-----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, I20vx+2U6CAjP49xHIRb/BP7Q8mvN23QmrQNWg+/Swa6HuKmjQV9xaruc+vcypwN gwydRsYS4+hp4gz5UM2iVA== 0001095811-01-002116.txt : 20010421 0001095811-01-002116.hdr.sgml : 20010421 ACCESSION NUMBER: 0001095811-01-002116 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20001231 FILED AS OF DATE: 20010419 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LITRONIC INC CENTRAL INDEX KEY: 0001078717 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER INTEGRATED SYSTEMS DESIGN [7373] IRS NUMBER: 330757190 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-26227 FILM NUMBER: 1606710 BUSINESS ADDRESS: STREET 1: 2030 MAIN STREET SUITE 1250 CITY: IRVINE STATE: CA ZIP: 92614 BUSINESS PHONE: 9498511085 MAIL ADDRESS: STREET 1: 2030 MAIN STREET SUITE 1250 CITY: IRVINE STATE: CA ZIP: 92614 10-K 1 a71207e10-k.txt FORM 10-K FISCAL YEAR ENDED DECEMBER 31,2000 1 ================================================================================ U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- FORM 10-K (MARK ONE) [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000. [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________. COMMISSION FILE NUMBER 000-26227 LITRONIC INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 33-0757190 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 17861 CARTWRIGHT ROAD, IRVINE, CALIFORNIA 92614 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE): (949) 851-1085 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK (TITLE OF CLASS) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act or 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the registrant's voting stock held by nonaffiliates was approximately $19,911,872 on March 22, 2001, based upon the closing sale price of such stock on March 22, 2001. Number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: As of March 22, 2001: Common Stock: 9,747,526 Shares DOCUMENTS INCORPORATED BY REFERENCE. List hereunder the following documents if incorporated by reference, and the part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) any annual report to security holders; (2) any proxy or information statement; and (3) any prospectus filed pursuant to Rule 424(b) or (c) of the Securities Act of 1933: Portions of the registrant's proxy statement related to the 2001 Annual Meeting of stockholders is incorporated by reference into Part III of this Form 10-K. ================================================================================ 2 PART I ITEM 1. BUSINESS INTRODUCTION For purposes of this Annual Report on Form 10-K, references to "we," "us," "our," "Litronic" and the "Company" shall mean or refer to Litronic Inc. In addition, unless the text indicates otherwise, the term "Litronic" refers to Litronic Inc. and its subsidiaries. This Annual Report on Form 10-K contains certain statements which are not historical in nature, and are intended to be, and are hereby identified as, "forward-looking statements" for purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements are principally contained in the sections entitled "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and include, without limitation, statements relating to (i) anticipated trends in our financial condition and results of operations (including expected changes in our gross margin and general, administrative and selling expenses); (ii) our ability to finance our working capital requirements; (iii) our business strategy for expanding our presence in the Internet data security market; and (iv) our ability to distinguish ourselves from our current and future competitors. These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Actual results could differ materially from these forward-looking statements. Important factors to consider in evaluating such forward-looking statements include (i) the shortage of reliable market data regarding the Internet data security market; (ii) changes in external competitive market factors or in our internal budgeting process which might impact trends in our results of operations; (iii) unanticipated working capital or other cash requirements; (iv) changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the proposal management and contract support services markets; and (v) various other factors that may prevent us from competing successfully in the marketplace. In light of these risks and uncertainties, many of which are described elsewhere in this document, there can be no assurance that the actual results will not differ materially from such forward-looking statements contained herein. When used in this report, the words "anticipate," "believe," "intends," "estimate," and "expect" and similar expressions as they relate to us or our management are intended to identify such forward-looking statements. We caution readers that forward-looking statements, including without limitation, those relating to our future business prospects, revenues, working capital, liquidity, and income, are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated in the forward-looking statements, due to several important facts herein identified, among others, and other risks and factors identified from time to time in our reports with the Securities and Exchange Commission. OVERVIEW Litronic Inc. provides professional Internet data security services and develops and markets software and microprocessor-based products, which serve to secure electronic commerce and communications over the Internet, and other communications networks based on Internet protocols. Our primary technology offerings utilize a computer security technology known as public key infrastructure, or PKI, which is the standard technology for securing Internet-based commerce and communications. PKI helps ensure the integrity and privacy of information being transmitted and verifies the identity, authenticity and authority of the sender and the recipient of that information. Our wholly owned subsidiary Pulsar Data Systems, Inc., or Pulsar, operates independently as a network solutions company specializing in deploying large-scale network solutions to organizations primarily in the government sector. INDUSTRY BACKGROUND Internet Data Security Market Consumers, government agencies and corporations are increasingly relying on the Internet and Internet protocol-based networks to conduct electronic commerce and communications. The increasing proliferation of, and reliance on, shared electronic data has caused data security to become a paramount concern of businesses, government, educational institutions, health care providers and consumers. Our data security products provide a solution for entities and consumers seeking to provide protection for their transactions and proprietary data. 2 3 Increased Need for Internet Data Security In addition to protecting against unauthorized access to proprietary information, data security enhances an enterprise's ability to conduct electronic commerce. Many companies have experienced growth in their online customer base and revenue as consumers execute an increasing number of transactions over the Internet. The Internet's ease of use, 24-hour availability, speed of delivery, global reach and ability to simplify product and vendor comparisons are fueling this growth. However, consumer concerns about the trustworthiness and security of the Internet have been one of the main impediments to even faster growth of electronic commerce and other communications. Hacking tools, such as password guessing and address spoofing programs, are freely available on the Internet and bulletin board systems. Merchants and consumers need assurances that consumers making electronic purchases are correctly identified and confirmed and that the confidentiality of information such as credit card and bank account numbers are maintained. We believe that continued expansion of electronic commerce will require the implementation of improved PKI security measures that will irrefutably verify the identity of a party over the Internet and ensure that the information being transmitted is kept private. We also believe the security required to fuel this continued expansion of electronic commerce and communication will be provided through the continued advancement in PKI mathematical formulas referred to as algorithms. Algorithms enable digital document signing and encryption of proprietary data. Requirements for End-to-End Data Security Today's client operating systems and Internet protocol-based networks often lack basic security and key Internet security features such as data privacy and integrity, identification, authentication, non-repudiation, and auditing. End-to-end data security concerns can be addressed by a variety of means. Traditionally, enterprises relied heavily on passwords to restrict access to proprietary information and materials. However, because of the risk of loss or theft, more advanced protective measures have been developed to include combinations of passwords and tokens with message encryption and biometric devices. Regardless of the form of the data security device, the level of security provided is evaluated based on a set of fundamental principles, which include the following: - Identification and Authentication. Verifies the identity of the authorized users to prevent unauthorized access to proprietary information and resources. - Confidentiality. Involves the encryption of data transmissions so that only the intended recipient can access the information to ensure privacy. - Data Integrity. Ensures that data is not compromised or manipulated. - Non-repudiation. Prevents the sender of data transmissions from disclaiming or repudiating authorship so that the sender cannot deny the occurrence of the transaction. - Audit Control. Retraces information access and facilities use over a particular time period at a systems administration level so an enterprise can monitor and record authorized and unauthorized user activity. - Secured System Administration. Maintains and controls corporate intranets centrally through file encryption, password maintenance, audit control, certificate and cryptographic key management and device accessibility control. The process of implementing Internet and Internet protocol-based network solutions requires specialized skills lacking in most corporate information technology departments. We provide the technology, products and services necessary for most companies to implement or manage their data security infrastructure. Cryptographic Technologies Cryptography is the process of encoding and decoding electronic messages using mathematical algorithms, or ciphers, to enable the confidential transmission of electronic messages only to authorized persons. Digital cryptography is performed using a combination of symmetric ciphers and asymmetric ciphers to achieve each of the basic data security elements of identification and authentication, confidentiality, integrity and non-repudiation. Symmetric ciphers are commonly referred to as symmetric-key or secret-key cryptography and asymmetric ciphers are commonly referred to as asymmetric-key or public-key cryptography. 3 4 Both symmetric-key and asymmetric-key cryptography use an encrypting and a decrypting key. The decrypting key is a user's unique number that is input to the mathematical algorithm, or the cipher, used to encrypt or decrypt the message. In symmetric-key cryptography, the encrypting key and the decrypting key, which is secret, are identical. Thus, to transmit a message, a secure key exchange must be performed so that the key can be shared with the recipient of the message. In asymmetric-key cryptography, the encrypting key, a public key, and the decrypting key, a secret key, are different and thus the public key can be distributed to authorized recipients without risk of security breach. Because asymmetric cryptography allows for wide distribution of the encrypting key, it permits secure communication among a large group of people without requiring manual distribution of the key. Additionally, asymmetric-key cryptography relies on the generation of digital certificates that can be used to provide the user authentication, data integrity and non-repudiation elements of the information security system. However, public-key cryptography requires the use of extremely complicated ciphers, so that encryption of large messages is relatively slow when compared to encryption using secret-key cryptography. Thus, asymmetric-key cryptography is commonly used to protect symmetric keys and symmetric-key cryptography is commonly used for bulk encryption. Identification and Authentication Authentication of a user's identity is generally accomplished by passwords. Because passwords are vulnerable to decoding or observation and subsequent use by unauthorized persons, they are less secure than if used with tokens. Tokens are small devices ranging from simple credit card-like objects, rings, proximity cards and plastic keys to more advanced secure tokens, including smart cards, PKI cards and PCMCIA cards. For greater protection, two-factor identification and authentication is implemented by combining tokens with a password or personal identification number to verify authentication of the user. For added security, three-factor authentication, which consists of token, password and biometric comparisons, can be implemented. PKI cards are credit card-sized semiconductor plastic cards that contain an embedded microprocessor, memory, a secure operating system and the user's secret key, password and digital certificates. PKI cards have significant advantages because of their ability to perform basic cryptographic functions on the card itself rather than on the computer, thus reducing the risk that a breach of security on the computer will lead to the unauthorized release of proprietary information. Through the use of PKI cards, e-mail messages, purchase orders, credit card numbers, video clips, data inquiries and other confidential transmissions are secured as they are sent and therefore can be opened only by the intended recipient. PCMCIA cards are parallel computer peripherals similar in size to a credit card, though thicker, which contain multiple microprocessor chips. PCMCIA cards have greater storage capacity, higher data exchange rate and greater processing power than conventional smart cards and therefore are capable of performing advanced cryptographic functions that cannot be performed on a conventional smart card. These advanced functions allow for use of more powerful algorithms and thus provide for a greater overall level of security through the use of PCMCIA cards. We are currently leading a joint effort with Atmel Corporation and the National Security Agency to develop Forte, an ultra fast 32-bit cryptographic System On Chip (SOC). We are embedding the Forte SOC into our new Forte smart card, which we expect will be the fastest and most cryptographically advanced PKI card. We anticipate that Forte will provide PCMCIA level performance at a price competitive with advanced smart cards. Forte is also being designed to be International Standards Organization compliant and therefore able to be used in conventional reader/writers as well as new high performance universal serial bus (USB) readers. PKI Digital Certificates The basic element of PKI, a cutting-edge development in the information security field, is the digital certificate. Digital certificate technology provides a highly advanced form of authentication and secure key exchange. PKI digital certificates are specially prepared software files through which the sender can digitally sign a message with a unique identification code. The recipient of the message can authenticate the identity of the sender and verify the integrity of the data through the use of a trusted third party known as a certificate authority by obtaining the sender's public key from the certificate digitally signed by the certificate authority. Furthermore, the uniqueness of the certificates provides for non-repudiation, which prevents the sender from denying that it sent the message. Such ability for non-repudiation is not available with less sophisticated techniques. With the development of secure-token technology, digital certificates can now be incorporated into smart cards, PKI cards and PCMCIA cards to provide an information security system that provides two-factor identification and authentication or three-factor identification and authentication with the incorporation of biometric technology. Biometric technology utilizes fingerprints or other unique characteristics of an individual to serve as a digital identification. We are currently demonstrating a prototype that combines a fingerprint scanner and a smart card reader. The use of 4 5 digital certificates is expanding rapidly across the Internet. In fact, several states now consider digital signatures contractually binding and there is a growing acceptance within the federal government to effectuate transactions through the use of digital certificates Systems Integration and Networking Solutions Industry In recent years, there has been an increasing demand for open system approaches designed to create interoperability among commercial off-the-shelf computer software and hardware products manufactured by different suppliers. In addition, excessive development costs and the rapid pace of technological change have led both governmental and commercial customers to demand more flexible systems created by adapting readily-available commercial off-the-shelf software and hardware. The emergence of the rapidly developing Internet protocol-based network technologies in the 1990s has further fueled the demand for network computer systems. Although information technologies, secure data transmissions, and data encryption have long been in use in the military intelligence arena, recent technological advancements in computer hardware and software have now made these applications economically viable for use by private companies. This has given rise to the need for specialized expertise in the areas of local and wide area network design and installation, network management and operation and network security, using new and complex information technology hardware and software products. Typically, the design and implementation of these systems in both commercial enterprises and government agencies also involves the resale of the required system hardware and software. Server Acceleration With the growth of Internet business, the need for secure web sites and servers has become paramount for building confidence in e-commerce and protecting sensitive government and corporate information. While various protocols are available, secure socket layer ("SSL") is the most widely used protocol for securing web connections. However, due to the intensive public key operations required during the SSL handshake, web server performance decreases dramatically resulting in slower response times and reduced number of transactions. With server acceleration, a hardware board in the server dramatically increases performance and improves server response time. SSL sessions are then processed significantly faster and no longer drain system resources for authentication functions. By incorporating multiple on-board processor chips on one board, organizations can eliminate the need for additional server platforms. PRODUCTS AND SERVICES Internet Data Security Products Our Internet data security products provide a high level of security for secure e-mail, secure file transport, file protection, remote access, authentication and authorization in an open multi-platform standards-based framework. The foundation of our Internet data security products is our extensive cryptographic library and device drivers supporting a variety of operating system platforms and token management systems which enable users to seamlessly integrate token-based security enhancements into existing networking environments or into newly designed and implemented networks. Our products can also be used by software developers to add token-based information security to applications such as browsers, firewalls, e-mail systems, database management systems and other client/server applications. Our data security products are designed with an open architecture, so they can operate independently of: - Algorithms -- our security products are designed to use different suites of algorithms depending upon the application requirements, such as, military, banking, finance and healthcare. - Platforms -- our security products may be used with many different computer types and operating systems, such as, Windows, and UNIX. - Applications -- our security products may be used with various software applications, such as, e-mail, e-commerce, database systems and word processors. - Tokens -- our security products function with various types of tokens, such as, software tokens, USB tokens and smart cards. As a result of this open architecture, these products are compatible with virtually all commonly used network hardware. Algorithm independence allows our products to be tailored to numerous encryption algorithms through software selection. As a result, our libraries, drivers and security devices are compatible with a variety of encryption algorithms, and popular software applications and operating systems. We develop and embed these cryptographic technologies in a multitude of devices and tokens, including smart cards, PKI cards, PCMCIA cards, embedded industry standard architecture, or ISA, and peripheral component interconnect, or PCI, 5 6 bus cards. We are also working with other companies to implement use of PCMCIA cards, PKI cards and smart cards to support biometric technologies such as fingerprint and voice recognition. These products provide the added protection of a security token utilizing public-key cryptography, key exchange techniques and electronic signatures on most popular operating systems and hardware platforms. In addition, our technologies permit functions to be scaled as performance and pricing requirements dictate. Internet Application Software NetSign and NetSign GT ("Global Trust"). These products are software adapters that integrate smart cards and digital certificate technology to enhance security in software systems designed to provide electronic commerce, e-mail, Internet access, file access and world-wide-web browsers such as Netscape Communicator and Microsoft Explorer. NetSign and NetSign GT software products are bundled with a smart card reader/writer and smart cards. NetSign GT has the added features necessary to support the Identrus bank security model and Profile Manager GT. Profile Manager and Profile Manager GT. Profile Manager is a complete, stand-alone, PKI lifecycle management solution. Profile Manager provides for token-based security systems management from initialization to secure archive and recovery. For the recovery of token-based information, Profile Manager provides an optional integration with a secured database of private keys and other user identification information and the use of third-party certificate authorities. Profile Manager integrates with NetSign, NetSign GT and other token-enabled products to provide a complete solution for an enterprise's security needs, including secure Internet access, digitally signed and encrypted e-mail, desk-top file encryption and secure remote network access. Profile Manager GT has the added features necessary to support the Identrus bank security model and NetSign GT. Maestro Cryptographic Library Maestro is a multi-protocol cryptographic library that enables software developers to incorporate secure token-based, symmetric-key and asymmetric-key cryptography into their application software. Maestro is a multi/concurrent access, cross-platform system that supports multiple types of tokens such as smart cards, PCMCIA cards and cryptographic algorithms. Coupled with token reader/writers, Maestro supports devices over commonly used interfaces, including keyboard, serial, small computer system interface, or SCSI, parallel port and universal serial bus. Maestro currently supports two commonly used cryptographic interface protocols. We are developing additional protocol adapters to expand the functionality of Maestro. Maestro is compatible with Windows 95, 98, 2000 and NT operating systems as well as all popular UNIX platforms. Security Tokens ISO smart cards. We offer a family of off-the-shelf International Standards Organization, or ISO, standard smart cards ranging from storage-only cards to cards containing cryptographic capabilities. Forte smart card. We are in the process of developing a next generation PKI card, the Forte smart card ("Forte"), in cooperation with Atmel Corporation and the National Security Agency. Forte is an ultra fast 32-bit microprocessor that is being designed with a high-speed USB interface in addition to the ISO interface. Forte is also to be designed with a larger storage capacity and processing speed than existing smart cards. We had previously anticipated that limited shipments of the Forte would begin in late 2000. However, due to upgraded specifications that include enhanced technologies and performance capabilities, shipments have been delayed. We now anticipate limited shipments beginning in the second half of 2001 with increasing shipments thereafter. Other Tokens. Because our products are open-architecture, open-platform, open-token, algorithm and API-independent, we work with third-party tokens, such as PCMCIA cards, smart cards, rings, proximity cards and plastic keys and other commercially available tokens, for use with our reader/writers and application software. Token Reader/Writers A token reader/writer is a hardware component that electronically reads the content of a smart card, PCMCIA card, or PKI card. We manufacture several different types of reader/writers. Following is a brief description of their features. Serial and Keyboard Port smart card and PKI Card Reader/Writers. We sell our reader/writers as a security product component or bundled with other products such as Profile Manager and NetSign to provide token-based data security solutions. 6 7 We manufacture and sell compact, hand-held smart card reader/writers that interface through the RS-232 serial port of a PC or workstation. The NetSignia Series 210 and 220 reader/writers are compatible with Windows 95/98/2000/NT and UNIX operating systems. We also offer a Series 410 reader/writer that connects to a computer through its PCMCIA slot. ARGUS 300. The ARGUS 300 consists of a tamper-resistant ISA or PCI board and external reader/writer and is connected to the keyboard. The ARGUS 300 incorporates DES encryption technologies and offers additional security features such as boot protection, electronic commerce security and protected PIN path directly through the board rather than through an external device that might be tampered with by an unauthorized user. The ARGUS 300 is validated for electronic signature by the National Institute of Standards and Technology, or NIST, the U.S. Treasury Department and General Accounting Office. PCMCIA Client Reader/Writer. We offer a series of single and dual-socket PCMCIA card reader/writers for both internal and external application, that interface via various ports such as SCSI, ISA bus, PCI bus, USB and parallel port. These reader/writers incorporate our proprietary device drivers, which provide the interface between the reader/writer and its application software such as Maestro and third-party application software. Argus 2108. We offer a reader/writer that contains sockets for up to eight PCMCIA cards, is used on the enterprise's server side and incorporates the device drivers and other technologies of our other PCMCIA readers. The Argus 2108 interfaces with the host server to enable the host server to provide rapid/simultaneous processing of cryptographic functions received from numerous clients. Server Accelerators CipherServer 440. We have developed a server accelerator that is specially designed to off-load the public key functions to on-board processors, free up CPU resources and provide almost instant responses back to the customer. Whether transactions need server and/or client authentication, the CipherServer 440 accelerates SSL transactions to handle multiple, simultaneous sessions for passing information securely between the client and sever. Shipments of our Cipherserver 440 are planned to begin in mid-2001. Product Reselling Pulsar focuses on sales of computer and network products primarily in the government information technology segment. Examples of these computer and network products include: - - Network Hardware Components. Servers, routers, hubs and switches configured to the customer's networking requirements. - - Client PC Systems. Desktop PC systems configured to customer's specific requirements. Pulsar offers components manufactured by leading vendors, including Cisco Systems, Inc., Bay Networks, Inc., Hewlett-Packard Company, Dell Computers, International Business Machines Corp., Lucent Technologies, Inc. and Sun MicroSystems, Inc. CUSTOMERS Our customers represent a wide range of commercial enterprises, including financial, telecommunications, healthcare, information service companies, airlines, automobile manufacturers, as well as federal, state, local and foreign government agencies. Our customer base includes: Bank of America, N.A. BIZ Interactive Zone, Inc. Booz Allen & Hamilton Inc British Telecom Federal National Mortgage Association Deloitte & Touche LLP Executive Offices of the President of the United States Federal Bureau of Investigation Lockheed Martin Corporation Los Angeles Film Office. Lucent Technologies, Inc. 7 8 Nippon Telephone and Telecommunications Data Corporation VeriSign U.S. Army Corps of Engineers National Security Agency During the year ended December 31, 2000, we derived 42% of our consolidated revenue from one customer. CUSTOMER SERVICE AND SUPPORT Our customer service and support staff consists of 13 persons, including engineers and technical support personnel, and works closely with customers and prospective customers to provide comprehensive service and support for our products and systems. SALES AND MARKETING We market our products and services through the Internet, our direct sales forces, indirect sales channels, including systems-integrators, value-added resellers and original equipment manufacturers, strategic alliances and international distributors. We intend to devote significant resources to marketing and business development activities to expand our business to additional distribution channels. Direct Marketing Effort As of February 28, 2001, we employed a direct sales and marketing force of 27 individuals, with 8 located in our California office, 11 in our Washington, D.C. office, and 8 in our Virginia office, to market our products and services to industry and vertical market segments, including e-commerce, financial, telecommunications, healthcare and information services companies and federal, state, local and foreign government agencies. Our sales force is responsible for soliciting prospective customers and providing technical advice and support with respect to our products and services. Additionally, we use telemarketing efforts to target commercial accounts and federal government agencies. We seek to achieve greater vertical market penetration by using direct sales personnel with significant market expertise, as well as consultants with established relationships in the commercial marketplace. Indirect Marketing Effort An important component of our sales strategy is the development of indirect sales channels such as systems integrators, value-added network service providers and original equipment manufacturers. Currently, we use these indirect sales channels to augment the efforts of our direct sales forces. We also use the services of third-party consultants with established relationships and contacts with prospective customers to which we would not otherwise have access. As part of our expansion strategy, we will seek to develop relationships with additional third-party sales channels. Strategic Alliances We plan to increase our vertical market penetration by continuing to develop strategic alliances with other companies in the data security and network integration industries. We have developed significant strategic alliances with companies in an effort to: - Incorporate our products into third parties' products; - Jointly develop products and services; - Conduct joint research and development efforts; - Jointly conduct proposals and presentations for products and services and reseller arrangements. These alliances assist us in expanding our marketing and technical capabilities and are intended to increase the distribution and market acceptance of our Internet, intranet and extranet security products and services. We believe that strategic alliances allow us to cost-effectively integrate third-party products into our product offerings to provide our clients with customized information technology solutions. Our strategic alliances currently include the following: 8 9 - Microsoft Corporation -- We are taking a leading role in developing end-to-end security solutions based on smart cards for Windows. - Netscape and Microsoft -- We provide enhanced e-mail security features to their browser programs through integration of our NetSign product lines. - VeriSign -- We have a marketing agreement with VeriSign and act as VeriSign's recommended PKI card partner. - Atmel Corporation and the National Security Agency -- We are currently leading a joint effort with Atmel Corporation and the National Security Agency to develop Forte, an advanced microprocessor, which we are embedding in our next generation PKI cards, the Forte PKI card. On March 1, 2001 we signed a teaming agreement with Atmel Corporation to further exploit the technologies incorporated in the Forte product. - RSA Data Security -- We have a distribution license agreement with RSA which allows us to incorporate RSA technology into our products. - Datacard -- Datacard is a service provider utilizing our PKI products. - Broadcom -- We have a supply agreement with Broadcom that provides us with early access to certain Broadcom security chips for inclusion in our products. - FingerPrint Cards AB -- We have a memorandum of understanding to jointly develop products that combine fingerprint biometrics and PKI technology. Sales to the Government Information Technology Market The government information technology market is generally characterized by highly structured procurement rules and procedures, large contracts, a relatively long sales cycle, significant barriers to entry and low collection risks. In response to these characteristics and requirements, a number of avenues, such as GSA schedule contracts, blanket purchase agreements and bidding procedures, have been developed to access this market. The GSA, which is the central procurement agency for the U.S. government, negotiates schedule contracts. Government agencies and other authorized purchasers, although not required to do so, may purchase goods and professional services under GSA schedule contracts at predetermined price ceilings, terms and conditions. GSA schedule contracts are awarded on the basis of a number of factors, the most important of which are compliance with applicable government regulations and the prices of the products to be sold. A blanket purchase agreement, or BPA, is a simplified but non-mandatory, fixed-price, indefinite delivery-indefinite quantity, contract for the government to purchase products, at pre-negotiated terms and conditions. Purchases made under BPAs are often paid for with a government-issued credit card. Federal government agencies are authorized to enter into BPAs with GSA schedule holders. The GSA-authorized BPAs incorporate many terms and conditions of GSA schedule contracts, often at lower prices than available on the GSA schedules. A significant portion of the purchases of computer products and services by the federal government is made under contracts or purchase orders awarded through formal competitive bids and negotiated procurements. Substantially all of these bids are awarded on the basis of a number of factors, including the best value to the government, which, depending on the bid can be a combination of price, technical expertise, and past performance on other government contracts. Major procurements can exceed millions of dollars in total revenue for a reseller, span many years, and provide a purchasing vehicle for many agencies. In addition, networking products are purchased by the federal government through open-market procurements. These procurements are separate and apart from GSA schedules, and include simplified acquisition procedures, requests for quotes, invitations for bids and requests for proposals. Most purchases in the state and local government market are made through individual competitive procurements. State and local procurements typically require formal responses and the posting of bid bonds or performance bonds to ensure complete and proper service by a prospective bidder. Each state maintains a separate code of procurement regulations that must be understood and complied with by entities selling products to the state. We are on most government bid lists relevant to our product offerings and respond with proposals to many bid solicitations each year. In addition, our marketing employees actively prepare bids for federal, state and local government agencies for open market procurements. 9 10 Advertising Our marketing efforts include maintaining a web site, direct mail, public relations, events, sales tools, broadcast messaging, telemarketing and corporate marketing materials. We believe that our future business activity depends in part on our marketing and sales through the Internet. Our website describes our business, products and services. Our public relation efforts are designed to target the appropriate press coverage and consist of press kits, targeted media lists and press releases. These efforts are designed to complement our sales and marketing efforts. Trade Shows and Presentations We attend and exhibit our products and services at trade shows in the U.S. and internationally each year in an effort to increase our market exposure. We intend to continue to attend trade shows as well as to make joint presentations with strategic partners to prospective customers relating to products and services. SUPPLIERS Some of the components incorporated into our Internet data security products are produced by other vendors. We also integrate third-party products and components into the networks we design and develop for our customers. To maintain quality control and enhance working relationships, we generally rely on multiple vendors for these products. RESEARCH AND DEVELOPMENT We conduct extensive research and development efforts that focus on the development of cryptographic PKI software and hardware products that can be readily integrated and adapted to the expanding requirements of the Internet, intranets and extranets. We expect to devote substantial additional research and development resources to enhance our data security product line. Our current research and development efforts include: - Expanding Maestro to offer additional application program interfaces, including an interface to the GSA Common Access Card ("CAC") protocol, porting of Maestro to a number of Unix operating system platforms, and adding to the suite of tokens supported by Maestro; - Enhancing the capabilities of Profile Manager to provide certificate exchange capabilities with additional third-party certificate authorities and increased capability for the PKI enterprise manager; - Developing Forte, an advanced 32-bit cryptographic SOC, which we are embedding in our Forte smart card. We expect the Forte smart card will be an ISO standard smart card with greater flexibility and a higher degree of processing power than existing PKI cards, due in part to the inclusion of a USB interface to the on-board Forte SOC. Given that Forte is an advanced security chip that will provide advanced security features, we expect to be able to embed it in a variety of devices, including PC mother boards; - Developing a series of USB interface reader/writers, some of which include a fingerprint biometric capability; - Developing technologies to incorporate a number of types (fingerprint, iris scan, voice recognition, handwriting recognition) of biometric technologies into our PKI products to provide further advanced identification and authentication protection; - Expanding the security features of applications programs such as NetSign and NetSign GT; and - Developing new versions of the Litronic CipherServer that provide acceleration of PKI function on web servers. The process of developing our products and services is extremely complex and requires significant continuing development efforts. As of February 28, 2001, our research and development staff consisted of 64 employees, of whom 45 were engineers. Approximately 90% of these engineers are engaged principally in the development of software, including cryptographic libraries and device drivers. 10 11 During the years ended December 31, 1998, 1999 and 2000, our net expenses for research and development were $1.3 million, $3.9 million and $5.8 million, respectively. COMPETITION We compete in numerous markets, including; - Internet and intranet electronic security; - Access control and token authentication; - Smart card-based security applications; - Electronic commerce applications; - Systems integration; - Product reselling; and - Government information technology markets. The markets for our products and services are intensely competitive and are characterized by rapidly changing technology and industry standards, evolving user needs and the frequent introduction of new products. We believe that the principal factors affecting competition in our markets include: - Product functionality; - Performance; - Flexibility and features; - Use of open standards technology; - Quality of service and support; - Company reputation; and - Price. We face significant competition from a number of different sources. Many of our competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than we have. Some of our significant data security competitors include: - International Business Machines Corp. - Motorola, Inc. - Gem Plus - Network Associates, Inc. - Secure Computing Corporation - RSA Data Security 11 12 - Rainbow Technologies, Inc. Some of our competitors for systems integration and product reselling include: - BTG, Inc. - InaCom Corporation - Government Technology Services, Inc. In addition there are several smaller or start-up companies with which we compete from time to time. We also expect that competition will increase as a result of consolidation in the information security technology and product reseller industries. INTELLECTUAL PROPERTY We depend substantially on our proprietary information and technologies. We rely on a combination of trademark, patent, copyright and trade secret laws, employee and third-party non-disclosure agreements, technical measures and other methods to protect our software products and other proprietary technologies and know-how. We also rely on standardized license agreements that are not signed by the end user to license our products and, therefore, may not always be enforceable. We currently have three patents issued by the U.S. Patent and Trademark Office, and five patent applications pending with the U.S. Patent and Trademark Office that cover aspects of data security technology. In addition, we have one patent pending foreign (PCT) patent application. Prosecution of these patent applications and any other patent applications that we may subsequently determine to file may require the expenditure of substantial resources. The issuance of a patent from the filing of a patent application is a lengthy process. We believe that, due to the rapid pace of technological innovation for network security products, our ability to establish, and if established, maintain a position of technological leadership in the industry, is dependent more upon the skills of our development personnel than upon legal protections afforded our existing or future technology. Because our products are designed with an open architecture and are algorithm-independent, they can be utilized with a variety of encryption algorithms. Some algorithms are in the public domain and can be incorporated into our products at no charge. To the extent that a customer desires to incorporate a proprietary algorithm into a security solution, the customer or we must obtain a license from the algorithm owner. Depending on the algorithm and its owner, the license fee may be a flat fee, a per unit royalty or a combination of the two. We are developing Forte under a task order issued under a contract with National Security Agency. The contract incorporates the Department of Defense's standard licenses for technical data and computer software, commonly known as the data rights clauses. Data rights clauses are only applicable to data or software actually delivered to the federal government under a contract. If the data rights clauses were applicable to our agreement with the National Security Agency to develop Forte, one of the data rights licenses, commonly called a government purpose rights license, would permit the federal government to create second sources of supply of the Forte technical data and source code for itself without paying us royalties. The government purpose license clause would not authorize the federal government to create competitors to us in the commercial market. We do not believe the data rights clauses generally, or the government purpose license specifically, apply to Forte because our contract with the National Security Agency does not provide for the delivery of Forte to the federal government. The task order provides that the National Security Agency will obtain detailed design information about Forte. We own or have rights to trademarks and trade names that we use in conjunction with the sale and licensing of our products. The following trademarks, many of which are mentioned in this annual report, are our registered trademarks: Argus, Active CryptOS, Advanced CryptOS, CipherServer, CryptOS, Forte, JcryptOS, Maestro, NetSign, Profile Manager, SecureDial, SecureSmart and SecureStart. We also own the trade names Litronic, Pulsar, Pulsar Data and Pulsar Data Systems, Inc. All other trademarks or trade names referred to in this annual report are the property of their owners. GOVERNMENT REGULATION Because we sell our products internationally, we must comply with federal laws regulating the export of, and applicable foreign government laws regulating the import of, our products. The U.S. government has recently relaxed the export restrictions for our 12 13 NetSign and Profile Manager products. However, the federal government may rescind these approvals at any time. Under current regulations these products can be exported without a license to most countries for use by banks, healthcare, insurance organizations and overseas subsidiaries of U.S. companies. Additionally, we may apply for export approval, on a specific criteria basis, for our future products. Government export regulation for security products is less stringent for products designed for banking and finance, e-commerce, health, insurance and for use by U.S. subsidiaries. We may not receive approval to export any future products on a timely basis, on the basis we request or at all. As a result of government regulation of our products, we may be at a disadvantage in competing for international sales compared to foreign companies that are not subject to these restrictions. EMPLOYEES As of February 28, 2001, we employed 134 people, of which 126 were full-time and 8 were part-time employees, including 64 in research, development and support, 5 in professional services, 27 in field operations including sales, marketing and customer management, and 38 in finance, human resources, business development, legal and administration. Our employees are not represented by labor unions. We do not expect that any of our employees will be represented by any labor unions. We consider our relations with our employees to be good. RECENT DEVELOPMENT In February 2001, we signed a Term Sheet with BIZ Interactive Zone, Inc. ("BIZ") relating to our proposed merger whereby Litronic Merger Corp., a Delaware corporation and a wholly owned subsidiary of the Company, will merge with and into BIZ. BIZ will become a wholly owned subsidiary of Litronic. On February 12, 2001, we issued a press release regarding our proposed merger with BIZ. ITEM 2. PROPERTIES We are headquartered in Irvine, California where we currently lease approximately 20,702 square feet of office space for our executive offices with a lease expiring in February 2007. Our facility has an annual rent of $428,865 and a lease term of 7 years. The facility is leased from KRDS, a related party. In addition, we will conduct a significant portion of our operations at Pulsar's offices in our 12,700 square foot Lanham, Maryland facility, which we use as office space for our executive offices and as warehouse space, under a lease that expires in August 2003 with an annual rent of $145,740. We are also subletting our former headquarters of 12,000 square feet in Irvine, California. The lease for our former headquarters expires in September 2001. In June of 2000, we opened a sales office in Virginia. That facility has a monthly rent of $9,420 with a lease expiring in May 2001. ITEM 3. LEGAL PROCEEDINGS We are involved from time to time in routine litigation that arises in the ordinary course of business. We are not currently involved in any litigation that we believe will have a material impact on our results of operations, financial condition or liquidity, including the following: On January 16, 1998, G2 Resources Inc. (G2) filed a complaint against Pulsar in the Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida. G2 claims that Pulsar breached a contract under which G2 agreed to provide services related to the monitoring of government contracts available for bid and the preparation and submission of bids on behalf of Pulsar. The contract provides that Pulsar pay G2 $500,000 in 30 monthly installments of $16,666 and an additional fee of 2% of the gross dollar amount generated by awards. In its complaint, G2 alleged that Pulsar failed to make payments under the contract and claimed damages in excess of $525,000 plus interest, costs and attorneys fees. In the course of discovery G2 asserted that its losses/costs arising out of its claim amounted to approximately $10.3 million. Pulsar has asserted that G2 failed to perform the services required under the contract and Pulsar filed a claim for compensatory damages, interest and attorneys fees against G2. Classical Financial Services, LLC intervened in the case. Classical claims that G2 assigned its accounts receivable to Classical under a financing program and that Pulsar breached its obligations to Classical by failing to make payments under the contract with G2. Pulsar has asserted defenses to Classical's claim. The Company believes that the claims of G2 and Classical against Pulsar are without merit and intends to continue to vigorously defend against the claims. If G2 or Classical were to prevail in this lawsuit, our business and financial condition could be materially adversely affected. We recently received a notice from Microsoft pertaining to alleged sales of unlicensed copies of Microsoft Office. The software in question was purchased from a major computer hardware manufacturer and was resold to one of our customers in a package that included both hardware and software. We are currently investigating the matter, and do not anticipate that the outcome will have a material impact on our results of operations, financial condition or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. 13 14 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our Common Stock is listed on The Nasdaq National Market under the symbol "LTNX." The following table sets forth, for the quarters indicated, the high and low closing sale prices per share of the Common Stock as reported on The Nasdaq National Market. The prices shown represent quotations by dealers, without retail markup, markdown or commissions and may not reflect actual transactions. On March 22, 2001, the last reported sale price for our Common Stock on The Nasdaq National Market was $4.00. As of March 22, 2001, the approximate number of holders of record of the Common Stock was 80. The Company has not paid dividends and does not anticipate declaring dividends on its Common Stock in the foreseeable future. High and low prices for the last seven quarters are as follows:
HIGH LOW ---- --- Fiscal quarter ended June 30, 1999 .................... $11.13 $ 6.56 Fiscal quarter ended September 30, 1999 ............... $11.44 $ 4.16 Fiscal quarter ended December 31, 1999 ................ $ 9.88 $ 4.00 Fiscal quarter ended March 31, 2000 ................... $26.00 $ 8.72 Fiscal quarter ended June 30, 2000 .................... $17.38 $ 6.69 Fiscal quarter ended September 30, 2000 ............... $ 9.50 $ 2.94 Fiscal quarter ended December 31, 2000 ................ $ 7.81 $ 2.34
Sales of Registered Securities and Use of Proceeds. During June 1999, the Company completed its initial public offering (the "Offering") of 3,700,000 shares of its common stock. The offering date was June 9, 1999. The Offering was closed on June 14, 1999. The lead underwriters in the offering were Bluestone Capital Partners, L.P. and Pacific Crest Securities Inc. The shares of common stock sold in the Offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (the "Registration Statement") (File No. 333-72151), which was declared effective by the SEC on June 9, 1999. A total of 3,700,000 shares of common stock were sold by the Company under the Registration Statement for an aggregate amount of $40,700,000 (based upon the offering price of $11.00 per share), before deduction of underwriting discounts, commissions and other expenses. After deducting underwriting discounts and commissions of $3.8 million and expenses of $1.6 million in connection with the Offering, the Company received net proceeds from the Offering of $35.3 million. To date, the Company has used these proceeds for direct or indirect payments to others as follow: (i) $16.7 million for reduction of debt and vendor settlements; (ii) $5.1 million for sales and marketing; (iii) $2.1 million for product development; and (iv) $11.4 million for working capital and general corporate purposes. 14 15 ITEM 6. SELECTED FINANCIAL DATA The selected data presented below under the captions "Selected Statements of Operations Data" and "Selected Balance Sheet Data" for, and as of the end of, each of the years in the five-year period ended December 31, 2000, are derived from the consolidated financial statements of Litronic Inc. and subsidiaries, which consolidated financial statements have been audited by KPMG LLP, independent certified public accountants. The consolidated financial statements as of December 31, 2000, and 1999, and for each of the years in the three-year period ended December 31, 2000, and the report thereon, are included elsewhere in this Annual Report. SELECTED STATEMENTS OF OPERATIONS DATA:
YEARS ENDED DECEMBER 31, ------------------------------------------------------------------------ 1996 1997 1998 1999(1) 2000(1) ----------- ----------- ----------- ----------- ----------- (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Revenues: Product .......................................... $ 7,855 $ 8,627 $ 5,214 $ 29,587 $ 37,421 License and service .............................. 1,541 1,539 1,041 1,270 1,935 Research and development ......................... -- -- 398 798 -- ----------- ----------- ----------- ----------- ----------- Total revenues .............................. 9,396 10,166 6,653 31,655 39,356 ----------- ----------- ----------- ----------- ----------- Costs and expenses: Cost of sales -- product ......................... 4,098 3,211 2,821 25,478 30,481 Cost of sales -- license and service ............. 581 643 950 590 679 Selling, general, and administrative ............. 2,052 3,487 2,631 7,194 9,559 Research and development ......................... 725 1,172 1,334 3,906 5,800 Impairment of goodwill and other intangibles ..... -- -- -- -- 31,415 Amortization of goodwill and other intangibles ... -- -- -- 1,448 2,828 ----------- ----------- ----------- ----------- ----------- Operating income (loss) ............................... 1,940 1,653 (1,083) (6,961) (41,406) Other (income) expense, net ........................... 19 42 418 168 (7) ----------- ----------- ----------- ----------- ----------- Earnings (loss) from continuing operations before income taxes ...................... 1,921 1,611 (1,501) (7,129) (41,399) Provision for (benefit from) income taxes ............. 29 22 (95) (43) 6 ----------- ----------- ----------- ----------- ----------- Earnings (loss) from continuing operations ............ $ 1,892 $ 1,589 $ (1,406) $ (7,086) $ (41,405) =========== =========== =========== =========== =========== Net earnings (loss) ................................... $ 906 $ 15,334 $ (1,406) $ (7,086) $ (41,405) =========== =========== =========== =========== =========== Earnings (loss) from continuing operations per share: basic and diluted ............. $ .49 $ .41 $ (.36) $ (1.00) $ (4.20) =========== =========== =========== =========== =========== Net earnings (loss) per share: basic and diluted ...... $ .23 $ 3.96 $ (.36) $ (1.00) $ (4.20) =========== =========== =========== =========== =========== Shares used in per share computations: basic and diluted ................................... 3,870,693 3,870,693 3,870,693 7,055,882 9,862,472 =========== =========== =========== =========== ===========
- ---------- (1) On June 14, 1999, we completed the acquisition of Pulsar Data Systems, Inc. ("Pulsar"). All outstanding shares of Pulsar were exchanged for 2,169,938 shares of the our common stock. The acquisition was accounted for using the purchase method of accounting, and accordingly, the results of operations of Pulsar have been included in our consolidated financial statements from June 14, 1999. SELECTED BALANCE SHEET DATA:
DECEMBER 31, -------------------------------------------------------------- 1996 1997 1998 1999 2000 ------- ------- ------- ------- ------- (IN THOUSANDS) Cash and cash equivalents ................... $ 862 $ 490 $ 898 $ 6,441 $ 4,120 Working capital ............................. 1,662 385 758 12,592 4,858 Total assets ................................ 7,409 2,347 2,791 51,104 11,768 Current installments of long-term debt ...... 545 -- 580 481 1,986 Long-term debt, less current installments ... 4,997 3,506 5,200 -- 19 Total liabilities ........................... 7,510 5,148 6,998 3,171 5,220 Total shareholders' equity (deficit) ........ (101) (2,801) (4,207) 47,933 6,548
During the year ended December 31, 1997, Litronic paid a cash dividend of $9.5 million to its stockholders. No other dividends have been paid during the periods presented. Our loan agreements restrict our ability to pay cash dividends. 15 16 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL We provide professional Internet data security services and develop and market software and microprocessor-based products needed to secure electronic commerce and communications over the Internet and other communications networks based on Internet protocols. Our primary technology offerings use PKI, which is the standard technology for securing Internet-based commerce and communications. In addition, Pulsar, a wholly owned subsidiary, is an established computer and networking product reseller that focuses on resales to government agencies, large corporate accounts and state and local governments. We acquired Pulsar in June 1999 in exchange for 2,169,938 shares of our common stock. Before 1990, we were solely a provider of electronic interconnect products to government and commercial entities. In 1990, we formed our data security division, which is the basis of our operations today. The data security division was engaged primarily in research and development until 1993 when it began to generate meaningful revenue. In September 1997, we sold our Intercon division, which consisted of the assets relating to our interconnect operations, for cash to Allied Signal Inc., a non-related, publicly traded company. RESULTS OF OPERATIONS -- COMPARISON OF YEARS ENDED DECEMBER 31, 1998, 1999 AND 2000 Because we acquired Pulsar in June 1999, for the fiscal year ended December 31, 1999, our revenue and expenses include the results of Pulsar's operations since June 14, 1999. Therefore, revenue and expenses are not comparable from period to period. TOTAL REVENUE. Total revenue increased 376% from $6.7 million during the year ended December 31, 1998 to $31.7 million during the year ended December 31, 1999 and increased 24% from $31.7 million during 1999 to $39.4 million during the year ended December 31, 2000. The increase from 1998 to 1999 consisted of $26.5 million of network solutions market revenue generated by Pulsar subsequent to the acquisition, a decrease of $1.9 million in information security products and services revenue, and an increase of $0.4 million in research and development revenue. The increase from 1999 to 2000 consisted of a $5.5 million increase in network solutions market revenue primarily attributable to a full year of sales in 2000 as compared to a partial year in 1999, a $3.0 million increase in information security products and services revenue primarily attributable to an increase in sales of existing data security products and services, and a $0.8 million decrease in research and development revenue attributable to the completion in 1999 of the contract that was responsible for generating research and development revenue. During 1998, 44%, 20% and 17% of revenue was generated from sales to Lockheed Martin Corporation, the National Security Agency and the U.S. Army Corps of Engineers, respectively. During 1999, 31% and 12% of revenue was generated from sales to the United States Immigration and Naturalization Service and the United States Department of State, respectively. During 2000, 42% of revenue was generated from sales to the United States Immigration and Naturalization Service. Sales to federal government agencies accounted for approximately 81%, 78% and 79% of sales during 1998, 1999 and 2000, respectively. PRODUCT REVENUE. Product revenue increased 467% from $5.2 million during 1998 to $29.6 million during 1999 and increased 26% from 1999 to $37.4 million during 2000. The increase from 1998 to 1999 consisted of $26.0 million of network deployment product revenue generated by Pulsar subsequent to the acquisition and a decrease of $1.6 million in data security product revenue. The increase from 1999 to 2000 consisted of a $5.6 million increase in network deployment products revenue and a $2.2 million increase in data security products revenue. LICENSE AND SERVICE REVENUE. License and service revenue increased 22% from $1.0 million during 1998 to $1.3 million during 1999 and increased 52% from $1.3 million during 1999 to $1.9 million during 2000. The increase from 1998 to 1999 was primarily attributable to service revenues of $436,000 associated with the electric security systems ("ESS") product line that was acquired as part of the Pulsar acquisition. The ESS product line did not fit into either of our primary business segments and in July 2000 we discontinued the ESS product line. We did not incur any significant expenses and we do not believe there will be any material impact on future results of operations as a result of our decision to discontinue the ESS product line. The increase from 1999 to 2000 was primarily attributable to an increase of $444,000 related to an ongoing government support contract that began in August 1999 and to the recognition of $137,000 of revenue, out of a total of $550,000 contract, that requires us to provide customer support for three years. The balance of this $550,000 contract has been recorded as deferred revenue and will be recognized over the remainder of the support period. RESEARCH AND DEVELOPMENT REVENUE. Research and development revenue represents amounts earned under a contract with the National Security Agency ("NSA") for the design of a microprocessor meeting minimum specifications established by the NSA. We have contracted with others to perform aspects of the project. All related project costs were expensed as research and development was incurred. Regardless of the results of the development efforts, the amounts received from the NSA are nonrefundable. The related research and development costs were not separately identifiable. Therefore, the corresponding costs of the entire development effort were included in research and development expenses. Research and development revenue increased 101% from $398,000 during 1998 16 17 to $798,000 during 1999. The increase from 1998 to 1999 was primarily attributable to a greater portion of total contract revenues being earned in 1999 than were earned in 1998. The contract that resulted in research and development revenue was completed in 1999 and no further research and development revenue is currently anticipated under this contract. PRODUCT GROSS MARGIN. Product gross margin decreased as a percentage of net product revenue from 46% during 1998 to 14% during 1999 and increased to 19% during 2000. The decrease from 1998 to 1999 was primarily attributable to the mix of low-margin versus high-margin products sold during 1999. During 1999 network deployment products represented 88% of product revenue as compared to data security products that represented 12% of product revenue. The increase from 1999 to 2000 was primarily attributable to the proportionately higher increase in revenue related to data security products as compared to network deployment products. During 2000 network deployment products represented 85% of product revenue as compared to data security products that represented 15% of product revenue. Margins from the sale of data security products are significantly greater than the margins from the sale of network deployment products. LICENSE AND SERVICE GROSS MARGIN. License and service gross margin increased as a percentage of license and service revenue from 9% during 1998 to 54% during 1999 and increased to 65% during 2000. The increase from 1998 to 1999 was primarily attributable to the Company's ability to reduce the underutilized labor cost that had resulted in lower gross margins in the prior year. The increase from 1999 to 2000 was primarily attributable to discontinuing the ESS product line. Gross margins associated with the ESS product line were significantly less than the gross margins associated with data security services. The ESS product line was discontinued in July 2000. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased 173% from $2.6 million during 1998 to $7.2 million during 1999 and increased 33% from 1999 to $9.6 million during 2000. The increase from 1998 to 1999 was primarily attributable to the additional selling, general and administrative expenses associated with Pulsar. The increase from 1999 to 2000 was primarily attributable to twelve months of Pulsar related selling, general and administrative expenses in 2000 as compared to approximately six months in 1999. As a percentage of revenue, selling, general and administrative expenses decreased from 40% during 1998 to 23% during 1999 and increased to 24% during 2000. The percentage decrease from 1998 to 1999 was primarily attributable to the revenues generated by Pulsar during 1999 and the percentage increase from 1999 to 2000 was primarily attributable to selling, general and administrative expenses increasing at a rate slightly higher than the rate of increase in revenues due to lower sales than planned. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased 193% from $1.3 million during 1998 to $3.9 million during 1999 and increased 48% from 1999 to $5.8 million during 2000. The increase from 1998 to 1999 was primarily attributable to significant increased staffing related to product development, including development efforts related to the Forte microprocessor, Maestro, Profile Manager, NetSign and token reader/writers. The increase from 1999 to 2000 was primarily attributable to continued significant staffing increases related to those same projects that were responsible for the staffing increases in 1999. As a percentage of revenue, research and development expenses decreased from 20% during 1998 to 12% during 1999 and increased to 15% during 2000. The percentage decrease from 1998 to 1999 was primarily attributable to the revenues generated by Pulsar. The percentage increase from 1999 to 2000 was primarily attributable to the continued expansion of our research and development efforts increasing at a rate of 48% while revenues increased at a rate of 24%. IMPAIRMENT OF GOODWILL AND OTHER INTANGIBLES. In June 1999, we acquired Pulsar. All of the outstanding shares of Pulsar were exchanged for 2,169,938 shares of our common stock. The acquisition was accounted for using the purchase method of accounting. In the fourth quarter we determined the integration of Pulsar would not be completed as planned and the anticipated operating synergies would not be realized, therefore, we are currently exploring various alternatives for the Pulsar operations. As a result, in accordance with Statement of Financial Accounting Standards No. ("Statement") 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", the Company has analyzed the recoverability of the goodwill and other intangibles relating to the acquisition of Pulsar. In order to evaluate the recoverability of the remaining goodwill and other intangible assets, the Company engaged the services of an independent valuation firm to perform a valuation. Based on the results of the independent valuation, the Company recorded an impairment charge of $31.4 million related to unamortized intangible assets acquired in the purchase of Pulsar. Based on the independent valuation, management believes that after the impairment charge of $31.4 million, no further impairment exists at December 31, 2000. The remaining unamortized intangible assets of $783,000 acquired in the purchase of Pulsar will be amortized over the remainder of their 10-year life. AMORTIZATION OF GOODWILL AND OTHER INTANGIBLES. The amortization of goodwill and other intangibles recorded during 1999 was attributable to the acquisition of Pulsar. The amortization recorded during the year ended December 31, 1999 of $1.4 million relates to the period June 14, 1999 through December 31, 1999. The amortization of goodwill and other intangibles increased 100% from 17 18 $1.4 million during 1999 to $2.8 million during 2000. The increase is primarily attributable to a full year of amortization expense related to unamortized intangible assets in 2000 compared to six months during 1999 when the Company acquired Pulsar. OTHER (INCOME) EXPENSE, NET. Other (income) expense, net, decreased 60% from $418,000 during 1998 to $168,000 during 1999 and decreased 104% from 1999 to ($7,000) during 2000. The decrease from 1998 to 1999 was primarily attributable to the reduction in interest expense that resulted when proceeds from our initial public offering were used to extinguish outstanding debt obligations. The decrease from 1999 to 2000 was primarily attributable to an increase in interest income of $75,000 and a reduction in interest expense of $27,000. INCOME TAXES. For 1998 the income tax benefit of $95,000 was primarily attributable to losses from continuing operations before income taxes of $1.5 million. For 1999 the income tax benefit of $43,000 was primarily attributable to prior year tax refunds received that exceeded amounts recorded as receivable in prior years. For 2000 the income tax expense of $6,000 was primarily attributable to minimum California franchise taxes. BACKLOG. At December 31, 1998, 1999 and 2000 total backlog was $717,000, $366,000 and $1.3 million, respectively. Orders are subject to cancellation in certain circumstances, and backlog may therefore not be indicative of future operating results. The increase in the backlog at December 31, 2000, was attributable to an increase of $409,000 related to data security products and $525,000 related to network deployment products. The backlog of data security products at December 31, 2000, consisted primarily of unfilled orders for the Argus 300. Materials required to assemble the Argus 300 were not received until January 2001. Once the necessary materials were received, the Argus 300 readers were assembled and shipped during the first quarter of 2001. The backlog of network deployment products at December 31, 2000, was the result of orders that were received too close to the end of the year to be shipped before the end of the year. LIQUIDITY AND CAPITAL RESOURCES In June 1999, we completed our initial public offering of common stock. The net proceeds of the offering were $35.3 million. In June 1999 we also entered into a three-year lending agreement with Guaranty Business Credit Corporation ("GBCC") permitting borrowings under a $20.0 million secured revolving line of credit facility that commenced on June 14, 1999. The agreement provided for an annual interest rate of prime plus .625%; and a pledge of substantially all of our personal and real property as collateral. Although the credit facility was for borrowings up to $20.0 million, under the terms of the agreement the amount of borrowing available to the Company was subject to a maximum borrowing limitation based on eligible collateral. Eligible collateral consisted of 85% of eligible accounts receivable plus the lesser of (a) 50% of the value of eligible on-hand inventory or (b) $1.0 million. As a result, the amount that was actually available to the Company at any particular time may have been significantly less than the full $20.0 million credit facility due to the maximum borrowing limitation calculation. The agreement with our lender included a number of covenants and restrictions that we were required to adhere to. These covenants and restrictions included maintenance of minimum levels of working capital, tangible net worth, and profitability. In addition, the agreement did not allow us to pay dividends. Our borrowings related to this agreement are included in current installments of long-term debt in the consolidated financial statements. At December 31, 2000, the maximum borrowing limitation based on our eligible collateral was $2.1 million. However, at December 31, 2000 we were not in compliance with the covenant related to net quarterly profits for the fourth quarter of 2000. During the first quarter of 2001 we requested and received a waiver for this violation. We amended the GBCC revolving line of credit facility effective March 31, 2001. Under the terms of the amended agreement, the maximum borrowings are $5.0 million. The amended agreement provides for an annual interest rate of prime plus .625%, and a pledge of substantially all of our personal and real property as collateral. Although the credit facility is for borrowings up to $5.0 million, under the terms of the agreement the amount of borrowing available to the Company is subject to a maximum borrowing limitation based on eligible collateral. Eligible collateral consists of 35% of eligible accounts receivable. As a result, the amount actually available to us at any particular time may be less than the full $5.0 million credit facility due to the maximum borrowing limitation calculation. The amended agreement with our lender includes a number of covenants and restrictions that we are required to adhere to. These covenants and restrictions include maintenance of minimum levels of working capital, tangible net worth, and profitability. In addition, the amended agreement does not allow us to pay dividends. We were in compliance with these covenants as of March 31, 2001. During the twelve months ended December 31, 2000, cash used in operations was $3.6 million primarily attributable to a net loss of $41.4 million, which included an impairment charge of $31.4 million related to unamortized goodwill and other intangible assets. The net loss was primarily offset by the $31.4 million noncash impairment charge of goodwill and other intangibles, $3.5 million of noncash depreciation and amortization and a reduction in accounts receivable of $2.7 million. During the twelve months ended December 31, 1999 cash used in operations was $11.5 million primarily due to a net loss of $7.1 million, an increase of $1.8 million in accounts receivable, a decrease of $4.0 million in accounts payable and a decrease of $0.6 million in accrued liabilities. These uses of cash were partially offset by $1.8 million of noncash depreciation and amortization. The amount of cash used in operating activities was $7.9 million less in 2000 as compared to 1999. The reduction in cash used in operating activities was primarily attributable to an increase in the net loss of $34.3 million that included a non-cash impairment charge of $31.4 million, an increase in depreciation and amortization of $1.7 million, a net decrease in net accounts receivable of $4.5 million, a net increase in accounts payable of $4.1 million, and a net increase in deferred revenue of $0.5 million. 18 19 During the twelve months ended December 31, 2000, cash used in investing activities was $251,000 versus $894,000 in 1999. The reduction was the result of $612,000 of cash related to our revolving line of credit that was restricted in 1999 and was subsequently unrestricted in 2000, and an increase in capital expenditures of $581,000 in 2000 as compared to 1999. During the twelve months ended December 31, 2000, cash provided by financing activities was $1.5 million versus $17.9 million in 1999. The cash provided by financing activities in 2000 was primarily the result of borrowings of $24.4 million under bank and other borrowing agreements. These borrowings were offset by repayments of $22.9 million under bank and other borrowing agreements. The cash provided by financing activities in 1999 was primarily the result of net proceeds from the initial public offering of $35.3 million, and borrowings of $27.0 million under bank and other borrowing agreements. These were partially offset by repayments of $44.4 million under bank and other borrowing agreements. We believe that existing cash and cash equivalents and the current availability under our amended $5.0 million revolving line of credit will be sufficient to satisfy our contemplated cash requirements for the next twelve months. Our amended $5.0 million revolving line of credit facility contains various covenants and restrictions including those noted above. As of December 31, 2000, the Company was not in compliance with certain covenants, and has obtained a waiver of these covenants. If we do not maintain our amended $5.0 million revolving line of credit, or receive waivers for future covenant violations, we may seek additional capital from one or more of the following sources: - Company merger -- In February 2001, we signed a Term Sheet with BIZ Interactive Zone, Inc. ("BIZ") relating to our proposed merger. We will be the surviving entity after the proposed merger is complete and will be renamed SSP Solutions, Inc. We anticipate that the combined entity will be in a more favorable position to access capital markets. If the merger is not completed in a timely manner or not at all, we may seek additional capital on terms less favorable than if the merger were completed in a timely manner. - Additional equity capital -- We may seek additional equity capital. Equity capital, if available, may be issued at a discount to market resulting in dilution to current stockholders. In addition, providers of new equity capital may require additional concessions in order for them to provide needed capital to the Company. We plan to begin shipping our new CypherServers in mid-2001. Our operating forecast assumes the CypherServer product launch goes as planned and anticipated sales of the CypherServers are realized. If the product launch is delayed or if the anticipated CypherServer sales are not realized, it will be necessary for us to reduce expenses. Expense reductions would include, but not be limited to, staffing reductions and reductions in other operating expenses as necessary. Our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors including, but not limited, to: - the market acceptance of our products and services - the levels of promotion and advertising that will be required to launch new products and services and attain a competitive position in the market place - research and development plans - levels of inventory and accounts receivable - technological advances - competitors' responses to our products and services - relationships with partners, suppliers and customers - our projected capital expenditures - the proposed merger with BIZ and successful integration 19 20 In addition, we may require additional capital to accommodate planned growth, hiring, infrastructure and facility needs or to consummate acquisitions of other businesses, products or technologies. New Accounting Standards In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. ("SFAS") 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS 133 requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. In June 1999, the FASB issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133", which defers the effective date of SFAS 133 to all fiscal quarters for fiscal years beginning after June 15, 2000. In June 2000, the FASB issued SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133 ("SFAS 138"). Although we continue to review the effect of the implementation of SFAS 133 and SFAS 138, we do not currently believe their adoption will have a material impact on our consolidated financial position or overall trends in results of operations, and do not believe adoption will result in significant changes to our financial risk management practices. BUSINESS ENVIRONMENT AND RISK FACTORS THE ANTICIPATED BENEFITS OF OUR PROPOSED MERGER WITH BIZ MAY NOT BE REALIZED In February 2001, we signed a term sheet with BIZ relating to our proposed merger. Even though we expect that our merger with BIZ will result in mutual benefits, those benefits may not be realized due to a number of factors: - If the merger is not completed in a timely manner or not at all, we may seek additional capital on terms less favorable than if the merger were completed in a timely manner. - The anticipated management and operational synergies of the proposed merger may not be realized. - The anticipated increase in sales resulting from the combined efforts and combined distribution channels may not be realized. - Potential adverse short-term effects on operating results, primarily as a result of increased costs resulting from the integration of the operation of the two companies may adversely affect our earnings. - Difficulties in creating and maintaining uniform standards, controls, procedures and policies may adversely affect the operations of the two companies. If we are unable to successfully integrate the operations of BIZ after the merger, our business, financial condition and operating results may be adversely affected. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY Our quarterly operating results may fluctuate significantly as a result of a variety of factors, many of which are outside our control. These factors include: - the length of our customer commitments - patterns of information technology spending by customers - the timing, size, mix and customer acceptance of our product and service product offerings and those of our competitors - the timing and magnitude of required capital expenditures - the need to use outside contractors to complete some assignments 20 21 AN INCREASE IN OUR FUTURE CAPITAL REQUIREMENTS COULD ADVERSELY AFFECT OUR ABILITY TO FUND OUR OPERATIONS. Future capital requirements may vary materially from those now planned. If our future capital requirements increase significantly, we may not be able to raise sufficient capital to fund our operations. The amount of capital that we will need in the future will depend on many factors including, but not limited to: - the market acceptance of our products and services - the levels of promotion and advertising that will be required to launch new products and services and attain a competitive position in the market place - research and development plans - levels of inventory and accounts receivable - technological advances - competitors' responses to our products and services - relationships with partners, suppliers and customers - our projected capital expenditures - the proposed merger with BIZ If we do need to raise additional capital it may be on terms that are unfavorable to us and may result in dilution to current shareholders. If we unable to raise additional capital to fund our operations, it may be necessary for us to restructure our business operations or implement other cost-cutting measures. Such a plan to cut costs may improve our cash flow but it may also inhibit our growth as we may not have the personnel and resources to implement our business strategies and expand our operations. WE HAVE A HISTORY OF LOSSES AND MAY INCUR FUTURE LOSSES. We may not become profitable or significantly increase our revenue. We incurred net losses of $7.1 million and $41.4 million for the years ended December 31, 1999 and 2000, respectively. A DEFAULT UNDER OUR SECURED CREDIT ARRANGEMENTS COULD RESULT IN A FORECLOSURE OF OUR ASSETS BY OUR CREDITORS. All of our assets are pledged as collateral to secure portions of our debt. This means that if we default on our secured debt obligations, our indebtedness could become immediately due and payable and the lenders could foreclose on our assets. From time to time, we have been in violation of financial covenants under our existing credit arrangements and have had to negotiate with our lenders for waivers or forbearance agreements for these violations. Although we have received waivers in the past, we may not be able to obtain waivers of continuing, or future covenant violations. THE TERMS OF OUR LOAN AGREEMENTS COULD LIMIT OUR ABILITY TO IMPLEMENT OUR BUSINESS STRATEGY. The terms of our loan agreements with our credit providers could limit our ability to implement our strategy. In addition to substantially prohibiting us from incurring additional indebtedness, our loan agreements with these creditors limit, or prohibit, us from the following unless we first obtain their consent: - declaring or paying cash dividends - making capital distributions or other payments to stockholders - merging or consolidating with another corporation - selling all or substantially all of our assets 21 22 WE DERIVE A SUBSTANTIAL PORTION OF OUR REVENUE FROM A SMALL NUMBER OF CUSTOMERS AND, THEREFORE, THE LOSS OF EVEN ONE OF THESE CUSTOMERS COULD SIGNIFICANTLY AND NEGATIVELY IMPACT OUR OPERATING RESULTS. We depend on a limited number of customers for a substantial portion of our revenue and many of our contracts with our significant customers are short-term contracts. The nonrenewal of any significant contract upon expiration, or a substantial reduction in sales to any of our significant customers, would adversely affect our business unless we were able to replace the revenue we received from these customers. During the year ended December 31, 2000, we derived 42% of our consolidated revenue from one customer. DOING BUSINESS WITH THE U.S. GOVERNMENT ENTAILS MANY RISKS, WHICH COULD ADVERSELY AFFECT US. Sales to U.S. government agencies accounted for 81% of our consolidated revenue for the year ended December 31, 2000. Our sales to these agencies are subject to risks, including: - early termination of our contracts; - disallowance of costs upon audit; and - the necessity to participate in competitive bidding and proposal processes, which is costly, time consuming and may result in unprofitable contracts. In addition, the government may be in a position to obtain greater rights with respect to our intellectual property than we would grant to other entities. Government agencies also have the power, based on financial difficulties or investigations of its contractors, to deem contractors unsuitable for new contract awards. Because we engage in the government contracting business, we have been and will be subject to audits and may be subject to investigation by governmental entities. Failure to comply with the terms of any of our governmental contracts could result in substantial civil and criminal fines and penalties, as well as our suspension from future government contracts for a significant period of time, any of which could adversely affect our business. IF USE OF THE INTERNET AND OTHER COMMUNICATIONS NETWORKS BASED ON INTERNET PROTOCOLS DOES NOT CONTINUE TO GROW, DEMAND FOR OUR PRODUCTS MAY NOT INCREASE. Increased demand for our products depends in large part on the continued growth of the Internet and Internet protocol-based networks and the widespread acceptance and use of these mediums for electronic commerce and communications. Because electronic commerce and communications over these networks are evolving, we cannot predict the size of the market and its sustainable growth rate. A number of factors may affect market size and growth rate, including: - the use of electronic commerce and communications may not increase, or may increase more slowly than we expect; - the Internet infrastructure and communications services to support electronic commerce may not be able to continue to support the demands placed on it by continued growth; and - the growth and reliability of electronic commerce and communications could be harmed by delays in development or adoption of new standards and protocols to handle increased levels of activity or by increased governmental regulation. IF PKI TECHNOLOGY IS COMPROMISED, OUR BUSINESS WOULD BE ADVERSELY AFFECTED. Many of our products are based on PKI technology. The security afforded by this technology depends on the integrity of a user's private key, which depends in part on the application of algorithms, or advanced mathematical factoring equations. The occurrence of any of the following could result in a decline in demand for our data security products: - any significant advance in techniques for attacking PKI systems, including the development of an easy factoring method or faster, more powerful computers - publicity of the successful decoding of cryptographic messages or the misappropriation of private keys - government regulation limiting the use, scope or strength of PKI 22 23 OUR INABILITY TO FIND ALTERNATIVE SUPPLIERS OF COMPONENTS MAY ADVERSELY AFFECT OUR BUSINESS. Some of the components incorporated into our products are produced by other vendors. We currently purchase some of these components from a single supplier, thus presenting a risk that they may not be available on commercially reasonable terms in the future or at all. Our inability to develop alternative sources, if necessary, may require us to redesign certain products which could result in delays or reductions in product shipments that could adversely affect our business. IF WE DO NOT RESPOND TO RAPID TECHNOLOGICAL CHANGES, OUR PRODUCTS AND SERVICE OFFERINGS COULD BECOME OBSOLETE. If we are unable to modify existing products and develop new products that are responsive to changing technology and standards and meet customer needs in a timely and cost effective manner, our business could be adversely affected. The markets we serve are characterized by rapidly changing technology, emerging industry standards and frequent introduction of new products. The introduction of products embodying new technologies and the emergence of new industry standards may render our products obsolete or less marketable. The process of developing our products and services is extremely complex and requires significant continuing development efforts. IF WE FAIL TO ESTABLISH AND MAINTAIN STRATEGIC RELATIONSHIPS, OUR ABILITY TO DEVELOP AND MARKET OUR PRODUCTS WOULD BE ADVERSELY AFFECTED. The loss of any of our existing strategic relationships, or the inability to create new strategic relationships in the future, could adversely affect our ability to develop and market our products. We depend upon our partners to develop and market products and to fund and perform their obligations as contemplated by our agreements with them. We do not control the time and resources devoted by our partners to these activities. These relationships may not continue or may require us to spend significant financial, personnel and administrative resources from time to time. We may not have the resources available to satisfy our commitments, which may adversely affect our strategic relationships. Further, our products and services may compete with the products and services of our strategic partners. This competition may adversely affect our relationships with our strategic partners, which could adversely affect our business. WE DEPEND ON KEY MANAGEMENT PERSONNEL. Our success will depend largely on the continuing efforts of our executive officers and senior management. Our business may be adversely affected if the services of any of our key personnel become unavailable to us. There is a risk that these individuals will not continue to serve for any particular period of time. While we have obtained a key person life insurance policy on the life of our current chief executive officer in the amount of $3.0 million, this amount may not be sufficient to offset the loss of his service. THERE IS SIGNIFICANT COMPETITION IN OUR INDUSTRY FOR HIGHLY SKILLED EMPLOYEES AND OUR FAILURE TO ATTRACT AND RETAIN TECHNICAL PERSONNEL WOULD ADVERSELY AFFECT OUR BUSINESS. We may not be able to successfully attract or retain highly skilled employees. Our inability to hire or retain highly qualified individuals may impede our ability to develop, install, implement and service our software and hardware systems, customers and potential customers or efficiently conduct our operations, all of which may adversely affect our business. The data security and networking solution industries are characterized by a high level of employee mobility, and the market for highly qualified individuals in the computer-related fields is intense. This competition means there are fewer highly qualified employees available to hire and the costs of hiring and retaining these individuals are high. Even if we are able to hire these individuals, we may be unable to retain them. Furthermore, there is increasing pressure to provide technical employees with stock options and other equity interests, which may dilute earnings per share. 23 24 POTENTIAL PRODUCT DEFECTS COULD SUBJECT US TO CLAIMS FROM CUSTOMERS. Products as complex as those we offer may contain undetected errors or result in failures when first introduced or when new versions are released. Despite our product testing efforts and testing by current and potential customers, it is possible that errors will be found in new products or enhancements after commencement of commercial shipments. The occurrence of product defects or errors could result in adverse publicity, delay in product introduction, diversion of resources to remedy defects, loss of or a delay in market acceptance or claims by customers against us, or could cause us to incur additional costs, any of which could adversely affect our business. WE MAY BE EXPOSED TO POTENTIAL LIABILITY FOR ACTUAL OR PERCEIVED FAILURE TO PROVIDE REQUIRED PRODUCTS OR SERVICES. Because our customers rely on our products for critical security applications, we may be exposed to potential liability claims for damage caused to an enterprise as a result of an actual or perceived failure of our products. An actual or perceived breach of enterprise network or data security systems of one of our customers, regardless of whether the breach is attributable to our products or solutions, could adversely affect our business reputation. Furthermore, our failure or inability to meet a customer's expectations in the performance of our services, or to do so in the time frame required by the customer, regardless of our responsibility for the failure, could: - result in a claim for substantial damages against us by the customer - discourage customers from engaging us for these services - damage our business reputation In addition, as a professional services provider, a portion of our business involves employing people and placing them in the workplace of other businesses. Therefore, we are also exposed to liability for actions taken by our employees while on assignment. WE FACE INTENSE COMPETITION FROM A NUMBER OF SOURCES. The markets for our products and services are intensely competitive and, as a result, we face significant competition from a number of different sources. We may be unable to compete successfully as many of our competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than we have. In addition, there are several smaller and start-up companies with which we compete from time to time. We also expect that competition will increase as a result of consolidation in the information security technology and product reseller industries. THIRD PARTIES COULD OBTAIN ACCESS TO OUR PROPRIETARY INFORMATION OR INDEPENDENTLY DEVELOP SIMILAR TECHNOLOGIES BECAUSE OF THE LIMITED PROTECTION FOR OUR INTELLECTUAL PROPERTY. Our business, financial condition and operating results could be adversely affected if we are unable to protect our intellectual property rights. Notwithstanding the precautions we take, third parties may copy or obtain and use our proprietary technologies, ideas, know-how and other proprietary information without authorization or independently develop technologies similar or superior to our technologies. In addition, the confidentiality and non-competition agreements between us and our employees, distributors, and clients may not provide meaningful protection of our proprietary technologies or other intellectual property in the event of unauthorized use or disclosure. Policing unauthorized use of our technologies and other intellectual property is difficult, particularly because the global nature of the Internet makes it difficult to control the ultimate destination or security of software or other data transmitted. Furthermore, the laws of other jurisdictions may afford little or no effective protection of our intellectual property rights. WE MAY FACE CLAIMS OF INFRINGEMENT OF PROPRIETARY RIGHTS. There is a risk that our products infringe the proprietary rights of third parties. In addition, whether or not our products infringe on proprietary rights of third parties, infringement or invalidity claims may be asserted or prosecuted against us and we could incur significant expense in defending them. If any claims or actions are asserted against us, we may be required to modify our products or seek licenses for these intellectual property rights. We may not be able to modify our products or obtain licenses on commercially reasonable terms, in a timely manner or at all. Our failure to do so could adversely affect our business. 24 25 OUR EFFORTS TO EXPAND INTERNATIONAL OPERATIONS ARE SUBJECT TO A NUMBER OF RISKS. We are currently seeking to increase our international sales. Our inability to maintain or to obtain federal or foreign regulatory approvals relating to the import or export of our products on a timely basis could adversely affect our ability to expand our international business. Additionally, our international operations could be subject to a number of risks, any of which could adversely affect our future international sales, including: - increased collection risks - trade restrictions - export duties and tariffs - uncertain political, regulatory and economic developments ~ inability to protect our intellectual property rights OUR ABILITY TO PRODUCE THE FORTE PKI CARD ON A TIMELY AND COST-EFFECTIVE BASIS DEPENDS ON THE AVAILABILITY OF A COMPUTER CHIP FROM A THIRD-PARTY SUPPLIER, WITH WHOM WE DO NOT EXPECT TO MAINTAIN A SUPPLY AGREEMENT. Any inability to receive adequate supplies of Atmel Corporation's specially designed Forte microprocessor would adversely affect our ability to complete and sell the Forte PKI card. We do not anticipate maintaining a supply agreement with Atmel Corporation for the Forte microprocessor. If Atmel were unable to deliver the Forte microprocessor for a lengthy period of time or terminated its relationship with us, we would be unable to produce the Forte PKI card until we could design a replacement computer chip for the Forte microprocessor. We anticipate this would take substantial time and resources to complete. A SMALL NUMBER OF STOCKHOLDERS, INCLUDING OUR OFFICERS AND DIRECTORS, WILL HAVE THE ABILITY TO CONTROL STOCKHOLDER VOTES. Kris Shah and members of his family presently beneficially own, in the aggregate, approximately 55% of our outstanding common stock. These stockholders, if acting together, would have the ability to elect our directors and to determine the outcome of corporate actions requiring stockholder approval, irrespective of how other stockholders may vote. This concentration of ownership may also have the effect of delaying or preventing a change in control. THERE IS A LAWSUIT PENDING AGAINST PULSAR, THAT COULD ADVERSELY AFFECT OUR BUSINESS IF IT IS RESOLVED AGAINST PULSAR. A Lawsuit is pending against Pulsar that, if resolved against Pulsar, could materially and adversely affect our business and financial condition. See "Item 3 -- Legal Proceedings." OUR STOCK PRICE IS EXTREMELY VOLATILE. The trading price of our common stock is highly volatile as a result of factors specific to us or applicable to our market and industry in general. These factors include: - variations in our annual or quarterly financial results or those of our competitors - company issued earnings announcements that vary from consensus analyst estimates - changes by financial research analysts in their recommendations or estimates of our earnings - conditions in the economy in general or in the information technology service sector in particular - announcements of technological innovations or new products or services by us or our competitors - unfavorable publicity or changes in applicable laws and regulations, or their judicial or administrative interpretations, affecting us or the information technology service sectors In addition, the stock market has recently been subject to extreme price and volume fluctuations. This volatility has significantly affected the market prices of securities issued by many companies for reasons unrelated to the operating performance of these 25 26 companies. In the past, following periods of volatility in the market price of a company's securities, some companies have been sued by their stockholders. If we were sued, it could result in substantial costs and a diversion of management's attention and resources, which could adversely affect our business. WE HAVE ANTI-TAKEOVER DEFENSES THAT COULD DELAY OR PREVENT AN ACQUISITION AND COULD ADVERSELY AFFECT THE PRICE OF OUR COMMON STOCK. Our certificate of incorporation and bylaws contain provisions that may deter a takeover or a change in control or prevent an acquisition not approved by our board of directors, or that may adversely affect the price of our common stock. THE NUMBER OF SHARES ELIGIBLE FOR FUTURE SALE AND THE EXISTENCE OF REGISTRATION RIGHTS COULD DEPRESS THE MARKET FOR OUR COMMON STOCK. The possibility that a substantial number of additional shares of common stock may become tradable in the public market in the future may adversely affect prevailing market prices for our common stock and could impair our ability to raise capital through the sale of equity securities. The shares that are restricted from trading, pursuant to agreement with the underwriter in our initial public offering, became available for sale in June 2000 and over succeeding months. We cannot predict the effect, if any, that sales of these additional securities or the availability of these additional securities for sale will have on the market prices prevailing from time to time. In addition, the representatives of the underwriters in our initial public offering were also granted registration rights, which commenced in June 2000 and provided for the registration under the Securities Act of the securities issuable upon exercise of the representatives' warrants. The exercise of these rights could result in substantial expense to us. Furthermore, if the representatives exercise their registration rights, they will be unable to make a market in our securities for up to nine days before the initial sales of the warrants until the discontinuation of sales. If the representatives cease making a market, the market and market prices for the securities may be adversely affected and the holders of these securities may be unable to sell them. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We entered into an agreement with Guaranty Business Credit Corporation permitting us to borrow under a $20.0 million secured revolving line of credit facility in June 1999. Under the agreement, we are subject to an annual interest rate of the prime rate plus 0.625%. An increase in the prime rate can adversely affect our ability to draw against this line of credit. Future operating results could also be adversely affected by increases in interest rates that occur while significant borrowings are outstanding. We had outstanding borrowings of $1.5 million related to this line of credit at December 31, 2000. A 10% change in the underlying prime rate would result in an approximately $15,000 change in the annual amount of interest paid on such debt. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements included in this Report at pages F-1 through F-18. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is incorporated herein by this reference to the section entitled "Election of Directors" in our definitive Proxy Statement for our 2001 Annual Meeting of Stockholders involving, among other things, the election of directors. We will file such Proxy Statement with the SEC not later than 120 days after the close of our fiscal year ended December 31, 2000. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is incorporated herein by this reference to the section entitled "Executive Compensation" in our definitive Proxy Statement for our 2001 Annual Meeting of Stockholders involving, among other things, the election of directors. We will file such Proxy Statement with the SEC not later than 120 days after the close of our fiscal year ended December 31, 2000. 26 27 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is incorporated herein by this reference to the section entitled "Security Ownership of Certain Beneficial Owners and Management" in our definitive Proxy Statement for our 2001 Annual Meeting of Stockholders involving, among other things, the election of directors. We will file such Proxy Statement with the SEC not later than 120 days after the close of our fiscal year ended December 31, 2000. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated herein by this reference to the section entitled "Executive Compensation --Certain Transactions" in our definitive Proxy Statement for our 2001 Annual Meeting of Stockholders involving, among other things, the election of directors. We will file such Proxy Statement with the Securities and Exchange Commission not later than 120 days after the close of our fiscal year ended December 31, 2000. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial statements The financial statements listed in the accompanying index to consolidated financial statements and financial statement schedules are filed or incorporated by reference as part of this annual report. (2) Financial statement schedules The financial statement schedule listed in the accompanying index to consolidated financial statements and financial statement schedules, is filed as part of this annual report. (3) Exhibits The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this annual report. (b) Reports on Form 8-K None. 27 28 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: April 17, 2001 LITRONIC INC. By: /s/ KRIS SHAH ------------------------------------- Kris Shah Chief Executive Officer Pursuant to the requirements of the Securities Act of 1934, this report is made by the following persons on behalf of the Registrant and in the capacities indicted.
NAME TITLE DATE ---- ----- ---- /s/ KRIS SHAH Chairman of the Board and Chief Executive Officer April 17, 2001 - ----------------------------------- (Principal Executive Officer) Kris Shah /s/ ROY LUNA Chief Financial Officer April 17, 2001 - ----------------------------------- (Principal Financial Officer and Roy Luna Principal Accounting Officer) /s/ GREGG AMBER Director April 17, 2001 - ----------------------------------- Gregg Amber /s/ MATTHEW MEDEIROS Director April 17, 2001 - ----------------------------------- Matthew Medeiros
28 29 LITRONIC INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
PAGE ---- Independent Auditors' Report........................................................................................ F-2 Consolidated Balance Sheets as of December 31, 1999 and 2000........................................................ F-3 Consolidated Statements of Operations for the years ended December 31, 1998, 1999 and 2000.......................... F-4 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1999 and 2000................ F-5 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1999 and 2000.......................... F-6 Notes to Consolidated Financial Statements.......................................................................... F-7 Schedule II -- Valuation and qualifying accounts.................................................................... S-1
F-1 30 INDEPENDENT AUDITORS' REPORT The Board of Directors Litronic Inc.: We have audited the accompanying consolidated financial statements of Litronic Inc. and subsidiaries as of December 31, 1999 and 2000 and for each of the years in the three-year period ended December 31, 2000 as listed in the accompanying index. In connection with our audit of the financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above, present fairly, in all material respects, the financial position of Litronic Inc. and subsidiaries as of December 31, 1999 and 2000 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Orange County, California March 26, 2001, except as to the seventh paragraph of Note 1 and the second paragraph of Note 5, which are dated as of April 17, 2001 F-2 31 LITRONIC INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER 31, ----------------------- 1999 2000 -------- -------- ASSETS Current assets: Cash and cash equivalents ............................................................. $ 6,441 $ 4,120 Restricted cash ....................................................................... 612 -- Accounts receivable (net of allowance for doubtful accounts of $390 and $268 as of December 31, 1999 and 2000, respectively) ........................................... 7,141 4,137 Inventories ........................................................................... 796 695 Prepaid expenses ...................................................................... 360 542 Other current assets .................................................................. 343 325 Note receivable -- related party ...................................................... 70 -- -------- -------- Total current assets ...................................................... 15,763 9,819 Property and equipment, net ........................................................... 646 823 Other assets .......................................................................... -- 343 Goodwill and other intangibles, net ................................................... 34,695 783 -------- -------- $ 51,104 $ 11,768 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current installments of long-term debt ................................................ $ 481 1,986 Accounts payable ...................................................................... 1,250 1,392 Accrued liabilities ................................................................... 1,411 1,366 Deferred revenue ...................................................................... 29 217 -------- -------- Total current liabilities ........................................................ 3,171 4,961 Long-term debt, less current installments ............................................. -- 19 Deferred revenue ...................................................................... -- 240 -------- -------- Total liabilities ............................................................. 3,171 5,220 Shareholders' equity: Preferred stock, $0.01 par value; Authorized 5,000,000 shares; no shares issued or outstanding ........................................................................ -- -- Common stock, $0.01 par value; Authorized 25,000,000 shares; issued and outstanding 9,856,944 and 9,743,573 shares at December 31, 1999 and 2000, respectively .......... 99 97 Additional paid-in capital ............................................................ 52,812 52,834 Accumulated deficit ................................................................... (4,978) (46,383) -------- -------- Total shareholders' equity ..................................................... 47,933 6,548 -------- -------- Commitments and contingencies (notes 10 and 15) Subsequent event (note 17) $ 51,104 $ 11,768 ======== ========
See accompanying notes to consolidated financial statements. F-3 32 LITRONIC INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA)
YEARS ENDED DECEMBER 31, ----------------------------------------------- 1998 1999 2000 ----------- ----------- ----------- Revenues: Product .................................................. $ 5,214 $ 29,587 $ 37,421 License and service ...................................... 1,041 1,270 1,935 Research and development ................................. 398 798 -- ----------- ----------- ----------- Total revenues ...................................... 6,653 31,655 39,356 ----------- ----------- ----------- Costs and expenses: Cost of sales -- product ................................. 2,821 25,478 30,481 Cost of sales -- license and service ..................... 950 590 679 Selling, general and administrative ...................... 2,631 7,194 9,559 Research and development ................................. 1,334 3,906 5,800 Impairment of goodwill and other intangibles ............. -- -- 31,415 Amortization of goodwill and other intangibles ........... -- 1,448 2,828 ----------- ----------- ----------- Operating loss ............................................. (1,083) (6,961) (41,406) Other (income) expense, net ................................ 418 168 (7) ----------- ----------- ----------- Loss before income taxes ................................... (1,501) (7,129) (41,399) Provision for (benefit from) income taxes .................. (95) (43) 6 ----------- ----------- ----------- Net loss ................................................... $ (1,406) $ (7,086) $ (41,405) =========== =========== =========== Net loss per share--basic and diluted ...................... $ (.36) $ (1.00) $ (4.20) =========== =========== =========== Shares used in per share computations--basic and diluted ... 3,870,693 7,055,882 9,862,472 =========== =========== ===========
See accompanying notes to consolidated financial statements. F-4 33 LITRONIC INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS)
TOTAL ADDITIONAL SHAREHOLDERS' COMMON STOCK PAID IN ACCUMULATED EQUITY SHARES AMOUNT CAPITAL DEFICIT (DEFICIT) -------- -------- ---------- ----------- ------------- Balance, December 31, 1997 ....................... 3,871 $ 39 $ -- $ (2,840) $ (2,801) Net loss ......................................... -- -- -- (1,406) (1,406) -------- -------- -------- -------- -------- Balance, December 31, 1998 ....................... 3,871 39 -- (4,246) (4,207) Proceeds from sale of common stock, net of issuance costs of $5,426 ....................... 3,700 37 35,237 -- 35,274 Common stock issued in connection with the acquisition of Pulsar .......................... 2,170 22 23,848 -- 23,870 Change from Subchapter S Corporation to C Corporation .................................... -- -- (6,354) 6,354 -- Stock options exercised .......................... 116 1 81 -- 82 Net loss ......................................... -- -- -- (7,086) (7,086) -------- -------- -------- -------- -------- Balance, December 31, 1999 ....................... 9,857 99 52,812 (4,978) 47,933 Stock options exercised .......................... 28 -- 20 -- 20 Treasury stock retired ........................... (141) (2) 2 -- -- Net loss ......................................... -- -- -- (41,405) (41,405) -------- -------- -------- -------- -------- Balance, December 31, 2000 ....................... 9,744 $ 97 $ 52,834 $(46,383) $ 6,548 ======== ======== ======== ======== ========
See accompanying notes to consolidated financial statements. F-5 34 LITRONIC INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, -------------------------------------- 1998 1999 2000 -------- -------- -------- Cash flows from operating activities: Net loss ................................................................ $ (1,406) $ (7,086) $(41,405) Adjustments to reconcile net loss to net cash used in operating activities: Provision for losses on receivables ..................................... 14 327 286 Impairment of goodwill and other intangibles ............................ -- -- 31,415 Depreciation and amortization ........................................... 203 1,803 3,514 Changes in assets and liabilities: Accounts receivable ..................................................... 242 (1,823) 2,718 Inventories ............................................................. (128) (64) 101 Prepaid expenses ........................................................ (16) (303) (182) Other current assets .................................................... (233) (8) 18 Notes receivable -- related party ....................................... -- (70) 70 Other assets ............................................................ -- 332 (343) Accounts payable ........................................................ 41 (3,964) 142 Accrued liabilities ..................................................... (407) (556) (376) Deferred revenue ........................................................ (58) (77) 428 -------- -------- -------- Net cash used in operating activities ..................................... (1,748) (11,489) (3,614) -------- -------- -------- Cash flows from investing activities: Purchases of property and equipment ..................................... (118) (282) (863) Restricted cash relating to line of credit .............................. -- (612) 612 -------- -------- -------- Net cash used in investing activities ..................................... (118) (894) (251) -------- -------- -------- Cash flows from financing activities: Stock options exercised ................................................. -- 82 20 Borrowings on revolving note payable to bank ............................ -- -- 23,666 Proceeds from insurance financing ....................................... -- 497 748 Proceeds from sale of common stock, net of issuance costs of $5,426 ............................................................. -- 35,274 -- Proceeds from revolving note payable to bank ............................ 6,496 23,837 -- Proceeds from line of credit ............................................ -- 1,129 -- Proceeds from long-term debt ............................................ 5,200 1,500 -- Principal payments on revolving line of credit and long-term notes payable to bank ....................................................... (6,522) (44,064) (22,469) Proceeds from related party note payable ................................ 600 -- -- Repayment of related party note payable ................................. (3,500) -- -- Repayment on insurance financing ........................................ -- (329) (421) -------- -------- -------- Net cash provided by financing activities ............................... 2,274 17,926 1,544 -------- -------- -------- Net increase (decrease) in cash ......................................... 408 5,543 (2,321) Cash and cash equivalents at beginning of year ............................ 490 898 6,441 -------- -------- -------- Cash and cash equivalents at end of year .................................. $ 898 $ 6,441 $ 4,120 ======== ======== ======== Supplemental disclosures of cash flow information: Cash paid during the year for: Interest ......................................................... 418 162 63 Income taxes ..................................................... -- 3 6 ======== ======== ======== Supplemental disclosure of noncash investing and financing activities: The Company issued 2,169,938 shares of common stock in connection with the acquisition of Pulsar. In connection with the acquisition, net assets purchased were as follows (note 2): Merger costs .......................................................... -- $ (122) -- Fair value of net assets acquired less liabilities assumed ............ -- (12,151) (331) Goodwill and other intangibles ........................................ -- 36,143 -- -------- -------- -------- Market value of common stock issued ....................................... $ -- 23,870 (331) ======== ======== ========
See accompanying notes to consolidated financial statements. F-6 35 LITRONIC INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 AND 2000 (IN THOUSANDS, EXCEPT PER SHARE DATA) (1) GENERAL INFORMATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General Litronic Inc. (through a reorganization with Litronic Industries, Inc., as described further below) (Litronic or the Company) designs and produces high-grade information security solutions. In addition, the Company also provides engineering and other services to various government agencies on a time and material basis. On December 31, 1997, the Company distributed KRDS, Inc. to the Company's primary shareholders (note 8). Through the acquisition of Pulsar Data Systems, Inc. (Pulsar), the Company engages in the sale of computer hardware, software, peripheral equipment, and support services to governmental agencies and commercial enterprises throughout the United States. Public Offering and Reorganization In June 1999, Litronic completed an initial public offering of common stock of Litronic Inc., a newly formed corporation with no operations (the "Offering"). The Company offered 3,700,000 shares of common stock at a purchase price of $11 per share, resulting in gross proceeds of $40,700. These proceeds were offset by issuance costs of $5,426, resulting in net proceeds of $35,274. Litronic Industries, Inc. also initiated certain events (the "Reorganization") in connection with the Offering that resulted in it becoming a wholly owned subsidiary of Litronic Inc. on June 8, 1999. The Reorganization was accomplished through a stock-for-stock exchange between Litronic Inc. and Litronic Industries, Inc. and was accounted for as an "as if pooling of interests" for entities under common control. Concurrent with the Reorganization, Litronic Industries, Inc. terminated its Subchapter S status and is subject to federal and state income taxes. Pursuant to the change from a Subchapter S to a C corporation, the cumulative loss from inception to June 9, 1999, as a Subchapter S corporation of $6,354 was transferred from accumulated deficit to additional paid in capital. All of the outstanding shares of Litronic Industries, Inc. were exchanged for 3,870,693 shares of the Company's common stock. Consequently, as of June 8, 1999, the consolidated group included the operations of Litronic Inc. and its wholly owned subsidiary, Litronic Industries, Inc. The prior period financial statements have been restated to reflect the exchange of these shares. The Company also entered into a stock acquisition agreement with Pulsar, which was effected simultaneously with the Offering. All of the outstanding shares of Pulsar were exchanged for 2,169,938 shares of the Company's common stock. The acquisition was accounted for using the purchase method of accounting, and accordingly, the results of operations of Pulsar have been included in the Company's consolidated financial statements from June 14, 1999. Basis of Financial Statement Presentation and Principles of Consolidation The consolidated financial statements and related notes presented herein have been retroactively adjusted to reflect the Reorganization. The capital structure presented in these consolidated financial statements is that of Litronic Inc. All references herein to "the Company" refer to Litronic Inc. as consolidated with Litronic Industries, Inc. The consolidated financial statements include the accounts of Litronic Inc., and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. These consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has incurred significant operating losses, has used cash in operating activities and has an accumulated deficit. The Company anticipates that its existing resources will be sufficient to meet its needs for working capital expenditures through at least fiscal 2001. In addition, the Company's chief executive officer and majority stockholder has committed to providing the personal financial resources necessary to enable the Company to meet all of its financial obligations as they become due through January 1, 2002. Ultimately, the Company's ability to continue as a going concern is dependent upon its ability to successfully launch its new product, grow revenue, attain operational efficiencies and sustain a profitable level of operations. Loss Per Share The Company applies Statement of Financial Accounting Standards No. (Statement) 128, "Earnings Per Share." Statement 128 provides for the calculation of basic and diluted earnings (loss) per share. Basic earnings (loss) per share includes no dilution and is F-7 36 computed by dividing earnings (loss) available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of an entity. Such shares are not included when there is a loss as the effect would be anti-dilutive. Revenue Recognition Revenue from product sales, including hardware (with embedded software) and software, is recognized upon shipment unless contract terms call for a later date. The Company records an allowance to cover estimated warranty costs in cost of sales. Customers do not have the right of return except for product defects, and product sales are not contingent upon customer testing, approval and/or acceptance. The costs of providing post contract customer support are not significant. Revenue under service and development contracts is recorded as services are rendered. The Company's revenue recognition policies for software are in compliance with the American Institute of Certified Public Accountants ("AICPA") Statements of Position (SOP) 97-2, Software Revenue Recognition. In December 1998, the AICPA issued SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. SOP 98-9 amended certain paragraphs of SOP 97-2 to require recognition of revenue using the "residual method" under certain circumstances. The adoption of SOP 98-9 did not have a significant impact on the Company's financial position or results of operations. Revenue under research arrangements with government agencies is recorded as revenue as services are rendered or products are shipped. Included in research and development revenue for the year ended December 31, 1998 and 1999 is $398 and $798, respectively, related to a contract with the National Security Agency ("NSA"). The Company is leading a joint effort with Atmel Corporation ("Atmel") and NSA to develop Forte, an ultra fast 32-bit cryptographic System On Chip (SOC) meeting certain minimum NSA specifications. The Company contracts with others to perform certain aspects of the project. All related project costs are expensed as research and development as incurred. The amounts received from the NSA are not refundable regardless of the results of the development efforts. No other amounts were recorded as research and development revenue during any of the periods presented. The related research and development costs are not separately identifiable; therefore the corresponding costs of the entire development effort are included in research and development expenses. Although no additional amounts related to the development of Forte are being received from NSA, the joint effort with Atmel and the NSA to develop Forte has continued. Revenue from time and material, network deployment service contracts is recognized on the basis of man-hours incurred plus other reimbursable contract costs incurred during the period. Revenue from network deployment products is recognized upon transfer of title, generally upon delivery. Product and service revenues from the Company's electric security systems contracts were recognized in accordance with SOP 81-1, "Accounting for Performance of Construction-Type and certain production-type contracts". The Company recognized this revenue on a percentage of completion basis, based on estimated labor dollars incurred. The Company's revenue recognition policies are in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin No. 101. Cash and Cash Equivalents The Company considers all highly liquid investments with maturities of three months or less at the date of purchase to be cash equivalents. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market (net realizable value). Property and Equipment and Goodwill and Other Intangibles Property and equipment are stated at cost. Depreciation of property and equipment is computed on a straight-line basis over the estimated useful lives of 2 to 3 years. The Company amortizes intangible assets relating to businesses acquired and costs in excess of the fair value of net assets of businesses acquired ("goodwill and other intangibles") using the straight-line method over the estimated useful lives of the intangible F-8 37 assets and business acquired. Amortization of goodwill and other intangibles was $1,448 and $2,828, respectively, for the years ended December 31, 1999 and 2000. The Company applies Statement 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." Statement 121 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Under the provisions of Statement 121, if the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying value of the asset, an impairment loss is recognized. The amount of impairment, if any, is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. The estimate of fair value considers prices for similar assets and the results of valuation techniques to the extent available in the circumstances. The Company engaged the services of an independent valuation firm to do a valuation of Pulsar. This valuation was undertaken because the Company determined the integration of Pulsar would not be completed as planned, and the anticipated operating synergies would not be realized. Based on the results of the independent valuation, the Company recorded an impairment charge of $31.4 million in the fourth quarter of 2000, related to unamortized goodwill and other intangible assets acquired in the purchase of Pulsar. The remaining unamortized intangible assets of $783 acquired in the purchase of Pulsar will be amortized over the remainder of the original 10 year useful life. Segment Reporting The Company applies Statement 131, "Disclosures about Segments of an Enterprise and Related Information", which requires entities to report financial and descriptive information about its reportable operating segments. The Company had historically operated in two business segments, information security solutions and electronic interconnect products. As of December 31, 1998, the Company's operations pertained only to its information security solution segment. On June 14, 1999, with the acquisition of Pulsar, the Company expanded into the network solution business segment (see note 7). Accounting for Stock Options The Company applies the provisions of Statement 123, "Accounting for Stock-Based Compensation," which requires entities to recognize as expense over the vesting period the fair value as of the date of grant of all stock based awards. Alternatively, Statement 123 allows entities to apply the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations, and to provide pro forma net income and pro forma net income per share disclosures for employee stock option grants made in 1996 and future years as if the fair-value-based method defined in Statement 123 had been applied. The Company has elected to apply the provisions of APB Opinion No. 25, under which compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price, and provide the pro forma disclosure provisions of Statement 123 in its annual financial statements (see note 12). Fair Value of Financial Instruments The Company applies the provisions of Statement 107, "Disclosures about Fair Value of Financial Instruments." Statement 107 requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized on the balance sheet, for which it is practicable to estimate fair value. Statement 107 defines fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. As of December 31, 1999 and 2000, management believes the fair value of all financial instruments approximated carrying value, due to their short-term nature. Income Taxes Prior to June 8, 1999, the Company had elected to be taxed as an S corporation under the provisions of Section 1362 of the Internal Revenue Code and used the accrual basis of reporting for income tax purposes. Accordingly, the Company had not provided for Federal income taxes since the liability was that of the shareholders. The Company was subject to state income taxes on earnings before taxes. The benefit for state income taxes was $95 for the year ended December 31, 1998. On June 8, 1999, the Company reorganized from an S corporation to C Corporation, and in accordance with Statement 109 "Accounting for Income Taxes," the Company now provides for federal income tax assets and liabilities. Statement 109 uses the asset and liability method of accounting for income taxes, which recognizes deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. F-9 38 Comprehensive Income The Company applies Statement 130, "Reporting Comprehensive Income." Statement 130 establishes rules for the reporting and display of comprehensive income and its components. The adoption of Statement 130 had no impact on the Company's consolidated financial statements as the Company has no transactions, other than net loss, that would be considered other comprehensive income. Use of Estimates The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods. Actual results could differ from those estimates. New Accounting Standards In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement 133, "Accounting for Derivative Instruments and Hedging Activities". Statement 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. Statement 133 requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. In June 1999, the FASB issued Statement 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement 133", which defers the effective date of Statement 133 to all fiscal quarters for fiscal years beginning after June 15, 2000. In June 2000, the FASB issued Statement 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of Statement 133. Although we continue to review the effect of the implementation of Statement 133 and Statement 138, we do not currently believe their adoption will have a material impact on our consolidated financial position or overall trends in results of operations, and do not believe adoption will result in significant changes to our financial risk management practices. Reclassifications Certain reclassifications were made to the 1998 and 1999 consolidated financial statements to conform to the 2000 presentation. (2) PULSAR ACQUISITION The Company entered into a stock acquisition agreement with Pulsar that was effected simultaneously with the Offering. This acquisition was completed on June 14, 1999. Litronic acquired all of the outstanding shares of Pulsar in exchange for 2,169,938 shares of the Company's common stock. The acquisition was accounted for using the purchase method and, accordingly, the results of operations of Pulsar have been included in the Company's consolidated financial statements from June 14, 1999. The excess of the purchase price over the fair value of the net assets acquired less the liabilities assumed, resulted in a total of $36.1 million recorded as goodwill and other intangible assets, to be amortized on a straight-line basis over 10-15 years (see note 1). The purchase price of the Pulsar acquisition of $23,870 or $11 per share was based on the fair market value of the common stock issued on June 14, 1999 and was allocated as follows: Merger costs ..................................... $ (122) Tangible assets .................................. 6,255 Liabilities and debt assumed ..................... (18,406) Identifiable intangible assets and goodwill: Distribution Channel ........................... 12,048 Customer Base .................................. 12,047 Goodwill ....................................... 12,048 -------- 36,143 Market value of common stock issued .............. $ 23,870 ========
F-10 39 The Company allocated the purchase price to tangible assets, liabilities, identifiable intangible assets and goodwill based on management's estimates of the fair value. During the fourth quarter of 1999, the Company recorded approximately $300 of adjustments to increase goodwill related to the acquisition of Pulsar. The adjustments were primarily attributable to a reduction in the fair value of certain assets as compared to the amount originally estimated and the settlement of a pre-existing lawsuit for $140, net of a reimbursement from the former majority shareholder of Pulsar and were partially offset by reductions in certain accounts payable and accrued liabilities not determined necessary after further investigation. During the second quarter of 2000, the Company recorded approximately $331 of adjustments to increase goodwill related to the acquisition of Pulsar. The adjustments were primarily attributable to additions in certain accounts payable and accrued liabilities and the settlement of a pre-existing lawsuit. The following unaudited pro forma financial information presents the combined results of operations of Litronic and Pulsar for 1998 and 1999 as if the acquisition had occurred as of the beginning of 1998 and 1999, after giving effect to certain adjustments including amortization of goodwill and other intangibles, increased interest expense on debt assumed and related income tax effects. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had Litronic and Pulsar constituted a single entity during such periods.
YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, 1998 1999 ------------ ------------ Total revenue .............................. $ 87,185 $ 49,230 ========= ======== Net loss ................................... $ (11,659) $(11,713) ========= ======== Net loss per share, basic and diluted ...... $ (1.20) $ (1.19) ========= ========
As part of the Pulsar acquisition the Company assumed $12,422 in debt. The majority of the debt was paid on June 14, 1999. The remaining outstanding debt was paid in July 1999. See discussion on impairment of goodwill and other intangibles at Note 1. (3) INVENTORIES A summary of inventories follows:
DECEMBER 31, ------------------ 1999 2000 ---- ---- Raw materials ................ $190 $258 Work-in-process .............. 136 86 Finished goods ............... 470 351 ---- ---- $796 $695 ==== ====
(4) PROPERTY AND EQUIPMENT A summary of property and equipment follows:
DECEMBER 31, ---------------------- 1999 2000 ------ ------ Leasehold improvements ..................................... $ 34 $ 65 Machinery and equipment .................................... 68 68 Furniture and fixtures ..................................... 1,308 2,140 ------ ------ 1,410 2,273 Less accumulated depreciation and amortization ............. 764 1,450 ------ ------ $ 646 $ 823 ====== ======
F-11 40 (5) LONG-TERM DEBT A summary of long-term debt follows:
DECEMBER 31, ---------------------- 1999 2000 ------ ------ Revolving note payable to bank with maximum availability of $20 million, bearing interest at prime plus .625% (9.125% and 10.125% at December 31, 1999 and 2000, respectively) interest payable monthly through maturity on May 10, 2002; secured by substantially all assets of the Company ................................................................ 312 1,509 Note payable for insurance financing due in nine monthly payments beginning July 9, 1999 at an annual percentage rate of 5.93% .................. 169 -- Note payable for insurance financing due in nine monthly payments beginning July 9, 2000 at an annual percentage rate of 7.15%................... -- 12 Note payable for insurance financing due in eighteen monthly payments beginning July 9, 2000 at an annual percentage rate of 8.18% .................. -- 484 ------ ------ 481 2,005 Less current installments ....................................................... 481 1,986 ------ ------ $ -- $ 19 ====== ======
In June 1999 we entered into a three-year lending agreement with Guaranty Business Credit Corporation ("GBCC") permitting borrowings under a $20,000 secured revolving line of credit facility commencing on June 14, 1999. The agreement provided for an annual interest rate of prime plus .625%; and a pledge of substantially all of our personal and real property as collateral. Although the credit facility was for borrowings up to $20,000, under the terms of the agreement the amount of borrowing available to the Company was subject to a maximum borrowing limitation based on eligible collateral. Eligible collateral consisted of 85% of eligible accounts receivable plus the lesser of (a) 50% of the value of eligible on-hand inventory or (b) $1,000. As a result, the amount actually available to the Company at any particular time was significantly less than the full $20,000 credit facility due to the maximum borrowing limitation calculation. The agreement with GBCC included a number of covenants and restrictions that the Company was required to adhere to. These covenants and restrictions included maintenance of minimum levels of working capital, tangible net worth, and profitability. In addition, the agreement did not allow the Company to pay dividends. Our borrowings related to this agreement are included in current installments of long-term debt in the accompanying consolidated balance sheet. At December 31, 2000, the maximum borrowing limitation based on the Company's eligible collateral was $2,100. However, at December 31, 2000 the Company was not in compliance with the covenant related to net quarterly profits for the fourth quarter of 2000. During the first quarter of 2001 the Company requested and received a waiver for this violation. The Company amended the GBCC revolving line of credit facility effective as of March 31, 2001. Under the terms of the amended agreement, the maximum borrowings are $5,000. The amended agreement provides for an annual interest rate of prime plus .625%, and a pledge of substantially all of the Company's personal and real property as collateral. Although the credit facility is for borrowings up to $5,000, under the terms of the agreement the amount of borrowing available to the Company is subject to a maximum borrowing limitation based on eligible collateral. Eligible collateral consists of 35% of eligible accounts receivable. As a result, the amount actually available to the Company at any particular time may be less than the full $5,000 credit facility due to the maximum borrowing limitation calculation. The amended agreement with GBCC includes a number of covenants and restrictions that the Company is required to adhere to. These covenants and restrictions include maintenance of minimum levels of working capital, tangible net worth, and profitability. In addition, the amended agreement does not allow the Company to pay dividends. At December 31, 1999, the bank required the Company to maintain a $612 cash deposit at the bank. For balance sheet presentation purposes, the funds were reflected as restricted cash, as the Company had no access to the funds. Beginning in the second quarter of 2000, the bank no longer required the Company to maintain a cash deposit. The Company has entered into insurance premium financing agreements with Cananwill, Inc. for the payment of certain insurance premiums. The premiums being financed cover policy periods from twelve to twenty-four months. The insurance premium financing agreements are payable in nine installments and cover a policy period of twelve months, and the insurance premium financing agreement payable in eighteen installments covers a policy period of twenty-four months. These insurance premium financing agreements are secured by the proceeds of the policies being financed. (6) ACCRUED LIABILITIES A summary of accrued liabilities follows:
DECEMBER 31, ---------------------- 1999 2000 ------ ------ Professional fees ...................... $ 212 $ 334 Accrued vacation ....................... 231 365 Accrued compensation ................... 432 426 Other .................................. 536 241 ------ ------ $1,411 $1,366 ====== ======
F-12 41 (7) BUSINESS SEGMENTS AND PRODUCT LINES In 1998 and prior to the acquisition of Pulsar in June 1999, the Company operated in one business segment. Subsequent to the acquisition of Pulsar, the Company operates in two industry segments, the information security segment and the network solutions segment. Following are the revenues, cost of sales, and identifiable assets of these segments as of and for the years ended December 31, 1999 and 2000.
TWELVE MONTHS ENDED ----------------------------------------- DECEMBER 31, 1999 DECEMBER 31, 2000 ----------------- ------------------ Revenue Information Security Products and Services ............... $ 4,399 $ 7,424 Network Solutions Market ................................. 26,458 31,932 ======= ======= Cost of sales Information Security Products and Services .............. 2,009 2,681 Network Solutions Market ................................ 24,059 28,479 ======= ======= DECEMBER 31, 1999 DECEMBER 31, 2000 ----------------- ------------------ Identifiable assets Information Security Products and Services .............. $ 798 1,373 Network Solutions Market ................................ 41,684 4,370 ======= =======
As the Chief Operating Decision Maker does not review operating expenses by segment beyond cost of sales or assets, except as identified, additional segment information is not available. During the years ended December 31, 2000 and 1999, the Company had four distinct product lines: network deployment products, data security products, license and service, and electric security systems. During the year ended December 31, 1998, the Company had two distinct product lines: data security products and license and service. Following is a summary of total revenues by product line.
TWELVE MONTHS ENDED ------------------------------------------ DECEMBER 31, DECEMBER 31, DECEMBER 31, 1998 1999 2000 ------------ ------------ ------------ Network deployment products ................................ $ -- $26,022 $31,668 Data security products ..................................... 5,214 3,565 5,753 License and service ........................................ 1,041 834 1,671 Electric security systems .................................. -- 436 264 ------- ------- ------- Total net product, license and service revenues ....... $ 6,255 $30,857 $39,356 ======= ======= =======
In July 2000 the Company decided to discontinue the electric security systems product line. The Company has not and does not anticipate incurring any significant expense as the result of this decision. Certain reclassifications were made to the above 1999 figures to conform to the 2000 presentation. (8) RELATED PARTY TRANSACTIONS The primary shareholders of Litronic Industries, Inc. formed KRDS, Inc., (KRDS) for the sole purpose of purchasing real estate property. KRDS's only operations consisted of a mortgage obligation, interest, depreciation and rental income from the Company related to the real estate property. The operations of KRDS were consolidated with the operations of Litronic Industries, Inc. through December 31, 1997, when concurrent with the sale of the Intercon division, the Company distributed KRDS to the Company's shareholders. As a result of the sale of the Intercon division on September 30, 1997, the Company distributed $9,534 in cash dividends and distributed the common stock of KRDS to the shareholders of Litronic on a pro rata basis in 1997. The net assets of KRDS consisted of $8,500 in cash at the time of the distribution. On December 31, 1997, the Company entered into two unsecured notes payable with KRDS in which the Company was extended $900 and $2,000 in working capital funds and a total of $2,900 was outstanding under these related party notes at December 31, 1997. In February 1998, the Company entered into a third unsecured note payable with KRDS under which the Company was extended $600 F-13 42 in working capital funds. Interest was at 10% for each of the unsecured notes payable and each of these unsecured notes and accrued interest were paid in full during 1998. The Company incurred $252 of interest expense on these notes in 1998. On December 31, 1999, the Company had a note receivable from William Davis, the former majority shareholder of Pulsar, for $70. This note receivable was paid in full in the fourth quarter of 2000. In February 2000, KRDS leased a building to the Company for its corporate headquarters. The lease expires in February 2007 (see note 10). The facility has an annual rent of approximately $429. (9) CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS Financial instruments that potentially subject the Company to concentration of credit risk are trade receivables. Credit risk on trade receivables is limited as a result of the Company's customer base and their dispersion across different industries and geographic regions. As of December 31, 1998, 1999 and 2000, accounts receivable included $308, $5,386 and $3,732, respectively, due from the U.S. Government and related agencies. Sales to the U.S. Government and related agencies accounted for 82%, 91% and 81% of total revenues for the years ended December 31, 1998, 1999 and 2000, respectively. The Company had sales to three customers that represented 44%, 17% and 20% of 1998 total revenue, respectively. The Company had sales to two customers that represented 31% and 12% of 1999 total revenue, respectively. The Company had sales to one customer that represented 42% of 2000 total revenue. No other customers accounted for more than 10% of total revenue in 1998, 1999 or 2000. Trade accounts receivable aggregated $493, $3,378 and $1,191 from the aforementioned major customers as of December 31, 1998, 1999 and 2000, respectively. (10) COMMITMENTS The Company leases office space under noncancelable operating leases. The terms of the leases range up to seven years. The following summarizes the future minimum lease payments under all noncancelable operating lease obligations: Year ending December 31, 2001 ............................ $ 667 2002 ............................ 575 2003 ............................ 526 2004 ............................ 429 2005 and thereafter ............. 893 ------ $3,090 ======
Rental expense under noncancelable operating leases was $310, $434 and $668 for the years ended December 31, 1998, 1999 and 2000, respectively. Rental expense and future minimum lease payments for the years 2000 and 2001 include offsetting income from subleases in the amounts of $126 and $153, respectively. In February 2000, the Company moved the corporate headquarters into a facility leased from a related party (see note 8). The remaining term on the previously existing lease extends until September 2001. In 1999, the Company recognized a net loss on the lease of $129; this loss includes offsetting subleases income. (11) LOSS PER SHARE The calculation of diluted net loss per share under Statement 128 excludes potential common shares if the effect is antidilutive. Potential common shares are composed of incremental shares of common stock issuable upon the exercise of stock options and warrants. The following table sets forth potential common shares that were excluded from the diluted net loss per share calculation for the years ended December 31, 1998, 1999 and 2000 because they are antidilutive for the periods indicated:
1998 1999 2000 ----- ----- ----- Warrants ..................... -- 370 370 Stock options ................ 281 236 490 --- --- --- 281 606 860 === === ===
F-14 43 (12) SHAREHOLDERS' EQUITY STOCK OPTION PLANS Under the Company's 1998 and 1999 Employee Stock Option Plans ("the Plans") which were established in April 1998 and April 1999, respectively, the exercise price of options granted will not be less than the fair market value of the related common stock at the date of grant. The total number of shares of common stock available for grant under these Plans is 1,500,000 shares. All stock options granted have 10-year terms. Unless otherwise provided by the Board of Directors or a committee of the Board administering the Plan, each option granted under the 1998 Plan vested on December 31, 1998 as to 10-15%, plus an additional 2.5% for each year of service with the Company, and 20% each December 31 thereafter until fully vested. Unless otherwise provided by the Board of Directors, or a committee of the Board administering the Plan, each option granted under the 1999 Plan vests 20% on each one year anniversary from the date of grant. WARRANTS Warrants to purchase 370,000 shares of common stock at $18.15 per share were issued to the underwriters as part of the Company's initial public offering to purchase. The warrants are exercisable at any time, in whole or in part, during the four-year period commencing on June 9, 2000. OPTIONS Following is a summary of stock option transactions:
WEIGHTED NUMBER AVERAGE OF EXERCISE PRICE SHARES PER SHARE ------ -------------- Options outstanding at December 31, 1997 ......... -- $ -- Granted ........................................ 285 0.70 Cancelled ...................................... (4) 0.70 ---- Options outstanding at December 31, 1998 ......... 281 0.70 Granted ........................................ 124 8.64 Cancelled ...................................... (53) 3.66 Exercised ...................................... (116) 0.70 ---- Options outstanding at December 31, 1999 ......... 236 4.17 Granted ........................................ 347 5.43 Cancelled ...................................... (65) 5.73 Exercised ...................................... (28) 0.70 ---- Options outstanding at December 31, 2000 ......... 490 5.05 ====
As of December 31, 1999 and 2000, the number of options exercisable was 57 at a weighted average exercise price of $0.70 and remaining contract life of 8.3 years and 61 at a weighted average exercise price of $2.55 and remaining contract life of 7.6 years, respectively. The Company applies APB Opinion No. 25 and related interpretations in accounting for its stock option plans. Accordingly, no compensation cost has been recognized for its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under Statement 123, the Company's net loss would have been increased to the pro forma amount indicated below.
YEAR ENDED DECEMBER 31, ----------------------------- 1999 2000 ------- ------- Net loss as reported ............................. $ 7,086 $41,405 Assumed stock compensation cost .................. 77 259 ------- ------- Pro forma net loss ............................... $ 7,163 $41,664 ======= ======= Pro forma net loss per share-basic and diluted ... $ 1.02 $ 4.22 ======= =======
The weighted-average fair value per option granted in 1999 and 2000 was $3.93 and $4.85, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions in 1999 and 2000: risk-free interest rate of 5.94% and of 6.08%; dividend yield of 0.00%; average expected lives of 6 and 5 years; and volatility of 1.21% and 1.38%, respectively. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely-tradable, fully-transferable options without vesting restrictions, which significantly F-15 44 differ from the Company's stock option plans. These models also require highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the grant date. (13) EMPLOYEE RETIREMENT SAVINGS PLAN Effective January 1, 1998, the Company established a retirement plan, which is intended to qualify under Section 401(k) of the Internal Revenue Code. Under the plan, eligible employees are able to contribute up to 20% of their compensation not to exceed the maximum IRS deferral amount. The Company may also match employee contributions at its discretion. During 1998, 1999 and 2000, the Company made contributions of $40, $86 and $142 to this plan, respectively. (14) INCOME TAXES Effective June 9, 1999, the Company became a C corporation as a result of the Company's initial public offering. Prior to June 9, 1999, the Company had elected to be taxed as an S corporation under the provision of Section 1362 of the Internal Revenue Code. Accordingly, prior to June 9, 1999, the Company had not recorded a provision for Federal income taxes since the liability was that of the shareholders and the S corporation was subject to a 1.5% California tax rate on earning before income taxes. The provision (benefit) for income taxes from continuing operations is comprised of the following for the year ended December 31:
DECEMBER 31, -------------------------------------------- 1998 1999 2000 ---- ---- ---- Current: Federal .................... $ -- $ -- $ -- State ...................... (95) (43) 6 Foreign .................... -- -- -- ---- ---- ---- Total .............. $(95) $(43) $ 6 ==== ==== ====
Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The significant components of deferred income taxes are as follows:
DECEMBER 31, ---------------------------------------- 1998 1999 2000 ----- ------- ------- Deferred tax assets Net operating loss carryforward ................ $ -- $ 1,165 $ 3,686 Credit carryforward ............................ -- 97 314 Accrued expenses ............................... -- 236 433 ----- ------- ------- Total deferred tax assets ........................ -- 1,498 4,433 Less valuation allowance ....................... -- (1,498) (4,433) ----- ------- ------- Net deferred tax assets ........................ $ -- $ -- $ -- ===== ======= =======
The Company has recorded a valuation allowance in the amount set forth above for certain deductible temporary differences, net operating loss carryforwards and credit carryforwards where it is more likely than not that the Company will not receive future tax benefits. The net change in the valuation allowance for the year ended December 31, 1999 and 2000 was $1,498 and $2,935 respectively. The year 1999 was the first year that the Company has recorded deferred tax assets, as the Company was previously an S corporation and thus no deferred tax assets had been recorded prior to June 9, 1999. As of December 31, 2000, the Company has Federal and state net operating losses (NOL) carryforwards of approximately $10,300 and $3,300, respectively. These NOL carryforwards will expire through year 2020 for the Federal NOL and 2005 for the state NOLs. Additionally, the Company has Federal and state research and experimentation (R&E) credit carryforwards of approximately $170 and $140 respectively. These R&E Credit carryforwards expire through 2020 for the Federal R&E Credit and indefinitely for the state R&E Credit. F-16 45 Income tax expense differs from the amount computed by applying the Federal corporate income tax rate of 34% to income (loss) before income taxes as follows:
YEAR ENDED DECEMBER 31 --------------------------------- 1998 1999 2000 ---- ---- ---- Statutory tax rate ............................................. (34%) (34%) (34%) Goodwill amortization and impairment of goodwill and other intangibles .................................................... -- 10% 32% S corporation not subject to taxes ............................. 34% -- -- Change in valuation allowance .................................. -- 30% 7% State income taxes, net ........................................ (1.5%) (6%) (5%) Research and experimentation credit ............................ (4%) -- -- Other .......................................................... (.5%) 1% -- --- --- --- Effective tax rate ........................................ (6%) 1% --% === === ===
Subsequent to the initial public offering, the Company had recognized a tax benefit of $285 in the second quarter ended June 30, 1999. During the fourth quarter of 1999, the Company determined it was more likely than not that the Company would not realize the benefit of the net deferred tax asset, and accordingly, recorded a tax-expense to eliminate the benefit and related deferred tax asset from the consolidated financial statements in the fourth quarter of 1999. (15) CONTINGENT LIABILITIES As the Company provides engineering and other services to various government agencies, it is subject to retrospective audits, which may result in adjustments to amounts recognized as revenues, and the Company may be subject to investigation by governmental entities. Failure to comply with the terms of any governmental contracts could result in civil and criminal fines and penalties, as well as suspension from future government contracts. The Company is not aware of any adjustments, fines or penalties, which could have a material adverse effect on its financial position or results of operations. The Company had cost reimbursable type contracts with the Federal Government. Consequently, the Company is reimbursed based upon the direct expenses attributable to the contract, plus a percentage based upon overhead, material handling, and general administrative expenses. The overhead, material handling, and general administrative rates are estimates. Accordingly, if the actual rates as determined by the Defense Contract Audit Agency are below the Company's estimates, a refund for the difference would be due to the Federal Government. It is management's opinion that no material liability will result from any contract audits. We are involved from time to time in various litigations that arise in the ordinary course of business. We are not currently involved in any litigation that we believe will have a material impact on our results of operations, financial condition or liquidity. On January 16, 1998, G2 Resources Inc. (G2) filed a complaint against Pulsar in the Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida. G2 claims that Pulsar breached a contract under which G2 agreed to provide services related to the monitoring of government contracts available for bid and the preparation and submission of bids on behalf of Pulsar. The contract provides that Pulsar pay G2 $500,000 in 30 monthly installments of $16,666 and an additional fee of 2% of the gross dollar amount generated by awards. In its complaint, G2 alleged that Pulsar failed to make payments under the contract and claimed damages in excess of $525,000 plus interest, costs and attorneys fees. In the course of discovery G2 asserted that its losses/costs arising out of its claim amounted to approximately $10.3 million. Pulsar has asserted that G2 failed to perform the services required under the contract and Pulsar filed a claim for compensatory damages, interest and attorneys fees against G2. Classical Financial Services, LLC intervened in the case. Classical claims that G2 assigned its accounts receivable to Classical under a financing program and that Pulsar breached its obligations to Classical by failing to make payments under the contract with G2. Pulsar has asserted defenses to Classical's claim. The Company believes that the claims of G2 and Classical against Pulsar are without merit and intends to continue to vigorously defend against the claims. If G2 or Classical were to prevail in this lawsuit, our business and financial condition could be materially adversely affected. The Company recently received a notice from Microsoft pertaining to alleged sales of unlicensed copies of Microsoft Office. The software in question was purchased from a major computer hardware manufacturer and was resold to one of the Company's customers in a package that included both hardware and software. The Company is currently investigating the matter, and does not anticipate that the outcome will have a material impact on its results of operations, financial condition or liquidity. (16) RETIRED SHARES As part of the Stock Acquisition Agreement dated February 9, 1999, whereby Litronic acquired all of the outstanding stock of Pulsar, Lillian Davis, as a selling shareholder of Pulsar, agreed to indemnify the Company for certain damages if incurred by the Company as specified in the Stock Acquisition Agreement. In November 2000, the Company entered into an agreement with Ms. Davis, a shareholder of the Company, whereby she would, in consideration for a release from specific potential indemnity obligations, transfer 141,573 shares of the Company's common stock to the Company for cancellation. The release was for specific potential indemnity obligations and Ms. Davis was not released from any potential indemnity obligations outlined in the Stock Acquisition Agreement that were not specified in the release. The 141,573 shares of stock subject to the agreement were transferred to the Company in December 2000 and retired. F-17 46 (17) SUBSEQUENT EVENT On February 9, 2001, the Company signed a term sheet to merge with privately held BIZ Interactive Zone, Inc. ("BIZ"), a provider of Internet security solutions for finance, health care, business, e-commerce and entertainment. Consummation of the transaction is subject to the execution of a definitive agreement, approval by Litronic's and BIZ's stockholders and other normal closing conditions. The proposed merger will be accounted for under the purchase method of accounting. (18) QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 2000 and 1999 is as follows:
Basic and Diluted Net Gross Net loss revenues profit loss per share 2000: Fourth quarter $ 10,473 $ 2,062 $(33,872) $(3.45) Third quarter 15,111 2,760 (1,652) (0.17) Second quarter 9,050 2,439 (2,420) (0.24) First quarter 4,722 935 (3,461) (0.35) -------- -------- -------- Total $ 39,356 $ 8,196 $(41,405) ======== ======== ======== 1999: Fourth quarter $ 11,370 $ 1,217 $ (3,215) $(0.33) Third quarter 16,128 2,775 (1,379) (0.14) Second quarter 2,747 713 (1,519) (0.31) First quarter 1,410 882 (973) (0.25) -------- -------- -------- Total $ 31,655 $ 5,587 $ (7,086) ======== ======== ========
F-18 47 SCHEDULE II LITRONIC INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1998, 1999 AND 2000 (IN THOUSANDS, EXCEPT SHARE DATA)
ADDITIONS BALANCE AT CHARGED TO ADDITIONS DEDUCTIONS-- BEGINNING COSTS AND DUE TO AMOUNTS BALANCE AT DESCRIPTION OF PERIOD EXPENSES ACQUISITION WRITTEN OFF END OF PERIOD - ----------- ---------- ---------- ----------- ----------- ------------- Year Ended December 31, 1998 Allowance for doubtful accounts ........ $ -- $ 14 $ -- $ -- $ 14 ===== ==== ===== ===== ==== Year Ended December 31, 1999 Allowance for doubtful accounts ........ $ 14 $327 $ 194 $ 145 $390 ===== ==== ===== ===== ==== Year Ended December 31, 2000 Allowance for doubtful accounts ........ $ 390 $286 $ --- $ 408 $268 ===== ==== ===== ===== ====
S-1 48 EXHIBITS
EXHIBIT PAGE NUMBER DESCRIPTION NUMBER - ------- ----------- ------ 3.1 Certificate of Incorporation, as amended on February 5, 1999 (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 3.2 Bylaws of the Registrant (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 3.3 Form of Amended and Restated Certificate of Incorporation (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 4.1 Registration Rights Agreement (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 4.2 Warrant Agreement (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 4.3 Stock Certificate (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.01 Employment Agreement with Kris Shah (incorporated by reference to exhibit of the same number contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.02 Award Contract between Maryland Procurement Office and Litronic Industries, Inc. dated June 27, 1997 (incorporated by reference to Exhibit 10.11 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.03 Sublease Agreement between Litronic Industries, Inc. and E. I. du Pont de Nemours and Company dated October 20, 1997 (incorporated by reference to Exhibit 10.14 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.04 Litronic Industries, Inc. Stock Option Plan dated April 1, 1998 (incorporated by reference to Exhibit 10.24 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.05 Litronic Industries, Inc. Stock Option Plan dated February 9, 1999 (incorporated by reference to Exhibit 10.25 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.06 Modification dated February 3, 1999 of Original GSA Contract GS-35F-4232D dated May 3, 1996 (incorporated by reference to Exhibit 10.26 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.07 Deed of Lease Agreement between Pulsar Data Systems, Inc. and Massachusetts Mutual Life Insurance Company dated August 11, 1998 (incorporated by reference to Exhibit 10.27 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999).
49
EXHIBIT PAGE NUMBER DESCRIPTION NUMBER - ------- ----------- ------ 10.08 Dallas Semiconductor Standard Consulting Agreement dated February 2, 1999 between Litronic and Dallas Semiconductor Corporation (incorporated by reference to Exhibit 10.37 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.09 Basic Ordering Agreement dated April 16, 1998 between the United States of America and Litronic (incorporated by reference to Exhibit 10.38 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.10 Nonexclusive Distributor Agreement dated April 27, 1999 among Litronic and Itochu Techno-Science Corporation and Itochu Corporation (incorporated by reference to Exhibit 10.39 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.11 Equipment Purchase, Software License and Maintenance Agreement dated April 20, 1999 between Bank of America and Litronic (incorporated by reference to Exhibit 10.40 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.12 Nonexclusive reseller agreement dated as of April 1, 1999 between Litronic and South African Certification Agency (incorporated by reference to Exhibit 10.41 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.13 Loan and Security Agreement dated as of May 10, 1999 between Litronic and Fidelity Funding Inc. (incorporated by reference to Exhibit 10.42 contained in Registrant's Registration Statement on Form S-1 filed with the Commission on or about February 11, 1999). 10.14 Lease agreement between KRDS, Inc., and the Company, dated January 2, 2000. 10.15 Strategic Development & Marketing Alliance Agreement between B12 Interactive Zone, Inc., and the Company, dated September 5, 2000. 21 Subsidiaries of the Registrant.
EX-10.14 2 a71207ex10-14.txt EXHIBIT 10.14 1 EXHIBIT 10.14 [LOGO] AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION STANDARD INDUSTRIAL/COMMERCIAL SINGLE-TENANT LEASE -- NET (DO NOT USE THIS FORM FOR MULTI-TENANT BUILDINGS) 1. BASIC PROVISIONS ("BASIC PROVISIONS") 1.1 PARTIES: This Lease ("LEASE"), dated for reference purposes only January 2, 2000, is made by and between KRDS, INC., a California corporation ("LESSOR") and LITRONIC INC. a Delaware corporation ("LESSEE"), (collectively the "PARTIES," or individually a "PARTY"). 1.2 PREMISES: That certain real property, including all improvements therein or to be provided by Lessor under the terms of this Lease, and commonly known as 17861 Cartwright, Irvine, located in the County of Orange, State of California, and generally described as (describe briefly the nature of the property and, if applicable, the "PROJECT", if the property is located within a Project) approximately 20,702 square foot office, research and development building on approximately 1.73 acres. ("PREMISES"). (See also Paragraph 2) 1.3 TERM: Seven (7) years and no (0) months ("ORIGINAL TERM") commencing February 1, 2000 ("COMMENCEMENT DATE") and ending February 28, 2007 ("EXPIRATION DATE"). (See also Paragraph 3) 1.4 EARLY POSSESSION: ______________________________________________ ("EARLY POSSESSION DATE"). (See also Paragraphs 3.2 and 3.3) 1.5 BASE RENT: $ SEE ADDENDUM per month ("BASE RENT"), payable on the first (1st) day of each month commencing February 1, 2000. (See also Paragraph 4) [X] If this box is checked, there are provisions in this Lease for the Base Rent to be adjusted. 1.6 BASE RENT PAID UPON EXECUTION: $31,674.06 as Base Rent for the period February 1, 2000 through February 29, 2000 1.7 SECURITY DEPOSIT: $31,674.06 ("SECURITY DEPOSIT"). (See also Paragraph 5) 1.8 AGREED USE: Any lawful use. (See also Paragraph 6) 1.9 INSURING PARTY: Lessee is the "INSURING PARTY" unless otherwise stated herein. (See also Paragraph 8) 1.11 GUARANTOR. The obligations of the Lessee under this Lease are to be guaranteed by N/A ("GUARANTOR"). (See also Paragraph 37) 1.12 ADDENDA AND EXHIBITS. Attached hereto is an Addendum or Addenda consisting of Paragraphs ______ through ______ and Exhibits ____________________ _________________________________, all of which constitute a part of this Lease. 2. PREMISES. 2.1 LETTING. Lessor hereby leases to Lessee, and Lessee hereby leases from Lessor, the Premises, for the term, at the rental, and upon all of the terms, covenants and conditions set forth in this Lease. Unless otherwise provided herein, any statement of size set forth in this Lease, or that may have been used in calculating rental, is an approximation which the Parties agree is reasonable and the rental based thereon is not subject to revision whether or not the actual size is more or less. 2.2 CONDITION. Lessor shall deliver the Premises to Lessee broom clean and free of debris on the Commencement Date or the Early Possession Date, whichever first occurs ("START DATE"), and, so long as the required service contracts described in Paragraph 7.1(b) below are obtained by Lessee within thirty (30) days following the Start Date, warrants that the existing electrical, plumbing, fire sprinkler, lighting, heating, ventilating and air conditioning systems ("HVAC"), loading doors, if any, and all other such elements in the Premises, other than those constructed by Lessee, shall be in good operating condition on said date and that the structural elements of the roof, bearing walls and foundation of any buildings on the Premises (the "BUILDING") shall be free of material defects. If a non-compliance with said warranty exists as of the Start Date, Lessor shall, as Lessor's sole obligation with respect to such matter, except as otherwise provided in this Lease, promptly after receipt of written notice from Lessee setting forth with specificity the nature and extent of such non-compliance, rectify same at Lessor's expense. If, after the Start Date, Lessee does not give Lessor written notice of any non-compliance with this warranty within: 1 (i) one (1) year as to all tenant improvement work constructed by Lessor on behalf of Lessee prior to the commencement of the Term; and (ii) forty-five (45) days as to the remaining systems and other elements of the Building, correction of such non-compliance shall be the obligation of Lessee at Lessee's sole cost and expense. 2.3 COMPLIANCE. Lessor warrants that the improvements on the Premises comply with all applicable laws, covenants or restrictions of record, building codes, regulations and ordinances ("APPLICABLE REQUIREMENTS") in effect on the Start Date. Said warranty does not apply to the use to which Lessee will put the Premises or to any Alterations or Utility Installations (as defined in Paragraph 7.3(a)) made or to be made by Lessee. NOTE: Lessee is responsible for determining whether or not the zoning is appropriate for Lessee's intended use, and acknowledges that past uses of the Premises may no longer be allowed. If the Premises do not comply with said warranty, Lessor shall, except as otherwise provided, promptly after receipt of written notice from Lessee setting forth with specificity the nature and extent of such non-compliance, rectify the same at Lessor's expense. If Lessee does not give Lessor written notice of a non-compliance with this warranty within forty-five (45) days following the Start Date, correction of that non-compliance shall be the obligation of Lessee at Lessee's sole cost and expense. If the Applicable Requirements are hereafter changed (as opposed to being in existence at the Start Date, which is addressed in Paragraph 6.2(e) below) so as to require during the term of this Lease the construction of an addition to or an alteration of the Building, the remediation of any Hazardous Substance, or the reinforcement or other physical modification of the Building ("CAPITAL EXPENDITURE"), Lessor and Lessee shall allocate the cost of such work as follows: 2 (a) Subject to Paragraph 2.3(c) below, if such Capital Expenditures are required as a result of the specific and unique use of the Premises by Lessee as compared with uses by tenants in general, Lessee shall be fully responsible for the cost thereof, provided, however that if such Capital Expenditure is required during the last two (2) years of this Lease and the cost thereof exceeds six (6) months' Base Rent, Lessee may instead terminate this Lease unless Lessor notifies Lessee, in writing, within ten (10) days after receipt of Lessee's termination notice that Lessor has elected to pay the difference between the actual cost thereof and the amount equal to six (6) months' Base Rent. If Lessee elects termination, Lessee shall immediately cease the use of the Premises which requires such Capital Expenditure and deliver to Lessor written notice specifying a termination date at least ninety (90) days thereafter. Such termination date shall, however, in no event be earlier than the last day that Lessee could legally utilize the Premises without commencing such Capital Expenditure. (b) If such Capital Expenditure is not the result of the specific and unique use of the Premises by Lessee (such as, governmentally mandated seismic modifications), then Lessor and Lessee shall allocate the obligation to pay for such costs pursuant to the provisions of Paragraph 7.1(c); provided, however, that if such Capital Expenditure is required during the last two years of this Lease or if Lessor reasonably determines that it is not economically feasible to pay its share thereof, Lessor shall have the option to terminate this Lease upon ninety (90) days prior written notice to Lessee unless Lessee notifies Lessor, in writing, within ten (10) days after receipt of Lessor's termination notice that Lessee will pay for such Capital Expenditure. If Lessor does not elect to terminate, and fails to tender its share of any such Capital Expenditure, Lessee may advance such funds and deduct same, with Interest, from Rent until Lessor's share of such costs have been fully paid. If Lessee is unable to finance Lessor's share, or if the balance of the Rent due and payable for the remainder of this Lease is not sufficient to fully reimburse Lessee on an offset basis, Lessee shall have the right to terminate this Lease upon thirty (30) days written notice to Lessor. (c) Notwithstanding the above, the provisions concerning Capital Expenditures are intended to apply only to non-voluntary, unexpected, and new Applicable Requirements. If the Capital Expenditures are instead triggered by Lessee as a result of an actual or proposed change in use, change in intensity of use, or modification to the Premises then, and in that event, Lessee shall be fully responsible for the cost thereof, and Lessee shall not have any right to terminate this Lease. 2.3(d) Lessee acknowledges that as of the execution of the Lease it will have had an adequate opportunity to inspect the Premises and to investigate its physical characteristics and conditions. Except as expressly provided in this Section 2.3, as of the execution of the Lease, Lessee shall be deemed to have waived any and all objections to the physical characteristics and conditions of the Premises which would be disclosed by a reasonable and diligent inspection. Lessee acknowledges that, except as specifically provided herein, neither Lessor nor any of its employees, agents, or representatives has made any representations, warranties or agreements to or with Lessee on behalf of Lessor as to any matters concerning the Premises, the present use thereof, or the suitability of Lessee's intended use of the Premises, and that Lessee accepts the Premises in their AS-IS condition. Without limiting the generality of the foregoing, Lessee understands and agrees that it leases the Premises without any representations or warranties by Lessor, or by any official, employee or agent of Lessor, regarding the existence, use, generation, manufacture, storage, transportation, release or disposal of Hazardous Substances and/or oil wells and/or underground storage tanks and/or pipelines on, under or about the Premises, or regarding that the Premises is or may be in violation of any federal, state or local law, ordinance or regulation relating to Hazardous Substances and/or oil wells and/or underground storage tanks and/or pipelines on, under or about the Premises including, without limitation, soil and ground water conditions. Lessee acknowledges and understands that it must perform its own "due diligence" with respect to all environmental matters relating to the Premises, inclusive of any environmental audits or assessments, and that Lessee is not relying on any environmental audits or assessments performed by or on behalf of Lessor. Lessee acknowledges that (i) asbestos containing materials ("ACMs") are or were present in the mastic binding portions of the tile in the Building; (ii) ACMs are or were present in a portion of the tiles in the Building; (iii) there exists wear, settling and cracking conditions in the slab underlying the Building; (iv) the Building may not be currently in compliance with the requirements of the Americans with Disabilities Act; and (v) a Southern California Edison transformer located on the Premises previously leaked oil. Without limiting any of the foregoing provisions in this Section, Lessee acknowledges Lessor's disclosures and agrees that Lessee shall take subject to all such defects, assumes all loss with respect thereto and is not relying on any information or warranties of Lessor with respect thereto, but will conduct its own investigation regarding same. 2.4 ACKNOWLEDGEMENTS. Lessee acknowledges that: (a) it has been advised by Lessor and/or Brokers to satisfy itself with respect to the condition of the Premises (including but not limited to the electrical, HVAC and fire sprinkler systems, security, environmental aspects, and compliance with Applicable Requirements), and their suitability for Lessee's intended use; (b) Lessee has made such investigation as it deems necessary with reference to such matters and assumes all responsibility therefor as the same relate to its occupancy of the Premises; and (c) neither Lessor, Lessor's agents, nor any Broker has made any oral or written representations or warranties with respect to said matters other than as set forth in this Lease. In addition, Lessor acknowledges that: (a) Broker has made no representations, promises or warranties concerning Lessee's ability to honor the Lease or suitability to occupy the Premises, and (b) it is Lessor's sole responsibility to investigate the financial capability and/or suitability of all proposed tenants. 2.5 LESSEE AS PRIOR OWNER/OCCUPANT. The warranties made by Lessor in Paragraph 2 shall be of no force or effect if immediately prior to the Start Date Lessee was the owner or occupant of the Premises. In such event, Lessee shall be responsible for any necessary corrective work. 3. TERM. 3.1 TERM. The Commencement Date, Expiration Date and Original Term of this Lease are as specified in Paragraph 1.3. 3.2 EARLY POSSESSION. If Lessee totally or partially occupies the Premises prior to the Commencement Date, the obligation to pay Base Rent shall be abated for the period of such early possession. All other terms of this Lease (including but not limited to the obligations to pay Real Property Taxes and insurance premiums and to maintain the Premises) shall, however, be in effect during such period. Any such early possession shall not affect the Expiration Date. 3.3 DELAY IN POSSESSION. Lessor agrees to use its best commercially reasonable efforts to deliver possession of the Premises to Lessee by the Commencement Date. If, despite said efforts, Lessor is unable to deliver possession as agreed, Lessor shall not be subject to any liability therefor, nor shall such failure affect the validity of this Lease. Lessee shall not, however, be obligated to pay Rent or perform its other obligations until it receives possession of the Premises. If possession is not delivered within sixty (60) days after the Commencement Date, Lessee may, at its option, by notice in writing within ten (10) days after the end of such sixty (60) day period, cancel this Lease, in which event the Parties shall be discharged from all obligations hereunder. If such written notice is not received by Lessor within said ten (10) day period, Lessee's right to cancel shall terminate. Except as otherwise provided, if possession is not tendered to Lessee by the Start Date and Lessee does not terminate this Lease, as aforesaid, any period of rent abatement that Lessee would otherwise have enjoyed shall run from the date of delivery of possession and continue for a period equal to what Lessee would otherwise have enjoyed under the terms hereof, but minus any days of delay caused by the acts or omissions of Lessee. If possession of the Premises is not delivered within four (4) months after the Commencement Date, this Lease shall terminate unless other agreements are reached between Lessor and Lessee, in writing. 3.4 LESSEE COMPLIANCE. Lessor shall not be required to tender possession of the Premises to Lessee until Lessee complies with its obligation to provide evidence of insurance (Paragraph 8.5). Pending delivery of such evidence, Lessee shall be required to perform all of its obligations under this Lease from and after the Start Date, including the payment of Rent, notwithstanding Lessor's election to withhold possession pending receipt of such evidence of insurance. Further, if Lessee is required to perform any other conditions prior to or concurrent with the Start Date, the Start Date shall occur but Lessor may elect to withhold possession until such conditions are satisfied. 4. RENT. 4.1. RENT DEFINED. All monetary obligations of Lessee to Lessor under the terms of this Lease (except for the Security Deposit) are deemed to be rent ("RENT"). 4.2 PAYMENT. Lessee shall cause payment of Rent to be received by Lessor in lawful money of the United States, without offset or deduction (except as specifically permitted in this Lease), on or before the day on which it is due. Rent for any period during the term hereof which is for less than one (1) full calendar month shall be prorated based upon the actual number of days of said month. Payment of Rent shall be made to Lessor at its address stated herein or to such other persons or place as Lessor may from time to time designate in writing. Acceptance of a payment which is less than the amount then due shall not be a waiver of Lessor's rights to the balance of such Rent, regardless of Lessor's endorsement of any check so stating. 5. SECURITY DEPOSIT. Lessee shall deposit with Lessor upon execution hereof the Security Deposit as security for Lessee's faithful performance of its obligations under this Lease. If Lessee fails to pay Rent, or otherwise Defaults under this Lease, Lessor may use, apply or retain all or any portion of said Security Deposit for the payment of any amount due Lessor or to reimburse or compensate Lessor for any liability, expense, loss or damage which Lessor may suffer or incur by reason thereof. If Lessor uses or applies all or any portion of said Security Deposit, Lessee shall within ten (10) days after written request therefor deposit monies with Lessor sufficient to restore said Security Deposit to the full amount required by this Lease. Lessor shall not be required to keep the Security Deposit separate from its general accounts. Within fourteen (14) days after the expiration or termination of this Lease, Lessor shall return that portion of the Security Deposit not used or applied by Lessor. No part of the Security Deposit shall be considered to be held in trust, to bear interest or to be prepayment for any monies to be paid by Lessee under this Lease. PAGE 2 3 6. USE. 6.1 USE. Lessee shall use and occupy the Premises only for the Agreed Use, or any other legal use which is reasonably comparable thereto, and for no other purpose. Lessee shall not use or permit the use of the Premises in a manner that is unlawful, creates damage, waste or a nuisance, or that disturbs owners and/or occupants of, or causes damage to neighboring properties. Lessor shall not unreasonably withhold or delay its consent to any written request for a modification of the Agreed Use, so long as the same will not impair the structural integrity of the improvements on the Premises or the mechanical or electrical systems therein, is not significantly more burdensome to the Premises. If Lessor elects to withhold consent, Lessor shall within five (5) business days after such request give written notification of same, which notice shall include an explanation of Lessor's objections to the change in use. 6.2 HAZARDOUS SUBSTANCES. (a) REPORTABLE USES REQUIRE CONSENT. The term "HAZARDOUS SUBSTANCE" as used in this Lease shall mean any product, substance, or waste whose presence, use, manufacture, disposal, transportation, or release, either by itself or in combination with other materials expected to be on the Premises, is either: (i) regulated or monitored by any governmental authority, or (ii) a basis for potential liability of Lessor to any governmental agency or third party under any applicable statute or common law theory. Hazardous Substances shall include, but not be limited to, hydrocarbons, petroleum, gasoline, and/or crude oil or any products, by-products or fractions thereof. Lessee shall not engage in any activity in or on the Premises which constitutes a Reportable Use of Hazardous Substances without the express prior written consent of Lessor and timely compliance (at Lessee's expense) with all Applicable Requirements. "REPORTABLE USE" shall mean (i) the installation or use of any above or below ground storage tank, (ii) the generation, possession, storage, use, transportation, or disposal of a Hazardous Substance that requires a permit from, or with respect to which a report, notice, registration or business plan is required to be filed with, any governmental authority in violation of any Applicable Requirements. Notwithstanding the foregoing, Lessee may use any ordinary and customary materials reasonably required to be used in the normal course of the Agreed Use, so long as such use is in compliance with all Applicable Requirements, is not a Reportable Use, and does not expose the Premises or neighboring property to any meaningful risk of contamination or damage or expose Lessor to any liability therefor. In addition, Lessor may condition its consent to any Reportable Use upon receiving such additional assurances as Lessor reasonably deems necessary to protect itself, the public, the Premises and/or the environment against damage, contamination, injury and/or liability, including, but not limited to, the installation (and removal on or before Lease expiration or termination) of protective modifications (such as concrete encasements) and/or increasing the Security Deposit. (b) DUTY TO INFORM LESSOR. If Lessee knows, or has reasonable cause to believe, that a Hazardous Substance has come to be located in, on, under or about the Premises in violation of any Applicable Requirements other than as previously consented to by Lessor, Lessee shall immediately give written notice of such fact to Lessor, and provide Lessor with a copy of any report, notice, claim or other documentation which it has concerning the presence of such Hazardous Substance. (c) LESSEE REMEDIATION. Lessee shall not cause or permit any Hazardous Substance to be spilled or released in, on, under, or about the Premises (including through the plumbing or sanitary sewer system) and shall promptly, at Lessee's expense, take all investigatory and/or remedial action reasonably recommended, whether or not formally ordered or required, for the cleanup of any contamination of, and for the maintenance, security and/or monitoring of the Premises or neighboring properties, that was caused or materially contributed to by Lessee, or pertaining to or involving any Hazardous Substance brought onto the Premises during the term of this Lease, by or for Lessee, or any third party. (d) LESSEE INDEMNIFICATION. Lessee shall indemnify, defend and hold Lessor, its agents, employees, lenders and ground lessor, if any, harmless from and against any and all loss of rents and/or damages, liabilities, judgments, claims, expenses, penalties, and attorneys' and consultants' fees arising out of or involving any Hazardous Substance brought onto the Premises by or for Lessee, or any third party (provided, however, that Lessee shall have no liability under this Lease with respect to underground migration of any Hazardous Substance under the Premises from adjacent properties). Lessee's obligations shall include, but not be limited to, the effects of any contamination or injury to person, property or the environment created or suffered by Lessee, and the cost of investigation, removal, remediation, restoration and/or abatement, and shall survive the expiration or termination of this Lease. NO TERMINATION, CANCELLATION OR RELEASE AGREEMENT ENTERED INTO BY LESSOR AND LESSEE SHALL RELEASE LESSEE FROM ITS OBLIGATIONS UNDER THIS LEASE WITH RESPECT TO HAZARDOUS SUBSTANCES, UNLESS SPECIFICALLY SO AGREED BY LESSOR IN WRITING AT THE TIME OF SUCH AGREEMENT. (e) LESSOR INDEMNIFICATION. Lessor and its successors and assigns shall indemnify, defend, reimburse and hold Lessee, its employees and lenders, harmless from and against any and all environmental damages, including the cost of remediation, which existed as a result of Hazardous Substances on the Premises prior to the Start Date or which are caused by Lessor, its agents or employees. Lessor's obligations, as and when required by the Applicable Requirements, shall include, but not be limited to, the cost of investigation, removal, remediation, restoration and/or abatement, and shall survive the expiration or termination of this Lease. (f) INVESTIGATIONS AND REMEDIATIONS. Lessor shall retain the responsibility and pay for any investigations or remediation measures required by governmental entities having jurisdiction with respect to the existence of Hazardous Substances on the Premises prior to the Start Date, unless such remediation measure is required as a result of Lessee's use (including "Alterations", as defined in Paragraph 7.3(a) below) of the Premises, in which event Lessee shall be responsible for such payment. Lessee shall cooperate fully in any such activities at the request of Lessor, including allowing Lessor and Lessor's agents to have reasonable access to the Premises at reasonable times in order to carry out Lessor's investigative and remedial responsibilities. (g) LESSOR TERMINATION OPTION. If a Hazardous Substance Condition occurs during the term of this Lease, unless Lessee is legally responsible therefor (in which case Lessee shall make the investigation and remediation thereof required by the Applicable Requirements and this Lease shall continue in full force and effect, but subject to Lessor's rights under Paragraph 6.2(d) and Paragraph 13), Lessor may, at Lessor's option, either (i) investigate and remediate such Hazardous Substance Condition, if required, as soon as reasonably possible at Lessor's expense, in which event this Lease shall continue in full force and effect, or (ii) if the estimated cost to remediate such condition exceeds twelve (12) times the then monthly Base Rent or $100,000, whichever is greater, give written notice to Lessee, within thirty (30) days after receipt by Lessor of knowledge of the occurrence of such Hazardous Substance Condition, of Lessor's desire to terminate this Lease as of the date sixty (60) days following the date of such notice. In the event Lessor elects to give a termination notice, Lessee may, within ten (10) days thereafter, give written notice to Lessor of Lessee's commitment to pay the amount by which the cost of the remediation of such Hazardous Substance Condition exceeds an amount equal to twelve (12) times the then monthly Base Rent or $100,000, whichever is greater. Lessee shall provide Lessor with said funds or satisfactory assurance thereof within thirty (30) days following such commitment. In such event, this Lease shall continue in full force and effect, and Lessor shall proceed to make such remediation as soon as reasonably possible after the required funds are available. If Lessee does not give such notice and provide the required funds or assurance thereof within the time provided, this Lease shall terminate as of the date specified in Lessor's notice of termination. 6.3 LESSEE'S COMPLIANCE WITH APPLICABLE REQUIREMENTS. Except as otherwise provided in this Lease, Lessee shall, at Lessee's sole expense, fully, diligently and in a timely manner, materially comply with all Applicable Requirements, the requirements of any applicable fire insurance underwriter or rating bureau, and the recommendations of Lessor's engineers and/or consultants which relate in any manner to the Premises, without regard to whether said requirements are now in effect or become effective after the Start Date. Lessee shall, within ten (10) days after receipt of Lessor's written request, provide Lessor with copies of all permits and other documents, and other information evidencing Lessee's compliance with any Applicable Requirements specified by Lessor, and shall immediately upon receipt, notify Lessor in writing (with copies of any documents involved) of any threatened or actual claim, notice, citation, warning, complaint or report pertaining to or involving the failure of Lessee or the Premises to comply with any Applicable Requirements. 6.4 INSPECTION; COMPLIANCE. Lessor and Lessor's "Lender" (as defined in Paragraph 30 below) and consultants shall have the right to enter into Premises at any time upon written notice to Lessee in the case of an emergency, and otherwise at reasonable times, for the purpose of inspecting the condition of the Premises and for verifying compliance by Lessee with this Lease. Lessee may require that all persons entering the Premises be escorted by Lessee's personnel. PAGE 3 4 7. MAINTENANCE; REPAIRS, UTILITY INSTALLATIONS; TRADE FIXTURES AND ALTERATIONS. 7.1 LESSEE'S OBLIGATIONS. (a) IN GENERAL. Subject to the provisions of Paragraph 2.2 (Condition), 2.3 (Compliance), 6.3 (Lessee's Compliance with Applicable Requirements), 7.2 (Lessor's Obligations), 9 (Damage or Destruction), and 14 (Condemnation), Lessee shall, at Lessee's sole expense, keep the Premises, Utility Installations, and Alterations in good order, condition and repair (whether or not the portion of the Premises requiring repairs, or the means of repairing the same, are reasonably or readily accessible to Lessee, and whether or not the need for such repairs occurs as a result of Lessee's use, any prior use, the elements or the age of such portion of the Premises), including, but not limited to, all equipment or facilities, such as plumbing, heating, ventilating, air-conditioning, electrical, lighting facilities, boilers, pressure vessels, fire protection system, fixtures, walls (interior and exterior), foundations, ceilings, roofs, floors, windows, doors, plate glass, skylights, landscaping, driveways, parking lots, fences, retaining walls, signs, sidewalks and parkways located in, on, or adjacent to the Premises. Lessee, in keeping the Premises in good order, condition and repair, shall exercise and perform good maintenance practices, specifically including the procurement and maintenance of the service contracts required by Paragraph 7.1(b) below. Lessee's obligations shall include restorations, replacements or renewals when necessary to keep the Premises and all improvements thereon or a part thereof in good order, condition and state of repair. Lessee shall, during the term of this Lease, keep the exterior appearance of the Building in a first-class condition consistent with the exterior appearance of other similar facilities of comparable age and size in the vicinity, including, when necessary, the exterior repainting of the Building. (b) SERVICE CONTRACTS. Lessee shall, at Lessee's sole expense, procure and maintain contracts, with copies to Lessor, in customary form and substance for, and with contractors specializing and experienced in the maintenance of the following equipment and improvements ("Basic Elements"), if any, if and when installed on the Premises: (i) HVAC equipment, (ii) boiler, and pressure vessels, (iii) fire extinguishing systems, including fire alarm and/or smoke detection, (iv) landscaping and irrigation systems, (v) roof covering and drains, (vi) driveways and parking lots, (vii) clarifiers (viii) basic utility feed to the perimeter of the Building, and (ix) any other equipment, if reasonably required by Lessor. (c) REPLACEMENT. Subject to Lessee's indemnification of Lessor as set forth in Paragraph 8.7 below, and without relieving Lessee of liability resulting from Lessee's failure to exercise and perform good maintenance practices, if the Basic Elements described in Paragraph 7.1(b) cannot be repaired other than at a cost which is in excess of 50% of the cost of replacing such Basic Elements, then such Basic Elements shall be replaced by Lessor, and the cost thereof shall be prorated between the Parties and Lessee shall only be obligated to pay, each month during the remainder of the term of this Lease, on the date on which Base Rent is due, an amount equal to the product of multiplying the cost of such replacement by a fraction, the numerator of which is one, and the denominator of which is the number of months of the useful life of such replacement as such useful life is specified pursuant to Federal income tax regulations or guidelines for depreciation thereof (including interest on the unamortized balance as is then commercially reasonable in the judgment of Lessor's accountants), with Lessee reserving the right to prepay its obligation at any time. 7.2 LESSOR'S OBLIGATIONS. Subject to the provisions of Paragraphs 2.2 (Condition), 2.3 (Compliance), 9 (Damage or Destruction) and 14 (Condemnation), it is intended by the Parties hereto that Lessor have no obligation, in any manner whatsoever, to repair and maintain the Premises, or the equipment therein, all of which obligations are intended to be that of the Lessee. It is the intention of the Parties that the terms of this Lease govern the respective obligations of the Parties as to maintenance and repair of the Premises, and they expressly waive the benefit of any statute now or hereafter in effect to the extent it is inconsistent with the terms of this Lease. 7.3 UTILITY INSTALLATIONS; TRADE FIXTURES; ALTERATIONS. (a) DEFINITIONS; CONSENT REQUIRED. The term "UTILITY INSTALLATIONS" refers to all floor and window coverings, air lines, power panels, electrical distribution, security and fire protection systems, communication systems, lighting fixtures, HVAC equipment, plumbing, and fencing in or on the Premises. The term "TRADE FIXTURES" shall mean Lessee's machinery and equipment that can be removed without doing material damage to the Premises. The term "ALTERATIONS" shall mean any modification of the improvements, other than Utility Installations or Trade Fixtures, whether by addition or deletion. "LESSEE OWNED ALTERATIONS AND/OR UTILITY INSTALLATIONS" are defined as Alterations and/or Utility Installations made by Lessee that are not yet owned by Lessor pursuant to Paragraph 7.4(a). Lessee shall not make any Alterations or Utility Installations to the Premises without Lessor's prior written consent which shall not be unreasonably withheld. Lessee may, however, make non-structural Utility Installations to the interior of the Premises (excluding the roof) without such consent but upon notice to Lessor, as long as they are not visible from the outside, do not involve puncturing, relocating or removing the roof or any existing walls, and the cumulative cost thereof during this Lease as extended does not exceed $50,000 in the aggregate or $10,000 in any one year. (b) CONSENT. Any Alterations or Utility Installations that Lessee shall desire to make and which require the consent of the Lessor shall be presented to Lessor in written form with detailed plans. Consent shall be deemed conditioned upon Lessee's: (i) acquiring all applicable governmental permits, (ii) furnishing Lessor with copies of both the permits and the plans and specifications prior to commencement of the work, and (iii) compliance with all conditions of said permits and other Applicable Requirements in a prompt and expeditious manner. Any Alterations or Utility Installations shall be performed in a workmanlike manner with good and sufficient materials. Lessee shall promptly upon completion furnish Lessor with as-built plans and specifications. For work which costs an amount equal to the greater of one month's Base Rent, or $50,000, Lessor may condition its consent upon Lessee providing a lien and completion bond in an amount equal to one and one-half times the estimated cost of such Alteration or Utility Installation and/or upon Lessee's posting an additional Security Deposit with Lessor. (c) INDEMNIFICATION. Lessee shall pay, when due, all claims for labor or materials furnished or alleged to have been furnished to or for Lessee at or for use on the Premises, which claims are or may be secured by any mechanic's or materialmen's lien against the Premises or any interest therein. Lessee shall give Lessor not less than ten (10) days' notice prior to the commencement of any work in, on or about the Premises, and Lessor shall have the right to post notices of non-responsibility. If Lessee shall contest the validity of any such lien, claim or demand, then Lessee shall, at its sole expense defend and protect itself, Lessor and the Premises against the same and shall pay and satisfy any such adverse judgment that may be rendered thereon before the enforcement thereof. If Lessor shall require, Lessee shall furnish a surety bond in an amount equal to one and one-half times the amount of such contested lien, claim or demand, indemnifying Lessor against liability for the same. If Lessor elects to participate in any such action, Lessee shall pay Lessor's attorneys' fees and costs. 7.4 OWNERSHIP; REMOVAL; SURRENDER; AND RESTORATION. (a) OWNERSHIP. All Alterations and Utility Installations made by Lessee shall be the property of Lessee, but considered a part of the Premises. Lessor may, at any time, elect in writing to be the owner of all or any specified part of the Lessee Owned Alterations and Utility Installations. Unless otherwise instructed per Paragraph 7.4(b) hereof, all Lessee Owned Alterations and Utility Installations shall, at the expiration or termination of this Lease, become the property of Lessor and be surrendered by Lessee with the Premises. (b) SURRENDER/RESTORATION. Lessee shall surrender the Premises by the Expiration Date or any earlier termination date, with all of the improvements, parts and surfaces thereof broom clean and free of debris, and in good operating order, condition and state of repair, ordinary wear and tear excepted. "Ordinary wear and tear" shall not include any damage or deterioration that would have been prevented by good maintenance practice. Lessee shall repair any damage occasioned by the installation, maintenance or removal of Trade Fixtures, Lessee Owned Alterations and/or Utility Installations, furnishings, and equipment as well as the removal of any storage tank installed by or for Lessee, and the removal, replacement, or remediation of any soil, material or groundwater contaminated by Lessee. Trade Fixtures shall remain the property of Lessee and shall be removed by Lessee. The failure by Lessee to timely vacate the Premises pursuant to this Paragraph 7.4(b) without the express written consent of Lessor shall constitute a holdover under the provisions of Paragraph 26 below. PAGE 4 5 8. INSURANCE; INDEMNITY. 8.1 PAYMENT FOR INSURANCE. Lessee shall pay for all insurance required under Paragraph 8 except to the extent of the cost attributable to liability insurance carried by Lessor under Paragraph 8.2(b) in excess of $2,000,000 per occurrence. Premiums for policy periods commencing prior to or extending beyond the Lease term shall be prorated to correspond to the Lease term. Payment shall be made by Lessee to Lessor within ten (10) days following receipt of an invoice. 8.2 LIABILITY INSURANCE. (a) CARRIED BY LESSEE. Lessee shall obtain and keep in force a Commercial General Liability Policy of Insurance protecting Lessee and Lessor against claims for bodily injury, personal injury and property damage based upon or arising out of the ownership, use, occupancy or maintenance of the Premises and all areas appurtenant thereto. Such insurance shall be on an occurrence basis providing single limit coverage in an amount not less than $2,000,000 per occurrence with an "ADDITIONAL INSURED -- MANAGERS OR LESSORS OF PREMISES ENDORSEMENT" and contain the "AMENDMENT OF THE POLLUTION EXCLUSION ENDORSEMENT" for damage caused by heat, smoke or fumes from a hostile fire. The Policy shall not contain any intra-insured exclusions as between insured persons or organizations, but shall include coverage for liability assumed under this Lease as an "insured contract" for the performance of Lessee's indemnity obligations under this Lease. The limits of said insurance shall not, however, limit the liability of Lessee nor relieve Lessee of any obligation hereunder. All insurance carried by Lessee shall be primary to and not contributory with any similar insurance carried by Lessor, whose insurance shall be considered excess insurance only. (b) CARRIED BY LESSOR. Lessor may maintain liability insurance as described in Paragraph 8.2(a), in addition to, and not in lieu of, the insurance required to be maintained by Lessee. Lessee shall not be named as an additional insured therein. 8.3 PROPERTY INSURANCE -- BUILDING, IMPROVEMENTS AND RENTAL VALUE. (a) BUILDING AND IMPROVEMENTS. The Insuring Party shall obtain and keep in force a policy or policies in the name of Lessor, with loss payable to Lessor, any ground lessor, and to any Lender(s) insuring loss or damage to the Premises. The amount of such insurance shall be equal to the full replacement cost of the Premises, as the same shall exist from time to time, or the amount required by any Lenders, but in no event more than the commercially reasonable and available insurable value thereof. If Lessor is the Insuring Party, however, Lessee Owned Alterations and Utility Installations, Trade Fixtures, and Lessee's personal property shall be insured by Lessee under Paragraph 8.4 rather than by Lessor. If the coverage is available and commercially appropriate, such policy or policies shall insure against all risks of direct physical loss or damage (except the perils of flood and/or earthquake unless required by a Lender), including coverage for debris removal and the enforcement of any Applicable Requirements requiring the upgrading, demolition, reconstruction or replacement of any portion of the Premises as the result of a covered loss. Said policy or policies shall also contain an agreed valuation provision in lieu of any coinsurance clause, waiver of subrogation, and inflation guard protection causing an increase in the annual property insurance coverage amount by a factor of not less than the adjusted U.S. Department of Labor Consumer Price Index for All Urban Consumers for the city nearest to where the Premises are located. If such insurance coverage has a deductible clause, the deductible amount shall not exceed $10,000 per occurrence, and Lessee shall be liable for such deductible amount in the event of an Insured Loss. (b) RENTAL VALUE. The Insuring Party shall obtain and keep in force a policy or policies in the name of Lessor with loss payable to Lessor and any Lender, insuring the loss of the full Rent for one (1) year. Said insurance shall provide that in the event the Lease is terminated by reason of an insured loss, the period of indemnity for such coverage shall be extended beyond the date of the completion of repairs or replacement of the Premises, to provide for one full year's loss of Rent from the date of any such loss. Said insurance shall contain an agreed valuation provision in lieu of any coinsurance clause, and the amount of coverage shall be adjusted annually to reflect the projected Rent otherwise payable by Lessee, for the next twelve (12) month period. Lessee shall be liable for any deductible amount in the event of such loss. (c) ADJACENT PREMISES. If the Premises are part of a larger building, or of a group of buildings owned by Lessor which are adjacent to the Premises, the Lessee shall pay for any increase in the premiums for the property insurance of such building or buildings if said increase is caused by Lessee's acts, omissions, use or occupancy of the Premises. 8.4 LESSEE'S PROPERTY/BUSINESS INTERRUPTION INSURANCE. (a) PROPERTY DAMAGE. Lessee shall obtain and maintain insurance coverage on all of Lessee's personal property, Trade Fixtures, and Lessee Owned Alterations and Utility Installations. Such insurance shall be full replacement cost coverage with a deductible of not to exceed $1,000 per occurrence. The proceeds from any such insurance shall be used by Lessee for the replacement of personal property, Trade Fixtures and Lessee Owned Alterations and Utility Installations. Lessee shall provide Lessor with written evidence that such insurance is in force. (b) BUSINESS INTERRUPTION. Lessee shall obtain and maintain loss of income and extra expense insurance in amounts as will reimburse Lessee for direct or indirect loss of earnings attributable to all perils commonly insured against by prudent lessees in the business of Lessee or attributable to prevention of access to the Premises as a result of such perils. (c) NO REPRESENTATION OF ADEQUATE COVERAGE. Lessor makes no representation that the limits or forms of coverage of insurance specified herein are adequate to cover Lessee's property, business operations or obligations under this Lease. 8.5 INSURANCE POLICIES. Insurance required herein shall be by companies duly licensed or admitted to transact business in the state where the Premises are located, and maintaining during the policy term a "General Policyholders Rating" of at least B+, V, as set forth in the most current issue of "Best's Insurance Guide", or such other rating as may be required by a Lender. Lessee shall not do or permit to be done anything which invalidates the required insurance policies. Lessee shall, prior to the Start Date, deliver to Lessor certified copies of policies of such insurance or certificates evidencing the existence and amounts of the required insurance. No such policy shall be cancelable or subject to modification except after thirty (30) days prior written notice to Lessor. Lessee shall, at least thirty (30) days prior to the expiration of such policies, furnish Lessor with evidence of renewals or "insurance binders" evidencing renewal thereof, or Lessor may order such insurance and charge the cost thereof to Lessee, which amount shall be payable by Lessee to Lessor upon demand. Such policies shall be for a term of at least one year, or the length of the remaining term of this Lease, whichever is less. If either Party shall fail to procure and maintain the insurance required to be carried by it, the other Party may, but shall not be required to, procure and maintain the same. 8.6 WAIVER OF SUBROGATION. Without affecting any other rights or remedies, Lessee and Lessor each hereby release and relieve the other, and waive their entire right to recover damages against the other, for loss of or damage to its property arising out of or incident to the perils required to be insured against herein. The effect of such releases and waivers is not limited by the amount of insurance carried or required, or by any deductibles applicable hereto. The Parties agree to have their respective property damage insurance carriers waive any right to subrogation that such companies may have against Lessor or Lessee, as the case may be, so long as the insurance is not invalidated thereby. 8.7 INDEMNITY. Except for Lessor's gross negligence or willful misconduct, Lessee shall indemnify, protect, defend and hold harmless the Premises, Lessor and its agents, Lessor's master or ground lessor, partners and Lenders, from and against any and all claims, loss of rents and/or damages, liens, judgments, penalties, attorneys' and consultants' fees, expenses and/or liabilities arising out of, involving, or in connection with, the use and/or occupancy of the Premises by Lessee. If any action or proceeding is brought against Lessor by reason of any of the foregoing matters, Lessee shall upon notice defend the same at Lessee's expense by counsel reasonably satisfactory to Lessor and Lessor shall cooperate with Lessee in such defense. Lessor need not have first paid any such claim in order to be defended or indemnified. 8.8 EXEMPTION OF LESSOR FROM LIABILITY. Except to the extent caused by the negligence or willful misconduct of Lessor, Lessor shall not be liable for injury or damage to the person or goods, wares, merchandise or other property of Lessee, Lessee's employees, contractors, invitees, customers, or any other person in or about the Premises, whether such damage or injury is caused by or results from fire, steam, electricity, gas, water or rain, or from the breakage, leakage, obstruction or other defects of pipes, fire sprinklers, wires, appliances, plumbing, HVAC or lighting fixtures, or from any other cause, whether the said injury or damage results from conditions arising upon the Premises or upon other portions of the Building of which the Premises are a part, or from other sources or places. Lessor shall not be liable for any damages arising from any act or neglect of any other tenant of Lessor. Notwithstanding Lessor's negligence or breach of this Lease, Lessor shall under no circumstances be liable for injury to Lessee's business or for any loss of income or profit therefrom. 9. DAMAGE OR DESTRUCTION. 9.1 DEFINITIONS. (a) "PREMISES PARTIAL DAMAGE" shall mean damage or destruction to the improvements on the Premises, other than Lessee Owned Alterations and Utility Installations, which can reasonably be repaired in six (6) months or less from the date of the damage or destruction. PAGE 5 6 Lessor shall notify Lessee in writing within thirty (30) days from the date of the damage or destruction as to whether or not the damage is Partial or Total. (b) "PREMISES TOTAL DESTRUCTION" shall mean damage or destruction to the Premises, other than Lessee Owned Alterations and Utility Installations and Trade Fixtures, which cannot reasonably be repaired in six (6) months or less from the date of the damage or destruction. Lessor shall notify Lessee in writing within thirty (30) days from the date of the damage or destruction as to whether or not the damage is Partial or Total. (c) "INSURED LOSS" shall mean damage or destruction to improvements on the Premises, other than Lessee Owned Alterations and Utility Installations and Trade Fixtures, which was caused by an event required to be covered by the insurance described in Paragraph 8.3(a), irrespective of any deductible amounts or coverage limits involved. (d) "REPLACEMENT COST" shall mean the cost to repair or rebuild the improvements owned by Lessor at the time of the occurrence to their condition existing immediately prior thereto, including demolition, debris removal and upgrading required by the operation of Applicable Requirements, and without deduction for depreciation. (e) "HAZARDOUS SUBSTANCE CONDITION" shall mean the occurrence or discovery of a condition involving the presence of, or a contamination by, a Hazardous Substance as defined in Paragraph 6.2(a), in, on, or under the Premises. 9.2 PARTIAL DAMAGE -- INSURED LOSS. If a Premises Partial Damage that is an Insured Loss occurs, then Lessor shall, at Lessor's expense, repair such damage (but not Lessee's Trade Fixtures or Lessee Owned Alterations and Utility Installations) as soon as reasonably possible and this Lease shall continue in full force and effect; provided, however, that Lessee shall, at Lessor's election, make the repair of any damage or destruction the total cost to repair of which is $10,000 or less, and, in such event, Lessor shall make any applicable insurance proceeds available to Lessee on a reasonable basis for that purpose. Notwithstanding the foregoing, if the required insurance was not in force or the insurance proceeds are not sufficient to effect such repair, the Insuring Party shall promptly contribute the shortage in proceeds (except as to the deductible which is Lessee's responsibility) as and when required to complete said repairs. In the event, however, such shortage was due to the fact that, by reason of the unique nature of the improvements, full replacement cost insurance coverage was not commercially reasonable and available, Lessor shall have no obligation to pay for the shortage in insurance proceeds or to fully restore the unique aspects of the Premises unless Lessee provides Lessor with the funds to cover same, or adequate assurance thereof, within ten (10) days following receipt of written notice of such shortage and request therefor. If Lessor receives said funds or adequate assurance thereof within said ten (10) day period, the party responsible for making the repairs shall complete them as soon as reasonably possible and this Lease shall remain in full force and effect. If such funds or assurance are not received, Lessor may nevertheless elect by written notice to Lessee within ten (10) days thereafter to: (i) make such restoration and repair as is commercially reasonable with Lessor paying any shortage in proceeds, in which case this Lease shall remain in full force and effect; or (ii) have this Lease terminate thirty (30) days thereafter. Lessee shall not be entitled to reimbursement of any funds contributed by Lessee to repair any such damage or destruction. Premises Partial Damage due to flood or earthquake shall be subject to Paragraph 9.3, notwithstanding that there may be some insurance coverage, but the net proceeds of any such insurance shall be made available for the repairs if made by either Party. 9.3 PARTIAL DAMAGE -- UNINSURED LOSS. If a Premises Partial Damage that is not an Insured Loss occurs, unless caused by a negligent or willful act of Lessee (in which event Lessee shall make the repairs at Lessee's expense), Lessor may either: (i) repair such damage as soon as reasonably possible at Lessor's expense, in which event this Lease shall continue in full force and effect, or (ii) terminate this Lease by giving written notice to Lessee within thirty (30) days after receipt by Lessor of knowledge of the occurrence of such damage. Such termination shall be effective sixty (60) days following the date of such notice. In the event Lessor elects to terminate this Lease, Lessee shall have the right within ten (10) days after receipt of the termination notice to give written notice to Lessor of Lessee's commitment to pay for the repair of such damage without reimbursement from Lessor. Lessee shall provide Lessor with said funds or satisfactory assurance thereof within thirty (30) days after making such commitment. In such event this Lease shall continue in full force and effect, and Lessor shall proceed to make such repairs as soon as reasonably possible after the required funds are available. If Lessee does not make the required commitment, this Lease shall terminate as of the date specified in the termination notice. 9.4 TOTAL DESTRUCTION. Notwithstanding any other provision hereof, if a Premises Total Destruction occurs, this Lease shall terminate sixty (60) days following such Destruction. If the damage or destruction was caused by the negligence or willful misconduct of Lessee, Lessor shall have the right to recover Lessor's damages from Lessee, except as provided in Paragraph 8.6. 9.5 DAMAGE NEAR END OF TERM. If at any time during the last six (6) months of this Lease there is damage for which the cost to repair exceeds one (1) month's Base Rent, whether or not an Insured Loss, Lessor may terminate this Lease effective sixty (60) days following the date of occurrence of such damage by giving a written termination notice to Lessee within thirty (30) days after the date of occurrence of such damage. Notwithstanding the foregoing, if Lessee at that time has an exercisable option to extend this Lease or to purchase the Premises, then Lessee may preserve this Lease by, (a) exercising such option needed to make the repairs on or before the earlier of (i) the date which is ten days after Lessee's receipt of Lessor's written notice purporting to terminate this Lease, or (ii) the day prior to the date upon which such option expires. If Lessee duly exercises such option during such period to the extent otherwise required by this Section 9, Lessor shall, at Lessor's and/or Lessee's, as applicable, commercially reasonable expense, repair such damage as soon as reasonably possible and this Lease shall continue in full force and effect. If Lessee fails to exercise such option and provide such funds or assurance during such period, then this Lease shall terminate on the date specified in the termination notice and Lessee's option shall be extinguished. 9.6 ABATEMENT OF RENT; LESSEE'S REMEDIES. (a) ABATEMENT. In the event of Premises Partial Damage or Premises Total Destruction or a Hazardous Substance Condition for which Lessee is not responsible under this Lease, the Rent payable by Lessee for the period required for the repair, remediation or restoration of such damage shall be abated in proportion to the degree to which Lessee's use of the Premises is impaired, but not to exceed the proceeds received from the Rental Value insurance. All other obligations of Lessee hereunder shall be performed by Lessee, and Lessor shall have no liability for any such damage, destruction, remediation, repair or restoration except as provided herein. (b) REMEDIES. If Lessor shall be obligated to repair or restore the Premises and does not commence, in a substantial and meaningful way, such repair or restoration within ninety (90) days after such obligation shall accrue, Lessee may, at any time prior to the commencement of such repair or restoration, give written notice to Lessor and to any Lenders of which Lessee has actual notice, of Lessee's election to terminate this Lease on a date not less than sixty (60) days following the giving of such notice. If Lessee gives such notice and such repair or restoration is not commenced within thirty (30) days thereafter, this Lease shall terminate as of the date specified in said notice. If the repair or restoration is commenced within said thirty (30) days, this Lease shall continue in full force and effect. "COMMENCE" shall mean either the unconditional authorization of the preparation of the required plans, or the beginning of the actual work on the Premises, whichever first occurs. 9.7 TERMINATION -- ADVANCE PAYMENTS. Upon termination of this Lease pursuant to Paragraph 6.2(g) or Paragraph 9, an equitable adjustment shall be made concerning advance Base Rent and any other advance payments made by Lessee to Lessor. Lessor shall, in addition, return to Lessee so much of Lessee's Security Deposit as has not been, or is not then required to be, used by Lessor. 9.8 WAIVE STATUTES. Lessor and Lessee agree that the terms of this Lease shall govern the effect of any damage to or destruction of the Premises with respect to the termination of this Lease and hereby waive the provisions of any present or future statute to the extent inconsistent herewith. 10. REAL PROPERTY TAXES. 10.1 DEFINITION OF "REAL PROPERTY TAXES." As used herein, the term "REAL PROPERTY TAXES" shall include any form of assessment; real estate, general, special, ordinary or extraordinary, or rental levy or tax (other than inheritance, personal income or estate taxes); improvement bond; and/or license fee imposed upon or levied against any legal or equitable interest of Lessor in the Premises, Lessor's right to other income therefrom, and/or Lessor's business of leasing, by any authority having the direct or indirect power to tax and where the funds are generated PAGE 6 7 with reference to the Building address and where the proceeds so generated are to be applied by the city, county or other local taxing authority of a jurisdiction within which the Premises are located. The term "REAL PROPERTY TAXES" shall also include any tax, fee, levy, assessment or charge, or any increase therein, imposed by reason of events occurring during the term of this Lease, including but not limited to, a change in the ownership of the Premises. 10.2 (a) PAYMENT OF TAXES. Lessee shall pay the Real Property Taxes applicable to the Premises during the term of this Lease. All such payments shall be made at least ten (10) days prior to any delinquency date. Lessee shall promptly furnish Lessor with satisfactory evidence that such taxes have been paid. If any such taxes shall cover any period of time prior to or after the expiration or termination of this Lease, Lessee's share of such taxes shall be prorated to cover only that portion of the tax bill applicable to the period that this Lease is in effect, and Lessor shall reimburse Lessee for any overpayment. If Lessee shall fail to pay any required Real Property Taxes, Lessor shall have the right to pay the same, and Lessee shall reimburse Lessor therefor upon demand. 10.3 JOINT ASSESSMENT. If the Premises are not separately assessed, Lessee's liability shall be an equitable proportion of the Real Property Taxes for all of the land and improvements included within the tax parcel assessed, such proportion to be conclusively determined by Lessor from the respective valuations assigned in the assessor's work sheets or such other information as may be reasonably available. 10.4 PERSONAL PROPERTY TAXES. Lessee shall pay, prior to delinquency, all taxes assessed against and levied upon Lessee Owned Alterations, Utility Installations, Trade Fixtures, furnishings, equipment and all personal property of Lessee. When possible, Lessee shall cause such property to be assessed and billed separately from the real property of Lessor. If any of Lessee's said personal property shall be assessed with Lessor's real property, Lessee shall pay Lessor the taxes attributable to Lessee's property within ten (10) days after receipt of a written statement. 11. UTILITIES. Lessee shall pay for all water, gas, heat, light, power, telephone, trash disposal and other utilities and services supplied to the Premises, together with any taxes thereon. If any such services are not separately metered to Lessee, Lessee shall pay a reasonable proportion, to be determined by Lessor, of all charges jointly metered. 12. ASSIGNMENT AND SUBLETTING. 12.1 LESSOR'S CONSENT REQUIRED. (a) Lessee shall have the right to assign this Lease or to sublet the Premises in whole or in part to any entity which controls, is controlled by, or is under common control with Lessee ("Affiliate"), provided that Lessee provides written notice to Lessor of any such subletting and of the identity of such assignee or sublessee and provided that the obligation of Lessee shall not be diminished or affected in any manner by reason of such assignment or subletting. Except for the foregoing, Lessee shall not voluntarily or by operation of law assign, transfer, mortgage or encumber (collectively, "ASSIGN OR ASSIGNMENT") or sublet all or any part of Lessee's interest in this Lease or in the Premises without Lessor's prior written consent which consent shall not be unreasonably withheld. (b) A sale or transfer of any stock of Lessee shall not constitute a transfer or assignment and shall not require the consent of Lessor. (d) Where Lessor's consent is required hereunder, an assignment or subletting without consent shall, at Lessor's option, be a Default curable after notice per Paragraph 13.1(c), or a noncurable Breach without the necessity of any notice and grace period. If Lessor elects to treat such unapproved assignment or subletting as a noncurable Breach, Lessor may either: (i) terminate this Lease. (e) Lessee's remedy for any breach of Paragraph 12.1 by Lessor shall be limited to compensatory damages and/or injunctive relief. 12.2 TERMS AND CONDITIONS APPLICABLE TO ASSIGNMENT AND SUBLETTING. (a) Regardless of Lessor's consent, any assignment or subletting shall not: (i) be effective without the express written assumption by such assignee or sublessee of the obligations of Lessee under this Lease, (ii) release Lessee of any obligations hereunder, or (iii) alter the primary liability of Lessee for the payment of Rent or for the performance of any other obligations to be performed by Lessee. (b) Lessor may accept Rent or performance of Lessee's obligations from any person other than Lessee pending approval or disapproval of an assignment. Neither a delay in the approval or disapproval of such assignment nor the acceptance of Rent or performance shall constitute a waiver or estoppel of Lessor's right to exercise its remedies for Lessee's Default or Breach. (c) Lessor's consent to any assignment or subletting shall not constitute a consent to any subsequent assignment or subletting. (d) In the event of any Default or Breach by Lessee, Lessor may proceed directly against Lessee, any Guarantors or anyone else responsible for the performance of Lessee's obligations under this Lease, including any assignee or sublessee, without first exhausting Lessor's remedies against any other person or entity responsible therefore to Lessor, or any security held by Lessor. (e) Each request for consent to an assignment or subletting shall be in writing, accompanied by information relevant to Lessor's determination as to the financial and operational responsibility and appropriateness of the proposed assignee or sublessee, including but not limited to the intended use and/or required modification of the Premises, if any, together with a fee of $1,000 (which amount shall be reduced to $500.00 in the case of any assignment or sublease to an Affiliate) as consideration for Lessor's considering and processing said request. Lessee agrees to provide Lessor with such other or additional information and/or documentation as may be reasonably requested. (f) Any assignee of, or sublessee under, this Lease shall, by reason of accepting such assignment or entering into such sublease, be deemed to have assumed and agreed to conform and comply with each and every term, covenant, condition and obligation herein to be observed or performed by Lessee during the term of said assignment or sublease, other than such obligations as are contrary to or inconsistent with provisions of an assignment or sublease to which Lessor has specifically consented to in writing. 12.3 ADDITIONAL TERMS AND CONDITIONS APPLICABLE TO SUBLETTING. The following terms and conditions shall apply to any subletting by Lessee of all or any part of the Premises and shall be deemed included in all subleases under this Lease whether or not expressly incorporated therein: (a) Lessee hereby assigns and transfers to Lessor all of Lessee's interest in all Rent payable on any sublease, and Lessor may collect such Rent and apply same toward Lessee's obligations under this Lease; provided, however, that until a Breach shall occur in the performance of Lessee's obligations, Lessee may collect said Rent. Lessor shall not, by reason of the foregoing or any assignment of such sublease, nor by reason of the collection of Rent, be deemed liable to the sublessee for any failure of Lessee to perform and comply with any of Lessee's obligations to such sublessee. Lessee hereby irrevocably authorizes and directs any such sublessee, upon receipt of a written notice PAGE 7 8 from Lessor stating that a Breach exists in the performance of Lessee's obligations under this Lease, to pay to Lessor all Rent due and to become due under the sublease. Sublessee shall rely upon any such notice from Lessor and shall pay all Rents to Lessor without any obligation or right to inquire as to whether such Breach exists, notwithstanding any claim from Lessee to the contrary. (b) In the event of a Breach by Lessee, Lessor may, at its option, require sublessee to attorn to Lessor, in which event Lessor shall undertake the obligations of the sublessor under such sublease from the time of the exercise of said option to the expiration of such sublease; provided, however, Lessor shall not be liable for any prepaid rents or security deposit paid by such sublessee to such sublessor or for any prior Defaults or Breaches of such sublessor. (c) Any matter requiring the consent of the sublessor under a sublease shall also require the consent of Lessor. (d) No sublessee shall further assign or sublet all or any part of the Premises without Lessor's prior written consent. (e) Lessor shall deliver a copy of any notice of Default or Breach by Lessee to the sublessee, who shall have the right to cure the Default of Lessee within the grace period, if any, specified in such notice. The sublessee shall have a right of reimbursement and offset from and against Lessee for any such Defaults cured by the sublessee. 13. DEFAULT; BREACH; REMEDIES. 13.1 DEFAULT; BREACH. A "DEFAULT" is defined as a failure by the Lessee to comply with or perform any of the terms, covenants, conditions or rules under this Lease. A "BREACH" is defined as the occurrence of one or more of the following Defaults, and the failure of Lessee to cure such Default within any applicable grace period: (a) The abandonment of the Premises; or the vacating of the Premises without providing a commercially reasonable level of security, or where the coverage of the property insurance described in Paragraph 8.3 is jeopardized as a result thereof, or without providing reasonable assurances to minimize potential vandalism. (b) The failure of Lessee to make any payment of Rent or any Security Deposit required to be made by Lessee hereunder, whether to Lessor or to a third party, when due, to provide reasonable evidence of insurance or surety bond, or to fulfill any obligation under this Lease which endangers or threatens life or property, where such failure continues for a period of three (3) business days following written notice to Lessee. (c) The failure by Lessee to provide (i) reasonable written evidence of compliance with Applicable Requirements, (ii) the service contracts, (iii) the rescission of an unauthorized assignment or subletting, (iv) a Estoppel Certificate, (v) a requested subordination, (vi) evidence concerning any guaranty and/or Guarantor, (vii) any document requested under Paragraph 42 (easements), or (viii) any other documentation or information which Lessor may reasonably require of Lessee under the terms of this Lease, where any such failure continues for a period of thirty (30) days following written notice to Lessee. (d) A Default by Lessee as to the terms, covenants, conditions or provisions of this Lease, or of the rules adopted under Paragraph 40 hereof, other than those described in subparagraphs 13.1(a), (b) or (c), above, where such Default continues for a period of thirty (30) days after written notice; provided, however, that if the nature of Lessee's Default is such that more than thirty (30) days are reasonably required for its cure, then it shall not be deemed to be a Breach if Lessee commences such cure within said thirty (30) day period and thereafter diligently prosecutes such cure to completion. (e) The occurrence of any of the following events: (i) the making of any general arrangement or assignment for the benefit of creditors; (ii) becoming a "DEBTOR" as defined in 11 U.S.C. Section 101 or any successor statute thereto (unless, in the case of a petition filed against Lessee, the same is dismissed within sixty (60) days); (iii) the appointment of a trustee or receiver to take possession of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where possession is not restored to Lessee within thirty (30) days; or (iv) the attachment, execution or other judicial seizure of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where such seizure is not discharged within thirty (30) days; provided, however, in the event that any provision of this subparagraph (e) is contrary to any applicable law, such provision shall be of no force or effect, and not affect the validity of the remaining provisions. (f) The discovery that any financial statement of Lessee or of any Guarantor given to Lessor was materially false. (g) If the performance of Lessee's obligations under this Lease is guaranteed: (i) the death of a Guarantor, (ii) the termination of a Guarantor's liability with respect to this Lease other than in accordance with the terms of such guaranty, (iii) a Guarantor's becoming insolvent or the subject of a bankruptcy filing, (iv) a Guarantor's refusal to honor the guaranty, or (v) a Guarantor's breach of its guaranty obligation on an anticipatory basis, and Lessee's failure, within sixty (60) days following written notice of any such event, to provide written alternative assurance or security, which, when coupled with the then existing resources of Lessee, equals or exceeds the combined financial resources of Lessee and the Guarantors that existed at the time of execution of this Lease. 13.2 REMEDIES. If Lessee fails to perform any of its affirmative duties or obligations, within ten (10) days after written notice (or in case of an emergency, without notice), Lessor may, at its option, perform such duty or obligation on Lessee's behalf, including but not limited to the obtaining of reasonably required bonds, insurance policies, or governmental licenses, permits or approvals. The costs and expenses of any such performance by Lessor shall be due and payable by Lessee upon receipt of invoice therefor. If any check given to Lessor by Lessee shall not be honored by the bank upon which it is drawn, Lessor, at its option, may require all future payments to be made by Lessee to be by cashier's check. In the event of a Breach, Lessor may, with or without further notice or demand, and without limiting Lessor in the exercise of any right or remedy which Lessor may have by reason of such Breach: (a) Terminate Lessee's right to possession of the Premises by any lawful means, in which case this Lease shall terminate and Lessee shall immediately surrender possession to Lessor. In such event Lessor shall be entitled to recover from Lessee: (i) the unpaid Rent which had been earned at the time of termination; (ii) the worth at the time of award of the amount by which the unpaid rent which would have been earned after termination until the time of award exceeds the amount of such rental loss that the Lessee proves could have been reasonably avoided; (iii) the worth at the time of award of the amount by which the unpaid rent for the balance of the term after the time of award exceeds the amount of such rental loss that the Lessee proves could be reasonably avoided; and (iv) any other amount necessary to compensate Lessor for all the detriment proximately caused by the Lessee's failure to perform its obligations under this Lease or which in the ordinary course of things would be likely to result therefrom, including but not limited to the cost of recovering possession of the Premises, expenses of reletting, including necessary renovation and alteration of the Premises, reasonable attorneys' fees, and that portion of any leasing commission paid by Lessor in connection with this Lease applicable to the unexpired term of this Lease. The worth at the time of award of the amount referred to in provision (iii) of the immediately preceding sentence shall be computed by discounting such amount at the discount rate of the Federal Reserve Bank of the District within which the Premises are located at the time of award plus one percent (1%). Efforts by Lessor to mitigate damages caused by Lessee's Breach of this Lease shall not waive Lessor's right to recover damages under Paragraph 12. If termination of this Lease is obtained through the provisional remedy of unlawful detainer, Lessor shall have the right to recover in such proceeding any unpaid Rent and damages as are recoverable therein, or Lessor may reserve the right to recover all or any part thereof in a separate suit. If a notice and grace period required under Paragraph 13.1 was not previously given, a notice to pay rent or quit, or to perform or quit given to Lessee under the unlawful detainer statute shall also constitute the notice required by Paragraph 13.1. In such case, the applicable grace period required by Paragraph 13.1 and the unlawful detainer statute shall run concurrently, and the failure of Lessee to cure the Default within the greater of the two such grace periods shall constitute both an unlawful detainer and a Breach of this Lease entitling Lessor to the remedies provided for in this Lease and/or by said statute. (b) Continue the Lease and Lessee's right to possession and recover the Rent as it becomes due, in which event Lessee may sublet or assign, subject only to reasonable limitations. Acts of maintenance, efforts to relet, and/or the appointment of a receiver to protect the Lessor's interests, shall not constitute a termination of the Lessee's right to possession. (c) Pursue any other remedy now or hereafter available under the laws or judicial decisions of the state wherein the Premises are located. The expiration or termination of this Lease and/or the termination of Lessee's right to possession shall not relieve Lessee from liability PAGE 8 9 under any indemnity provisions of this Lease as to matters occurring or accruing during the term hereof or by reason of Lessee's occupancy of the Premises. 13.3 INTENTIONALLY OMITTED 13.4 LATE CHARGES. Lessee hereby acknowledges that late payment by Lessee of Rent will cause Lessor to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to ascertain. Such costs include, but are not limited to, processing and accounting charges, and late charges which may be imposed upon Lessor by any Lender. Accordingly, if any Rent shall not be received by Lessor within five (5) days after such amount shall be due, then, without any requirement for notice to Lessee, Lessee shall pay to Lessor a one-time late charge equal to five percent (5%) of each such overdue amount. The Parties hereby agree that such late charge represents a fair and reasonable estimate of the costs Lessor will incur by reason of such late payment. Acceptance of such late charge by Lessor shall in no event constitute a waiver of Lessee's Default or Breach with respect to such overdue amount, nor prevent the exercise of any of the other rights and remedies granted hereunder. 13.5 INTEREST. Any monetary payment due Lessor hereunder, other than late charges, not received by Lessor, within five (5) days of when due as to scheduled payments (such as Base Rent) or within thirty (30) days following the date on which it was due for non-scheduled payment, shall bear interest from the date when due, as to scheduled payments, or the thirty-first (31st) day after it was due as to non-scheduled payments. The interest ("INTEREST") charged shall be equal to ten percent (10%) per annum. 13.6 BREACH BY LESSOR. (a) NOTICE OF BREACH. Lessor shall not be deemed in breach of this Lease unless Lessor fails within a reasonable time to perform an obligation required to be performed by Lessor. For purposes of this Paragraph, a reasonable time shall in no event be less than thirty (30) days after receipt by Lessor, and any Lender whose name and address shall have been furnished Lessee in writing for such purpose, of written notice specifying wherein such obligation of Lessor has not been performed; provided, however, that if the nature of Lessor's obligation is such that more than thirty (30) days are reasonably required for its performance, then Lessor shall not be in breach if performance is commenced within such thirty (30) day period and thereafter diligently pursued to completion. (b) PERFORMANCE BY LESSEE ON BEHALF OF LESSOR. In the event that neither Lessor nor Lender cures said breach within thirty (30) days after receipt of said notice, or if having commenced said cure they do not diligently pursue it to completion, then Lessee may elect to cure said breach at Lessee's expense and offset from Rent an amount equal to the greater of one month's Base Rent or the Security Deposit, and to pay an excess of such expense under protest, reserving Lessee's right to reimbursement from Lessor. Lessee shall document the cost of said cure and supply said documentation to Lessor. 14. CONDEMNATION. If the Premises or any portion thereof are taken under the power of eminent domain or sold under the threat of the exercise of said power (collectively "CONDEMNATION"), this Lease shall terminate as to the part taken as of the date the condemning authority takes title or possession, whichever first occurs. If more than ten percent (10%) of any building portion of the premises, or more than twenty-five percent (25%) of the land area portion of the premises not occupied by any building, is taken by Condemnation, Lessee may, at Lessee's option, to be exercised in writing within ten (10) days after Lessor shall have given Lessee written notice of such taking (or in the absence of such notice, within ten (10) days after the condemning authority shall have taken possession) terminate this Lease as of the date the condemning authority takes such possession. If Lessee does not terminate this Lease in accordance with the foregoing, this Lease shall remain in full force and effect as to the portion of the Premises remaining, except that the Base Rent shall be reduced in proportion to the reduction in utility of the Premises caused by such Condemnation. Condemnation awards and/or payments shall be the property of Lessor, whether such award shall be made as compensation for diminution in value of the leasehold, the value of the part taken, or for severance damages; provided, however, that Lessee shall be entitled to any compensation for Lessee's relocation expenses, loss of business goodwill and/or Trade Fixtures, without regard to whether or not this Lease is terminated pursuant to the provisions of this Paragraph. All Alterations and Utility Installations made to the Premises by Lessee, for purposes of Condemnation only, shall be considered the property of the Lessee and Lessee shall be entitled to any and all compensation which is payable therefor. In the event that this Lease is not terminated by reason of the Condemnation, Lessor shall repair any damage to the Premises caused by such Condemnation. 16. ESTOPPEL CERTIFICATES. (a) Each Party (as "RESPONDING PARTY") shall within ten (10) days after written notice from the other Party (the "REQUESTING PARTY") execute, acknowledge and deliver to the Requesting Party a statement in writing in form similar to the then most current "ESTOPPEL CERTIFICATE" form published by the American Industrial Real Estate Association, plus such additional information, confirmation and/or statements as may be reasonably requested by the Requesting Party. (b) If the Responding Party shall fail to execute or deliver the Estoppel Certificate within such ten day period, the Requesting Party may execute an Estoppel Certificate stating that: (i) the Lease is in full force and effect without modification except as may be represented by the Requesting Party, (ii) there are no uncured defaults in the Requesting Party's performance, and (iii) if Lessor is the Requesting Party, not more than one month's Rent has been paid in advance. Prospective purchasers and encumbrancers may rely upon the Requesting Party's Estoppel Certificate, and the Responding Party shall be estopped from denying the truth of the facts contained in said Certificate. PAGE 9 10 (c) If Lessor desires to finance, refinance, or sell the Premises, or any part thereof, Lessee and all Guarantors shall deliver to any potential lender or purchaser designated by Lessor such financial statements as may be reasonably required by such lender or purchaser, including, but not limited to, Lessee's financial statements for the past three (3) years. All such financial statements shall be received by Lessor and such lender or purchaser in confidence and shall be used only for the purposes herein set forth. 16. INTENTIONALLY OMITTED 17. DEFINITION OF LESSOR. The term "LESSOR" as used herein shall mean the owner or owners at the time in question of the fee title to the Premises, or, if this is a sublease, of the Lessee's interest in the prior lease. In the event of a transfer of Lessor's title or interest in the Premises or this Lease, Lessor shall deliver to the transferee or assignee (in cash or by credit) any unused Security Deposit held by Lessor. Except as provided in Paragraph 15, upon such transfer or assignment and delivery of the Security Deposit, as aforesaid, the prior Lessor shall be relieved of all liability with respect to the obligations and/or covenants under this Lease thereafter to be performed by the Lessor. Subject to the foregoing, the obligations and/or covenants in this Lease to be performed by the Lessor shall be binding only upon the Lessor as hereinabove defined. Notwithstanding the above, and subject to the provisions of Paragraph 20 below, the original Lessor under this Lease, and all subsequent holders of the Lessor's interest in this Lease shall remain liable and responsible with regard to the potential duties and liabilities of Lessor pertaining to Hazardous Substances as outlined in Paragraph 6 above. 18. SEVERABILITY. The invalidity of any provision of this Lease, as determined by a court of competent jurisdiction, shall in no way affect the validity of any other provision hereof. 19. DAYS. Unless otherwise specifically indicated to the contrary, the word "days" as used in this Lease shall mean and refer to calendar days. 20. LIMITATION ON LIABILITY. Subject to the provisions of Paragraph 17 above, the obligations of Lessor under this Lease shall not constitute personal obligations of Lessor, the individual partners of Lessor or its or their individual partners, directors, officers or shareholders, and Lessee shall look to the Premises, and to no other assets of Lessor, for the satisfaction of any liability of Lessor with respect to this Lease, and shall not seek recourse against the individual partners of Lessor, or its or their individual partners, directors, officers or shareholders, or any of their personal assets for such satisfaction. 21. TIME OF ESSENCE. Time is of the essence with respect to the performance of all obligations to be performed or observed by the Parties under this Lease. 22. NO PRIOR OR OTHER AGREEMENTS; BROKER DISCLAIMER. This Lease contains all agreements between the Parties with respect to any matter mentioned herein, and no other prior or contemporaneous agreement or understanding shall be effective. Lessor and Lessee each represents and warrants to the Brokers that it has made, and is relying solely upon, its own investigation as to the nature, quality, character and financial responsibility of the other Party to this Lease and as to the nature, quality and character of the Premises. Brokers have no responsibility with respect thereto or with respect to any default or breach hereof by either Party. The liability (including court costs and Attorneys' fees), of any Broker with respect to negotiation, execution, delivery or performance by either Lessor or Lessee under this Lease or any amendment or modification hereto shall be limited to an amount up to the fee received by such Broker pursuant to this Lease; provided, however, that the foregoing limitation on each Broker's liability shall not be applicable to any gross negligence or willful misconduct of such Broker. 23. NOTICES. 23.1 NOTICE REQUIREMENTS. All notices required or permitted by this Lease shall be in writing and may be delivered in person (by hand or by courier) or may be sent by regular, certified or registered mail or U.S. Postal Service Express Mail, with postage prepaid, or by facsimile transmission, and shall be deemed sufficiently given if served in a manner specified in this Paragraph 23. The addresses noted adjacent to a Party's signature on this Lease shall be that Party's address for delivery or mailing of notices. Either Party may by written notice to the other specify a different address for notice, except that upon Lessee's taking possession of the Premises, the Premises shall constitute Lessee's address for notice. A copy of all notices to Lessor shall be concurrently transmitted to such party or parties at such addresses as Lessor may from time to time hereafter designate in writing. 23.2 DATE OF NOTICE. Any notice sent by registered or certified mail, return receipt requested, shall be deemed given on the date of delivery shown on the receipt card, or if no delivery date is shown, the postmark thereon. If sent by regular mail the notice shall be deemed given forty-eight (48) hours after the same is addressed as required herein and mailed with postage prepaid. Notices delivered by United States Express Mail or overnight courier that guarantee next day delivery shall be deemed given twenty-four (24) hours after delivery of the same to the Postal Service or courier. Notices transmitted by facsimile transmission or similar means shall be deemed delivered upon telephone confirmation of receipt, provided a copy is also delivered via delivery or mail. If notice is received on a Saturday, Sunday or legal holiday, it shall be deemed received on the next business day. 24. WAIVERS. No waiver by Lessor of the Default or Breach of any term, covenant or condition hereof by Lessee, shall be deemed a waiver of any other term, covenant or condition hereof, or of any subsequent Default or Breach by Lessee of the same or of any other term, covenant or condition hereof. Lessor's consent to, or approval of, any act shall not be deemed to render unnecessary the obtaining of Lessor's consent to, or approval of, any subsequent or similar act by Lessee, or be construed as the basis of an estoppel to enforce the provision or provisions of this Lease requiring such consent. The acceptance of Rent by Lessor shall not be a waiver of any Default or Breach by Lessee. Any payment by Lessee may be accepted by Lessor on account of monies or damages due Lessor, notwithstanding any qualifying statements or conditions made by Lessee in connection therewith, which such statements and/or conditions shall be of no force or effect whatsoever unless specifically agreed to in writing by Lessor at or before the time of deposit of such payment. 25. RECORDING. Either Lessor or Lessee shall, upon request of the other, execute, acknowledge and deliver to the other a short form memorandum of this Lease for recording purposes. The Party requesting recordation shall be responsible for payment of any fees applicable thereto. 26. NO RIGHT TO HOLDOVER. Lessee has no right to retain possession of the Premises or any part thereof beyond the expiration or termination of this Lease. In the event that Lessee holds over, then the Base Rent shall be increased to one hundred fifty percent (150%) of the Base Rent applicable during the month immediately preceding the expiration or termination. Nothing contained herein shall be construed as consent by Lessor to any holding over by Lessee. 27. CUMULATIVE REMEDIES. No remedy or election hereunder shall be deemed exclusive but shall, wherever possible, be cumulative with all other remedies at law or in equity. 28. COVENANTS AND CONDITIONS; CONSTRUCTION OF AGREEMENT. All provisions of this Lease to be observed or performed by Lessee are both covenants and conditions. In construing this Lease, all headings and titles are for the convenience of the Parties only and shall not be considered a part of this Lease. Whenever required by the context, the singular shall include the plural and vice versa. This Lease shall not be construed as if prepared by one of the Parties, but rather according to its fair meaning as a whole, as if both Parties had prepared it. 29. BINDING EFFECT; CHOICE OF LAW. This Lease shall be binding upon the parties, their personal representatives, successors and assigns and be governed by the laws of the State in which the Premises are located. Any litigation between the Parties hereto concerning this Lease shall be initiated in the county in which the Premises are located. 30. SUBORDINATION; ATTORNMENT; NON-DISTURBANCE. 30.1 SUBORDINATION. This Lease and any Option granted hereby shall be subject and subordinate to any ground lease, mortgage, deed of trust, or other hypothecation or security device (collectively, "SECURITY DEVICE"), now or hereafter placed upon the Premises, to any and all advances made on the security thereof, and to all renewals, modifications, and extensions thereof. Lessee agrees that the holders of any such Security Devices (in this Lease together referred to as "Lessor's Lender") shall have no liability or obligation to perform any of the obligations of Lessor under this Lease. Any Lender may elect to have this Lease and/or any Option granted hereby superior to the lien of its Security Device by giving written notice thereof to Lessee, whereupon this Lease and such Options shall be deemed prior to such Security Device, notwithstanding the relative dates of the documentation or recordation thereof. 30.2 ATTORNMENT. Subject to the non-disturbance provisions of Paragraph 30.3, Lessee agrees to attorn to a Lender or any other party who acquires ownership of the Premises by reason of a foreclosure of a Security Device, and that in the event of such foreclosure, such new PAGE 10 11 owner shall not: (i) be liable for any act or omission of any prior lessor or with respect to events occurring prior to acquisition of ownership; (ii) be subject to any offsets or defenses which Lessee might have against any prior lessor; or (iii) be bound by prepayment of more than one (1) month's rent. 30.3 NON-DISTURBANCE. With respect to Security Devices entered into by Lessor after the execution of this Lease, Lessee's subordination of this Lease shall be subject to receiving a commercially reasonable non-disturbance agreement (a "NON-DISTURBANCE AGREEMENT") from the Lender which Non-Disturbance Agreement provides that Lessee's possession of the Premises, and this Lease, including any options to extend the term hereof, will not be disturbed so long as Lessee is not in Breach hereof and attorns to the record owner of the Premises. Further, within sixty (60) days after the execution of this Lease, Lessor shall use its commercially reasonable efforts to obtain a Non-Disturbance Agreement from the holder of any pre-existing Security Device which is secured by the Premises. In the event that Lessor is unable to provide the Non-Disturbance Agreement within said sixty (60) days, then Lessee may, at Lessee's option, directly contact Lessor's lender and attempt to negotiate for the execution and delivery of a Non-Disturbance Agreement. 30.4 SELF-EXECUTING. The agreements contained in this Paragraph 30 shall be effective without the execution of any further documents; provided, however, that, upon written request from Lessor or a Lender in connection with a sale, financing or refinancing of the Premises, Lessee and Lessor shall execute such further writings as may be reasonably required to separately document any subordination, attornment and/or Non-Disturbance Agreement provided for herein. 31. ATTORNEYS' FEES. If any Party or Broker brings an action or proceeding involving the Premises to enforce the terms hereof or to declare rights hereunder, the Prevailing Party (as hereafter defined) in any such proceeding, action, or appeal thereon, shall be entitled to reasonable attorneys' fees. Such fees may be awarded in the same suit or recovered in a separate suit, whether or not such action or proceeding is pursued to decision or judgment. The term, "PREVAILING PARTY" shall include, without limitation, a Party or Broker who substantially obtains or defeats the relief sought, as the case may be, whether by compromise, settlement, judgment, or the abandonment by the other Party or Broker of its claim or defense. The attorneys' fees award shall not be computed in accordance with any court fee schedule, but shall be such as to fully reimburse all attorneys' fees reasonably incurred. In addition, Lessor shall be entitled to attorneys' fees, costs and expenses incurred in the preparation and service of notices of Default and consultations in connection therewith, whether or not a legal action is subsequently commenced in connection with such Default or resulting Breach. 32. LESSOR'S ACCESS; SHOWING PREMISES; REPAIRS. Lessor and Lessor's agents shall have the right to enter the Premises at any time, in the case of an emergency, and otherwise at reasonable times for the purpose of making such alterations, repairs, improvements or additions to the Premises as Lessor may deem necessary. All such activities shall be without abatement of rent or liability to Lessee. Lessee may at any time place on or about the Premises any ordinary "FOR SUBLEASE" sign. 33. AUCTIONS. Lessee shall not conduct, nor permit to be conducted, any auction upon the Premises without Lessor's prior written consent. Lessor shall not be obligated to exercise any standard of reasonableness in determining whether to permit an auction. 34. SIGNS. Subject to compliance with all Applicable Requirements and reasonable approval by Lessor, Lessee shall be entitled to all signage rights on the Premises. All signs must comply with all Applicable Requirements. 35. TERMINATION; MERGER. Unless specifically stated otherwise in writing by Lessor, the voluntary or other surrender of this Lease by Lessee, the mutual termination or cancellation hereof, or a termination hereof by Lessor for Breach by Lessee, shall automatically terminate any sublease or lesser estate in the Premises; provided, however, that Lessor may elect to continue any one or all existing subtenancies. Lessor's failure within ten (10) days following any such event to elect to the contrary by written notice to the holder of any such lesser interest, shall constitute Lessor's election to have such event constitute the termination of such interest. 36. CONSENTS. Except as otherwise provided herein, wherever in this Lease the consent of a Party is required to an act by or for the other Party, such consent shall not be unreasonably withheld or delayed. Lessor's actual reasonable costs and expenses (including, but not limited to, architects', attorneys', engineers' and other consultants' fees) incurred in the consideration of, or response to, a request by Lessee for any Lessor consent, including, but not limited to, consents to an assignment, a subletting or the presence or use of a Hazardous Substance, shall be paid by Lessee upon receipt of an invoice and supporting documentation therefor. Lessor's consent to any act, assignment or subletting shall not constitute an acknowledgment that no Default or Breach by Lessee of this Lease exists, nor shall such consent be deemed a waiver of any then existing Default or Breach, except as may be otherwise specifically stated in writing by Lessor at the time of such consent. The failure to specify herein any particular condition to Lessor's consent shall not preclude the imposition by Lessor at the time of consent of such further or other conditions as are then reasonable with reference to the particular matter for which consent is being given. In the event that either Party disagrees with any determination made by the other hereunder and reasonably requests the reasons for such determination, the determining party shall furnish its reasons in writing and in reasonable detail within ten (10) business days following such request. 37. INTENTIONALLY OMITTED. 38. QUIET POSSESSION. Subject to payment by Lessee of the Rent and performance of all of the covenants, conditions and provisions on Lessee's part to be observed and performed under this Lease, Lessee shall have quiet possession and quiet enjoyment of the Premises during the term hereof. 39. OPTIONS. 39.1 DEFINITION. "OPTION" shall mean: (a) the right to extend the term of or renew this Lease. 39.4 EFFECT OF DEFAULT ON OPTIONS. (a) Lessee shall have no right to exercise an Option: (i) during the period commencing with the giving of any notice of Default and continuing until said Default is cured, (ii) during the period of time any Rent is unpaid (without regard to whether notice thereof is given Lessee), (iii) during the time Lessee is in Breach of this Lease, or (iv) in the event that Lessee has been given three (3) or more notices of separate Default, whether or not the Defaults are cured, during the twelve (12) month period immediately preceding the exercise of the Option. (b) The period of time within which an Option may be exercised shall not be extended or enlarged by reason of Lessee's inability to exercise an Option because of the provisions of Paragraph 39.4(a). (c) An Option shall terminate and be of no further force or effect, notwithstanding Lessee's due and timely exercise of the Option, if, after such exercise and prior to the commencement of the extended term, (i) Lessee fails to pay Rent for a period of thirty (30) days after such Rent becomes due (without any necessity of Lessor to give notice thereof), (ii) Lessor gives to Lessee three (3) or more notices of separate Default during any twelve (12) month period, whether or not the Defaults are cured, or (iii) if Lessee commits a material uncured Breach of this Lease. PAGE 11 12 the care and cleanliness of the grounds and including the parking, loading and unloading of vehicles, and that Lessee will pay its fair share of common expenses incurred in connection therewith. 40. INTENTIONALLY OMITTED. 41. SECURITY MEASURES. Lessee hereby acknowledges that the rental payable to Lessor hereunder does not include the cost of guard service or other security measures, and that Lessor shall have no obligation whatsoever to provide same. Lessee assumes all responsibility for the protection of the Premises, Lessee, its agents and invitees and their property from the acts of third parties. 42. RESERVATIONS. Lessor reserves to itself the right, from time to time, to grant, without the consent or joinder of Lessee, such easements, rights and dedications that Lessor deems necessary, and to cause the recordation of parcel maps and restrictions, so long as such easements, rights, dedications, maps and restrictions do not unreasonably interfere with the use of the Premises by Lessee. Lessee agrees to sign any documents reasonably requested by Lessor to effectuate any such easement rights, dedication, map or restrictions. 43. PERFORMANCE UNDER PROTEST. If at any time a dispute shall arise as to any amount or sum of money to be paid by one Party to the other under the provisions hereof, the Party against whom the obligation to pay the money is asserted shall have the right to make payment "under protest" and such payment shall not be regarded as a voluntary payment and there shall survive the right on the part of said Party to institute suit for recovery of such sum. If it shall be adjudged that there was no legal obligation on the part of said Party to pay such sum or any part thereof, said Party shall be entitled to recover such sum or so much thereof as it was not legally required to pay. 44. AUTHORITY. If either Party hereto is a corporation, trust, limited liability company, partnership, or similar entity, each individual executing this Lease on behalf of such entity represents and warrants that he or she is duly authorized to execute and deliver this Lease on its behalf. Each Party shall, within thirty (30) days after request, deliver to the other Party satisfactory evidence of such authority. 45. CONFLICT. Any conflict between the printed provisions of this Lease and the typewritten or handwritten provisions shall be controlled by the typewritten or handwritten provisions. 46. OFFER. Preparation of this Lease by either Party or their agent and submission of same to the other Party shall not be deemed an offer to lease to the other Party. This Lease is not intended to be binding until executed and delivered by all Parties hereto. 47. AMENDMENTS. This Lease may be modified only in writing, signed by the Parties in interest at the time of the modification. As long as they do not materially change Lessee's obligations hereunder, Lessee agrees to make such reasonable non-monetary modifications to this Lease as may be reasonably required by a Lender in connection with the obtaining of normal financing or refinancing of the Premises. 48. MULTIPLE PARTIES. If more than one person or entity is named herein as either Lessor or Lessee, such multiple Parties shall have joint and several responsibility to comply with the terms of this Lease. 49. MEDIATION AND ARBITRATION OF DISPUTES. An Addendum requiring the Mediation and/or the Arbitration of all disputes between the Parties and/or Brokers arising out of this Lease [ ] IS [ ] IS NOT attached to this Lease. 50. See Addendum 50. LESSOR AND LESSEE HAVE CAREFULLY READ AND REVIEWED THIS LEASE AND EACH TERM AND PROVISION CONTAINED HEREIN, AND BY THE EXECUTION OF THIS LEASE SHOW THEIR INFORMED AND VOLUNTARY CONSENT THERETO. THE PARTIES HEREBY AGREE THAT, AT THE TIME THIS LEASE IS EXECUTED, THE TERMS OF THIS LEASE ARE COMMERCIALLY REASONABLE AND EFFECTUATE THE INTENT AND PURPOSE OF LESSOR AND LESSEE WITH RESPECT TO THE PREMISES. ________________________________________________________________________________ ATTENTION: NO REPRESENTATION OR RECOMMENDATION IS MADE BY THE AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION OR BY ANY BROKER AS TO THE LEGAL SUFFICIENCY, LEGAL EFFECT, OR TAX CONSEQUENCES OF THIS LEASE OR THE TRANSACTION TO WHICH IT RELATES. THE PARTIES ARE URGED TO: 1. SEEK ADVICE OF COUNSEL AS TO THE LEGAL AND TAX CONSEQUENCES OF THIS LEASE. 2. RETAIN APPROPRIATE CONSULTANTS TO REVIEW AND INVESTIGATE THE CONDITION OF THE PREMISES. SAID INVESTIGATION SHOULD INCLUDE BUT NOT BE LIMITED TO: THE POSSIBLE PRESENCE OF HAZARDOUS SUBSTANCES, THE ZONING OF THE PREMISES, THE STRUCTURAL INTEGRITY, THE CONDITION OF THE ROOF AND OPERATING SYSTEMS, AND THE SUITABILITY OF THE PREMISES FOR LESSEE'S INTENDED USE. WARNING: IF THE PREMISES IS LOCATED IN A STATE OTHER THAN CALIFORNIA, CERTAIN PROVISIONS OF THE LEASE MAY NEED TO BE REVISED TO COMPLY WITH THE LAWS OF THE STATE IN WHICH THE PREMISES IS LOCATED. ________________________________________________________________________________ The parties hereto have executed this Lease at the place and on the dates specified above their respective signatures. Executed at:_________________________ Executed at:___________________________ on:__________________________________ on:____________________________________ By LESSOR: By LESSEE: KRDS, INC., LITRONIC INC., a California corporation a Delaware corporation By: /s/ Dilip Shah By: /s/ Kris Shah Name Printed: DILIP SHAH Name Printed: KRIS SHAH Title: Partner KRDS Title: CEO By:__________________________________ By:____________________________________ Name Printed:________________________ Name Printed:__________________________ Title:_______________________________ Title:_________________________________ Address:_____________________________ Address:_______________________________ _____________________________ _______________________________ Telephone: ( )_____________________ Telephone: ( )_______________________ Facsimile: ( )_____________________ Facsimile: ( )_______________________ Federal ID No._______________________ Federal ID No._________________________ NOTE: These forms are often modified to meet the changing requirements of law and industry needs. Always write or call to make sure you are utilizing the most current form: AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION, 700 So. Flower Street, Suite 600, Los Angeles, California 90017. (213) 687-8777. Fax No. (213) 687-8616 PAGE 12 13 ADDENDUM TO STANDARD INDUSTRIAL/COMMERCIAL SINGLE-TENANT LEASE - NET This Addendum is attached to and forms a part of that certain Standard Industrial /Commercial Single Tenant Lease - Net dated January 2, 2000, by and between KRDS, INC., a California corporation, as Lessor and LITRONIC INDUSTRIES, INC., a California corporation, as Lessee, for the Premises located at 17861 Cartwright, Irvine, California (the "Lease"). This Addendum modifies and supplements the Lease by adding the following paragraphs thereto: 1. BASE RENT. Base Rent shall be increased each lease year in accordance with the following schedule and shall be further increased upon commencement of the Extension Term in accordance with Paragraph 2 of this Addendum. (In the event that the term commences on a day other than the first day of a calendar month, the first month in the following table shall be the first full calendar month following the commencement of the term): Months Monthly Base Rent 01 - 12 $31,674.06 13 - 24 $32,941.02 25 - 36 $34,258.66 37 - 48 $35,629.01 49 - 60 $37,054.17 61 - 72 $38,536.34 73 - 84 $40,077.79 2. EXTENSION OPTION. (a) Provided Lessee is not in Breach or Default under this Lease, and no event or circumstance has occurred which, with the giving of notice or the passage of time, or both, would constitute a Default or Breach under this Lease, Lessee shall have one (1) option to extend the term of this Lease (the "Extension Option") for a five (5) year period (the "Extension Term"). (b) The Extension Term shall commence when the Original Term expires. The Extension Term shall be on all of the same terms and conditions as applicable to the Original Term, except for the Base Rent, which shall be determined as provided hereinbelow. (c) Lessee shall exercise the Extension Option, if at all, by delivering to Lessor written notice of Lessee's election to exercise such Extension Option not less than six (6) months prior to expiration of the Original Term. (d) Effective as of commencement of the Extension Term (the "FMRR Adjustment Date"), the Base Rent then payable under the Lease shall be adjusted to an amount equal to the greater of (i) the Fair Market Rental Rate of the Premises ("FMRR") determined as provided hereinbelow; or (ii) one hundred four percent (104%) of the Base Rent payable immediately prior to the Extension Term. For purposes of this Lease, FMRR shall mean the annual current rent per rentable square foot that a willing lessee would pay and a willing lessor would accept, dealing at arm's length, for comparable space as the Premises, giving consideration to annual rental rates per rentable square foot, improvements, escalations, the quality of construction of the building and the Premises and other generally applicable terms and consideration of tenancy for the space in question at or about the time that such FMRR is deemed to take effect. (e) The FMRR and new Base Rent for the Extension Term shall be determined as follows: (i) Lessor and Lessee shall attempt to agree upon the FMRR for the Extension Term within thirty (30) days after Lessee has exercised its Extension Option for the Extension Term. (ii) If Lessor and Lessee are unable to agree on the FMRR within such thirty (30) day period, then Lessor and Lessee shall, within ten (10) days thereafter, attempt to agree upon a mutually acceptable Appraiser (as defined hereinbelow) to establish the new FMRR. As used in this Lease, the term "Appraiser" shall mean a real estate broker with at least five (5) years' full-time experience in industrial building leasing in the geographic area in which the Premises are located. If Lessor and Lessee agree on an Appraiser, they shall appoint such Appraiser within ten (10) days thereafter, and such sole Appraiser shall, within thirty (30) days thereafter, determine the FMRR in accordance with this Lease. The cost of the sole Appraiser shall be borne equally by Lessor and Lessee. (iii) If Lessor and Lessee cannot agree on a mutually acceptable Appraiser within said ten (10) day period, then either party may, by giving notice to the other party, select and appoint the Appraiser of their choice to establish the FMRR. Each party shall bear the cost of the Appraiser appointed by it. If either party does not select an Appraiser within ten (10) days following receipt of written notice of the other party's selection of an Appraiser, then the Appraiser appointed by the other party shall be the sole Appraiser and shall, within thirty (30) days thereafter, determine the FMRR in accordance with this Lease. (iv) If two Appraisers are appointed by the parties, then the two Appraisers shall attempt, within thirty (30) days after appointment of the latter of them, to agree on the determination of the FMRR in accordance with this Lease. (v) If the two Appraisers cannot agree on the FMRR within such time period, then, within ten (10) days after expiration of such thirty (30) day period, then the two Appraisers shall select a third Appraiser, who shall have not previously acted in any capacity for Lessor, Lessee or either Appraiser. If the two Appraisers are unable to agree on the third Appraiser, either Lessor or Lessee, by giving ten (10) days' notice to the other party, can apply to the presiding judge of the Superior Court of Orange County, for the selection of a third Appraiser. The costs of the third Appraiser shall be equally borne by both Lessor and Lessee. (vi) Within thirty (30) days after the selection of the third Appraiser, a majority of the Appraisers shall determine the FMRR. If a majority of the Appraisers are unable to agree on the FMRR within such thirty (30) day period, the three determinations of the FMRR derived by each Appraiser shall be added together and their total divided by three (3); the resulting quotient shall be the FMRR; provided, however, that if the lowest determination of FMRR and/or the highest determination of FMRR are/is more than fifteen percent (15%) lower and/or higher than the middle determination of FMRR, the lowest and/or the highest determination of FMRR shall be discarded, and the others averaged together to determine the FMRR (or if both the lowest and highest determination are both discarded, the middle determination of FMRR shall control). (vii) Upon the establishment of the FMRR, the new Base Rent under the Lease shall be the greater of (i) the FMRR so established; or (ii) one hundred four percent (104%) of the Base Rent payable immediately prior to the Extension Term, which new Base Rent shall also be used for the purpose of calculating future increases in Base Rent under the Lease. (f) The Base Rent for the Extension Term, as determined pursuant to the foregoing, shall be increased annually, effective as of the anniversary of the commencement of the Extension Term, to one hundred four percent (104%) of the Base Rent payable during the prior lease year. 3. PARKING. Lessee shall have exclusive use of all parking located on the Premises. EX-10.15 3 a71207ex10-15.txt EXHIBIT 10.15 1 EXHIBIT 10.15 STRATEGIC DEVELOPMENT & MARKETING ALLIANCE AGREEMENT BETWEEN LITRONIC, INC. AND BIZ INTERACTIVE ZONE, INC. "AGREEMENT" THIS ALLIANCE AGREEMENT is made and entered into as of Sept. 05, 2000, by and between BIZ Interactive Zone, Inc., having an office at 2030 Main Street, Suite 1250, Irvine, CA 92614 (hereinafter referred to as "BIZ") and LITRONIC, INC., having an office at 17861 Cartwright Road, Irvine, CA 92614 (hereinafter referred to as "Litronic"). WHEREAS, BIZ and Litronic desire to form an alliance for the purpose of cooperatively developing the hardware and software technology that will enable BIZ to establish, deploy, and grow the worldwide industry standard for processing real-time, secure, transactions over the Internet. WHEREAS, BIZ has reviewed Litronic's products, and found the basic designs to be desirable; BIZ wishes to have Litronic develop and manufacture private labeled and derivative versions of the products for BIZ, using BIZ trademarks and with certain designs specified by BIZ in the case of derivative versions (the "Private Label Product" and "Derivative Products); and WHEREAS, BIZ is interested in purchasing on a private label contract manufacturing basis, certain models of Litronic's products, manufactured by Litronic using the trademark or tradename "BIZ" or other BIZ designations (said private label versions of Litronic's products to be hereinafter referred to as the "Private Label Products") and Litronic is willing to manufacture and sell the Private Label Products to BIZ under the terms and conditions as specified in this Agreement; and WHEREAS, BIZ is interested in purchasing on a private label contract manufacturing basis, derivative versions of certain models of Litronic's products, manufactured by Litronic using the trademark or tradename "BIZ" or other BIZ designations (said private label versions of Litronic's Products to be hereinafter referred to as the "Derivative Products") and Litronic is willing to manufacture and sell the Derivative Products to BIZ under the terms and conditions as specified in this Agreement; and WHEREAS, BIZ and Litronic desire to set forth the terms and conditions which shall apply to Purchase Orders issued by BIZ for the procurement of Litronic's products and service; and WHEREAS, Litronic is willing to provide quantities of such products to BIZ for marketing by BIZ in conjunction with BIZ's product series; and WHEREAS, BIZ is willing to accept and pay for certain quantities of such products under the terms and conditions of this agreement; and WHEREAS, BIZ intends to combine such product(s) with other products so as to market such products to end-users, and system integrators; NOW THEREFORE, the parties hereto agree as follows: 1 2 1. Definitions (a) "Private Label Products" means standard Litronic products labeled with the BIZ trade name with the tradename design and location specified by BIZ. (b) "Derivative Products" means those products that are derivatives of standard Litronic designs but with design modification and enhancement variations that meet the specifications of BIZ. 2. Term of Agreement This agreement shall be effective from the date first above written and shall continue for a period of Five (5) years, and unless noted to the contrary no later then sixty days before expiration, automatically renews annually. 3. Exclusivity of Undertaking The Derivative Products that Litronic designs, develops and manufactures, based on the specification provided by BIZ in consultation with Litronic and as specified in the Exhibit A attached hereto, shall be considered as the work made for hire for BIZ. 4. Trademark Rights Litronic shall use reasonable efforts to adhere to instructions received from BIZ regarding the placement of the "BIZ" or other designated tradename, service mark or trademark designated by BIZ, on the Private Label Products and Derivative Products. The Parties hereby expressly acknowledge the exclusive right, title, and interest of each Party in and to the Party's own trademark, service mark, trade name or trade dress, and of the goodwill and reputation appertaining thereto. Neither Party shall acquire any right, title or interest to, nor shall have any other right to use of the trade name, trademark, service mark, or trade dress of the other Party, or the goodwill and reputation appertaining thereto, except as pursuant to the order of the other Party (for example as regards to placing the "BIZ" tradename or trademark to such Private Label Products as are ordered by BIZ pursuant to this Agreement). 5. Industrial Property Rights It is hereby expressly agreed as between the Parties hereto, that any and all proprietary property rights in any feature or structure incorporated in the Derivative Products are and shall be solely the property of the Parties to this Agreement. Any BIZ industrial property, proprietary rights, or technology to be integrated into the Derivative Products must be specified by BIZ in writing prior to manufacture or design integration into said Private Label Products. 6. Purchase Orders A written Purchase Order shall be the basis for purchase of products under this agreement. All Purchase Orders shall be subject to the terms and conditions of this Agreement. Any terms or conditions contained upon BIZ's Purchase Order which add to or differ from the terms and conditions of this Agreement must be approved in writing by Litronic. The incorporation of any additional or different terms or liability in a BIZ's Purchase Order shall be deemed objected to by Litronic unless expressly accepted in writing by an authorized representative of Litronic at its office in Irvine, California. Acknowledgment of the receipt of any Purchase Order, including signing and returning to BIZ his acknowledgment copy, if any, shall not constitute acceptance by Litronic of 2 3 any additional or different terms or conditions, nor shall Litronic's commencement of effort, in itself, be construed as acceptance of any Order containing additional or different terms and conditions. The provisions of this Agreement will prevail over any terms and conditions contained in the BIZ's Purchase Order. 7. Prices As a result of this AGREEMENT, the specifications and prices shown in Exhibit A and B will prevail. (a) Prices do not include excise, sales, use, gross receipts, value added, property or other taxes, broker fees, customs duties and other similar charges which may be assessed or charged in connection with the sale, transportation or handling of the product(s) sold hereunder, and BIZ shall pay all such charges, and shall reimburse Litronic in full upon demand for all such charges which Litronic may be required to pay. (b) Prices do not include freight charges for transportation from Litronic's factory in Irvine, California, which charges shall be the responsibility of and paid by BIZ. (c) Prices include standard commercial packaging for each product or lot of products; special preservation and packing and/or export boxing is extra. (d) Prices do not include an installation/operating manual. One (1) copy of the installation/operating manual will be provided with each delivery of products to BIZ. A restricted license is hereby granted to copy and distribute each manual with product sold by BIZ. (e) Litronic may revise the prices herein, unless pricing is specifically guaranteed under purchase order for a period longer than 30 days. This price revision will be provided with thirty (30) days prior written notice. 8. Payment Terms. Subject to approval of BIZ's credit, the full net amount of each invoice is due and payable in cash or letter of credit from a chartered bank, within thirty (30) days of shipment. Lot shipments will be invoiced on a pro rata basis. Minor inadvertent administrative errors contained in an invoice are subject to correction and shall not constitute reason for untimely payment. 9. Price Warranty Litronic warrants that the terms and prices offered hereby are in compliance with all local, state and federal laws. 10. Freight, Insurance, Exporter's Charges, Duties All transportation costs, exporter's charges and insurance are the responsibility of the BIZ. Litronic will either (a) add these charges to the prices specified herein, (b) add these charges to Litronic's invoices as separate items, or (c) ship with charges to be collected by the carrier or exporter. Documentation and duties are the responsibility of the BIZ. 11. Shipment and Delivery. 3 4 (a) Shipment and delivery shall be F.O.B. Litronic's factory in Irvine, California, and title and risk of loss shall pass to BIZ upon delivery to a carrier at such time and place of shipment. Litronic shall not be liable for delay, damage, or breakage to the product(s) sold hereunder after delivery has been made to the carrier, and all claims for loss in respect thereof occasioned after such delivery shall be made to the responsible carrier. (b) In the absence of shipping instructions from BIZ, Litronic will use its discretion in selecting shipping services and routings. (c) Changes in shipping schedules requested by BIZ will require written approval by Litronic and the assumption by BIZ of all additional costs resulting therefrom. (d) BIZ may delay shipment of any product(s) purchased hereunder; provided however, that if such delay is in excess of sixty (60) days from the quoted date of shipment, Litronic may invoice BIZ for such product(s) and hold them at BIZ's risk and expense pending instructions from BIZ. In the event such delay extends beyond six (6) months from the quoted shipping date, BIZ agrees to pay prices in effect at the time of shipment. 12. Taxes Prices stated are net of any taxes applicable to the goods sold. BIZ shall be responsible for payment of any and all taxes due. 13. Title Title and risk of loss for products furnished by Litronic shall pass to BIZ upon delivery to a common carrier, or other delivery as directed by BIZ, at Litronic's plant. 14. Warranty and Limitation of Liability Litronic warrants its product(s) to the original purchaser, to be free from defects in material and workmanship and to be made in accordance with BIZ's specifications which have been accepted in writing by Litronic. In no event, however, shall Litronic be liable or have any responsibility under such warranty if the product(s) has been improperly stored, installed, used or maintained, if the product(s) is damaged or fails to operate properly as a result of interconnection with the equipment of BIZ, or if BIZ has permitted any unauthorized modifications, adjustments and/or repairs to be made to such product(s). Litronic's obligation hereunder is limited solely to repairing or replacing (at its option), at its factory, any product(s) or parts thereof, which prove to Litronic's satisfaction to be defective as a result of defective materials or workmanship within ninety (90) days from date (of shipment to the original BIZ); provided, however, that written notice of any claimed defect shall have been given to Litronic within thirty (30) days from the date any such defect is first discovered. The product(s) or part(s) claimed to be defective must be returned to Litronic, transportation pre-paid by BIZ, with written specification of the claimed defect. Evidence acceptable to Litronic must be furnished that the claimed defects were not caused by misuse, abuse, or neglect by anyone other than Litronic. Litronic's obligations hereunder do not include any responsibility for any costs occasioned by removal, claims, or remedies with respect to direct damage, loss of use, lost profits, or other secondary or consequential damage of any kind, however occasioned. Litronic's total obligation under this warrant is limited to the original purchase price of the products or services found to be defective within the terms of this warranty. THE FOREGOING WARRANTY IS IN LIEU OF ALL OTHER WARRANTIES (EXCEPT AS TO TITLE), WHETHER EXPRESS OR IMPLIED, INCLUDING WITHOUT LIMITATION, ANY WARRANTY OF MERCHANTABILITY OR OF FITNESS FOR ANY PARTICULAR PURPOSE, 4 5 OTHER THAN AS EXPRESSLY SET FORTH AND TO THE EXTENT SPECIFIED HEREIN, AND IS IN LIEU OF ALL OTHER OBLIGATIONS OR LIABILITIES ON THE PART OF LITRONIC. LITRONIC'S MAXIMUM LIABILITY WITH RESPECT TO THIS QUOTATION AND ANY RESULTING SALE, ARISING FROM ANY CAUSE WHATSOEVER, INCLUDING WITHOUT LIMITATION, BREACH OF CONTRACT OR NEGLIGENCE, SHALL NOT EXCEED THE PRICE SPECIFIED HEREIN OF THE PRODUCT(S) GIVING RISE TO THE CLAIM, AND IN NO EVENT SHALL LITRONIC BE LIABLE UNDER THIS WARRANTY OR OTHERWISE FOR SPECIAL, INCIDENTAL OR CONSEQUENTIAL DAMAGES, INCLUDING WITH LIMITATION, DAMAGE OR LOSS RESULTING FROM INABILITY TO USE THE PRODUCT(S), CONSEQUENTIAL DAMAGES, WHETHER SIMILAR OR DISSIMILAR, OF ANY NATURE ARISING OR RESULTING FROM THE PURCHASE, INSTALLATION, REMOVAL, REPAIR, OPERATION, USE OF OR BREAKDOWN OF THE PRODUCT(S), OR ANY OTHER CAUSE WHATSOEVER, INCLUDING NEGLIGENCE. The foregoing warranty shall also apply to products or parts which have been repaired or replaced pursuant to such warranty for a period of ninety (90) days from and after the date such repaired or replaced products or parts are shipped by Litronic; provided, however, that such warranty shall cover only the specific items repaired or replaced. Litronic does not warrant (except as to title) any fabrics or plastic materials. No person, including any agent or representative of Litronic, is authorized to make any representation or warranty on behalf of Litronic concerning any product manufactured by Litronic, except to refer purchasers to this warranty. 15. Excusable Delay Litronic shall not be responsible for any failure to perform due to causes beyond its control. These causes shall include but not be restricted to fire, storm, flood, accident, earthquake, explosion, acts of the public enemy, war sabotage, quarantine restrictions, failure of vendors to make timely deliveries, labor shortages, transportation embargoes, or failure or delays in transportation, inability to secure raw materials or machinery for the manufacture of its devices, acts of God, acts of the Federal Government or any agency thereof, acts of any state or local government or agency thereof, and judicial action. 16. Control of Information Data (including Designs, Drawings, Reports, or other Information) furnished by either party in connection with such Purchase Order and identified as proprietary, restricted, or limited rights data shall not be disclosed by the receiving party outside of its own organization without the prior written consent of the furnishing party except to the extent that such data is otherwise available to the receiving party on a restricted basis or is in the public domain. These restrictions also include the terms, conditions and prices of this Agreement. 17. Business Relationship Nothing in this Agreement shall be construed to constitute BIZ as the partner, employee, or agent of the Company, nor shall either party have any authority to bind the other in any respect. Each party shall remain an independent contractor responsible for its own actions and business expenses. 18. BIZ Orders (a) Within 14 days after receiving a Purchase Order from the BIZ, submitted in accordance 5 6 with the terms hereof, Litronic shall accept such Purchase Order unless Litronic determines that it cannot reasonably ship the quantities called for in the Purchase Order. Acceptance by Litronic of each of BIZ's Purchase Orders shall be deemed to have occurred if Litronic fails to notify BIZ within 14 days after receiving such Purchase Order. Litronic's acceptance shall constitute a binding commitment to ship to the BIZ the quantities and types of product stated in the Purchase Order, in accordance with the terms and conditions hereof. If Litronic does not accept said Purchase Order, Litronic shall provide BIZ with written notice within 14 days of Litronic's receipt of such Purchase Order as to what portion of such Purchase Order Litronic will accept. BIZ may, in such an event, order from Litronic all or any portion of such products that are available. (b) BIZ agrees to receive, inspect, and accept shipments made pursuant to Purchase Orders. 19. Governing Law This Agreement shall be governed by the law of the State of California, including the Uniform Commercial Code as enacted in that state. 20. Non-Waiver Except as otherwise specifically provided for in this Agreement: (a) No failure or delay on the part of BIZ or Litronic in exercising any right or power under this Agreement shall operate as a waiver thereof, nor shall any single or partial exercise of any such right or power preclude any other or further exercise thereof or the exercise of any other right or power hereunder; and No waiver of any provision of this Agreement shall be effective unless the same shall be made in writing and signed by the Party against whom such waiver is sought to be enforced. 21. Notices Any notice made in connection with this Agreement, or in the performance of the terms and conditions hereof, shall be sent to the addresses first above written, or to such other addresses as the Parties may subsequently notify each other, from time to time, by registered airmail or telegram, or by telex and facsimile, followed immediately by confirmation letter by registered airmail. When notice is dispatched as proved above, said notice shall be deemed to have bee made upon receipt at the address so specified, or in the event of any delay in actual receipt, seven (7) business days following the date of dispatch thereof. All notices to each Party shall be sent to the following: Litronic, Inc. Biz Interactive Zone, Inc Attention: CEO Attention: CEO 17861 Cartwright Road 2030 Main Street, 12th Floor Irvine, California 92614 Irvine, CA 92614 Tel: 949-851-1085 Tel: 949-655-4500 Fax: 949-851-8679 Fax: 949-655-4501 22. Indemnity By Litronic. Notwithstanding the provisions of Article 15 hereof, Litronic shall indemnify and hold harmless BIZ/BCP and its affiliates, partners, officers, employees, directors, agents, 6 7 contractors, representatives, successors and assigns, as such, from and against any losses, damages, liabilities, and expenses (including reasonable attorneys' fees) which arise out of or result from any third party claim that: (i) Litronic does not have sufficient right, title or interest in Litronic's materials necessary to enter into this Agreement, or that the Litronic's technology violates an existing United States patent (in existence as of the date on which this Agreement is executed), copyright, trademark, trade secret or other United States intellectual property right of any third party; and (ii) Litronic has breached a covenant, representation or warranty set forth in this Agreement or otherwise. Litronic shall further indemnify and hold harmless BIZ/BCP and its affiliates, partners, officers, employees, directors, agents, contractors, representatives, successors and assigns, as such, from and against any and all liabilities, claims, actions, proceedings, suits, damages, losses, penalties, judgments, costs, expenses, fines, disbursements and other obligations of any kind or nature whatsoever (including, among other things, reasonable attorneys' fees and other expenses of investigation, defense, litigation and settlement, whether or not a lawsuit or a request for arbitration is filed) regardless of when the same shall be made or incurred by BIZ/BCP, whether prior to or after any termination or expiration of this Agreement (a "Claim") which Claim is based upon, asserted in connection with, arises out of, or in any way relates to, this Agreement, or to any action taken or not taken by Litronic hereunder. By BIZ. Notwithstanding the provisions of Article 15 hereof, BIZ shall indemnify and hold harmless Litronic and its affiliates, partners, officers, employees, directors, agents, contractors, representatives, successors and assigns, as such, from and against any losses, damages, liabilities, and expenses (including reasonable attorneys' fees) which arise out of or result from any third-party claim that: (i) BIZ does not have sufficient right, title or interest in any materials necessary to enter into this Agreement, or that any such material violates an existing United States copyright, trademark, trade secret or other United States intellectual property right of any third party; and/or (ii) BIZ has breached a covenant, representation or warranty set forth in this Agreement or otherwise. BIZ shall further indemnify and hold harmless Litronic and its affiliates, partners, officers, employees, directors, agents, contractors, representatives, successors and assigns, as such, from and against any and all Claims made or incurred by Litronic, whether prior to or after any termination or expiration of this Agreement which Claim is based upon, asserted in connection with, arises out of, or in any way relates to this Agreement and results, in whole or in part, from the negligence or willful misconduct of BIZ or any of its employees or agents or the failure of BIZ to perform its duties and obligations under this Agreement; provided, however, that this indemnification shall not apply to any Claim whose associated damages were primarily and proximately caused by the negligence or willful misconduct of Litronic, any of its employees, agents, representatives or associates or the failure of Litronic to perform its duties and obligations. under this Agreement. 23. Assignment. The Parties hereto shall not assign, pledge, subcontract or otherwise dispose of its rights or duties under this Agreement without the prior written consent of the other Party. AS WITNESS THE HANDS OF THE PARTIES HERETO: Signed /s/ ROBERT J. GORMAN Date: 09/05/00 Name: ROBERT J. GORMAN Title: President & COO For and on behalf of BIZ Interactive Zone, Inc. 7 8 Signed /s/ KRIS SHAH Date: Sept 6, 00 Name: KRIS SHAH Title: Chairman/CEO For and on behalf of Litronic, Inc. 8 EX-21 4 a71207ex21.txt EXHIBIT 21 1 EXHIBIT 21 Subsidiaries of the Registrant Litronic Industries, Inc. Pulsar Data Systems, Inc. -----END PRIVACY-ENHANCED MESSAGE-----