PCTEL Secure

3 Months Ended

Mar. 31, 2012

PCTEL Secure [Abstract]

PCTEL Secure

7. PCTEL Secure

On January 5, 2011, the Company formed PCTEL Secure LLC (“PCTEL Secure”), a joint venture limited liability company, with Eclipse Design Technologies, Inc. (“Eclipse”). PCTEL Secure designs Android-based, secure communication products. The Company contributed $2.5 million in cash on the formation of the joint venture in return for 51% ownership of the joint venture. In return for 49% ownership of the joint venture, Eclipse contributed $2.4 million of intangible assets in the form of intellectual property and a services agreement, including an assembled workforce, to provide services.

The initial capitalization of PCTEL Secure was $4.9 million, consisting of $2.5 million of cash, $1.1 million of in-process research and development, $0.8 million for non-compete agreements, and $0.5 million for service agreements. The values for the intangible assets were the fair values of the intangible assets modeled at the time of execution of the agreements. The intangible assets are being amortized for book purposes, but are not deductible for tax purposes. At the date of acquisition, the weighted average amortization period of the intangible assets acquired was 2.4 years. The Company estimated the fair value (and remaining useful lives) of the assets.

Based on review of accounting rules for consolidation, the Company concluded that (a) it has financial control of PCTEL Secure as it holds two of the three board seats and (b) Eclipse’s rights under the agreements are protective rights that do not override the presumption that the majority-owned subsidiary should be consolidated. Therefore, the Company has consolidated the financial results of PCTEL Secure into the Company’s consolidated financial statements for the three months ended March 31, 2012 and 2011.

The Company provides services to PCTEL Secure at cost for facilities, financial services, general and administrative services, order management, manufacturing and distribution, and marketing services. The term of the Company’s service agreement is through December 31, 2013, with one year extensions thereafter as agreed by the parties. The Company also entered into a line of credit agreement with PCTEL Secure. Under the terms of the line of credit agreement, the Company agreed to lend PCTEL Secure up to $4.0 million at an 8% fixed interest rate. The maturity date for this agreement is June 30, 2014. There have been no borrowings under this line of credit. PCTEL Secure has adequate cash to fund operations through the third quarter 2012.

The limited liability company agreement of PCTEL Secure (“LLC Agreement”) provided several mechanisms for the orderly transition of the Company’s ownership from 51% to 100%. Since the execution of the LLC Agreement, the Company and Eclipse have changed PCTEL Secure’s business model selling mobile phones with secure software embedded licensing its proprietary secure software to third parties for integration on their devices. While the cash flow does not change with the new licensing business model, the revenue decreases dramatically because the licensing royalty per unit is significantly less than the sales price per unit of an entire secure phone. The formulas set forth in the LLC Agreement used to calculate the enterprise value of PCTEL Secure (“EV”) for the purpose of the orderly transition of ownership through call and put rights are multiples of revenue and backlog. Thus the most likely value of Eclipse’s put right and the Company’s call rights are the minimum value expressed in the formula. Based on this model change, the Company and Eclipse agreed to modify the agreement in a first amendment to the LLC Agreement effective December 31, 2011 (“LLC Amendment”).

The features of the LLC Agreement, as amended by the LLC Amendment, are summarized as follows:

The Company’s first call right: The Company exercised its first call right on March 30, 2012 in accordance with the provision of the LLC Agreement requiring Eclipse to sell to the Company 19% of the membership interests in PCTEL Secure for a price of $0.9 million. In its notice to Eclipse, the Company designated as the closing date for the purchase May 29, 2012 or such earlier date on which the Company exercises its mandatory call right (as described below).

Eclipse put right: In the event that the Company did not exercise its first call right, Eclipse had a put right pursuant to which Eclipse could require the Company to purchase 19% of the membership interests in PCTEL Secure; however, such put right has been rendered ineffective because the Company has given notice that it will exercise its first call right.

Mandatory call right: The Company is obligated to purchase from Eclipse all outstanding PCTEL Secure membership interests if a baseline product is delivered by March 31, 2012 and passes a defined acceptance test. This mandatory call expires if the baseline product is not delivered by March 31, 2012 or the baseline product is determined by the designated arbiter to have deficiencies after a second round of acceptance testing. The baseline product was delivered by such date, but testing by the designated arbiter is ongoing as of the date of this report. The mandatory call price is $0.8 million.

The Company’s second call right: This call right is exercisable by the Company if the mandatory call expires unexercised and terminates on December 31, 2013. The Company’s second call price is based on the EV, which was reduced from $4.9 million to $2.66 million by the LLC Amendment. This translates into a reduction of Eclipse’s remaining 30% of the membership interests from $1.5 million to $0.8 million.

The Company’s third call right: If the second call right is not exercised, and after 8 months from the December 31, 2013 expiration date Eclipse fails to complete a sale of its membership interests to a third party, then the Company has the right to purchase Eclipse’s membership interests using the EV calculated at the expiration of the second call right.

In accordance with accounting rules for redeemable financial instruments, the Company recorded redeemable equity of $1.7 million at March 31, 2012 and December 31, 2011. The redeemable equity consists of the $0.9 million fair value of the first call right and the $0.8 million fair value for the mandatory call right. At March 31, 2012, the $0.9 million is redeemable equity because the Company exercised the first call, and $0.8 million is redeemable equity because the baseline product was delivered under the terms of the mandatory call right.

Eclipse identified an employee of PCTEL Secure and two contractors for Eclipse as key contributors of services. Eclipse entered into cash bonus arrangements with the three key contributors. The bonus agreements grant these key contributors the right for each to receive a cash bonus from the net proceeds received by Eclipse upon exercise of Eclipse’s put right, the Company’s second call right, or the Company’s third call right, which results in a qualifying sale of Eclipse’s membership interests in PCTEL Secure. Participation in the net proceeds paid to Eclipse from a qualifying sale of Eclipse’s membership interests is equivalent to each key contributor having been a 5% owner of PCTEL Secure. The Company determined that the qualifying sale of Eclipse’s membership interests was probable upon the date of formation, January 5, 2011. The Company has control over the entity based on its ownership position and number of board seats. PCTEL has the ability to exercise the call rights based on its available cash and investments and lack of indebtedness. The development program undertaken within PCTEL Secure is part of the Company’s strategic growth strategy, and it is the Company’s intent to acquire all membership interests in PCTEL Secure for the products it is creating.

The Company recorded $0.1 million of compensation expense for share-based payments in accordance with accounting for stock compensation for the three key contributors of PCTEL Secure referenced above during the three months ended March 31, 2012 and 2011. Each key contributor receives a specific percentage of the net proceeds received by Eclipse upon a qualifying sale of its interests and the amount of proceeds for the qualifying sale is determined based on a predetermined multiple of revenues and backlog. Forfeiture is unlikely because of sufficiently large disincentives for nonperformance. For these key contributors, the Company recorded the pro-rata portion of the total expense of $0.4 million to be recognized over the service period ending March 31, 2012. The service period is based on the exercise of the first call right and the probable exercise of the mandatory call right as of March 31, 2012. The fair value of the bonus amounts was based on 15% of the EV of $2.66 million. Since the Company is a noncontributing investor to the share-based payment arrangements, the Company recognized income equal to the amount that its interest in PCTEL Secure’s equity increased as a result of the disproportionate funding of the compensation costs. This amount is included in other income, net in the condensed consolidated statements of operations for the three months ended March 31, 2012 and March 31, 2011, respectively.

PCTEL Secure incurred losses of $0.7 million for the three months ended March 31, 2012. Since the allocation of PCTEL Secure’s profits and losses is based on its 51% membership interest, the Company recorded approximately $0.4 as net loss attributable to noncontrolling interest for the three months ended March 31, 2012. See the segment information in Note 13 for information related to the financial results of PCTEL Secure. The noncontrolling equity on the balance sheet reflects Eclipse’s share of the equity of PCTEL Secure. The noncontrolling equity includes permanent equity of $0.3 million and the redeemable equity of $1.7 million. The redeemable equity is reflected in the mezzanine section of the balance sheet.

The summary of noncontrolling interest during the year ended March 31, 2012 is as follows:

	Noncontrolling Interest
	Permanent			Redeemable			Total
Balance at December 31, 2011	$	531		$	1,731		$	2,262
Share-based payments for PCTEL Secure		24			15			39
Adjustment to temporary equity for PCTEL Secure		—			122			122
Net loss attributable to noncontrolling interest		(216	)		(137	)		(353	)
Balance at March 31, 2012	$	339		$	1,731		$	2,070

During the three months ended March 31, 2012, 30% of the share-based payment expense associated with the awards to key contributors is credited to Eclipse’s noncontrolling interest and 19% of the share-based expense associated with the award to key contributors is credited to redeemable equity. Since the redeemable equity is fixed at $1.7 million at March 31, 2012, the Company recorded a $0.1 million adjustment to retained earnings during the three months ended March 31, 2012.