SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2013
or
| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission file number: 001-33852
VirnetX Holding Corporation
(Exact name of registrant as specified in its charter)
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Delaware
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77-0390628
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(State or other jurisdiction of incorporation or organization)
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(I.R.S. Employer Identification Number)
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308 Dorla Court, Suite 206
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Zephyr Cove, Nevada
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89448
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(Address of principal executive offices)
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(Zip Code))
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Registrant’s telephone number, including area code: (775) 548-1785
Former name, former address and former fiscal year, if changed since last report:
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 Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
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Large accelerated filer x
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Accelerated filer o
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Non-accelerated filer o
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Smaller reporting company o
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(Do not check if a smaller reporting company)
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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
The number of shares outstanding of the Registrant’s Common Stock as of August 3, 2013, was 51,203,141.
VIRNETX HOLDING CORPORATION
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Page
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PART I — FINANCIAL INFORMATION
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1
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1
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1
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2
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2
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3
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4
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12
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17
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17
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PART II — OTHER INFORMATION
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18
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18
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20
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20
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26
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27
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||
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29
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||
VIRNETX HOLDING CORPORATION
(in thousands, except share amounts)
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June 30, 2013
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December 31, 2012
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||||||
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(Unaudited)
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|||||||
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ASSETS
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||||||||
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Current assets:
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||||||||
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Cash and cash equivalents
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$
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32,878
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$
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19,661
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||||
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Investments available for sale
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13,382
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26,493
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||||||
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Prepaid taxes
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—
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14,963
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||||||
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Prepaid expense and other current assets
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601
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114
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||||||
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Total current assets
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46,861
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61,231
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||||||
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Property and equipment, net
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65
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70
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||||||
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Intangible and other assets
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—
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12
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||||||
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Total assets
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$
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46,926
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$
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61,313
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||||
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LIABILITIES AND STOCKHOLDERS' EQUITY
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||||||||
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Current liabilities:
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||||||||
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Accounts payable and accrued liabilities
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$
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1,861
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$
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3,197
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||||
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Derivative liability
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2,686
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4,172
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||||||
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Total current liabilities
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4,547
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7,369
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||||||
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Stockholders' equity:
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||||||||
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Preferred stock, par value $0.0001 per share
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||||||||
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Authorized: 10,000,000 shares at June 30, 2013, and December 31, 2012, Issued and outstanding: none
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—
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—
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||||||
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Common stock, par value $0.0001 per share
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||||||||
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Authorized: 100,000,000 shares at June 30, 2013 and December 31, 2012, Issued and outstanding: 51,203,141 shares at June 30, 2013, and 51,150,242 shares at December 31, 2012
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5
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5
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||||||
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Additional paid in capital
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120,229
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116,856
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||||||
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Accumulated deficit
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(77,847
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)
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(62,925
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)
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||||
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Accumulated other comprehensive income (loss)
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(8
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)
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8
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|||||
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Total stockholders' equity
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42,379
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53,944
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||||||
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Total liabilities and stockholders' equity
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$
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46,926
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$
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61,313
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||||
See accompanying notes to condensed consolidated financial statements.
VIRNETX HOLDING CORPORATION
(in thousands, except per share amounts)
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Three Months Ended
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Six Months Ended
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||||||||||||||
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June 30, 2013
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June 30, 2012
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June 30, 2013
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June 30, 2012
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||||||||||||
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Revenue
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$
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6
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$
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36
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$
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300
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$
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36
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||||||||
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Operating expense:
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||||||||||||||||
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Research and development
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382
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274
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686
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530
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||||||||||||
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General, selling and administrative
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6,202
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11,496
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15,722
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18,463
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Total operating expense
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6,584
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11,770
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16,408
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18,993
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||||||||||||
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Loss from operations
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(6,578
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)
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(11,734
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)
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(16,108
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)
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(18,957
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)
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||||||||
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Gain (loss) on change in value of derivative liability
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(120
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)
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(2,248
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)
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1,486
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(1,979
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)
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|||||||||
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Interest income, net
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23
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128
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56
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202
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||||||||||||
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Loss before taxes
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(6,675
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)
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(13,854
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)
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(14,566
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)
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(20,734
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)
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Income tax (expense) benefit
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(354
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)
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3,590
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(356
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)
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5,763
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Net loss
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$
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(7,029
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)
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$
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(10,264
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)
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$
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(14,922
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)
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$
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(14,971
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)
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Basic and diluted loss per share:
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$
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(0.14
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)
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$
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(0.20
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)
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$
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(0.29
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)
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$
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(0.29
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)
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Weighted average shares outstanding basic and diluted
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51,179
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50,874
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51,165
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50,766
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||||||||||||
VIRNETX HOLDING CORPORATION
(in thousands)
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Three Months Ended
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Six Months Ended
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||||||||||||||
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June 30, 2013
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June 30, 2012
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June 30, 2013
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June 30, 2012
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Net loss
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$
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(7,029
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)
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$
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(10,264
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)
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$
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(14,922
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)
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$
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(14,971
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)
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Other comprehensive income (loss):
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Change in equity adjustment from Foreign currency translation, net of tax
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(12 | ) |
—
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(12 | ) |
—
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Change in unrealized gain (loss) on investments, net of tax
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4
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1
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(4
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)
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(17
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)
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(8) | 1 | (16 | ) |
(17
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) | ||||||||||
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Comprehensive loss
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$
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(7,037
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)
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$
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(10,263
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)
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$
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(14,938
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)
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$
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(14,988
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)
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||||
See accompanying notes to condensed consolidated financial statements.
VIRNETX HOLDING CORPORATION
(in thousands)
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Six Months
Ended
June 30,
2013
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Six Months
Ended
June 30,
2012
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||||||
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Cash flows from operating activities:
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Net loss
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$
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(14,922
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)
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$
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(14,971
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)
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Adjustments to reconcile net loss to net cash used in operating activities:
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Depreciation and amortization
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23
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36
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Stock-based compensation
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3,344
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2,340
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Net change in deferred taxes
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—
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204
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Change in value of derivative liability
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(1,486
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)
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1,979
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Changes in assets and liabilities:
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Prepaid taxes
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14,963
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5,192
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Prepaid expenses and other current assets
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(487
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) |
(259
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)
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Accounts payable and accrued liabilities
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(1,336
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)
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4,032
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Net cash provided by (used in) operating activities
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99 |
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(1,447
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)
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Cash flows from investing activities:
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Purchase of property and equipment
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(7
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)
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(26
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)
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Purchase of investments
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(13,000
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)
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(33,599
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)
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Proceeds from sale or maturity of investments
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26,094
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22,208
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||||||
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Net cash provided by (used in) investing activities
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13,087
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(11,417
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)
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|||||
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Cash flows from financing activities:
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||||||||
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Proceeds from exercise of stock options
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31
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1,175
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||||||
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Proceeds from exercise of warrants
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—
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156
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||||||
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Net cash provided by financing activities
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31
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1,331
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||||||
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Net increase (decrease) in cash and cash equivalents
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13,217
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(11,533
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)
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|||||
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Cash and cash equivalents, beginning of period
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19,661
|
49,482
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||||||
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Cash and cash equivalents, end of period
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$
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32,878
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$
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37,949
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||||
See accompanying notes to condensed consolidated financial statements.
VIRNETX HOLDING CORPORATION
(in thousands, except share and per share amounts)
(Unaudited)
Note 1 — Business Description and Basis of Presentation
VirnetX, Inc. (“we”, “our”, “us” or “VirnetX”) develops software and technology solutions for securing real-time communications over the Internet. Our patented GABRIEL Connection Technology™ combines industry standard encryption protocols with our patented techniques for automated domain name system, or DNS, lookup mechanisms, and enables users to create a secure communication link using secure domain names over wired or wireless (4G/LTE) networks.
Our portfolio of intellectual property is the foundation of our business model. We currently own 21 patents in the United States and 41 foreign patents, as well as several pending U.S. and foreign patent applications. Our patent portfolio is primarily focused on securing real-time communications over the Internet, as well as related services such as the establishment and maintenance of a secure domain name registry. Our patented methods also have additional applications in operating systems and network security.
Our software and technology solutions provide the security platform required by next-generation Internet-based applications such as instant messaging, or IM, voice over Internet protocol, or VoIP, mobile services, streaming video, file transfer and remote desktop. Our technology generates secure connections on a “zero-click” or “single-click” basis, significantly simplifying the deployment of secure real-time communication solutions by eliminating the need for end-users to enter any encryption information.
We have executed licenses and intend to seek further licensees for our technology, including our GABRIEL Connection Technology™ to original equipment manufacturers, or OEMs, of chips, servers, smart phones, tablets, e-Readers, laptops, net books and other devices, within the IP-telephony, mobility, fixed-mobile convergence and unified communications markets including 4G/LTE.
During interim periods, we follow the accounting policies set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 and apply appropriate interim financial reporting standards for a fair statement of our operating results and financial position in conformity with accounting principles generally accepted in the United States of America, as codified by the Financial Accounting Standards Board (FASB) in the Accounting Standards Codification (ASC) (referred to herein as U.S. GAAP), as indicated below. Users of financial information produced for interim periods are encouraged to read this Quarterly Report on Form 10-Q in conjunction with our consolidated financial statements and notes thereto filed with the Securities and Exchange Commission (SEC) in our 2012 Annual Report on Form 10-K.
Interim financial reporting standards require us to make estimates that are based on assumptions regarding the outcome of future events and circumstances not known at that time, including the use of estimated effective tax rates. Inevitably, some assumptions will not materialize, unanticipated events or circumstances may occur which vary from those estimates and such variations may significantly affect our future results. Our financial results have varied significantly from period to period. Additionally, interim results may not be indicative of our results for future interim periods or our annual results.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the SEC’s requirements for Form 10-Q and, in the opinion of management, contain all adjustments, of a normal and recurring nature, which are necessary for a fair statement of (i) the condensed consolidated statements of operations for the three and six month periods ended June 30, 2013 and 2012; (ii) the condensed consolidated statements of comprehensive loss for the three and six month periods ended June 30, 2013 and 2012; (iii) the condensed consolidated balance sheets at June 30, 2013 and December 31, 2012; and (iv) the condensed consolidated statements of cash flows for the six month periods ended June 30, 2013 and 2012. However, the accompanying unaudited condensed consolidated financial statements do not include all information and notes required by U.S. GAAP. The condensed consolidated balance sheet, included in this report, as of December 31, 2012 was derived from our 2012 audited financial statements, but does not include all disclosures required by U.S. GAAP.
Note 2 – Summary of Significant Accounting Policies
Revenue Recognition
We derive our revenue from patent licensing. The timing and amount of revenue recognized from each licensee depends upon a variety of factors, including the specific terms of each agreement and the nature of the deliverables and obligations. Such agreements can be complex and may or may not include multiple elements. These agreements may include, without limitation, elements related to the settlement of past patent infringement liabilities, up-front and non-refundable license fees for the use of patents, patent licensing royalties on covered products sold by licensees, and the compensation structure and ownership of intellectual property rights associated with contractual technology development arrangements. Licensing agreements are accounted for under the FASB revenue recognition guidance, "Revenue Arrangements with Multiple Deliverables." This guidance requires consideration to be allocated to each element of an agreement that has stand-alone value using the relative fair value method. In other circumstances, such as those agreements involving consideration for past and expected future patent royalty obligations, after consideration of the particular facts and circumstances, the appropriate recording of revenue between periods may require the use of judgment. In all cases, revenue is only recognized after all of the following criteria are met: (1) written agreements have been executed; (2) delivery of technology or intellectual property rights has occurred or services have been rendered; (3) fees are fixed or determinable; and (4) collectability of fees is reasonably assured.
Patent License Agreements: Upon signing a patent license agreement, we provide the licensee permission to use our patented technology in specific applications. We account for patent license agreements in accordance with the guidance for revenue arrangements with multiple deliverables and the guidance for revenue recognition. Under our patent license agreements, we typically receive one or a combination of the following forms of payment as consideration for permitting our licensees to use our patented inventions in specific applications and products:
| · | Consideration for Past Sales: Consideration related to a licensee’s product sales from prior periods may result from a negotiated agreement with a licensee that utilized our patented technology prior to signing a patent license agreement with us or from the resolution of a disagreement or arbitration with a licensee over the specific terms of an existing license agreement. We may also receive royalty for past sales in connection with the settlement of patent litigation where there was no prior patent license agreement. These amounts are negotiated based upon application of a royalty rate to historical sales prior to the execution of the license agreement. In each of these cases, since delivery has occurred, we record the consideration as revenue when we have obtained a signed agreement, identified a fixed or determinable price, and determined that collectability is reasonably assured. |
| · | Current Royalty Payments: These are ongoing royalty payments covering a licensee’s obligations to us related to its sales of covered products in the current contractual reporting period. Licensees that owe Current Royalty Payments are obligated to provide us with quarterly or semi-annual royalty reports that summarize their sales of covered products and their related royalty obligations to us. We expect to receive these royalty reports subsequent to the period in which our licensees’ underlying sales occurred. As a result, it is impractical for us to recognize revenue in the period in which the underlying sales occur, and, in most cases, we will recognize revenue in the period in which the royalty report is received and other revenue recognition criteria are met due to the fact that without royalty reports from our licensees, our visibility into our licensees’ sales is limited. |
For the three and six months ended June 30, 2013, we recognized royalty revenue of $6 and $300 respectively, compared to $36 for the three and six months ended June 30, 2012, as part of license agreements entered into with customers during the patent infringement actions (see “Legal Proceedings”). In accordance with our revenue recognition policy related to a licensee’s product sales from prior periods, the amounts recognized resulted from negotiated agreements with licensees that utilized our patented technology prior to signing a patent license agreement with us. We record the consideration as revenue when we have obtained a signed agreement, identified a fixed or determinable price, and determined that collectability is reasonably assured. In the patent infringement actions we did not request, nor receive any amounts allocable to settlement fees, expense reimbursement, damages or any other amount unrelated to historical sales. Revenue from forward licensing agreements entered into as a result of the litigation will be recognized as the earnings process is completed, license fees are fixed and determinable, and in accordance with our revenue recognition policy.
Earnings Per Share
Basic earnings per share are computed by dividing earnings available to common stockholders by the weighted average number of outstanding common shares during the period. Diluted earnings per share are computed by dividing net income by the weighted average number of shares outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued.
Concentration of Credit Risk and Other Risks and Uncertainties
Our cash and cash equivalents are primarily maintained at two major financial institutions in the United States. A portion of those balances are insured by the Federal Deposit Insurance Corporation. During the six months ended June 30, 2013 we had, at times, funds which were uninsured. We do not believe that we are subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships with major financial institutions. We have not experienced any losses on our deposits of cash and cash equivalents.
Derivative Instruments
Our Series I Warrants are required to be accounted for as derivative liabilities and carried at fair value on our Condensed Consolidated Balance Sheets as a result of an anti-dilution provision which precludes them from being considered indexed to our stock. The warrant liabilities are marked-to-market each period and the change in the fair value is recorded as gain or loss on derivative liability in the accompanying Condensed Consolidated Statements of Operations.
Impairment of Long-Lived Assets
On an annual basis we identify and record impairment losses on long-lived assets when events and changes in circumstances indicate that the carrying amount of an asset might not be recoverable. Recoverability is measured by comparison of the anticipated future net undiscounted cash flows to the related assets’ carrying value. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future net cash flows arising from the asset.
Fair Value of Financial Instruments
Fair value is the price that would result from an orderly transaction between market participants at the measurement date. A fair value hierarchy prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). Level 2 measurements utilize either directly or indirectly observable inputs in markets other than quoted prices in active markets.
Our financial instruments are stated at amounts that equal, or approximate, fair value. When we approximate fair value, we utilize market data or assumptions that we believe market participants would use in pricing the financial instrument, including assumptions about risk and inputs to the valuation technique. We use valuation techniques, primarily the income and market approach that maximize the use of observable inputs and minimize the use of unobservable inputs for recurring fair value measurements.
Certificate of deposits: Fair value measured at face value plus accrued interest.
Corporate bonds: Fair value measured at the closing price reported on the active market on which the individual securities are traded.
Series I Warrants: Fair value measured by using a binomial valuation model. The assumptions used to measure fair value of our outstanding Series I Warrants carried as derivative liabilities on our Condensed Consolidated Balance Sheet for June 30, 2013, included a warrant exercise price of $3.59 per share, a common share price of $19.99, a discount rate of 1.41%, and a volatility of 93%. The assumptions used for December 31, 2012, were a warrant exercise price of $3.59 per share, a common share price of $29.28, a discount rate of 0.72%, and a volatility of 94%.
The following tables show the adjusted cost, gross unrealized gains, gross unrealized losses and fair value of our securities by significant investment category as of June 30, 2013 and December 31, 2012.
|
|
June 30, 2013
|
|||||||||||||||
|
Level 1:
|
Adjusted Cost
|
Unrealized
Gains
|
Unrealized
Losses
|
Fair Value
|
||||||||||||
|
Certificates of deposit
|
$
|
351
|
$
|
—
|
$
|
—
|
$
|
351
|
||||||||
|
|
||||||||||||||||
|
Corporate Bonds:
|
||||||||||||||||
|
AA
|
13,027
|
4
|
—
|
13,031
|
||||||||||||
|
Total Corporate Bonds
|
13,027
|
4
|
—
|
13,031
|
||||||||||||
|
|
||||||||||||||||
|
Total Investments at Fair Value
|
$
|
13,378
|
$
|
4
|
$
|
—
|
$
|
13,382
|
||||||||
|
December 31, 2012
|
||||||||||||||||
|
Level 1:
|
Adjusted Cost
|
Unrealized
Gains
|
Unrealized
Losses
|
Fair Value
|
||||||||||||
|
Certificates of deposit
|
$
|
17,836
|
$
|
—
|
$
|
—
|
$
|
17,836
|
||||||||
|
Corporate bonds:
|
||||||||||||||||
|
AA
|
4,099
|
—
|
—
|
4,099
|
||||||||||||
|
A
|
4,039
|
8
|
—
|
4,047
|
||||||||||||
|
BAA
|
511
|
—
|
—
|
511
|
||||||||||||
|
Total corporate bonds
|
8,649
|
8
|
—
|
8,657
|
||||||||||||
|
Total investments at fair value
|
$
|
26,485
|
$
|
8
|
$
|
—
|
$
|
26,493
|
||||||||
The following tables set forth by level within the fair value hierarchy, our liabilities stated at fair value as of June 30, 2013 and December 31, 2012.
|
June 30, 2013
|
||||||||||||||||
|
Quoted
Prices in
Active
Markets for
Identical
Assets
|
Significant
Other
Observable
Inputs
|
Significant
Unobservable
Inputs
|
||||||||||||||
|
(Level 1)
|
(Level 2)
|
(Level 3)
|
Total
|
|||||||||||||
|
Series l Warrants
|
$ |
—
|
$ |
—
|
$ |
2,686
|
$ |
2,686
|
||||||||
|
December 31, 2012
|
||||||||||||||||
|
Quoted
Prices in
Active
Markets
for
Identical
Assets
|
Significant
Other
Observable
Inputs
|
Significant
Unobservable
Inputs
|
||||||||||||||
|
(Level 1)
|
(Level 2)
|
(Level 3)
|
Total
|
|||||||||||||
|
Series l Warrants
|
$
|
—
|
$
|
—
|
$
|
4,172
|
$
|
4,172
|
||||||||
The following table sets forth a summary of changes in the fair value of our Level 3 liability stated at fair value for the six months ended June 30, 2013 and 2012
.
|
|
Six Months Ended
June 30, 2013
|
|
Six Months Ended
June 30, 2012
|
||||||
|
|
Fair Value
Measurements
Using
Significant
Unobservable
Inputs (Level 3)
|
|
Fair Value
Measurements
Using
Significant
Unobservable
Inputs (Level 3)
|
||||||
|
Balance December 31, 2012
|
$
|
4,172
|
Balance December 31, 2011
|
$
|
4,699
|
||||
|
Gain on derivative liability included in net loss
|
(1,486
|
)
|
Loss on derivative liability included in net loss
|
1,979
|
|||||
|
Settlements
|
—
|
Settlements
|
(1,415
|
)
|
|||||
|
Balance June 30, 2013
|
$
|
2,686
|
Balance June 30, 2012
|
$
|
5,263
|
||||
New Accounting Pronouncement
In July 2013, the FASB issued Accounting Standards Update (“ASU”) No. 2013-11 “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.” ASU No. 2013-11 is a new accounting standard on the financial statement presentation of unrecognized tax benefits. The new standard provides that a liability related to an unrecognized tax benefit would be presented as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. The new standard becomes effective for us on January 1, 2014 and will be applied prospectively to unrecognized tax benefits that exist at the effective date with retrospective application permitted. We are currently assessing the impacts of this new standard.
In February 2013, the FASB issued final guidance on the presentation of reclassifications out of other comprehensive income. The amendments require an entity to provide information about the amounts reclassified out of other comprehensive income by component. In addition, an entity is required to present, either on the face of the income statement or in a footnote, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, only if the amount reclassified is required by GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide detail about those amounts. This amendment was effective for interim and fiscal years beginning after December 15, 2012. The amended standard did not impact our financial position or results of operations.
Note 3 — Patent Portfolio
As of June 30, 2013, we own 21 issued U.S. and 41 issued foreign patents, in addition to several pending U.S. and foreign patent applications. Our issued U.S. and foreign patents expire at various times during the period from 2019 to 2024. Some of our issued patents and pending patent applications were acquired by our principal operating subsidiary, VirnetX, Inc., from Science Applications International Corporation, or SAIC, in 2006 and we are required to make payments to SAIC based on cash or certain other values generated from those patents. The amount of such payments depends upon the type of value generated, and certain categories are subject to maximums and other limitations. As of June 30, 2010, we met our maximum royalty payment requirement; however, SAIC is also entitled under certain circumstances to receive a portion of the proceeds paid to us for certain acquisitions of VirnetX or from the settlement of certain patent infringement claims of ours. Capitalized patent costs, net of amortization, are included in intangible and other assets in the accompanying Condensed Consolidated Balance Sheet at December 31, 2012, and were fully amortized at June 30, 2013.
Note 4 - Income Taxes
The income tax expense for the three months ended June 30, 2013 was $354, which was a negative effective income tax rate of 5 percent. The income tax expense for the six months ended June 30, 2013 was $356, which was a negative effective income tax rate of 2.5 percent. As a result of net operating losses during the periods the provision reflects only minimum tax payments and prior year tax true-up. The tax expense was calculated using the statutory U.S. federal rate primarily as a result of the change of the valuation allowance of $5,695, stock based compensation expense and non-deductible derivative loss. We have valuation allowances covering our deferred tax assets including net operating loss carry-forwards.
The income tax benefit for the three months ended June 30, 2012 was $3,590, which was an effective income tax rate of 26 percent. The income tax benefit for the six months ended June 30, 2012 was $5,763, which was an effective income tax rate of 28 percent.
In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of deferred assets will not be realized. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based on the available objective evidence, management believes it is more likely than not that the net deferred tax assets at June 30, 2013 will not be fully realizable. Accordingly, management has maintained a valuation allowance against our net deferred tax assets at June 30, 2013. The valuation allowance carried against our net deferred tax assets was $11,423 and $6,970 at June 30, 2013 and December 31, 2012, respectively.
At June 30, 2013, we have federal and state net operating loss carry-forwards of approximately $15,527 and $52,756 respectively, expiring beginning in 2027 and 2016, respectively.
Effective January 1, 2009, we adopted accounting guidance for income taxes, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements and prescribes a recognition threshold and measurement attribute for the financial statements recognition and measurement of a tax position taken or expected to be taken in a tax return. We are now required to recognize in the financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position.
Our tax years for 2005 and forward are subject to examination by the U.S. tax authority and various state tax authorities. These years are open due to net operating losses and tax credits remaining unutilized from such years.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of June 30, 2013, we had accrued immaterial amounts of interest and penalties related to the uncertain tax positions.
Note 5 — Commitments
On October 30, 2011, we entered into a new lease agreement for our corporate headquarters. The lease commencement date was October 30, 2011 and includes monthly payments of $5 until the lease term expires in October 2013
We entered into a non-cancelable agreement for corporate promotional and marketing purposes for a period of ten years at a cost of $4,000. Initial payments of $250 have been prepaid and are included in prepaid expenses and other current assets on our Condensed Consolidated Balance Sheet. The remaining balance is due on March 1 of the year the facility will become available for use, which the lessor anticipates will be in 2014 or 2015, at which time we will begin amortizing the agreement over the contract period. The lease terms include certain refunds, deductions, etc. in the event construction is delayed or not completed within specified time-frames.
Note 6 — Stock-Based Compensation
On May 22, 2013, our stockholders approved the VirnetX Holding Corporation 2013 Equity Incentive Plan (the "Plan) at our 2013 annual stockholders' meeting. The Plan provides for the issuance of up to 2,500,000 shares of our common stock. To the extent that any award should expire, become un-exercisable or is otherwise forfeited, the shares subject to such award will again become available for issuance under the Plan. The Plan provides for the granting of stock options and restricted stock purchase rights (RSU) to our employees and consultants. Stock options granted under the Plan may be incentive stock options or nonqualified stock options. Incentive stock options ("ISO") may only be granted to our employees (including officers and directors). Nonqualified stock options ("NSO") and stock purchase rights may be granted to our employees and consultants.
The Plan will expire 10 years after it was approved by our Board of Directors. Options may be granted under the Plan with an exercise price determined by our Board of Directors, or a duly appointed committee thereof, provided, however, that the exercise price of an option granted to any employee shall be not less than 100% of the fair market value at the date of grant in the case of ISO or 85% of the fair market value at the date of grant in the case of an NSO, the exercise price of an ISO or NSO granted to one of our Named Executive Officers shall not be less than 100% fair market value of the shares at the date of grant and the exercise price of an ISO granted to a 10% shareholder shall not be less than 110% of the fair market value of the shares on the date of grant. Stock options granted under the Plan typically vest over four years and have a 10 year term. All RSUs are considered to be granted at the fair value of our stock on the date of grant because they have no exercise price. RSUs typically vest over four years.
We had 5,009,849 and 4,776,224 options outstanding at June 30, 2013 and December 31, 2012, respectively, with a weighted-average exercise price of $7.87 and $6.94, respectively. At June 30, 2013 and December 31, 2012, we had 248,915 and 151,665 RSU’s outstanding with a weighted-average grant-date fair value of $24.10 and $25.60, respectively.
During the six months ended June 30, 2013 and 2012, we granted options for a total of 274,625 and 277,500 shares respectively. The weighted average fair values at the grant dates for options issued during the six months ending June 30, 2013 and 2012 were $19.24 and $22.26 per option, respectively. The fair value of options at the grant date was estimated utilizing the Black-Scholes valuation model with following weighted average assumptions for the six months ending June 30, 2013 and 2012, respectively: (i) dividend yield on our common stock of 0 percent and 0 percent; (ii) expected stock price volatility of 93 percent and 115 percent; (iii) a risk-free interest rate of 2.06 percent and 1.92 percent; and (iv) an expected option term of 6 and 7 years.
During the six months ended June 30, 2013 and 2012, we also granted RSUs totaling 156,415 and 151,665 units, respectively, that vest ratably over one to four years. The weighted-average fair values of each issued RSU on the dates of grant were $23.72 and $25.60, respectively. RSUs, which are subject to forfeiture if employment terminates prior to the shares vesting, are expensed ratably over the vesting period.
Stock-based compensation expense is measured at grant date, based on the fair value of the award, and is recognized over the employees’ requisite service period. Stock-based compensation expense included in general and administrative expense was $1,759 and $3,344 for the three and six months ended June 30, 2013, respectively, and $1,466 and $2,340 for the three and six months ended June 30, 2012, respectively.
As of June 30, 2013 and 2012, the unrecognized stock-based compensation expense related to non-vested stock options and RSUs was $15,372 and $5,372, respectively, which will be amortized over an estimated weighted average vesting amortization period of approximately 2.72 and 3.21 years, respectively.
Note 7 — Warrants
Information about warrants outstanding during the six months ended June 30, 2013 follows:
|
Original
Number of
Warrants
Issued
|
Exercise
Price per
Common
Share
|
Exercisable at
December 31,
2012
|
Became
Exercisable
|
Exercised
|
Terminated /
Cancelled /
Expired
|
Exercisable
at June 30,
2013
|
Expiration
Date
|
||||||||||||||||||||||
|
2,619,036
|
(1
|
)
|
$
|
3.59
|
159,967
|
—
|
—
|
—
|
159,967
|
March 2015
|
|||||||||||||||||||
|
Total
|
159,967
|
—
|
—
|
159,967 |
|
||||||||||||||||||||||||
|
(1)
|
Referred to as our Series I Warrants.
|
Note 8 — Litigation
We have five intellectual property infringement lawsuits pending against multiple parties in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these parties infringe on certain of our patents. We seek damages and injunctive relief in all the complaints. We have one complaint with the United States International Trade Commission (ITC) alleging that Apple, Inc. has engaged in unfair trade practices by the importation, sale for importation, and sale after importation of certain devices with secure communication capabilities that infringe one or more claims of our U.S. Patent No. 8,051,181. On February 27, 2013, we announced our intent to withdraw our complaint with the ITC and pursue comprehensive relief from Apple Inc.’s infringement through the district courts. The ITC case has been terminated.
VirnetX Inc. et al., v. Microsoft Corporation
On April 22, 2013, we initiated a lawsuit by filing a complaint against Microsoft Corporation in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that Microsoft has infringed U.S. Patent Nos. 6,502,135, 7,188,180, 7,418,504, 7,490,151, 7,921,211, and 7,987,274. We seek damages and injunctive relief. No hearing or trial dates have been set.
VirnetX Inc. v. Cisco Systems, Inc. et al and VirnetX Inc. v. Apple Inc. (Severed Case)
On August 11, 2010, we initiated a lawsuit by filing a complaint against Aastra, Apple, Cisco, and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these parties infringe on certain of our patents. We seek damages and injunctive relief. On February 4, 2011, we amended our original complaint, filed on August 11, 2010, against Aastra, Apple, Cisco and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, to assert U.S. Patent No. 7,418,504 against Apple and Aastra. On April 5, 2011, we again amended our complaint against Aastra, Apple, Cisco and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, to include Apple’s iPad 2 in the list of Apple products that are accused of infringing our patents. We also asserted our newly-issued patent, U.S. Patent No. 7,921,211 against all of the defendants in that lawsuit. A claim construction hearing was held on January 5, 2012 and the court issued a Markman ruling on April 25, 2012. Aastra and NEC have signed license agreements with us and we have agreed to drop all the accusations of infringement against them. At the pre-trial hearing, the judge decided to postpone the trial against Cisco to March 4, 2013 and just try the case against Apple. On November 6, 2012, a Jury in the United States Court for the Eastern District of Texas, Tyler Division, awarded us over $368,000 in a verdict against Apple Corporation for infringing four of our patents. A post-trial hearing in the case against Apple was held on December 20, 2012. On February 26, 2013, the United States District Court for the Eastern District of Texas, Tyler Division issued its Memorandum Opinion and Order regarding post-trial motions resulting from the prior jury verdict. The Court denied Apple’s motion to reduce the damages awarded by the jury for past infringement. The Court further denied Apple’s request for a new trial on the liability and damages portions of the verdict. Additionally, the Court granted our motions for pre-judgment interest, post-judgment interest, and post-verdict damages to date. Specifically, the Court ordered that Apple pay $34 in daily interest up to final judgment and $330 in daily damages for infringement up to final judgment for certain Apple devices included in the verdict. The Court denied our request for a permanent injunction. In doing so, the Court ordered the parties to mediate over a license in the following 45 days for Apple’s future infringing use not covered by the Court’s Order, and ordered us to file an appropriate motion with the court if the parties fail to agree to a license. On March 28, 2013, Apple filed a motion to alter or amend the judgment entered by the Court. The mediation was held on April 9, 2013 and the parties did not come to an agreement on an ongoing royalty rate for infringing Apple products. We filed our opposition to this motion on April 10, 2013. As ordered by the Court, we filed a sealed motion with the Court on April 16, 2013, requesting the Court’s assistance in deciding an appropriate royalty rate for all infringing products shipped by Apple that are “not colorably different” with regards to the accused functionality. However, the judgment may be appealed and no assurances can be given as to when or if we will receive any proceeds in connection with these matters, and accordingly there has been no recognition of the jury awards or royalties in our accompanying financial statements. Under our agreements with Science Applications International Corporation (SAIC), we would pay to SAIC 25% of the proceeds obtained by us in this lawsuit against Apple after reduction for attorneys’ fees and costs incurred in litigating those claims. We are awaiting the Court’s decision in this matter. On July 1, 2013, the Court entered an Order setting a hearing on VirnetX’s motion for an ongoing royalty for August 15, 2013. On July 3, 2013, Apple filed an appeal of the judgment dated February 27, 2013 and order dated June 4, 2013 denying Apple’s motion to alter or amend the judgment to the United States Court of Appeals for the Federal Circuit.
The jury trial against Cisco was held on March 4, 2013. At the end of the trial, the jury came back with a verdict of non-infringement in the trial. The same jury also found that all our patents-in-suit were valid and enforceable. On April 3, 2013, we filed a request for a new trial regarding Cisco’s infringement of four of our patents based primarily on our allegations of Cisco’s inappropriate conduct and arguments during the jury trial that concluded on March 14, 2013. In addition to the request for a new trial, we filed a motion for a judgment as a matter of law on Cisco’s infringement of the ‘759 patent. On April 11, 2013, in response to our motion, Cisco filed its renewed motion to dismiss as moot its invalidity counterclaims against the claims in our patents that were not asserted in the lawsuit as well as a conditional motion for a new trial on certain limited claims and defenses. We are awaiting the Court’s decision in this matter. A hearing on VirnetX’s motion for new trial and Cisco’s renewed motion to dismiss as moot its invalidity counterclaims and conditional motion for a new trial was held on June 17, 2013. We are awaiting the Court’s ruling on these motions.
VirnetX Inc. v. Mitel Networks Corporation et al
On January 12, 2011, we initiated a lawsuit by filing a complaint against Siemens and Mitel in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these companies infringe three of our patents. We seek damages and injunctive relief. On April 12, 2011 we again amended our complaint against Siemens and Mitel in the United States District Court for the Eastern District of Texas, Tyler Division, to add Avaya Inc. as a defendant. On July 11, 2012, Mitel Network Corporation signed a license agreement with us and we dismissed the patent infringement case against them. On July 12, 2012 we had a claims construction hearing in this case and a Markman order was issued on August 1, 2012. On January 29, 2013 Siemens signed a license agreement with us and we dismissed the patent infringement case against them. On April 9, 2013, the Court issued a new docket control order in our lawsuit against the remaining defendant Avaya Inc. According to this new order, jury selection is set for September 3, 2013 followed by a jury trial on September 9, 2013. A pretrial conference has been scheduled for August 22, 2013.
VirnetX Inc. v. Apple, Inc.
On November 1, 2011, we initiated a lawsuit against Apple in the United States District Court, Tyler Division, pursuant to which we allege that Apple infringes one or more claims of our U.S. Patent No. 8,051,181. We seek damages and injunctive relief. No hearing or trial dates have been set. On June 17, 2013 the Court granted VirnetX’s unopposed motion to lift the stay ordered by the Court on December 15, 2011. On June 18, 2013 the Court granted the parties unopposed motion to consolidate this case with Civil Action No. 6:12-cv-00855-LED.
VirnetX Inc. v. Apple, Inc.
On November 6, 2012, we filed a new complaint against Apple Inc., in the United States District Court for the Eastern District of Texas, Tyler Division for willfully infringing four of our patents, U.S. Patent Nos. 6,502,135, 7,418,504, 7,921,211 and 7,490,151, and seeking both damages and injunctive relief. The accused products include the iPhone 5, iPod Touch 5th Generation, iPad 4th Generation, iPad mini, and the latest Macintosh computers. Due to their release dates, these products were not included in the previous lawsuit that concluded with a Jury verdict on November 6, 2012 that was subsequently upheld by the United States District Court for the Eastern District of Texas, Tyler Division, on February 26, 2013. On July 1, 2013, we filed a consolidated and amended complaint to include U.S. Patent No. 8,051,181 and consolidate Civil Action No. 6:11-cv-00563-LED.
ITC Investigation No. 337-TA-858
On July 18, 2012, the Administrative Law Judge (ALJ) assigned to investigate our complaint against Apple Inc., identified a procedural discrepancy with our complaint and dismissed it. On September 14, 2012, we re-filed our complaint with the ITC jointly with Science Applications International Corporation (SAIC) [NYSE: SAI] to remove a procedural standing issue that was identified as the reason for dismissal of our previous complaint. On October 16, 2012, the United States International Trade Commission (ITC) accepted our complaint and instituted an investigation against Apple and assigned ALJ E. James Gildea to preside over this investigation. Subsequently on October 23, 2012, ALJ Gildea issued an order setting up February 21, 2014 as the target date for completion of this investigation. The hearing in-front of ALJ Gildea was scheduled for May 20, 2013. On February 27, 2013, we announced our intent to withdraw our complaint with the ITC and pursue comprehensive relief from Apple Inc.’s infringement through the district courts. The ITC case has been terminated.
One or more potential intellectual property infringement claims may also be available to us against certain other companies who have the resources to defend against any such claims. Although we believe these potential claims are worth pursuing, commencing a lawsuit can be expensive and time-consuming, and there is no assurance that we will prevail on such potential claims. In addition, bringing a lawsuit may lead to potential counterclaims which may preclude our ability to commercialize our initial products, which are currently in development. Currently, we are not a party to any other pending legal proceedings, and are not aware of any proceeding threatened or contemplated against us by any governmental authority or other party.
Note 9 — Subsequent Events
On August 7, 2013, we signed a Patent License Agreement (the “Agreement”) with Avaya Inc. Under the terms of the Agreement, VirnetX has agreed to license certain of its patents to Avaya, in exchange for multiple payments to VirnetX and an ongoing reasonable royalty for future sales through the expiration of the licensed patents as outlined in the Agreement with respect to certain current and future IP-encrypted products. In further consideration, Avaya has agreed to license certain of its patents to VirnetX for its ongoing Gabriel technology product development.
Under the terms of the Agreement, the Parties have also agreed to dismiss the patent infringement case brought by VirnetX before the U.S. District Court for the Eastern District of Texas. All other aspects of the agreement were not disclosed.
Note About Forward-Looking Statements
Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.
Company Overview
We develop software and technology solutions for securing real-time communications over the Internet. Our patented GABRIEL Connection Technology™ combines industry standard encryption protocols with our patented techniques for automated domain name system, or DNS, lookup mechanisms, and enables users to create a secure communication link using secure domain names over wired or wireless (4G/LTE) networks. We are currently beta testing our GABRIEL Connection Technology™ as part of our Secure Domain Name Initiative, or (SDNI), on various platforms including PCs, smart phones and tablets. We also intend to establish the exclusive secure domain name registry in the United States and other key markets around the world.
Our portfolio of intellectual property is the foundation of our business model. We currently own 21 patents in the United States and 41 foreign patents, as well as several pending U.S. and foreign patent applications. Our patent portfolio is primarily focused on securing real-time communications over the Internet, as well as related services such as the establishment and maintenance of a secure domain name registry. Our patented methods also have additional applications in operating systems and network security. We have submitted a declaration with the 3rd Generation Partnership Project, or 3GPP, identifying a group of our patents and patent applications that we believe are or may become essential to certain developing specifications in the 3GPP LTE, System Architecture Evolution (SAE) project. We have agreed to make available a non-exclusive patent license under fair, reasonable and non-discriminatory terms and conditions, with compensation, or FRAND, to 3GPP members desiring to implement the technical specifications identified by us. We believe that we are positioned to license our essential security patents to 3GPP members as they move into 4G.
We have an ongoing Gabriel Licensing Program under which we offer licenses to our patent portfolio, technology and software, including our secure domain name registry service, to domain infrastructure providers, communication service providers as well as to system integrators. Our Gabriel Connection TechnologyTM License is offered to OEM customers who want to adopt the GABRIEL Connection Technology™ as their solution for establishing secure connections using secure domain names within their products. We have developed GABRIEL Connection Technology™ Software Development Kit (SDK) to assist with rapid integration of these techniques into existing software implementations with minimal code changes and include object libraries, sample code, testing and quality assurance tools and the supporting documentation necessary for a customer to implement our technology. Customers who want to develop their own implementation of the VirnetX patented techniques for supporting secure domain names, or other techniques that are covered by our patent portfolio for establishing secure communication links, can purchase a patent license. The number of patents licensed, and therefore the cost of the patent license to the customer, will depend upon which of the patents are used in a particular product or service. These licenses will typically include an initial license fee, as well as an ongoing royalty.
We intend to license our patent portfolio, technology and software, including our secure domain name registry service, to domain infrastructure providers, communication service providers as well as to system integrators. We believe that the market opportunity for our software and technology solutions is large and expanding as secure domain names are now an integral part of securing the next generation 4G/LTE wireless networks. We also believe that all 4G mobile devices will require unique secure domain names and become part of a secure domain name registry.
In connection with the settlement of our lawsuit against Microsoft Corporation in 2010, Microsoft became our first licensee. Pursuant to the Settlement and License Agreement between us and Microsoft, Microsoft paid us $200 million, which was recognized as gain on settlement and Microsoft was granted a worldwide, irrevocable, nonexclusive, non-sublicenseable fully paid up license for our patents for Microsoft products. We have Patent License Agreements with Aastra USA, Inc. Mitel Networks Corporation, NEC Corporation and NEC Corporation of America, to license certain of our US patents, for a one-time payment to VirnetX and an ongoing royalty for all future sales through the expiration of the licensed patents with respect to certain current and future IP-encrypted products. We intend to seek further license of our technology, including our GABRIEL Connection Technology™ to enterprise customers, developers and original equipment manufacturers, or OEMs, of chips, servers, smart phones, tablets, e-Readers, laptops, net books and other devices, within the IP-telephony, mobility, fixed-mobile convergence and unified communications markets including 4G/LTE.
We have five intellectual property infringement lawsuits pending against multiple parties in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that Apple, Inc., Cisco Systems, Inc., and Avaya Inc. infringe on certain of our patents. We seek damages and injunctive relief in all the complaints. We have one complaint pending with the United States International Trade Commission (ITC) against Apple, Inc. On October 31, 2012, a jury trial began regarding our Compliant against Apple. On November 6, 2012, jurors found that Apple infringed four of our patents. (see Legal Proceedings). The jury trial against Cisco was held on March 4, 2013. At the end of the trial, the jury came back with a verdict of non-infringement in the trial. The same jury also found that all our patents-in-suit were valid and enforceable. We have a motion pending in the court requesting a new trial (see Legal Proceedings). The trial against Avaya is now scheduled for jury selection on September 3, 2013. On February 27, 2013 we filed a motion to withdraw our complaint against Apple in the ITC. On April 22, 2013, the ALJ assigned to investigate our complaint against Apple at the ITC, issued an order with the initial determination granting our motion to terminate the investigation against Apple and denying Apple’s motion for sanctions against us.
Our employees include the core development team behind our patent portfolio, technology and software. This team has worked together for over ten years and is the same team that invented and developed this technology while working at Science Application International Corporation, or SAIC. SAIC is a FORTUNE 500® scientific, engineering and technology applications company that uses its deep domain knowledge to solve problems of vital importance to the nation and the world, in national security, energy and the environment, critical infrastructure and health. The team has continued its research and development work started at SAIC and expanded the set of patents we acquired in 2006 from SAIC into a larger portfolio with 62 issued U.S. and foreign patents and numerous pending U.S. and foreign patent applications. This portfolio now serves as the foundation of our licensing business and planned service offerings and is expected to generate the majority of our future revenue in license fees and royalties. We intend to continue our research and development efforts to further strengthen and expand our patent portfolio.
We intend to grow our licensing business by offering incentives to early licensing targets or asserting our rights for use of our patents. We also intend to expand our design pilot in participation with leading 4G/LTE companies (domain infrastructure providers, chipset manufacturers, service providers, and others) and build our secure domain name registry.
Recent Developments
In August 2013 we were granted two new patents by the U.S. Patent and Trademark Office. U.S. Patent No. 8,504,696 (696 Patent) and No. 8,504,697 (697 Patent) System and Method Employing an Agile Network Protocol for Secure Communications Using Secure Domain Names and filed papers with the U.S. District Court for the Eastern District of Texas seeking to add allegations that Apple Inc. defendant in its currently-pending patent infringement lawsuit, VirnetX Inc. et al v. Apple Inc., (Case 6:12-cv-00855-LED) infringes the new '697 patent.
Competition
We believe our technology and solutions will compete primarily against various proprietary security solutions. We group these solutions into three main categories:
| ● | Proprietary or home-grown application specific security solutions have been developed by vendors and integrated directly into their products for our target markets including IP-telephony, mobility, fixed-mobile convergence, and unified communications. These proprietary solutions have been developed due to the lack of standardized approaches to securing real-time communications. This approach has led to corporate networks that are isolated and, as a result, restrict enterprises to using these next-generation networks within the boundaries of their private network. These solutions generally do not provide security for communications over the Internet or require network administrators to manually exchange keys and other security parameters with each destination network outside their corporate network boundary. The cost-savings and other benefits of IP-based real-time communications are significantly limited by this approach to securing real-time communications. |
| ● | A session border controller, or SBC, is a device used in networks to exert control over the signaling and media streams involved in establishing, conducting and terminating VoIP calls. A traditional firewall or network address translation, or NAT, device typically block information like endpoint IP addresses and port numbers required by signaling protocols, such as SIP and XMPP, to reach and communicate with their intended destination. SBCs are used in physical networks to address these limitations and enable real-time session traffic to cross the boundaries created by firewalls and other NAT devices and enable VoIP calls to be established successfully. However, SBCs must decrypt and analyze every single data packet for the information to be transmitted successfully, thereby preventing end-to-end encryption. This network design results in SBCs becoming a single point of congestion on the network, as well as a single point of failure. SBCs are also limited to the physical network they secure. |
| ● | SIP firewalls, or SIP-aware firewalls, and application layer gateways, manage and protect the traffic, flow and quality of VoIP and other SIP-related communications. They perform real-time network address translation, dynamic firewall functions; support multiple signaling protocols, and media functionality, allowing secure interconnection and the flow of IP media streams across multiple networks. While SIP firewalls assist in analyzing SIP traffic transmitted over the corporate network to filter out various threats, they do not necessarily encrypt the traffic. As a result, this traffic is not entirely secure from end-to-end nor is it protected against threats like man-in-middle and eavesdropping. |
New Accounting Pronouncements
In July 2013, the FASB issued Accounting Standards Update (“ASU”) No. 2013-11 “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.” ASU No. 2013-11 is a new accounting standard on the financial statement presentation of unrecognized tax benefits. The new standard provides that a liability related to an unrecognized tax benefit would be presented as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. The new standard becomes effective for us on January 1, 2014 and will be applied prospectively to unrecognized tax benefits that exist at the effective date with retrospective application permitted. We are currently assessing the impacts of this new standard.
In February 2013, the FASB issued final guidance on the presentation of reclassifications out of other comprehensive income. The amendments require an entity to provide information about the amounts reclassified out of other comprehensive income by component. In addition, an entity is required to present, either on the face of the income statement or in a footnote, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, only if the amount reclassified is required by GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide detail about those amounts. This amendment was effective for interim and fiscal years beginning after December 15, 2012. The amended standard did not impact our financial position or results of operations.
Results of Operation
Three and Six Months Ended June 30, 2013
Compared with Three and Six Months Ended June 30, 2012
(in thousands, except per share amounts)
Revenue
We had $6 and $300, in revenue for the three and six months ended June 30, 2013, respectively, and $36, for the three and six months ended June 30, 2012.
For the three and six months ended June 30, 2013, we recognized royalty revenue, as part of settlement agreements entered into with customers during our patent infringement actions (see “Legal Proceedings”). In accordance with our revenue recognition policy related to a licensee’s product sales from prior periods, the amounts recognized resulted from negotiated agreements with licensees that utilized our patented technology prior to signing a patent license agreement with us. We record the consideration as revenue when we have obtained a signed agreement, identified a fixed or determinable price, and determined that collectability is reasonably assured. In the patent infringement actions, we did not request or receive any amounts allocable to settlement fees, expense reimbursement, damages or any other amount unrelated to historical sales. Revenue to be earned from forward licensing agreements entered into as a result of the litigation will be recognized as the earnings process is completed, license fees are fixed and determinable, and in accordance with our revenue recognition policy.
Research and Development Expenses
Research and development expenses were $382 and $274 for the three months ended June 30, 2013 and 2012, respectively, representing an increase of $108. Research and development expenses were $686 and $530 for the six months ended June 30, 2013 and 2012, respectively, representing an increase of $156. The increases were primarily due to increased wage and medical costs and share-based compensation expense to our employees.
Selling, General and Administrative Expenses
Selling, general and administrative expenses include management and administrative personnel, as well as outside legal, accounting, and consulting services.
Our selling, general and administrative expenses decreased by $5,294 to $6,202 for the three months ended June 30, 2013, from $11,496 for the three months ended June 30, 2012, and by $2,741 to $15,722 for the six months ended June 30, 2013, from $18,463 for the comparable period in 2012. This decrease is primarily due to a decrease in legal fees of $5,587, for the three months ending June 30, 2013 and $3,839 for the six months ending June 30, 2013, compared to the three months and six months ended June 30, 2012 respectively as a result of the decrease in legal fees associated with our patent infringement actions. We expect to incur the same levels or increased legal fees over the next two quarters as we enter the final phases in these infringement actions and expect to report losses from operations as a result. See Note 8 of the financial statements for additional information regarding these infringement actions. Management believes our legal expenses will decrease materially after our current court schedule is complete.
Other Income and Expenses
For the three months ended June 30, 2013, the non-cash loss related to the periodic revaluation of our Series I Warrants liability was $120, which compares to a non-cash loss of $2,248 for the three months ended June 30, 2012, and for the six months ended June 30, 2013, the non-cash gain was $1,486 as compared to the non-cash loss of $1,979 for the six months ended June 30, 2012. The liability for the Series I Warrants decreased to $2,686 at June 30, 2013, from $4,172 at December 31, 2012. The gain from the revaluations of the warrant liability in the six months ended June 30, 2013 was primarily the result of decreases in our common share price during the period.
Interest income decreased by $105 to $23 for the three months ended June 30, 2013, from $128 for the comparable 2012 period, and decreased by $146 to $56 for the six months ended June 30, 2013, from $202 for the six months ended June 30, 2012.
Liquidity and Capital Resources
As of June 30, 2013, our cash and cash equivalents totaled approximately $32,878 and our short-term investments totaled approximately $13,382, compared to cash equivalents of approximately $19,661 and short-term investments of approximately $26,493 at December 31, 2012. Working capital was $42,314 at June 30, 2013 and $53,862 at December 31, 2012. The decrease in cash and investments during the periods reported are primarily attributed to costs incurred for legal expenses in defense of our patent infringement actions, and losses incurred during the periods reported.
We expect that our cash and cash equivalents and short-term investments as of June 30, 2013, will be sufficient to fund our operations and provide working capital for general corporate purposes and legal expenses for at least the next several years. Over the long term, we expect to derive the majority of our future revenue from license fees and royalties associated with our patent portfolio, technology, software and secure domain name registry in the United States and other markets around the world.
Income Taxes
The income tax expense for the three months ended June 30, 2013 was $354, which was a negative effective income tax rate of 5 percent. The income tax expense for the six months ended June 30, 2013 was $356, which was a negative effective income tax rate of 2.5 percent. As a result of net operating losses during the periods the provision reflects only minimum tax payments and prior year tax true-up. The tax expense was calculated using the statutory U.S. federal rate primarily as a result of the change of the valuation allowance of $5,695, stock based compensation expense and non-deductible derivative loss. We have valuation allowances covering our deferred tax assets including net operating loss carry-forwards.
The income tax benefit for the three months ended June 30, 2012 was $3,590, which was an effective income tax rate of 26 percent. The income tax benefit for the six months ended June 30, 2012 was $5,763, which was an effective income tax rate of 28 percent.
In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of deferred assets will not be realized. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based on the available objective evidence, management believes it is more likely than not that the net deferred tax assets at June 30, 2013 will not be fully realizable. Accordingly, management has maintained a valuation allowance against our net deferred tax assets at June 30, 2013. The valuation allowance carried against our net deferred tax assets was $11,423 and $6,970 at June 30, 2013 and December 31, 2012, respectively.
At June 30, 2013, we have federal and state net operating loss carry-forwards of approximately $15,527and $52,756 respectively, expiring beginning in 2027 and 2016, respectively.
Effective January 1, 2009, we adopted accounting guidance for income taxes, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements and prescribes a recognition threshold and measurement attribute for the financial statements recognition and measurement of a tax position taken or expected to be taken in a tax return. We are now required to recognize in the financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position.
Our tax years for 2005 and forward are subject to examination by the U.S. tax authority and various state tax authorities. These years are open due to net operating losses and tax credits remaining unutilized from such years.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of June 30, 2013, we had accrued immaterial amounts of interest and penalties related to the uncertain tax positions.
Contractual Obligations
There have been no material changes to the contractual obligations disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.
Off-Balance Sheet Arrangements
None.
Interest Rate Risk
We invest our excess cash primarily in highly liquid instruments including time deposits, money market, and corporate debt securities. We seek to limit the amount of our credit exposure to any one issuer.
Investments in fixed rate instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates. Due in part to these factors, our income from investments may decrease in the future.
We considered the historical volatility of short-term interest rates and determined that it was reasonably possible that an adverse change of 100 basis points could be experienced in the near term but would have an immaterial impact in the fair value of our marketable securities, which generally mature within six months of June 30, 2013.
Other Market Risks
We have no obligation to settle our Series I Warrant obligations in cash. However, these derivative instruments are accounted for as liabilities on our consolidated balance sheets and are marked-to-market each period based on their estimated fair value. The non-cash gains or losses from the decreases and increases in the estimated fair value of the warrant liability are recognized in earnings each period. The estimated fair value is determined in large part by reference to our assumptions and estimates of various factors. Our liability will increase by approximately $200 and we may recognize significant non-cash losses, all other factors being constant if the market price of our common shares increases by $1. Conversely, our liability will decrease by approximately $200 and we may recognize significant non-cash gains, if all other factors being constant, if the market price of our common shares decreases by $1.
We considered the historical volatility of our stock prices and determined that it was reasonably possible that the fair market value of our stock price could increase or decrease substantially in the near term and could have a material impact to our consolidated balance sheets and statement of operations.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of June 30, 2013.
The purpose of this evaluation was to determine whether as of June 30, 2013 our disclosure controls and procedures were effective to provide reasonable assurance that the information we are required to disclose in our filings with the SEC, (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2013, our disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
We have five intellectual property infringement lawsuits pending against multiple parties in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these parties infringe on certain of our patents. We seek damages and injunctive relief in all the complaints. We have one complaint with the United States International Trade Commission (ITC) alleging that Apple, Inc. has engaged in unfair trade practices by the importation, sale for importation, and sale after importation of certain devices with secure communication capabilities that infringe one or more claims of our U.S. Patent No. 8,051,181. On February 27, 2013, we announced our intent to withdraw our complaint with the ITC and pursue comprehensive relief from Apple Inc.’s infringement through the district courts. The ITC case has been terminated.
VirnetX Inc. et al., v. Microsoft Corporation
On April 22, 2013, we initiated a lawsuit by filing a complaint against Microsoft Corporation in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that Microsoft has infringed U.S. Patent Nos. 6,502,135, 7,188,180, 7,418,504, 7,490,151, 7,921,211, and 7,987,274. We seek damages and injunctive relief. No hearing or trial dates have been set.
VirnetX Inc. v. Cisco Systems, Inc. et al and VirnetX Inc. v. Apple Inc. (Severed Case)
On August 11, 2010, we initiated a lawsuit by filing a complaint against Aastra, Apple, Cisco, and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these parties infringe on certain of our patents. We seek damages and injunctive relief. On February 4, 2011, we amended our original complaint, filed on August 11, 2010, against Aastra, Apple, Cisco and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, to assert U.S. Patent No. 7,418,504 against Apple and Aastra. On April 5, 2011, we again amended our complaint against Aastra, Apple, Cisco and NEC in the United States District Court for the Eastern District of Texas, Tyler Division, to include Apple’s iPad 2 in the list of Apple products that are accused of infringing our patents. We also asserted our newly-issued patent, U.S. Patent No. 7,921,211 against all of the defendants in that lawsuit. A claim construction hearing was held on January 5, 2012 and the court issued a Markman ruling on April 25, 2012. Aastra and NEC have signed license agreements with us and we have agreed to drop all the accusations of infringement against them. At the pre-trial hearing, the judge decided to postpone the trial against Cisco to March 4, 2013 and just try the case against Apple. On November 6, 2012, a Jury in the United States Court for the Eastern District of Texas, Tyler Division, awarded us over $368,000 in a verdict against Apple Corporation for infringing four of our patents. A post-trial hearing in the case against Apple was held on December 20, 2012. On February 26, 2013, the United States District Court for the Eastern District of Texas, Tyler Division issued its Memorandum Opinion and Order regarding post-trial motions resulting from the prior jury verdict. The Court denied Apple’s motion to reduce the damages awarded by the jury for past infringement. The Court further denied Apple’s request for a new trial on the liability and damages portions of the verdict. Additionally, the Court granted our motions for pre-judgment interest, post-judgment interest, and post-verdict damages to date. Specifically, the Court ordered that Apple pay $34 in daily interest up to final judgment and $330 in daily damages for infringement up to final judgment for certain Apple devices included in the verdict. The Court denied our request for a permanent injunction. In doing so, the Court ordered the parties to mediate over a license in the following 45 days for Apple’s future infringing use not covered by the Court’s Order, and ordered us to file an appropriate motion with the court if the parties fail to agree to a license. On March 28, 2013, Apple filed a motion to alter or amend the judgment entered by the Court. The mediation was held on April 9, 2013 and the parties did not come to an agreement on an ongoing royalty rate for infringing Apple products. We filed our opposition to this motion on April 10, 2013. As ordered by the Court, we filed a sealed motion with the Court on April 16, 2013, requesting the Court’s assistance in deciding an appropriate royalty rate for all infringing products shipped by Apple that are “not colorably different” with regards to the accused functionality. However, the judgment may be appealed and no assurances can be given as to when or if we will receive any proceeds in connection with these matters, and accordingly there has been no recognition of the jury awards or royalties in our accompanying financial statements. Under our agreements with Science Applications International Corporation (SAIC), we would pay to SAIC 25% of the proceeds obtained by us in this lawsuit against Apple after reduction for attorneys’ fees and costs incurred in litigating those claims. We are awaiting the Court’s decision in this matter. On July 1, 2013, the Court entered an Order setting a hearing on VirnetX’s motion for an ongoing royalty for August 15, 2013. On July 3, 2013, Apple filed an appeal of the judgment dated February 27, 2013 and order dated June 4, 2013 denying Apple’s motion to alter or amend the judgment to the United States Court of Appeals for the Federal Circuit.
The jury trial against Cisco was held on March 4, 2013. At the end of the trial, the jury came back with a verdict of non-infringement in the trial. The same jury also found that all our patents-in-suit were valid and enforceable. On April 3, 2013, we filed a request for a new trial regarding Cisco’s infringement of four of our patents based primarily on our allegations of Cisco’s inappropriate conduct and arguments during the jury trial that concluded on March 14, 2013. In addition to the request for a new trial, we filed a motion for a judgment as a matter of law on Cisco’s infringement of the ‘759 patent. On April 11, 2013, in response to our motion, Cisco filed its renewed motion to dismiss as moot its invalidity counterclaims against the claims in our patents that were not asserted in the lawsuit as well as a conditional motion for a new trial on certain limited claims and defenses. We are awaiting the Court’s decision in this matter. A hearing on VirnetX’s motion for new trial and Cisco’s renewed motion to dismiss as moot its invalidity counterclaims and conditional motion for a new trial was held on June 17, 2013. We are awaiting the Court’s ruling on these motions.
VirnetX Inc. v. Mitel Networks Corporation et al
On January 12, 2011, we initiated a lawsuit by filing a complaint against Siemens and Mitel in the United States District Court for the Eastern District of Texas, Tyler Division, pursuant to which we allege that these companies infringe three of our patents. We seek damages and injunctive relief. On April 12, 2011 we again amended our complaint against Siemens and Mitel in the United States District Court for the Eastern District of Texas, Tyler Division, to add Avaya Inc. as a defendant. On July 11, 2012, Mitel Network Corporation signed a license agreement with us and we dismissed the patent infringement case against them. On July 12, 2012 we had a claims construction hearing in this case and a Markman order was issued on August 1, 2012. On January 29, 2013 Siemens signed a license agreement with us and we dismissed the patent infringement case against them. On April 9, 2013, the Court issued a new docket control order in our lawsuit against the remaining defendant Avaya Inc. According to this new order, jury selection is set for September 3, 2013 followed by a jury trial on September 9, 2013. A pretrial conference has been scheduled for August 22, 2013.
VirnetX Inc. v. Apple, Inc.
On November 1, 2011, we initiated a lawsuit against Apple in the United States District Court, Tyler Division, pursuant to which we allege that Apple infringes one or more claims of our U.S. Patent No. 8,051,181. We seek damages and injunctive relief. No hearing or trial dates have been set. On June 17, 2013 the Court granted VirnetX’s unopposed motion to lift the stay ordered by the Court on December 15, 2011. On June 18, 2013 the Court granted the parties unopposed motion to consolidate this case with Civil Action No. 6:12-cv-00855-LED.
VirnetX Inc. v. Apple, Inc.
On November 6, 2012, we filed a new complaint against Apple Inc., in the United States District Court for the Eastern District of Texas, Tyler Division for willfully infringing four of our patents, U.S. Patent Nos. 6,502,135, 7,418,504, 7,921,211 and 7,490,151, and seeking both damages and injunctive relief. The accused products include the iPhone 5, iPod Touch 5th Generation, iPad 4th Generation, iPad mini, and the latest Macintosh computers. Due to their release dates, these products were not included in the previous lawsuit that concluded with a Jury verdict on November 6, 2012 that was subsequently upheld by the United States District Court for the Eastern District of Texas, Tyler Division, on February 26, 2013. On July 1, 2013, we filed a consolidated and amended complaint to include U.S. Patent No. 8,051,181 and consolidate Civil Action No. 6:11-cv-00563-LED.
ITC Investigation No. 337-TA-858
On July 18, 2012, the Administrative Law Judge (ALJ) assigned to investigate our complaint against Apple Inc., identified a procedural discrepancy with our complaint and dismissed it. On September 14, 2012, we re-filed our complaint with the ITC jointly with Science Applications International Corporation (SAIC) [NYSE: SAI] to remove a procedural standing issue that was identified as the reason for dismissal of our previous complaint. On October 16, 2012, the United States International Trade Commission (ITC) accepted our complaint and instituted an investigation against Apple and assigned ALJ E. James Gildea to preside over this investigation. Subsequently on October 23, 2012, ALJ Gildea issued an order setting up February 21, 2014 as the target date for completion of this investigation. The hearing in-front of ALJ Gildea was scheduled for May 20, 2013. On February 27, 2013, we announced our intent to withdraw our complaint with the ITC and pursue comprehensive relief from Apple Inc.’s infringement through the district courts. The ITC case has been terminated.
One or more potential intellectual property infringement claims may also be available to us against certain other companies who have the resources to defend against any such claims. Although we believe these potential claims are worth pursuing, commencing a lawsuit can be expensive and time-consuming, and there is no assurance that we will prevail on such potential claims. In addition, bringing a lawsuit may lead to potential counterclaims which may preclude our ability to commercialize our initial products, which are currently in development. Currently, we are not a party to any other pending legal proceedings, and are not aware of any proceeding threatened or contemplated against us by any governmental authority or other party.
You should carefully consider the following material risks in addition to the other information set forth in this Quarterly Report on Form 10-Q, as well as our Annual Form 10-K filed March 1, 2013 before making any investment in our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. If any of these risk factors occurs, you could lose substantial value or your entire investment in our shares.
Risks Related to Our Business and Our Financial Reporting
We may not be able to capitalize on market opportunities related to our licensing strategy or our patent portfolio.
Our business strategy includes licensing our patents and technology to other companies in order to reach a larger end-user base than we could reach through direct sales and marketing efforts; as such, our business strategy and revenues will depend on intellectual property licensing fees and royalties for the majority of our revenues. We currently derive minimal revenue from licensing activities and we cannot assure you that we will successfully capitalize on our market opportunities or that our current business strategy will succeed. Factors that may affect our ability to execute our current business strategy including, but are not limited to:
| ● | Although we have to date entered into a limited number of settlement and license agreements, we may not be successful in entering into further licensing relationships and existing settlement and license agreements may not generate the financial results we expect; |
| ● | Third parties may challenge the validity of our patents; |
| ● | The pendency of our various litigations may cause potential licensees not to do business with us; |
| ● | We face, and we expect to continue to face, intense competition from new and established competitors who may have superior products and services or better marketing, financial or other capacities than we do; and |
| ● | It is possible that one or more of our potential customers or licensees develops or otherwise sources products or technologies similar to, competitive with or superior to ours. |
If we are not able to adequately protect our patent rights, our business would be negatively impacted.
We believe our patents are valid, enforceable and valuable. Notwithstanding this belief, third parties may make claims of infringement or invalidity claims with respect to our patents and such claims could give rise to material cost for defense or settlement or both, jeopardize or substantially delay a successful outcome of litigation we are or may become involved in, divert resources away from our other activities, limit or cease our revenues related to such patents, or otherwise materially and adversely affect our business. Similar challenges could also prevent us from obtaining additional patents in the future. Even if we are successful in enforcing our rights, our patents may not ultimately provide us with any competitive advantages and may be less valuable than we currently expect. These risks may be heightened in countries other than the United States where laws regarding patent protection are less developed, and may be negatively affected by the fact that legal standards in the United States and elsewhere for protection of intellectual property rights in Internet-related businesses are uncertain and still evolving. In addition, there are a significant number of United States and foreign patents and patent applications in our areas of interest, and we expect that significant litigation in these areas will continue, and will add uncertainty to the value of certain patents and other intellectual property rights in our areas of interest. If we are unable to protect our intellectual property rights or otherwise realize value from them, our business would be negatively affected.
We are involved and will continue to be involved in numerous litigation matters defending our patent portfolio, which can be time-consuming and costly and we cannot anticipate the results.
We spend a significant amount of our financial and management resources to pursue our current litigation matters. We believe that these litigation matters and others that we may in the future determine to pursue could continue for years and continue to consume significant financial and management resources. The counterparties to our litigation are all large, well-financed companies with substantially greater resources than us. We cannot assure you that any of our current or future litigation matters will result in a favorable outcome for us. In addition, even if we obtain favorable interim rulings or verdicts in particular litigation matters, they may not be predictive of the ultimate resolution of the dispute. Also, we cannot assure you that we will not be exposed to claims or sanctions against us which may be costly or impossible for us to defend. Unfavorable or adverse outcomes may result in losses, exhaustion of financial resources or other adverse effects, which could encumber our ability to develop and commercialize products.
We can provide no assurances that the licensing of our essential security patents under FRAND will be successful.
At the request of the European Telecommunications Standards Institute (ETSI), and the Alliance for Telecommunications Industry Solutions (ATIS), we agreed to update our licensing declaration to ETSI and ATIS under their respective Intellectual Property Rights (IRP) policies. This was in response to our Statement of Patent Holder identifying a group of our patents and patent applications that we believe are or may become essential to certain developing specifications in the 3rd Generation Partnership Project (3GPP) Long Term Evolution (LTE), Systems Architecture Evolution (SAE) project. We will make available a non-exclusive patent license under FRAND (fair, reasonable and non-discriminatory terms and conditions, with compensation) for the patents identified by VirnetX that are or become essential, to applicants desiring to implement the Technical Specifications identified by VirnetX, as set forth in the updated licensing declaration under the ATIS and ETSI IPR policies. Our licensing declarations under the ATIS and ETSI IPR policies may limit our flexibility in determining royalties and license terms for certain of our patents. Consequently, we cannot assure you that the licensing of the essential security patents will be successful or that third parties will be willing to enter into licenses with VirnetX on reasonable terms or at all, which could have an adverse effect on our business and harm our competitive position.
Because our business is conducted or expected to be conducted in an environment that is subject to rapid change, we may be subject to various developments in regulation, law and consumer preferences to which we may not be able to adapt successfully.
The current regulatory environment for our products and services remains unclear. We can give no assurance that our planned product offerings will be in compliance with laws and regulations of local, state, United States federal or foreign authorities. Further, we can give no assurance that we will not unintentionally violate such laws or regulations or that such laws or regulations will not be modified, or that new laws or regulations will be enacted in the future which would cause us to be in violation of such laws or regulations. For example, Voice-over-Internet Protocol (or VoIP) services are not currently subject to all of the same regulations that apply to traditional telephony, but it is possible that similar regulations may be applied to VoIP in the future and that these could result in substantial costs which adversely affect the marketability of our products and planned products related to VoIP. For further example, the use of the Internet and private Internet Protocol (IP) networks for communication is largely unregulated within the United States, but may become regulated in the future; also several foreign governments have enacted measures that could restrict or prohibit voice communications services over the Internet or private IP networks.
Our business depends on the growth of instant messaging, VoIP, mobile services, streaming video, file transfer and remote desktop and other next-generation Internet-based applications which are relatively new. A decline in the use of these applications due to complexity or cost of these applications relative to alternate traditional or newly developed communications channels, or development of alternative technologies, could cause a material decline in the number of users in these areas.
More aggressive domestic or international regulation of the Internet in general, and Internet telephony providers and services specifically or a lack of growth in acceptance of the Internet as a long term viable marketplace for communications services may materially and adversely affect our business, financial condition, operating results and future prospects.
Our exposure to outside influences beyond our control, including new legislation, court rulings or actions by the United States Patent and Trademark Office, could adversely affect our licensing and enforcement activities and results of operations.
Our licensing and enforcement activities are subject to numerous risks from outside influences, including the following:
| ● | New legislation, regulations or rules related to obtaining patents or enforcing patents could significantly increase our operating costs and decrease our revenue. For instance, the United States Supreme Court has recently modified some tests used by the United States Patent and Trademark Office (USPTO) in granting patents during the past 20 years which may decrease the likelihood that we will be able to obtain patents and increase the likelihood of challenge of any patents we obtain or license. In addition, the United States recently enacted sweeping changes to the United States patent system under the Leahy-Smith America Invents Act (“AIA”), including changes that transition the United States from a “first-to-invent” system to a “first to file” system and alter the processes for challenging issued patents. |
| ● | More patent applications are filed each year resulting in longer delays in getting patents issued by the USPTO. |
| ● | Federal courts are becoming more crowded, and as a result, patent enforcement litigation is taking longer. |
| ● | As patent enforcement becomes more prevalent, it may become more difficult for us to voluntarily license our patents. |
If we experience security breaches, we could be exposed to liability and our reputation and business could suffer.
We expect to retain certain confidential customer information in our secure data centers and secure domain name registry. It will be critical to our business strategy that our facilities and infrastructure remain secure and are perceived by the marketplace to be secure. Our secure domain name registry operations will also depend on our ability to maintain our computer and telecommunications equipment in effective working order and to reasonably protect our systems against interruption, and potentially depend on protection by other registrars in the shared registration system. The secure domain name servers that we will operate will be critical hardware to our registry services operations. Therefore, we expect to have to expend significant time and money to maintain or increase the security of our facilities and infrastructure. Security technologies are constantly being tested by computer professionals, academics and “hackers.” Advances in the techniques for attacking security solutions could make some or all of our products obsolete or unmarketable. Likewise, if any of our products are found to have significant security vulnerabilities, then we may need to dedicate engineering and other resources to eliminate the vulnerabilities and to repair or replace products already sold or licensed to our customers. Despite our security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, attacks by hackers or similar disruptive problems. It is possible that we may have to expend additional financial and other resources to address such problems. Any physical or electronic break-in or other security breach or compromise of the information stored at our secure data centers and domain name registration systems may jeopardize the security of information stored on our premises or in the computer systems and networks of our customers. In such an event, we could face significant liability and customers could be reluctant to use our services. Such an occurrence could also result in adverse publicity and therefore adversely affect the market’s perception of the security of electronic commerce and communications over IP networks as well as the security or reliability of our services.
A security breach could require a substantial amount of expense to rectify and could result in a product liability claim that causes us to incur substantial liability and related legal and other costs. A security breach may also harm our reputation and make it more difficult or impossible for us to successfully market to others. These matters could harm our operating results and financial condition.
We expect that we will experience long and unpredictable sales cycles, which may impact our operating results.
We expect that our sales cycles will be long and unpredictable due to a number of uncertainties such as:
| ● | The need to educate potential customers about our patent rights and our product and service capabilities; |
| ● | Customers’ willingness to invest potentially substantial resources and modify their network infrastructures to take advantage of our products; |
| ● | Customers’ budgetary constraints; |
| ● | The timing of customers’ budget cycles; and |
| ● | Delays caused by customers’ internal review processes. |
| ● | Long sales cycles may increase the risk that our financial resources are exhausted before we are able to generate significant revenue. |
We expect that we will be substantially dependent on a concentrated number of customers. If we are unable to establish, maintain or replace our relationships with customers and develop a diversified customer base, our revenues may fluctuate and our growth may be limited.
We expect that in the future, a significant portion of our revenues will be generated from a limited number of customers. There can be no guarantee that we will be able to obtain additional customers, or if we do so, to sustain our revenue levels from these prospective customers. If we are not able to establish, maintain or replace the limited group of prospective customers that we anticipate may generate a substantial majority of our revenues in the future, or if they do not generate revenues at the levels or at the times that we anticipate, our ability to maintain or grow our revenues will be adversely affected.
Our products are highly technical and may contain undetected errors, which could cause harm to our reputation and adversely affect our business.
Our products are highly technical and complex and, when deployed, may contain errors or defects. Despite testing, some errors in our products may only be discovered after a product has been installed and used by customers. Any errors or defects discovered in our products after commercial release could result in failure to achieve market acceptance, loss of revenue or delay in revenue recognition, loss of customers and increased service and warranty cost, any of which could adversely affect our business, operating results and financial condition. In addition, we could face claims for product liability, tort or breach of warranty, including claims relating to changes to our products made by our channel partners. The performance of our products could have unforeseen or unknown adverse effects on the networks over which they are delivered as well as on third-party applications and services that utilize our services, which could result in legal claims against us, harming our business. Furthermore, we expect to provide implementation, consulting and other technical services in connection with the implementation and ongoing maintenance of our products, which typically involves working with sophisticated software, computing and communications systems. We expect that our contracts with customers will contain provisions relating to warranty disclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divert management’s attention and adversely affect the market’s perception of us and our products. In addition, if our business liability insurance coverage proves inadequate or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.
Malfunctions of third-party communications infrastructure, hardware and software expose us to a variety of risks we cannot control.
Our business will depend upon, among other things, the capacity, reliability and security of the infrastructure owned by third parties that we will use to deploy our offerings. We have no control over the operation, quality or maintenance of a significant portion of that infrastructure or whether or not those third parties will upgrade or improve their equipment. We depend on these companies to maintain the operational integrity of our connections. If one or more of these companies is unable or unwilling to supply or expand its levels of service to us in the future, our operations could be severely interrupted. Also, to the extent the number of users of networks utilizing our future products suddenly increases, the technology platform and secure hosting services which will be required to accommodate a higher volume of traffic may result in slower response times or service interruptions. System interruptions or increases in response time could result in a loss of potential or existing users and, if sustained or repeated, could reduce the appeal of the networks to users. In addition, users depend on real-time communications; outages caused by increased traffic could result in delays and system failures. These types of occurrences could cause users to perceive that our solution does not function properly and could therefore adversely affect our ability to attract and retain licensees, strategic partners and customers.
System failure or interruption or our failure to meet increasing demands on our systems could harm our business.
The success of our license and service offerings will depend on the uninterrupted operation of various systems, secure data centers and other computer and communication networks that we establish. To the extent the number of users of networks utilizing our future products suddenly increases, the technology platform and hosting services which will be required to accommodate a higher volume of traffic may result in slower response times, service interruptions or delays or system failures. Our systems and operations will also be vulnerable to damage or interruption from:
| ● | power loss, transmission cable cuts and other telecommunications failures; |
| ● | damage or interruption caused by fire, earthquake, and other natural disasters; |
| ● | computer viruses or software defects; and |
| ● | physical or electronic break-ins, sabotage, intentional acts of vandalism, terrorist attacks and other events beyond our control. |
System interruptions or failures and increases or delays in response time could result in a loss of potential or existing users and, if sustained or repeated, could reduce the appeal of the networks to users. These types of occurrences could cause users to perceive that our solution does not function properly and could therefore adversely affect our ability to attract and retain licensees, strategic partners and customers.
Any significant problem with our systems or operations could result in lost revenue, customer dissatisfaction or lawsuits against us. A failure in the operation of our secure domain name registration system could result in the inability of one or more registrars to register and maintain secure domain names for a period of time. A failure in the operation or update of the master directory that we plan to maintain could result in deletion or discontinuation of assigned secure domain names for a period of time. The inability of the registrar systems we establish, including our back office billing and collections infrastructure, and telecommunications systems to meet the demands of an increasing number of secure domain name requests could result in substantial degradation in our customer support service and our ability to process registration requests in a timely manner.
Our ability to sell our solutions will be dependent on the quality of our technical support, and our failure to deliver high-quality technical support services could have a material adverse effect on our sales and results of operations.
If we do not effectively assist our customers in deploying our products, succeed in helping our customers quickly resolve post-deployment issues and provide effective ongoing support, or if potential customers perceive that we may not be able achieve to the foregoing, our ability to sell our products would be adversely affected, and our reputation with potential customers could be harmed. In addition, as we expand our operations internationally, our technical support team will face additional challenges, including those associated with delivering support, training and documentation in languages other than English. Our failure to deliver and maintain high-quality technical support services to our customers could result in customers choosing to use our competitors’ products instead of ours in the future.
Telephone carriers have petitioned governmental agencies to enforce regulatory tariffs, which, if granted, would increase the cost of online communication, and such increase in cost may impede the growth of online communication and adversely affect our business.
Use of the Internet has over-burdened existing telecommunications infrastructures, and many high traffic areas have begun to experience interruptions in service. As a result, certain local telephone carriers have petitioned governmental agencies to enforce regulatory tariffs on IP telephony traffic that crosses over their traditional telephone networks. If the relief sought in these petitions is granted, the costs of communicating via online could increase substantially, potentially adversely affecting the growth in the use of online secure communications. Any of these developments could have an adverse effect on our business.
The departure of Kendall Larsen, our Chief Executive Officer and President, and/or other key personnel could compromise our ability to execute our strategic plan and may result in additional severance costs to us.
Our success largely depends on the skills, experience and efforts of our key personnel, including Kendall Larsen, our Chief Executive Officer and President. We have no employment agreements with any of our key executives that prevent them from leaving us at any time. In addition, we do not maintain key person life insurance for any of our officers or key employees. The loss of Mr. Larsen, or our failure to retain other key personnel, would jeopardize our ability to execute our strategic plan and materially harm our business.
We will need to recruit and retain additional qualified personnel to successfully grow our business.
Our future success will depend in part on our ability to attract and retain qualified operations, marketing and sales personnel as well as engineers. Inability to attract and retain such personnel could adversely affect our business. Competition for engineering, sales, marketing and executive personnel is intense, particularly in the technology and Internet sectors and in the regions where our facilities are located. We can provide no assurance that we will attract or retain such personnel.
The fair value of accounting for our Series I Warrants as derivative liabilities may materially impact our results of our operations in future periods.
We record the Series I Warrants as a derivative liability in accordance with ASC 815-40, “Derivatives and Hedging – Contracts in Entity’s Own Equity.” These derivative liabilities are reported at fair value each reporting period with changes in the fair value recognized as gain or loss during each reporting period. An increase in our share price or measure of our share price volatility, for example, will generally result in an increase in the fair value of our warrant liability and a non-cash charge during the period of such increase, which could materially and negatively impact our results of operations in future periods.
We may identify future material internal control weaknesses which may result in late filings, increased costs or declines in our share price.
Although we believe that we currently maintain effective control over our disclosures and procedures and internal control over financial reporting, we may in the future identify deficiencies regarding the design and effectiveness of our system of internal control over financial reporting. If we experience any material weaknesses in our internal control over financial reporting the future or are unable to provide unqualified management or attestation reports about our internal controls, we may be unable to meet financial and other reporting deadlines and may incur costs associated with remediation, and any of which could cause our share price to decline.
Risks Related to Our Stock
We do not currently pay dividends on our common stock and thus stockholders must look to appreciation of our common stock to realize a gain on their investments.
Although we paid a special cash dividend to holders of our common stock with a record date of July 1, 2010, we do not currently pay regular dividends on our common stock and instead, retain future earnings to fund our business plan. Our future dividend policy is within the discretion of our Board of Directors and will depend upon various factors, including our business, financial condition, results of operations, capital requirements, and investment opportunities. We therefore can’t assure you that our Board of Directors will determine to pay regular or special dividends in the future. Accordingly, unless our Board of Directors determines to pay dividends, stockholders will be required to look to appreciation of our common stock to realize a gain on their investment. This appreciation may not occur.
The exercise of our outstanding stock options would result in a dilution of our current stockholders' voting power and an increase in the number of shares eligible for future resale in the public market which may negatively impact the market price of our stock.
The exercise of our outstanding vested stock options would dilute the ownership interests of our existing stockholders. As of June 30, 2013, we had outstanding options to purchase an aggregate of 5,009,849 shares of common stock representing 9.8% of our total shares outstanding as of June 30, 2013, of which 4,262,724 are vested and therefore exercisable. To the extent outstanding stock options are exercised, additional shares of common stock will be issued, and such issuance would dilute non-exercising stockholders' percentage voting interests and increase the number of shares eligible for resale in the public market.
Trading in our common shares is limited and the price of our common shares may be subject to substantial volatility, particularly in light of the instability in the financial and capital markets.
Our common stock is listed on NYSE MKT. Over the past years the market price of our common stock has experienced significant fluctuations. Between July 1, 2012, and June 30, 2013, the reported last sale price on NYSE MKT for our common stock ranged between $16.45 and $40.47 per share. The price of our common stock may continue to be volatile as a result of a number of factors, some of which are beyond our control. These factors include, but not limited to, the following:
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developments in any then-outstanding litigation;
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quarterly variations in our operating results;
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large purchases or sales of common stock or derivative transactions related to our stock;
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actual or anticipated announcements of new products or services by us or competitors;
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general conditions in the markets in which we compete; and
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general economic and financial conditions.
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In addition, we believe there has been and may continue to be substantial off-market transactions in derivatives of our stock, including short selling activity or related similar activities, which are beyond our control and which may be beyond the full control of the SEC and Financial Institutions Regulatory Authority ("FINRA"). While SEC and FINRA rules prohibit some forms of short selling and other activities that may result in stock price manipulation, such activity may nonetheless occur without detection or enforcement. We have held conversations with regulators concerning trading activity in our stock; however, there can be no assurance that should there be any illegal manipulation in the trading of our stock it will be detected, prosecuted or successfully eradicated. Significant short selling or other types of market manipulation could cause our stock trading price to decline, to become more volatile, or both.
The market price of our common stock may decline because our operating results may not be consistent and may be difficult to predict.
Our reported net income has fluctuated in the past due to several factors. We expect that our future operating results may also fluctuate due to the same or similar factors. We had net income of $41.4 million for the year ended December 31, 2010, a net loss of $17.3 million for the year ended December 31, 2011, a net loss $26.9 million for the year ended December 31, 2012 and a net loss $14.9 million for the six months ended June 30, 2013 with an accumulated deficit of $77.8 million. The following include some of the factors that may cause our operating results to fluctuate:
| · | the outcome of actions to enforce our intellectual property rights currently in progress or that we may undertake in the future, and the timing thereof; |
| · | the amount and timing of receipt of license fees from potential infringers, licensees or customers; |
| · | the rate of adoption of our patented technologies; |
| · | the number of new license arrangements we may execute, or that may expire, within a particular period and the scope of those licenses, including the number of our patents which are licensed, the extent of prior infringement of our patent rights, royalty rates, timing of payment obligations, expiration date etc; |
| · | the success of a licensee in selling products that use our patented technologies; and |
| · | the amount and timing of expenses related to our patent filings and enforcement proceedings, including litigation, related to our intellectual property rights. |
These fluctuations may make our business particularly difficult to manage, adversely affect our business and operating results, make our operating results difficult for investors to predict and, further, cause our results to fall below investor’s expectations and adversely affect the market price of our common stock.
Because ownership of our common stock is concentrated, investors may have limited influence on stockholder decisions.
As of June 30, 2013, our executive officers and directors beneficially owned approximately 20% of our then outstanding common stock. In addition, a group of stockholders that, as of December 31, 2007, held 4,766,666 shares, or approximately 12%, of our then outstanding common stock, have entered into a voting agreement with us that requires them to vote all of their shares of our voting stock in favor of the director nominees approved by our Board of Directors at each director election going forward, and in a manner that is proportional to the votes cast by all other voting shares as to any other matters submitted to the stockholders for a vote. However, we cannot be certain how many shares of our common stock this group of stockholders currently owns. Because of their beneficial ownership interest, our officers and directors could significantly influence stockholder actions of which you disapprove or that are contrary to your interests. This ability to exercise significant influence could prevent or significantly delay another company from acquiring or merging with us.
Our protective provisions could make it difficult for a third party to successfully acquire us even if you would like to sell your stock to them.
We have a number of protective provisions that could delay, discourage or prevent a third party from acquiring control of us without the approval of our Board of Directors. Our protective provisions include:
| ● | A staggered Board of Directors: This means that only one or two directors (since we have a five-person Board of Directors) will be up for election at any given annual meeting. This has the effect of delaying the ability of stockholders to effect a change in control of us because it would take two annual meetings to effectively replace a majority of the Board of Directors. |
| ● | Blank check preferred stock: Our Board of Directors has the authority to establish the rights, preferences and privileges of our 10,000,000 authorized, but unissued, shares of preferred stock. Therefore, this stock may be issued at the discretion of our Board of Directors with preferences over your shares of our common stock in a manner that is materially dilutive to you. In addition, blank check preferred stock can be used to create a “poison pill” which is designed to deter a hostile bidder from buying a controlling interest in our stock without the approval of our Board of Directors. We have not adopted such a “poison pill;” but our Board of Directors has the ability to do so in the future, very rapidly and without stockholder approval. |
| ● | Advance notice requirements for director nominations and for new business to be brought up at stockholder meetings : Stockholders wishing to submit director nominations or raise matters to a vote of the stockholders must provide notice to us within very specific date windows and in very specific form in order to have the matter voted on at a stockholder meeting. This has the effect of giving our Board of Directors and management more time to react to stockholder proposals generally and could also have the effect of disregarding a stockholder proposal or deferring it to a subsequent meeting to the extent such proposal is not raised properly. |
| ● | No stockholder actions by written consent: No stockholder or group of stockholders may take actions rapidly and without prior notice to our Board of Directors and management or to the minority stockholders. Along with the advance notice requirements described above, this provision also gives our Board of Directors and management more time to react to proposed stockholder actions. |
| ● | Super majority requirement for stockholder amendments to the By-laws: Stockholder proposals to alter or amend our By-laws or to adopt new By-laws can only be approved by the affirmative vote of at least 66 2/3% of the outstanding shares of our common stock. |
| ● | No ability of stockholders to call a special meeting of the stockholders: Only the Board of Directors or management can call special meetings of the stockholders. This could mean that stockholders, even those who represent a significant percentage of our shares of common stock, may need to wait for the annual meeting before nominating directors or raising other business proposals to be voted on by the stockholders. |
In addition, the provisions of Section 203 of the Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a certain period of time.
These and other provisions in our amended and restated certificate of incorporation, our By-laws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions.
Not applicable
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Exhibit Number
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Description
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31.1
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Certification of the President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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31.2
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Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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32.1*
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Certification of the President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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32.2*
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Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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101**
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Interactive Data Files
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| * | This exhibit is furnished herewith, but not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section. Such certifications will not be deemed to be incorporated by reference in any filing under the Securities Act or the Exchange Act, except to the extent that we explicitly incorporate them by reference. |
Pursuant to the requirements 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.
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VIRNETX HOLDING CORPORATION
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By:
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/s/ Kendall Larsen
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Name
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Kendall Larsen
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Title
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Chief Executive Officer (Principal Executive Officer)
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By:
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/s/ Richard Nance
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Name
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Richard H. Nance
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Title
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Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)
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Date: August 09, 2013
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Exhibit Number
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Description
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Certification of the President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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Certification of the President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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101**
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Interactive Data Files
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| * | This exhibit is furnished herewith, but not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section. Such certifications will not be deemed to be incorporated by reference in any filing under the Securities Act or the Exchange Act, except to the extent that we explicitly incorporate them by reference. |
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