10-Q 1 q30510q.txt 3RD QUARTER 2005 FORM 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2005 Commission File Number: 0-21683 ---------------------- GraphOn Corporation (Exact name of Registrant as specified in its charter) ---------------------- Delaware 13-3899021 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 5400 Soquel Avenue, Suite A2 Santa Cruz, CA 95062 (Address of principal executive offices) Registrant's telephone number: (800) 472-7466 ---------------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [ ] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] As of November 14, 2005, there were issued and outstanding 46,167,047 shares of the Registrant's Common Stock, par value $0.0001. ================================================================================ GRAPHON CORPORATION FORM 10-Q Table of Contents Page PART I.FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004 2 Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three months ended September 30, 2005 and 2004 and for the nine months ended September 30, 2005 and 2004 3 Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 4 Notes to Unaudited Condensed Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk 24 Item 4. Controls and Procedures 25 PART II. OTHER INFORMATION Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 25 Item 6.Exhibits 25 Signatures 26 PART I--FINANCIAL INFORMATION ITEM 1 Financial Statements
GRAPHON CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS September 30, December 31, 2005 2004 ASSETS ------------- ------------ ------------ (Unaudited) Current Assets: Cash and cash equivalents ..................... $ 3,125,900 $ 675,300 Accounts receivable, net of allowance for doubtful accounts of $62,000 and $46,800 ..... 459,200 518,900 Prepaid expenses and other current assets ..... 10,300 24,100 ------------ ------------ Total Current Assets .......................... 3,595,400 1,218,300 ------------ ------------ Property and equipment, net ...................... 93,500 75,400 Capitalized software, net ........................ 128,500 273,700 Patents, net ..................................... 4,827,400 -- Deferred acquisition costs ....................... -- 269,700 Note receivable - related party .................. -- 350,000 Other assets ..................................... 9,400 37,300 ------------ ------------ TOTAL ASSETS ................................ $ 8,654,200 $ 2,224,400 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current Liabilities: Accounts payable .............................. $ 122,900 $ 250,200 Accrued expenses .............................. 231,100 231,400 Accrued wages ................................. 327,400 260,100 Deferred revenue .............................. 818,800 689,800 ------------ ------------ Total Current Liabilities ..................... 1,500,200 1,431,500 Deferred revenue .............................. 567,400 426,600 ------------ ------------ TOTAL LIABILITIES ........................... 2,067,600 1,858,100 ------------ ------------ Commitments and contingencies Stockholders' Equity: Preferred stock, $0.01 par value, 5,000,000 shares authorized, no shares issued and outstanding .... -- -- Common stock, $0.0001 par value, 195,000,000 shares authorized, 46,167,047 and 21,716,765 shares issued and outstanding ................... 4,600 2,200 Additional paid in capital ....................... 58,397,500 46,930,700 Deferred Compensation ............................ (6,900) -- Notes receivable - directors ..................... -- (50,300) Note receivable - shareholder .................... (347,400) -- Accumulated other comprehensive loss ............. -- (400) Accumulated deficit .............................. (51,461,200) (46,515,900) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY .................. 6,586,600 366,300 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .. $ 8,654,200 $ 2,224,400 ============ ============ See accompanying notes to condensed consolidated financial statements.
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GRAPHON CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- 2005 2004 2005 2004 ------------ ------------ ------------ ------------ (Unaudited) (Unaudited) (Unaudited) (Unaudited) Revenue: Product licenses .............................. $ 829,700 $ 568,800 $ 2,666,900 $ 1,645,800 Service fees .................................. 338,000 257,700 939,400 751,700 Other ......................................... 8,700 105,000 26,300 114,300 ------------ ------------ ------------ ------------ Total Revenue .............................. 1,176,400 931,500 3,632,600 2,511,800 ------------ ------------ ------------ ------------ Cost of Revenue: Product costs ................................. 53,000 60,000 156,800 517,100 Service costs ................................. 62,300 87,100 210,200 244,800 ------------ ------------ ------------ ------------ Total Cost of Revenue ...................... 115,300 147,100 367,000 761,900 ------------ ------------ ------------ ------------ Gross Profit ............................... 1,061,100 784,400 3,265,600 1,749,900 ------------ ------------ ------------ ------------ Operating Expenses: Selling and marketing ......................... 337,100 356,700 1,014,000 1,119,500 General and administrative .................... 756,900 357,000 2,252,000 869,700 Research and development ...................... 333,200 366,800 969,900 1,226,400 ------------ ------------ ------------ ------------ Total Operating Expenses ...................... 1,427,200 1,080,500 4,235,900 3,215,600 ------------ ------------ ------------ ------------ Loss From Operations .......................... (366,100) (296,100) (970,300) (1,465,700) ------------ ------------ ------------ ------------ Other Income (Expense): Interest and other income .................. 10,200 2,500 30,000 9,000 Interest and other expense ................. (3,500) -- (5,000) -- ------------ ------------ ------------ ------------ Total Other Income ......................... 6,700 2,500 25,000 9,000 ------------ ------------ ------------ ------------ Net Loss ...................................... (359,400) (293,600) (945,300) (1,456,700) Other Comprehensive Income (Loss), net of tax: Foreign currency translation gain (loss) ... -- (100) -- 400 ------------ ------------ ------------ ------------ Comprehensive Loss ............................ (359,400) (293,700) (945,300) (1,456,300) Deemed dividends on preferred stock ........... -- -- (4,000,000) -- ------------ ------------ ------------ ------------ Loss Attributable to Common Shareholders ...... $ (359,400) $ (293,700) $ (4,945,300) $ (1,456,300) ============ ============ ============ ============ Basic and Diluted Loss per Common Share ....... $ (0.01) $ (0.01) $ (0.12) $ (0.07) ============ ============ ============ ============ Weighted Average Common Shares Outstanding .... 46,158,786 21,679,723 40,373,157 21,218,971 ============ ============ ============ ============ See accompanying notes to condensed consolidated financial statements.
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GRAPHON CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30, 2005 2004 ------------ ------------ (Unaudited) (Unaudited) Cash Flows From Operating Activities: Net loss .............................................. $ (945,300) $ (1,456,700) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization ...................... 777,300 596,000 Amortization of deferred compensation .............. 2,000 -- Provision for doubtful accounts .................... 15,200 -- Proceeds from notes receivable - directors .......... 50,300 -- Proceeds from note receivable - shareholder ......... 2,600 -- Interest accrued on notes receivable - directors ... (300) (1,400) Interest accrued on note receivable - shareholder .. (9,600) -- Proceeds from interest accrued on notes receivable - directors ........................................ 4,300 -- Proceeds from interest accrued on note receivable - Shareholder ...................................... 1,200 -- Changes in operating assets and liabilities: Accounts receivable ................................ 44,500 (17,200) Prepaid expenses and other current assets .......... 13,800 6,000 Accounts payable ................................... 12,100 33,400 Accrued expenses ................................... (38,600) (144,300) Accrued wages ...................................... 67,300 63,500 Deferred revenue ................................... 269,800 56,600 ------------ ------------ Net Cash Provided By (Used In) Operating Activities ... 266,600 (864,100) ------------ ------------ Cash Flows From Investing Activities: Cash paid for NES acquisition ......................... (697,500) -- Capital expenditures .................................. (55,500) (33,400) Other assets .......................................... (4,600) 5,200 ------------ ------------ Net Cash Used In Investing Activities .............. (757,600) (28,200) ------------ ------------ Cash Flows From Financing Activities: Proceeds from private placement of preferred stock and warrants ...................... 3,335,000 1,150,000 Costs of private placement of preferred stock and warrants ......................................... (402,000) (215,200) Proceeds from sale of common stock under employee stock purchase plan ......................... 10,000 9,000 Proceeds from exercise of warrants .................... -- 6,900 ------------ ------------ Net Cash Provided By Financing Activities .......... 2,943,000 950,700 ------------ ------------ Effect of exchange rate fluctuations on cash and cash equivalents ................................... (1,400) 400 ------------ ------------ Net Increase in Cash and Cash Equivalents ............. 2,450,600 58,800 Cash and Cash Equivalents, beginning of period ........ 675,300 1,025,500 ------------ ------------ Cash and Cash Equivalents, end of period .............. $ 3,125,900 $ 1,084,300 ============ ============ See accompanying notes to condensed consolidated financial statements.
4 GRAPHON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation The unaudited condensed consolidated financial statements of GraphOn Corporation (the Company) and its subsidiaries included herein have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes necessary for a complete presentation of the Company's results of operations, financial position and cash flows. The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments in the three and nine-month periods ended September 30, 2005 and 2004) that are, in the opinion of management, necessary to state fairly the results for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with the Company's audited financial statements contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2004, which was filed with the Securities and Exchange Commission (the Commission) on April 15, 2005. The interim results presented herein are not necessarily indicative of the results of operations that may be expected for the full fiscal year ending December 31, 2005, or any future period. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates include the allowance for doubtful accounts, the estimated lives of intangible assets, depreciation of fixed assets and accrued liabilities, among others. Actual results could differ materially from those estimates. Significant intercompany accounts and transactions are eliminated upon consolidation. 2. Patents (Network Engineering Software Acquisition). On January 31, 2005, the Company acquired all of the outstanding common stock of Network Engineering Software ("NES") in exchange for 9,599,993 shares of the Company's common stock, valued at $3,916,800, and approximately $897,800 in cash payments to settle various claims against NES prior to the acquisition. Approximately $665,000 of the $897,800 cash payments was made in December 2004 by AIGH Investment Partners, LLC ("AIGH"), an affiliate of a principal stockholder (Orin Hirschman), to settle, on the Company's behalf, certain third party litigation against NES. The Company reimbursed this amount through a partial credit against the price of our securities acquired by AIGH in the 2005 private placement (See Note 3). The Company incurred $563,500 of transaction costs, resulting in a purchase price of $5,378,100. The acquisition was accounted for as a business combination. Accordingly, the assets acquired (primarily consisting of patents, patent applications, and in-process patent applications) have been recorded at their estimated fair value. In connection with the acquisition, the Company recorded a deferred tax liability of $2,151,200, resulting from a difference between the tax basis and 5 financial statement basis of the assets acquired. Furthermore, the Company has recorded a corresponding $2,151,200 reduction in its valuation allowance on its deferred tax assets as of March 31, 2005 to reflect management's estimate that it is more likely than not that the Company will realize the tax benefits from utilization of certain of its tax net operating loss carryforwards from future reversals of the taxable temporary differences arising from the NES acquisition. These amounts have been netted together on the Company's condensed balance sheet. The estimated cost of the patent related assets is being amortized over a 6-year period using the straight-line method. For the three and nine-month periods ended September 30, 2005, approximately $224,200 and $594,700 of amortization was charged against the cost of the patent related assets. No such amortization was charged in the corresponding periods of the prior year. The estimated cost of these assets and their estimated useful lives may change as a result of the completion of a valuation study and as all direct acquisition costs are finalized. The final adjustments to the estimated costs of these assets are not expected to be material. As of December 31, 2004, prior to the consummation of the acquisition, the Company had deferred approximately $269,700 of the acquisition costs. These deferred acquisition costs are included in the transaction costs above. The following unaudited pro forma information presents the consolidated results of the Company as if the NES acquisition had occurred at the beginning of the respective periods. The pro forma information is not necessarily indicative of what would have occurred had the acquisition been made as of such period, nor is it indicative of future results of operations. The pro forma amounts give effect to appropriate adjustments for the fair value of the patents, amortization and income taxes.
Nine Months Ended September 30, 2005 2004 -------------- -------------- Revenue $ 3,632,600 $ 2,511,800 Net loss (1,051,400) (2,668,800) Net loss attributable to common shareholders (5,051,400) (6,668,800) Loss per share - basic and diluted (0.11) (0.14)
3. Stockholders' Equity During the first quarter of 2005, the Company issued 15,489 shares of common stock to employees under provisions of the Employee Stock Purchase Plan (the ESPP), resulting in cash proceeds of approximately $4,600. During the first quarter of 2005, the Company completed a private placement (the "2005 Private Placement"), which, after the Company's stockholders approved an amendment to the Company's Certificate of Incorporation, resulted in the issuance of 14,814,800 shares of common stock and gross cash proceeds of approximately $3,335,000, net of the $665,000 credit issued to AIGH (See Note 2 and Note 9)). Also during the first quarter of 2005, the Company issued 9,599,993 shares of common stock, with a value of $3,916,800, to consummate its acquisition of NES (See Note 2). During the first quarter of 2005, the Company reclassified note receivable - third party from the long-term assets section of its balance sheet to the equity section under the title note receivable - shareholder to reflect the replacement of the NES stock that had been collateralizing the note, as of December 31, 2004, with Company stock, upon the consummation of the acquisition of NES (See Note 2) on January 31, 2005. During the first quarter of 2005, the Company received an aggregate of approximately $54,600 as payment in full of the principal and accrued interest due from the notes receivable - directors. During the third quarter of 2005, the Company issued 20,000 shares of common 6 stock to employees under provisions of the ESPP, resulting in cash proceeds of approximately $5,400. 4. Litigation The Company is currently not involved in any litigation that it believes would have a materially adverse affect upon its financial results or financial position. 5. Stock-Based Incentive Programs The Company accounts for stock-based compensation under the intrinsic value method of accounting for stock awards, in accordance with Accounting Principles Board Opinion number 25, "Accounting for Stock Issued to Employees" (APB 25) as permitted by Statement of Financial Accounting Standards number 123, "Stock-Based Compensation" (SFAS 123). The Company has not changed to the fair value method of accounting for stock-based employee compensation. Had the Company applied the fair value recognition provisions of SFAS 123 to stock-based compensation, the Company's net loss and basic and diluted loss per share would have been changed from the "as reported" amounts to the "pro forma" amounts as follows for each of the respective periods:
Three months ended September 30, ---------- ---------- 2005 2004 Net loss: As reported: $ (359,400) $ (293,600) Add: stock-based compensation expense included in net loss, net of related tax effects 500 - Deduct: total stock-based compensation expense determined under fair-value method for all awards, net of related tax effects (122,600) (51,000) ---------- ---------- Pro forma net loss attributable to common shareholders: $ (481,500) $ (344,600) ========== ========== Basic and diluted loss per share: As reported $ (0.01) $ (0.01) Pro forma $ (0.01) $ (0.02)
Nine months ended September 30, 2005 2004 ------------ ------------ Net loss: As reported: $ (945,300) $ (1,456,700) Less: Deemed dividends on preferred stock (4,000,000) - 7 Add: stock-based compensation expense included in net loss, net of related tax effects 2,000 - Deduct: total stock-based compensation expense determined under fair-value method for all awards, net of related tax effects (316,900) (232,600) ------------ ------------ Pro forma net loss attributable to common shareholders: $ (5,260,200) $ (1,689,300) ============ ============ Basic and diluted loss per share: As reported $ (0.11) $ (0.07) Pro forma $ (0.11) $ (0.08)
6. Commitments and Contingencies In October 2004, the Company renewed its operating lease for an approximate 3,300 square foot facility in New Hampshire. This lease is cancelable by the landlord or the Company upon 30-days written notice. Monthly rental payments for this facility are approximately $5,300. The Company currently occupies approximately 1,900 square feet of office space in Santa Cruz, California. The office space is rented pursuant to a three-year operating lease, which became effective August 1, 2005. Rent on this facility will approximate $2,900 per month over the course of the lease. The Company has an option to extend the lease term for one additional three-year period. The Company has been occupying leased facilities in Rolling Hills Estates, California, on a month-to-month basis since October 2002. Rent on this facility is approximately $1,000 per month. The Company has also been renting an office in Berkshire, England, United Kingdom since December 2002. This operating lease runs through December 2005. Rent on this office, which can fluctuate depending on exchange rates, is approximately $400 per month. As a condition of a private placement that occurred during January 2004 (the "2004 private placement"), the Company entered into an Investment Advisory Agreement with Orin Hirschman, a significant stockholder of the Company, pursuant to which it was agreed that in the event the Company completes a transaction with a third party introduced by Mr. Hirschman, the Company shall pay to Mr. Hirschman 5% of the value of that transaction. The agreement, as amended, expires on January 29, 2008. 7. Supplemental Disclosure of Cash Flow Information The Company disbursed no cash for the payment of income taxes during either the three or nine-month periods ended September 30, 2005 or 2004. The Company disbursed approximately $2,600 for the payment of interest expense during the three and nine-month period ended September 30, 2005. The Company disbursed no cash for the payment of interest during the three or nine-month periods ended September 30, 2004. In conjunction with its acquisition of NES (See Note 2), the Company issued 9,599,993 shares of its common stock, with a value of $3,916,800. As of December 31, 2004, the Company had capitalized approximately $179,500 and $31,000 of deferred acquisition costs, related to the NES acquisition, that 8 were included in accounts payable and accrued expenses, respectively. Additionally, the Company accrued approximately $32,500 of deferred financing costs, related to the 2005 private placement, as other assets, as of December 31, 2004. As of September 30, 2005, the Company had capitalized approximately $0 and $81,800 of costs, related to the NES acquisition, that were included in accounts payable and accrued expenses, respectively. Additionally, as of September 30, 2005, the Company included approximately $20,000 and $40,100 of costs, related to the 2005 private placement, in accrued expenses and accounts payable, respectively. 8. Loss Per Share Potentially dilutive securities have been excluded from the computation of diluted loss per common share, as their effect is antidilutive. For the quarters ended September 30, 2005 and 2004, 19,022,157 and 6,043,951 shares, respectively, of common stock equivalents were excluded from the computation of diluted loss per share since their effect would be antidilutive. 9. Deemed Dividends on Preferred Stock On February 2, 2005, the Company completed the 2005 Private Placement, which raised a total of $4,000,000 (inclusive of the $665,000 credit issued to AIGH, see Note 2) through the sale of 148,148 shares of Series A preferred stock and five-year warrants to purchase 74,070 shares of Series B preferred stock. The deemed fair value of the Series A preferred stock was estimated based on the market price and underlying number of common shares they would have converted into had the conversion occurred immediately upon their issuance. The market price for the Company's common stock on on the commitment date of the 2005 private placement was $0.46 and the Series A preferred stock would have converted into 14,814,800 common shares, thus deriving an estimated fair value of approximately $6,814,800 at that date. The fair value of the warrants was estimated to be $1,877,700 and was calculated using the Black-Scholes option pricing model with the following weighted average assumptions: a risk free interest rate of 1.5%, a volatility factor of 60%, a dividend yield of 0% and a five year contractual life. Based on the relative fair values of the Preferred Shares and the warrants at the time of their issuance, the Company allocated $3,136,000 of the $4,000,000 proceeds of the 2005 Private Placement to the Preferred Shares and $864,000 to the warrants. The Preferred Shares issued by the Company contained a non-detachable conversion feature (the "Beneficial Conversion Feature") that was in-the-money upon completion of the 2005 Private Placement, in that the deemed fair value of Common Stock into which the Preferred Shares could be converted exceeded the allocated value of $3,136,000 by $3,678,800 (using the intrinsic value method). This discount resulting from recording the Beneficial Conversion Feature was limited to the allocated proceeds of $3,136,000 and has been recognized as if this amount had been declared a non-cash dividend to the preferred shareholders during the quarter ended March 31, 2005. Additionally, the approximate $864,000 discount resulting from the allocation of the proceeds of the 2005 Private Placement on a relative fair value basis to the Series A preferred shares and the warrants issued in the 2005 Private Placement has also been recognized as if this amount had been declared a 9 non-cash dividend to the preferred shareholders during the quarter ended March 31, 2005. 10. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, "Share-Based Payment," which requires companies to expense the value of employee stock options and similar awards. As of the effective date, the Company will be required to expense all awards granted, modified, cancelled or repurchased as well as the portion of prior awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. The Company will apply SFAS No. 123R using a modified version of prospective application. Under this method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123 for either recognition or pro forma disclosures. The Company expects to adopt Statement 123(R) on January 1, 2006. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results and the timing of certain events could differ materially from those anticipated in these forward-looking statements as a result of certain factors. Such factors, including: o our history of operating losses, and expectation that those losses will continue; o the uncertainty as to whether or not we will realize the anticipated benefits of acquiring NES; o that a significant portion of our revenue has been and continues to be earned from a very limited number of significant customers; o that our stock price has been volatile and you could lose your investment; and o other factors set forth under "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2004 and in other documents we filed with the Securities and Exchange Commission, could have a material adverse effect upon our business, results of operations and financial condition. Overview We are developers of business connectivity software, including Unix, Linux and Windows server-based software, with an immediate focus on web-enabling applications for use by independent software vendors (ISVs), application service providers (ASPs), corporate enterprises, governmental and educational institutions, and others. Server-based computing, sometimes referred to as thin-client computing, is a computing model where traditional desktop software applications are relocated to run entirely on a server, or host computer. This centralized deployment and 10 management of applications reduces the complexity and total costs associated with enterprise computing. Our software architecture provides application developers with the ability to relocate applications traditionally run on the desktop to a server, or host computer, where they can be run over a variety of connections from remote locations to a variety of display devices. With our server-based software, applications can be web enabled, without any modification to the original application software required, allowing the applications to be run from browsers or portals. Our server-based technology can web-enable a variety of Unix, Linux or Windows applications. On January 31, 2005, we acquired NES, which is engaged in the development and patenting of proprietary technologies relating to the submission, storage, retrieval and security of information remotely accessed by computers, typically through computer networks or the Internet. In a contemporaneous transaction, we issued, in the 2005 private placement Series A Preferred Stock and warrants to purchase Series B Preferred Stock. These transactions are described in our Current Report on Form 8-K, filed with the Securities and Exchange Commission (SEC) on February 4, 2005. In order to ensure that we will be able to realize our assets and settle our liabilities within the normal course of our business operations, we must consider several aggressive strategic initiatives aimed at increasing revenue or securing additional alternative sources of financing. If we were unsuccessful in increasing revenues or finding additional alternative sources of financing, we would face a severe constraint on our ability to sustain operations in a manner that would create future growth and viability, and we may need to cease operations entirely. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires us to make judgments, assumptions and estimates that affect the amounts reported in the Condensed Financial Statements and accompanying notes. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, revenue recognition, the impairment of intangible assets, contingencies and other special charges and taxes. Actual results could differ materially from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Condensed Consolidated Financial Statements. Revenue Recognition Generally, software license revenues are recognized when a non-cancelable license agreement has been signed and the customer acknowledges an unconditional obligation to pay, the software product has been delivered, there are no uncertainties surrounding product acceptance, the fees are fixed or determinable and collection is considered probable. Delivery is considered to have occurred when title and risk of loss have been transferred to the customer, which occurs when the customer is given access to the licensed programs. If collectibility is not considered probable, revenue is recognized when the fee is collected. Revenue earned on software arrangements involving multiple elements is allocated to each element arrangement based on the relative fair values of the elements. If there is no evidence of the fair value for all the elements in a 11 multiple element arrangement, all revenue from the arrangement is deferred until such evidence exists or until all elements are delivered. We recognize revenue from the sale of software licenses when all the following conditions are met: o Persuasive evidence of an arrangement exists; o Delivery has occurred or services have been rendered; o Our price to the customer is fixed or determinable; and o Collectibility is reasonably assured. Revenues recognized from multiple-element software arrangements are allocated to each element of the arrangement based on the fair values of the elements, such as licenses for software products, maintenance or customer training. The determination of fair value is based on objective evidence. We limit our assessment of objective evidence for each element to either the price charged when the same element is sold separately or the price established by management having the relevant authority to do so, for an element not yet sold separately. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. Certain of our Independent Software Vendors ("ISVs"), Value-Added Resellers ("VARs") or Application Service Provider ("ASPs") customers (who we refer to as "resellers") prepay for licenses they intend to resell. Upon receipt of the prepayment, if all other revenue recognition criteria outlined above have been met, we recognize licensing revenue when the reseller is given access to the licensed programs. The resellers provide monthly sell-through reports that detail, for the respective month, the number of licenses purchased from us, the number they have sold to other parties, the ending balance of licenses they hold as inventory available for future sale and in some cases certain information pertaining to their customers such as customer name, licenses purchased, purchase date and contact information. We monitor and reconcile the resellers' inventory records to our records via the monthly sell-through reports. Other resellers will only purchase licenses from us when they have already closed a deal to sell the product(s) to another party. These resellers will typically submit a purchase order in order to receive product that they can deliver to their customer. In these cases, assuming all other revenue recognition criteria, as set forth above, have been satisfied, we recognize licensing revenue when the reseller has been given access to the licensed programs. There are no rights of return granted to resellers or other purchasers of our software programs. We recognize revenue from service contracts ratably over the related contract period, which generally ranges from 1-5 years. Allowance for Doubtful Accounts The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer's credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. 12 Capitalized Software Development Costs Software development costs incurred in the research and development of new products are expensed as incurred until technological feasibility, in the form of a working model, has been established, at which time such costs are typically capitalized until the product is available for general release to customers. Capitalized costs are amortized based on either estimated current and future revenue for the product or straight-line amortization over the shorter of three years or the remaining estimated life of the product, whichever produces the higher expense for the period. Patents The estimated cost of the patents and patent-related assets acquired in the NES acquisition is being amortized over a 6-year period using the straight-line method. The estimated cost of these assets and their estimated useful lives may change as a result of the completion of a valuation study and as all direct acquisition costs are finalized. The final adjustments to the estimated costs of these assets are not expected to be material. Impairment of Intangible Assets We perform impairment tests on our intangible assets on an annual basis or when circumstances indicate that a potential impairment may have occurred. In response to changes in industry and market conditions, we may strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of intangible assets. Loss Contingencies We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of the loss or impairment of an asset or the incurrence of a liability as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount of the loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted. Stock Compensation We apply Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations thereof (hereinafter collectively referred to as APB 25) when accounting for our employee and directors stock options and employee stock purchase plans. In accordance with APB 25, we apply the intrinsic value method in accounting for employee stock options. Accordingly, we generally recognize no compensation expense with respect to stock-based awards to employees. We have determined pro forma information regarding net income and earnings per share as if we had accounted for employee stock options under the fair value method as required by Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS 148 (hereinafter collectively referred to as SFAS 123). The fair value of these stock-based awards to employees was estimated using the Black-Scholes 13 option-pricing model. Had compensation cost for our stock option plans and employee stock purchase plan been determined consistent with SFAS 123, our reported net loss and net loss common per share would have been changed to the amounts discussed elsewhere in this Form 10-Q. Loss Per Share of Common Stock Basic loss per share includes no dilution and is computed by dividing loss attributable to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted loss per share reflects the potential dilution of securities by adding other common stock equivalents, including common stock options, warrants and redeemable convertible preferred stock, in the weighted average number of common shares outstanding for a period, if dilutive. Potentially dilutive securities have been excluded from the computation, as their effect is antidilutive. For the quarters ended September 30, 2005 and 2004, 19,022,157 and 6,043,951 shares, respectively, of common stock equivalents were excluded from the computation of diluted loss per share since their effect would be antidilutive. Results of Operations for the Three and Nine-Month Periods Ended September 30, 2005 Versus the Three and Nine-Month Periods Ended September 30, 2004. Revenue Product line revenue for the three-month periods ended September 30, 2005 and 2004, was as follows:
Change in Product licenses 2005 2004 Dollars Percent ---------------- ----------- ----------- ------------ --------- Windows $ 580,100 $ 284,900 $ 295,200 103.6% Unix 249,600 283,900 (34,300) (12.1) ----------- ----------- ------------ 829,700 568,800 260,900 45.9 ----------- ----------- ------------ Service fees Windows 174,100 126,900 47,200 37.2 Unix 163,900 130,800 33,100 25.3 ----------- ----------- ------------ 338,000 257,700 80,300 31.2 ----------- ----------- ------------ Other (1) 8,700 105,000 (96,300) (91.7) ----------- ----------- ------------ Total Revenue $ 1,176,400 $ 931,500 $ 244,900 26.3% =========== =========== ============
(1) Amortization of private labeling and other fees. Private labeling fees are derived when we contractually agree to allow a customer to brand our product with their name. We defer these fees upon contract signing and recognize the revenue ratably over the initial term of the contract, typically, three years. 2004 includes $100,000 from the sale of a software developer's kit ("SDK"). SDKs allow customers to add value by integrating additional software layers with our products. Product line revenue for the nine-month periods ended September 30, 2005 and 2004, was as follows:
Change in Product licenses 2005 2004 Dollars Percent ---------------- ------------ ------------ ------------ --------- Windows $ 1,721,200 $ 893,800 $ 827,400 92.6% Unix 945,700 752,000 193,700 25.8 ------------ ------------ ------------ 2,666,900 1,645,800 1,021,100 62.0 ------------ ------------ ------------ Service fees Windows 478,400 380,100 98,300 25.9 Unix 461,000 371,600 89,400 24.1 ------------ ------------ ------------ 939,400 751,700 187,700 25.0 ------------ ------------ ------------ Other (1) 26,300 114,300 (88,000) (77.0) ------------ ------------ ------------ Total Revenue $ 3,632,600 $ 2,511,800 $ 1,120,800 44.6% ============ ============ ============
14 (1) Amortization of private labeling and other fees and the sale of a software developer's kit. The changes in both Windows and Unix-based product licenses revenue for the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, were reflective of how such revenue varies because a significant portion of this revenue has been, and continues to be earned from a limited number of significant customers, most of whom are VARs. Consequently, if any of these significant customers change their order level or fail to order during the reporting period, our revenue could be materially adversely impacted. We expect this situation to continue throughout 2005. During the three-month period ended September 30, 2005, three of our significant Windows customers purchased approximately an aggregate $208,100 more product licenses than they did during the same period of 2004. Also during the three-month period ended September 30, 2005, one of our large Unix enterprise customers made no Unix product purchases, as compared with approximately $68,000 in the same period of 2004. This decrease was partially offset by an increase of approximately $47,800 in Unix product purchases during the three-month period ended September 30, 2005 from one of our large Unix VARs, as compared with the same period of 2004. The remainder of the changes in third quarter 2005 Windows and Unix-based product revenue, as compared with the third quarter of 2004, was due to a combination of the demand by and composition of our various smaller customers. During the nine-month period ended September 30, 2005, six of our significant Windows customers purchased approximately an aggregate $734,700 more product licenses than they did during the same period in 2004. Included in this increase were purchases of $72,000 and $25,000 received from new Windows customers during the nine-month period ended September 30, 2005. Partially offsetting this increase was an aggregate decrease of approximately $103,000 resulting from reduced product purchases from three significant Windows customers. During the nine-month period ended September 30, 2005, three of our significant Unix customers increased their aggregate product purchases by approximately $282,700 as compared with the similar period in 2004. Partially offsetting this increase was a decrease in aggregate product purchases of approximately $137,500 received from three significant Unix customers during the nine-month period ended September 30, 2005 as compared with the same period in 2004. The remainder of the changes in Windows and Unix-based product revenue for the first nine months of 2005, as compared with the same period of 2004, was due to a combination of the demand by and composition of our various smaller customers. Our customers typically purchase a maintenance contract at the time they license our product. Our Windows-based maintenance contracts are primarily for a one-year time period and generally are renewed upon expiration. Our Unix-based maintenance contracts vary in term from one to five years and generally are renewed upon expiration. Service fees associated with maintenance contracts are deferred and recognized as revenue ratably over the underlying service period of the maintenance contract. The increase in both Windows and Unix-based service fees for the three and nine-month periods ended September 30, 2005, as compared with the same periods 15 of the prior year was primarily due to higher levels of maintenance contract purchases that began approximately during the third quarter of 2004 and have continued throughout 2005. The decrease in other revenue for both the three and nine-month periods ended September 30, 2005, as compared with the respective periods of the prior year, was due to the sale of an SDK during the three-month period ended September 30, 2004. No SDK was sold during either the three or nine-month periods ended September 30, 2005. Cost of Revenue Cost of revenue consists primarily of the amortization of capitalized technology developed in-house and customer service costs. Shipping and packaging materials are immaterial as virtually all of our deliveries are made via electronic means over the Internet. Under accounting principles generally accepted in the United States, research and development costs for new product development, after technological feasibility is established, are recorded as "capitalized software" on our balance sheet. Such capitalized costs are subsequently amortized as cost of revenue over the shorter of three years or the remaining estimated life of the products. Cost of revenue decreased by $31,800, or 21.6%, to $115,300 for the third quarter of 2005, from $147,100 for the third quarter of 2004. Product costs decreased by $7,000, or 11.7%, to $53,000 for the third quarter of 2005, from $60,000 for the third quarter of 2004. Service costs decreased by $24,800, or 28.5%, to $62,300 for the third quarter of 2005, from $87,100 for the third quarter of 2004. Cost of revenue decreased by $394,900, or 51.8%, to $367,000 for the nine months ended September 30, 2005, from $761,900 for the same period of 2004. Product costs decreased by $360,300, or 69.7%, to $156,800 for the nine months ended September 30, 2005, from $517,100 for the same period of 2004. Service costs decreased by $34,600, or 14.1%, to $210,200 for the nine months ended September 30, 2005, from $244,800 for the same period of 2004. The decrease in product costs for both the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004 was because our purchased technology became fully amortized as of June 30, 2004. Product costs incurred during both the three and nine-month periods ended September 30, 2005 primarily consisted of the amortization of capitalized software development costs. We expect these costs to remain consistent throughout 2005. The decrease in service costs for the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, resulted from certain engineers spending more time in other engineering-related tasks than customer service in 2005, as compared with 2004. The amount of time our engineers spend in customer service is a function of the number of customer service inquiries received, and their complexity. Whenever the resolution of customers' inquiries permit, engineers whose first priority is customer service will assist with other engineering-related tasks. We expect costs of revenue to remain fairly constant over the next few reporting periods. Cost of revenue was approximately 9.8% and 15.8% of revenue for the third quarter of 2005 and 2004, respectively, and 10.1% and 30.3% of revenue for the nine-month periods ended September 30, 2005 and 2004, respectively. 16 Selling and Marketing Expenses Selling and marketing expenses primarily consist of employee costs, consulting services and travel and entertainment. Selling and marketing expenses for the third quarter of 2005 decreased by $19,600, or 5.5%, to $337,100 from $356,700 for the third quarter of 2004. Selling and marketing expenses for the first nine months of 2005 decreased by $105,500, or 9.4%, to $1,014,000 from $1,119,500 for the first nine months of 2005. Expense categories that were primary contributors to the net decrease in the third quarter of 2005 as compared with the third quarter of 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- --------- Employees costs $ (49,800) Commissions and bonuses 52,300 Consulting services (16,200) Other items (5,900) --------- $ (19,600) ========= Expense categories that were primary contributors to the net decrease in the first nine months of 2005 as compared with the same period of 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- ---------- Employees costs $ (106,800) Commissions and bonuses 159,800 Consulting services (95,200) Recruitment (17,000) Travel & entertainment (19,900) Other items (26,400) ---------- $ (105,500) ========== The decrease in employee costs for the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, resulted primarily from having two fewer sales representatives during these periods of 2005 as compared with 2004. The increase in commissions and bonuses for the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, resulted from an increase in new orders during these periods in 2005, as compared with 2004, and the attainment of certain performance objectives during each of these periods in 2005, respectively. Consulting services were decreased during both the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, as we began deferring certain planned selling and marketing activities towards the end of the fourth quarter of 2004 and have continued doing so in 2005 as we strive to determine the most cost effective use of our marketing expenditures. Recruitment expenses were lower during the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, as we did not fill either of the two positions of the terminated sales representatives, discussed above. 17 Cumulative travel and entertainment expense for the first nine months of 2005 is lower than that for the same period in 2004 primarily as a result of having two fewer sales representatives, as discussed above. We anticipate that selling and marketing expenses for 2005 will approximate 2004 levels. Selling and marketing expenses were 28.7% and 38.3% of revenue for the third quarter of 2005 and 2004, respectively, and 27.9% and 44.6% of revenue for the first nine months of 2005 and 2004, respectively. General and Administrative Expenses General and administrative expenses primarily consist of employee costs, legal, professional and other outside services, amortization and depreciation, travel and entertainment, certain costs associated with being a publicly held corporation, and bad debts expense. Additionally included in general and administrative costs are the costs associated with deriving economic benefits from the patent-related assets acquired from NES. General and administrative expenses for the third quarter of 2005 increased by $399,900, or 112.0%, to $756,900 from $357,000 for the third quarter of 2004, and by $1,382,300, or 158.9%, to $2,252,000 for the first nine months of 2005, as compared with $869,700 for the same period of 2004. Expense categories that were primary contributors to the net increase in general and administrative expense for the third quarter 2005 as compared with 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- ---------- Employee costs $ 188,400 Professional services (35,400) Depreciation and amortization 225,200 Other items 21,700 ---------- $ 399,900 ========== Expense categories that were primary contributors to the net increase in general and administrative expense for the first nine months of 2005 as compared with the same period in 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- ----------- Employee costs $ 410,200 Professional services 270,600 Depreciation and amortization 588,600 Bad debts expense 15,200 Other items 97,700 ----------- $ 1,382,300 =========== The increase in employee costs in the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, was primarily due to having five more employees. Two of these employees, hired during the first quarter of 2005, have been tasked with developing revenue opportunities for the patents and patent applications we acquired in conjunction with the NES acquisition as well as developing additional patent applications. Two employees were hired into the accounting department during 2005, one of whom replaced an outside consultant. 18 Professional services decreased during the third quarter of 2005 as compared with the third quarter of 2004 primarily as a result of the due diligence and other general services provided by our attorneys during the third quarter of 2004 related to our evaluation of NES as a potential acquisition target prior to our acquisition of NES. No such comparable services were performed during the third quarter of 2005. The primary reason for the increase in professional services for the nine-month period ended September 30, 2005, as compared with the same period in 2004, was legal fees related to the administration of the patent portfolio, which we began incurring upon the consummation of the NES acquisition in January 2005. Depreciation and amortization expense increased in both the three and nine-month periods ended September 30, 2005, as compared with the same periods in 2004, primarily due to the commencement of amortization of the patent-related assets acquired from NES in January 2005. We expect depreciation and amortization to be significantly higher for the remainder of 2005, as compared with the comparable periods in 2004, due to the amortization of the patent-related assets. As a result of the increased volume of new business and related uncertainties, we increased our allowance for doubtful accounts during the nine-month period ended September 30, 2005. We anticipate that aggregate general and administrative expenses for 2005 will be substantially higher than 2004, primarily due to the additional personnel, the amortization of the patent-related assets and the professional costs associated with the process of realizing the anticipated benefits of the NES acquisition. General and administrative expenses were approximately 64.3% and 38.3% of revenues for the third quarter of 2005 and 2004, respectively, and approximately 62.0% and 34.6% of revenue for the nine-month periods ended September 30, 2005 and 2004, respectively. Research and Development Expenses Research and development expenses consist primarily of employee costs, payments to contract programmers, rent, depreciation and computer related supplies. Research and development expenses for the third quarter of 2005 decreased by $33,600, or 9.2%, to $333,200 from $366,800 for the third quarter of 2004, and by $256,500, or 20.9%, to $969,900 for the first nine months of 2005, as compared with $1,226,400 for the same period in 2004. Under accounting principles generally accepted in the United States, all costs of product development incurred once technological feasibility has been established, but prior to general release of the product, are typically capitalized and amortized to expense over the estimated life of the underlying product, rather than being charged to expense in the period incurred. No product development costs were capitalized during either the three or nine-month periods ended September 30, 2005 or 2004. Expense categories that were primary contributors to the net decrease in third quarter 2005 as compared with 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- --------- Employee costs $ (34,700) Contract programmers 15,500 Depreciation (9,500) 19 Other items (4,900) --------- $ (33,600) ========= Expense categories that were primary contributors to the net decrease in the first nine months of 2005 as compared with the period in 2004 are summarized as follows: Increase (Decrease) Expense From 2004 ------- ---------- Employee costs $ (159,700) Contract programmers (27,500) Depreciation (41,100) Other items (28,200) ---------- $ (256,500) ========== The decrease in employee costs for the three and nine-month periods ended September 30, 2005, as compared with the same periods of 2004, was primarily due to having two fewer engineers. The increase in contract programmers for the third quarter of 2005, as compared with the third quarter of 2004, was due to the timing of work we contracted the programmers to perform. Conversely, the decrease in contract programmers for the nine-month periods ended September 30, 2005, as compared with the same period of 2004, was due to the non-renewal of certain contracts upon their expiration. Once certain elements of the work being performed for us was completed, the underlying programmers' contracts were not renewed as their services were not immediately required. We believe that we will be able to enter into new contracts with these engineers, or ones with similar talents, without difficulty in the future, should we need their services again. We chose not to immediately renew their contracts in effort to reduce our cash expenditures in order use our research and development dollars most efficiently. Depreciation expense was lower in the both the three and nine-month periods ended September 30, 2005, as compared with the same periods of 2004, because during 2003 and 2004, we purchased virtually no new capitalizable assets in support of our research and development efforts. Since the beginning of 2003, various assets have become fully depreciated more quickly than we have replaced them and hence, depreciation expense has steadily declined. We expect to make more fixed asset purchases in 2005 than we did in 2004, however, we do not expect to replace all the assets that have, or will, become fully depreciated. Consequently, we expect depreciation expense for 2005 to remain lower than 2004 levels. We anticipate that research and development expenses for 2005 will be lower than those incurred during 2004, primarily due to the lower number of engineers and lower depreciation, as outlined above. Research and development expenses were approximately 28.3% and 39.4% of revenues for the third quarter of 2005 and 2004, respectively, and approximately 26.7% and 48.8% of revenue for the nine-month periods ended September 30, 2005 and 2004, respectively. Interest and other income During the three and nine-month periods ended September 30, 2005, interest and other income consisted primarily of interest income on excess cash and note receivable - shareholder. During the three and nine-month periods ended September 30, 2004, interest and other income consisted primarily of interest income on excess cash. Also included in interest and other income for the nine-month period ended September 30, 2004 was interest income on notes receivable - directors. 20 Interest and other income for the third quarter of 2005 increased by $7,700, or 308.0%, to $10,200 from $2,500 for the third quarter of 2004. Interest and other income for the first nine months of 2005 increased by $21,000, or 233.3%, to $30,000 from $9,000 for the same period of 2004. Interest income on excess cash for both the three and nine-month periods ended September 30, 2005, approximately $10,200 and $30,000, respectively, as compared with the same periods of 2004, approximately $2,500 and $9,000, respectively, was higher, primarily due to higher average cash balances and rates of interest being earned on those balances in 2005 as compared with 2004. The increase in the average cash balances in 2005, as compared with 2004, was primarily due to the net proceeds of the 2005 private placement, approximately $2,933,000, as compared with the net proceeds of the 2004 private placement, approximately $934,800. Our excess cash is held in interest bearing money market accounts. Interest income on the note receivable - shareholder was approximately $3,200 and $9,600 for the three and nine-month periods ended September 30, 2005. No such note receivable was outstanding during the same three and nine-month periods of 2004. We anticipate that interest income for the remainder of 2005 will be higher than comparable periods from 2004 as we expect that we will continue to have higher average cash balances for the remainder of the year, as compared with the prior year. Net Loss As a result of the foregoing items, net loss for the third quarter of 2005 was $359,400, an increase of $65,700, or 22.4%, from a net loss of $293,700 for the third quarter of 2004. Net loss for the first nine months of 2005 was $945,300, a decrease of $511,000, or 35.1%, from a net loss of $1,456,300 for the same period of 2004. As a result of our continued operating loss we intend to continue to pursue revenue growth opportunities through all available means. Net loss attributable to common shareholders for the third quarter of 2005 was $359,400, an increase of $65,800, or 22.4%, from a net loss attributable to common shareholders of $293,700 for the third quarter of 2004. Net loss attributable to common shareholders for the first nine months of 2005 was $4,945,300, an increase of $3,489,000, or 239.6%, from a net loss attributable to common shareholders of $1,456,300 for the same period in 2004. The increase in net loss attributable to common shareholders for the first nine months of 2005 was due to the deemed dividends on preferred stock, as discussed below. Deemed Dividends on Preferred Stock On February 2, 2005, we completed the 2005 private placement, which raised a total of $4,000,000 through the sale of 148,148 shares of Series A preferred stock and five-year warrants to purchase 74,070 shares of Series B preferred stock. The deemed fair value of the Series A preferred stock was estimated based on the market price and underlying number of common shares they would have converted into had the conversion occurred immediately upon their issuance. The market price for our common stock on February 2, 2005 was $0.46 and the Series A preferred stock would have converted into 14,814,800 common shares, thus deriving an estimated fair value of approximately $6,814,800 at that date. 21 The fair value of the warrants was estimated to be $1,877,700 and was calculated using the Black-Scholes option pricing model with the following weighted average assumptions: a risk free interest rate of 1.5%, a volatility factor of 60%, a dividend yield of 0% and a five year contractual life. Based on the relative fair values of the Preferred Shares and the warrants at the time of their issuance, we allocated $3,136,000 of the $4,000,000 proceeds of the 2005 Private Placement to the Preferred Shares and $864,000 to the warrants. The Preferred Shares we issued contained a non-detachable conversion feature (the "Beneficial Conversion Feature") that was in-the-money upon completion of the 2005 Private Placement, in that the deemed fair value of Common Stock into which the Preferred Shares could be converted exceeded the allocated value of $3,136,000 by $3,678,800 (using the intrinsic value method). This discount resulting from recording the Beneficial Conversion Feature was limited to the allocated proceeds of $3,136,000 and has been recognized as if this amount had been declared a non-cash dividend to the preferred shareholders during the quarter ended March 31, 2005. Additionally, the approximate $864,000 discount resulting from the allocation of the proceeds of the 2005 Private Placement on a relative fair value basis to the Series A preferred shares and the warrants issued in the 2005 Private Placement has also been recognized as if this amount had been declared a non-cash dividend to the preferred shareholders during the quarter ended March 31, 2005. Liquidity and Capital Resources We continue to manage our operations to bring our cash expenditures in line with our revenues in order to determine the most cost effective use of our cash on hand. We are simultaneously looking at ways to improve our revenue stream. Additionally, we continue to review potential merger opportunities as they present themselves to us and at such time as a merger might make financial sense and add value for our shareholders, we will pursue that merger opportunity. We believe that improving or maintaining our current revenue stream, coupled with our cash on hand, including the cash raised in the 2005 private placement will sufficiently support our operations during 2005. On January 31, 2005, we acquired NES for 9,599,993 shares of common stock, the assumption of approximately $232,800 of NES' indebtedness and the reimbursement to AIGH Investment Partners, LLC ("AIGH"), an affiliate of a principal stockholder (Orin Hirschman), of $665,000 for its advance on our behalf of a like sum in December 2004 to settle certain third party litigation against NES. We reimbursed the advance through a partial credit against the price of our securities acquired by AIGH in the 2005 private placement. The 2005 private placement, which was consummated on February 2, 2005, raised a total of $4,000,000, inclusive of the $665,000 credit issued to AIGH. As of September 30, 2005 we had consumed approximately $402,000 and $730,000 of the cash raised paying for expenses related to the 2005 private placement and the NES acquisition, respectively. We estimate that we will disburse an additional $60,100 and $81,800 of cash paying for expenses related to the 2005 private placement and the NES acquisition, respectively, however, there can be no guarantees that these amounts will be final. We anticipate incurring further costs associated with the development of the patents and patent-related assets acquired from NES for the next several 22 reporting periods. We expect to fund these development costs through working capital. Until the revenues we derive from either the sale of software products or the licensing of patents are sufficient enough to generate positive cash flows from operations, we will continue to experience operating losses. Although we believe that we will be able to attain sufficient sales levels to meet our operational needs, there can be no certainty that we will be able to do so. Should the cash flows generated from sales and working capital be insufficient to satisfy short term operating needs, or should we be unsuccessful in securing alternative sources of financing, we may have to significantly curtail the current nature of our operations. As of September 30, 2005, cash and cash equivalents totaled $3,125,900, an increase of $2,450,600, or 362.9%, from $675,300 as of December 31, 2004. The increase in cash and cash equivalents was primarily attributable to the $2,933,000 net cash infusion from the 2005 private placement, which comprises the majority of the cash provided by our financing activities for the first nine months of 2005. The balance of the cash provided by our financing activities was derived from the sale of stock to employees through our employee stock purchase program. Our net loss for the first nine months of 2005 was $945,300. Included in the net loss were non-cash charges, comprised of depreciation and amortization, which aggregated approximately $779,300. Our operating assets and liabilities provided approximately $368,900 of cash for our operations during the first nine months of 2005, primarily resulting from a $269,800 increase in aggregate deferred revenue. Accounts Receivable The decrease in accounts receivable was primarily due to the timing and collection of various sales transactions. The decrease in accounts receivable also included an increase in our allowance for doubtful accounts, which resulted from the increased volume of new business and related uncertainties. Deferred Revenue The increase in total deferred revenue, aggregate short and long-term, generated $269,800 of cash flow during the first nine months of 2005. Included in deferred revenue as of September 30, 2005, were deferred private labeling and other fees, aggregating approximately $43,800, which we expect to recognize as revenue, generally, over the underlying term of the respective private labeling agreement. These agreements typically are for a three-year period and the revenue is recognized on a straight-line basis over such period. Also included in deferred revenue at September 30, 2005 was approximately $14,100 of deferred licensing sales. Generally, product sales that do not satisfy all criteria for revenue recognition at the time of the transaction are deferred until all such criteria are met. We anticipate recognizing this revenue during the next twelve months. Accounts Payable Accounts payable as of September 30, 2005 decreased by $127,300, or 50.9%, to $122,900 from $250,200 as of December 31, 2004. Accounts payable as of September 30, 2005 were primarily comprised of various operating expenses. Accounts payable as of December 31, 2004 were comprised of operating expenses and significant costs associated with the NES acquisition and the 2005 private 23 placement. The amounts related to the NES acquisition and the 2005 private placement were paid during the first quarter of 2004 and their payment was the primary reason for the decrease in accounts payable. Accrued Expenses Accrued expenses as of September 30, 2005 approximated those as of December 31, 2004. Accrued expenses are charges for services rendered for which an invoice has not yet been received and typically include legal, accounting and outside consultant fees, utilities and other items. Accrued Wages Accrued wages as of September 30, 2005 increased by $67,300, or 25.9%, to $327,400 from $260,100 as of December 31, 2004. The increase was primarily due to hiring five new general and administrative employees during the first nine months of 2005, an increase in commissions and bonuses, based on third quarter 2005 sales, as well as an increase in the costs of employee benefits. Deferred Compensation During the first nine months of 2005, we deferred, and amortized, compensation totaling approximately $8,900 and $2,000, respectively, related to stock options granted to our interim Chief Executive Officer, Robert Dilworth. We are amortizing this amount monthly on the straight-line method, to compensation expense over a three-year period ending in January 2008. Notes Receivable - Directors During the first quarter of 2005, we received payment in full of our notes receivable - directors, generating operating cash of $50,300. Also during the first quarter of 2005, we received a $2,600 principal repayment of the note receivable - shareholder. Working Capital As of September 30, 2005, we had current assets of $3,595,400 and current liabilities of $1,500,200, which netted to working capital of $2,095,200. Included in current liabilities was the current portion of deferred revenue of $818,800. We have been successful in significantly reducing operating costs through a series of strategic restructurings and work force reductions that began in September of 2001. Based on our current operating revenues and reduced operating cost structure, and the cash raised in the 2005 private placement, we believe that we will be able to support our operational needs with currently available resources for at least the next twelve months. However, due to inherent uncertainties associated with predicting future operations, there can be no assurances that these resources will be sufficient to fund our anticipated expenses during the next twelve months. ITEM 3. Quantitative and Qualitative Disclosures About Market Risk We are currently not exposed to any significant financial market risks from changes in foreign currency exchange rates or changes in interest rates and do not use derivative financial instruments. A substantial majority of our revenue and capital spending is transacted in U.S. dollars. However, in the future, we may enter into transactions in other currencies. An adverse change in exchange rates would result in a decline in income before taxes, assuming that each 24 exchange rate would change in the same direction relative to the U.S. dollar. In addition to the direct effects of changes in exchange rates, such changes typically affect the volume of sales or foreign currency sales price as competitors' products become more or less attractive. ITEM 4. Controls and Procedures Our management carried out an evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of September 30, 2005. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission. There has not been any change in our internal control over financial reporting in connection with the evaluation required by Rule 13a-15(d) under the Exchange Act that occurred during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART II--OTHER INFORMATION ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds During the three-month period ended September 30, 2005, we granted the following stock options: o stock options to purchase an aggregate 85,000 shares of common stock, at exercise prices ranging from $0.35 to $0.40 per share, were granted to two non-executive employees; The grant of such stock options to the above-listed persons was not registered under the Securities Act of 1933, because the stock options either did not involve an offer or sale for purposes of Section 2(a)(3) of the Securities Act, in reliance on the fact that the stock options were granted for no consideration, or were offered and sold in transactions not involving a public offering, exempt from registration under the Securities Act pursuant to Section 4(2). ITEM 6. Exhibits Exhibit 31 - Rule 13a-14(a)/15d-14(a) Certifications Exhibit 32 - Section 1350 Certifications 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GraphOn Corporation (Registrant) Date: November 21, 2005 By: /s/ Robert Dilworth --------------------------------- Robert Dilworth, Chief Executive Officer (Interim) and Chairman of the Board (Principal Executive Officer) Date: November 21, 2005 By: /s/ William Swain --------------------------------- William Swain, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) 26