PCTEL Secure

6 Months Ended

Jun. 30, 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 held two of the three board seats (and three as of July 2, 2012) 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 and six months ended June 30, 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 were no borrowings under this line of credit as of June 30, 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 from selling mobile phones with secure software embedded to 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 were 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 a 19% membership interest in PCTEL Secure for a price of $0.9 million. The closing date for the purchase was May 29, 2012.

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 exercised its first call right.

Mandatory call right: The Company was obligated to purchase from Eclipse all remaining PCTEL Secure membership interests held by Eclipse if a baseline product was delivered by March 31, 2012 and passed a defined acceptance test. This mandatory call would have expired if the baseline product was not delivered by March 31, 2012 or the baseline product was determined by the designated arbiter to have deficiencies after a second round of acceptance testing. The baseline product was delivered by such date, and passed the defined acceptance tests. The Company gave notice of acceptance in June 2012 and purchased all remaining membership interests held by Eclipse on July 2, 2012 at the mandatory call price of $0.8 million.

The Company’s second call right: This call right would have been exercisable by the Company if the mandatory call expired unexercised. It terminated 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 exercise of the mandatory call right rendered the second call right ineffective.

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

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 granted 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 was the Company’s intent to acquire all membership interests in PCTEL Secure for the products it was creating. The bonuses were paid to the key contributors by Eclipse subsequent to the Company’s exercise of the mandatory call right on July 2, 2012.

The Company recorded $0 and $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 June 30, 2012 and 2011. 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 six months ended June 30, 2012 and 2011, respectively. For the key contributors, the Company recorded the pro-rata portion of the total expense of $0.4 million recognized over the service period ending June 30, 2012. The service period was based on the exercise of the first call right in May 2012 and the irrevocable exercise of the mandatory call right in June 2012 for the purchase of the outstanding membership interests in PCTEL Secure on July 2, 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 six months ended June 30, 2012 and for the three and six months ended June 30, 2011.

PCTEL Secure incurred losses of $0.8 million and $1.5 million for the three and six months ended June 30, 2012, respectively. PCTEL Secure incurred losses of $0.5 million and $1.0 million for the three and six months ended June 30, 2011, respectively. For 2011 and through May 2012, the allocation of PCTEL Secure’s losses were based on PCTEL’s 51% membership interest. In June, the allocation of losses was based on its 70% membership interest. The Company recorded approximately $0.3 million and $0.7 million as net loss attributable to noncontrolling interest for the three and six months ended June 30, 2012. The Company recorded $0.2 million and $0.5 million as net loss attributable to noncontrolling interest for the three and six months ended June 30, 2011. 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 $0.5 million and the redeemable equity of $0.8 million. The redeemable equity is reflected in the mezzanine section of the balance sheet. At June 30, 2012, the redeemable equity consisted of the $0.8 million fair value for the mandatory call right. At December 31, 2011, the redeemable equity consisted of the $0.9 million fair value of the first call right and the $0.8 million fair value for the mandatory call right.

The summary of noncontrolling interest during the six months ended June 30, 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		0		39			39
Purchase of 19% membership interest		0		(931	)		(931	)
Adjustment to temporary equity for PCTEL		0		648			648
Net loss attributable to noncontrolling interest		0		(687	)		(687	)
Balance at June 30, 2012	$	531	$	800		$	1,331

During the six months ended June 30, 2012, the share-based payment expense associated with the awards to key contributors is credited to redeemable equity. Since all noncontrolling interest was recorded as redeemable equity, the Company recorded a $0.6 million adjustment to retained earnings during the six months ended June 30, 2012.

PCTEL paid for the memberships interests in May 2012 and July 2012 from its existing cash. With the purchase of the final 30% interest in July 2012, PCTEL Secure became a wholly-owned subsidiary of PCTEL.