for Registration Payment Arrangements, which the Company adopted as of
December 31, 2006, and SFAS No. 5, Accounting for Contingencies.
The Sub-Debt Notes
contain several embedded derivative features (both assets and liabilities) that
have been accounted for at fair value. The various embedded derivative features
of the Sub-Debt Notes have been valued at the date of inception of the Sub-Debt
Financing and at the end of each reporting period thereafter. The material
derivative features include: (1) the
standard conversion feature of the debentures, (2) a limitation on the
conversion by the holder, and (3) the Companys right to force conversion. An
independent valuation firm valued the embedded derivative features and
determined that, except for the above-noted features, the remaining derivative
attributes (both assets and liabilities) were immaterial, both individually and
in the aggregate, and effectively offset each other. The value of the embedded
derivatives were bifurcated from the Sub-Debt Notes and recorded as derivative
liability, with the initial amount recorded as discount on the related Sub-Debt
Notes. This discount is being amortized to interest expense over the life of
the Sub-Debt Notes.
The Company determined
that the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19
because share settlement of these financial instruments was not within the
control of the Company, since the Company could not conclude that it had
sufficient authorized but unissued common shares available to satisfy its
potential share obligations under the warrant agreements. The Company reached
this conclusion because: (1) the Company
has an obligation to file a registration statement with the SEC to register the
common stock underlying warrants, and to have such registration statement
declared effective, and to maintain effective such registration statement, or
to pay penalties in the form of liquidated damages for each thirty-day period
that such registration statement is not effective, (2) the warrants contained
dilution protection features, with no limit or cap on the number of shares that
could be issued by the Company pursuant to such provisions, and (3) the
warrants contained certain price reset features. Because the warrants contain
certain anti-dilution and price reset provisions, as well as have registration
rights, the fair value of the warrants was accounted for as a derivative and
presented as warrant liability.
Pursuant to the terms of a letter agreement, dated July 15, 2005,
by and between the Company and Broadband Capital Management LLC (Broadband),
effective July 28, 2005, the Company issued to Broadband a Sub-Debt Note in the
amount of $1,460,500 (in addition to the $30,000,000 referred to above) and
five-year warrants to purchase 1,516,935 shares of common stock with an
exercise price of $1.55 per share. The notes and warrants issued to Broadband
or its affiliates were issued on the same terms and conditions granted to the
other Sub-Debt Financing investors. The securities were issued as partial
consideration for Broadbands services as the Companys placement agent in the
Sub-Debt Financing and the Senior Financing. The securities were issued in
reliance upon exemptions from registration pursuant to
Section 4(2) under the Securities Act and Rule 506 promulgated
thereunder. The Broadband warrants were valued at $1,077,024 based on a
valuation report prepared by an independent valuation firm utilizing the
Black-Scholes option-pricing model.
22
The aggregate value of the Sub-Debt Note, the warrants and additional
cash payments to Broadband aggregating $299,500 were charged to deferred
financing costs and are being amortized to other expense over the term of the
debt. The securities issued to Broadband were accounted for in a manner
consistent with the accounting for the Sub-Debt Notes and Sub-Debt Warrants as
described above.
Pursuant to the terms of a letter agreement, dated June 21, 2005,
by and between the Company and Libra FE, LP (Libra), effective July 28, 2005,
the Company issued to Libra a seven-year warrant to purchase 237,500 shares of
its common stock with an exercise price of $2.00 per share upon the closing of
the Senior Financing (the Libra Warrant). The Libra Warrant was issued as
partial consideration for Libras services as the Companys placement agent in
the Senior Financing described above. The Company entered into a Registration
Rights Agreement with Libra on July 28, 2005 (the Libra Registration
Rights Agreement), pursuant to which the Company will include the shares
underlying the Libra Warrant in the registration statement covering the
securities issued in the Senior Financing and the Sub-Debt Financing described
above. The Libra Warrant was issued in reliance upon exemptions from registration
pursuant to Section 4(2) under the Securities Act and Rule 506
promulgated thereunder. The Libra Warrant was valued at $175,750 based on a
valuation report prepared by an independent valuation firm utilizing the
Black-Scholes option-pricing model. The aggregate value of the Libra Warrant
and additional payments to Libra of $450,997 were charged to deferred financing
costs and are being amortized to other expense over the term of the debt.
The Libra Warrant was
subject to certain registration rights requiring the Company to file and
maintain effective a registration statement with the SEC covering the shares of
common stock underlying such warrant, which if not complied with could subject
the Company to a cash penalty of $5,000 per thirty-day period. In accordance
with EITF 00-19, the fair value of the Libra Warrant was recorded as warrant
liability at July 28, 2005, and was being adjusted to reflect any material
changes in such liability from the date of issuance to the end of each
subsequent reporting period, with any such changes included in other income
(expense) in the statement of operations. Effective April 19, 2006, the Libra
Warrant was exercised on a cashless basis at $2.00 per share, resulting in the
issuance of 123,864 shares of common stock.
At the date of exercise of any of the Senior Warrants, the Sub-Debt
Warrants or the Libra Warrant, or the conversion of Sub-Debt Notes into common
stock, the pro rata fair value of the related warrant liability and/or embedded
derivative liability is transferred to additional paid-in capital.
Pursuant to the Senior
Financing and Sub-Debt Financing documents, the Company is required to comply
on a quarterly basis with certain financial covenants, including minimum
working capital, maximum capital expenditures, minimum leverage ratio, minimum
EBITDA and minimum fixed charge coverage ratio. These financial covenants are
identical in the Senior Financing and the Sub-Debt Financing documents.
Due to the accounting
classification of the warrants issued in conjunction with the Senior Financing
and the Sub-Debt Financing as a current liability in accordance with SFAS No.
133 and EITF 00-19, the Company was not in compliance with certain of these
financial covenants at December 31, 2005.
On April
7, 2006, the lenders provided waivers with respect to such past events of
default under the Senior Notes and amended their loan documents such that the
warrant liability and any change thereto in future periods will not affect
future covenant and excess cash flow calculations. In consideration thereof,
the Company offered to temporarily reduce the exercise price of the 3,250,000
warrants held by the investors in the Senior Financing from $2.00 to $1.85 per
share through April 30, 2006, and agreed to permanently reduce the exercise
price of the 1,596,744 warrants held by the investors in the Sub-Debt Financing
from $1.55 to $1.43 per share on certain terms and conditions. Any
exercise of the aforementioned warrants at the reduced exercise price was
required to be for cash only. The conversion price of the Sub-Debt Notes
of $1.55 per share was not affected. The Company also entered into
similar agreements, as applicable, and provided identical temporary and
permanent reductions to warrant exercise prices, with Broadband Capital
Management LLC (1,516,935 warrants originally exercisable at $1.55 per share)
and Libra FE, LP (237,500 warrants originally exercisable at $2.00 per
share). The Company also agreed to utilize 25% of the net proceeds from
the exercise of the warrants held by the investors in the Senior Financing to
reduce the respective principal balances on the Senior Notes payable held by
such exercising investors, and to pay any related unpaid accrued interest on
such principal payments. The aforementioned waivers did not extend to the
embedded derivative liabilities associated with the Sub-Debt.
Effective April
27, 2006, certain of the investors in the Senior Financing exercised their
warrants to purchase 2,816,667 shares of common stock at $1.85 per share,
resulting in the issuance of 2,816,667 shares of common stock in exchange for
cash proceeds of $5,212,000, of which $1,303,000 was used to reduce the
respective principal balances on the Senior Notes payable held by such
exercising investors. There was no conversion of subordinated convertible notes
payable during April 2006 in relation to this transaction.
23
As a result of the $0.15
warrant exercise price reduction offered to the investors in the Senior
Financing in April 2006, the Company recorded a charge to operations during the
nine months ended September 30, 2006 for the aggregate fair value of such
exercise price reductions of $423,000 relating to the warrants held and
exercised by the Senior Financing investors in April 2006. The Company provided
this consideration primarily in exchange for a waiver of and amendment to
certain of the financial covenants contained in the loan agreements entered
into in conjunction with the July 2005 acquisition of MediaDefender. The amount
charged to operations was calculated by multiplying the $0.15 reduction, which
represented the fair value of the consideration transferred, by the number of
warrants that elected to accept the Companys offer and exercise, as
follows: $0.15 x 2,816,667 = $423,000. This
charge to operations was presented as reduction in exercise price of warrants
and was included in other income (expense) in the statement of operations.
As a result of the $0.12
warrant exercise price reduction provided to the investors in the Sub-Debt
Financing in April 2006, the Company recorded a charge to operations during the
nine months ended September 30, 2006 for the aggregate fair value of such
exercise price reductions of $218,000 relating to the warrants held by the investors
in the Sub-Debt Financing in April 2006. The Company provided this
consideration in exchange for a waiver of and amendment to certain of the
financial covenants contained in the loan agreements entered into in
conjunction with the July 2005 acquisition of MediaDefender. This amount was
calculated by determining the difference between the fair value of the warrants
held by the investors in the Sub-Debt Financing, based on a comparison of
updated Black-Scholes calculations using the original $1.55 exercise price and
the reduced $1.43 exercise price. The Company utilized revised Black-Scholes
input metrics to reflect updated changes, in particular to estimated life and
volatility. The result was that the Black-Scholes value of the Sub-Debt
warrants was $3.54, based on the original $1.55 exercise price, as compared to
a Black-Scholes value of $3.61, based on the reduced exercise price of $1.43. The
amount charged to operations was calculated by multiplying the $0.07 difference
($3.61 - $3.54), which represented the fair value of the consideration
transferred, by the number of warrants affected, as follows: $0.07 x 3,113,709 = $218,000. This charge to
operations was presented as reduction in exercise price of warrants and was
included in other income (expense) in the statement of operations.
On November 7, 2006, the
Company entered into a waiver (the Sub-Debt Waiver) with the holders of the
Sub-Debt Notes. A provision of the Sub-Debt Notes contains a negative
covenant pertaining to the Companys Consolidated Fixed Charge Coverage Ratio
(as such term is defined in the Sub-Debt Notes), which is to be calculated on a
quarterly basis (the Fixed Charge Covenant). The Fixed Charge Covenant
as originally drafted did not contemplate that the first cash payment of
accrued interest was not due and payable to the holders of the Sub-Debt Notes
until September 30, 2006 (the First Interest Payment), an approximate
fourteen-month period from the original issuance date of the Sub-Debt
Notes. As a result of the Company timely making the First Interest
Payment of $1,307,000, the Company was forced to breach the Fixed Charge
Covenant. The holders of the Sub-Debt Notes agreed to waive this event of
default under the Sub-Debt Notes that may have been triggered due to a breach
of the Fixed Charge Covenant resulting from the First Interest Payment.
On November 7, 2006, the
Company also entered into a waiver (the Senior Waiver) with the purchasers of
the Senior Notes originally issued by the Company. The Note Purchase Agreement
contains the same Fixed Charge Covenant that is contained in the Sub-Debt Notes
(the Senior Fixed Charge Covenant). As a result of the Company timely
making the First Interest Payment of $1,307,000, the Company was forced to
breach the Senior Fixed Charge Covenant. The holders of the Senior Notes
agreed to waive the event of default under the Note Purchase Agreement that may
have been triggered due to a breach of the Senior Fixed Charge Covenant
resulting from the First Interest Payment.
The financing documents
governing the terms and conditions of the senior and subordinated indebtedness
required the Company to maintain an effective registration statement covering
the resale of shares of common stock underlying the various securities issued by
the Company to each holder. A resale registration statement on Form SB-2, as
amended, was declared effective by the SEC on December 9, 2005. The
Company subsequently filed Post-Effective Amendment No. 1 to the registration
statement on Form SB-2, which was declared effective by the SEC on May 1, 2006,
and Post-Effective Amendment No. 2 to the registration statement on Form SB-2,
which was declared effective by the SEC on July 6, 2007. As a result of
the determination to restate previously issued financial statements (see Note
1), the Form SB-2 was not available for use by the holders between December 21,
2006 and July 6, 2007.
The financing documents
specify that an event of default of the senior and subordinated indebtedness is
triggered if a resale registration statement is unavailable for use by the
holders for a period of more than ten consecutive trading days after the
expiration of an allowable ten-day grace period. The Company invoked its
use of the ten-day allowable grace period on December 21, 2006, which expired
on December 31, 2006. The Company delivered notice to holders of its
outstanding senior and subordinated indebtedness that, as of January 18, 2007,
an event of default had been triggered under their respective senior and
subordinated financing documents.
24
As of January 18, 2007, the Form SB-2 remained unavailable for use by
the holders, and it continued to be unavailable for use until July 6, 2007,
when Amendment No. 2 to the registration statement on Form SB-2 was declared
effective by the SEC. Accordingly, at December 31, 2006, March 31, 2007
and June 30, 2007, the registration statement covering the resale of shares of
common stock underlying the various securities issued by the Company to each
holder of the senior and subordinated indebtedness was not effective. As a
result, an event of default, among others, with respect to the senior and
subordinated indebtedness was triggered by the unavailability of the Form SB-2
to the holders between December 21, 2006 and July 6, 2007. The financing
documents provide that while the Form SB-2 remains unavailable for use, holders
of senior indebtedness are entitled to a cash penalty equal to 1.5% of the
original Senior Financing, on a pro rata basis, and the holders of subordinated
indebtedness are entitled to a cash penalty equal to 1.0% of the original
Sub-Debt Financing, on a pro rata basis. These cash penalties are due and
payable by the Company at the end of each thirty-day period while the Form SB-2
remains unavailable. The first cash penalty payment was due on January
30, 2007, and monthly thereafter.
In accordance with EITF 00-19-2, which the Company adopted as of
December 31, 2006, and SFAS No. 5, the Company accrued seven months liquidated
damages (through mid-August 2007) under the registration rights agreements
aggregating approximately $3,777,000 as a charge to operations at December 31,
2006, which was reduced by $719,000 at June 30, 2007 as a result of the Companys
registration statement being declared effective on July 6, 2007, which was
earlier than originally estimated, and by an aggregate of $500,000 of advance
payments made to the holders of the Senior Financing during the nine months
ended September 30, 2007 for liquidated damages under the registration rights
agreement. Accordingly, liquidated damages payable under registration rights
agreements were $2,558,000 at September 30, 2007 and $3,777,000 at December 31,
2006, and were reflected as a current liability at such dates. The
Company believes that the amount of the liquidated damages accrued reflects the
undiscounted maximum potential amount of liquidated damages payable to the
holders of the Senior Financing and the Sub-Debt Financing since the underlying
shares become generally available for resale under an effective registration
statement on July 6, 2007
Since the registration
rights component of the derivative liabilities was not material through
September 30, 2006, there was no cumulative-effect adjustment recorded as a
result of the transition rules with respect to the adoption of EITF-00-19-2 at
December 31, 2006. The Company will continue to review the status of the
registration statement and adjust the accrued liquidated damages under the
registration rights agreements at each quarter end to the extent necessary.
A summary of the
registration penalty accrual at September 30, 2007 and December 31, 2006 is
presented below.
|
|
September 30,
|
|
December 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Senior secured notes payable
|
|
$
|
775,000
|
|
$
|
1,575,000
|
|
Subordinated convertible notes payable
|
|
1,783,000
|
|
2,202,000
|
|
Total registration penalty accrual
|
|
$
|
2,558,000
|
|
$
|
3,777,000
|
|
As of September 30, 2007 and December 31, 2006, approximately
$13,307,000 principal amount was outstanding with respect to the Senior
Financing, and approximately $27,658,000 principal amount was outstanding with
respect to the Sub-Debt Financing. In addition, at September 30, 2007,
approximately $775,000 and $1,783,000 was outstanding with respect to accrued registration
delay penalties to the holders of the Senior Financing and the Sub-Debt
Financing, respectively, and approximately $116,000 and $2,207,000 was
outstanding with respect to accrued interest payable to the holders of the
Senior Financing and the Sub-Debt Financing, respectively. The Company has not
paid the registration delay penalties to either the holders of the Senior Notes
or the Sub-Debt Notes, although it has made advance payments to the holders of
the Senior Notes aggregating $500,000. As a result of the registration failure,
the failure to pay the registration delay penalties and the various financial
covenant and other breaches of the terms of the Senior Financing and the
Sub-Debt Financing, multiple events of default exist under the Senior Financing
and the Sub-Debt Financing. The terms of the Subordination Agreement among the
Company and the creditor parties thereto (the Subordination Agreement)
prevent the Company from making any cash payments to the Sub-Debt Note holders
until the events of default under the Senior Financing are either cured or
waived. Furthermore, upon the occurrence of an event of default, holders of at
least 25% of the outstanding senior indebtedness may declare the outstanding
principal and accrued interest on all senior notes immediately due and payable
upon written notice to the Company, and each holder of outstanding subordinated
indebtedness may only demand redemption of all or any portion of their
respective notes under certain circumstances as described in the Subordination
Agreement.
25
On October 16, 2007, the Company received an Event of Default
Redemption Notice from the holders of approximately $2,693,000 principal amount
of Sub-Debt Notes demanding that the Company redeem their Sub-Debt Notes. The
Company believes and has advised these Sub-Debt Note holders that redemption
(including the demand for redemption) is not permitted under the terms of the
Subordination Agreement. On November 1, 2007, the Company received a copy of a
letter to the Sub-Debt Note holders from Senior Note holders representing
approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note
holders that the Subordination Agreement prohibits the Company from redeeming
any Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any
remedies. The letter further stated that the Senior Note holders were inclined
to give the Company until November 30, 2007 to either cure the existing events
of default or to pay off the obligations to the Senior Note holders in full, or
the Senior Note holders expect they will likely begin to exercise additional
remedies to obtain payment of their outstanding obligations. The Company does
not have the capital resources necessary to cure the existing events of
default, or to repay any accelerated indebtedness or redemption or penalty
amounts.
All quarterly interest payments due on the outstanding senior and
subordinated indebtedness were timely paid by the Company through December 2006.
In addition, the quarterly interest payments due on the outstanding senior
indebtedness in March 2007, June 2007 and September 2007 were timely paid. Pursuant
to the terms of the Subordination Agreement, interest on the outstanding
subordinated convertible notes payable cannot be paid as a result of the
existence of the events of default described herein.
A summary of accrued interest payable at September 30, 2007 and
December 31, 2006 is presented below.
|
|
September 30,
|
|
December 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Senior secured notes payable
|
|
$
|
62,000
|
|
$
|
67,000
|
|
Subordinated convertible notes payable
|
|
2,095,000
|
|
|
|
Liquidated damages payable under
registration rights agreements with respect to:
|
|
|
|
|
|
Senior secured notes payable
|
|
54,000
|
|
|
|
Subordinated convertible notes payable
|
|
112,000
|
|
|
|
Total accrued interest payable
|
|
$
|
2,323,000
|
|
$
|
67,000
|
|
Pursuant to a Forbearance
and Consent Agreement with the investors in the Senior Financing, such
investors agreed to forbear from the exercise of their rights and remedies
under the Senior Financing documents as a result of the events of default with
respect to the unavailability of the Companys registration statement, as well
as certain other events of default that existed or that could come into
existence during the forbearance period, from April 17, 2007 through July 31,
2007, in exchange for aggregate cash payments of $500,000. The payments made by
the Company under the Forbearance and Consent Agreement may be credited against
the registration delay cash penalties or any other amounts ultimately
determined to be due the investors in the Senior Financing. On July 6, 2007,
the Companys registration statement was declared effective by the SEC, thus
making it available to the investors in the Senior Financing and Sub-Debt
Financing. Although the Company and its representatives and advisors are in
ongoing discussions with the investors in the Senior Financing and the
investors in the Sub-Debt Financing as to a comprehensive resolution of the
matters discussed herein, the Company cannot predict the ultimate outcome of
such discussions.
On August 3, 2007, the
Company entered into a Waiver and Forbearance Agreement with the holders of the
Sub-Debt Financing pursuant to which the holders agreed to waive their right to
charge the 12.0% default interest rate triggered by the Companys defaults
under the Subordinated Financing transaction documents and instead charge the
4.0% standard interest rate on the Sub-Debt Notes for the period from July 16,
2007 through August 31, 2007 (the Forbearance Period). The holders of the
Sub-Debt Financing also agreed to forbear from exercising any of their other
rights and remedies under the Sub-Debt Financing transaction documents during
the Forbearance Period, upon the terms and conditions in the Waiver and
Forbearance Agreement. Effective September 1, 2007, the interest rate returned
to the 12.0% default interest rate.
The Forbearance and
Consent Agreement that the Company entered into with the investors in the
Senior Financing did not impact the investors in the Sub-Debt Financing. Since
the Subordination Agreement (as described above) limits the rights of the
investors in the Sub-Debt Financing, the Company has not paid any interest or
penalties to the investors in the Sub-Debt Financing in 2007.
Primarily as a result of
the requirement to restate previously issued financial statements, which
resulted in the recording of an embedded derivative liability, the
reclassification of the senior and subordinated indebtedness to current
liabilities, and the recording of estimated liquidated damages payable under
registration rights agreements, the Company was not in compliance with certain
of its financial covenants under both the Senior Financing and the Sub-Debt
Financing at September 30, 2007 and December 31, 2006.
26
Notwithstanding such
developments, the Company believes that it would have been out of compliance
with certain of its financial covenants at September 30, 2007.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company and its representatives and advisors are in ongoing
discussions with the holders of its senior and subordinated debt obligations to
obtain a waiver of and amendment to certain of the financing documents with
respect to the events of default, the impact of the restatements, the payment
of cash penalties and default interest, and various related matters. The
Company is exploring various alternatives to resolve the defaults under its
senior and secured debt obligations, but is unable to predict the outcome of
such negotiations. To the extent that the Company is unable to restructure its
senior and subordinated debt obligations in a satisfactory manner and/or the
lenders begin to exercise additional remedies to enforce their rights, the
Company will not have sufficient cash resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the
United States Bankruptcy Code.
5.
DERIVATIVE FINANCIAL INSTRUMENTS
In conjunction
with the financing for the acquisition of MediaDefender on July 28, 2005 (see
Notes 3 and 4), the Company completed a $15,000,000 senior secured debt
transaction (the Senior Financing) and a $30,000,000 convertible subordinated
debt transaction (the Sub-Debt Financing). The Company also issued various
warrants in conjunction with such financings.
The Sub-Debt Notes
contain multiple embedded derivative features (both assets and liabilities)
that have been accounted for at fair value as a compound embedded derivative. The
compound embedded derivative associated with the Sub-Debt Notes has been valued
at the date of inception of the Sub-Debt Financing and at the end of each
reporting period thereafter. The compound embedded derivative includes the
following material features: (1) the
standard conversion feature of the debentures, (2) a limitation on the
conversion by the holder, and (3) the Companys right to force conversion.
An independent valuation
firm valued the various derivative features in the compound embedded derivative
and determined that, except for the above-noted features, the remaining
derivative attributes (both assets and liabilities) were immaterial, both
individually and in the aggregate, and they effectively offset one another. The
value of the compound embedded derivative that includes the above-noted
features was bifurcated from the Sub-Debt Notes and recorded as derivative
liability. This initial amount was recorded as a discount on the related
Sub-Debt Notes. This discount is being amortized to interest expense over the
life of the Sub-Debt Notes.
The Company, with the assistance of an independent valuation firm,
calculated the fair value of the compound embedded derivative associated with
the Sub-Debt Notes in accordance with SFAS No. 133 Implementation Issue No.
B15, Embedded Derivatives: Separate
Accounting for Multiple Derivative Features Embedded in a Single Hybrid
Instrument, which requires that when multiple derivatives (both assets and
liabilities) exist within a financial instrument, they are bundled together as a
single hybrid compound instrument. The calculation model utilized a complex,
customized, binomial lattice model suitable for the valuation of path-dependent
American options. The model uses the risk neutral binomial methodology to
simulate the scenarios and stock price paths. The model also uses backward
dynamic programming to value the payoffs at each node considering all the
embedded options simultaneously.
27
The valuation model used the following assumptions for the original
valuation and for each succeeding quarterly valuation:
|
|
2005
|
|
2006
|
|
2007
|
|
Embedded derivatives
|
|
7/28
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Initial fair value of common stock
|
|
$
|
1.43
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value of common stock at each
subsequent reporting period end
|
|
|
|
$
|
2.50
|
|
$
|
3.30
|
|
$
|
4.50
|
|
$
|
3.50
|
|
$
|
3.25
|
|
$
|
2.35
|
|
$
|
1.90
|
|
$
|
2.00
|
|
$
|
1.80
|
|
Conversion price
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
Terminal time period in months
|
|
48
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
31
|
|
28
|
|
25
|
|
22
|
|
Expected return
|
|
4.04
|
%
|
4.18
|
%
|
4.35
|
%
|
4.82
|
%
|
5.10
|
%
|
4.59
|
%
|
4.69
|
%
|
4.58
|
%
|
4.87
|
%
|
3.97
|
%
|
Initial volatility factor
|
|
55
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Volatility factor for each subsequent
reporting period
|
|
|
|
54
|
%
|
59
|
%
|
56
|
%
|
63
|
%
|
63
|
%
|
53
|
%
|
60
|
%
|
56
|
%
|
63
|
%
|
Triggering events to forced conversion:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Event 1 - stock price equal or above
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
$
|
2.32
|
|
Event 2 - daily share trading volume equal
or above
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
200,000
|
|
Lack of liquidity discount for the
limitation on conversion
|
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
The Company determined
that the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19
because share settlement of these financial instruments was not within the
control of the Company, since the Company could not conclude that it had
sufficient authorized but unissued common shares available to satisfy its
potential share obligations under the warrant agreements. The Company reached
this conclusion because: (1) the Company
has an obligation to file a registration statement with the SEC to register the
common stock underlying warrants, and to have such registration statement
declared effective, and to maintain effective such registration statement, or
to pay penalties in the form of liquidated damages for each thirty-day period
that such registration statement is not effective, (2) the warrants contained
dilution protection features, with no limit or cap on the number of shares that
could be issued by the Company pursuant to such provisions, and (3) the
warrants contained certain price reset features. Because the warrants contain
certain anti-dilution and price reset provisions, as well as have registration
rights, the fair value of the warrants was accounted for as a derivative and
presented as warrant liability.
The Company calculated the fair value of the various warrants using the
Black-Scholes option-pricing model, using the volatility factor determined by
the independent valuation firm. The valuation model used the following
assumptions for the original valuation and for each succeeding quarterly
valuation:
|
|
2005
|
|
2006
|
|
2007
|
|
Warrant liability
|
|
7/28
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Initial fair value of common stock
|
|
$
|
1.43
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value of common stock at each
subsequent reporting period end
|
|
|
|
$
|
2.50
|
|
$
|
3.30
|
|
$
|
4.50
|
|
$
|
3.50
|
|
$
|
3.25
|
|
$
|
2.35
|
|
$
|
1.90
|
|
$
|
2.00
|
|
$
|
1.80
|
|
Exercise price:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Senior warrants
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
Sub-debt warrants
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.55
|
|
$
|
1.43
|
|
$
|
1.43
|
|
$
|
1.43
|
|
$
|
1.43
|
|
$
|
1.43
|
|
$
|
1.55
|
|
Libra warrants
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
$
|
2.00
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Time period in months:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Senior warrants
|
|
60
|
|
58
|
|
55
|
|
52
|
|
49
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
Sub-debt warrants
|
|
60
|
|
58
|
|
55
|
|
52
|
|
49
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
Libra warrants
|
|
84
|
|
82
|
|
79
|
|
76
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected return
|
|
4.04
|
%
|
4.18
|
%
|
4.35
|
%
|
4.82
|
%
|
5.10
|
%
|
4.59
|
%
|
4.69
|
%
|
4.58
|
%
|
4.87
|
%
|
3.97
|
%
|
Initial volatility factor
|
|
55
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Volatility factor for each subsequent
reporting period
|
|
|
|
54
|
%
|
59
|
%
|
56
|
%
|
63
|
%
|
63
|
%
|
53
|
%
|
60
|
%
|
56
|
%
|
63
|
%
|
The Companys Sub-Debt
Notes contain compound embedded derivatives (as described above) that required
that they be bifurcated from the debt host instrument at the date of issuance
and valued. The calculation of the fair value of the compound embedded
derivatives required the use of a more sophisticated valuation model than a
Black-Scholes option-pricing model. Accordingly, the Company retained an
independent valuation firm to calculate the fair value of the compound embedded
derivatives, and the changes in fair value at each subsequent period end.
28
The Company, with the
assistance of the independent valuation firm, calculated the fair value of the
compound embedded derivatives associated with the Sub-Debt Notes in accordance
with SFAS No. 133 Implementation Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple Derivative
Features Embedded in a Single Hybrid Instrument, by utilizing a complex,
customized, binomial lattice model suitable in the valuation of path-dependent
American options. This model utilized subjective and theoretical assumptions
that can materially affect fair values from period to period.
The independent valuation firm concluded that the Companys historical
pattern of stock prices as of July 28, 2005, and for some time thereafter,
would not provide a sufficient indication of the long-term expected volatility
of the Companys stock going forward for purposes of the calculation of the
fair value of the compound embedded derivatives, due to the significant changes
in the business operations and capital structure of the Company on July 28,
2005 as a result of the acquisition of MediaDefender and the related financing
transactions.
Accordingly,
the Companys independent valuation firm based its calculation of the
Companys expected stock price volatilities on the volatility factors of
similar public companies. The independent valuation firm identified four
companies that were similar to the Company in terms of industry, market
capitalization, stock price and profitability:
Easylink Services Corporation; Forgent Networks, Inc.; Inforte Corp.;
and Think Partnership, Inc. Using historical stock returns data for a period of
one year, the independent valuation firm calculated the volatilities of these
companies at the various reporting dates. The expected volatilities for the
Company as of the reporting dates were calculated based on the average of the
volatilities of these comparable companies. The resulting volatilities were
then used to calculate the fair value, and the changes in fair value, of the
Companys compound embedded derivative liabilities at each period end. The
Company also utilized these volatilities to calculate the fair value, and the
changes in fair value, of the Companys warrant derivative liabilities at each
period end.
Paragraph
A32 of SFAS No. 123R lists factors to consider in estimating expected
volatility. The independent valuation firm retained by the Company to value the
compound embedded derivatives contained in the Sub-Debt Notes determined that
the appropriate methodology to calculate volatility with respect to the Companys
compound embedded derivatives was to
consider the Company as similar to a newly public
company without a trading history because of the significant transformative
changes resulting from the acquisition and financing of the MediaDefender transaction
on July 28, 2005. With reference to newly public companies, section (c) of
paragraph A32 of SFAS No. 123R suggests that the expected volatility of similar
entities be considered. The independent valuation firm arrived at this
determination due to the Companys acquisition of MediaDefender on July 28,
2005 and the related equity-based financing transactions that provided the
capital to fund the acquisition.
6. MEDIADEFENDER
SECURITY BREACH
During the weekend of
September 15 and 16, 2007, MediaDefender experienced an unlawful online
security breach by hackers, which resulted in approximately 6,000 e-mails, as
well as access to other confidential information and data, for the period from
mid-December 2006 through September 10, 2007 being stolen and posted at
numerous web-sites on the Internet. These e-mails contained confidential
information and communications covering a wide variety of internal issues,
including personal data, customer data and pricing information, and other
sensitive information. This matter has been referred to the appropriate
federal, state and local law enforcement organizations and an investigation is
ongoing. An internal investigation of this matter is continuing, as a result of
which the Company has revised various procedures and policies and enhanced its
online and Internet security protocols. The Company does not believe that this
breach has any impact on the Companys accounting and financial controls or
reporting systems.
As a result of this
development, MediaDefender recorded approximately $600,000 for service credits
to customers, which were recorded as a reduction to revenues during the three
months ended September 30, 2007. This amount was determined based on various
factors, including discussions with customers, and is subject to adjustment in
future periods based on additional information. MediaDefender also recorded
approximately $225,000 of legal, consulting and other direct costs related to
the breach during the three months ended September 30, 2007.
7. GOODWILL
Goodwill
at September 30, 2007 and December 31, 2006 was $31,085,000, which was recorded
in conjunction with the acquisition of MediaDefender in July 2005 (see Note
3). In accordance with SFAS No. 142, Goodwill and Other Intangible
Assets, an intangible asset that is not subject to amortization such as
goodwill shall be tested for impairment at least on an annual basis, and more
often under certain circumstances, and written down when impaired. An
interim impairment test is required if an event occurs or conditions change
that would more likely than not reduce the fair value of the reporting unit
below its carrying value. The first step of the impairment test consists of a
comparison of the total fair value of each reporting unit to the reporting
units net assets on the date of the test.
29
If
the fair value is in excess of the net assets, there is no indication of
impairment and thus no need to perform the second step of the impairment
test.
During
the three months ended September 30, 2007, the Company performed its
second annual impairment test relating to the acquisition of MediaDefender and
determined that there was no indication of impairment.
The
Company does not currently believe that there is a long-term impact on Media
Defender due to the security breach described at Note 6. However, due to the
fluid nature of the situation as it relates to the status of MediaDefenders
customer relationships and future business prospects, this assessment could change.
Accordingly, the Company intends to perform another impairment test at December
31, 2007.
8. RELATED PARTY
TRANSACTIONS
Effective
as of January 1, 2006, the Company
entered into a one-year
consulting agreement with Eric Pulier, a director of the Company, through WNT
Consulting Group, a California limited liability company wholly-owned by Mr.
Pulier (WNT). The consulting agreement was approved by the disinterested
members of the Companys Board of Directors. Effective January 12, 2007, the
parties mutually agreed to terminate this consulting agreement, which had
automatically renewed for a second one-year term through December 31,
2007. Under the terms of the original consulting agreement, Mr. Pulier
received a base fee of $10,000 per month, certain other mandatory payments, and
was also eligible to receive cash bonuses on the achievement of certain
specified milestones. Mr. Pulier had also agreed to waive all stock
options and other stock-based compensation granted to outside members of the Companys
Board of Directors during the term of his original consulting agreement. The
termination agreement provided for a one-time cash payment to Mr. Pulier
(through WNT) in the amount of $100,000 (which was paid in January 2007), in
consideration for the termination of the consulting agreement and an
acknowledgement and complete release of any and all claims related to unpaid
compensation, bonus amounts or other out-of-pocket expenses (in cash or
otherwise) that may have been owed by the Company as of January 12, 2007. The
termination agreement was approved by the Compensation Committee of the Companys
Board of Directors. Mr. Pulier will continue to serve as a member of the
Companys Board of Directors.
On January 12, 2007, the
Company entered into a new consulting agreement with Mr. Pulier (through
WNT). During the term of the new consulting agreement, which commenced
January 12, 2007 and continues in effect until any party provides ten days
prior written notice to the other parties of its intention to terminate, Mr.
Pulier will provide non-exclusive consulting and advisory services to the
Company outside of the ordinary course of his services as a member of the Board
of Directors. In consideration, Mr. Pulier (through WNT) is entitled to
receive hourly compensation at the rate of $500 per hour. Any consulting
request made by the Company must be approved in advance by all parties prior to
commencement of services. The new consulting agreement was approved by
the Compensation Committee of the Companys Board of Directors. During the
three months and nine months ended September 30, 2007, Mr. Pulier (through WNT)
did not earn any fees under the new consulting agreement.
Effective
August 31, 2007, Robert N. Weingarten, the Chief Financial Officer and Secretary
of the Company resigned from all positions he held with the Company. The
Company and Mr. Weingarten entered into a Separation Agreement and Release
dated August 31, 2007, whereas the Company and Mr. Weingarten mutually agreed
to terminate their employment relationship as of August 31, 2007 and the
parties released each other from any and all claims. As a result of this
resignation, the Company and Mr. Weingarten entered into an Agreement for
Consulting Services (the Consulting Agreement) dated August 31, 2007 whereas
Mr. Weingarten will be retained as a consultant for a twelve-month period,
unless sooner terminated pursuant to the terms of the Consulting Agreement, and
shall be paid a base consulting fee of $16,250 per month.
In
addition, the Company and Mr. Weingarten entered into an Omnibus Stock Option
Amendment Agreement (the Option Agreement) dated August 31, 2007 whereas the
Company agreed to amend certain provisions of stock options previously granted
to Mr. Weingarten (see Note 9). Mr. Weingarten will be allowed to exercise the
120,000 stock options granted to him in 2004 until the original expiration date
of March 29, 2011 without regard to his resignation from the Company. Pursuant
to the Option Agreement, the vesting of time-vesting options to acquire 275,000
shares shall be accelerated provided he does not breach the Consulting
Agreement such that the remaining unvested time-vesting options became fully
vested and exercisable as of August 31, 2007. The vesting of the
performance-vesting options to acquire 275,000 shares shall occur only upon the
closing of a sale, merger or other change of control transaction at a price
above $3.10 per share occurring prior to August 31, 2008 provided he does not
breach the Consulting Agreement. In addition, Mr. Weingarten will be able
to exercise the time-vesting options and the performance-vesting options, if
vested, until August 5, 2010, without regard to his resignation provided he
does not breach the Consulting Agreement.
30
During
the three months and nine months ended September 30, 2007, the Company incurred
legal fees of $3,000 and $6,000, respectively, to Davis Shapiro Lewit &
Hayes, LLP, a law firm in which Fred Davis, a director of the Company, is a
partner. During the three months and nine months ended September 30, 2006, the
Company incurred legal fees to such law firm of $61,000 and $63,000,
respectively.
9. EQUITY-BASED
TRANSACTIONS
On May 6, 2005, the Company issued to a
consultant a stock option to purchase an aggregate of 22,000 shares of the
Companys common stock pursuant to the Companys 1999 Employee Stock Option
Plan exercisable for a period of five years at $1.00 per share, the market
price on the date of the grant, pursuant to a short-term consulting agreement. The
option was subject to milestones, one of which was partially attained during
the nine months ended September 30, 2006, as a result of which options for
10,000 shares vested during such period. The fair value of the vested portion
of this option, calculated pursuant to the Black-Scholes option-pricing model,
of $35,000 was charged to operations during the nine months ended September 30,
2006.
During
the nine months ended September 30, 2006, the Company issued 84,287 shares of
common stock upon the exercise of stock options previously issued to employees
and consultants, and received cash proceeds of approximately $71,000.
During
the nine months ended September 30, 2006, the Company issued 2,112,902 shares
of common stock upon the conversion of $3,275,000 of subordinated convertible
notes payable. As a result, $1,580,000 was charged to operations during
the nine months ended September 30, 2006, consisting of related deferred
financing costs of $349,000, debt discount costs related to warrants of
$292,000, and debt discount costs related to embedded derivatives of $939,999. There
were no conversions during the three months ended September 30, 2006.
Effective
April 7, 2006, the Company entered into various agreements with the
investors in its Senior Financing and Sub-Debt Financing (see Note 4) to amend
their respective registration rights agreements and to amend and waive certain
financial covenants. In consideration thereof, the Company offered to
temporarily reduce the exercise price of the 3,250,000 warrants held by the
investors in the Senior Financing from $2.00 to $1.85 per share through April
30, 2006, and agreed to permanently reduce the exercise price of the 1,596,744
warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43
per share on certain terms and conditions. Any exercise of the
aforementioned warrants at the reduced exercise price was required to be for
cash only. The conversion price of the Sub-Debt Notes of $1.55 per share
was not affected. The Company also entered into similar agreements, as
applicable, and provided identical temporary and permanent reductions to
warrant exercise prices, with Broadband Capital Management LLC (1,516,935
warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500
warrants originally exercisable at $2.00 per share). The Company also
agreed to utilize 25% of the net proceeds from the exercise of the warrants
held by the investors in the Senior Financing to reduce the respective principal
balances on the Senior Notes payable held by such exercising investors, and to
pay any related unpaid accrued interest on such principal payments.
Effective April 27, 2006,
certain of the investors in the Senior Financing exercised their warrants to purchase
2,816,667 shares of common stock at $1.85 per share, resulting in the issuance
of 2,816,667 shares of common stock in exchange for cash proceeds of
$5,212,000, of which $1,303,000 was used to reduce the respective principal
balances on the Senior Notes payable held by such exercising investors (see
Note 4).
Effective April 19, 2006,
the Libra Warrant was exercised on a cashless basis at $2.00 per share,
resulting in the issuance of 123,864 shares of common stock (see Note 4).
As
a result of the exercise by the warrant holders of certain of the Senior
Warrant Shares and of the Libra Warrant Shares during April 2006, $9,311,000 of
the warrant liability at March 31, 2006 was transferred to additional paid-in
capital during the nine months ended September 30, 2006.
As
a result of the aforementioned warrant exercise price reductions, the Company
recorded a charge to operations during the nine months ended September 30, 2006
for the aggregate fair value of such exercise price reductions of $641,000,
consisting of $218,000 relating to the warrants held by the investors in the
Sub-Debt Financing and $423,000 relating to the warrants held by the investors
in the Senior Financing (see Note 4).
Information with respect to common stock and stock options issued pursuant
to consulting agreements during the three months and nine months ended
September 30, 2007 is provided at Note 8.
31
As a result of the
resignation of the Companys former Chief Financial Officer effective August
31, 2007 (see Note 8), the Company agreed to amend certain provisions of stock
options previously granted to the former Chief Financial Officer, including the
accelerated vesting of certain options. The Company recorded the fair value of
these amendments, calculated pursuant to the Black-Scholes option-pricing
model, of $215,000 as a charge to operations during the three months and nine
months ended September 30, 2007. The assumptions used in the Black-Scholes
option-pricing model to calculate the fair value of the amendments to the
options were as follows:
Stock price on date of grant
|
|
$3.00
|
|
Risk-free interest rate
|
|
5.0
|
%
|
Volatility
|
|
146.3
|
%
|
Dividend yield
|
|
0
|
%
|
Weighted average expected life (years)
|
|
5
|
|
Weighted average fair value of option
|
|
$2.81
|
|
2006 Equity
Incentive Plan:
During the three months
and nine months ended September 30, 2007, the Company issued 5,769 shares and
17,307 shares of common stock, respectively, pursuant to a consulting agreement
(see Note 10), and options to purchase 15,000 shares and 470,000 shares of
common stock, respectively, including options to purchase 0 and 350,000 shares
to management, respectively, as discussed below.
Effective February 2,
2007, the Company issued to Rene L. Rousselet, the Companys Corporate
Controller and Chief Accounting Officer, a stock option to purchase 50,000
shares of common stock exercisable through February 2, 2012 at $1.50 per share,
the fair market value on the date of grant. The stock option vests and becomes
exercisable in equal installments on March 31, 2007, June 30, 2007, September
30, 2007 and December 31, 2007. The fair value of the stock option, determined
pursuant to the Black-Scholes option-pricing model, was $60,000, of which
$15,000 and $45,000 were charged to operations during the three months and nine
months ended September 30, 2007, respectively.
Effective February 2,
2007, the Company issued to its newly-appointed Vice President of Worldwide
Sales, a stock option to purchase 300,000 shares of common stock exercisable
through February 2, 2012 at $1.50 per share, the fair market value on the date
of grant. The option with respect to 175,000 shares vests in seven equal
quarterly installments on June 30, 2007, September 30, 2007, December 31, 2007,
March 31, 2008, June 30, 2008, September 30, 2008 and December 31, 2008, and
the option with respect to 125,000 shares vests on the achievement of
performance targets to be mutually determined by the parties. The fair value of
the time-vested portion of this stock option, determined pursuant to the
Black-Scholes option-pricing model, was $208,000, of which $30,000 and $60,000
were charged to operations during the three months and nine months ended
September 30, 2007.
Effective June 29, 2007,
the Company issued to its six non-officer directors stock options to purchase
an aggregate of 80,000 shares exercisable through June 29, 2012 at $2.00 per
share, the fair market value on the date of grant. The options vested 50% on
June 30, 2007 and 25% each on September 30, 2007 and December 31, 2007. The
fair value of these stock options, determined pursuant to the Black-Scholes
option-pricing model, was $130,000, of which $32,500 and $97,500 were charged
to operations during the three months and nine months ended September 30, 2007.
The assumptions used in
the Black-Scholes option-pricing model to calculate the fair value of the
aforementioned options were as follows:
Stock price on date of grant
|
|
$1.50 $2.00
|
|
Risk-free interest rate
|
|
4.84 4.88
|
%
|
Volatility
|
|
1.065 1.116
|
%
|
Dividend yield
|
|
0
|
%
|
Weighted average expected life (years)
|
|
5
|
|
Weighted average fair value of option
|
|
$1.19 $1.62
|
|
32
A summary of stock option
activity under the 2006 Equity Incentive Plan during the nine months ended
September 30, 2007 is as follows:
|
|
Options Outstanding
|
|
|
|
Number
of Shares
|
|
Weighted
Average
Exercise Price
|
|
|
|
|
|
|
|
Options outstanding at December 31,
2006
|
|
126,551
|
|
$
|
3.20
|
|
Granted
|
|
480,000
|
|
$
|
1.63
|
|
Exercised
|
|
|
|
|
|
Canceled/Expired
|
|
|
|
|
|
Options outstanding at September 30, 2007
|
|
606,551
|
|
$
|
1.96
|
|
Options exercisable at September 30, 2007
|
|
322,801
|
|
$
|
2.33
|
|
The weighted average grant date fair value of stock options issued
during the nine months ended September 30, 2007 was $1.63 per share.
The intrinsic value of exercisable but unexercised in-the-money options
at September 30, 2007 was $29,000.
1999 Employee
Stock Option Plan:
A summary of
stock option activity under the 1999 Employee Stock Option Plan during the nine
months ended September 30, 2007 is as follows:
|
|
Options Outstanding
|
|
|
|
Number of
Shares
|
|
Weighted
Average
Exercise
Price
|
|
|
|
|
|
|
|
Options outstanding at December 31,
2006
|
|
864,762
|
|
$
|
3.88
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
(35,375
|
)
|
$
|
0.79
|
|
Canceled/Expired
|
|
(8,394
|
)
|
$
|
120.56
|
|
Options outstanding at September 30, 2007
|
|
820,993
|
|
$
|
2.82
|
|
Options exercisable at September 30, 2007
|
|
668,612
|
|
$
|
2.78
|
|
The intrinsic value of exercisable but unexercised in-the-money options
at September 30, 2007 was $133,000. The intrinsic value of options exercised
during the nine months ended September 30, 2007 and 2006 was $45,000 and
$253,000, respectively.
As of September 30, 2007, unrecognized compensation cost related to
unvested stock options will be charged to operations as follows (amounts are in
thousands):
Years Ending December 31,
|
|
|
|
2007 (three months)
|
|
$
|
401
|
|
2008
|
|
1,002
|
|
2009
|
|
26
|
|
Total
|
|
$
|
1,429
|
|
10. COMMITMENTS
AND CONTINGENCIES
Employment
Agreements:
In connection
with the acquisition of MediaDefender (see Note 3), the Company acknowledged
the terms of Employment Agreements entered into on July 28, 2005 by
MediaDefender with each of Randy Saaf, who serves as Chief Executive Officer of
MediaDefender, and Octavio Herrera, who serves as President of MediaDefender. Mr. Saaf
and Mr. Herrera will each earn a base salary of no less than $350,000 per
annum during the initial term of the agreements, which continue until
December 31, 2008, and are also entitled to receive performance bonuses of
up to $350,000 if MediaDefender achieves defined operating earnings before
interest, taxes, depreciation and amortization (calculated using the same
accounting methods and policies as MediaDefender has historically used)
exceeding $7,000,000 and $7,500,000 in fiscal 2007 and fiscal 2008,
respectively. The Company has recorded a charge to general and administrative
expense and an accrued liability of $175,000 and $525,000 during the three
months and nine months ended September 30, 2007, respectively, with respect to
this matter.
33
Consulting
Agreements:
On October 9, 2006, the
Company entered into an eighteen-month non-exclusive consulting agreement with
Wood River Ventures, LLC and Jonathan Dolgen for consulting and advisory
services with respect to the business and operations of the Company. The
consulting agreement provided for an aggregate cash fee of $187,500, payable
quarterly in six installments of $31,250, and a stock award valued at $112,500,
consisting of 34,615 shares of common stock based on the Companys closing
stock price on October 10, 2006 of $3.25 per share to be issued under the
Companys 2006 Equity Incentive Plan. The shares vest pro rata over the
eighteen-month period of the consulting agreement, beginning on October 10,
2006 and thereafter monthly on the first day of each month of the term of the
consulting agreement through March 2008. In accordance with EITF 96-18, Accounting
for Equity Instruments That Are Issued to Other Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services, the shares granted under
this consulting agreement are valued each month based on the closing market
price on the first day of each month to determine the amount to be recorded as
a charge to operations over the eighteen-month term of the consulting agreement.
Accordingly, during the three months and nine months ended September 30, 2007,
the Company issued 5,769 and 17,307 shares of common stock, respectively, under
this consulting agreement and recorded a related charge to operations of
$19,000 and $57,000, respectively, during such periods.
On October 1,
2006, the Company entered into a one-year non-exclusive consulting agreement
with an entity for business development consulting services. The consulting
agreement provided for a base monthly fee of $7,500, certain
performance-related bonuses, and stock options to acquire 5,000 shares of
common stock on the last day of each month of the term of the consulting
agreement through September 30, 2007. Accordingly, during the three months and
nine months ended September 30, 2007, the Company issued options to acquire
15,000 shares and 45,000 shares of common stock pursuant to the Companys 2006
Equity Incentive Plan, exercisable through November 30, 2011, at prices ranging
from $1.55 to $2.30 per share, the market price on the date of each grant. The
options were fully vested when issued. The aggregate fair value of the options,
calculated pursuant to the Black-Scholes option-pricing model, of $25,000 and
$71,000, respectively, was charged to operations during the three months and
nine months ended September 30, 2007. The assumptions used in the Black-Scholes
option-pricing model to calculate the fair value of the options were as
follows:
Stock price on date of grant
|
|
$1.55 - $2.30
|
|
Risk-free interest rate
|
|
4.82 5.06
|
%
|
Volatility
|
|
105.8 114.0
|
%
|
Dividend yield
|
|
0
|
%
|
Weighted average expected life (years)
|
|
4.25 4.85
|
|
Weighted average fair value of option
|
|
$1.22 - $1.80
|
|
Sub-Lease
Agreement:
On
January 30, 2006, the Company entered into a sub-lease agreement for new
office facilities in Santa Monica, California, effective February 2, 2006
through November 30, 2011, to house the operations of ADI and
MediaDefender. In connection with the sub-lease agreement, the Company provided
an irrevocable standby bank letter of credit for $180,000 as security for the
Companys obligations under the sub-lease agreement, which was secured by cash
of $180,000, which was classified as restricted cash in the Companys balance
sheet. Pursuant to the terms of the sub-lease agreement, the letter of credit
was reduced to $90,000 during February 2007.
This lease contains predetermined fixed increases in the minimum rental
rate during the initial lease term. The Company began to recognize the related
rent expense on a straight-line basis on the effective date of the lease. The
Company records the difference between the amount charged to expense and the
rent paid as deferred rent on the Companys balance sheet.
34
Future cash payments
under such operating lease are as follows (amounts are in thousands):
Years Ending December 31,
|
|
|
|
|
|
|
|
2007 (three months)
|
|
$
|
114
|
|
2008
|
|
469
|
|
2009
|
|
483
|
|
2010
|
|
498
|
|
2011
|
|
470
|
|
|
|
$
|
2,034
|
|
Sufficiency of Authorized but Unissued Shares:
The Company has concluded, for the reasons described
below, that it is highly probable
that the Company will have sufficient shares available to satisfy its existing
option and warrant obligations to officers, directors, employees, consultants,
advisors and others for the foreseeable future (excluding the warrants issued
in conjunction with the financing of the MediaDefender transaction described at
Note 4, which are accounted for as a derivative liability).
Paragraphs 28 to 35 of SFAS No. 123R describe the
types of equity awards that should be classified as a liability, including an
option (or similar instrument) that could require the employer to pay an
employee cash or other assets, unless cash settlement is based on a contingent
event that is (a) not probable
and (b) outside the control of the employee. The Company has concluded that any
cash settlement obligation represented by its outstanding options and warrants
issued to employees, officers and directors would be triggered only by a
contingent event that is both not
probable and is outside the control of the equity holder.
Most of the Companys outstanding options and warrants
were issued to employees, officers and directors in compensatory transactions
accounted for under SFAS No. 123R. Of the 5,642,671 options and warrants
outstanding at September 30, 2007, 5,224,484 were issued to employees, officers
and directors. The potential impact pursuant to EITF 00-19-2 of the remaining
418,187 options and warrants issued to consultants, advisors and others is not
material to the consolidated financial statements.
The Company currently has 60,000,000 shares of common
stock authorized, of which 10,333,127 shares of common stock were issued at
September 30, 2007, resulting in 49,649,566 unissued shares at such date. If
all of the Companys equity-based instruments were converted or exercised into
shares of common stock in accordance with their respective original terms,
without regard to whether such instruments have vested or are in-the-money,
approximately 28,000,000 additional shares would be issued, resulting in a
total of approximately 38,000,000 shares of common stock issued and outstanding.
Accordingly, this calculation results in approximately 22,000,000 shares of
common stock available for issuance, in excess of all equity commitments that
the Company currently has outstanding.
The Company has approximately $27,658,000 of Sub-Debt
Notes outstanding at September 30, 2007, which are convertible into common
stock at $1.55 per share and which represent the single largest component of
such potential dilution (approximately 17,850,000 shares). However, the
financing agreements contain provisions that expressly prohibit the Company
from issuing shares to a Sub-Debt Note holder if after the conversion, such Sub-Debt
Note holder would exceed the respective limit called for in their Sub-Debt
Note, either 4.99% or 9.99% of the Companys outstanding common shares, thus it
is very unlikely that all of the 17,850,000 shares issuable to the holders of
the Sub-Debt Notes would be issued at one time or even in a short period of
time.
Accordingly, based on the foregoing analysis and the
Companys current capital structure, the Company has concluded that it is
highly probable that the Company
will have sufficient shares available to satisfy its existing option and
warrant obligations for the foreseeable future. The Company will continue to
evaluate this issue and if it becomes probable that there are insufficient
authorized shares, the Company will consider alternative accounting treatment
at that time.
Legal Matters:
The Company is periodically subject to various pending and threatened
legal actions that arise in the normal course of business. The Companys
management believes that the impact of any such litigation will not have a
material adverse impact on the Companys financial position or results of
operations.
35
11.
INCOME TAXES
As a result of the non-deductibility of certain non-cash charges and
accruals and the non-inclusion of certain non-cash gains for tax reporting
purposes, the Company incurred a taxable loss during the three months and nine
months ended September 30, 2007 and therefore did not record a provision for
income taxes for such periods.
As
a result of the profitable operations of MediaDefender during the three months
and nine months ended September 30, 2006, the non-deductibility of certain
non-cash charges and accruals for tax reporting purposes, and permanent
limitations on the Companys ability to utilize its net operating loss
carry-forwards, the Company recorded a provision for income taxes of $536,000
and $797,000 for the three months and nine months ended September 30, 2006,
respectively.
At
December 31, 2006, the Company had net operating loss carryforwards of
approximately $111,000,000 for Federal income tax purposes expiring beginning
in 2020 and California state net operating loss carryforwards of approximately
$102,000,000 expiring beginning in 2008.
In assessing
the potential realization of deferred tax assets, management considers whether
it is more likely than not that some portion or all of the deferred tax assets
will be realized. The ultimate realization of deferred tax assets (primarily
net operating loss carryforwards) is dependent upon the Company attaining
future taxable income during the periods in which those temporary differences
become deductible. As of September 30, 2007 and December 31, 2006, management
was unable to determine if it is more likely than not that the Companys
deferred tax assets will be realized and has therefore recorded an appropriate
valuation allowance against deferred tax assets at such dates.
Due to the restrictions imposed by Internal Revenue Code
Section 382 regarding substantial changes in the stock ownership of
companies with loss carryforwards, the utilization of the Companys federal net
operating loss carryforward was severely limited as a result of the change in
the effective stock ownership of the Company resulting from the debt financings
arranged in conjunction with the acquisition of MediaDefender.
As of September 30, 2007, the Companys 2005 U.S. federal income tax
return was undergoing examination by the Internal Revenue Service. The Internal
Revenue Service has proposed various adjustments to the Companys 2005 taxable
income. Estimated taxes and interest relating to such adjustments have been
accrued as income taxes payable. As the Internal Revenue Service has not
completed its examination, the Company is unable to predict the final outcome
of the examination.
12. CONCENTRATIONS AND
SEGMENT INFORMATION
During
the three months and nine months ended September 30, 2007 and 2006, the Companys
operations consisted of three reportable segments: e-commerce, media, and anti-piracy and
file-sharing services.
Concentrations:
During the three months
ended September 30, 2007 and 2006, approximately 53% and 69%, respectively, of
e-commerce revenues were generated from the products related to a single
merchandising entity. During the nine months ended September 30, 2007 and 2006,
approximately 59% and 69%, respectively, of e-commerce revenues were generated
from the products related to a single merchandising entity. The Company
restructured its relationship with this merchandising entity effective August
31, 2007 to eliminate merchandise sales and focus on music sales, which will
have a significant negative impact on future e-commerce revenues, although it
is expected to have a limited impact on operating margins.
During the three months and
nine months ended September 30, 2007, the Companys media revenues were
generated by two outsides sales organizations that represented the Company with
respect to advertising and sponsorship on the Companys web-site and through
affiliated web-sites, as well as by in-house sales personnel. During the three
months and nine months ended September 30, 2006, the Companys media revenues
were generated primarily by a single outside sales organization. During the
three months September 30, 2007, two customers accounted for approximately
$423,000 and $324,000 of media revenues, representing 21% and 16% of media
revenues, respectively. During the nine months ended September 30, 2007, one
customer accounted for approximately $847,000 of media revenues, representing
16% of media revenues.
During
the three months ended September 30, 2007, approximately 66% of MediaDefenders
consolidated revenues were from four customers, with one customer accounting
for 21%, a second customer accounting for 18%, a third customer accounting for
15%, and a fourth customer accounting for 12%. During the three months ended
September 30, 2006, approximately 68% of MediaDefenders consolidated revenues
were from four customers, with one customer accounting for 23%, a second
customer accounting for 20%, a third customer accounting for 15%, and a fourth
customer accounting for 10%.
36
During
the nine months ended September 30, 2007, approximately 66% of MediaDefenders
consolidated revenues were from four customers, with one customer accounting
for 20%, a second customer accounting for 17%, a third customer accounting for
17%, and a fourth customer accounting for 12%. During the nine months ended
September 30, 2006, approximately 67% of MediaDefenders consolidated revenues
were from four customers, with one customer accounting for 25% , a second
customer accounting for 21%, a third customer accounting for 11%, and a fourth
customer accounting for 10%. At September 30, 2007, the amounts due from these
four customers were $1,274,000, $1,054,000, $520,000, and $510,000,
respectively, which were included in accounts receivable.
During
the three months ended September 30, 2007, MediaDefender purchased
approximately 88% of its bandwidth from four suppliers. During the nine months
ended September 30, 2007, MediaDefender purchased approximately 75% of its
bandwidth from five suppliers.
During
the three months ended September 30, 2006, MediaDefender purchased
approximately 73% of its bandwidth from three suppliers. During the nine months
ended September 30, 2006, MediaDefender purchased approximately 67% of its
bandwidth from three suppliers.
At
September 30, 2007, amounts payable to these suppliers aggregated approximately
$4,000. Although there are other suppliers of bandwidth, a change in suppliers
could cause delays, which could adversely affect operations in the short-term.
Segment
Information:
Information
with respect to the Companys operating segments for the three months and nine
months ended September 30, 2007 and 2006 is presented below.
The factors for determining reportable segments were based on services
and products. Each segment is responsible for executing a unique marketing and
business strategy. The Company evaluates performance based on, among other
factors, earnings or loss before interest, taxes, depreciation and amortization
(Adjusted EBITDA). Adjusted EBITDA also excludes stock-based compensation,
changes in the fair value of warrant liability and derivative liability, and
other non-cash write-offs and charges. Included in Adjusted EBITDA are direct
operating expenses for each segment.
The following
table summarizes net revenue and Adjusted EBITDA by operating segment for the
three months and nine months ended September 30, 2007 and 2006. Corporate
expenses consist of general operating expenses that are not directly related to
the operations of the segments. A reconciliation of Net Income (Loss) to
Adjusted EBITDA is also provided.
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
(in thousands)
|
|
Net Revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
337
|
|
$
|
663
|
|
$
|
1,340
|
|
$
|
1,917
|
|
Media
|
|
1,974
|
|
1,572
|
|
5,139
|
|
3,937
|
|
Anti-piracy and file-sharing marketing
services
|
|
3,627
|
|
4,158
|
|
11,498
|
|
11,781
|
|
|
|
$
|
5,938
|
|
$
|
6,393
|
|
$
|
17,977
|
|
$
|
17,635
|
|
|
|
|
|
|
|
|
|
|
|
EBITDA:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
(71
|
)
|
$
|
27
|
|
$
|
(194
|
)
|
$
|
33
|
|
Media
|
|
667
|
|
771
|
|
1,744
|
|
1,495
|
|
Anti-piracy and file-sharing marketing services
|
|
1,009
|
|
2,435
|
|
4,140
|
|
7,230
|
|
|
|
1,605
|
|
3,233
|
|
5,690
|
|
8,758
|
|
Corporate general and administrative
expenses
|
|
(1,178
|
)
|
(870
|
)
|
(3,816
|
)
|
(3,430
|
)
|
Reduction in liquidated damages payable
under registration rights agreements
|
|
|
|
|
|
719
|
|
|
|
|
|
$
|
427
|
|
$
|
2,363
|
|
$
|
2,593
|
|
$
|
5,328
|
|
37
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
(in thousands
)
|
|
Reconciliation of Adjusted EBITDA to Net
Income (Loss):
|
|
|
|
|
|
|
|
|
|
Adjusted EBITDA per segments
|
|
$
|
427
|
|
$
|
2,363
|
|
$
|
2,593
|
|
$
|
5,328
|
|
Stock-based compensation
|
|
(702
|
)
|
(652
|
)
|
(1,690
|
)
|
(1,736
|
)
|
Depreciation and amortization
|
|
(276
|
)
|
(145
|
)
|
(723
|
)
|
(405
|
)
|
Amortization of intangible assets
|
|
(888
|
)
|
(937
|
)
|
(2,714
|
)
|
(2,813
|
)
|
Amortization of deferred financing costs
|
|
(212
|
)
|
(212
|
)
|
(629
|
)
|
(646
|
)
|
Write-off of unamortized discount on debt
and deferred financing costs due to principal payments on senior secured notes
payable and conversion of subordinated convertible notes payable
|
|
|
|
|
|
|
|
(1,580
|
)
|
Interest income
|
|
59
|
|
45
|
|
160
|
|
76
|
|
Other income
|
|
|
|
10
|
|
|
|
63
|
|
Interest expense, including amortization of
discount on debt of $777 and $779 for the three months ended September 30,
2007 and 2006, and $2,306 and $2,363 for the nine months ended September 30,
2007 and 2006
|
|
(1,805
|
)
|
(1,472
|
)
|
(5,733
|
)
|
(4,411
|
)
|
Change in fair value of warrant liability
|
|
512
|
|
1,139
|
|
1,643
|
|
(1,818
|
)
|
Change in fair value of derivative
liability
|
|
2,702
|
|
1,236
|
|
7,056
|
|
(2,765
|
)
|
Reduction in exercise price of warrants
|
|
|
|
|
|
|
|
(641
|
)
|
Write-off of fixed assets
|
|
|
|
|
|
(97
|
)
|
|
|
Provision for income taxes
|
|
|
|
(536
|
)
|
|
|
(797
|
)
|
Net income (loss)
|
|
$
|
(183
|
)
|
$
|
839
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
The following
table summarizes assets as of September 30, 2007 and December 31, 2006. Assets
by segment are those assets used in or employed by the operations of each
segment. Corporate assets are principally made up of cash and cash equivalents,
short-term investments, prepaid expenses, computer equipment, leasehold
improvements and other assets.
|
|
September
30, 2007
|
|
December
31, 2006
|
|
|
|
(in thousands)
|
|
Assets:
|
|
|
|
|
|
Corporate
|
|
$
|
2,611
|
|
$
|
2,791
|
|
E-commerce
|
|
256
|
|
1,383
|
|
Media
|
|
2,614
|
|
3,730
|
|
Anti-piracy and file-sharing marketing
services
|
|
46,576
|
|
47,068
|
|
|
|
$
|
52,057
|
|
$
|
54,972
|
|
38
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
Overview:
The Company conducts
its media and e-commerce business operations through an online music network
appealing to music fans, artists and marketing partners. The ARTISTdirect
Network (www.artistdirect.com) is a network of web-sites offering multi-media
content, music news and information, communities organized around shared music
interests, music-related specialty commerce and digital music services.
On
July 28, 2005, the Company completed the acquisition of
MediaDefender, Inc., a privately-held Delaware corporation (MediaDefender),
which is a leading provider of anti-piracy solutions in the
Internet-piracy-protection (IPP) industry. This transaction was accounted for
as a purchase in accordance with SFAS No. 141, Business Combinations,
and the operations of the two companies have been consolidated commencing
August 1, 2005. The stockholders of MediaDefender received aggregate
consideration of $42,500,000 in cash, subject to certain holdbacks and
adjustments.
During the
year ended December 31, 2006, MediaDefender also began to offer file-sharing
marketing services, wherein MediaDefender redirects, for a fee, specific
peer-to-peer traffic on the Internet to designated client destinations.
Going Concern:
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United
States of America, which contemplate continuation of the Company as a going
concern. As a result of the matters described herein, the Companys independent
registered public accounting firm, in its report on the Companys 2006
consolidated financial statements, expressed substantial doubt about the
Companys ability to continue as a going concern. The consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or the amounts and classification of
liabilities that could result from the outcome of this uncertainty.
As a result of communications with the Staff of the SEC in 2006, in
particular regarding the application of accounting rules and interpretations
related to embedded derivatives associated with the Companys subordinated
convertible notes payable issued in July 2005, the Company determined that it
was necessary to restate previously issued financial statements. As a result,
in December 2006, the Company was required to suspend the use of its then
effective registration statement for the holders of its senior and subordinated
indebtedness, which then triggered an event of default with respect to its
registration rights agreements with the holders of such indebtedness. Accordingly,
beginning January 18, 2007, the Company began to incur liquidated damages under
its registration rights agreements aggregating approximately $540,000 per
month, and the interest rate on its subordinated convertible notes payable
increased from 4.0% per annum to 12.0% per annum, an increase of approximately
$183,000 per month. The Company has not paid the outstanding liquidated
damages.
The adjustments to the financial statements with respect to the
restatements were non-cash in nature and were not caused by or related to any
changes in the underlying operating performance of the Companys business,
including revenues, operating costs and expenses, operating income or loss,
income taxes, operating cash flows or adjusted EBITDA. The fair value of
these bifurcated derivatives of $10,534,000, as determined by an independent
valuation firm, was calculated using a binomial lattice option-pricing model
utilizing highly subjective and theoretical assumptions that can materially
affect fair values from period to period. The recognition of these derivative
amounts, initially recorded as a reduction to the related debt and being
amortized to interest expense through the life of the debt, with the resulting
changes in fair value of the liability being included as other income (expense)
in the statement of operations each subsequent reporting period, did not have
any impact on the Companys revenues, operating expenses, income taxes or cash
flows. However, such restatements had a material negative impact on the Companys
previously reported results of operations and earnings per share, current
liabilities, net working capital and shareholders equity (deficiency).
During 2005 and 2006 and the nine months ended September 30, 2007, the
Companys consolidated operations generated sufficient cash flows from
operations to enable the Company to fund its operating requirements and its
originally scheduled (i.e., undefaulted) debt service obligations to both the
senior and subordinated debt holders, and management currently anticipates that
cash flows from operations will be adequate to fund operating and debt service
requirements (based on the original terms as contemplated in the senior and subordinated
loan agreements and excluding the registration penalty amounts) for the
remainder of 2007 and generate operating cash flows in excess of pre-default
amounts for at least the next twelve months.
39
Primarily as a result of the requirement to restate previously issued
financial statements, which resulted in the recording of an embedded derivative
liability, the reclassification of the senior and subordinated indebtedness to
current liabilities, and the recording of estimated liquidated damages payable
under registration rights agreements, the Company was not in compliance with
certain of its financial covenants under both the Senior Financing and the
Sub-Debt Financing at September 30, 2007 and December 31, 2006. Notwithstanding
such developments, the Company believes that it would have been out of
compliance with certain of its financial covenants at September 30, 2007.
As of September 30, 2007 and December 31, 2006, approximately
$13,307,000 principal amount was outstanding with respect to the Senior
Financing, and approximately $27,658,000 principal amount was outstanding with
respect to the Sub-Debt Financing. In addition, at September 30, 2007,
approximately $775,000 and $1,783,000 was outstanding with respect to accrued
registration delay penalties to the holders of the Senior Financing and the
Sub-Debt Financing, respectively, and approximately $116,000 and $2,207,000 was
outstanding with respect to accrued interest payable to the holders of the
Senior Financing and the Sub-Debt Financing, respectively. The Company has not
paid the registration delay penalties to either the holders of the Senior Notes
or the Sub-Debt Notes, although it has made advance payments to the holders of
the Senior Notes aggregating $500,000. As a result of the registration failure,
the failure to pay the registration delay penalties and the various financial
covenant and other breaches of the terms of the Senior Financing and the
Sub-Debt Financing, multiple events of default exist under the Senior Financing
and the Sub-Debt Financing. The terms of the Subordination Agreement among the
Company and the creditor parties thereto (the Subordination Agreement)
prevent the Company from making any cash payments to the Sub-Debt Note holders
until the events of default under the Senior Financing are either cured or
waived. Furthermore, upon the occurrence of an event of default, holders of at
least 25% of the outstanding senior indebtedness may declare the outstanding
principal and accrued interest on all senior notes immediately due and payable
upon written notice to the Company, and each holder of outstanding subordinated
indebtedness may only demand redemption of all or any portion of their
respective notes under certain circumstances as described in the Subordination
Agreement.
On October 16, 2007, the Company received an Event of Default
Redemption Notice from the holders of approximately $2,693,000 principal amount
of Sub-Debt Notes demanding that the Company redeem their Sub-Debt Notes. The
Company believes and has advised these Sub-Debt Note holders that redemption
(including the demand for redemption) is not permitted under the terms of the
Subordination Agreement. On November 1, 2007, the Company received a copy of a
letter to the Sub-Debt Note holders from Senior Note holders representing
approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note
holders that the Subordination Agreement prohibits the Company from redeeming
any Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any
remedies. The letter further stated that the Senior Note holders were inclined
to give the Company until November 30, 2007 to either cure the existing events
of default or to pay off the obligations to the Senior Note holders in full, or
the Senior Note holders expect they will likely begin to exercise additional
remedies to obtain payment of their outstanding obligations. The Company does
not have the capital resources necessary to cure the existing events of default,
or to repay any accelerated indebtedness or redemption or penalty amounts.
All quarterly interest
payments due on the outstanding senior and subordinated indebtedness were
timely paid by the Company through December 2006. In addition, the quarterly interest
payments due on the outstanding senior indebtedness in March 2007, June 2007
and September 2007 were timely paid. Pursuant to the terms of the Subordination
Agreement, interest on the outstanding subordinated convertible notes payable
cannot be paid as a result of the existence of the events of default described
herein.
Pursuant to a Forbearance
and Consent Agreement with the investors in the Senior Financing, such
investors agreed to forbear from the exercise of their rights and remedies
under the Senior Financing documents as a result of the events of default with
respect to the unavailability of the Companys registration statement, as well
as certain other events of default that existed or that could come into
existence during the forbearance period, from April 17, 2007 through July 31,
2007, in exchange for aggregate cash payments of $500,000. The payments made by
the Company under the Forbearance and Consent Agreement may be credited against
the registration delay cash penalties or any other amounts ultimately
determined to be due the investors in the Senior Financing. On July 6, 2007,
the Companys registration statement was declared effective by the SEC, thus
making it available to the investors in the Senior Financing and Sub-Debt
Financing. Although the Company and its representatives and advisors are in
ongoing discussions with the investors in the Senior Financing and the
investors in the Sub-Debt Financing as to a comprehensive resolution of the
matters discussed herein, the Company cannot predict the ultimate outcome of
such discussions.
On August 3, 2007, the Company entered into a Waiver and Forbearance
Agreement with the holders of the Sub-Debt Financing pursuant to which the
holders agreed to waive their right to charge the 12.0% default interest rate
triggered by the Companys defaults under the Subordinated Financing
transaction documents and instead charge the 4.0% standard interest rate on the
Sub-Debt Notes for the period from July 16, 2007 through August 31, 2007 (the Forbearance
Period). The holders of the Sub-Debt Financing also agreed to forbear from
exercising any of their other rights and remedies under the Sub-Debt Financing
transaction documents during the Forbearance Period, upon the terms and
conditions in the Waiver and Forbearance Agreement.
40
Effective September 1, 2007, the interest rate returned to the 12.0%
default interest rate.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company and its representatives and advisors are in ongoing
discussions with the holders of its senior and subordinated debt obligations to
obtain a waiver of and amendment to certain of the financing documents with
respect to the events of default, the impact of the restatements, the payment
of cash penalties and default interest, and various related matters. The
Company is exploring various alternatives to resolve the defaults under its
senior and secured debt obligations, but is unable to predict the outcome of
such negotiations. To the extent that the Company is unable to restructure its
senior and subordinated debt obligations in a satisfactory manner and/or the
lenders begin to exercise additional remedies to enforce their rights, the
Company will not have sufficient cash resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the
United States Bankruptcy Code.
Critical Accounting
Policies:
The
discussion and analysis of the Companys financial condition and results of
operations is based upon the Companys consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. The preparation of these financial statements
requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure
of contingent assets and liabilities. On an ongoing basis, the Company
evaluates its estimates with respect to
allowances for bad debts,
impairment of long-lived assets, impairment of fixed assets, stock-based
compensation, the valuation allowance on deferred tax assets, and the change in
fair value of the warrant liability and derivative liability.
The Company bases its estimates on historical
experience and on various other assumptions that it believes to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ materially from
these estimates under different assumptions or conditions. The Company believes
that the following critical accounting policies affect its more significant
judgments and estimates used in the preparation of its consolidated financial
statements: revenue recognition,
stock-based compensation, goodwill, intangible assets and long-lived assets,
derivative instruments, income taxes, and accounts receivable. These accounting
policies are discussed in Item 6. Managements Discussion and Analysis or Plan
of Operation contained in the Companys December 31, 2006 Annual Report on
Form 10-KSB, as well as in the notes to the December 31, 2006 consolidated
financial statements. There have not been any significant changes to these
accounting policies since they were previously reported at December 31, 2006.
Adoption of New
Accounting Policies:
In December 2006, the FASB issued FSP EITF 00-19-2,
Accounting for
Registration Payment Arrangements (EITF 00-19-2), which
addresses an issuers accounting for registration payment arrangements. EITF
00-19-2 specifies that the contingent obligation to make future payments or
otherwise transfer consideration under a registration payment arrangement,
whether issued as a separate agreement or included as a provision of a
financial instrument or other agreement, should be separately recognized and
measured in accordance with FASB No. 5,
Accounting for Contingencies
.
EITF 00-19-2 further clarifies that a financial instrument subject to a
registration payment arrangement should be accounted for in accordance with
other applicable generally accepted accounting principles without regard to the
contingent obligation to transfer consideration pursuant to the registration
payment arrangement. EITF 00-19-2 is effective immediately for registration
payment arrangements and the financial instruments subject to those
arrangements that are entered into or modified subsequent to the date of
issuance of EITF 00-19-2. For registration payment arrangements and financial
instruments subject to those arrangements that were entered into prior to the
issuance of EITF 00-19-2, EITF 00-19-2 is effective for financial statements
issued for fiscal years beginning after December 15, 2006, and interim periods
within those fiscal years. Early adoption of EITF 00-19-2 for interim or annual
periods for which financial statements or interim reports have not been issued
is permitted. The Company chose to early adopt EITF 00-19-2 effective December
31, 2006.
In June 2006, the
Emerging Issues Task Force (EITF) reached a consensus on EITF Issue 06-3, How
Taxes Collected From Customers and Remitted to Governmental Authorities Should
Be Presented in the Income Statement (That Is, Gross versus Net Presentation)
(EITF 06-3). The scope of EITF 06-3 includes any tax assessed by a
governmental authority that is directly imposed on a revenue-producing
transaction between a seller and a customer, and provides that a company may
adopt a policy of presenting taxes either on a gross basis - that is, including
the taxes within revenue - or on a net basis. For any such taxes that are
reported on a gross basis, a company should disclose the amounts of those taxes
for each period for which an income statement is presented if those amounts are
significant. The Company collects various state sales taxes that fall under the
scope of EITF 06-3 on goods that it sells in its e-commerce business segment
and is accounting for and reporting such taxes on a net basis.
41
EITF 06-3 is
effective for financial reports for interim periods and annual reporting
periods beginning after December 15, 2006. The Company adopted EITF 06-3
effective January 1, 2007. The adoption of EITF 06-3 did not have a material
effect on the Companys financial statements.
Effective January
1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
Accounting for Income Taxes (FIN 48). FIN 48 addresses the determination of
whether tax benefits claimed or expected to be claimed on a tax return should
be recorded in the financial statements. Under FIN 48, the Company may
recognize the tax benefit from an uncertain tax position only if it is more
likely than not that the tax position will be sustained on examination by the
taxing authorities, based on the technical merits of the position. The tax
benefits recognized in the financial statements from such a position should be
measured based on the largest benefit that has a greater than fifty percent
likelihood of being realized upon ultimate settlement. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties on income
taxes, accounting in interim periods and requires increased disclosures. The
adoption of the provisions of FIN 48 did not have a material effect on the
Companys financial statements. As of September 30, 2007, no liability for
unrecognized tax benefits was required to be recorded.
The Company files
income tax returns in the U.S. federal jurisdiction and various states. The
Company is subject to U.S. federal or state income tax examinations by tax
authorities for years after 2002.
The Companys
policy is to record interest and penalties on uncertain tax provisions as
income tax expense.
Recent
Accounting Pronouncements:
In February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, The Fair Value Option for Financial Assets and Financial
Liabilities (SFAS No. 159), which provides companies with an option to
report selected financial assets and liabilities at fair value. SFAS No.
159s objective is to reduce both complexity in accounting for financial
instruments and the volatility in earnings caused by measuring related assets
and liabilities differently. Generally accepted accounting principles have
required different measurement attributes for different assets and liabilities
that can create artificial volatility in earnings. SFAS No. 159 helps to
mitigate this type of accounting-induced volatility by enabling companies to
report related assets and liabilities at fair value, which would likely reduce
the need for companies to comply with detailed rules for hedge accounting. SFAS
No. 159 also establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different measurement
attributes for similar types of assets and liabilities. SFAS No. 159 requires
companies to provide additional information that will help investors and other
users of financial statements to more easily understand the effect of the
companys choice to use fair value on its earnings. SFAS No. 159 also requires
companies to display the fair value of those assets and liabilities for which
the company has chosen to use fair value on the face of the balance
sheet. SFAS No. 159 does not eliminate disclosure requirements included
in other accounting standards, including requirements for disclosures about
fair value measurements included in SFAS No. 157 and SFAS No. 107. SFAS No. 159
is effective as of the beginning of a companys first fiscal year beginning
after November 15, 2007. Early adoption is permitted as of the beginning
of the previous fiscal year provided that the company makes that choice in the
first 120 days of that fiscal year and also elects to apply the provisions of
SFAS No. 157. The Company is currently assessing the potential effect of SFAS
No. 159 on its financial statements.
In
September 2006, the FASB issued Statement of Financial Accounting
Standards No. 157, Fair Value Measurements (SFAS No. 157), which
establishes a formal framework for measuring fair value under Generally
Accepted Accounting Principles (GAAP). SFAS No. 157 defines and codifies the
many definitions of fair value included among various other authoritative
literature, clarifies and, in some instances, expands on the guidance for
implementing fair value measurements, and increases the level of disclosure
required for fair value measurements. Although SFAS No. 157 applies to and
amends the provisions of existing FASB and American Institute of Certified
Public Accountants (AICPA) pronouncements, it does not, of itself, require
any new fair value measurements, nor does it establish valuation standards. SFAS
No. 157 applies to all other accounting pronouncements requiring or permitting
fair value measurements, except for:
SFAS No. 123R, share-based payment and related pronouncements, the
practicability exceptions to fair value determinations allowed by various other
authoritative pronouncements, and AICPA Statements of Position 97-2 and 98-9
that deal with software revenue recognition. SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15,
2007, and to interim periods within those fiscal years. The Company is
currently assessing the potential effect of SFAS No. 157 on its financial
statements.
Other than the foregoing, management does not believe that any other
recently issued, but not yet effective, accounting standards, if currently
adopted, would have a material effect on the Companys consolidated financial
statements.
42
Results
of Operations Three Months and Nine Months Ended September 30, 2007 and 2006:
The following table presents information with
respect to the Companys condensed consolidated statements of operations as to
actual amounts and as a percentage of total net revenue for the three months
ended September 30, 2007 and 2006.
Condensed Consolidated Statements of
Operations ($000):
|
|
Three Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
$
|
|
%
|
|
$
|
|
%
|
|
|
|
|
|
|
|
(Restated)
|
|
(Restated)
|
|
Net revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
337
|
|
5.7
|
%
|
$
|
663
|
|
10.4
|
%
|
Media
|
|
1,974
|
|
33.2
|
%
|
1,572
|
|
24.6
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
3,627
|
|
61.1
|
%
|
4,158
|
|
65.0
|
%
|
Total net revenue
|
|
5,938
|
|
100.0
|
%
|
6,393
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
Cost of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
353
|
|
5.9
|
%
|
612
|
|
9.6
|
%
|
Media
|
|
969
|
|
16.3
|
%
|
709
|
|
11.1
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
2,414
|
|
40.7
|
%
|
2,040
|
|
31.9
|
%
|
Total cost of revenue
|
|
3,736
|
|
62.9
|
%
|
3,361
|
|
52.6
|
%
|
Gross profit
|
|
2,202
|
|
37.1
|
%
|
3,032
|
|
47.4
|
%
|
|
|
|
|
|
|
|
|
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
Sales and marketing
|
|
553
|
|
9.3
|
%
|
296
|
|
4.6
|
%
|
General and administrative, including
stock-based compensation
|
|
2,982
|
|
50.2
|
%
|
2,107
|
|
33.0
|
%
|
Development and engineering
|
|
106
|
|
1.8
|
%
|
|
|
|
%
|
Total operating costs
|
|
3,641
|
|
61.3
|
%
|
2,403
|
|
37.6
|
%
|
Income (loss) from operations
|
|
(1,439
|
)
|
(24.2
|
)%
|
629
|
|
9.8
|
%
|
|
|
|
|
|
|
|
|
|
|
Other income (expense):
|
|
|
|
|
|
|
|
|
%
|
Interest income
|
|
59
|
|
1.0
|
%
|
45
|
|
0.7
|
%
|
Interest expense
|
|
(1,805
|
)
|
(30.4
|
)%
|
(1,472
|
)
|
(23.0
|
)%
|
Other income
|
|
|
|
|
%
|
10
|
|
0.2
|
%
|
Change in fair value of warrant liability
|
|
512
|
|
8.6
|
%
|
1,139
|
|
17.8
|
%
|
Change in fair value of derivative
liability
|
|
2,702
|
|
45.5
|
%
|
1,236
|
|
19.3
|
%
|
Amortization of deferred financing costs
|
|
(212
|
)
|
(3.6
|
)%
|
(212
|
)
|
(3.3
|
)%
|
Income (loss) before income taxes
|
|
(183
|
)
|
(3.1
|
)%
|
1,375
|
|
21.5
|
%
|
Provision for income taxes
|
|
|
|
|
%
|
536
|
|
8.4
|
%
|
Net income (loss)
|
|
$
|
(183
|
)
|
(3.1
|
)%
|
$
|
839
|
|
13.1
|
%
|
43
The
following table presents information with respect to the Companys condensed
consolidated statements of operations as to actual amounts and as a percentage
of total net revenue for the nine months ended September 30, 2007 and 2006.
Condensed
Consolidated Statements of Operations ($000):
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
$
|
|
%
|
|
$
|
|
%
|
|
|
|
|
|
|
|
(Restated)
|
|
(Restated)
|
|
Net revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
1,340
|
|
7.4
|
%
|
$
|
1,917
|
|
10.9
|
%
|
Media
|
|
5,139
|
|
28.6
|
%
|
3,937
|
|
22.3
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
11,498
|
|
64.0
|
%
|
11,781
|
|
66.8
|
%
|
Total net revenue
|
|
17,977
|
|
100.0
|
%
|
17,635
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
Cost of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
1,378
|
|
7.7
|
%
|
1,799
|
|
10.2
|
%
|
Media
|
|
2,562
|
|
14.3
|
%
|
2,110
|
|
12.0
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
6,928
|
|
38.5
|
%
|
5,617
|
|
31.8
|
%
|
Total cost of revenue
|
|
10,868
|
|
60.5
|
%
|
9,526
|
|
54.0
|
%
|
Gross profit
|
|
7,109
|
|
39.5
|
%
|
8,109
|
|
46.0
|
%
|
|
|
|
|
|
|
|
|
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
Sales and marketing
|
|
1,439
|
|
8.0
|
%
|
839
|
|
4.8
|
%
|
General and administrative, including
stock-based compensation
|
|
8,490
|
|
47.2
|
%
|
6,896
|
|
39.1
|
%
|
Development and engineering
|
|
419
|
|
2.3
|
%
|
|
|
|
%
|
Write-off of fixed assets
|
|
97
|
|
0.6
|
%
|
|
|
|
%
|
Total operating costs
|
|
10,445
|
|
58.1
|
%
|
7,735
|
|
43.9
|
%
|
Income (loss) from operations
|
|
(3,336
|
)
|
(18.6
|
)%
|
374
|
|
2.1
|
%
|
|
|
|
|
|
|
|
|
|
|
Other income (expense):
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
160
|
|
0.9
|
%
|
76
|
|
0.4
|
%
|
Interest expense
|
|
(5,733
|
)
|
(31.9
|
)%
|
(4,411
|
)
|
(25.0
|
)%
|
Loss on foreign currency transactions
|
|
(14
|
)
|
|
%
|
|
|
|
%
|
Other income
|
|
|
|
|
%
|
63
|
|
0.4
|
%
|
Reduction in liquidated damages payable
under registration rights agreements
|
|
719
|
|
4.0
|
%
|
|
|
|
%
|
Change in fair value of warrant liability
|
|
1,643
|
|
9.1
|
%
|
(1,818
|
)
|
(10.3
|
)%
|
Change in fair value of derivative
liability
|
|
7,056
|
|
39.3
|
%
|
(2,765
|
)
|
(15.7
|
)%
|
Reduction in exercise price of warrants
|
|
|
|
|
%
|
(641
|
)
|
(3.6
|
)%
|
Amortization of deferred financing costs
|
|
(629
|
)
|
(3.5
|
)%
|
(646
|
)
|
(3.7
|
)%
|
Write-off of unamortized discount on debt
and deferred financing costs resulting from principal payments on senior
secured notes payable and conversion of subordinated convertible notes
payable
|
|
|
|
|
%
|
(1,580
|
)
|
(9.0
|
)%
|
Loss before income taxes
|
|
(134
|
)
|
(0.7
|
)%
|
(11,348
|
)
|
(64.4
|
)%
|
Provision for income taxes
|
|
|
|
|
%
|
797
|
|
4.5
|
%
|
Net loss
|
|
$
|
(134
|
)
|
(0.7
|
)%
|
$
|
(12,145
|
)
|
(68.9
|
)%
|
44
The Company
evaluates performance based on, among other factors, earnings or loss before
interest, taxes, depreciation and amortization (Adjusted EBITDA), which is a
non-GAAP financial measure. Adjusted EBITDA also excludes stock-based
compensation, changes in the fair value of warrant liability and derivative
liability, and other non-cash write-offs and charges. Management excludes these
items in assessing financial performance, primarily due to their
non-operational nature or because they are outside of the Companys normal
operations. The Company has provided this information because management
believes that it is useful to investors in understanding the Companys
financial condition and results of operations.
Management
believes that Adjusted EBITDA enhances an overall understanding of the Companys
financial performance by investors because it is frequently used by securities
analysts and other interested parties in evaluating companies in its industry
segment. In addition, management believes that Adjusted EBITDA is useful in
evaluating the Companys operating performance compared to that of other
companies in its industry segment because the calculation of Adjusted EBITDA
eliminates the accounting effects of financing costs, income taxes and capital
spending, which items may vary for different companies for reasons unrelated to
overall operating performance.
However,
Adjusted EBITDA is not a recognized measurement under GAAP, and when analyzing
the Companys operating performance, investors should use Adjusted EBITDA in
addition to, and not as an alternative for, income (loss) from operations,
income (loss) before income taxes, and net income (loss), or any other measure
utilized in determining the Companys operating performance that is calculated
in accordance with GAAP. Because Adjusted EBITDA is not calculated in
accordance with GAAP, it may not be comparable to similarly-titled measures
utilized by other companies. Furthermore, Adjusted EBITDA is not intended to be
a measure of the Companys free cash flow, as it does not consider certain
ongoing cash requirements, such as a required debt service payments and income
taxes.
Included in Adjusted EBITDA are direct operating expenses for each
segment. Corporate expenses consist of general operating expenses that are not
directly related to the operations of the segments.
The following table summarizes net revenue and Adjusted EBITDA by
operating segment for the three months ended September 30, 2007 and 2006,
respectively.
|
|
Three Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Net Revenue:
|
|
|
|
|
|
E-commerce
|
|
$
|
337
|
|
$
|
663
|
|
Media
|
|
1,974
|
|
1,572
|
|
Anti-piracy and file-sharing marketing
services
|
|
3,627
|
|
4,158
|
|
|
|
$
|
5,938
|
|
$
|
6,393
|
|
|
|
|
|
|
|
Adjusted EBITDA:
|
|
|
|
|
|
E-commerce
|
|
$
|
(71
|
)
|
$
|
27
|
|
Media
|
|
667
|
|
771
|
|
Anti-piracy and file-sharing marketing
services
|
|
1,009
|
|
2,435
|
|
|
|
1,605
|
|
3,233
|
|
Corporate general and administrative
expenses
|
|
(1,178
|
)
|
(870
|
)
|
|
|
$
|
427
|
|
$
|
2,363
|
|
45
The following table reconciles Net Income (Loss) to
Adjusted EBITDA for the three months ended September 30, 2007 and 2006,
respectively.
|
|
Three Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Adjusted EBITDA per segments
|
|
$
|
427
|
|
$
|
2,363
|
|
Stock-based compensation
|
|
(702
|
)
|
(652
|
)
|
Depreciation and amortization
|
|
(276
|
)
|
(145
|
)
|
Amortization of intangible assets
|
|
(888
|
)
|
(937
|
)
|
Amortization of deferred financing costs
|
|
(212
|
)
|
(212
|
)
|
Interest income
|
|
59
|
|
45
|
|
Other income
|
|
|
|
10
|
|
Interest expense, including amortization of
discount on debt of $777 and $779 in 2007 and 2006, respectively
|
|
(1,805
|
)
|
(1,472
|
)
|
Change in fair value of warrant liability
|
|
512
|
|
1,139
|
|
Change in fair value of derivative
liability
|
|
2,702
|
|
1,236
|
|
Provision for income taxes
|
|
|
|
(536
|
)
|
Net income (loss)
|
|
$
|
(183
|
)
|
$
|
839
|
|
The following table summarizes net revenue and Adjusted EBITDA by
operating segment for the nine months ended September 30, 2007 and 2006,
respectively.
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Net Revenue:
|
|
|
|
|
|
E-commerce
|
|
$
|
1,340
|
|
$
|
1,917
|
|
Media
|
|
5,139
|
|
3,937
|
|
Anti-piracy and file-sharing marketing
services
|
|
11,498
|
|
11,781
|
|
|
|
$
|
17,977
|
|
$
|
17,635
|
|
|
|
|
|
|
|
Adjusted EBITDA:
|
|
|
|
|
|
E-commerce
|
|
$
|
(194
|
)
|
$
|
33
|
|
Media
|
|
1,744
|
|
1,495
|
|
Anti-piracy and file-sharing marketing
services
|
|
4,140
|
|
7,230
|
|
|
|
5,690
|
|
8,758
|
|
Corporate general and administrative
expenses
|
|
(3,816
|
)
|
(3,430
|
)
|
Reduction in liquidated damages payable
under registration rights agreements
|
|
719
|
|
|
|
|
|
$
|
2,593
|
|
$
|
5,328
|
|
46
The following table reconciles Net Loss to Adjusted
EBITDA for the nine months ended September 30, 2007 and 2006, respectively.
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
(Restated)
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Adjusted EBITDA per segments
|
|
$
|
2,593
|
|
$
|
5,328
|
|
Stock-based compensation
|
|
(1,690
|
)
|
(1,736
|
)
|
Depreciation and amortization
|
|
(723
|
)
|
(405
|
)
|
Amortization of intangible assets
|
|
(2,714
|
)
|
(2,813
|
)
|
Amortization of deferred financing costs
|
|
(629
|
)
|
(646
|
)
|
Write-off of unamortized discount on debt
and deferred financing costs due to principal payments on senior secured
notes payable and conversion of subordinated convertible notes payable
|
|
|
|
(1,580
|
)
|
Interest income
|
|
160
|
|
76
|
|
Other income
|
|
|
|
63
|
|
Interest expense, including amortization of
discount on debt of $2,306 and $2,363 in 2007 and 2006, respectively
|
|
(5,733
|
)
|
(4,411
|
)
|
Change in fair value of warrant liability
|
|
1,643
|
|
(1,818
|
)
|
Change in fair value of derivative
liability
|
|
7,056
|
|
(2,765
|
)
|
Reduction in exercise price of warrants
|
|
|
|
(641
|
)
|
Write-off of fixed assets
|
|
(97
|
)
|
|
|
Provision for income taxes
|
|
|
|
(797
|
)
|
Net loss
|
|
$
|
(134
|
)
|
$
|
(12,145
|
)
|
Three Months Ended September 30, 2007 and 2006:
Net Revenue. The Companys
net revenue decreased by $455,000 or 7.1%, to $5,938,000 for the three months
ended September 30, 2007, as compared to $6,393,000 for the three months ended
September 30, 2006, primarily as a result of decreases in e-commerce of
$326,000 and anti-piracy and file-sharing marketing services of $531,000,
offset by an increase in media revenue of $402,000. E-commerce revenue declined
in part as a result of the Company restructuring its relationship with a
merchandising entity effective August 31, 2007 to eliminate merchandise sales
(and the related inventory) and focus on music sales, which will have a
significant impact on future e-commerce revenue. MediaDefenders revenue for
the three months ended September 30, 2007 was negatively impacted by
approximately $600,000 of service credits provided to customers (which were
recorded as a reduction to revenues) as a result of the online security breach
that occurred in mid-September 2007. MediaDefenders revenue accounted for
61.1% of the Companys total net revenue for the three months ended September
30, 2007, as compared to 65.0% of the Companys total net revenue for the three
months ended September 30, 2006. The Company expects that revenues from
MediaDefender will represent a significant percentage of the Companys total
revenues in the foreseeable future.
During
the three months ended September 30, 2007, approximately 66% of MediaDefenders
consolidated revenues were from four customers, with one customer accounting
for 21%, a second customer accounting for 18%, a third customer accounting for
15%, and a fourth customer accounting for 12%. During the three months ended
September 30, 2006, approximately 68% of MediaDefenders consolidated revenues
were from four customers, with one customer accounting for 23%, a second
customer accounting for 20%, a third customer accounting for 15%, and a fourth
customer accounting for 10%.
During July 2007, MediaDefender announced a major initiative to offer
sponsored audio content to the worlds largest concentrated audience of music
consumers on the file-sharing networks. The program leverages
MediaDefenders proprietary technology to distribute downloads of high quality
audio files that include a sponsors logo. MediaDefender is currently in
discussions with several major artists and potential sponsors regarding this
new business initiative.
During the weekend of
September 15 and 16, 2007, MediaDefender experienced an unlawful online
security breach by hackers, which resulted in approximately 6,000 e-mails, as
well as access to other confidential information and data, for the period from
mid-December 2006 through September 10, 2007 being stolen and posted at
numerous web-sites on the Internet. These e-mails contained confidential
information and communications covering a wide variety of internal issues,
including personal data, customer data and pricing information, and other
sensitive information. This matter has been referred to the appropriate
federal, state and local law enforcement organizations and an investigation is
ongoing.
47
An internal investigation of
this matter is continuing, as a result of which the Company has revised various
procedures and policies and enhanced its online and Internet security
protocols.
Media revenue increased by
$402,000 or 25.6% to $1,974,000 for the three months ended September 30, 2007,
as compared to $1,572,000 for the three months ended September 30, 2006. Media
revenue increased in 2007 as compared to 2006 as a result of the Company
entering into a
strategic
partnership with T-Mobile in April 2007 with the launch of a specially designed
United Kingdom counterpart to the Companys United States-based online music
destination web-site. The United Kingdom version of ARTISTdirect.com
(www.ARTISTdirect.com/uk) includes numerous T-Mobile enhancements, including
exclusive branded content provided by T-Mobile. The agreement represents
aggregate potential revenue to the Company of more than $1,000,000 over a
twelve-month period in 2007 and 2008, subject to meeting certain performance
metrics. During the three months
ended September 30, 2007, approximately $423,000 or 21% of media revenues were
generated by T-Mobile.
The Company
markets and sells advertising on a CPM basis to advertising agencies and
directly to various companies seeking to reach one or more of the distinct
demographic audiences viewing content in the ARTISTdirect Network. The Company
also markets and sells sponsorships for various portions of the ARTISTdirect
Network. Customers may purchase advertising space on the entire ARTISTdirect
Network, or they may tailor advertising to specific areas or sections of the
Companys web-sites.
During the three months
ended September 30, 2007, the Companys media revenues were generated by two
outsides sales organizations that represented the Company with respect to
advertising and sponsorship on the Companys web-site and through affiliated
web-sites, as well as by in-house sales personnel. During the three months
ended September 30, 2006, the Companys media revenues were generated primarily
by a single outside sales organization. In
February 2007, the Company
hired an advertising industry veteran as vice president of worldwide sales to
be responsible for domestic and international advertising and sales initiatives,
which has resulted in the Company beginning to reduce its reliance on the
single outside sales organization. During the three months ended September 30,
2007, two customers accounted for approximately $423,000 and $324,000 of media
revenues, representing 21% and 16% of media revenues, respectively.
E-commerce revenue decreased
by $326,000 or 49.2%, to $337,000 for the three months ended September 30,
2007, as compared to $663,000 for the three months ended September 30, 2006,
primarily due to a successful sales campaign that the Company ran in 2006 for
products for a specific band and the impact of online specialty web-sites
offering similar products.
During the three months
ended September 30, 2007 and 2006, approximately 53% and 69%, respectively, of
e-commerce revenues were generated from the products related to a single
merchandising entity. The Company restructured its relationship with this
merchandising entity effective August 31, 2007 to eliminate merchandise sales
and focus on music sales, which will have a significant negative impact on
future e-commerce revenues, although it is expected to have a limited impact on
operating margins..
Cost
of Revenue. The Companys total cost of revenue increased by $375,000 or 11.2%
to $3,736,000 for the three months ended September 30, 2007, as compared to
$3,361,000 for the three months ended September 30, 2006, primarily as a result
of an increase in MediaDefender cost of revenue of $374,000 and media cost of
revenues of $260,000, offset by a reduction in e-commerce cost of revenues of
$259,000. Depreciation of property and equipment is included in cost of revenue
for all business segments.
As previously
disclosed, MediaDefender has experienced increasing bandwidth, operating,
personnel and occupancy costs, which are continuing to have a negative impact
on cost of revenue in 2007 as compared to 2006. Contributing to this increase
in costs during the three months ended September 30, 2007 was MediaDefenders
relocation of its servers to a higher quality co-location facility and a change
in bandwidth providers in early 2007, which was done in order to improve the
reliability and increase the capacity of MediaDefenders services. Included in
MediaDefenders cost of revenue for the three months ended September 30, 2007
and 2006 was the amortization of proprietary technology acquired in the
MediaDefender transaction of $634,000.
As
a result of the increase in media revenue referred to above, media cost of
revenue increased by $260,000 or 36.7% to $969,000 for the three months ended
September 30, 2007, as compared to $709,000 for the three months ended
September 30, 2006.
E-commerce
cost of revenue decreased by $259,000 or 42.3% to $353,000 for the three months
ended September 30, 2007, as compared to $612,000 for the three months ended
September 30, 2006, primarily as a result of the decrease in e-commerce
revenues.
48
As
a result of the foregoing, total gross profit was $2,202,000 for the three
months ended September 30, 2007, as compared to $3,032,000 for the three months
ended September 30, 2006, reflecting a combined gross margin of 37.1% and
47.4%, respectively. A summary of gross profit and gross margin by segment is
as follows ($000):
|
|
Three Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
Segment:
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
Gross
Profit
|
|
Gross
Margin
|
|
E-commerce
|
|
$
|
(16
|
)
|
(4.7
|
)%
|
$
|
51
|
|
7.7
|
%
|
Media
|
|
1,005
|
|
50.9
|
%
|
863
|
|
54.9
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
1,213
|
|
33.4
|
%
|
2,118
|
|
50.9
|
%
|
Totals
|
|
$
|
2,202
|
|
37.1
|
%
|
$
|
3,032
|
|
47.4
|
%
|
Sales
and Marketing. The Companys sales and marketing expense increased by $257,000
or 86.8%, to $553,000 for the three months ended September 30, 2007, as
compared to $296,000 for the three months ended September 30, 2006, primarily
as a result of additional personnel-related costs. Included in sales and
marketing expense for the three months ended September 30, 2007 and 2006 is the
amortization of customer relationships acquired in the MediaDefender transaction
of $189,000 and $188,000, respectively.
General and Administrative. The
Companys general and administrative expense increased by $875,000 or 41.5%, to
$2,982,000 for the three months ended September 30, 2007, as compared to
$2,107,000 for the three months ended September 30, 2006. Included in general
and administrative expense for the three months ended September 30, 2007 and
2006 are stock-based compensation costs of $702,000 and $652,000, respectively,
and the amortization of non-competition agreements of $66,000 and $116,000,
respectively, resulting from the MediaDefender transaction.
Also
included in general and administrative expense for the three months ended
September 30, 2007 was approximately $225,000 of legal, consulting and other
direct costs related to the MediaDefender security breach and $175,000 that was
accrued with respect to 2007 performance bonuses for the Chief Executive
Officer and the President of MediaDefender.
During the
three months ended September 30, 2007 and 2006, the Company incurred legal,
accounting, consulting and printing fees and costs of approximately $487,000
and $95,000, respectively, relating to the preparation and filing of various
documents with the SEC, negotiations with senior and subordinated note holders,
review and analysis of various restructuring alternatives, amendments to
financing agreements, and other ordinary course legal and accounting matters. As
a result of the necessity to restate the Companys previously-issued financial
statements (which were filed with the SEC on April 19, 2007) and the resultant
default on the Companys senior and subordinated debt agreements in January
2007 (see Going Concern above), the Company expects to incur significant
continuing costs in this regard for at least the remainder of 2007.
Significant
components of general and administrative expense consist of management
compensation (and bonuses, when applicable), personnel and personnel-related
costs, insurance, legal and accounting fees, board compensation, consulting fees
and occupancy costs.
Development and Engineering.
Development and engineering costs were $106,000 for the three months ended
September 30, 2007.
During the three months ended September 30, 2006,
these costs, which were not material, were included in cost of revenue.
Development and engineering costs consist primarily of third-party
development costs and payroll and related expenses for in-house development
costs incurred in the design and production of the Companys content and
services, including revisions to the Companys web-site.
Income
(Loss) from Operations. As a result of the aforementioned factors, the loss
from operations was $1,439,000 for the three months ended September 30, 2007,
as compared to income from operations of $629,000 for the three months ended
September 30, 2006.
Interest
Income. Interest income was $59,000 for the three months ended September 30,
2007, as compared to $45,000 for the three months ended September 30, 2006.
Interest
Expense.
Interest expense of $1,805,000 and $1,472,000 for the three
months ended September 30, 2007 and 2006, respectively, relates to the
$15,000,000 of secured notes payable issued in the Senior Financing, which bear
interest at 11.25% per annum, and the $30,000,000 of subordinated convertible
notes payable issued in the Sub-Debt Financing, which bear interest at 4.0% per
annum, both of which were issued to finance the acquisition of MediaDefender in
July 2005.
49
Effective January 18, 2007, the interest rate on the Sub-Debt Financing
increased from 4.0% to 12.0% due to the default on the Companys senior and
subordinated debt agreements in January 2007 (see Going Concern above). On
August 3, 2007, the Company entered into a Waiver and Forbearance Agreement
with the holders of the Sub-Debt Financing pursuant to which the holders agreed
to waive their right to charge the 12.0% default interest rate triggered by the
Companys defaults under the Subordinated Financing transaction documents and
instead charge the 4.0% standard interest rate on the Sub-Debt Notes for the
period from July 16, 2007 through August 31, 2007. Effective September 1, 2007,
the interest rate returned to the 12.0% default interest rate. Included in
interest expense for the three months ended September 30, 2007 is interest
expense of $80,000 relating to the accrued registration penalty obligation.
Additional consideration in the form of warrants issued to the lenders
was accounted for at fair value and recorded as a reduction to the carrying
amount of the debt, and is being amortized to interest expense over the term of
the debt. Accordingly, the amortization of this discount on debt included in
interest expense for the three months ended September 30, 2007 and 2006 was
$181,000 and $180,000, respectively.
The Sub-Debt Notes contain several embedded derivative features that
have been accounted for at fair value. The various embedded derivative features
of the Sub-Debt Notes have been valued at the date of inception of the Sub-Debt
Financing and at the end of each reporting period thereafter. The value of the
embedded derivatives were bifurcated from the Sub-Debt Notes and recorded as
derivative liability, with the initial amount recorded as discount on the
related Sub-Debt Notes. This discount is being amortized to interest expense
over the life of the Sub-Debt Notes. Accordingly, the amortization of this
discount on debt included in interest expense for the three months ended
September 30, 2007 and 2006 was $596,000 and $599,000, respectively.
Change in Fair Value of Warrant Liability. In accordance with EITF
00-19, the fair value of the warrants issued in connection with the financing
of the MediaDefender acquisition in July 2005 was recorded as warrant liability.
The carrying value of the warrants is adjusted quarterly to reflect any changes
in the fair value such liability and is included in the statement of operations
as other income (expense). For the three months ended September 30, 2007 and
2006, the Company recorded income of $512,000 and $1,139,000, respectively, to
reflect the change in warrant liability during such periods.
Change in Fair Value of Derivative Liability. In accordance with EITF
00-19, the fair value of the embedded derivatives was bifurcated from the
subordinated convertible notes payable issued in connection with the financing
of the MediaDefender acquisition in July 2005 and recorded as a derivative
liability. The carrying value of the derivative liability is adjusted quarterly
to reflect any changes in the fair value of such liability and is included in
the statement of operations as other income (expense). For the three months
ended September 30, 2007 and 2006, the Company recorded income of $2,702,000
and $1,236,000, respectively, to reflect the change in derivative liability
during such periods.
Amortization
of Deferred Financing Costs.
Amortization of deferred financing costs
was $212,000 for the three months ended September 30, 2007 and 2006. Deferred
financing costs consist of consideration paid to third parties with respect to
the acquisition and financing of the MediaDefender transaction, including cash
payments, subordinated convertible notes payable and the fair value of warrants
issued for placement agent fees, which were deferred and are being amortized
over the term of the related debt.
Income
(Loss) Before Income Taxes. As a result of the aforementioned factors, the loss
before income taxes was $183,000 for the three months ended September 30, 2007,
as compared to income before income taxes of $1,375,000 for the three months
ended September 30, 2006.
Provision
for Income Taxes.
As a result of the non-deductibility of certain
non-cash charges and accruals and the non-inclusion of certain non-cash gains
for tax reporting purposes, the Company incurred a taxable loss during the
three months ended September 30, 2007 and therefore did not record a provision
for income taxes for such period.
As
a result of the profitable operations of MediaDefender during the three months
ended September 30, 2006, the non-deductibility of certain non-cash charges and
accruals for tax reporting purposes, and permanent limitations on the Companys
ability to utilize its net operating loss carry-forwards, the Company recorded
a provision for income taxes of $536,000 for such period.
Net
Income (Loss). As a result of the aforementioned factors, the Company had a net
loss of $183,000 for the three months ended September 30, 2007, as compared to
net income of $839,000 for the three months ended September 30, 2006.
50
Nine Months Ended September 30, 2007 and 2006:
Net
Revenue. The Companys net revenue increased by $342,000 or 1.9%, to
$17,977,000 for the nine months ended September 30, 2007, as compared to
$17,635,000 for the nine months ended September 30, 2006, primarily as a result
of an increase in media revenue of $1,202,000, offset by decreases in
e-commerce revenues of $577,000 and anti-piracy and file-sharing marketing
services of $283,000. E-commerce revenue declined in part as a result of the
Company restructuring its relationship with a merchandising entity effective
August 31, 2007 to eliminate merchandise sales (and the related inventory) and
focus on music sales, which will have a significant impact on future e-commerce
revenue. MediaDefenders revenue for the nine months ended September 30, 2007
was negatively impacted by approximately $600,000 of service credits provided
to customers (which were recorded as a reduction to revenues) as a result of
the online security breach that occurred in mid-September 2007. MediaDefenders
revenue accounted for 64.0% of the Companys total net revenue for the nine
months ended September 30, 2007, as compared to 66.8% of the Companys total
net revenue for the nine months ended September 30, 2006. The Company expects
that revenues from MediaDefender will represent a significant percentage of the
Companys total revenues in the foreseeable future.
During
the nine months ended September 30, 2007, approximately 66% of MediaDefenders
consolidated revenues were from four customers, with one customer accounting
for 20% a second customer accounting for
17%, a third customer accounting for 17%, and a fourth customer accounting for
12%. During the nine months ended September 30, 2006, approximately 67% of
MediaDefenders consolidated revenues were from four customers, with one
customer accounting for 25%, a second customer accounting for 21%, a third
customer accounting for 11%, and a fourth customer accounting for 10%.
During July 2007, MediaDefender announced a major initiative to offer
sponsored audio content to the worlds largest concentrated audience of music
consumers on the file-sharing networks. The program leverages
MediaDefenders proprietary technology to distribute downloads of high quality
audio files that include a sponsors logo. MediaDefender is currently in
discussions with several major artists and potential sponsors regarding this
new business initiative.
During
the weekend of September 15 and 16, 2007, MediaDefender experienced an unlawful
online security breach by hackers, which resulted in approximately 6,000
e-mails, as well as access to other confidential information and data, for the
period from mid-December 2006 through September 10, 2007 being stolen and posted
at numerous web-sites on the Internet. These e-mails contained confidential
information and communications covering a wide variety of internal issues,
including personal data, customer data and pricing information, and other
sensitive information. This matter has been referred to the appropriate
federal, state and local law enforcement organizations and an investigation is
ongoing. An internal investigation of this matter is continuing, as a result of
which the Company has revised various procedures and policies and enhanced its
online and Internet security protocols.
Media revenue increased by
$1,202,000 or 30.5% to $5,139,000 for the nine months ended September 30, 2007,
as compared to $3,937,000 for the nine months ended September 30, 2006. Media
revenue increased in 2007 as compared to 2006 as a result of the Company
entering into a
strategic
partnership with T-Mobile in April 2007 with the launch of a specially designed
United Kingdom counterpart to the Companys United States-based online music
destination web-site. The United Kingdom version of ARTISTdirect.com
(www.ARTISTdirect.com/uk) includes numerous T-Mobile enhancements, including
exclusive branded content provided by T-Mobile. The agreement represents
aggregate potential revenue to the Company of more than $1,000,000 over a
twelve-month period in 2007 and 2008, subject to meeting certain performance
metrics. During the nine months
ended September 30, 2007, approximately $847,000 or 16% of media revenues were
generated by T-Mobile.
The Company markets
and sells advertising on a CPM basis to advertising agencies and directly to
various companies seeking to reach one or more of the distinct demographic
audiences viewing content in the ARTISTdirect Network. The Company also markets
and sells sponsorships for various portions of the ARTISTdirect Network.
Customers may purchase advertising space on the entire ARTISTdirect Network, or
they may tailor advertising to specific areas or sections of the Companys
web-sites.
During the nine months ended
September 30, 2007, the Companys media revenues were generated by two outsides
sales organizations that represented the Company with respect to advertising
and sponsorship on the Companys web-site and through affiliated web-sites, as
well as by in-house sales personnel. During the nine months ended September 30,
2006, the Companys media revenues were generated primarily by a single outside
sales organization. In
February 2007, the Company hired an advertising
industry veteran as vice president of worldwide sales to be responsible for
domestic and international advertising and sales initiatives, which has
resulted in the Company beginning to reduce its reliance on the single outside
sales organization. During the nine months ended September 30, 2007, one customer
accounted for approximately $847,000 of media revenues, representing 16% of
media revenues.
51
E-commerce revenue decreased
by $577,000 or 30.1%, to $1,340,000 for the nine months ended September 30,
2007, as compared to $1,917,000 for the nine months ended September 30, 2006,
primarily due to a successful sales campaign that the Company ran in 2006 for
products for a specific band and the impact of online specialty web-sites
offering similar products.
During the nine months ended
September 30, 2007 and 2006, approximately 59% and 69%, respectively, of
e-commerce revenues were generated from the products related to a single
merchandising entity. The Company restructured its relationship with this merchandising
entity effective August 31, 2007 to eliminate merchandise sales and focus on
music sales, which will have a significant negative impact on future e-commerce
revenues, although it is expected to have a limited impact on operating
margins.
Cost
of Revenue. The Companys total cost of revenue increased by $1,342,000 or
14.1% to $10,868,000 for the nine months ended September 30, 2007, as compared
to $9,526,000 for the nine months ended September 30, 2006, primarily as a
result of an increase in MediaDefender cost of revenue of $1,311,000 and media
cost of revenues of $452,000, offset by a reduction in e-commerce cost of
revenues of $421,000. Depreciation of property and equipment is included in
cost of revenue for all business segments.
As previously
disclosed, MediaDefender has experienced increasing bandwidth, operating,
personnel and occupancy costs, which are continuing to have a negative impact
on cost of revenue in 2007 as compared to 2006, but which are expected to
provide increased revenue opportunities in the long-term. Contributing to this
increase in costs during the nine months ended September 30, 2007 was
MediaDefenders relocation of its servers to a higher quality co-location
facility and a change in bandwidth providers in early 2007, which was done in
order to improve the reliability and increase the capacity of MediaDefenders
services. Included in MediaDefenders cost of revenue for the nine months ended
September 30, 2007 and 2006 was the amortization of proprietary technology acquired
in the MediaDefender transaction of $1,900,000.
As
a result of the increase in media revenue referred to above, media cost of
revenue increased by $452,000 or 21.4% to $2,562,000 for the nine months ended
September 30, 2007, as compared to $2,110,000 for the nine months ended
September 30, 2006.
E-commerce
cost of revenue decreased by $421,000 or 23.46% to $1,378,000 for the nine
months ended September 30, 2007, as compared to $1,799,000 for the nine months
ended September 30, 2006, primarily as a result of the decrease in e-commerce
revenues.
As
a result of the foregoing, total gross profit was $7,109,000 for the nine
months ended September 30, 2007, as compared to $8,109,000 for the nine months
ended September 30, 2006, reflecting a combined gross margin of 39.5% and
46.0%, respectively. A summary of gross profit and gross margin by segment is
as follows ($000):
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
Segment:
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
Gross
Profit
|
|
Gross
Margin
|
|
E-commerce
|
|
$
|
(38
|
)
|
(2.8
|
)%
|
$
|
118
|
|
6.2
|
%
|
Media
|
|
2,577
|
|
50.1
|
%
|
1,827
|
|
46.4
|
%
|
Anti-piracy and file-sharing marketing
services
|
|
4,570
|
|
39.7
|
%
|
6,164
|
|
52.3
|
%
|
Totals
|
|
$
|
7,109
|
|
39.5
|
%
|
$
|
8,109
|
|
46.0
|
%
|
Sales
and Marketing. The Companys sales and marketing expense increased by $600,000
or 71.5%, to $1,439,000 for the nine months ended September 30, 2007, as
compared to $839,000 for the nine months ended September 30, 2006, primarily as
a result of additional personnel-related costs. Included in sales and marketing
expense for the nine months ended September 30, 2007 and 2006 is the
amortization of customer relationships acquired in the MediaDefender
transaction of $566,000 and $565.000, respectively.
General and Administrative.
The Companys general and administrative expense increased by $1,594,000 or
23.1%, to $8,490,000 for the nine months ended September 30, 2007, as compared
to $6,896,000 for the nine months ended September 30, 2006. Included in general
and administrative expense for the nine months ended September 30, 2007 and
2006 are stock-based compensation costs of $1,690,000 and $1,736,000,
respectively, and the amortization of non-competition agreements of $247,000
and $348,000, respectively, resulting from the MediaDefender transaction.
Also
included in general and administrative expense for the nine months ended
September 30, 2007 was approximately $225,000 of legal, consulting and other
direct costs related to the MediaDefender security breach and $525,000 that was
accrued with respect to 2007 performance bonuses for the Chief Executive
Officer and the President of MediaDefender.
52
During the
nine months ended September 30, 2007 and 2006, the Company incurred legal,
accounting, consulting and printing fees and costs of approximately $1,666,000
and $845,000, respectively, relating to the preparation and filing of various
documents with the SEC (including the restated financial statements and the
currently effective registration statement), negotiations with senior and
subordinated note holders, review and analysis of various restructuring
alternatives, amendments to financing agreements, and other ordinary course
legal and accounting matters. As a result of the necessity to restate the
Companys previously-issued financial statements (which were filed with the SEC
on April 19, 2007) and the resultant default on the Companys senior and
subordinated debt agreements in January 2007 (see Going Concern above), the
Company expects to incur significant continuing costs in this regard at least
for the remainder of 2007.
Significant
components of general and administrative expense consist of management
compensation (and bonuses, when applicable), personnel and personnel-related
costs, insurance, legal and accounting fees, board compensation, consulting
fees and occupancy costs.
Development and Engineering.
Development and engineering costs were $419,000 for the nine months ended
September 30, 2007.
During the nine months ended September 30, 2006,
these costs, which were not material, were included in cost of revenue.
Development and engineering costs consist primarily of third-party
development costs and payroll and related expenses for in-house development
costs incurred in the design and production of the Companys content and
services, including revisions to the Companys web-site.
Write-off of Fixed Assets. During the nine months ended September 30,
2007, the Company recorded a charge to operations of $97,000 to write-off the
net book value of obsolete computer equipment that it does not expect to
utilize in future periods.
Income
(Loss) from Operations. As a result of the aforementioned factors, the loss
from operations was $3,336,000 for the nine months ended September 30, 2007, as
compared to income from operations of $374,000 for the nine months ended
September 30, 2006.
Interest
Income. Interest income was $160,000 for the nine months ended September 30,
2007, as compared to $76,000 for the nine months ended September 30, 2006.
Interest Expense.
Interest
expense of $5,733,000 and $4,411,000 for the nine months ended September 30,
2007 and 2006, respectively, relates to the $15,000,000 of secured notes
payable issued in the Senior Financing, which bear interest at 11.25% per
annum, and the $30,000,000 of subordinated convertible notes payable issued in
the Sub-Debt Financing, which bear interest at 4.0% per annum, both of which
were issued to finance the acquisition of MediaDefender in July 2005. Effective
January 18, 2007, the interest rate on the Sub-Debt Financing increased from
4.0% to 12.0% due to the default on the Companys senior and subordinated debt
agreements in January 2007 (see Going Concern above). On August 3, 2007, the
Company entered into a Waiver and Forbearance Agreement with the holders of the
Sub-Debt Financing pursuant to which the holders agreed to waive their right to
charge the 12.0% default interest rate triggered by the Companys defaults
under the Subordinated Financing transaction documents and instead charge the
4.0% standard interest rate on the Sub-Debt Notes for the period from July 16,
2007 through August 31, 2007. Effective September 1, 2007, the interest rate
returned to the 12.0% default interest rate. Included in interest expense for
the nine months ended September 30, 2007 is interest expense of $166,000
relating to the accrued registration penalty obligation.
Additional
consideration in the form of warrants issued to the lenders was accounted for
at fair value and recorded as a reduction to the carrying amount of the debt,
and is being amortized to interest expense over the term of the debt.
Accordingly, the amortization of this discount on debt included in interest
expense for the nine months ended September 30, 2007 and 2006 was $536,000 and
$547,000, respectively.
The Sub-Debt
Notes contain several embedded derivative features that have been accounted for
at fair value. The various embedded derivative features of the Sub-Debt Notes
have been valued at the date of inception of the Sub-Debt Financing and at the
end of each reporting period thereafter. The value of the embedded derivatives
were bifurcated from the Sub-Debt Notes and recorded as derivative liability,
with the initial amount recorded as discount on the related Sub-Debt Notes.
This discount is being amortized to interest expense over the life of the
Sub-Debt Notes. Accordingly, the amortization of this discount on debt included
in interest expense for the nine months ended September 30, 2007 and 2006 was
$1,769,000 and $1,816,000, respectively.
53
Loss on
Foreign Currency Transactions. The loss on foreign currency transactions was
$14,000 for the nine months ended September 30, 2007. The Company did not have
any loss on foreign currency transactions for the nine months ended September
30, 2006.
Other Income.
Other income was $63,000 for the nine months ended September 30, 2006. The
Company did not have any other income for the nine months ended September 30,
2007.
Reduction in
Liquidated Damages Payable Under Registration Rights Agreements. In accordance
with EITF 00-19-2, which the Company adopted as of December 31, 2006, and SFAS
No. 5, the Company accrued seven months liquidated damages (through mid-August
2007) under the registration rights agreements aggregating approximately
$3,777,000 as a charge to operations at December 31, 2006. As a result of the
Companys registration statement being declared effective on July 6, 2007,
which was earlier than originally estimated, the Company recorded a reduction
to the original accrual of $719,000 in other income (expense) in the statement
of operations during the nine months ended September 30, 2007.
Change in Fair Value of Warrant Liability. In accordance with EITF
00-19, the fair value of the warrants issued in connection with the financing
of the MediaDefender acquisition in July 2005 was recorded as warrant
liability. The carrying value of the warrants is adjusted quarterly to reflect
any changes in the fair value such liability and is included in the statement of
operations as other income (expense). For the nine months ended September 30,
2007 and 2006, the Company recorded income (expense) of $1,643,000 and
$(1,818,000), respectively, to reflect the change in warrant liability during
such periods.
Change in Fair Value of Derivative Liability. In accordance with EITF
00-19, the fair value of the embedded derivatives was bifurcated from the
subordinated convertible notes payable issued in connection with the financing
of the MediaDefender acquisition in July 2005 and recorded as a derivative
liability. The carrying value of the derivative liability is adjusted quarterly
to reflect any changes in the fair value of such liability and is included in
the statement of operations as other income (expense). For the nine months
ended September 30, 2007 and 2006, the Company recorded income (expense) of
$7,056,000 and $(2,765,000), respectively, to reflect the change in derivative
liability during such periods.
Amortization
of Deferred Financing Costs.
Amortization of deferred financing costs
was $629,000 and $646,000 for the nine months ended September 30, 2007 and
2006, respectively. Deferred financing costs consist of consideration paid to
third parties with respect to the acquisition and financing of the
MediaDefender transaction, including cash payments, subordinated convertible
notes payable and the fair value of warrants issued for placement agent fees,
which were deferred and are being amortized over the term of the related debt.
Write-Off
of Unamortized Discount on Debt and Deferred Financing Costs Resulting from
Principal Payments on Senior Secured Notes Payable and Conversion of
Subordinated Convertible Notes Payable.
Deferred financing costs and
debt discount costs aggregating $1,580,000 were charged to operations as a
result of principal payments on senior secured notes payable and conversion of
subordinated convertible notes payable during the nine months ended September
30, 2006. There were no principal payments on senior secured notes payable or
conversions of subordinated convertible notes payable during the nine months
ended September 30, 2007.
Loss
Before Income Taxes. As a result of the aforementioned factors, the loss before
income taxes was $134,000 for the nine months ended September 30, 2007, as
compared to a loss before income taxes of $11,348,000 for the nine months ended
September 30, 2006.
Provision
for Income Taxes.
As a result of the non-deductibility of certain
non-cash charges and accruals and the non-inclusion of certain non-cash gains
for tax reporting purposes, the Company incurred a taxable loss during the nine
months ended September 30, 2007 and therefore did not record a provision for
income taxes for such period.
As
a result of the profitable operations of MediaDefender during the nine months
ended September 30, 2006, the non-deductibility of certain non-cash charges and
accruals for tax reporting purposes, and permanent limitations on the Companys
ability to utilize its net operating loss carry-forwards, the Company recorded
a provision for income taxes of $797,000 for such period.
Net
Loss. As a result of the aforementioned factors, the Company had a net loss of
$134,000 for the nine months ended September 30, 2007, as compared to a net
loss of $12,145,000 for the nine months ended September 30, 2006.
54
Liquidity
and Capital Resources September 30, 2007:
As more fully described above at Going Concern, as a result of
communications with the Staff of the SEC in 2006, in particular regarding the
application of accounting rules and interpretations related to embedded
derivatives associated with the Companys subordinated convertible notes
payable issued in July 2005, the Company determined that it was necessary to
restate previously issued financial statements.
As a result, in December 2006, the Company was required to suspend the
use of its then effective registration statement for the holders of its senior
and subordinated indebtedness and thus incurred an event of default with
respect to it registration rights agreements with the holders of such
indebtedness. Accordingly, beginning January 18, 2007, the Company began to
incur liquidated damages under its registration rights agreements aggregating
approximately $540,000 per month, and the interest rate on its subordinated
convertible notes payable increased from 4.0% per annum to 12.0% per annum, an
increase of approximately $183,000 per month. The Company has not paid the
outstanding liquidated damages.
The
Company believes that the amount of the liquidated damages accrued reflects the
undiscounted maximum potential amount of liquidated damages payable to the
holders of the Senior Financing and the Sub-Debt Financing since on July 6,
2007, the underlying shares become generally available for resale under an
effective registration statement.
A summary of the
registration penalty accrual at September 30, 2007 and December 31, 2006 is
presented below.
|
|
September 30,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Senior secured notes payable
|
|
$
|
775,000
|
|
$
|
1,575,000
|
|
Subordinated convertible notes payable
|
|
1,783,000
|
|
2,202,000
|
|
Total registration penalty accrual
|
|
$
|
2,558,000
|
|
$
|
3,777,000
|
|
|
|
|
|
|
|
|
|
|
|
A summary of accrued interest payable at September 30, 2007 and
December 31, 2006 is presented below.
|
|
September 30,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Senior secured notes payable
|
|
$
|
62,000
|
|
$
|
67,000
|
|
Subordinated convertible notes payable
|
|
2,095,000
|
|
|
|
Liquidated damages payable under
registration rights agreements with respect to:
|
|
|
|
|
|
Senior secured notes payable
|
|
54,000
|
|
|
|
Subordinated convertible notes payable
|
|
112,000
|
|
|
|
Total accrued interest payable
|
|
$
|
2,323,000
|
|
$
|
67,000
|
|
Primarily as a result of the requirement to restate previously issued
financial statements, which resulted in the recording of an embedded derivative
liability, the reclassification of the senior and subordinated indebtedness to
current liabilities, and the recording of estimated liquidated damages payable
under registration rights agreements, the Company was not in compliance with
certain of its financial covenants under both the Senior Financing and the
Sub-Debt Financing at September 30, 2007 and December 31, 2006. Notwithstanding
such developments, the Company believes that it would have been out of compliance
with certain of its financial covenants at September 30, 2007.
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United
States of America, which contemplate continuation of the Company as a going
concern. As a result of the foregoing, the Companys independent registered
public accounting firm, in its report on the Companys 2006 consolidated
financial statements, expressed substantial doubt about the Companys ability
to continue as a going concern. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that
could result from the outcome of this uncertainty.
Pursuant to a Forbearance and Consent Agreement with the investors in
the Senior Financing, such investors agreed to forbear from the exercise of
their rights and remedies under the Senior Financing documents as a result of the
events of default with respect to the unavailability of the Companys
registration statement, as well as certain other events of default that existed
or that could come into existence during the forbearance period, from April 17,
2007 through July 31, 2007, in exchange for aggregate cash payments of
$500,000. The payments made by the Company under the Forbearance and Consent
Agreement may be credited against the registration delay cash penalties or any
other amounts ultimately determined to be due the investors in the Senior
Financing.
55
On July 6, 2007, the Companys registration statement was declared
effective by the SEC, thus making it available to the investors in the Senior
Financing and Sub-Debt Financing. Although the Company and its representatives
and advisors are in ongoing discussions with the investors in the Senior
Financing and the investors in the Sub-Debt Financing as to a comprehensive
resolution of the matters discussed herein, the Company cannot predict the
ultimate outcome of such discussions, or what actions, if any, the investors in
the Senior Financing may decide to take, and when, under their financing
documents.
On August 3, 2007, the Company entered into a Waiver and Forbearance Agreement
with the holders of the Sub-Debt Financing pursuant to which the holders agreed
to waive their right to charge the 12.0% default interest rate triggered by the
Companys defaults under the Subordinated Financing transaction documents and
instead charge the 4.0% standard interest rate on the Sub-Debt Notes for the
period from July 16, 2007 through August 31, 2007 (the Forbearance Period).
The holders of the Sub-Debt Financing also agreed to forbear from exercising
any of their other rights and remedies under the Sub-Debt Financing transaction
documents during the Forbearance Period, upon the terms and conditions in the
Waiver and Forbearance Agreement. Effective September 1, 2007, the interest
rate returned to the 12.0% default interest rate.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company and its representatives and advisors are in ongoing
discussions with the holders of its senior and subordinated debt obligations to
obtain a waiver of and amendment to certain of the financing documents with
respect to the events of default, the impact of the restatements, the payment
of cash penalties and default interest, and various related matters. The
Company is exploring various alternatives to resolve the defaults under its
senior and secured debt obligations, but is unable to predict the outcome of
such negotiations. To the extent that the Company is unable to restructure its
senior and subordinated debt obligations in a satisfactory manner and/or the
lenders begin to exercise additional remedies to enforce their rights, the
Company will not have sufficient cash resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the
United States Bankruptcy Code.
Overview:
Until the acquisition of MediaDefender effective July 28, 2005, the
Company financed its continuing operations primarily from the sale of its
equity securities. Concurrent with the acquisition of MediaDefender in July
2005, the Company completed a $15,000,000 Senior Financing and a $30,000,000
Sub-Debt Financing, which generated approximately $1,000,000 for general
working capital purposes. In addition, MediaDefender had working capital of
$2,745,000 at the acquisition date. The Company anticipates that this business
will continue to generate profitable results of operations and positive cash
flows.
As of
September 30, 2007 and December 31, 2006, the Company had $6,360,000 and
$5,602,000 of unrestricted cash and cash equivalents, respectively. At
September 30, 2007, the Company had a working capital deficiency of
$45,397,000, primarily because of the classification of senior secured notes
payable and subordinated convertible notes payable as current liabilities, the
accrual of liquidated damages payable under registration rights agreements of
$2,558,000, and warrant liability of $3,073,000 and derivative liability of
$11,300,000 at such date. At December 31, 2006, the Company had a working
capital deficiency of $50,816,000, primarily because of the reclassification of
senior secured notes payable and subordinated convertible notes payable from
long-term liabilities to current liabilities, the accrual of liquidated damages
payable under registration rights agreements of $3,777,000, and warrant
liability of $4,715,000 and derivative liability of $18,356,000 at such date.
Excluding the
warrant liability and derivative liability, the working capital deficiency
increased by $3,279,000 during the nine months ended September 30, 2007, to
$31,024,000 at September 30, 2007 as compared to $27,745,000 at December 31,
2006.
During 2005
and 2006 and the nine months ended September 30, 2007, the Companys
consolidated operations generated sufficient cash flows from operations to
enable the Company to fund its operating requirements and its originally
scheduled (i.e., undefaulted) debt service obligations to both the senior and
subordinated debt holders, and management currently anticipates that cash flows
from operations will be adequate to fund operating and debt service
requirements (based on the original terms as contemplated in the senior and subordinated
loan agreements and excluding the registration penalty amounts) for the
remainder of 2007 and generate operating cash flows in excess of pre-default
amounts for at least the next twelve months.
Operating. Net
cash provided by operating activities for the nine months ended September 30,
2007 was $961,000, as compared to net cash provided by operating activities of
$146,000 for the nine months ended September 30, 2006.
56
Despite a
decrease in operating margins in the MediaDefender business segment, operating
cash flow increased in 2007 as compared to 2006, primarily as a result of an
increase in media revenues and the positive impact on cash flows from changes
in operating assets and liabilities, in particular accounts receivable, accrued
expenses and accrued interest payable.
Investing. Net
cash used in investing activities for the nine months ended September 30, 2007
and 2006 was $391,000 and $955,000, respectively, for additions to property and
equipment. Included in additions to property and equipment in 2006 were
leasehold improvements related to the Companys new Santa Monica office
facility of $247,000 and purchases of property and equipment of $576,000,
primarily by MediaDefender.
Financing. Net cash provided by financing activities for the nine
months ended September 30, 2007 was $188,000, which consisted of a decrease of
$86,000 in restricted cash and $102,000 from the exercise of stock options. Net
cash provided by financing activities for the nine months ended September 30,
2006 was $3,586,000, which consisted of $5,212,000 from the exercise of
warrants and $71,000 from the exercise of stock options, offset by principal
payments on senior secured notes payable of $1,693,000 and an increase of
$4,000 in restricted cash
.
Contractual
Obligations:
As of
September 30, 2007, the Companys principal commitments for the next five
fiscal years consisted of contractual commitments as summarized below. The
summary shown below assumes that the senior secured notes payable and the
subordinated convertible notes payable are outstanding for their full terms
(based on the original terms as contemplated in the senior and subordinated
loan agreements), without any early reduction of the principal balances of the
senior secured notes payable based on cash flows.
|
|
|
|
Payments Due by Year (in thousands)
|
|
Contractual cash obligations ($ 000)
|
|
Total
|
|
2007
|
|
2008
|
|
2009
|
|
2010
|
|
2011
|
|
|
|
|
|
(3 months)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Employment and consulting contracts (1)
|
|
$
|
1,873
|
|
$
|
400
|
|
$
|
1,440
|
|
$
|
33
|
|
$
|
|
|
$
|
|
|
Lease obligations
|
|
4,757
|
|
614
|
|
1,618
|
|
1,442
|
|
613
|
|
470
|
|
Liquidated damages payable under
registration rights agreements (2)
|
|
2,558
|
|
2,558
|
|
|
|
|
|
|
|
|
|
Interest on liquidated damages payable
under registration rights agreements
|
|
166
|
|
166
|
|
|
|
|
|
|
|
|
|
Senior secured notes payable
|
|
13,307
|
|
|
|
|
|
13,307
|
|
|
|
|
|
Interest on senior secured notes payable
|
|
2,707
|
|
378
|
|
1,518
|
|
811
|
|
|
|
|
|
Subordinated convertible notes payable
|
|
27,658
|
|
|
|
|
|
27,658
|
|
|
|
|
|
Interest on subordinated convertible notes
payable (3)
|
|
4,670
|
|
2,931
|
|
1,106
|
|
633
|
|
|
|
|
|
Total contractual cash obligations
|
|
$
|
57,696
|
|
$
|
7,047
|
|
$
|
5,682
|
|
$
|
43,884
|
|
$
|
613
|
|
$
|
470
|
|
(1) Base
compensation only; does not include any performance bonuses.
(2) Calculation based on the period from January 18, 2007 through July
6, 2007.
(3) Assumes interest at 12% default rate through December 31, 2007 and
4% thereafter.
Capital
Expenditures:
The
Company estimates that it will have capital expenditures aggregating
approximately $250,000 for the remainder of the year ending December 31, 2007.
Off-Balance
Sheet Arrangements:
At September 30, 2007, the Company did not have any transactions,
obligations or relationships that could be considered off-balance sheet
arrangements.
57
ITEM 3. CONTROLS AND
PROCEDURES
(a) Evaluation of Disclosure Controls and
Procedures
Disclosure controls and
procedures are controls and other procedures that are designed to ensure that
information required to be disclosed in the reports filed or submitted by the
Company under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the
rules and forms of the Securities and Exchange Commission. Disclosure controls
and procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the Companys reports filed
under the Securities Exchange Act of 1934, as amended, is accumulated and
communicated to the Companys management, including the Chief Executive Officer
and the Interim Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure. Management recognizes that any
controls and procedures, no matter how well-designed and operated, can provide
only reasonable assurance of achieving their objectives, and management
necessarily applies its judgment in evaluating the cost-benefit relationship of
possible controls and procedures.
The Company carried out an
evaluation, under the supervision and with the participation of its management,
including its Chief Executive Officer and Interim Chief Financial Officer, of
the effectiveness of the Companys disclosure controls and procedures as of the
end of the period covered by this report. Based upon and as of the date of that
evaluation, the Companys Chief Executive Officer and Interim Chief Financial
Officer concluded that the Companys disclosure controls and procedures were
effective.
(b) Changes in Internal Control Over Financial
Reporting
There were no changes in the
Companys internal control over financial reporting or in other factors that
materially affected, or are reasonably likely to materially affect, those
controls subsequent to the date of the Companys most recent evaluation.
58