-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, M2eiXWfcCmfJjWIYJXGSysYNK6nffgCexFNWqFXn4ddnB22BzKvd07w5U38WOaoC H2M65zKTgoJlSrvFtkp+3Q== 0001021435-06-000015.txt : 20060814 0001021435-06-000015.hdr.sgml : 20060814 20060814161203 ACCESSION NUMBER: 0001021435-06-000015 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060814 DATE AS OF CHANGE: 20060814 FILER: COMPANY DATA: COMPANY CONFORMED NAME: GRAPHON CORP/DE CENTRAL INDEX KEY: 0001021435 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 133899021 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-21683 FILM NUMBER: 061030566 BUSINESS ADDRESS: STREET 1: 5400 SOQUEL AVENUE STREET 2: SUITE A2 CITY: SANTA CRUZ STATE: CA ZIP: 95062 BUSINESS PHONE: 8004727466 MAIL ADDRESS: STREET 1: 5400 SOQUEL AVENUE STREET 2: SUITE A2 CITY: SANTA CRUZ STATE: CA ZIP: 95062 FORMER COMPANY: FORMER CONFORMED NAME: UNITY FIRST ACQUISITION CORP DATE OF NAME CHANGE: 19960823 10QSB 1 q20610q.txt Q206 FORM 10-QSB ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 -------------- FORM 10-QSB -------------- |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2006 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from to Commission File Number: 0-21683 -------------- GraphOn Corporation (Exact name of small business issuer 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) Issuer's telephone number: (800) 472-7466 Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the issuer 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 issuer is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No |X| As of August 3, 2006, there were issued and outstanding 46,792,250 shares of the issuer's Common Stock, par value $0.0001. Transitional Small Business Disclosure Format (Check one): Yes [ ] No |X| GRAPHON CORPORATION FORM 10-QSB Table of Contents PART I. FINANCIAL INFORMATION Page ---- Item 1. Financial Statements Unaudited Condensed Consolidated Balance Sheet as of June 30, 2006 2 Unaudited Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three and Six Months Ended June 30, 2006 and 2005 3 Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005 4 Notes to Unaudited Condensed Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis or Plan of Operation 9 Item 3. Controls and Procedures 21 PART II. OTHER INFORMATION Item 1. Legal Proceedings 22 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 22 Item 6. Exhibits 22 Signatures PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements
GraphOn Corporation Condensed Consolidated Balance Sheet (Unaudited; $000s) Assets June 30, 2006 Current Assets ------------- Cash and cash equivalents $ 3,138 Accounts receivable, net 837 Other current assets 92 ------------- Total Current Assets 4,067 Patents, net 4,075 Property and equipment, net, and other assets 160 ------------- Total Assets $ 8,302 ============= Liabilities and Shareholders' Equity Current Liabilities Accounts payable and accrued expenses $ 610 Deferred revenue 1,110 ------------- Total Current Liabilities 1,720 Deferred revenue 1,025 ------------- Total Liabilities 2,745 Commitments and contingencies - Shareholders' Equity Common stock, $0.0001 par value, 195,000,000 shares authorized, 46,192,250 shares issued and outstanding 5 Additional paid-in capital 58,562 Note receivable - shareholder (260) Accumulated deficit (52,750) ------------ Total Shareholders' Equity 5,557 ------------ Total Liabilities and Shareholders' Equity $ 8,302 ============ See accompanying notes to unaudited condensed consolidated financial statements
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GraphOn Corporation Condensed Consolidated Statements of Operations and Comprehensive Loss (Unaudited; $000s, except per share data) Three months ended June 30, Six months ended June 30, --------------------------- --------------------------- 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Revenue $ 1,451 $ 1,276 $ 2,757 $ 2,456 Cost of Revenue 151 131 262 252 ---------- ---------- ---------- ---------- Gross Profit 1,300 1,145 2,495 2,204 ---------- ---------- ---------- ---------- Operating Expenses Selling and marketing 426 342 840 677 General and administrative 925 768 1,915 1,495 Research and development 452 313 846 636 ---------- ---------- ---------- ---------- Total Operating Expenses 1,803 1,423 3,601 2,808 ---------- ---------- ---------- ---------- Loss From Operations (503) (278) (1,106) (604) ---------- ---------- ---------- ---------- Other Income, net 12 11 22 18 ---------- ---------- ---------- ---------- Loss Before Provision for Income Tax (491) (267) (1,084) (586) Provision for income tax 3 - 3 - ---------- ---------- ---------- ---------- Net Loss (494) (267) (1,087) (586) Other Comprehensive Income (Loss) - - - - ---------- ---------- ---------- ---------- Comprehensive Loss (494) (267) (1,087) (586) Deemed Dividend on Preferred Stock - - - (4,000) ---------- ---------- ---------- ---------- Loss Attributable to Common Shareholders $ (494) $ (267) $ (1,087) $ (4,586) ========== ========== ========== ========== Basic and Diluted Loss per Common Share $ (0.01) $ (0.01) $ (0.02) $ (0.12) ========== ========== ========== ========== Weighted Average Common Shares Outstanding 46,192,250 46,147,047 46,188,073 37,432,395 ========== ========== ========== ========== See accompanying notes to unaudited condensed consolidated financial statements
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GraphOn Corporation Condensed Consolidated Statement of Cash Flows (Unaudited; $000s) Six Months Ended June 30, Cash Flows From operating Activities 2006 2005 - ------------------------------------ ---------- ---------- Net loss $ (1,087) $ (586) Adjustments to reconcile net loss to net cash (used in) provided by operating activities: Depreciation and amortization 514 492 Amortization of deferred compensation - 1 Stock-based compensation expense 226 - Provision for doubtful accounts - 15 Proceeds from accrued interest on directors' notes receivable - 4 Proceeds from accrued interest on note receivable - shareholder - 1 Interest accrued on note receivable - shareholder (5) (6) Changes in operating assets and liabilities: Accounts receivable (73) (229) Other assets (48) 11 Accounts payable and accrued liabilities (159) 134 Deferred revenue 343 239 ---------- ---------- Net Cash (Used In) Provided By Operating Activities (289) 76 ---------- ---------- Cash Flows Used In Investing Activities - --------------------------------------- Acquisition costs - (675) Capital expenditures and other assets (48) (19) ---------- ---------- Net Cash Used In Investing Activities (48) (694) ---------- ---------- Cash Flows (Used In) Provided By Financing Activities - ----------------------------------------------------- Employee stock purchases 5 5 Proceeds from note receivable - shareholder - 3 Repayment of directors' notes receivable - 50 Proceeds from private placement of preferred stock and warrants - 3,335 Costs of private placement of preferred stock and warrants (58) (316) ---------- ---------- Net Cash (Used In) Provided By Financing Activities (53) 3,077 ---------- ---------- Effect of exchange rate fluctuations on cash and cash equivalents - (1) ---------- ---------- Net (Decrease) Increase in Cash and Cash Equivalents (390) 2,458 Cash and Cash Equivalents, beginning of period 3,528 675 ---------- ---------- Cash and Cash Equivalents, end of period $ 3,138 $ 3,133 ========== ========== See accompanying notes to unaudited condensed consolidated financial statements
4 GRAPHON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation The unaudited condensed consolidated financial statements included herein have been prepared in accordance with the instructions for Form 10-QSB and, therefore, do not include all information and footnotes necessary for a complete presentation of 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 six-month periods ended June 30, 2006 and 2005) that are, in the opinion of management, necessary to state fairly the results for the periods presented. This Quarterly Report on Form 10-QSB should be read in conjunction with the audited consolidated financial statements of GraphOn Corporation (the "Company") contained in the Company's Annual Report on Form 10-KSB for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission (the "SEC") on April 17, 2006, and amended on June 12, 2006. 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, 2006, 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, determination of stock-based compensation expense and accrued liabilities, among others. Actual results could differ materially from those estimates. Significant intercompany accounts and transactions are eliminated upon consolidation. 2. Stock-Based Compensation Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB No. 25") and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS No. 123"). The Company did not recognize compensation cost related to stock options granted to its employees and non-employee directors that had an exercise price equal to or above the market value of the underlying common stock on the date of grant in its condensed consolidated statement of operations and comprehensive loss prior to January 1, 2006. Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R, "Share-Based Payment," ("FAS123R") and related interpretations using the modified prospective transition method. Under that method, compensation cost recognized in the three and six-month periods ended June 30, 2006 includes (a) compensation cost for all stock-based awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of FAS No. 123 and (b) compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS123R. Results for prior periods have not been restated. As a result of adopting FAS123R on January 1, 2006, the Company's loss from operations, loss before provision for income taxes and net loss for the three-months ended June 30, 2006 are each $116 thousand higher than if the Company had continued to account for stock-based compensation under APB No. 25. The Company's loss from operations, loss before provision for income taxes and net loss for the six-months ended June 30, 2006 are each $226 thousand higher than if the Company had continued to account for stock-based compensation under APB No. 25. Pro Forma Information under FAS No. 123 for Periods Prior to January 1, 2006 The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of FAS No. 123 to stock-based awards in the three and six-month periods ended June 30, 2005: 5
(Unaudited; $000s, except per share data) Three Months Ended Six Months Ended June 30, 2005 June 30, 2005 ------------------ ----------------- Net loss, as reported: $ (267) $ (586) Less: deemed preferred dividends - (4,000) Add: stock-based compensation expense included in net loss, net of related tax effects 1 1 Deduct: total stock-based compensation expense determined under the fair-value method for all awards, net of related tax effects (111) (194) ------------------ ----------------- Pro forma net loss $ (377) $ (4,779) ================== ================= Basic and diluted loss per share As reported $ (0.01) $ (0.12) Pro forma $ (0.01) $ (0.13)
For purposes of the pro forma calculations, the fair value of each option was estimated on the date of the grant using the Black-Scholes option-pricing model, assuming no dividends, expected volatility of 60%, risk free interest rate of 1.5% and an expected term of five years. The weighted average fair value of stock-based awards granted during the three and six-month periods ended June 30, 2005 were $0.39 and $0.50, respectively. No stock options were exercised during either the three or six-month periods ended June 30, 2005 and forfeitures were recognized as they occurred. Valuation and Expense Information under FAS123R The Company recorded stock-based compensation expense of $116 thousand and $226 thousand in the three and six-month periods ended June 30, 2006, respectively. As required by FAS123R, the Company estimates forfeitures of employee stock-based awards and recognizes compensation cost only for those awards expected to vest. Forfeiture rates are estimated based on an analysis of historical experience and are adjusted to actual forfeiture experience as needed. The following table illustrates the stock-based compensation expense recorded during the three and six-month periods ended June 30, 2006 by income statement classification ($000s):
Three months Six months ended ended June 30, 2006 June 30, 2006 Income statement classification ------------- ------------- Cost of revenue $ 4 $ 8 Selling and marketing expense 3 17 General and administrative expense 97 181 Research and development expense 12 20 ------------- ------------- $ 116 $ 226 ============= =============
In connection with the adoption of FAS123R, the Company estimated the fair value of each stock option granted during the three-month period ended June 30, 2006 on the date of grant using a binomial model, with the following assumptions: no dividends, an approximate risk free annual interest rate of 5.02%, estimated forfeiture rate of 10% and an estimated exercise factor of 10%. For stock option grants, the following additional assumptions were also used: expected volatility of 157% and an expected term of 7.5 years. For employee stock purchase plan ("ESPP") grants, the assumptions previously listed in this paragraph were also used, except as follows: expected volatility of 147%, risk free interest rate of 3.73% and an expected term of 0.5 years. For assumptions used for grants made during the three-month period ended March 31, 2006, please refer to our Quarterly Report on Form 10-QSB as filed with the SEC on May 15, 2006. The Company does not anticipate paying dividends on its common stock for the foreseeable future. The Company used the historical volatility of its daily closing price since it went public (July 13, 1999) through June 30, 2006 as the 6 basis of its calculation for stock option grants. The volatility calculation for ESPP grants was based on the historical volatility of the Company's daily closing price from August 1, 2005 to January 31, 2006 as these were the two most recent dates used in determining the purchase price of the shares sold under the ESPP. The approximate risk free interest rate was based on the implied yield available on U.S. Treasury issues with remaining terms equivalent to the Company's expected term on its options. The expected term of the Company's stock options was based on the historical option holder exercise patterns and considered the market performance of the Company's common stock and other items. The expected term of the ESPP shares was six months, which is the length of time between the ESPP grant date and the purchase date. The estimated forfeiture rate was based on an analysis of historical data and considered the impact of events such as the work force reductions the Company carried out during previous years. The estimated exercise factor was based on an analysis of historical data and included a comparison of historical and current share prices. For grants made during the three and six-month periods ended June 30, 2006, the weighted average fair value of stock options was $0.21 and $0.21, respectively, and for ESPP shares was $0.1785 and $0.1785, respectively. The following table presents a summary of the status and activity of the Company's stock option awards for the three and six-month periods ended June 30, 2006.
Weighted Weighted Average ($000s) Average Remaining Aggregate Exercise Contractual Intrinsic Shares Price Term (Years) Value --------- ---------- ----------- --------- Outstanding at December 31, 2005 5,716,272 $ 0.53 Granted 985,000 0.21 Exercised - - Forfeited or expired - - --------- Outstanding at March 31, 2006 6,701,272 $ 0.48 7.98 $ 74 Granted 10,000 0.21 Exercised - - Forfeited or expired (16,217) --------- Outstanding at June 30, 2006 6,695,055 $ 0.48 7.73 $ 55 ========= Vested or expected to vest at June 30, 2006 (1) 6,438,408 $ 0.49 7.68 $ 55 ========= Exercisable at June 30, 2006 (2) 6,695,055 $ 0.48 7.73 $ 55 =========
(1) Of the options outstanding as of June 30, 4,025,123 were vested and 2,413,285 were estimated to vest in future periods, prior to their estimated forfeiture. (2) All options are exercisable immediately upon grant. Options vest, generally ratably over a 33-month period commencing in the fourth month after the grant date. The Company has the right to repurchase exercised options that have not vested upon their forfeiture at the respective option's exercise price. No stock-based compensation awards were exercised during either the three or six-month periods ended June 30, 2006. As of June 30, 2006, there was $597 thousand of total unrecognized compensation cost related to stock-based compensation. That cost is expected to be recognized over a weighted-average period of approximately 1.0 year. 7 3. Revenue Revenue for the three-month periods ended June 30, 2006 and 2005 was comprised as follows:
Change in Revenue ($000s) 2006 2005 Dollars Percent --------------- --------- --------- --------- -------- Product licenses Windows $ 433 $ 520 $ (87) (16.7)% Unix 605 429 176 41.0 --------- --------- --------- 1,038 949 89 9.4 --------- --------- --------- Service Fees Windows 204 161 43 26.7 Unix 195 154 41 26.6 --------- --------- --------- 399 315 84 26.7 --------- --------- --------- Other 14 12 2 16.7 --------- --------- --------- Total Revenue $ 1,451 $ 1,276 $ 175 13.7 ========= ========= =========
Revenue for the six-month periods ended June 30, 2006 and 2005 was comprised as follows:
Change in Revenue ($000s) 2006 2005 Dollars Percent --------------- --------- --------- --------- -------- Product licenses Windows $ 1,060 $ 1,141 $ (81) (7.1)% Unix 863 696 167 24.0 --------- --------- --------- 1,923 1,837 86 4.7 --------- --------- --------- Service Fees Windows 417 304 113 37.2 Unix 378 297 81 27.3 --------- --------- --------- 795 601 194 32.3 --------- --------- --------- Other 39 18 21 116.7 --------- --------- --------- Total Revenue $ 2,757 $ 2,456 $ 301 12.3 ========= ========= =========
4. Patents As of June 30, 2006, patents consisted of the following:
(000s) ----------- Patents $ 5,340 Accumulated amortization (1,265) ----------- $ 4,075 ===========
Patent amortization, which aggregated $223 thousand and $445 thousand during the three and six-month periods ended June 30, 2006, respectively, is a component of general and administrative expenses. 5. Supplemental Disclosure of Cash Flow Information The Company disbursed no cash for the payment of income taxes or interest during either of the six-month periods ended June 30, 2006 or 2005. 6. 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 three and six-month periods ended June 30, 2006 and 2005, 19,544,255 and 22,457,157 shares, respectively, of common stock equivalents were excluded from the computation of diluted loss per share since their effect would be antidilutive. 8 ITEM 2. Management's Discussion and Analysis or Plan of Operation 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, 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 Network Engineering Software, Inc. ("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, including those set forth under Item 6. "Management's Discussion and Analysis or Plan of Operation - Risk Factors" in our Annual Report on Form 10-KSB for the year ended December 31, 2005 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 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. A variety of Unix, Linux or Windows applications can be web-enabled with our server-based technology. 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 2006. If we are unsuccessful in maintaining our current revenue level or finding additional alternative sources of financing, we will face a severe constraint on our ability to sustain operations in a manner that creates future growth and viability. Critical Accounting Policies We believe that several accounting policies are important to understanding our historical and future performance. We refer to these policies as "critical" because these specific areas generally require us to make judgments and estimates about matters that are uncertain at the time we make the estimates, and different estimates, which also would have been reasonable, could have been used, which would have resulted in different financial results. The critical accounting policies listed below should be read in conjunction with those identified in our most recent Annual Report on Form 10-KSB for the fiscal year ended December 31, 2005, as amended, which included: the allowance for doubtful accounts, patents, capitalized software development costs, impairment of intangible assets, loss contingencies and stock compensation. With the adoption of FAS123R, on January 1, 2006, we have identified the estimates and assumptions that accompany the fair value determination of our stock-based 9 compensation awards as critical, as discussed below. Our discussion of revenue recognition has been revised in order to disclose polices that have been applied for the first time during the current reporting period. It is important that the discussion of our operating results that follows be read in conjunction with the critical accounting policies discussed below as well as those disclosed in our Annual Report on Form 10-KSB, as filed with the SEC on April 17, 2006, and Amendment Number 1 to our Annual Report on Form 10-KSB, as filed with the SEC on June 12, 2006. Revenue Recognition Generally, software license revenues are recognized when: o Persuasive evidence of an arrangement exists, i.e., when we sign a non-cancelable license agreement wherein the customer acknowledges an unconditional obligation to pay, or upon receipt of the customer's purchase order. o Delivery has occurred or services have been rendered and there are no uncertainties surrounding product acceptance, i.e., when the title and risk of loss have been transferred to the customer, which generally occurs when the media containing the licensed programs is provided to a common carrier or in the case of electronic delivery, delivery occurs when the customer is given access to the licensed program. o Our price to the customer is fixed or determinable, as typically evidenced in the signed non-cancelable contract, or the customer's purchase order. o Collectibility is reasonably assured. If collectiblity is not considered probable, revenue is recognized when the fee is collected. Revenue recognized on software arrangements involving multiple elements is allocated to each element of the arrangement based on vendor-specific objective evidence ("VSOE") of the fair values of the elements; such elements include licenses for software products, maintenance, consulting services or customer training. We limit our assessment of VSOE 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 sufficient VSOE of fair values does not exist so as to permit the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until such evidence exists or until all elements are delivered. If evidence of VSOE 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 ISV, VAR or ASP 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 us with monthly sell-through reports that detail, for the respective month, various items, such as 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 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 our product to another party. These resellers will typically submit a purchase order to us 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 one to five years. 10 Stock-Based Compensation Prior to January 1, 2006, we accounted for our stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB No. 25") and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation." ("FAS No. 123") We did not recognize compensation cost related to stock options granted to our employees and non-employee directors that had an exercise price equal to or above the market value of the underlying common stock on the date of grant in our condensed consolidated statement of income prior to January 1, 2006. Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R, "Share-Based Payment," ("FAS123R") and related interpretations using the modified prospective transition method. Under that method, compensation cost recognized in the three and six-month periods ended June 30, 2006 includes (a) compensation cost for all stock-based awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of FAS No. 123 and (b) compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS123R. Results for prior periods have not been restated. As a result of adopting FAS123R on January 1, 2006, our loss from operations, loss before provision for income taxes and net loss for the three and six-months ended June 30, 2006 are $116 thousand and $226 thousand higher, respectively, than if we had continued to account for stock-based compensation under APB No. 25. The valuation of employee stock options is an inherently subjective process, since market values are generally not available for long-term, non-transferable employee stock options. Accordingly, an option pricing model is utilized to derive an estimated fair value. In calculating the estimated fair value of our stock options, we used a binomial pricing model which requires the consideration of the following variables for purposes of estimating fair value: o the expected volatility of our common stock, o the annualized forfeiture/termination rate, o the prior forfeiture/termination rate, o the expected term of the option, o the exercise factor for optionees, o the risk free interest rate for the expected option term, and o expected dividends on our common stock (we do not anticipate paying dividends for the foreseeable future). Of the variables above, the selection of an expected term, an annualized forfeiture rate and expected stock price volatility are the most subjective. Our estimate of the expected option term was 7.5 years and was derived based on our analysis of historical data and future projections. We derived an annualized forfeiture rate of 10% by analyzing our historical forfeiture data, including consideration of the impact of certain non-recurring events, such as reductions in work force. In estimating our stock price volatility for grants awarded during the three-month period ended June 30, 2006, we analyzed our historic volatility since we became a public entity (July 13, 1999) through June 30, 2006, by reference to actual stock prices during this period and calculated an estimated volatility of approximately 157%. We believe that each of these estimates is reasonable in light of the data we analyzed. However, as with any estimate, the ultimate accuracy of these estimates is only verifiable over time. We also recognized compensation costs for shares purchased under our Employee Stock Purchase Plan ("ESPP") during the three months ended June 30, 2006. We applied the same variables to the calculation of the costs associated with the ESPP shares purchased as the stock option grants noted above, except as follows: expected stock price volatility was 147%, the risk free interest rate was 3.73% and the expected term was 0.5 years. In estimating stock price volatility for the ESPP shares purchased, we analyzed our historical volatility from August 1, 2005 to January 31, 2006. These are the two dates whose closing prices were used as the basis of determining the purchase price for shares most recently purchased under the ESPP. Since August 1, 2005 to January 31, 2006 is a six-month period, the estimated term was deemed to be 0.5 years. The specific valuation assumptions noted above were applied to stock options that we granted during the three-month period ended June 30, 2006 and ESPP shares that were granted February 1, 2006. For assumptions used for grants made during the three-month period ended March 31, 2006, please refer to our Quarterly Report on Form 10-QSB as filed with the SEC May 15, 2006. We expect that stock-based compensation expense will continue to have a material impact on our financial results for the remainder of the fiscal year. For the remainder of fiscal 2006 we expect to incur stock-based compensation expense of approximately $120 thousand per quarter. 11 Results of Operations for the Three and Six Month Periods Ended June 30, 2006 and 2005. Revenue The changes in both Windows and Unix-based product licenses revenue for the three and six-month periods ended June 30, 2006 and 2005 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 impacted. We expect this situation to continue throughout the next several quarterly reporting periods. Revenue for the three-month periods ended June 30, 2006 and 2005 was as follows:
Change in Revenue ($000s) 2006 2005 Dollars Percent --------------- --------- --------- --------- -------- Product licenses Windows $ 433 $ 520 $ (87) (16.7)% Unix 605 429 176 41.0 --------- --------- --------- 1,038 949 89 9.4 --------- --------- --------- Service Fees Windows 204 161 43 26.7 Unix 195 154 41 26.6 --------- --------- --------- 399 315 84 26.7 --------- --------- --------- Other 14 12 2 16.7 --------- --------- --------- Total Revenue $ 1,451 $ 1,276 $ 175 13.7 ========= ========= =========
(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. During the three-month period ended June 30, 2006, fifteen Windows customers purchased an aggregate $274 thousand of Windows product, which accounted for 63.3% of Windows product license revenue for the period. These fifteen customers' purchases were $188 thousand lower than their purchases during the same period of 2005, which aggregated $462 thousand, or 88.8% of Windows product license revenue. The decrease in revenue is primarily due to our decision to defer revenue recognition for a purchase made during the three-month period ended June 30, 2006 by a significant customer who is a reseller. We determined that sufficient VSOE did not exist for the allocation of revenue to the various elements of the purchase. When such evidence exists we will recognize revenue from this transaction. We expect that future purchases by this customer will also be deferred for the foreseeable future. Five Unix product customers, including our most significant Unix customer (Alcatel - all worldwide locations) and the new enterprise customer discussed below, purchased an aggregate $477 thousand of Unix products, which accounted for 78.8% of Unix product license revenue for the three-month period ended June 30, 2006. These five customers' purchases were an aggregate $318 thousand higher than their purchases during the same period of 2005, which aggregated $159 thousand, or 37.1% of Unix product license revenue for the prior period. During the three-month period ended June 30, 2006, one new enterprise customer made a one-time purchase of an aggregate $250 thousand of Unix product licenses, all of which was recognized as revenue during the period. Our customers typically purchase a maintenance contract at the time they license our product. Our Windows-based maintenance contracts vary in term from one to three years 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-month period ended June 30, 2006, as compared with the same period of the prior year was primarily due to higher levels of maintenance contract purchases that occurred during 2005 and has continued through the first six months of 2006. We expect this trend to continue throughout 2006. 12 Revenue for the six-month periods ended June 30, 2006 and 2005 was comprised as follows:
Change in Revenue ($000s) 2006 2005 Dollars Percent --------------- --------- --------- --------- -------- Product licenses Windows $ 1,060 $ 1,141 $ (81) (7.1)% Unix 863 696 167 24.0 --------- --------- --------- 1,923 1,837 86 4.7 --------- --------- --------- Service Fees Windows 417 304 113 37.2 Unix 378 297 81 27.3 --------- --------- --------- 795 601 194 32.3 --------- --------- --------- Other 39 18 21 116.7 --------- --------- --------- Total Revenue $ 2,757 $ 2,456 $ 301 12.3 ========= ========= =========
During the six-month period ended June 30, 2006, eighteen Windows customers purchased an aggregate $728 thousand of Windows product, which accounted for 68.7% of Windows product license revenue for the period. These eighteen customers' purchases were $146 thousand lower than their purchases during the same period of 2005, which aggregated $874 thousand, or 76.6% of Windows product license revenue. As discussed previously, we made the decision to defer revenue recognition for a purchase made during the three-month period ended June 30, 2006 by a significant customer who is a reseller. We determined that sufficient VSOE did not exist for the allocation of revenue to the various elements of the purchase. When such evidence exists we will recognize revenue from this transaction. We expect that future purchases by this customer will also be deferred for the foreseeable future. Twelve Unix product customers, including our most significant Unix customer (Alcatel - all worldwide locations) and the new enterprise customer previously discussed, purchased an aggregate $681 thousand of Unix products, which accounted for 78.9% of Unix product license revenue for the six-month period ended June 30, 2006. These twelve customers' purchases were an aggregate $158 thousand higher than their purchases during the same period of 2005, which aggregated $523 thousand, or 75.1% of Unix product license revenue. The increase in both Windows and Unix-based service fees for the six-month period ended June 30, 2006, as compared with the same period of the prior year was primarily due to higher levels of maintenance contract purchases that occurred during 2005 and has continued through the first six months of 2006. We expect this trend to continue throughout 2006 Cost of Revenue Cost of revenue is comprised primarily of service costs, which represent the costs of customer service, and product costs, which are primarily the amortization of capitalized technology developed in-house. 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 for the three-month periods ended June 30, 2006 and 2005 was as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Product costs $ 30 $ 53 $ (23) (43.4)% Service costs 121 78 43 55.1 ------ ------ ------- $ 151 $ 131 $ 20 15.3% ====== ====== =======
Cost of revenue increased by $20 thousand, or 15.3%, to $151 thousand for the three months ended June 30, 2006, from $131 thousand for the comparable period of 2005. Service costs increased by $43 thousand, or 55.1%, from $78 thousand to $121 thousand. Partially offsetting this increase was a $23 thousand decrease, or 43.4%, in product costs from $53 thousand to $30 thousand. The decrease in product costs for the three-month period ended June 30, 2006, as compared with the same period in 2005 was primarily due to a decrease in the amortization of capitalized software development costs. We expect product costs 13 to remain lower throughout 2006, as compared with 2005, as certain elements of our capitalized software development costs became fully amortized during 2005 and others will become fully amortized during 2006. The increase in service costs for the three-month period ended June 30, 2006, as compared with the same period in 2005, resulted primarily from increasing the number of engineers performing customer service and from the adoption of FAS123R, as explained elsewhere in this Form 10-QSB. In order to better meet the needs of our customers, as we have sold more maintenance contracts over the course of the last several quarters, we increased the number of engineers providing customer service to our customers to eight during the three months ended June 30, 2006, from four for the same period of the prior year. Additionally, in accordance with FAS123R, we expensed $4 thousand of stock-based compensation expense related to our customer service engineers during the three-month period ended June 30, 2006. No such expense was recorded during the same period of the prior year. We expect service costs to remain higher throughout 2006, as compared with 2005. Cost of revenue for the six-month periods ended June 30, 2006 and 2005 was as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Product costs $ 65 $ 104 $ (39) (37.5)% Service costs 197 148 49 33.1 ------ ------ ------- $ 262 $ 252 $ 10 4.0% ====== ====== =======
Cost of revenue increased by $10 thousand, or 4.0%, to $262 thousand for the six months ended June 30, 2006, from $252 thousand for the comparable period of 2005. Product costs decreased by $39 thousand, or 37.5%, from $104 thousand to $65 thousand. This decrease was partially offset by an increase in service costs, which increased by $49 thousand, or 33.1%, to $197 thousand from $148 thousand. The decrease in product costs for the six-month period ended June 30, 2006, as compared with the same period in 2005 was primarily due to a decrease in the amortization of capitalized software development costs. We expect product costs to remain lower throughout 2006, as compared with 2005, as certain elements of our capitalized software development costs became fully amortized during 2005 and others will become fully amortized during 2006. The increase in service costs for the six-month period ended June 30, 2006, as compared with the same period in 2005, resulted primarily from increasing the number of engineers performing customer service and from the adoption of FAS123R, as explained elsewhere in this Form 10-QSB. In order to better meet the needs of our customers, as we have sold more maintenance contracts over the course of the last several quarters, we increased the number of engineers providing customer service to our customers to eight during the three months ended June 30, 2006, from four for the same period of the prior year. Additionally, in accordance with FAS123R, we expensed $8 thousand of stock-based compensation expense related to our customer service engineers during the six-month period ended June 30, 2006. No such expense was recorded during the same period of the prior year. We expect service costs to remain higher throughout 2006, as compared with 2005. Selling and Marketing Expenses Selling and marketing expenses primarily consist of employee costs, outside services, travel and entertainment, tradeshow expense and stock-based compensation expense. Selling and marketing expenses were 29.4% and 26.8% of revenue for the three months ended June 30, 2006 and 2005, respectively, and 30.5% and 27.6% of revenue for the six months ended June 30, 2006 and 2005, respectively. Selling and marketing expenses for the three months ended June 30, 2006 increased by $84 thousand, or 24.6%, to $426 thousand from $342 thousand for the same period of 2005. For the six months ended June 30, 2006, selling and marketing expenses increased $163 thousand, or 24.1%, to $840 thousand from $677 thousand for the same period of 2005. 14 Selling and marketing expenses for the three months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Employee costs $ 305 $ 257 $ 48 18.7% Outside services 52 53 (1) (1.9) Travel & entertainment 41 23 18 78.3 Tradeshow expense 6 1 5 500.0 Stock-based compensation 3 - 3 na Other 19 8 11 137.5 ------ ------ ------- $ 426 $ 342 $ 84 24.6% ====== ====== =======
The increase in employee costs for the three-month period ended June 30, 2006, as compared with the same period in 2005, resulted primarily from increased commissions and the hiring of a sales engineer. The increase in travel & entertainment and tradeshow expense for the three-month period ended June 30, 2006, as compared with the same period in 2005, resulted from increased tradeshow participation as well as an increase in visiting customers and prospects. We expect these trends to continue; consequently, we expect 2006 travel and entertainment and tradeshow expense levels to exceed 2005 levels. We adopted FAS123R as of January 1, 2006, as explained elsewhere in this Form 10-QSB, and as a result began recording stock-based compensation expense. For the three-month period ended June 30, 2006, such selling and marketing stock-based compensation expense amounted to $3 thousand. No such stock-based compensation expense was recorded during 2005. Selling and marketing expenses for the six months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Employee costs $ 591 $ 522 $ 69 13.2% Outside services 108 93 15 16.1 Travel & entertainment 73 34 39 114.7 Tradeshow expense 21 5 16 320.0 Stock-based compensation 17 - 17 na Other 30 23 7 30.4 ------ ------ ------- $ 840 $ 677 $ 163 24.1% ====== ====== =======
The increase in employee costs for the six-month period ended June 30, 2006, as compared with the same period in 2005, was primarily the result of higher commissions and a new sales engineer hired during 2006. The increase in outside services for the six-months ended June 30, 2006, as compared with the same period in 2005, was the result of the increased activity of our outside Asian sales representative and increasing overall marketing activities. We expect this trend to continue as we anticipate increasing our outside Asian sales representative's activities in 2006 over 2005 levels and to continue increased overall marketing efforts. 15 The increases in travel and entertainment and tradeshow expense for the six months ended June 30, 2006, as compared with the same period in 2005, were primarily as a result of our participation in more tradeshows and undertaking more visits to customers and prospects. Of note, we participated in CeBIT in Hanover, Germany during the six months ended June 30, 2006. This is one of, if not the largest technology tradeshow in Europe annually. Although we attended CeBIT during 2005, we did not set up a display; consequently, our 2006 CeBIT participation costs were greater than those in 2005. We expect this trend to continue as we anticipate setting up our display at other tradeshows during 2006. Based on the above items and trends, we anticipate that 2006 selling and marketing expense will exceed 2005 selling and marketing expense. General and Administrative Expenses General and administrative expenses primarily consist of employee costs, amortization and depreciation, stock-based compensation expense, legal, professional and other outside services (including those related to realizing benefits from our patent-related assets), travel and entertainment, certain costs associated with being a publicly held corporation, and bad debts expense. General and administrative expenses were approximately 63.7% and 60.2% of revenues for the three-month periods ended June 30, 2006 and 2005, respectively. For the six-month periods ended June 30, 2006 and 2005, general and administrative expenses were approximately 69.5% and 60.9% of revenues, respectively. General and administrative expenses increased by $157 thousand, or 20.4%, to $925 thousand from $768 thousand for the three-month period ended June 30, 2006, as compared with the same period in 2005. For the six-month period ended June 30, 2006, general and administrative expenses increased by $420 thousand, or 28.1%, to $1,915 thousand from $1,495 thousand for the six-month period ended June 30, 2005. General and administrative expenses for the three months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Employee costs $ 313 $ 249 $ 64 25.7% Depreciation and amortization 228 225 3 1.3 Outside services 169 198 (29) (14.6) Travel & entertainment 56 10 46 460.0 Stock-based compensation 97 1 96 960.0 Other 62 85 (23) (27.1) ------ ------ ------- $ 925 $ 768 $ 157 20.4% ====== ====== =======
The increase in employee costs in the three months ended June30, 2006, as compared with the same period of 2005, was primarily due to having approximately three more employees and salary adjustments made subsequent to June 30, 2005. Partially offsetting these items was a decrease in accrued bonuses. We expect 2006 employee costs to exceed 2005 levels. Outside services decreased by $29 thousand during the three months ended June 30, 2006, as compared with the same period of 2005 primarily as a result of hiring an in-house attorney during 2005, to oversee the administration of our patents. Partially offsetting these cost savings was an increase in consulting fees charged to us by our CEO (Chief Executive Officer). During 2006, our CEO significantly increased his activities in our general business operations in addition to pursuing business development opportunities as they presented themselves. We expect these trends to continue during 2006. 16 The $46 thousand increase in travel and entertainment during the three months ended June 30, 2006, as compared with the same period of the previous year, was primarily a result of our CEO's travels to our various facilities, as well as travel incurred by management while exploring potential business development opportunities. We expect 2006 travel and entertainment levels to exceed those of 2005. We adopted FAS123R as of January 1, 2006, as explained elsewhere in this Form 10-QSB, and as a result, began recording stock-based compensation expense. For the three-month period ended June 30, 2006 such general and administrative stock-based compensation expense amounted to $97 thousand. During the three-month period ended June 30, 2005, we recorded $1 thousand of compensation expense in accordance with FAS123, which was derived from stock options that had been previously issued to our CEO. We anticipate 2006 stock-based compensation expense to exceed 2005 levels as we continue to comply with FAS123R. General and administrative expenses for the six months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------- ------- ------- ------- Employee costs $ 628 $ 469 $ 159 33.9% Depreciation and amortization 452 372 80 21.5 Outside services 373 462 (89) (19.3) Travel & entertainment 105 30 75 250.0 Stock-based compensation 181 1 180 1,800.0 Other 176 161 15 9.3 ------- ------- ------- $ 1,915 $ 1,495 $ 420 28.1% ======= ======= =======
The increase in employee costs for the six months ended June30, 2006, as compared with the same period of 2005, was primarily due to having approximately three more employees and salary adjustments made subsequent to June 30, 2005. Partially offsetting these items was a decrease in accrued bonuses. We expect 2006 employee costs to exceed 2005 levels. Depreciation and amortization expense increased during the six months ended June 30, 2006, as compared with the same period in 2005, primarily as a result of increased patent amortization. Costs associated with acquiring the patents from NES were capitalized at various times throughout the six month period ended June 30, 2005 and since costs can not be amortized until they are capitalized, the cost basis upon which the patent amortization was calculated grew larger throughout the six-month period ended June 30, 2005. All patent costs were capitalized prior to 2006; consequently, all such costs were included in the cost basis upon which the patent amortization was calculated during the six months ended June 30, 2006. Outside services decreased during the six months ended June 30, 2006, as compared with the same period of 2005 primarily as a result of hiring an in-house attorney during 2005, to oversee the administration of our patents. Partially offsetting these cost savings was an increase in consulting fees charged to us by our CEO (Chief Executive Officer). During 2006, our CEO significantly increased his activities in our general business operations in addition to pursuing business development opportunities on our behalf as they presented themselves. We expect these trends to continue during 2006. The increase in travel and entertainment during the six months ended June 30, 2006, as compared with the same period of the previous year, was primarily a result of our CEO's travels to our various facilities, as well as travel incurred by management while exploring potential business development opportunities. We expect 2006 travel and entertainment levels to exceed those of 2005. We adopted FAS123R as of January 1, 2006, as explained elsewhere in this Form 10-QSB, and as a result, began recording stock-based compensation expense. For the six-month period ended June 30, 2006 such general and administrative 17 stock-based compensation expense amounted to $181 thousand. During the six-month period ended June 30, 2005, we recorded $1 thousand of compensation expense in accordance with FAS123, which was derived from stock options that had been previously issued to our CEO. We anticipate 2006 stock-based compensation expense to exceed 2005 levels as we continue to comply with FAS123R. We anticipate that aggregate general and administrative expenses for 2006 will be higher than 2005, primarily due to the additional personnel, the amortization of the patents, stock option compensation expense we will record as a result of adopting FAS123R, and increased activity by certain executive managers. Research and Development Expenses Research and development expenses consist primarily of employee costs, payments to contract programmers, rent, stock-based compensation expense, depreciation and computer related supplies. Research and development expenses were approximately 31.2% and 24.5% of revenues for the three-month periods ended June 30, 2006 and 2005, respectively, and approximately 30.7% and 25.9% of revenues for the six-month periods ended June 30, 2006 and 2005, respectively. Research and development expenses for the three-month period ended June 30, 2006 increased by $139 thousand, or 44.4%, to $452 thousand from $313 thousand for the three-month period ended June 30, 2005. Research and development expenses for the six-month period ended June 30, 2006 increased by $210 thousand, or 33.0%, to $846 thousand from $636 thousand for the six-month period ended June 30, 2005. 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 six-month periods ended June 30, 2006 or 2005. Research and development expenses for the three-months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Employee costs $ 227 $ 224 $ 3 1.3% Outside services 169 50 119 238.0 Stock-based 12 - 12 na compensation Other 44 39 5 12.8 ------ ------ ------- $ 452 $ 313 $ 139 44.4 ====== ======= =======
Employee costs for the three-month periods ended June 30, 2006 and 2005 are net of $116 thousand and $77 thousand, respectively, which related to employee costs reported as customer service cost of revenue. The increase in employee costs noted in the table immediately preceding this paragraph was primarily due to salary adjustments enacted subsequent to June 30, 2005 and increases in employee benefits, which were partially offset by the customer service employee costs that were reported as cost of revenue. More than half of the increase in outside services for the three-month period ended June 30, 2006, as compared with the same period of 2005, related to fees paid to an executive recruiting agency assisting us in our search for a new vice-president of engineering. The balance of the increase was incurred primarily by expanding our use of consulting engineers to help enhance our product development efforts. Subsequent to June 30, 2006 we hired a new vice-president of engineering. We expect to continue making greater use of consulting engineers throughout 2006 to assist in product development efforts. Based on these items, we anticipate that expenses related to outside services in 2006 will exceed 2005 levels. We adopted FAS123R as of January 1, 2006, as explained elsewhere in this Form 10-QSB, and as a result began recording stock-based compensation expense. For the three-month period ended June 30, 2006 such research and development stock-based compensation expense amounted to $16 thousand, of which $4 thousand 18 was reported as customer service cost of revenue. No such stock-based compensation expense was recorded during 2005. We anticipate 2006 stock-based compensation expense to exceed 2005 levels as we continue to comply with FAS123R. Research and development expenses for the six-months ended June 30, 2006 and 2005 were as follows:
($000s) Change in 2006 2005 Dollars Percent ------ ------ ------- ------- Employee costs $ 489 $ 447 $ 42 9.4% Outside services 245 105 140 133.3 Stock-based 20 - 20 na compensation Other 92 84 8 9.5 ------ ------ ------- $ 846 $ 636 $ 210 33.0 ====== ====== =======
Employee costs for the six-month periods ended June 30, 2006 and 2005 are net of $188 thousand and $148 thousand, respectively, which related to employee costs reported as customer service cost of revenue. The increase in employee costs noted in the table immediately preceding this paragraph was primarily due to the hiring of two additional engineers during 2006, salary adjustments enacted subsequent to June 30, 2005 and increases in employee benefits, which were partially offset by the customer service employee costs that were reported as cost of revenue. The increase in outside services for the six-month period ended June 30, 2006, as compared with the same period of 2005, was primarily related to fees paid to an executive recruiting agency assisting us in our search for a new vice-president of engineering. The balance of the increase was incurred primarily by expanding our use of consulting engineers to help enhance our product development efforts. Subsequent to June 30, 2006 we hired a new vice-president of engineering. We expect to continue making greater use of consulting engineers throughout 2006 to assist in product development efforts. Based on these items, we anticipate that expenses related to outside services in 2006 will exceed 2005 levels. We adopted FAS123R as of January 1, 2006, as explained elsewhere in this Form 10-QSB, and as a result began recording stock-based compensation expense. For the six-month period ended June 30, 2006 such research and development stock-based compensation expense amounted to $28 thousand, of which $8 thousand was reported as customer service cost of revenue. No such stock-based compensation expense was recorded during 2005. We anticipate 2006 stock-based compensation expense to exceed 2005 levels as we continue to comply with FAS123R. During the three-months ended June 30, 2006, we established an engineering facility in Israel that will conduct business under the name GraphOn Research Labs, Ltd. No significant costs were incurred during the period to establish this wholly-owned subsidiary. It commenced operations during July 2006. Based on the above factors, we anticipate that research and development expenses for 2006 will be higher than those incurred during 2005. Other Income During the three and six-month periods ended June 30, 2006 and 2005, other income consisted primarily of interest income on excess cash and note receivable - - shareholder. During the six-month period ended June 30, 2005, other income also included interest income on notes receivable - directors. Other income for the three-month period ended June 30, 2006 increased by $1 thousand, or 9.1%, to $12 thousand from $11 thousand for the same period of 2005. For the six-month period ended June 30, 2006, other income increased by $4 thousand, or 22.2%, to $22 thousand from $18 for the same period of 2005. We anticipate that interest and other income for 2006 will approximate 2005 levels as we anticipate having similar or lower average cash balances for the remainder of the year, partially offset by higher interest rates. 19 Net Loss As a result of the foregoing items, net loss for the three-month period ended June 30, 2006 was $494 thousand, an increase of $227 thousand, or 85.0%, from a net loss of $267 thousand for the same period of 2005. Net loss for the six-month period ended June 30, 2006 was $1,087 thousand, an increase of $501 thousand, or 85.5%, from a net loss of $586 for the same period of 2005. 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 six-month period ended June 30, 2006 was $1,087 thousand, a decrease of $3,499 thousand, or 76.3%, from $4,586 thousand for the same period of 2005. The decrease for the six-month period ended June 30, 2006, as compared with the same period of the prior year 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 thousand 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 $6,815 thousand at that date. The fair value of the warrants was estimated to be $1,878 thousand 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 thousand of the $4,000 thousand proceeds of the 2005 Private Placement to the Preferred Shares and $864 thousand 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 thousand by $3,679 thousand (using the intrinsic value method). This discount resulting from recording the Beneficial Conversion Feature was limited to the allocated proceeds of $3,136 thousand 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 thousand 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 During 2006 we anticipate increasing our net cash investments in our operations by approximately $1.0 million over our 2005 levels. We anticipate increasing our net cash investments in our research and development efforts internally through our newly-established Israeli subsidiary (GraphOn Research Labs, Ltd.) and externally through greater use of consulting engineers to help enhance our product development efforts. Additionally, we expect that our net cash administrative investments will increase as we devote more resources to the continued growth of our business internally and through the exploration of potential business combinations and other opportunities. We also expect our net cash administrative investments to grow in relation to increases in the costs of doing business as a public entity. Our net cash sales and marketing investments will increase as we continue with our general plan of increasing our sales and marketing endeavors. We are simultaneously looking at ways to improve our revenue stream. 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 over the course of the next several quarterly reporting periods. 20 On January 31, 2005, we acquired NES for 9,599,993 shares of common stock, the assumption of approximately $233 thousand of NES' indebtedness and the reimbursement to AIGH Investment Partners, LLC ("AIGH"), an affiliate of a principal stockholder (Orin Hirschman), of $665 thousand 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 thousand, inclusive of the $665 thousand credit issued to AIGH. As of June 30, 2006, we had consumed approximately $525 thousand and $700 thousand of the cash raised paying for expenses related to the 2005 private placement and the NES acquisition, respectively. We estimate that we will have no further disbursements of cash related to either the 2005 private placement or the NES acquisition. We anticipate incurring further costs associated with the development of our patents for the next several reporting periods. We expect to fund these development costs through working capital. Additionally, we anticipate increasing our rate of investment in our both our research and development and sales and marketing activities in 2006 over 2005 levels and to fund these costs through working capital. Working Capital As of June 30, 2006, we had current assets of $4,067 thousand and current liabilities of $1,720 thousand, which netted to working capital of $2,347 thousand. Included in current liabilities was the current portion of deferred revenue of $1,110 thousand. Based on our current operating revenues, 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. 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 June 30, 2006. 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 June 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 21 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings On November 23, 2005, we initiated a proceeding against AutoTrader.com in the United States District Court in the Eastern District of Texas, (the "Court") alleging that Autotrader.com was infringing two of our patents, namely Nos. 6,324,538 and 6,850,940 (the "538" and "940" patents, respectively), which protect our unique method of maintaining an automated and network accessible database, on its AutoTrader.com website. We seek preliminary and permanent injunctive relief along with unspecified damages and fees. Autotrader.com filed its Answer and Counterclaims on January 17, 2006 seeking a declaratory judgment that it does not infringe the 538 and 940 patents and that both patents are invalid. On March 24, 2006, Autotrader.com filed a motion for summary judgment seeking to invalidate the 538 and 940 patents. On May 1, 2006 we filed a response in opposition to AutoTrader's motion. On August 8, 2006, AutoTrader's motion for summary judgment was denied. On August 9, 2006, the Court filed a Docket Control Order setting forth proposed pretrial deadlines. The most significant dates set were for the Markman Hearing (May 31, 2007) and jury selection (December 3, 2007). ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds During the three-month period ended June 30, 2006, we granted the following stock options: o stock options to purchase an aggregate 10,000 shares of common stock, at exercise prices ranging from $0.18 to $0.23, 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 22 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: August 11, 2006 By: /s/ Robert Dilworth ------------------- Robert Dilworth Chief Executive Officer (Interim) and Chairman of the Board (Principal Executive Officer) Date: August 11, 2006 By: /s/ William Swain ----------------- William Swain Chief Financial Officer (Principal Financial Officer and (Principal Accounting Officer) EX-31 2 exbt311.txt 302 CERTIFICATIONS Exhibit 31 I, Robert Dilworth, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of GraphOn Corporation ("registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 11, 2006 /s/ Robert Dilworth ------------------- Robert Dilworth Chief Executive Officer (Interim) and Chairman of the Board I, William Swain, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of GraphOn Corporation ("registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 11, 2006 /s/ William Swain ----------------- William Swain Chief Financial Officer EX-32 3 exbt321.txt 906 CERTIFICATIONS Exhibit 32 (a) Certification of Quarterly Report by Chief Executive Officer. CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of GraphOn Corporation (the "Company") on Form 10-QSB for the period ending June 30, 2006 as filed with the Securities and Exchange Commission (the "Report"), I, Robert Dilworth, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Robert Dilworth ------------------------------- Robert Dilworth Chief Executive Officer August 11, 2006 (b) Certification of Quarterly Report by Chief Financial Officer. CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of GraphOn Corporation (the "Company") on Form 10-QSB for the period ending June 30, 2006 as filed with the Securities and Exchange Commission (the "Report"), I, William Swain, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ William Swain ------------------ William Swain Chief Financial Officer August 11, 2006 -----END PRIVACY-ENHANCED MESSAGE-----