-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Ok861F8M14jv0oYFIFjLSXyX5u2ad/7ALz1msaLWsuYDWQD0vPE7JyaaxGbpuYeH QdmbwWUuuuvM5L5FH+uFCA== 0001012870-99-001913.txt : 19990615 0001012870-99-001913.hdr.sgml : 19990615 ACCESSION NUMBER: 0001012870-99-001913 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 9 FILED AS OF DATE: 19990611 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CORTELCO SYSTEMS INC CENTRAL INDEX KEY: 0001084752 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661] IRS NUMBER: 621482178 STATE OF INCORPORATION: DE FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: S-1/A SEC ACT: SEC FILE NUMBER: 333-77021 FILM NUMBER: 99645136 BUSINESS ADDRESS: STREET 1: 4119 WILLOW LAKE BOULEVARD CITY: MEMPHIS STATE: TN ZIP: 38118 BUSINESS PHONE: 9013657774 MAIL ADDRESS: STREET 1: 4119 WILLOW LAKE BOULEVARD CITY: MEMPHIS STATE: TN ZIP: 38118 S-1/A 1 AMENDMENT NO. 1 TO FORM S-1 As filed with the Securities and Exchange Commission on June 11, 1999 Registration No. 333-77021 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- AMENDMENT NO. 1 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------- Cortelco Systems, Inc. (Name of Registrant as specified in its charter) Delaware 3661 62-1482176 (Primary Standard Industrial (I.R.S. Employer (State or other Classification Code) Identification No.) jurisdiction of incorporation or organization) 4119 Willow Lake Blvd. Memphis, TN 38118 (901) 365-7774 (Address and telephone number of principal executive offices and principal place of business) J. Michael O'Dell President and Chief Executive Officer Cortelco Systems, Inc. 4119 Willow Lake Blvd. Memphis, TN 38118 (901) 365-7774 (Name, address and telephone number of agent for service) Copies to: James C. Kitch, Esq. Alan Dean, Esq. COOLEY GODWARD LLP DAVIS POLK & WARDWELL Five Palo Alto Square 450 Lexington Avenue 3000 El Camino Real New York, NY 10017 Palo Alto, California 94036 (212) 450-4000 (650) 843-5000 --------------- Approximate date of proposed sale to the public: As soon as practicable after the registration statement becomes effective. --------------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, please check the following box. [_] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [_] The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ +The information in this preliminary prospectus is not complete and may be + +changed. These securities may not be sold until the registration statement + +filed with the Securities and Exchange Commission is effective. This prelimi- + +nary prospectus is not an offer to sell nor does it seek an offer to buy + +these securities in any jurisdiction where the offer or sale is not permit- + +ted. + ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Prospectus Subject To Completion, Dated June 11, 1999 3,120,000 Shares [Cortelco Logo Appears Here] Cortelco Systems, Inc. Common Stock Cortelco Systems, Inc. is offering 2,300,000 shares of its common stock. The selling stockholders are offering an additional 820,000 shares. We will not receive any of the proceeds from the sale of shares by the selling stockholders. This is our initial public offering and no public market currently exists for our common stock. We estimate that the initial public offering price will be between $10.00 and $12.00 per share. We have filed an application to qualify our common stock for quotation on the Nasdaq National Market under the symbol "CORT." Investing in the common stock involves risks. See "Risk Factors" beginning on page 4. NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. - --------------------------------------------------------------------------------
Proceeds to Price to Underwriting Proceeds to Selling Public Discounts Cortelco Stockholders - --------------------------------------------------------------------- Per Share $ $ $ $ - --------------------------------------------------------------------- Total $ $ $ $ - ---------------------------------------------------------------------
Cortelco has granted the underwriters the right to purchase up to an additional 37,288 shares of common stock to cover over-allotments and the selling stockholders have granted the underwriters the right to purchase up to an additional 430,712 shares of common stock to cover overallotments. J.P. Morgan & Co. Needham & Company, Inc. A.G. Edwards & Sons, Inc. , 1999 Demanding Customers Choose Cortelco for Feature-Rich Communications Solutions Circuit City Circuit City has implemented our products in stores throughout the U.S. Circuit City's customer service centers use our Real-Time Automatic Call Distributor package. The Millennium's flexible call routing and automatic call distribution capabilities and its easy installation and programming were important factors in choosing a Cortelco solution. Los Angeles Dodgers Cortelco has equipped Dodger Stadium with its Millennium communications systems, Voice Processing System, Real-Time Automatic Call Distributor and Orbit Wireless Communications System. Our solution handles both general stadium communications traffic and automatic call distribution for the club's Merchandise and Special Event Ticket agents. Automatic Call Distribution In-building & Campus Centralized Voice Wireless Functionality Processing & Unified Messaging Remote Agent & Telecommuter Internet Protocol Services Services Computer Telephony Circuit Switched Integration Data
Federal Aviation Administration The FAA operates 61 Automated Flight Service Stations, all equipped with Cortelco's DSP1000 Automatic Call Distributor. The FAA chose the DSP1000 because it needed to replace existing call center technology with a highly reliable, Y2K compliant solution. The FAA now has a feature-rich platform, capable of custom applications including Computer Telephony Integration, screen-pop skill-based routing, home agent and full PBX functionality. Celebration Schools Celebration School, a Disney corporation partner, has networked their Millennium communications systems to handle general purpose voice traffic and support video conferencing for distance learning. Cortelco's Voice Processing System facilitates parent-teacher communications and the Orbit Wireless Communications System provides teachers and administrators with mobile communications throughout the campus without airtime charges. Cortelco Provides Flexible Networked Systems for Voice, Video and Data Communications Automatic Call Distribution: Provides real-time routing and built-in networking for traditional or virtual call centers. In-building & Campus Centralized Voice Wireless Processing & Unified Functionality: The Messaging: Cortelco's Orbit Wireless VPS links multiple Communications System networked locations provides private into a single voice mobile voice and fax messaging communications without system. Integration of airtime charges. e-mail with unified messaging available in 1999. Cortelco's Multi-Site Networked Digital Communications Platforms Internet Protocol Remote Agent & Services: Provides a Telecommuter Services: gateway for Internet Provides access to services, such as full desk-top voice-over-IP, virtual functionality for private networks and remote service agents virtual call centers. and telecommuters to Available 1999. conduct business as if they were on site. Circuit Switched Data: Computer Telephony Converges voice and Integration: Provides data communications connectivity between through built-in telephony and computer support of virtually platforms to allow any switched digital access to proprietary communications device and third party such as video programs such as conferencing systems. customer information databases, graphical user interfaces and tools for applications developers. Table of Contents
Page Prospectus Summary.................... 1 Risk Factors.......................... 4 Forward-Looking Statements............ 10 Company Background.................... 10 Use of Proceeds....................... 11 Dividend Policy....................... 11 Capitalization........................ 12 Dilution.............................. 13 Selected Pro Forma Consolidated Financial Data....................... 14 Selected Consolidated Financial Data.. 15 Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 16
Page Business............................ 25 Management.......................... 40 Principal and Selling Stockholders.. 48 Certain Transactions................ 50 Description of Capital Stock........ 52 Shares Eligible for Future Sale..... 54 Underwriting........................ 56 Legal Matters....................... 58 Experts............................. 58 Additional Information.............. 58 Index to Financial Statements....... F-1
--------------- In deciding whether to buy our common stock, you should rely only on the information contained in this prospectus. To understand this offering fully, you should read this entire prospectus carefully, including the financial statements and notes. Individual sections of this prospectus, such as the Prospectus Summary, are not complete and do not contain all of the information that you should consider before investing in our common stock. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of the common stock. Until , 1999, all dealers that buy, sell or trade our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers' obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. --------------- Prospectus Summary You should read the following summary together with the more detailed information and financial statements and related notes appearing elsewhere in this prospectus. Cortelco Systems, Inc. Cortelco designs, develops and markets integrated enterprise communications systems for routing and controlling the voice, video and data communications of businesses and other organizations. Our solutions are primarily designed for enterprises with complex communications needs and small and medium-sized telephony installations. We serve a variety of vertical markets such as education, retail, government agencies, emergency-911 services and catalog sales, as illustrated by the variety of organizations that have bought our products: Bell Atlantic, Budget Rent-A-Car, Circuit City, the Federal Aviation Administration and U-Haul. Our products are installed in over 7,100 locations worldwide. In addition to selling our products, we also resell cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. Our products have won numerous awards, including "Best of Show" awards at CT Expo in 1997 and 1998 and "Product of the Year" awards in 1997 and 1998 from Call Center magazine and in 1999 from Call Center Solutions magazine. Our communications systems are based on two platforms, the Millennium and the DSP Series. Both of our platforms support multi-site networking and other advanced features such as dynamic call routing, interactive voice response, voicemail and computer telephony integration. The Millennium is a full-function routing and control system that primarily serves customers averaging approximately 110 communications ports per installation. The Millennium also includes automatic call distribution features. The DSP Series is primarily an advanced automatic call distribution system that also includes a full-function routing and control system. The DSP Series is typically used in installations requiring advanced computer telephony integration applications such as those used in sophisticated call centers. Both the Millennium and the DSP Series interface with a variety of popular third-party products through standard protocols. Our integrated communications systems are flexible enough to meet the needs of enterprises with small to medium-sized installations, yet are scalable enough to accommodate these enterprises as they grow. Key elements of our strategy include: . targeting enterprises with small to medium-sized installations at one or more locations . providing customers with cost-effective, integrated solutions for their voice communications requirements . expanding both our direct sales force and our dealer network to more aggressively pursue our target markets . continuing to enhance our core product lines and develop new features and applications that leverage our existing Millennium and DSP Series platforms As a result of these initiatives and a contract with the FAA accounting for $9.7 million of revenue during the nine months ended April 30, 1999, our revenues on a pro-forma basis increased 48.3% from $26.2 million for the nine months ended April 30, 1998 to $38.9 million for the nine months ended April 30, 1999. Current development efforts address emerging market needs, such as unified messaging, voice-over-Internet Protocol ("voice-over-IP") and Web-based virtual call center capabilities. We are a Delaware corporation with executive offices located at 4119 Willow Lake Blvd., Memphis, Tennessee 38118 and our telephone number is (901) 365- 7774. Our Web site address is www.cortelcosystems.com. The information on our Web site is not part of this prospectus. 1 The Offering Common stock offered by Cortelco............. 2,300,000 shares Common stock offered by the selling stockholders................................ 820,000 shares Common stock outstanding after the offering.. 11,374,826 shares Use of proceeds.............................. To repay debt and for working capital and general corporate purposes. See "Use of Proceeds." Proposed Nasdaq National Market symbol....... CORT
Unless otherwise indicated, the references to numbers and percentages of shares of common stock in this prospectus assume that: . the underwriters' over-allotment option is not exercised . 1,463,206 shares of Series A convertible preferred stock shall, by its terms, convert into 1,434,894 shares of common stock upon the closing of this offering All references to shares of common stock in this prospectus reflect the impact of a 1-for-10 reverse split of the common stock effected in April 1999. The information above excludes outstanding options to purchase up to 1,415,766 shares of common stock as of April 30, 1999 and 1,262,018 shares of common stock reserved for future issuance under our 1999 Equity Incentive Plan and 1999 Employee Stock Purchase Plan. 2 Summary Financial Data The following table contains summary pro forma and historical financial data of Cortelco. The summary pro forma financial data should be read together with our Unaudited Pro Forma Consolidated Financial Information and related notes, Cortelco's consolidated financial statements and related notes, BCS' financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The summary historical financial data should be read together with Cortelco's consolidated financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The pro forma financial data in the table below reflects adjustments to the historical financial statements of Cortelco that (1) reflect the purchase method of accounting for the acquisition of BCS and (2) eliminate the results of operations and related assets and liabilities not acquired from the merger with Cortelco Systems Puerto Rico. The as adjusted balance sheet data is adjusted to reflect the sale of 2,300,000 shares of common stock in this offering, the net proceeds from which are estimated to be approximately $23.0 million after deducting underwriting discounts and commissions and estimated offering expenses payable by Cortelco and the repayment of long-term debt from the net proceeds. In thousands, except per share data
-------------------------------------------------- Nine Months Ended Year Ended -------------------------------- Consolidated Statement July 31, 1998 April 30, 1998 April 30, 1999 of Operations Data: ------------- -------------- -------------- Pro Forma (unaudited) Net revenues............. $ 37,395 $ 26,206 $ 38,878 Gross profit............. 16,747 11,639 19,696 Operating expenses....... 16,023 12,179 14,568 Income (loss) from operations.............. 724 (540) 5,128 Net income (loss)........ $ (527) $ (1,569) $ 2,886 ============ =========== =========== Basic pro forma net income (loss) per share................... $ (0.06) $ (0.19) $ 0.35 Diluted pro forma net income (loss) per share................... $ (0.06) $ (0.19) $ 0.30 Weighted average shares outstanding Basic.................. 8,155 8,147 8,134 Diluted................ 8,155 8,147 9,744 Historical Net revenues............. $ 30,949 $ 22,812 $ 27,626 Gross profit............. 12,445 9,340 11,789 Operating expenses....... 11,452 8,798 10,312 Income (loss) from operations.............. 993 542 1,477 Net income (loss)........ $ (133) $ (389) $ 698 ============ =========== =========== Basic net income (loss) per share............... $ (0.03) $ (0.10) $ 0.17 Diluted net income (loss) per share............... $ (0.03) $ (0.10) $ 0.13 Weighted average shares outstanding Basic.................. 3,918 3,910 4,159 Diluted................ 3,918 3,910 5,769
--------------------- At April 30, 1999 --------------------- Actual Actual As Adjusted --------- ----------- Consolidated Balance Sheet Data: Cash and cash equivalents..... $ 1,822 $ 19,878 Working capital.. 5,182 26,115 Goodwill, net.... 11,266 11,266 Total assets..... 35,006 52,440 Long term debt... 2,314 -- Common stock..... 8 11 Total stockholders' equity.......... 16,614 39,239
3 Risk Factors This offering involves a high degree of risk. You should carefully consider the risks and uncertainties described below and the other information in this prospectus before deciding whether to invest in shares of our common stock. Fluctuations in Our Quarterly Operating Results Could Adversely Affect the Price of Our Common Stock Our operating results are likely to fluctuate significantly from quarter to quarter in the future due to a number of factors, many of which are beyond our control. As a result, our operating results will likely not meet expectations in some future quarters, which could have a material adverse effect on the market price of our common stock. Factors that could affect our quarterly operating results include the following: . variations in the mix of products sold . variations in the timing or size of orders from our customers . completion of significant contracts such as the FAA contract . delays or difficulties in introducing new products and/or in implementing common applications across both our Millennium and DSP Series platforms . price decreases and other actions by our competitors Quarterly operating results are also likely to fluctuate due to seasonal factors that affect customers in some of our vertical markets. For example, U.S. government customers typically make substantial purchases during the quarter ended October 31, the last quarter of the government's fiscal year, and these purchases decline significantly in the next quarter. Customers in other vertical markets such as education and retail have also exhibited seasonal buying patterns and do not purchase substantial amounts of equipment during the quarter ended January 31. As a result, revenues in the quarter ended January 31 are often lower than in the previous quarter. The uncertainty of our sales cycle also makes the timing of sales difficult to predict and may cause fluctuations in our quarterly operating results. The purchase of our products may involve a significant commitment of our customers' personnel, financial and other resources to conduct technical evaluations, to support installation and training and to fund purchases. As a result, our sales cycles vary from one to six months for Millennium systems, which range in price from $22,000 to $36,000 depending on the system configuration, and from four to twelve months for DSP Series systems, which range in price from $75,000 to $230,000 depending on the system configuration. Additionally, our reliance on dealers and value added resellers to market our products makes it even more difficult to predict the timing of sales because we have little control over their selling efforts to end-user customers. We generally recognize revenues on the date of shipment for Millennium systems, but upon acceptance for DSP Series systems due to the customized nature of the installation. Delays in shipment or acceptance due to late deliveries by our contract manufacturers and other factors beyond our control could adversely affect revenues in a quarter. Our Recent Results Have Been Affected by Our Contract with the FAA Our recent revenues have been significantly influenced by one large customer, the FAA. In June 1998, we began installing DSP Series systems in approximately 61 FAA sites. The FAA contract accounted for $9.7 million in revenues, or 25.0% of our pro forma revenues, for the nine months ended April 30, 1999. The FAA contract is expected to be completed in June 1999. We cannot guarantee that we will be able to obtain sufficient additional customer contracts to avoid a decline in revenues after the FAA 4 contract is completed. Because of the significant contribution of the FAA contract to our revenues during the nine months ended April 30, 1999, we expect that our revenue growth in the next quarter will be less than the 48% growth seen over the last nine months ended April 30, 1999. We Have a Limited Combined Operating History with BCS and Cortelco Systems Puerto Rico We have a limited combined operating history because we only recently acquired BCS and merged with Cortelco Systems Puerto Rico. As a result, unanticipated difficulties or delays may arise during the process of integrating our product lines, our product development and sales and marketing efforts. Our operating results may be adversely affected if we are not able to realize anticipated operating efficiencies through the consolidation of certain administrative and corporate functions and if we are not able to effectively integrate our corporate cultures. See "Company Background." We Have Many Established Competitors in the Communications Equipment Market The market for our products is highly competitive and subject to rapid technological change. We expect competition to increase significantly in the future. Our principal competitors in the voice communications equipment market include Lucent Technologies, Mitel, NEC, Nortel Networks and Siemens. We also compete with Aspect Telecommunications and Rockwell Electronic Commerce in the call center market. As voice and data communications networks converge, data equipment vendors such as Cisco Systems and 3Com may also compete in our market. In addition, alliances and mergers between telecommunications and computer companies may strengthen our competitors' positions or result in new entrants into our market. Many of our current and potential competitors have significantly greater financial, technical, marketing, customer services and other resources, greater name recognition and a larger installed customer base than we do. As a result, our competitors may be able to respond to new or emerging technologies and changes faster than we can. They may also be able to devote greater resources to the development, promotion and sale of their products. Actions by our competitors could result in price reductions, reduced margins and loss of market share, any of which would have a material adverse effect on our financial condition. We cannot assure you that we can compete successfully against our competitors or that competitive pressures would not have a material adverse effect on our operating results and financial condition. We Have a Limited Direct Sales Force and Rely on Dealers and Value Added Resellers We have a limited direct sales force and rely on our dealers and value added resellers to market our products. Authorized dealers and value added resellers accounted for approximately 30% of our pro forma revenues in fiscal 1998. Generally, our authorized dealers and value added resellers have no obligation to sell our products and in many cases also offer our competitors' products. Our authorized dealers and value added resellers could discontinue selling our products at any time in favor of our competitors' products or for any other reason. A reduction or loss of orders from our dealers and value added resellers could have a material adverse effect on our operating results and financial condition. We Need to Increase Our Sales Capability In order to increase sales, both domestically and internationally, we will need to add to our direct sales force, expand existing distribution channels and establish new distribution channels for our products. A failure to increase existing or establish new distribution channels or hire personnel necessary to develop and enhance such distribution channels could have a material adverse effect on our operating results and financial condition. We have increased our sales force by approximately 48% since April 30, 1998. We cannot assure you that new sales personnel, dealers and value added 5 resellers will be effective at increasing sales or will achieve the same levels of productivity as our existing sales resources. In addition, as we expand our distribution channels, our direct sales force, dealers and value added resellers may compete with each other for the same customers. Our Product Platforms Must Integrate with Changing Protocols, Applications and Third Party Technology to Remain Competitive The markets for our products are characterized by rapid technological change, evolving industry standards, changes in end-user customer requirements and frequent new product introductions and enhancements. Our future success will depend upon our ability to enhance our existing products and to develop and introduce new products that will achieve market acceptance. A key feature of our product platforms is their ability to integrate with most standard protocols and transmission systems, computer telephony integration and automatic call distribution applications and protocols, operating systems and databases. In the event that our product platforms cannot be readily integrated with third-party technology or newly developed technological advances which we may fail to predict, we could be required to redesign our core product platforms. In addition, the introduction or market acceptance of products incorporating superior technologies or the emergence of alternative technologies and new industry standards could also render our existing products, as well as products currently under development, obsolete and unmarketable. Redesigning any of our products may require significant resources, and any failure to release new products or to enhance or redesign our existing products in a timely manner could have a material adverse effect on our operating results and financial condition. We Depend on a Single Source of Supply for Some Electronic Components Our products are manufactured using components or subassemblies procured from third-party suppliers. We receive some electronic components from a single source. For example, we rely on Siemens to provide the digital signal processors and associated chip sets for our Millennium and DSP Series products. We rely on Natural Microsystems to supply the voice processors for our Cortelco Voice Processing System and on CTP Systems to supply our Orbit Wireless Communications handsets and base stations. Any interruption in the availability of components from our key suppliers could adversely affect our ability to meet our scheduled product deliveries. We also could experience difficulties in identifying alternative sources or modifying product designs to use alternative components. Resulting delays or reductions in product shipments could damage customer relationships and adversely affect our operating results. Further, a significant increase in the price of one or more third-party components or subassemblies would have a material adverse effect on our gross profit and operating results. We Depend on Third-Party Contract Electronic Manufacturers We depend heavily upon the manufacturing capabilities of CMC Industries, Inc. and Pensar Corporation, our primary contract electronic manufacturers. Our ability to deliver products on a timely basis could be adversely affected by any failure of CMC or Pensar to manufacture our products. In addition, we could have difficulty finding other manufacturers to build our products. Resulting delays in manufacturing or shipping or an inability to meet customer orders could adversely affect our customer relationships and our operating results. We Depend on Management and Key Engineering Personnel and Need to Attract Qualified New Employees We are dependent on the principal members of our management team and key members of our engineering staff. If we lose any of these persons, our business, financial condition and operating results may be adversely affected. Due to the specialized nature of our business, we are highly dependent on the continued service of, and on the ability to attract and retain, qualified engineering, sales, marketing 6 and senior management personnel. Highly skilled employees with the education and training that we require, especially qualified service technicians and employees with significant experience and expertise in computer telephony integration applications, are in high demand. If we are unable to hire additional qualified personnel as needed, we may not be able to grow our business effectively, adequately manage and complete our existing sales commitments or bid for and execute additional sales opportunities. Failure to attract and retain the qualified personnel necessary for the development of our business could have a material adverse effect on our operating results and financial condition. We Face Many Risks in Expanding Our International Operations into the Caribbean and Latin America Sales outside of the United States and Puerto Rico accounted for approximately 2% of our total pro forma revenues for the nine months ended April 30, 1999 and were made primarily through our dealer network. We expect to increase sales to customers outside of the United States as we establish our distribution channels in the Caribbean and Latin America. However, foreign markets for our products may develop more slowly than currently anticipated. We may not be able to successfully establish international distribution channels, or we may not be able to hire the additional personnel necessary to support such distribution channels. In addition, payment cycles with customers located outside the United States are generally longer than those within the United States. Our Products May Have Undetected Errors Leading to Product Returns or Claims of Liability Our products, despite testing, may contain undetected errors or failures. The occurrence of errors could result in product returns and other losses to us or our customers. This occurrence also could result in the loss of, or delay in, market acceptance of our products. In addition, any failure by our products to properly perform could result in claims against us. Our purchase agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, the limitation of liability provisions contained in our purchase agreements may not be effective as a result of federal, state or local laws or ordinances or unfavorable judicial decisions in the United States or other countries. We maintain insurance to protect against certain claims associated with the use of our products, but our insurance coverage may not adequately cover all possible claims asserted against us. In addition, even claims that ultimately are unsuccessful could result in our expenditure of funds in litigation and management time and resources. We May Be Subject to Intellectual Property Litigation As we grow and gain brand recognition, our products are more likely to be subjected to infringement litigation. Responding to, defending against, or bringing claims related to our intellectual property rights could result in substantial costs and diversion of management and technical resources which could adversely affect our business, operating results and financial condition. In addition, we rely on a combination of patent, trademark, copyright and trade secret laws and contractual restrictions to establish and protect our proprietary rights. These statutory and contractual arrangements may not provide sufficient protection to prevent misappropriation of our technology or to deter independent third-party development of similar technologies. Such litigation could result in our expenditure of funds and management time and resources. We May Be Affected by Year 2000 Problems in Our Systems or Those of Our Key Suppliers, Manufacturers or Customers We are heavily dependent upon the ability of our own computer or data-dependent systems to correctly interpret century data. This includes, but is not limited to, our systems in information, 7 business, finance, operations and service. Any failure or malfunctioning on the part of these or other systems could adversely affect us in ways that are not currently known, discernible, quantifiable or otherwise anticipated by us. We currently have only limited information on the Year 2000 compliance of our key suppliers, manufacturers and customers. Our business and operating results could experience material adverse effects if our key suppliers or manufacturers were to experience Year 2000 issues that cause them to delay production or shipment of key components or systems. In addition, our operating results could experience material adverse effects if any of our key customers encounter Year 2000 issues that cause them to delay or cancel substantial purchase orders or delivery of our product. For a discussion of our Year 2000 plans, see "Management's Discussion and Analysis of Financial Condition and Results of Operations--Year 2000 Compliance." We Are Controlled by Our Principal Stockholders and Management Upon completion of this offering, our executive officers, directors and principal stockholders and their affiliates will own approximately 5,405,369 shares, or 47.5%, of the outstanding shares of common stock, or shares, or %, if the underwriters' over-allotment option is exercised in full. As a result, they will have the ability to effectively control us and direct our affairs, including the election of directors and approval of significant corporate transactions. This concentration of ownership also may have the effect of delaying, deferring or preventing a change in control of our company and may make some transactions more difficult or impossible without the support of these stockholders. The interests of these stockholders may conflict with those of other stockholders. We also have transactions with businesses in which our principal stockholders maintain interests, such as CMC. We believe that these transactions are conducted at an arm's length basis, but we cannot assure you that these transactions would have the same terms if conducted with an unrelated third-party. Our Stock Previously Had No Active Public Market and Our Stock Price May Be Volatile Prior to this offering, there has been no public market for our common stock. We have applied to list the common stock for trading on the Nasdaq National Market. The initial public offering price will be determined by negotiations among the underwriters, us and the selling stockholders and may not be indicative of the market price for the common stock after this offering. We do not know the extent to which investor interest will lead to the development of a public market. Investors may not be able to resell the common stock at or above the initial public offering price. Many factors could cause the market price of the common stock after this offering to fluctuate substantially, including future announcements concerning us or our competitors, variations in operating results, loss of key customers, changes in pricing policies, or changes in earnings estimates by analysts. General economic, political and market conditions may also have a material adverse effect on the price of our common stock. Some Anti-Takeover Provisions May Adversely Affect Our Stock Price The board of directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the preferences, rights and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock may be adversely affected by the rights of the holders of any preferred stock that may be issued in the future. Certain provisions of our certificate of incorporation and bylaws may make it more difficult for a third-party to acquire control of us without the consent of our board of directors, even if such changes were favored by a majority of the stockholders. These include provisions that provide for a staggered board of directors, prohibit stockholders from taking action by written consent and restrict the ability of stockholders to call special meetings. 8 Significant Number of Shares Eligible for Future Sale May Decrease Our Stock Price Sales of substantial amounts of our common stock in the public market after this offering, including shares issued upon the exercise of outstanding options, or the perception that such sales could occur, could adversely affect the market price of our common stock. These sales also might make it more difficult for us to raise funds through future offerings of common stock. Upon completion of this offering, we will have outstanding 11,374,826 shares of common stock. All of the shares sold in this offering will be freely transferable without restriction or further registration under the Securities Act of 1933, except for shares purchased by our "affiliates," as defined in Rule 144 under the Securities Act. The remaining 8,254,826 shares of common stock that will be outstanding upon completion of this offering are "restricted securities" as defined in Rule 144. These restricted securities may be sold in the future without registration under the Securities Act to the extent permitted under Rule 144, Rule 701, or another exemption under the Securities Act. Cortelco, our officers, directors and stockholders holding approximately 7,277,419 shares of common stock will agree not to, without the prior written consent of J.P. Morgan Securities Inc., directly or indirectly, sell, offer, contract to sell, transfer the economic risk of ownership in, make any short sale, pledge or otherwise dispose of any shares of common stock or any securities convertible into, or exchangeable, or exercisable for, or any other rights to purchase or acquire shares of common stock owned by them during the 180-day period commencing on the date of this prospectus. 9 Forward-Looking Statements Statements contained in this prospectus may be forward-looking statements concerning our operations, economic performance and financial condition. Forward-looking statements are included, for example, in the discussions about: the timing and availability of products under development; variations in operating results; our strategy; Year 2000 issues; and the market for voice communications equipment. Those forward-looking statements involve risks and uncertainties and actual results may differ materially from those expressed or implied in those statements. Factors that could cause differences include, but are not limited to, those discussed under "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Company Background We were incorporated on July 23, 1991 as one of several corporations related through common ownership that were formed to hold various telecommunications equipment and other businesses that had been acquired primarily from Alcatel, N.V. in 1990. In August 1993, we became a subsidiary of Cortelco Systems Holding Corporation, a corporation formed to act as the holding company for the telecommunications equipment businesses, while CMC Industries, Inc., a contract electronic manufacturer, became a separate company. See "Business-- Manufacturing." In March 1997, our subsidiary in the automatic call distribution products business was spun off to the Cortelco Systems Holding Corporation stockholders, merged with Business Communications Systems, Inc., and renamed "BCS Technologies, Inc." In April 1999: . Cortelco Systems Holding Corporation distributed its shares of Cortelco common stock in a spin-off transaction . we merged with Cortelco Systems Puerto Rico, Inc., another subsidiary of Cortelco Systems Holding Corporation, in exchange for 553,880 shares of our common stock . we acquired BCS in exchange for 3,969,681 shares of our common stock BCS and Cortelco Systems Puerto Rico are now wholly-owned subsidiaries of Cortelco. 10 Use of Proceeds Our net proceeds from the sale of the 2,300,000 shares of common stock offered by us are estimated to be approximately $23.0 million or approximately $23.4 million if the underwriters exercise the over-allotment option in full, after deducting underwriting discounts and commissions and estimated offering expenses payable by us. We will not receive any proceeds from the sale of common stock by the selling stockholders. We currently intend to use our net proceeds from this offering: . to fully repay a $2.3 million long-term subordinated note with ChinaVest IV, L.P. that accrues interest at an 8.0% annual rate and matures in July 2002 . to fully repay $2.6 million of senior debt under two credit facilities with Foothill Capital, one of which accrues interest at a rate equal to the prime rate plus 0.375% and matures in July 2001, and the other of which accrues interest at a rate equal to the prime rate plus 1.25% and matures in August 2001 . for working capital and general corporate purposes We may also use some of the proceeds to acquire other companies, technologies or products that complement our business, although we have not yet developed any plans regarding these transactions. Pending use of the net proceeds as described above, we intend to invest the net proceeds from this offering in short-term, investment-grade securities. Dividend Policy We have declared cash dividends in the past in connection with intercompany financing transactions with our parent company. See "Certain Transactions." Cortelco currently anticipates that it will retain earnings to support operations and finance the growth and development of its business and does not anticipate declaring cash dividends for the foreseeable future. Future dividends, if any, will be at the discretion of the board of directors, which will base its decision on a number of factors, including our operating results and financial requirements. The terms of our senior debt, which will be repaid from the net proceeds of this offering, prohibit the declaration and payment of dividends without the approval of the lender. 11 Capitalization The following table sets forth our capitalization as of April 30, 1999 on an actual basis and on an adjusted basis after giving effect to the sale of 2,300,000 shares of common stock in this offering and net proceeds after deducting underwriting discounts and commissions and estimated offering expenses payable by us. The capitalization on an actual basis excludes 1,415,766 shares of common stock issuable upon exercise of options outstanding as of April 30, 1999 and 1,012,018 shares reserved as of April 30, 1999 for future issuance under our 1999 Equity Incentive Plan. This table should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this prospectus and "Management's Discussion and Analysis of Financial Condition and Results of Operations."
---------------------- As of April 30, 1999 ---------------------- Actual Actual As Adjusted Dollars in thousands, except share data --------- ----------- Long-term debt (excluding current portion)................. $ 2,314 $ -- Stockholders' equity (1): Preferred stock, $.001 par value, 10,000,000 shares authorized; 1,463,206 shares issued and outstanding, actual; no shares issued and outstanding, as adjusted... 660 -- Common stock, $.001 par value, 50,000,000 shares authorized; 7,639,932 shares issued and outstanding, actual; 11,374,826 shares issued and outstanding, as adjusted... 8 11 Additional paid-in capital............................... 24,148 47,430 Note receivable from affiliate (former parent)........... (2,634) (2,634) Retained earnings ....................................... (5,568) (5,568) --------- --------- Total stockholders' equity............................. 16,614 39,239 --------- --------- Total capitalization................................... $ 18,928 $ 39,239 ========= =========
- ------------------- (1) Upon the closing of this offering, the 1,463,206 shares of Series A convertible preferred stock shall, by its terms, convert into 1,434,894 shares of common stock. 12 Dilution Our net tangible book value at April 30, 1999 was approximately $4.4 million, or $0.57 per share of common stock. Net tangible book value per share represents the amount of total assets, less: . goodwill and identifiable intangible assets . total liabilities . preferred stock divided by the number of outstanding shares of common stock. After giving effect to the sale of 2,300,000 shares of common stock offered to new investors by Cortelco at an assumed initial public offering price of $11.00 per share, and after deducting underwriting discounts and commissions and estimated offering expenses, our pro forma net tangible book value at April 30, 1999 would have been approximately $27.7 million, or $2.43 per share. This represents an immediate increase in pro forma net tangible book value of $1.86 per share to existing stockholders and an immediate dilution in net tangible book value of $8.57 per share to new investors. The following table illustrates the per share dilution: Assumed initial public offering price per share................... $11.00 Net tangible book value per share as of April 30, 1999.......... $0.57 Pro forma increase in net tangible book value per share attributable to new investors.................................. $1.86 ----- Pro forma net tangible book value per share after this offering... 2.43 ------ Dilution per share to new investors............................... $ 8.57 ======
The following table summarizes on a pro forma basis as of April 30, 1999 the differences between the existing stockholders and the new investors with respect to the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid:
------------------------------------------------------ Shares Purchased Total Consideration ------------------- -------------------- Average Price Number Percent Amount Percent Per Share ---------- -------- ----------- -------- ------------- Existing stockholders (1).................... 9,074,826 79.8% $ 6,206,000 19.7% $ 0.68 New investors........... 2,300,000 21.2 25,300,000 80.3 $11.00 ---------- -------- ----------- -------- Total................. 11,374,826 100% $31,506,000 100% ========== ======== =========== ========
- ------------------- (1) Excludes 1,415,766 shares of common stock issuable upon exercise of options outstanding as of April 30, 1999 and 1,012,018 shares reserved as of April 30, 1999 for future issuance under our 1999 Equity Incentive Plans. 13 Selected Pro Forma Consolidated Financial Data The following pro forma consolidated statement of operations data for the year ended July 31, 1998 and the nine months ended April 30, 1998 and 1999 represent the unaudited pro forma operating results as if the acquisition of BCS had occurred as of August 1, 1997. The pro forma financial data reflects adjustments to our consolidated financial statements that: . reflect the purchase method of accounting for the acquisition of BCS . eliminate the results of operations and related assets and liabilities not acquired from the merger with Cortelco Systems Puerto Rico The pro forma financial data does not purport to represent what our results of operations actually would have been had the transactions occurred on the dates indicated, or to project our results of operations at any future date or for any future period. The following pro forma financial data should be read in conjunction with Cortelco's consolidated financial statements and related notes, BCS' consolidated financial statements and related notes and the Unaudited Pro Forma Consolidated Financial Information and related notes, all of which are included elsewhere in this prospectus, and "Management's Discussion and Analysis of Financial Condition and Results of Operations."
--------------------------------------------- Nine Months Ended Year Ended ------------------------------ In thousands, except per share July 31, 1998 April 30, 1998 April 30, 1999 data ------------- -------------- -------------- Consolidated Statement of Operations Data: Net revenues................... $ 37,395 $ 26,206 $ 38,878 Cost of revenues............... 20,648 14,567 19,182 ---------- ---------- ---------- Gross profit................. 16,747 11,639 19,696 Operating expenses: Selling, general and administrative............... 13,347 10,196 11,988 Research and development...... 2,111 1,559 2,156 Amortization of goodwill...... 565 424 424 ---------- ---------- ---------- Total operating expenses..... 16,023 12,179 14,568 ---------- ---------- ---------- Income (loss) from operations.................. 724 (540) 5,128 Interest expense............... 499 394 308 Management fee expense, net.... 185 148 23 Other expenses, net............ 513 438 394 ---------- ---------- ---------- Income (loss) before income taxes....................... (473) (1,520) 4,403 Income tax expense............. -- -- 1,511 ---------- ---------- ---------- Income (loss) before minority interest.................... (473) (1,520) 2,892 Minority interest ............. (54) (49) (6) ---------- ---------- ---------- Net income (loss)............ $ (527) $ (1,569) $ 2,886 ========== ========== ========== Basic pro forma net income (loss) per share.............. $ (0.06) $ (0.19) $ 0.35 Diluted pro forma net income (loss) per share.............. $ (0.06) $ (0.19) $ 0.30 Weighted average shares outstanding (1): Basic......................... 8,155 8,147 8,134 Diluted....................... 8,155 8,147 9,744
- ------------------- (1) See notes to Unaudited Pro Forma Consolidated Financial Information for determination of shares used in computing basic and diluted pro forma net income (loss) per share. 14 Selected Consolidated Financial Data The selected consolidated financial data represent the results of Cortelco and Cortelco Systems Puerto Rico and include the operating results of BCS beginning April 12, 1999, the date on which BCS was acquired. The statement of operations data set forth below for each of the fiscal years ended July 31, 1996, 1997 and 1998, and the selected balance sheet data at July 31, 1997 and 1998, are derived from consolidated financial statements audited by Deloitte & Touche LLP, independent auditors, whose reports appear elsewhere in this prospectus. The consolidated balance sheet data at July 31, 1996 is derived from audited financial statements not included in this prospectus. The statement of operations data for the nine months ended April 30, 1998 and 1999 and the year ended July 31, 1995 and the balance sheet data as of July 31, 1995 and April 30, 1999 are derived from unaudited financial statements. However, in the opinion of management, the selected financial data for such periods include all adjustments, which include only normal recurring adjustments, necessary for a fair presentation of the data. This data should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this prospectus and "Management Discussion and Analysis of Financial Condition and Results of Operations." The results of operations for the nine months ended April 30, 1999 are not necessarily indicative of the results to be expected for the full year.
----------------------------------------------------------------- Nine Months Ended Year Ended July 31, April 30, ------------------------------------------ --------------------- In thousands, 1995 1996 1997 1998 1998 1999 except per share data --------- --------- --------- --------- --------- ---------- Consolidated Statement of Operations Data: Net revenues........... $ 33,774 $ 38,518 $ 35,635 $ 30,949 $ 22,812 $ 27,626 Cost of revenues....... 23,919 26,742 24,153 18,504 13,472 15,837 --------- --------- --------- --------- --------- ---------- Gross profit......... 9,855 11,776 11,482 12,445 9,340 11,789 Operating expenses: Selling, general and administrative....... 7,235 7,853 10,103 10,045 7,760 8,795 Research and development.......... 1,403 1,256 1,310 1,407 1,038 1,489 Amortization of goodwill............. -- -- -- -- -- 28 --------- --------- --------- --------- --------- ---------- Total operating expenses............ 8,638 9,109 11,413 11,452 8,798 10,312 --------- --------- --------- --------- --------- ---------- Income from operations.......... 1,217 2,667 69 993 542 1,477 Interest expense....... 1,186 1,004 915 826 633 584 Management fee expense, net.......... 134 178 406 185 148 23 Other expenses (income), net......... 83 (54) 272 61 101 85 --------- --------- --------- --------- --------- ---------- Income (loss) before income taxes........ (186) 1,539 (1,524) (79) (340) 785 Income tax expense .... -- 607 -- -- -- 81 --------- --------- --------- --------- --------- ---------- Income (loss) before minority interest... (186) 932 (1,524) (79) (340) 704 Minority interest...... -- -- -- (54) (49) (6) --------- --------- --------- --------- --------- ---------- Income (loss) from continuing operations.......... (186) 932 (1,524) (133) (389) 698 Discontinued operations............ (958) (1,207) (515) -- -- -- --------- --------- --------- --------- --------- ---------- Net income (loss).... $ (1,144) $ (275) $ (2,039) $ (133) $ (389) 698 ========= ========= ========= ========= ========= ========== Basic net income (loss) per share............. $ (0.30) $ (0.07) $ (0.53) $ (0.03) $ (0.10) $ 0.17 Diluted net income (loss) per share...... $ (0.30) $ (0.07) $ (0.53) $ (0.03) $ (0.10) $ 0.13 Weighted average shares outstanding (1)(2): Basic................. 3,825 3,825 3,825 3,918 3,910 4,159 Diluted............... 3,825 3,825 3,825 3,918 3,910 5,769 ----------------------------------------------------------------- At July 31, ------------------------------------------ At 1995 1996 1997 1998 April 30, 1999 In thousands --------- --------- --------- --------- --------------------- Consolidated Balance Sheet Data: Cash and cash equivalents........... $ 76 $ 183 $ 320 $ 126 $ 1,822 Working capital........ 4,836 6,364 4,510 2,329 5,182 Goodwill, net.......... -- -- -- -- 11,266 Total assets........... 20,169 21,830 18,417 17,835 35,006 Long term debt......... 2,903 2,751 5,621 6,400 2,314 Common stock........... 4 4 4 4 8 Total stockholders' equity (deficit)...... 5,175 4,900 1,611 (1,122) 16,614
- ------------------ (1) See note 19 to our consolidated financial statements for determination of shares used in computing basic and diluted net income (loss) per share for the years ended July 31, 1996, 1997 and 1998. (2) See note 2 to our unaudited consolidated financial statements for determination of shares used in computing basic and diluted net income (loss) per share for the nine months ended April 30, 1998 and 1999. 15 Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our results of operations and financial condition should be read in conjunction with the consolidated financial statements and related notes and other financial information included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may be materially different from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Risk Factors" and elsewhere in this prospectus. Overview Cortelco designs, develops and markets integrated enterprise communications systems for small and medium-sized telephony installations in a range of vertical markets such as education, retail, government agencies, emergency-911 services and catalog sales. Our operations are conducted through three business units: Systems Business Operations, ACD Business Operations and Caribbean and Latin American Operations. The Systems Business Operations unit primarily focuses on the Millennium product line. The ACD Business Operations unit primarily focuses on the DSP Series product line. The Caribbean and Latin American Operations unit currently distributes the Millennium and DSP Series systems and resells cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. In April 1999, Cortelco merged with its sister company, Cortelco Systems Puerto Rico, which became the Caribbean and Latin American Operations unit, and acquired BCS, which became the ACD Business Operations unit. Prior to April 1999, our three business units shared substantial common ownership and prior to March 1997 had been part of the same corporate family. Cortelco and Cortelco Systems Puerto Rico had previously been subsidiaries of Cortelco Systems Holding Corporation and were under common control. As a result, the merger of Cortelco and Cortelco Systems Puerto Rico has been recorded for all periods presented at historical costs and the financial statements are presented on a consolidated basis for all historical periods. The acquisition of BCS has been accounted for using the purchase method of accounting and goodwill in the amount of $11.3 million was recorded in the BCS acquisition and is being amortized over 20 years. BCS has been included in our consolidated financial statements from April 12, 1999, the date on which it was acquired. Our revenues are primarily derived from our sale of Millennium and DSP Series systems, related systems products and services and the resale of cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. Revenue is recognized upon shipment of product to our dealers and end-user customers for Millennium systems and third-party systems, and upon acceptance for DSP Series systems due to the customized nature of each installation. In addition, our Caribbean and Latin American Operations unit generates revenue from the resale of cellular airtime and cellular telephones in Puerto Rico and recognizes these revenues when earned. Typical selling prices range from $22,000 to $36,000 for Millennium systems and $75,000 to $230,000 for DSP Series systems, depending on the system configuration. For the nine months ended April 30, 1999, on a pro forma basis, we generated approximately 43% of our revenue from the sale of Millennium products and approximately 34% from the sale of DSP Series products. Pro forma revenues increased 48.3% from $26.2 million for the nine months ended April 30, 1998 to $38.9 million for the nine months ended April 30, 1999. In the past several years, we have undergone some significant changes. In fiscal 1994, we introduced a new digital platform, the Millennium, to replace an older analog product, which was ultimately discontinued in fiscal 1998. During fiscal 1996 and fiscal 1997, we sold a substantial number of 16 Millennium systems to a single customer for installations in Southeast Asia. This customer ceased placing new orders with us in 1997 due to general economic instability in Southeast Asia, which resulted in a $2.9 million decrease in purchases by this customer in fiscal 1998 as compared to fiscal 1997. Moreover, in fiscal 1997, Cortelco Systems Puerto Rico redirected its marketing of cellular airtime and cellular telephones to focus on higher quality customers, mainly businesses, in order to minimize credit losses and increase margins. This resulted in a reduction of Cortelco Systems Puerto Rico's revenues from the resale of cellular airtime and cellular telephones from $9.8 million in fiscal 1997 to $6.7 million in fiscal 1998. Beginning in the second quarter of fiscal 1998, Cortelco, under the leadership of a new president, refocused its overall marketing strategy and began to target markets for which the Millennium system is particularly well-suited. Product development programs have been directed to new software and other initiatives to strengthen the Millennium product line and increase gross margins. We also increased our sales staff and expanded our dealer and value added reseller network. As a result of these changes and programs, Cortelco has become profitable and our operating results have continued to improve in recent quarters. Pro Forma Results of Operations As a result of the recent acquisition of BCS, our historical financial statements for past periods do not accurately reflect our current results of operations. We have therefore included the results of operations on a pro forma basis for each of the seven quarters ended April 30, 1999 so that you can better understand our business. The following tables present the pro forma results as if the acquisition of BCS had occurred as of August 1, 1997. We believe that all necessary adjustments, consisting of only normal recurring adjustments, have been included in the amounts stated below. The pro forma financial data are presented for illustrative purposes only and do not purport to represent what our results of operations actually would have been had the transactions occurred on the dates indicated, or to project our results of operations for any future period. This data should be read in conjunction with the Unaudited Pro Forma Consolidated Financial Information and the related notes, our consolidated financial statements and the related notes and BCS' financial statements and the related notes, all of which are included elsewhere in this prospectus. 17
----------------------------------------------------------------------------------- Three Months Ended ----------------------------------------------------------------------------------- October 31, January 31, April 30, July 31, October 31, January 31, April 30, In thousands, except per 1997 1998 1998 1998 1998 1999 1999 share data ----------- ----------- --------- -------- ----------- ----------- --------- Consolidated Statement of Operations Data: Net revenues............ $ 9,273 $ 8,399 $ 8,534 $ 11,189 $ 12,487 $ 11,710 $ 14,681 Cost of revenues........ 5,242 4,689 4,636 6,081 6,131 6,008 7,043 -------- -------- -------- -------- -------- -------- -------- Gross profit........... 4,031 3,710 3,898 5,108 6,356 5,702 7,638 Operating expenses: Selling, general and administrative........ 3,366 3,356 3,474 3,151 3,538 3,831 4,619 Research and development........... 501 533 525 552 770 814 572 Amortization of goodwill.............. 141 142 141 141 141 141 142 -------- -------- -------- -------- -------- -------- -------- Total operating expenses............. 4,008 4,031 4,140 3,844 4,449 4,786 5,333 Income (loss) from operations........... 23 (321) (242) 1,264 1,907 916 2,305 Interest expense........ 131 143 120 105 101 128 79 Management fee expense (income), net.......... 53 (15) 110 37 (5) (5) 33 Other expenses ......... 103 77 258 75 122 136 136 -------- -------- -------- -------- -------- -------- -------- Income (loss) before income taxes......... (264) (526) (730) 1,047 1,689 657 2,057 Income tax expense...... -- -- -- -- 577 299 635 -------- -------- -------- -------- -------- -------- -------- Net income (loss) before minority interest............. (264) (526) (730) 1,047 1,112 358 1,422 Minority interest....... (36) (26) 13 (5) (8) 2 -- -------- -------- -------- -------- -------- -------- -------- Net income (loss)..... $ (300) $ (552) $ (717) $ 1,042 $ 1,104 $ 360 $ 1,422 ======== ======== ======== ======== ======== ======== ======== Basic pro forma net income (loss) per share.................. $ (0.04) $ (0.07) $ (0.09) $ 0.13 $ 0.14 $ 0.04 $ 0.18 Diluted pro forma net income (loss) per share.................. $ (0.04) $ (0.07) $ (0.09) $ 0.11 $ 0.11 $ 0.04 $ 0.15 Weighted average shares outstanding (1): Basic.................. 8,140 8,145 8,147 8,155 8,157 8,157 8,088 Diluted................ 8,140 8,145 8,147 9,694 9,720 9,744 9,698
- ------------------- (1) See notes to Unaudited Pro Forma Consolidated Financial Information for determination of shares used in computing basic and diluted pro forma net income (loss) per share. Quarterly results of operations, in particular the quarters ended October 31 and January 31, are likely to fluctuate due to a number of factors, including seasonal factors that affect customers in some of our vertical markets. For example, U.S. government customers typically make substantial purchases during the quarter ended October 31, the last quarter of the government's fiscal year, and these purchases decline significantly in the next quarter. Customers in other vertical markets such as education and retail have also exhibited seasonal buying patterns and do not purchase substantial amounts of equipment during the quarter ended January 31. As a result, revenues in the quarter ended January 31 are often lower than in the previous quarter. The uncertainty of our sales cycle also makes the timing of sales difficult to predict and may cause fluctuations in our quarterly results of operations. The purchase of our products may involve a significant commitment of our customers' personnel, financial and other resources to conduct technical evaluations, to support installation and training and to fund purchases. As a result, our sales cycles vary from one to six months for Millennium systems and from four to twelve months for the DSP Series systems. 18 Revenues. Our revenues are primarily derived from the sales of Millennium and DSP Series systems, related systems products and services and the resale of cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. Our pro forma quarterly revenues have increased over the prior year for the last three quarters ended April 30, 1999, due primarily to the FAA contract, enhancements of our product line and expansion of our sales force. Systems revenue from sales of third-party voice communications systems in Puerto Rico generally account for approximately 5% to 10% of pro forma total revenues in each quarter. Our pro forma cellular airtime and cellular telephone revenues have generally decreased as a percentage of total revenues since the quarter ended October 31, 1997, primarily due to our limiting sales activities to higher quality customers, and were 8.7% of pro forma revenues for the quarter ended April 30, 1999. Our pro forma revenues for the quarters ended January 31, 1998 and 1999 have been influenced by seasonal buying patterns in some of our vertical markets. Consequently, pro forma revenues are lower in the quarters ended January 31 than in the quarters ended October 31. Furthermore, our revenues were adversely affected in the first half of fiscal 1998 due to a decrease in orders from our single largest customer due to general economic instability in Southeast Asia and the unexpected loss of a key sales executive. Pro forma revenues reflect purchases by the FAA of $2.6 million, $2.6 million and $4.5 million for the last three quarters ended April 30, 1999 under a contract scheduled to expire in June 1999. Although revenues from the U.S. government will decline after June 1999 due to the completion of installations under the FAA contract, we expect U.S. government agencies to continue to account for a significant portion of our systems revenue. Pro forma revenues increased 48.3% from $26.2 million for the nine months ended April 30, 1998 to $38.9 million for the nine months ended April 30, 1999. The increase was primarily due to $9.7 million in purchases of DSP Series systems by the FAA and an increase in Millennium revenues of $3.2 million, partially offset by a decrease in cellular revenues of $0.9 million. Millennium systems sales increased primarily due to the expansion of our sales force and the introduction of new product features during the last year, while cellular revenues decreased during the period due primarily to our decision to target higher quality customers. For the nine months ended April 30, 1999, the FAA accounted for 25.0% of our total pro forma revenues. As a result of the completion of the FAA contract, we expect our revenue growth will slow during the quarter ended July 31, 1999. Cost of Revenues and Gross Profit. Cost of revenues consists primarily of purchases from our contract manufacturers and other suppliers. Pro forma gross profit increased in year over year comparative quarters due primarily to higher revenues and a change in product mix in favor of higher margin products, primarily DSP Series systems. Lower pro forma gross profit in the quarters ended January 31, 1998 and 1999 were due primarily to seasonal declines in revenues caused by our customers' purchasing cycles. Pro forma gross profit increased 69.2% from $11.6 million for the nine months ended April 30, 1998 to $19.7 million for the nine months ended April 30, 1999. The increase was primarily due to an increase in DSP Series gross profit from $2.3 million for the nine months ended April 30, 1998 to $8.9 million for the nine months ended April 30, 1999. Millennium systems gross profit increased from $6.0 million for the nine months ended April 30, 1998 to $8.5 million for the nine months ended April 30, 1999 due primarily to higher revenues. Gross profit from the resale of cellular airtime and cellular telephones decreased from $1.2 million for the nine months ended April 30, 1998 to $1.1 million for the nine months ended April 30, 1999 due primarily to lower cellular revenues. Pro forma gross margin increased from 44.4% for the nine months ended April 30, 1998 to 50.7% for the nine months ended April 30, 1999 due primarily to the increase in DSP Series revenues and an increase in gross margin for the DSP Series from 63.2% of DSP Series revenues for the nine months 19 ended April 30, 1998 to 66.6% of DSP Series revenues for the nine months ended April 30, 1999. We expect our gross margins to decline in the quarter ended July 31, 1999 as our DSP Series revenues decrease due to the completion of the FAA contract. Historical Results of Operations of Cortelco and Cortelco Systems Puerto Rico Cortelco Systems Puerto Rico was merged with Cortelco in April 1999 and has been recorded for all periods presented at historical costs and the financial statements are presented on a consolidated basis for all historical periods. We acquired BCS on April 12, 1999 in a merger accounted for using the purchase method of accounting. As a result, the historical results of operations for the nine months ended April 30, 1998 and the fiscal years ended July 31, 1996, 1997 and 1998 represent the results of Cortelco Systems Puerto Rico and Cortelco and include the operating results of BCS beginning on April 12, 1999. Nine Months Ended April 30, 1998 and 1999 Revenues. Total revenues increased 21.1% from $22.8 million for the nine months ended April 30, 1998 to $27.6 million for the nine months ended April 30, 1999. The increase resulted primarily from increased systems sales in Puerto Rico of $2.7 million, increased systems sales to the U.S. government of $1.6 million, DSP Series revenues of $1.1 million subsequent to the April 12, 1999 merger with BCS and increased sales of Cortelco Voice Processing Systems of $0.8 million. These increases were partially offset by decreases in cellular airtime and cellular telephone revenues in Puerto Rico of $0.9 million in an effort to target higher quality customers. Cost of Revenues and Gross Profit. Gross profit increased 26.2% from $9.3 million for the nine months ended April 30, 1998 to $11.8 million for the nine months ended April 30, 1999. The increase in gross profit was due primarily to $0.9 million in DSP Series gross profit in the current period, increased gross profit for systems sales in Puerto Rico of $0.8 million, increased gross profit for systems sales to the U.S. government of $0.6 million and increased gross profit for the Cortelco Voice Processing Systems of $0.3 million. The gross margin was 40.9% for the nine months ended April 30, 1998 and 42.7% for the nine months ended April 30, 1999. Operating Expenses. Operating expenses increased 17.2% from $8.8 million for the nine months ended April 30, 1998 to $10.3 million for the nine months ended April 30, 1999. The increase was due primarily to the hiring of additional engineering and sales personnel during the period. Results for the nine months ended April 30, 1999 include $0.5 million in operating expenses for the ACD Business Operations Division that was established at the time of the merger with BCS. Operating expenses decreased as a percentage of revenues from 38.6% for the nine months ended April 30, 1998 to 37.3% for the nine months ended April 30, 1999. Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and benefit costs, advertising and trade show related costs, and facilities and other overhead expenses incurred to support the growth of our business. Costs incurred for final assembly, quality assurance and installation of our systems are included as selling, general and administrative expenses instead of cost of revenues. Selling, general and administrative expenses increased from $7.8 million for the nine months ended April 30, 1998 to $8.8 million for the nine months ended April 30, 1999. The increased expense was due primarily to the growth of the business and the hiring of additional sales personnel. These expenses as a percentage of revenues decreased from 34.0% for the nine months ended April 30, 1998 to 31.8% for the nine months ended April 30, 1999. We expect selling, general and administrative expenses to increase as we invest in new sales and service personnel; however, we anticipate that these expenses will decrease as a percentage of revenues in future periods. 20 Research and Development. Research and development expenses consist primarily of personnel and related expenses for our engineering staff and depreciation of related equipment. Research and development expenses have generally increased since the quarter ended October 31, 1997 due primarily to the hiring of additional engineering personnel. Research and development expenses increased from $1.0 million for the nine months ended April 30, 1998 to $1.5 million for the nine months ended April 30, 1999. The increased expenses were due primarily to the hiring of additional engineering personnel as well as additional equipment purchases. These expenses as a percentage of revenues increased from 4.6% for the nine months ended April 30, 1998 to 5.4% for the nine months ended April 30, 1999. We expect research and development expenses to continue to increase in dollars and as a percentage of revenues in future periods as we hire additional engineers to support our new product initiatives. Amortization of Goodwill. Cortelco recorded $11.3 million of goodwill related to the acquisition of BCS in April 1999 and began amortizing the amount over a 20-year period on April 12, 1999. Management Fee Expense, Net. Management fee expense consists primarily of net administrative expenses incurred by or provided to our former parent company related to administrative services. Minority Interest. Minority interest represents the minority stockholder's 45% share of income in Longhai Telecommunications Equipment Co., Ltd. in China. Cortelco acquired a 55% interest in Longhai in August 1997. Cortelco does not currently anticipate investing in additional joint ventures in China. See note 9 to our consolidated financial statements. Income from Operations. Income from operations increased 172.3% from $0.5 million for the nine months ended April 30, 1998 to $1.5 million for the nine months ended April 30, 1999. This was due primarily to a $2.7 million increase in systems sales in Puerto Rico and $1.1 million of DSP revenues subsequent to the merger with BCS on April 12, 1999. Gross profit increased primarily due to the higher revenues of $4.9 million in the period and the mix of higher margin products, including the DSP Series. While operating expenses on an absolute basis for the nine months ended April 30, 1999 increased due primarily to the hiring of additional sales and engineering personnel, operating growth was slower than growth in revenues and gross profit for the period. Years Ended July 31, 1996, 1997 and 1998 Revenues. Revenues were $38.5 million for fiscal 1996, $35.6 million for fiscal 1997 and $30.9 million for fiscal 1998. The decrease from fiscal 1996 to fiscal 1997 resulted primarily from a decrease of $2.0 million in revenues as we phased out our older analog product and decreases of $0.4 million in cellular airtime and cellular telephone revenues in Puerto Rico. The decrease from fiscal 1997 to fiscal 1998 was due primarily to a $3.1 million decrease in cellular airtime and cellular telephone revenues resulting from our decision to target higher quality customers and a $2.9 million decrease in orders from our single largest customer due to general economic instability in Southeast Asia. Cost of Revenues and Gross Profit. Gross profit was $11.8 million for fiscal 1996, $11.5 million for fiscal 1997 and $12.4 million for fiscal 1998. The decrease in gross profit from fiscal 1996 to fiscal 1997 was due primarily to the decrease in revenues. The increase in gross profit from fiscal 1997 to fiscal 1998 was due primarily to the increased sale of higher margin Millennium products such as the Cortelco Voice Processing System. Gross margin was 30.6% for fiscal 1996, 32.2% for fiscal 1997 and 40.2% for fiscal 1998. Operating Expenses. Operating expenses were $9.1 million for fiscal 1996, $11.4 million for fiscal 1997 and $11.5 million for fiscal 1998. Research and development expenses increased during the periods due mainly to hiring of additional engineering personnel, while selling, general and administrative expenses decreased during fiscal 1998 due primarily to a decrease in administrative expenses associated with the decreased cellular airtime and cellular telephone sales during the year. 21 Income from Operations. Income from operations decreased 97.4% from $2.7 million for fiscal 1996 to $0.1 million for fiscal 1997 due primarily to the $2.9 million decrease in revenues and the $2.3 million increase in operating expenses for fiscal 1997. Operating expenses increased in fiscal 1997 due primarily to higher administrative costs associated with cellular airtime and cellular telephone revenues in Puerto Rico and costs associated with evaluating investment opportunities in China. Income from operations increased 1,339.1% from $0.1 million for fiscal 1997 to $1.0 million for fiscal 1998 due primarily to the $0.9 million increase in gross profit that resulted from the increased sales of higher margin products. Operating expenses were essentially unchanged for fiscal 1998 as research and development costs increased by $0.1 million, while increased systems sales expenses were primarily offset by lower cellular airtime and cellular telephone administrative costs resulting from our decision to target higher quality customers. Discontinued Operations. Discontinued operations represent the results of operations of a former subsidiary of Cortelco that was spun off in March 1997 to the stockholders of our former parent, merged with Business Communications Systems, Inc. and renamed "BCS Technologies, Inc." At the time of spin-off, the subsidiary had experienced substantial net losses and our former parent decided to concentrate its focus on realizing the Millennium's business potential. Liquidity and Capital Resources We have funded our operations primarily through cash generated from operations, periodic borrowings under our existing credit facilities, a $3.0 million subordinated convertible note financing and acquisition financing provided by Alcatel in connection with the purchase of our business from Alcatel in 1990. Net cash provided by operating activities was $1.6 million for fiscal 1996, $1.1 million for fiscal 1997, $1.1 million for fiscal 1998, $1.2 million for the nine months ended April 30, 1998 and $1.2 million for the nine months ended April 30, 1999. Cash provided by operating activities in fiscal 1997 and fiscal 1998 primarily resulted from improved collection procedures implemented during these years. Net cash provided by (used in) investing activities was ($0.5) million for fiscal 1996, ($0.9) million for fiscal 1997, ($0.2) million for fiscal 1998, ($0.5) million for the nine months ended April 30, 1998 and $2.8 million for the nine months ended April 30, 1999. In each year, cash used in investing activities was primarily attributable to purchases of equipment and, in fiscal 1997, to the purchase of $0.3 million of software applications for the Millennium. The $2.8 million provided by investing activities for the nine months ended April 30, 1999 was due primarily to the $3.1 million cash balance of BCS on the date of the acquisition. To the extent that we continue to grow our research and development activities and invest in new technologies in the future, we expect net cash used in investing activities will increase. Net cash used in financing activities was $1.1 million for fiscal 1996, $0.2 million for fiscal 1997, $1.1 million for fiscal 1998, $0.9 million for the nine months ended April 30, 1998 and $2.3 million for the nine months ended April 30, 1999. Cash used in financing activities in the year ended July 31, 1998 consisted primarily of a decrease in outstanding checks, repayments under the revolving credit line and partial repayment of a note to our former parent company, Cortelco Systems Holding Corporation. The primary source of cash from financing activities in fiscal 1997 was a $3.0 million subordinated convertible note financing. The net cash used in financing transactions for the nine months ended April 30, 1999 was due primarily to the $2.0 million loan made to CSHC to retire the acquisition financing provided by Alcatel. See "Certain Transactions." In July and August 1997, we entered into two credit facilities with Foothill Capital which allows us to borrow up to an aggregate of $9.0 million based on accounts receivable and inventory levels. As of 22 April 30, 1999, there was $2.6 million outstanding under these credit facilities which will be repaid using the net proceeds from this offering. See note 11 to our consolidated financial statements. We believe that the proceeds from this offering, together with available funds, anticipated cash flows from operations and our line of credit, will satisfy our projected working capital and capital expenditure requirements at least through fiscal 2000. To the extent that we grow more rapidly than expected in the future, we may need additional cash to finance our operating and investing activities. Year 2000 Compliance The Year 2000 issue is the result of computer programs written using two digits rather than four to define the applicable year (the "Year 2000 Issue"). Computer programs that have such date-sensitive software may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. We are heavily dependent upon the proper functioning of our own computer or data-dependent systems. This includes, but is not limited to, our systems in information, business, finance, operations and service. Any failure or malfunctioning on the part of these or other systems could adversely affect us in ways that are not currently known, discernible, quantifiable or otherwise anticipated by us. Our operations are also dependent on the Year 2000 readiness of third parties that do business with us. We are dependent on third-party suppliers of infrastructure elements such as electric power and banking facilities. We do not depend to any significant degree upon electronic transaction processing with individual vendors for merchandise purchases, however, many of our customers pay their invoices via electronic payment. We have begun to evaluate those areas of our business that may be affected by the Year 2000 Issue and have devised a plan to become Year 2000 compliant in a timely manner which includes: . assessment of our own computer systems and the products we sell . communications with all our key suppliers, manufacturers and customers to determine the extent to which we are vulnerable to their failure to remedy their own Year 2000 Issues . correction, upgrade, replacement or retirement of our computer systems which are affected by the Year 2000 Issue . testing for and validation of our Year 2000 compliance . development of contingency plans to address situations that may result if we are unable to achieve Year 2000 compliance of our critical operations Based on our assessment to date, we have determined that we will be required to upgrade a portion of our software so that our computer systems will function properly with respect to dates in the Year 2000 and thereafter. We estimate that our information systems will be Year 2000 compliant by July 1999. We estimate that costs associated with the upgrade of existing computer software will be less than $75,000. Costs incurred and expensed in the nine months ended April 30, 1999 were less than $30,000. These costs related entirely to modifications of existing software and represented approximately 10% of our information systems budget for information technology in the period. Of the remaining portion of our estimated Year 2000 costs, approximately $30,000 of the costs will be incurred in the fiscal quarter ending July 31, 1999. We may address non-critical Year 2000 Issues beyond the Year 2000. There is no assurance that total costs will not exceed our estimates. We are in communications with key suppliers, manufacturers and customers to determine the extent to which we will be vulnerable to such parties' failure to remedy their own Year 2000 Issues. We 23 currently have only limited information on the Year 2000 compliance of our key suppliers, manufacturers and customers. Our business and results of operations could experience material adverse effects if our key suppliers or manufacturers were to experience Year 2000 Issues that caused them to delay production or shipment of key components or systems. In addition, our results of operations could be materially adversely affected if any of our key customers encounter Year 2000 Issues that cause them to delay or cancel substantial purchase orders or delivery of our product. There can be no assurance that we will be able to upgrade any or all of our major systems in accordance with our plan to address the Year 2000 Issue. In addition, there can be no assurance that any such upgrades will effectively address the Year 2000 Issue. If required upgrades are not completed or are unsuccessful, there would be a material adverse impact on our operations. Furthermore, there can be no guarantee that the systems of other companies on which our own systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with our systems, would not have a material adverse effect on us. We intend to, but have not yet established, a contingency plan detailing actions that will be taken in the event that the assessment of the Year 2000 Issue is not successfully completed on a timely basis. We believe that the worst case Year 2000 scenario would involve disruption in utilities, transportation, and banking facilities. 24 Business Cortelco designs, develops and markets integrated enterprise communications systems for routing and controlling the voice, video and data communications of businesses and other organizations. Our solutions are primarily designed for enterprises with complex communications needs and small and medium-sized telephony installations, typically between 25 to 500 communications ports. We serve a range of vertical markets such as education, retail, government agencies, emergency-911 services and catalog sales. Some of our customers have multiple installations networked together and are as large as national retail chains or multi-location branches of the U.S. government. Our customers include Bell Atlantic, Budget Rent-A-Car, Circuit City, the FAA, PETsMART and U-Haul. Our products are installed in over 7,100 locations worldwide. In addition to selling our products, we also resell cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. Our products have won numerous awards, including "Best of Show" awards at CT Expo in 1997 and 1998 and "Product of the Year" awards in 1997 and 1998 from Call Center magazine and in 1999 from Call Center Solutions magazine. On a pro forma basis, our revenues increased 48.3% from $26.2 million for the nine months ended April 30, 1998 to $38.9 million for the nine months ended April 30, 1999. Our communications systems are based on two platforms, the Millennium and the DSP Series. Both platforms are based on flexible, modular hardware and software architectures that are easy to configure. Our platforms support multi-site networking and other advanced features such as dynamic call routing, interactive voice response, voicemail and computer telephony integration. The Millennium is a full-function routing and control system that primarily serves customers averaging approximately 110 communications ports per installation and addresses a broad range of voice, video and data communications requirements. The Millennium also includes automatic call distribution features. The DSP Series is primarily an advanced automatic call distribution system that also includes a full-function routing and control system. The DSP Series is typically used in installations requiring advanced computer telephony integration applications such as those used in sophisticated call centers. The architecture of our platforms is designed to permit easy configuration and subsequent upgrading to meet changing customer needs. Customer desired features can be incorporated through the installation of optional add-in cards and software. Millennium systems can be connected over the public service telephone network or private data networks and can support ISDN based systems such as videoconferencing. Both the Millennium and the DSP Series interface with a variety of popular third-party products through standard protocols. We also offer other products to provide our customers with cost-effective, integrated communications solutions. For example, the Cortelco Voice Processing System offers integrated, multi-lingual voice and fax messaging services across multiple networked locations. Our Illuminations software package enables self- service access to databases, such as product pricing information or school course registration options, using touch-tone telephones or the Internet. We also offer software that organizes call center data into real-time, customizable, graphical user interfaces and reports for agents and supervisors. Industry Overview According to Dataquest, the U.S. private branch exchange and call center systems markets totaled $5.7 billion in 1998. Traditionally, the voice switching requirements of large enterprises have been addressed by private branch exchange equipment. Enterprises with smaller installations that have not been able to justify the expense of private branch exchange equipment have utilized key telephone systems that, while more economical, have limited functionality and scalability. Technology advances and the demands of increasingly sophisticated customers are driving changes in today's 25 telecommunications equipment industry. Businesses and organizations have come to rely on complex voice and data networks to meet mission critical needs. Recent technology advances have resulted in the introduction of increasingly sophisticated features and applications in enterprise communications systems that extend beyond traditional voice switching. Enterprises of all sizes are now demanding telecommunications systems with the latest features and applications in order to meet their business objectives. These features include dynamic call routing, computer telephony integration, support for the convergence of voice and data networks, multi-site networking and mobile workforce support. Dynamic Call Routing Advanced call routing capabilities have recently been introduced that dynamically screen, distribute and queue incoming calls based on specific caller information, such as the number dialed or the state from which the call is made. The growing number of "1-800" and "1-900" mail order, e-commerce and customer support centers, driven by a focus on customer service, is generating increased demand for dynamic call routing capabilities. These capabilities, originally available only in dedicated automatic call distribution systems for large stand-alone call centers, are now available as optional features on standard private branch exchange equipment, and are being used for more general business applications in various departments, such as human resources and customer support. Computer Telephony Integration Computer telephony integration is the combination of voice communications and computing capabilities which link telephony equipment to voicemail servers, telephone directories, customer information databases and PC applications. Enterprises increasingly seek voice communications systems that can use standard protocols to interface with numerous third-party computer applications. Such integrated applications include interactive voice response, call accounting and unified messaging. For example, computer telephony integration applications can be used to personalize call handling based on a customer database and other information provided from the business' data network. When an incoming call is connected to the customer service agent, pertinent information concerning the particular caller can be displayed on the agent's monitor, enabling the agent to provide a prompt and informed response to the customer. Convergence of Voice and Data Networks Advances in networking and computing technologies offer the prospect of combining voice and data networks which until now have been built and operated as separate networks. The ability to combine separate voice and data networks into one converged network could improve functionality, reduce network administration and provide cost savings. For example, the widespread implementation of Internet Protocol-based data networks has led to the development of voice-over-Internet Protocol ("voice-over-IP") technology that permits transmission of voice communications over public or private Internet Protocol networks. According to Dataquest, transmission of voice traffic over Internet Protocol networks in smaller enterprises is projected to grow at a compound annual growth rate of 313% to 18.8 billion minutes of use in 2000. Multi-Site Networking Enterprises are increasingly dependent on distributed voice and data networks to support their operations across multiple locations. A networked voice communications solution delivers voice communication functions across multiple locations as an integrated system, thereby increasing productivity and user convenience and reducing costs. For example, messaging can be centralized so that voicemail, e-mail and faxes can be delivered seamlessly to all locations across the network. 26 Support for a Mobile Workforce Today's work environment is characterized by the need for real-time communications that support increasingly mobile workers. Employees need to have access to, and be accessible through, the enterprise's communications network to make informed decisions quickly, improve productivity and respond to customer needs rapidly. Remote access capabilities also allow off-site workers to access all functions of the enterprise's communications system as if they were on-site. Traditional voice communications systems were designed to provide a broad range of capabilities, but were not designed to be readily adaptable. Implementing new features and applications on these systems often requires substantial development effort and the purchase of ancillary equipment. Further customization may be necessary to meet the needs of a particular installation. Given the expense of ancillary equipment and customized development and the need to allocate development resources to support larger customers, communications systems vendors have generally addressed the small to medium- sized installation segment of the market with equipment that is often costly and less flexible. Thus, while traditional private branch exchange systems have been able to adapt to the changing needs of large installations, the complexity of these systems has limited the ability of traditional vendors to provide flexible and cost-effective communications solutions for small and medium-sized installations. The Cortelco Solution Cortelco provides integrated communications systems flexible enough to meet the immediate needs of enterprises with small to medium-sized installations, yet scalable enough to accommodate these businesses and organizations as they grow. Our systems are based on a general purpose bus architecture designed from the outset to permit the dynamic addition and variation of inputs, outputs and features through software and configuration of the system through add-in cards. Our solution offers functionality previously not readily available or cost- effective for small to medium-sized installations. Our communications platforms provide advanced features at an affordable cost and without the need for extensive specialized software and hardware or complex installation procedures. The flexible architecture of our Millennium and DSP Series platforms is the backbone for all of our products. Our comprehensive solutions are designed to improve the productivity and efficiency of our customers by providing them with a variety of communications capabilities, such as: . advanced call routing allowing for dynamic distribution of incoming voice, video and data traffic . easy integration of voice communications and computing capabilities . cost-effective multi-site networking . advanced mobility features to provide in-building and campus wireless communications and remote access by off-site workers We believe that we have achieved significant advantages in the configurability of and the ease of programming these capabilities and other new features relative to many competitors. Our flexible core platforms and range of options offer enterprises with small to medium-sized installations the combination of features and functions that best suit their particular needs. Strategy Cortelco's objective is to provide comprehensive, cost-effective communications systems for small and medium-sized installations in selected vertical markets. Our strategy incorporates the following key elements: 27 Target Small to Medium-Sized Installations We target enterprises with small to medium-sized installations, typically 25 to 500 communications ports, at one or more locations and that may have complex communications needs. We focus our sales efforts on selected vertical markets in which we have identified needs that can be especially well served by our systems and are characterized by enterprises with small to medium-sized installations, complex communications needs and cost-sensitivity. Our current targeted vertical markets include education, retail, government agencies, emergency-911 services and catalog sales. The inherent flexibility and configurability of our Millennium and DSP Series platforms make us uniquely suited to meet the needs of our targeted customers. Provide Cost-Effective, Integrated Customer Solutions We provide customers with cost-effective, integrated solutions for their voice communications requirements, including solutions to seamlessly integrate their voice and data networks. We believe our customers prefer to purchase integrated solutions from a single vendor due to convenience, consistency of service, ease of upgrade and vendor accountability. We offer an integrated family of communications products that interface with a wide range of third-party products through industry standard protocols, enabling us and our dealers to configure and deliver complete, customized voice communications systems that meet the specific needs of each customer. Expand Distribution Capabilities We are expanding both our direct sales force and our dealer network to more aggressively pursue our target markets. Since April 30, 1998, we have increased our sales force by approximately 48% and we plan further increases over the next year. We believe our use of indirect sales channels is especially effective because our dealers often have experience in our targeted vertical markets and because our flexible platforms enable them to sell, configure and service advanced features with relatively little expertise. As of April 30, 1999, we had approximately 130 authorized dealers and value added resellers. We are also expanding our geographic coverage by recruiting new dealers, value added resellers and strategic partners in the United States, the Caribbean and Latin America. Develop New Product Capabilities We intend to continue to enhance our core product line and develop new features and applications that leverage our existing Millennium and DSP Series platforms, address emerging market needs and increase gross margins. For example, we recently introduced new features and applications such as circuit switched data capabilities for data intensive applications and PC-based phone control. We expect to introduce several additional product capabilities during 1999, including: . integrated in-building and campus wireless capabilities which increase the range and maximum number of users on the existing Orbit Wireless Communications product and add desktop equivalent capabilities . unified messaging which provides integrated access to voice, fax and e-mail messages in a multi-site networked communications system . Internet Protocol capabilities such as voice-over-Internet Protocol ("voice-over-IP"), virtual private networks for voice and data applications and other Internet-based applications . Web-based virtual call center capabilities allowing agents and supervisors located anywhere in the world to access their call centers over the Internet We are also developing our next generation automatic call distribution and switching architecture to address the integration of emerging voice and data communications technologies. 28 Products and Services Cortelco offers the Millennium and the DSP Series, two feature-rich communications platforms targeted at specific market segments. Each platform provides advanced features that are easy to program and cost-effective due to an innovative modular hardware design and flexible software. Both platforms support multi-site networking and advanced features such as dynamic call routing, interactive voice response, voicemail and computer telephony integration. Our platforms share a suite of applications and hardware, including voice processing systems, an in-building and campus wireless communications system, a number of advanced computer telephony integration products and digital handsets. Both platforms also interface to a range of popular third-party products through standard protocols. These two communications systems allow us to provide an integrated communications solution for our target markets. We also sell a variety of other products for use with our platforms. Our Caribbean and Latin American Operations unit sells communications systems and products produced by Cortelco and resells cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. The Millennium The Millennium is a fully-featured private branch exchange with automatic call distribution capabilities, primarily targeting enterprises with small to medium-sized installations. It can be expanded in a modular manner from 32 to 1,024 communications ports and supports up to 100 automatic call distribution agents. Customers can increase the number of ports and add new features and applications through the simple installation of add-in cards and software. Dynamic call routing and control functions are provided by an integrated system controller running a real-time operating system. PC-based applications and system features are accessed via a serial interface. The Millennium can be networked with Cortelco platforms at other sites via a digital network interface. The following is a diagram of the functional architecture of the Millennium platform. [Millennium Network Diagram] 29 We believe that the Millennium platform is well-suited to address the voice switching needs of enterprises with small to medium-sized installations, including schools and school districts, retail sales and service locations, distribution centers, broadcast and extended health care facilities, government agencies and small call centers. The key strengths of the Millennium are multi- site networking, affordable automatic call distribution applications and server capabilities. Multi-Site Networking. Millennium systems can be connected across multiple locations, creating a private communications network that operates as if all sites were on a single system. Therefore, connected locations can share the Millennium's flexible call routing capabilities and applications. For example, networked Millennium systems employing our proprietary VoiceClusters technology can share a single Cortelco Voice Processing System, simplifying system management and ensuring answering and call routing consistency across locations. Similarly, networked Millennium systems employing the recently announced integrated Orbit Wireless Communications System at each location enables use of the same wireless handset across all locations. Affordable Automatic Call Distribution Applications. A standard feature of the Millennium is automatic call distribution. The system's dynamic call routing and report generation capabilities can be enhanced with an optional, real-time automatic call distribution package that provides call center management data collection and reporting capabilities for smaller call centers. The Millennium RealTime Automatic Call Distributor received a "Product of the Year" award from Call Center Solutions magazine in January 1999. Server Capabilities. The Millennium can be used to perform a variety of server- like functions. For example, the Millennium can be used as a protocol converter between E1 trunks, communications links used primarily by European carriers, and T1 trunks, communications links used primarily in North America. The Millennium can also be used as a channel bank, a device which merges multiple voice and data circuits into a single digital communications stream, or act as the switch in a wireless local loop network. In addition, one Millennium system at the hub can serve as the single entry point for T1, PRI (Primary Rate ISDN) and dedicated fiber optic links for the entire enterprise.
KEY FEATURES OF THE MILLENNIUM - ------------------------------------------------------------------------------- Digital Switching Networking and Server Automatic Call Distribution Architecture Capabilities . Extensive Call Routing . 32 to 1,024 . ISDN Support Communications Ports . Real-Time Automatic Call . Multi-Site Networking Distribution Agent Reporting . Modular Upgrade Path . Circuit Switched Data . Software-Based . Personal . Supports up to 100 Configuration Communications Service Automatic Call and Upgrades Access Distribution Agents (typically between 20 . Fiber Remote and 50 agents) Telephony Features Capability Illuminations Applications . Integrated Voicemail . Communications Suite Protocol Conversion . Caller ID Support . Channel Banking Unified Messaging . Auto Attendant (available in late 1999) . Communications Hub . Interactive Voice Response . In-building and Campus Wireless (Add-In . PC Attendant Console available in 1999) (Navigator) . Voice-over-Internet . Computer Telephony Protocol Gateway (Add- Integration Links In available in 1999) and Host Links
30 The DSP Series The DSP Series is a fully-featured automatic call distributor platform with integrated private branch exchange capabilities, primarily targeting the call center market and enterprises with larger installations. It can be expanded in a modular manner from 8 to 3,500 communications ports and supports up to 1,000 automatic call distribution agents. Its call routing flexibility can support up to 32,000 routes, each with 64 different steps. Customers can increase the number of ports and add new features and applications through the simple installation of add-in cards and software. Dynamic call routing and control functions are provided by redundant Pentium PCs running a real-time Linux-based operating system. PC-based applications and system features are accessed via an integrated Ethernet LAN interface. The DSP Series can be networked with Cortelco platforms at other sites via a digital network interface. The following is a diagram of the functional architecture of the DSP Series platform. [DSP Series Network Diagram] Our DSP Series is primarily designed for call centers across a broad range of industries including financial services, utilities, catalog sales, service bureaus and emergency-911 services. The DSP Series is designed to ensure uninterrupted service by including redundant processing units and power supplies and using a real-time Linux-based operating system. We believe the DSP Series is one of the most powerful and economical systems available on a cost- per-agent basis. The DSP Series won "Best of Show" awards at the 1997 and 1998 CT Expo and "Product of the Year" awards in 1997 and 1998 from Call Center magazine and in 1999 from Call Center Solutions magazine. The DSP Series provides the platform to handle, manage and improve all aspects of call center management. Its advanced automatic call distribution capabilities include real-time dynamic call routing, skill-based routing, simultaneous queuing among multiple gates and multiple networked systems, intelligent messages and caller identification number directed routing. The DSP Series also provides a comprehensive, customizable report and display package and can support computer 31 telephony integration applications for both inbound and outbound call center solutions. We currently offer the DSP1000 and DSP2000. The DSP2000 is an updated version of the DSP1000 which provides an upgrade path to 3,500 communications ports and support for a greater number of call center agents. The key strengths of the DSP Series are advanced automatic call distribution capabilities, host computer telephony integration and PC Phone Control with ActiveX. Advanced Automatic Call Distribution Capabilities. The advanced automatic call distribution capabilities of the DSP Series include: . Home Agent--This feature allows an agent to call into the system from a touch-tone phone, sign-on and conduct business as if he or she were on-site. The home agent can perform all operations and enter all modes as any other on-site agent. Supervisor displays, historical data gathering and computer telephony integration applications work identically for off-site and on-site agents. Additionally, the home agent with a modem-connected PC can retrieve information from enterprise databases. . Automatic Agent Greetings (AgentVoice)--This feature allows an agent to pre-record a number of different greetings that can be played based upon a caller's identification number. The agent and the caller hear the greeting simultaneously, providing a "whisper announce" notification for the agent. Pre-recorded responses can be played on demand to provide consistent, automated answers to frequently-asked questions from callers. AgentVoice is particularly useful for high volume call centers and service bureaus in which agents answer calls for a variety of different businesses. . Intelligent Announcement System--This feature enables our customers to provide inbound callers with a number of customized interactive, promotional, informational, holiday, after hours and delay messages. In addition, it can provide the caller with real-time call statistics such as estimated wait time, number of calls waiting and number of agents available. Our customers can choose from a set of pre-recorded voices or create a personalized message from a touch-tone phone or a Microsoft Windows-based interface. . Agent Call Back--This feature allows a call center agent with automatic number identification capability to flag a call, enabling a caller who calls back within a given period of time to be routed to the agent who originally handled the call. Host Computer Telephony Integration. The DSP Series offers an applications link for direct, redundant TCP/IP communications to host computers using 10/100BaseT Ethernet, a standard data networking protocol. This link allows data and commands to flow between the DSP Series and multiple host computers, permitting a networked implementation of a variety of enhanced applications such as screen synchronization, automated outbound dialing, automatic number identification screening and call routing. The link uses a standard Computer Supported Telecommunications Application ("CSTA") protocol which functions with many commercially available computer telephony integration protocols such as Novell TSAPI, IBM Call Path and Dialogic CT Connect applications. Unlike other similar competitive offerings, no intermediate computers are required for the CSTA interface. PC Phone Control with ActiveX. PC Phone Control is a graphical user interface for agents to access call center functions such as available/unavailable status, group pickup, redial and multi-line support. The ActiveX component of our PC Phone Control provides tools for developers of call center applications to use a variety of programming languages, including C, C++, Borland Delphi, Visual Basic and Java, to develop custom applications without the need to understand complex computer telephony integration protocols. We have won numerous awards for this product, including a "Best of Show" award at the 1998 CT Expo and a "Product of the Year" award in 1997 from Call Center magazine. 32 KEY FEATURES OF THE DSP SERIES - -------------------------------------------------------------------------------- Digital Switching Redundant Embedded CSTA Advanced Automatic Call Architecture Server Distribution . 8 to 3,500 Networking and Server . Skill-based Routing Communications Capabilities Ports . Automatic Agent . Caller-ID Support Greeting (AgentVoice) . Modular Upgrade Path . Multi-Site Networking . Intelligent Announcement System . Software-Based . Integrated In- Configuration and building and Campus . Agent Call Back Upgrades Wireless (Add-In available in 2000) . Agent Service Observation Telephony Features . Voice-over-Internet Protocol ("Voice- . Redundant Power . Voicemail (Add-In) over-IP") Supplies and Gateway (Add-In Processing Units available in 1999) . ISDN Support . Auto Attendant Basic Automatic Call . Multi-Site, Networked Distribution Automatic Call Distribution Support . Interactive Voice Response . Extensive Call . Advanced Call Center Routing Management Information . Computer Telephony System Integration Links and Host Links . Real-Time Automatic Call Distribution Agent Reporting . Supports up to 1,000 Client Application Automatic Call Computer Telephony Distribution Agents Integration Toolkit (typically between 25 and 300 agents) . Remote/Home Agent Embedded SQL/ODBC Server PC Phone Control with . Custom Automatic Call ActiveX Distribution Display Packages
Other Products We also offer a variety of other products for use with both the Millennium and DSP Series. Voice Processing System. The Cortelco Voice Processing System manages voice and fax messaging through integration of the telephone and messaging systems. This system provides a full range of voice and fax messaging services across networks running Microsoft NT, Novell NetWare, IBM OS/2 Warp and Artisoft LANtastic. Our proprietary VoiceClusters technology links multiple Cortelco Voice Processing System servers into a global messaging system, using existing wide-area networks to exchange messages between systems. This capability enables voice and fax message distribution to locations worldwide, improving message access and reducing transmission costs and delivery time. The system offers capabilities to support multiple languages simultaneously and language preference can be programmed by system, group or individual users. The Cortelco Voice Processing System is expandable from 4 to 48 ports and supports voicemail applications for up to 3,000 mailboxes, the Millennium and DSP Series platforms and many other voice communications platforms. In-building Wireless Communications. Cortelco's Orbit Wireless Communications System utilizes micro-cellular technology in the 1.92 to 1.93 gigahertz frequency band to provide a private digital wireless voice/data communications network within a building or campus. The system consists of a controller, base stations and user handsets and can be used with our systems or with any third- party private branch exchange or key telephone system. These system components are purchased and licensed from a third-party supplier under an OEM purchase agreement. We recently announced a Millennium Wireless Services Card of our own design which we expect to make available during the third calendar quarter of 1999. This add-in card and software enables full desktop equivalent features on the Orbit wireless handsets and significantly increases the range of the system and number of users it can simultaneously support. We plan to provide a similar add-in card for the DSP Series. The Orbit Wireless Communications System won a "Best of Show" award at the 1998 CT Expo. 33 Interactive Voice Response. Cortelco's Illuminations packages are Interactive Voice Response and Web-enabled self-service information retrieval packages customized for certain vertical markets. We released the first Illuminations package, Illuminations for Education, in August 1998. Illuminations for Education supports such common applications as automated course registration, automated attendance validation and grade reporting. We are considering the development of additional packages for the e-commerce, call center, broadcast and retail markets. PC-Based Attendant Console. The Navigator attendant console is a hardware and software based answering and messaging package for use with our Millennium system. The Navigator enhances an attendant's performance by presenting appropriate answer phrases, associated company directories, current availability status of individuals and other useful information with each inbound call. Calls can be connected to desired parties, on- or off-site, with a single keystroke or the click of a mouse. Messages can be taken for unavailable parties or digital pagers can be dialed with preprogrammed callback numbers displayed. The Navigator provides the attendant with the information necessary to efficiently answer and process each call presented to the console. The Navigator is particularly well-suited for multi-tenant applications. A new version of this product, to be introduced in the third calendar quarter of 1999, provides the ability to integrate with popular e-mail packages such as Microsoft Outlook. This product won a "Best of Show" award at the 1997 CT Expo. Third-Party Products and Services in Puerto Rico We resell cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. These third-party products include voice communications systems from Hitachi and Lucent, sold under distributor agreements for the Puerto Rico market. Cellular airtime services are resold under agreements with CellularOne and GTE and cellular telephone equipment is resold for a variety of equipment suppliers, including Ericsson, Motorola and Nokia. Customers Cortelco's customers are typically enterprises with small to medium-sized installations which often have complex communications needs. Many of these customers are in selected vertical markets in which we have identified needs that can be especially well served by our systems. These markets currently include education, retail, government agencies, emergency-911 services and catalog sales. Some of our customers have multiple installations networked together and are as large as national retail chains, such as Circuit City and U-Haul, or multi-location branches of the U.S. government, such as the FAA and the U.S. Coast Guard. For example, Circuit City, one of the nation's largest retailers of brand-name consumer electronics equipment, has implemented our products in several hundred stores throughout the United States. Circuit City's customer service centers use the Millennium Real-Time Automatic Call Distributor package. The Millennium's flexible call routing and automatic call distributor capabilities and its easy installation, programming and setup were important factors for Circuit City in choosing a Cortelco solution. We have also sold over sixty DSP Series systems to the FAA for use in their Automated Flight Service Stations. Whenever a general aviation pilot files a flight plan, checks aviation weather or national airspace information, the call is answered and routed through a DSP Series system. The DSP Series provides the FAA with an automatic call distribution platform for applications such as computer telephony integration, skill-based call routing and remote agents, as well as full voice routing and control functionality. 34 Our products have been installed for over 5,400 customers in over 7,100 locations. We believe the following list of customers is typical of our customer base by virtue of the industries they represent and the types of applications they implement using our products: Retail Sales and Service Education Budget Rent-A-Car Celebration School (Disney Circuit City partner) Hartz Mountain Pennsylvania State School PETsMART Systems U-Haul St. Cloud, Minnesota School District Media/Entertainment Universidad Politechnica KQED Washington University Los Angeles Dodgers Penske Motorsports California General Business Speedway Baxter Caribe Punch Productions Comair (Delta) Trinity Productions Consolidated Freightways Florida Power Call Centers Island Finance Bell Atlantic (emergency- 911) Government Agencies Bell South (emergency-911) Federal Aviation Adminis- Bellco Federal Credit tration Union National Park Service Birkenstock Shoes U.S. Coast Guard California Highway Patrol U.S. Customs Service Current, Inc. U.S. Marshals Service Whistler Resorts
Sales and Marketing For the fiscal year ended 1998, approximately 70% of our pro forma revenues were generated by our direct distribution channels and approximately 30% of our pro forma revenues were generated by our indirect distribution channels. We use a direct sales force to market our Millennium systems to national accounts and the federal government and for all DSP Series system sales. Approximately 130 authorized dealers and value added resellers sell, install and service our Millennium systems. We directly install, maintain and support our DSP Series systems. All of our sales in Puerto Rico are made through our direct sales force. We also offer systems integration services and customized system development. As of April 30, 1999, we had approximately 74 sales and marketing personnel. We have increased the number of sales and marketing personnel by approximately 48% since 1998 and anticipate further increases in the future. Through our office in San Juan, Puerto Rico, our Caribbean and Latin American Operations unit expects to develop a network of authorized dealers for sales and service of the Millennium and DSP Series product lines in countries in the Caribbean, Central America and the northern portion of South America. Additionally, we expect to open an office in Santiago, Chile, which will develop and manage a network of authorized dealers for sales and service in Argentina, Bolivia, Chile, Equador and Peru. Our marketing efforts focus on building brand awareness and increasing sales to customers directly and through our dealer network and value added resellers. We seek to educate customers in our targeted vertical markets about the benefits of our flexible product platforms and integrated communications solutions and the quality of our customer support and services. 35 Research and Development Our research and development efforts focus on enhancing our core product lines and developing the next generation automatic call distribution and switching architecture. We routinely conduct market research and solicit input from our customers and a select set of dealers as an integral part of our product planning. Current product initiatives include: . Platform Extensions--Extend and enhance the capabilities of the Millennium and DSP Series platforms. Examples include: unified messaging support, enhanced integration of our Cortelco Voice Processing System, an Orbit Wireless Services Card for the DSP Series and 2-wire telephone support for the Millennium. . Internet-Based Products--Integrate Internet capabilities into traditional switched telephony applications. Examples include: voice- over-Internet Protocol ("voice-over-IP") and Web-based virtual call center capabilities. . Computer Telephony Integration Applications--Extend programming interfaces, develop applications and certify third-party computer telephony integration products for targeted vertical markets. Examples include: TAPI standard computer telephony integration interface, Illuminations packages for call centers and retail markets and enhanced PC Phone Control with ActiveX. . Next Generation Core Products--Establish design concepts and architecture for new core products that will extend and enhance the capabilities of our current Millennium and DSP Series products. Consistent with our strategy, new core products will be based on an open architecture, will support a broader set of industry standard protocols than our current products and will more fully integrate emerging voice and data technologies. Examples of the new technologies and capabilities we are addressing include: a local area network telephony gateway, an Internet Protocol-based dynamic call routing server for voice and data, frame relay and asynchronous transfer mode protocol support, and local area network-based Internet Protocol telephones. As of April 30, 1999, we had 32 employees engaged in research and development. We have increased the total number of engineers by approximately 25% since 1998. We expect to continue to increase the number of our research and development employees at a faster rate than other areas and to focus these additional resources on our new product development initiatives. In particular, we will expand our capability to design and develop new software features which are based on industry standard network interfaces, such as asynchronous transfer mode and frame relay, and industry standard operating systems, such as Linux, Unix and Windows NT. Manufacturing We currently rely on two contract electronic manufacturers to produce the Millennium, CMC Industries, Inc. in Corinth, Mississippi and Pensar Corporation in Appleton, Wisconsin. Both contract manufacturers perform printed circuit board assembly and soldering, in-circuit and functional testing and packaging. We believe that CMC and Pensar have sufficient capacity and technical capabilities to respond to foreseeable increases in customer demand and advances in in-process technology. After final assembly by either manufacturer, we inspect and perform quality assurance testing at our facility in Corinth, Mississippi prior to shipment to our dealers or customers. Our contract with CMC provides for the purchase of units through purchase orders with pricing to be negotiated annually. The term of the contract is from August 1, 1998 through July 31, 1999 with one year renewals upon written notice by Cortelco. We make purchases from Pensar through purchase orders. Due to the customized nature of call center installations, each DSP Series sys- tem is custom-configured at our facility in Kennesaw, Georgia. We use various contract electronic manufacturers to manufacture 36 line cards, trunk cards and other DSP Series components and subassemblies. We receive, inspect and test components and subassemblies at our Kennesaw facili- ty. We then assemble and test each DSP Series system, configured in accordance with the customer's order, and ship the product directly to the customer's site. We are dependent on certain key suppliers for a number of our product components. For example, we rely on Siemens for our primary digital signal processors and chip sets, Natural Microsystems to supply the voice processors for our Cortelco Voice Processing System and CTP Systems for our Orbit wireless handsets and base stations. Our contract electronic manufacturers use standard components and subassemblies manufactured to our specifications. We make purchases from these suppliers through purchase orders. Interruptions in the availability of components from our key suppliers could result in delays or reductions in product shipments, which could damage our customer relationships and have an adverse effect on our operating results. We could also have difficulties finding alternate suppliers or modifying product designs to use alternative components. Competition Our principal competitors include Lucent Technologies, Mitel, NEC, Nortel Networks and Siemens in the voice communications equipment market and Aspect Telecommunications and Rockwell Electronic Commerce in the call center market. We also compete with vendors in markets for our ancillary products, such as voicemail, wireless communications and computer telephony integration applications. As voice and data communications networks converge, data equipment vendors such as Cisco Systems and 3Com may also compete in our market. In addition, alliances and mergers between telecommunications and computer companies may strengthen our competitors' positions or result in new entrants into our market. Many of our current and potential competitors have significantly greater financial, technical, marketing, customer service and other resources, greater name recognition and a larger installed customer base than we do. As a result, our competitors may be able to respond to new or emerging technologies and changes faster than we can. They may also be able to devote greater resources to the development, promotion and sale of their products. Actions by our competitors could result in price reductions, reduced margins and loss of market share, any of which would have a material adverse effect on our financial condition. There can be no assurance that we can compete successfully against our competitors or that competitive pressures would not have a material adverse effect on our financial condition and results of operations. Intellectual Property Cortelco relies on patent, trademark, copyright, trade secret protection and confidentiality and license agreements with its employees, clients, partners and others to protect its proprietary rights. We currently have 23 patents issued in the United States and additional patents pending. There can be no assurance that any patent applications now pending or hereafter filed by Cortelco will result in patents being issued. The patent position of technology companies involves complex legal and factual questions and, therefore, their validity and enforceability cannot be predicted with certainty. There can be no assurance that the steps taken by Cortelco to protect its proprietary rights will be adequate or that third parties will not infringe or misappropriate our patents, trade secrets, trademarks and similar proprietary rights. Furthermore, there can be no assurance that others will not independently develop similar technologies or duplicate any technology developed by Cortelco. A failure by Cortelco to protect its intellectual property could have a material adverse effect on its business, financial condition and results of operations. In addition, litigation may be necessary in the future to enforce our intellectual property rights, protect our trade secrets or determine the validity and 37 scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of management and technical resources, which could have a material adverse effect on our business, financial condition and results of operations. "BCS Technologies," "DSP1000," "Millennium," "DSP2000," "Illuminations," "Navigator," "Orbit," "VoiceClusters" and the Cortelco logo are trademarks of Cortelco. Facilities We currently lease the following facilities: . Memphis, Tennessee--approximately 25,000 square feet of office space for our corporate headquarters as well as administration, sales and marketing, customer support and Millennium engineering departments . Kennesaw, Georgia--approximately 23,000 square feet of office space for our DSP Series engineering, manufacturing operations and quality assurance departments . San Juan, Puerto Rico--approximately 15,000 square feet of office space for our Caribbean and Latin American Operations unit . Corinth, Mississippi--approximately 11,000 square feet of warehouse space for our Millennium manufacturing operations and quality assurance departments . Englewood, Colorado--approximately 7,000 square feet of office space for ACD Business Operations unit sales and marketing and customer support departments . Guelph, Ontario, Canada--approximately 5,000 square feet of office space for a software engineering group We expect to relocate our headquarters to a larger facility in Memphis, Tennessee in 2000. We believe that these facilities will be adequate to accommodate our needs for the foreseeable future. Employees As of April 30, 1999, we employed approximately 243 people, including approximately 74 in sales and marketing, approximately 32 in research and development, approximately 75 in service, technical support and training, approximately 24 in manufacturing operations and quality assurance and approximately 38 in finance and administration. We also employ independent contractors and other temporary employees. None of our employees is represented by a labor union, and we consider our employee relations to be good. Competition for qualified personnel in our industry is intense, particularly for qualified service technicians and software engineers trained in computer telephony integration and other technical staff. We believe that our future success will depend in part on our ability to attract, hire and retain qualified personnel. Legal Proceedings In the ordinary course of our business, we may from time to time be involved in litigation with employees, customers and others. In July 1998, we were served with a complaint by CBC Distribution & Marketing, Inc. ("CDM"), alleging essentially that a Millennium system purchased by CDM failed to function as represented. The complaint, which also named our dealer, Technicom Communications, Inc., and CDM's insurance carrier as defendants, seeks actual damages of approximately $1.5 million due to disruption of its fantasy football pool operations plus punitive damages and attorneys' fees. CDM later amended the complaint to add Sprint International Communications as a defendant. CDM's insurance carrier also filed a cross-claim against us. CDM's claim against its insurance carrier and the insurance carrier's cross-claim against us have since been voluntarily dismissed. We believe that this litigation is without merit and will not have a material adverse effect on our business. 38 In addition, in November 1998, WSI, Inc., as debtor in possession in a chapter XI bankruptcy proceeding, filed an action against Cortelco Puerto Rico, Cortelco Systems Holding Corporation and David S. Lee, one of our directors, in bankruptcy court. WSI is a distributor of telecommunications systems in Puerto Rico. The complaint essentially alleges that the defendants misused confidential information and otherwise engaged in unfair competition with WSI by attempting to discredit WSI with Lucent Technologies, Inc. and WSI's customers in Puerto Rico and to hire WSI employees. The complaint seeks damages in excess of $15.0 million plus costs and attorneys' fees. We believe that this litigation is without merit and will not have a material adverse effect on our business. 39 Management Executive Officers and Directors The executive officers and directors of Cortelco, and their ages as of April 30, 1999, are as follows:
Name Age Position - ------------------------ --- ------------------------------------------------------ J. Michael O'Dell....... 51 President, Chief Executive Officer and Director Stephen N. Samp......... 34 Chief Financial Officer, Vice President of Finance and Administration and Secretary Robert R. Cash.......... 44 Vice President of Sales and Marketing David M. Fredrick....... 46 Vice President/General Manager of ACD Business Operations Sergio R. Moren......... 54 Vice President/General Manager of Caribbean and Latin American Operations David S. Lee (1)........ 61 Chairman of the Board Stephen R. Bowling (1) 56 Director (2).................... Robert P. Dilworth (2).. 54 Director W. Frank King (1)....... 59 Director Jenny Hsui Theleen (1) 47 Director (2)....................
- ------------------------- (1) Member of the Compensation Committee. (2) Member of the Audit Committee. J. Michael O'Dell has served as Chief Executive Officer and a director of Cortelco since April 1998 and as President since October 1997. He also served as Chief Operating Officer of Cortelco from October 1997 to April 1998. From May 1993 to October 1997, Mr. O'Dell held various management positions at VTEL Corporation, a visual communications company, the most recent being Vice President and General Manager for the Enterprise Systems Division. Prior to VTEL, Mr. O'Dell served as Vice President, PC Products at Dell Computer Corporation, a personal computer manufacturer, and in various management capacities at IBM Corporation, a computer and electronics company. Mr. O'Dell received an M.S. in computer science from the United States Naval Postgraduate School and a B.S. from the United States Naval Academy in Annapolis, Maryland. Stephen N. Samp has served as Chief Financial Officer, Vice President of Finance and Administration and Secretary of Cortelco since March 1998. From June 1995 to February 1998, Mr. Samp was Vice President, Controller and Chief Accounting Officer at Guardsmark, Inc., a private security services firm. Mr. Samp previously worked with Deloitte, Haskins & Sells, an accounting firm. From August 1993 to May 1995, Mr. Samp attended the Wharton Graduate School of Business at the University of Pennsylvania where he earned an M.B.A. Mr. Samp received a B.S. in business administration from the Ohio State University. Robert R. Cash has served as Vice President of Sales and Marketing for Cortelco since March 1998. From June 1996 to March 1998, he was Senior Vice President at Coherent Communications Systems Corporation, a telephone apparatus company. From 1991 to 1994, Mr. Cash served as Vice President of Consumer Products and Vice President and General Manager for the Wireless Terminal Strategic Business Unit, a division of AT&T, a telecommunications company. He also has experience as New Business Development Vice President, as well as Product Manager, responsible for Key System Products at AT&T General Business Systems. Mr. Cash received an M.B.A. from Rutgers University and a B.A. in accounting from Lipscomb University. 40 David M. Fredrick has served as Vice President/General Manager of ACD Business Operations since April 1999. From 1988 until BCS was acquired by Cortelco in April 1999, Mr. Fredrick served as President and a director of BCS and its predecessor. Prior to BCS, Mr. Fredrick served as Vice President and Chief Operating Officer of Big O Tire Dealers and a consultant for a healthcare franchise company. Mr. Fredrick received an M.B.A. and a B.A. in business administration from the University of Denver. Sergio R. Moren has served as Vice President/General Manager of Caribbean and Latin American Operations since April 1999. Mr. Moren joined Cortelco Systems Puerto Rico in February 1998 and served as its President until it merged with Cortelco in April 1999. He joined Cortelco from Integrated Technologies, a contract manufacturer in the Dominican Republic, where he was Vice President from January 1996 to February 1998. Mr. Moren has also held a number of executive manufacturing and sales and marketing positions with various companies, including ITT Industries, Inc. in Puerto Rico and Latin America, where he last held the position of President and General Manager of ITT Qume Caribe, Puerto Rico. Mr. Moren received a masters degree from Harvard University's program for management development and a B.S. in electrical engineering from Santa Maria University in Chile. David S. Lee has served as the Chairman of Cortelco since 1991. Mr. Lee also serves as a director of CMC Industries, Inc., a contract electronic manufacturer; Centigram Communications Corporation, a communications management system company; and Linear Technology Corporation, a semiconductor company. Mr. Lee is a private investor and also serves as a Regent of the University of California. Mr. Lee was the President and Chairman of Data Technology Corporation from 1985 to 1988. Previously he served as Group Executive and Chairman of the Business Information Systems Group of ITT Corporation, and President of ITT Qume, formerly Qume Corporation. Mr. Lee co-founded Qume Corporation in 1973 and served as Executive Vice President until the company was acquired by ITT in 1978. Mr. Lee received an M.S. in mechanical engineering from North Dakota State University. Mr. Lee received a B.S. in mechanical engineering and an honorary doctorate of engineering from Montana State University. Stephen R. Bowling has served on the board of directors of Cortelco since September 1993. From 1994 to October 1997, he was the President of Cortelco and, from 1994 to April 1998, he was the Chief Executive Officer of Cortelco. Mr. Bowling is a private investor and since September 1993, he has served as President, Chief Executive Officer and a director of Cortelco Systems Holding Corporation. From 1978 to 1984, Mr. Bowling held several executive positions with Qume Corporation, a computer systems peripherals company, where his last position was Executive Vice President and General Manager. Mr. Bowling received an M.B.A. from Stanford University and a B.A. in economics from Williams College. Robert P. Dilworth has served on the board of directors of Cortelco since July 1998. He is presently serving as Senior Vice President of the Computer and Consumer Products Group at VLSI Technology, Inc., a semiconductor manufacturer, where he continues to serve as a director. Mr. Dilworth is also presently serving as the Chairman of Metricom, Inc., a wireless data communications company, and served as its President from 1987 to 1997, and its Chief Executive Officer from 1987 to 1998. Mr. Dilworth is a director of Photonics Corporation, a computer communications equipment company. Mr. Dilworth received a B.S. in business administration from Los Angeles State University. W. Frank King has served on the board of directors of Cortelco since September 1998. He is currently a private investor and a director of PSW Technologies, Inc., a software integration consulting 41 firm, where he served as President and Chief Executive Officer from 1992 to 1998. He currently serves on the boards of directors of Excalibur Technologies Corporation, a software company; Auspex Systems Inc., a computer server manufacturer; Best Software, Inc., an application software company; and Natural Microsystems Corporation, a telecommunications company. Dr. King earned a Ph.D. in electrical engineering from Princeton University, an M.S. in electrical engineering from Stanford University and a B.S. in electrical engineering from the University of Florida. Jenny Hsui Theleen has served on the board of directors of Cortelco since July 1997. She is currently serving as the Chairman of CV Transportation Services, an integrated transportation and distribution company. In 1984, Ms. Theleen co- founded ChinaVest, a private equity investment firm, and presently serves as a managing director. Ms. Theleen earned her post-graduate degree from L'Institut d'Etudes Politiques in Paris, France, and a bachelor's degree from the University of Singapore. Committees of the Board of Directors Our board of directors consists of six members, including our Chief Executive Officer. In accordance with the terms of our certificate of incorporation, the terms of office of the board of directors will be divided into three classes: Class I, whose term will expire at the annual meeting of stockholders to be held in 2000, Class II, whose term will expire at the annual meeting of stockholders to be held in 2001, and Class III, whose term will expire at the annual meeting of stockholders to be held in 2002. The Class I directors are Stephen R. Bowling and Jenny Hsui Theleen, the Class II directors are Robert P. Dilworth and David S. Lee, and the Class III directors are W. Frank King and J. Michael O'Dell. At each annual meeting of stockholders after the initial classification, the successors to directors whose terms will then expire will be elected to serve from the time of election and qualification until the third annual meeting following election. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes so that, as nearly as possible, each class will consist of one-third of the directors. Our board of directors has established an audit committee and a compensation committee. The audit committee consists of independent directors Stephen R. Bowling, Robert P. Dilworth and Jenny Hsui Theleen. The audit committee makes recommendations to the board regarding the selection of independent auditors, reviews the results and scope of the audit and other services provided by the Cortelco's independent auditors, and reviews and evaluates Cortelco's audit and control functions. The compensation committee consists of Stephen R. Bowling, W. Frank King, David S. Lee and Jenny Hsui Theleen. Director Compensation Directors currently do not receive any cash compensation for services provided as a board member but are reimbursed for out-of-pocket expenses they incur in connection with attendance at board meetings. Pursuant to the 1997 Equity Incentive Plan, Robert P. Dilworth and W. Frank King were each granted an option to purchase 18,000 shares of common stock at an exercise price of $0.70 per share in July 1998 and September 1998, respectively, and an option to purchase 17,027 shares of common stock at an exercise price of $6.50 per share in December 1998. Directors are eligible to receive discretionary option grants pursuant to the 1999 Equity Incentive Plan and employee directors will also be eligible to participate in the 1999 Employee Stock Purchase Plan. See "--Stock Incentive Plans." Compensation Committee Interlocks and Insider Participation In April 1998, our board of directors established a compensation committee. The compensation committee is responsible for approving all compensation arrangements for our officers and for 42 administering our employee stock option and stock purchase plans. In the last fiscal year, the compensation committee was composed of Stephen R. Bowling, David S. Lee and Jenny Hsui Theleen. W. Frank King joined the compensation committee in February 1999. Other than Stephen R. Bowling, who served as Cortelco's President from 1994 to October 1997 and as Cortelco's Chief Executive Officer from 1994 to April 1998, none of the members of the compensation committee are, or have ever been, officers or employees of Cortelco. Prior to the formation of the compensation committee, all decisions regarding compensation arrangements for our officers were made by the board of directors. See "Certain Transactions." Executive Compensation The following table sets forth certain information concerning the compensation earned for the fiscal year ended July 31, 1998 for (a) Cortelco's Chief Executive Officer and (b) each other executive officer of Cortelco whose total salary and bonus exceeded $100,000 for services rendered to Cortelco and its subsidiaries during the fiscal year 1998 (the "Named Executive Officers"). For information regarding terms of the stock options, see "--Stock Incentive Plans." The annual compensation of each of Robert R. Cash, David M. Fredrick and Sergio R. Moren exceeds $100,000. However, because each of the above individuals were hired during fiscal year 1998, their total compensation earned as of the end of fiscal year 1998 did not exceed $100,000 and therefore they are not included in the following table as Named Executive Officers. J. Michael O'Dell joined Cortelco as President and Chief Operating Officer in October 1997 and became the Chief Executive Officer of Cortelco in April 1998. Stephen R. Bowling previously served as President of Cortelco until October 1997 and Chief Executive Officer until April 1998. Summary Compensation Table
--------------------------------------------- Long-Term Annual Compensation Compensation ----------------------------- ------------ Securities Other Annual Underlying Name and Principal Position Salary Bonus Compensation Options - --------------------------- -------- ------- ------------ ------------ J. Michael O'Dell................ $156,153 $33,400 $68,000(1) 85,000 Stephen R. Bowling............... 180,000 -- -- --
- ------------------- (1) Represents reimbursement of relocation expenses. Option Grants in Last Fiscal Year The following table sets forth each grant of stock options made during the fiscal year ended July 31, 1998 to each of the Named Executive Officers. Options generally vest at a rate of 12.5% beginning on the date six months after the vesting commencement date and the remaining options vest in equal installments on a monthly basis over a three and one-half year period thereafter. These options have a term of 10 years. The potential realizable value is calculated based on the term of the option at the time of grant, which is 10 years. Stock price appreciation of 5% and 10% is assumed pursuant to rules promulgated by the SEC and does not represent our prediction of our stock price performance. The potential realizable value at 5% and 10% appreciation is calculated by assuming that the exercise price on the date of 43 grant appreciates at the indicated rate for the entire term of the option and that the option is exercised at the exercise price and sold on the last day of its term at the appreciated price.
-------------------------------------------------------------------------- Individual Grants ------------------------------------------- Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term ------------------------------ Percentage Number of of Total Securities Options Underlying Granted in Exercise Options Fiscal Price Expiration Name Granted 1998(1) Per Share Date 5% 10% - ---- ---------- ---------- --------- ---------- -------------- --------------- J. Michael O'Dell....... 85,000 61.0% $ 1.00 10/15/07 $ 53,456 $ 135,468 Stephen R. Bowling...... -- -- -- -- -- --
- ------------------- (1) Based on an aggregate of 139,311 shares subject to options granted to employees of Cortelco under the 1997 Equity Incentive Plan in fiscal 1998, including the Named Executive Officers. Aggregated Options Exercised in Fiscal 1998 and Year-End Option Values The following table sets forth, for the Named Executive Officers, the shares acquired and the value realized on each exercise of stock options during the year ended July 31, 1998, and the number and value of securities underlying unexercised options held by the Named Executive Officers at July 31, 1998. Options generally vest at a rate of 12.5% on the date six months after the date of grant and the remaining options vest in equal installments on a monthly basis over a three and one-half year period thereafter. These options have a term of 10 years. There was no public trading market for the common stock as of April 30, 1999. Accordingly, the value of unexercised in-the-money options have been calculated based on the average of the range of the initial offering price as set forth on the cover page of this prospectus.
------------------------------------------------------------------------------------- Number of Securities Underlying Value of Unexercised Shares Unexercised Options (1) In-The-Money Options Acquired Value ---------------------------------- ------------------------- Name on Exercise Realized Exercisable Unexercisable Exercisable Unexercisable - ---- ----------- --------- --------------- ---------------- ----------- ------------- J. Michael O'Dell....... -- -- 15,938 69,062 $159,380 $690,620 Stephen R. Bowling...... -- -- 59,173 -- $ 608,890 --
Stock Incentive Plans 1999 Equity Incentive Plan In April 1999, our board of directors adopted, and the stockholders approved, the 1999 Equity Incentive Plan (the "1999 Incentive Plan"). There is currently an aggregate of 2,000,000 shares of common stock authorized for issuance under the 1999 Incentive Plan. The 1999 Incentive Plan provides for the grant of incentive stock options, as defined under the Internal Revenue Code of 1986, as amended (the "Code"), to employees and nonstatutory stock options, restricted stock purchase awards, stock bonuses and stock appreciation rights to employees, directors and consultants of Cortelco and its affiliates. The 1999 Incentive Plan is administered by a committee appointed by the board of directors which determines recipients and types of awards to be granted, including the exercise price, the number of shares subject to the award, the vesting rate and the exercisability of awards. The terms of options granted under the 1999 Incentive Plan may not exceed 10 years. The exercise price is determined by the board of directors, provided that, the exercise price for an incentive stock 44 option cannot be less than 100% of the fair market value of the common stock on the date of the option grant, and the exercise price for a nonstatutory stock option cannot be less than 85% of the fair market value of the common stock on the date of the option grant. Generally, the optionee may not transfer a stock option other than by will or the laws of descent or distribution unless the optionee holds a nonstatutory stock option that provides for transfer in the stock option agreement. However, an optionee may designate a beneficiary who may exercise the option following the optionee's death. An optionee whose service relationship with Cortelco or any affiliate ceases for any reason may exercise vested options for the term provided in the option agreement. No incentive stock option may be granted to any person who, at the time of the grant, owns, or is deemed to own, stock possessing more than 10% of the total combined voting power of Cortelco or any affiliate of Cortelco, unless the option exercise price is at least 110% of the fair market value of the stock subject to the option on the date of grant and the term of the option does not exceed five years from the date of grant. In addition, the aggregate fair market value, determined at the time of grant, of the shares of common stock with respect to which incentive stock options are exercisable for the first time by an optionee during any calendar year, under all Cortelco stock plans and its affiliates, may not exceed $100,000. When Cortelco becomes subject to Section 162(m) of the Code, which denies a deduction to publicly held corporations for certain compensation paid to specified employees in a taxable year to the extent that the compensation exceeds $1,000,000, no person may be granted options under the 1999 Incentive Plan covering more than 500,000 shares of common stock in any calendar year. Shares subject to stock awards that have expired or otherwise terminated without having been exercised in full again become available for the grant of awards under the 1999 Incentive Plan. Restricted stock purchase awards granted under the 1999 Incentive Plan may be granted pursuant to a repurchase option in favor of Cortelco in accordance with a vesting schedule and at a price determined by the board of directors. Stock bonuses may be awarded in consideration of past services without a purchase payment. Unless otherwise specified, rights under a stock bonus or restricted stock bonus agreement generally may not be transferred other than by will or the laws of descent and distribution during such period as the stock awarded pursuant to such an agreement remains subject to the agreement. If there is any sale of substantially all of Cortelco's assets, any merger, reverse merger or any consolidation in which Cortelco is not the surviving corporation, or any acquisition by certain persons, entities or groups of 50% or more of Cortelco's stock, all outstanding awards under the 1999 Incentive Plan either will be assumed or substituted by any surviving entity. If the surviving entity determines not to assume or substitute such awards, the vesting provisions of such stock awards will be accelerated and the awards terminated if not exercised prior to the such transaction. As of April 30, 1999, no stock bonuses or restricted stock awards had been granted, options to purchase 987,982 shares of common stock were outstanding, no options had been exercised and 1,012,018 shares remained available for future grants pursuant to the 1999 Incentive Plan. The 1999 Incentive Plan will terminate in April 2009. 1997 Equity Incentive Plan In April 1998, our board of directors and stockholders approved the 1997 Stock Incentive Plan (the "1997 Incentive Plan"), which provides for the grant of incentive stock options, nonqualified stock options and restricted stock awards to employees and consultants. A maximum of 450,000 shares of common stock have been reserved for issuance under the 1997 Incentive Plan. In addition, the aggregate fair market value, determined at the time of grant, of the shares of common stock with 45 respect to which incentive stock options are exercisable for the first time by an optionee during any calendar year, under all stock plans of Cortelco and its affiliates, may not exceed $100,000. The 1997 Incentive Plan is administered by the board of directors, which has the authority to determine which eligible individuals are to receive options or restricted stock awards, the terms of such options or awards, the status of such options as incentive or nonqualified stock options under the federal income tax laws, including the number of shares, exercise or purchase prices and exercisability, vesting schedule and the time, manner and form of payment upon exercise of an option. The exercise price of options granted under the 1997 Incentive Plan is determined by the compensation committee. The options expire after a specified period that may not exceed ten years or in the case of a stockholder holding greater than 10% of the voting power, five years. As of April 30, 1999, options to purchase 333,505 shares were outstanding, no options had been exercised, and 116,495 shares remained available for future grants pursuant to the 1997 Incentive Plan. The 1997 Incentive Plan will terminate in April 2008. Our board of directors has determined that no further options will be granted under the 1997 Incentive Plan after the completion of this offering. 1997 Equity Incentive Plan of BCS Technologies, Inc. In April 1999, in connection with the acquisition of BCS, we assumed the 1997 Stock Incentive Plan of BCS, (the "BCS 1997 Incentive Plan"), which provides for the grant of incentive stock options, nonqualified stock options and restricted stock awards to employees and consultants. A maximum of 96,495 shares of our common stock have been reserved for issuance under the BCS 1997 Incentive Plan. As of April 30, 1999, options to purchase 94,279 shares were outstanding, no options had been exercised, and 2,216 shares remained available for future grants pursuant to the BCS 1997 Incentive Plan. The BCS 1997 Incentive Plan will terminate in January 2007. Our board of directors has determined that no further options will be granted under the BCS 1997 Incentive Plan after the completion of this offering. 1999 Employee Stock Purchase Plan In April 1999, our board of directors and stockholders approved the 1999 Employee Stock Purchase Plan, which enables eligible employees to acquire shares of common stock through payroll deductions. The 1999 Employee Stock Purchase Plan is intended to qualify as an "employee stock purchase plan" under Section 423 of the Code. The initial offering period will start on the date of this prospectus and end on August 31, 2000, with purchase dates on February 29, 2000 and August 31, 2000, unless otherwise determined by our board of directors. Each offering under the 1999 Employee Stock Purchase Plan after the initial offering will run for one year, unless otherwise determined by the board of directors prior to the beginning of such offering. During each offering period, an eligible employee may select a rate of payroll deduction of up to 15% of compensation. The purchase price for the common stock purchased under the 1999 Employee Stock Purchase Plan is 85% of the lesser of the fair market value of the shares on the first day or the purchase date. An aggregate of 250,000 shares of common stock have been reserved for issuance under the 1999 Employee Stock Purchase Plan. Employment Agreement With the exception of David M. Fredrick, Vice President/General Manager of ACD Business Operations, none of our executive officers has an employment agreement, and each of such executive officers serves at the discretion of our board of directors. On April 12, 1999, Cortelco entered into an employment agreement with Mr. Fredrick. Pursuant to the terms of such agreement, Mr. Fredrick is to receive annual salary of $165,000 in 1999 and an annual salary of $175,000 in 2000. Mr. Fredrick will receive an option to purchase 70,000 shares of common stock, 60,000 shares of which vest on January 2, 2001 and 10,000 shares of which vest on January 2, 2002. 46 401(k) Plan Effective July 15, 1990, as amended on October 1, 1995, our board of directors adopted an employee savings and retirement plan (the "401(k) Plan") covering certain of our employees. Pursuant to the 401(k) Plan, eligible employees may elect to reduce their current compensation by up to the lesser of 16% of such compensation or the statutorily prescribed annual limit ($10,000 in 1998) and have the amount of such reduction contributed to the 401(k) Plan. Cortelco may make contributions equal to 50% of the first 6% of the total of an employee's elective contribution and/or their after-tax employee contribution up to a maximum of $2,000 to the 401(k) Plan on behalf of eligible employees. Additionally, we may make an additional non-matching contribution on a discretionary basis on behalf of all eligible employees. The 401(k) Plan is intended to qualify under Section 401 of the Code so that contributions by employees or by Cortelco to the 401(k) Plan, and income earned on the 401(k) Plan contributions, and so that contributions by Cortelco, if any, will be deductible by us when made. The trustee under the 401(k) Plan, at the direction of each participant, invests the 401(k) Plan employee salary deferrals in selected investment options. We made contributions to the 401(k) Plan in fiscal 1998 and in the first quarter of fiscal 1999. We presently expect to make monthly contributions to the 401(k) Plan during fiscal 1999. Limitation of Liability and Indemnification Matters Our bylaws provide that we will indemnify our directors and executive officers and may indemnify our other officers, employees and agents to the fullest extent permitted by Delaware law. We are also empowered under our bylaws to enter into indemnification contracts with our directors and executive officers and to purchase insurance on behalf of any person we are required, or permitted, to indemnify. Pursuant to this provision, we expect to enter into indemnity agreements with each of our directors and executive officers. In addition, our certificate of incorporation provides that, to the fullest extent permitted by Delaware law, our directors will not be liable for monetary damages for breach of the directors' fiduciary duty of care to us and our stockholders. This provision in the certificate of incorporation does not eliminate the duty of care, and in appropriate circumstances equitable remedies such as an injunction or other forms of non-monetary relief would remain available under Delaware law. Each director will continue to be subject to liability for breach of the director's duty of loyalty to us, acts or omissions not in good faith or involving intentional misconduct, knowing violations of law, for any transaction from which the director derived an improper personal benefit, improper transactions between the director and us and improper distributions to stockholders and loans to directors and officers. This provision also does not affect a director's responsibilities under any other laws, such as the federal securities laws or state or federal environmental laws. We expect to enter into agreements with our directors and officers that require us to indemnify such persons against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred (including expenses of a derivative action) in connection with any proceeding, whether actual or threatened, to which any such person may be made a party by reason of the fact that such person is or was a director or officer of Cortelco or any of its affiliated enterprises, provided such person acted in good faith and in a manner such person reasonably believed to be in, or not opposed to, the best interests of Cortelco and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The indemnification agreements also set forth certain procedures that will apply in the event of a claim for indemnification thereunder. 47 Principal and Selling Stockholders The following table sets forth certain information with respect to the beneficial ownership of Cortelco's outstanding common stock as of April 30, 1999 and as adjusted to reflect the sale of the common stock being offered hereby by: . each person (or group of affiliated persons) who is known by Cortelco to own beneficially more than 5% of the common stock . each of the Named Executive Officers . each of the directors . all directors and executive officers of Cortelco as a group . each of Cortelco's current stockholders who is expected to sell shares in the offering. Unless otherwise specified, the address of the stockholder is the address of Cortelco set forth in this prospectus. Beneficial ownership is determined in accordance with the rules of the SEC and generally means sole or shared power to vote or direct the voting or to dispose or direct the disposition of any common stock. Except as indicated by footnote, and subject to community property laws where applicable, the persons named in the table below have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them. The percentage of beneficial ownership is based on 9,074,826 shares of common stock outstanding as of April 30, 1999 and 11,374,826 shares of common stock outstanding after completion of this offering assuming no exercise of the underwriters' over- allotment option. If the underwriters' over-allotment option is exercised in full, Cortelco and certain stockholders will sell up to 3,588,000 shares of common stock, and 11,412,114 shares of common stock will be outstanding after the completion of this offering.
-------------------------------------------------------------- Beneficial Ownership Beneficial Ownership Prior to Offering After Offering ---------------------- ---------------------- Number of Number of Number of Beneficial Owner Shares Percent Shares Offered Shares Percent - ---------------- ------------ --------- -------------- ------------ --------- David S. Lee (1)........ 3,551,119 39.1% -- 3,082,568 27.1% ChinaVest and affiliated entities (2)........... 1,888,457 20.8 -- 1,888,457 16.6 Cortelco Systems Holding Corporation (3)........ 793,246 8.7 104,733 688,513 6.1 CMC Industries, Inc. (4).................... 612,530 6.7 363,818 248,712 2.2 David M. Fredrick (5)... 636,518 7.0 136,364 426,356 3.7 Frank Naso (6).......... 616,445 6.8 136,364 406,284 3.6 J. Michael O'Dell (7)... 43,792 * -- 43,792 * Jenny Hsui Theleen (8).. 1,888,457 20.8 -- 1,888,457 16.6 Stephen R. Bowling (9).. 860,406 9.4 -- 755,673 6.6 Robert P. Dilworth (10)................... 6,253 * -- 6,253 * W. Frank King (11)...... 5,128 * -- 5,128 * All directors and executive officers as a group (10 persons) (12) ....................... 6,210,127 67.5 136,364 5,602,212 48.7 Other selling stockholders (13) ..... 147,595 1.6 78,721 68,874 *
- ------------------- * Represents beneficial ownership of less than 1%. (1) Includes 2,145,343 shares held directly by David S. Lee, 793,246 shares held by Cortelco Systems Holding Corporation and 612,530 shares held by CMC prior to this offering. David S. Lee is both Chairman and a principal stockholder of each of Cortelco Systems Holding Corporation and CMC. David S. Lee disclaims beneficial ownership of the shares held by Cortelco Systems Holding Corporation and the shares held by CMC. 48 (2) Consists entirely of 1,624,072 shares held by ChinaVest IV, L.P., 186,958 shares held by ChinaVest IV-A, L.P. and 77,427 shares held by ChinaVest IV-B, L.P. (collectively, "ChinaVest"). The address for ChinaVest is 19/F Dina House, 11 Duddell Street, Central, Hong Kong. (3) The address for Cortelco Systems Holding Corporation is 1703 Sawyer Road, Corinth, Mississippi. (4) The address for CMC Industries, Inc. is 4950 Patrick Henry Drive, Santa Clara, California. CMC announced on May 10, 1999 that it has signed a definitive agreement to be acquired by ACT Manufacturing Inc. (5) Includes 73,798 shares prior to this offering subject to purchase by certain employees of BCS pursuant to options exercisable upon this offering. (6) Includes 73,797 shares prior to this offering subject to purchase by certain BCS employees pursuant to options exercisable upon this offering. Frank Naso is an employee of Cortelco and a former principal stockholder of BCS. (7) Consists entirely of 43,792 shares issuable upon the exercise of options that will become exercisable within 60 days of April 30, 1999. (8) Consists entirely of 1,888,457 shares held by ChinaVest. ChinaVest Partners IV is a general partner of ChinaVest IV, L.P. and ChinaVest IV-A, L.P. ChinaVest Management Ltd. is a general partner of ChinaVest IV-B, L.P. Jenny Hsui Theleen is a general partner of ChinaVest Partners IV and a stockholder of ChinaVest Management Ltd. Jenny Hsui Theleen disclaims beneficial ownership of these shares except to the extent of her proportional partnership interest therein. (9) Includes 7,988 shares held directly by Stephen R. Bowling and 793,246 shares held by Cortelco Systems Holding Corporation prior to this offering which includes 83,165 shares of common stock held by Cortelco Systems Holding Corporation which are issuable to Stephen R. Bowling upon the exercise of options to purchase shares of Cortelco Systems Holding Corporation that will become exercisable within 60 days of April 30, 1999. Also includes 59,172 shares issuable upon the exercise of options that will become exercisable within 60 days of April 30, 1999. Stephen R. Bowling is the President, Chief Executive Officer and a director of Cortelco Systems Holding Corporation. Other than his option for 83,165 shares of common stock, Stephen R. Bowling disclaims beneficial ownership of the shares held by Cortelco Systems Holding Corporation. (10) Consists entirely of 6,253 shares issuable upon the exercise of options that will become exercisable within 60 days of April 30, 1999. (11) Consists entirely of 5,128 shares issuable upon the exercise of options that will become exercisable within 60 days of April 30, 1999. (12) Includes 126,045 shares issuable upon the exercise of options that will become exercisable within 60 days of April 30, 1999. (13) Consists entirely of 73,798 shares held by David M. Fredrick prior to this offering and 73,797 shares held by Frank Naso prior to this offering, all of which are subject to purchase by certain employees of BCS pursuant to options exercisable upon this offering. These employees are Mary Ann Alderman, Ed Barker, Michael Carothers, Jim Coker, Michael Countryman, Tom Fiore, Dale Goulette, Robert Havens, Willie Humbert, Dave Kelly, Tom McNeese, Keith Nansteel, John Nicholson, Wojciech Pawlowski, Barbara Putnam and Robert Van de Steeg. 49 Certain Transactions Prior to April 1999, Cortelco was a subsidiary of Cortelco Systems Holding Corporation and from time to time engaged in intercompany transactions with its parent and affiliates. See note 15 to our consolidated financial statements. The Cortelco common stock held by our parent company was pledged to secure a debt obligation in the amount of $3,600,000 as of December 31, 1998. In order to release this stock from the pledge so that Cortelco Systems Holding Corporation could distribute it to the holders of its capital stock and facilitate the acquisition of BCS, an agreement was entered into with the lender on February 25, 1999 to repay the remaining principal of this obligation in several installments, the last of which was paid on May 28, 1999. We loaned $2,600,000 at an interest rate equal to the prime rate plus 1.5% to Cortelco Systems Holding Corporation to be used for these payments. We have also declared dividends in the amount of $2,658,000, payable upon completion of this offering, which will be applied to repaying the principal of the loan. Following release of the pledge, Cortelco Systems Holding Corporation distributed a total of 2,856,944 shares of our common stock to its stockholders in April 1999 (the "Spin-Off"). In connection with the Spin-Off, Cortelco Systems Holding Corporation distributed: 1,137,364 shares of common stock to David S. Lee, chairman of Cortelco; 612,530 shares to CMC Industries; and 4,667 shares to Stephen R. Bowling, a director of Cortelco. David S. Lee is also Chairman and a principal stockholder of Cortelco Systems Holding Corporation. Stephen R. Bowling is also President, Chief Executive Officer and a director of Cortelco Systems Holding Corporation. CMC Industries is affiliated with Cortelco through common stock ownership. Pursuant to a Convertible Note Purchase Agreement dated as of July 31, 1997, we sold a convertible promissory note in the aggregate principal amount of $3,000,000 to ChinaVest, a principal stockholder. The note matures on July 31, 2002 and accrues interest at the rate of 8.0%, payable on the maturity date or sixty days following the date of conversion. On April 12, 1999, in accordance with the terms of the note, ChinaVest converted $686,000 of outstanding principal into 1,463,206 shares of Series A Convertible Preferred Stock. The Series A Convertible Preferred Stock automatically converts into 1,434,894 shares of our common stock upon completion of this offering. The remaining principal amount of $2,314,000, plus accrued interest, outstanding under the note will be paid from the net proceeds of this offering. Jenny Hsui Theleen, a director of Cortelco, is a managing director of ChinaVest. In July 1997, we loaned Cortelco Systems Holding Corporation the principal amount of $3,184,000. The note accrues interest at the rate of 8.0% per annum. In April 1999, we repurchased 250,000 shares of our common stock from Cortelco Systems Holding Corporation in exchange for the cancellation of $2,500,000 of the principal amount of the note. The remaining principal amount of $684,000, plus accrued interest, is due in November 2000. In October 1997, we loaned J. Michael O'Dell, our Chief Executive Officer and a director, the principal amount of $132,000 in connection with relocation expenses. J. Michael O'Dell repaid $61,000 of principal on the note in October 1998. The balance is due in October 1999. In April 1998, we sold a Millennium system to a public television station for $210,000. The funding for the purchase was based on a directed donation from David S. Lee through the Asia Cultural Teachings Corporation, a charitable foundation. David S. Lee is the honorary president of Asia Cultural Teachings Corporation. In April 1998, David S. Lee loaned Cortelco the principal amount of $250,000, payable on demand. The note was non-interest bearing and was repaid in full in October 1998. In February 1999, we 50 distributed a note receivable from David S. Lee in the amount of $250,000, which had been recorded as an offset to stockholders equity, to Cortelco Systems Holding Corporation as a dividend. In April 1999, we declared and paid a stock dividend of 195,684 shares of common stock. In connection with the BCS acquisition, we issued 1,036,014 shares of our common stock to David S. Lee, 636,518 shares to David M. Fredrick, 616,445 shares to Frank Naso, 453,562 shares to ChinaVest and 3,321 shares to Stephen R. Bowling in exchange for their stockholdings in BCS. See "Company Background." We also entered into employment agreements with David M. Fredrick and Frank Naso. See "Management--Employment Agreements." Since 1993, CMC Industries, Inc., a principal stockholder, has provided certain manufacturing services on a non-exclusive basis. The current agreement with CMC, dated as of August 1, 1998, expires on July 31, 1999, and is renewable annually by Cortelco. David S. Lee is Chairman and a principal stockholder of CMC. CMC announced on May 10, 1999 that it had signed a definitive agreement to be acquired by ACT Manufacturing Inc. We purchase single line phones from, and sell Millennium related products to, Cortelco International, Inc., a wholly-owned subsidiary of Cortelco Systems Holding Corporation. David S. Lee and Stephen R. Bowling are directors of Cortelco International, Inc. In fiscal 1998, our purchases from Cortelco International, Inc. totaled $85,000 and our sales totaled $188,000. Cortelco believes that all of the transactions set forth above were made on terms no less favorable to Cortelco than could have been otherwise obtained from unaffiliated third parties. As a matter of policy, all future transactions between Cortelco and any of its officers, directors or principal stockholders will be approved by a majority of the board of directors, including a majority of the independent and disinterested members of the board. 51 Description of Capital Stock The following description of our capital stock and provisions of our certificate of incorporation and bylaws is a summary and is qualified in its entirety by the provisions of our certificate of incorporation and bylaws, which have been filed as exhibits to our registration statement, of which this prospectus is a part. Upon the closing of this offering, our authorized capital stock will consist of 50,000,000 shares of common stock, $.001 par value per share, and 10,000,000 shares of preferred stock, $.001 par value per share. As of April 30, 1999, there were 9,074,826 shares of common stock outstanding held of record by approximately 125 stockholders. Common Stock The holders of common stock are entitled to one vote for each share held of record on all matters submitted to a vote of the stockholders. The holders of common stock are not entitled to cumulative voting rights with respect to the election of directors, and as a consequence, minority stockholders will not be able to elect directors on the basis of their votes alone. Subject to preferences that may be applicable to any then outstanding shares of preferred stock, holders of common stock are entitled to receive ratably such dividends as may be declared by the board of directors out of funds legally available for dividends. In the event of our liquidation, dissolution or winding up, holders of the common stock are entitled to share ratably in all assets remaining after payment of liabilities and the liquidation preference of the preferred stock, if any, then outstanding. Holders of common stock have no preemptive rights and no right to convert their common stock into any other securities. There are no redemption or sinking fund provisions applicable to the common stock. Preferred Stock The board of directors has the authority, without further action by the stockholders, to issue any undesignated shares of preferred stock in one or more series and to fix the rights, preferences, privileges and restrictions of any shares of preferred stock, including dividend rights, conversion rights, voting rights, terms of redemption, liquidation preferences, sinking fund terms and the number of shares constituting any series or the designation of such series, without any further vote or action by stockholders. The issuance of preferred stock could adversely affect the voting power of holders of common stock and the likelihood that such holders will receive dividend payments and payments upon liquidation and could have the effect of delaying, deferring or preventing a change in control of Cortelco. We have no present plan to issue any shares of preferred stock. Registration Rights After this offering, the holders of approximately 2,825,682 shares of common stock will be entitled to rights to require the registration of such shares under the Securities Act. If we propose to register any of our securities under the Securities Act, either for our own account or for the account of other security holders exercising registration rights, such holders are entitled to notice of such registration and are entitled, subject to certain limitations, to include their shares to be registered. The holders may also require us to file a registration statement under the Securities Act with respect to their shares, and we are required to use our best efforts to effect up to two such registrations. Furthermore, the holders may require us to register their shares on Form S-3 when we become eligible to use such form. Generally, we are required to bear all registration and selling expenses incurred in connection with any registrations except for underwriting discounts and commissions. These rights are subject to conditions and limitations, including the right of the underwriters of an offering to limit the number of shares included in such registration. 52 Delaware Anti-Takeover Law and Certain Charter Provisions We are subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law. In general, the statute prohibits a publicly held Delaware corporation from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. For purposes of Section 203, a "business combination" includes a merger, asset sale or other transaction resulting in a financial benefit to the interested stockholder, and an "interested stockholder" is a person who, together with affiliates and associates, owns or within three years prior did own, 15% or more of the corporation's voting stock. Our certificate of incorporation, effective upon the closing of this offering, also requires that: . the terms of the board of directors will be staggered into three classes . any action required or permitted to be taken by stockholders of Cortelco must be effected at a duly called annual or special meeting of the stockholders and may not be effected by written consent . the stocholders may amend our bylaws or adopt new bylaws only by the affirmative vote of 66 2/3% of the outstanding voting securities . special meetings of our stockholders may be called only by the board of directors, the Chairman of the Board or the Chief Executive Officer These provisions may have the effect of delaying, deferring or preventing a change in control of Cortelco. Transfer Agent and Registrar American Securities Transfer and Trust has been appointed as the transfer agent and registrar for our common stock. Its telephone number is (303) 298-5370. 53 Shares Eligible for Future Sale Prior to this offering, there has been no market for our common stock. Future sales of substantial amounts of common stock in the public market could adversely affect market prices prevailing from time to time. Furthermore, since only a limited number of shares will be available for sale shortly after this offering because of contractual and legal restrictions on resale described below, sales of substantial amounts of common stock in the public market after the restrictions lapse could adversely affect the prevailing market price and our ability to raise equity capital in the future. Upon completion of the offering, we will have 11,374,826 shares of common stock outstanding, assuming no exercise of the underwriters' over-allotment option and no exercise of outstanding options and warrants and based upon the number of shares outstanding as of April 30, 1999. Of these shares, the shares sold in this offering will be freely tradable without restriction or further registration under the Securities Act, unless such shares are purchased by our "affiliates," as that term is defined in Rule 144 under the Securities Act. The remaining 8,254,826 shares held by existing stockholders, and any shares purchase by affiliates in this offering, will be "restricted securities" as that term is defined in Rule 144 under the Securities Act. Our affiliates hold 5,405,369 of the restricted shares. Restricted shares may be sold in the public market only if registered or if they qualify for an exemption from registration under Rules 144, 144(k) or 701 under the Securities Act, which are summarized below. Upon completion of this offering, the holders of 2,825,682 shares of common stock, or their transferees, will be entitled to rights to require the registration of such shares under the Securities Act. Registration of such shares under the Securities Act would result in such shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by our affiliates, immediately upon the effectiveness of such registration. See "Description of Capital Stock--Registration Rights." We, our officers, directors and stockholders holding approximately 7,277,419 shares of common stock will agree under written lock-up agreements not to, without the prior written consent of J.P. Morgan Securities Inc., sell any shares of common stock for 180 days after the date of this prospectus. See "Underwriting." In general, under Rule 144 as currently in effect, beginning 90 days after the date of this prospectus, stockholders who have beneficially owned restricted shares for at least one year will be entitled to sell in any three-month period a number of shares that does not exceed the greater of one percent of the then outstanding shares of our common stock or the average weekly trading volume of our common stock in the Nasdaq National Market during the four calendar weeks immediately preceding the date on which notice of the sale is filed with the SEC. Sales pursuant to Rule 144 are subject to certain requirements relating to manner of sale, notice and availability of current public information about Cortelco. A person, or person whose shares may be aggregated, who is not deemed to have been one of our affiliates at any time during the 90 days immediately preceding the sale and who has beneficially owned restricted shares for at least two years is entitled to sell such shares pursuant to Rule 144(k) without regard to the limitations described above. Any of our employees, directors or consultants who purchased, or was awarded shares or options to purchase shares pursuant to a written compensatory plan or contract is entitled to rely on the resale provisions of Rule 701 under the Securities Act, which permits stockholders to sell their Rule 701 shares without having to comply with Rule 144's holding period restrictions, in each case commencing 90 days after the date of this prospectus. In addition, holders who are not affiliates may sell Rule 701 shares without complying with the public information, volume and notice provisions of Rule 144. 54 We intend to file a registration statement under the Securities Act covering shares of common stock reserved for issuance under our Stock Incentive Plans and the Purchase Plan. Based on the number of options outstanding and options and shares reserved for issuance at April 30, 1999, such registration statement will cover approximately 2,677,784 shares. Such registration statement is expected to be filed and to become effective as soon as practicable after the date of this prospectus. Shares registered under such registration statement will, subject to Rule 144 volume limitations applicable to affiliates, be available for sale in the open market, unless such shares are subject to vesting restrictions with Cortelco or the lock-up agreements described above. 55 Underwriting Subject to the terms and conditions contained in an underwriting agreement dated , 1999, the underwriters named below, for whom J.P. Morgan Securities Inc., Needham & Company, Inc. and A.G. Edwards & Sons, Inc. are acting as representatives, have severally agreed to purchase, and we and the selling stockholders have severally agreed to sell to them, an aggregate of 3,120,000 shares of common stock. We are selling 2,300,000 shares and the selling stockholders are selling an aggregate of 820,000 shares. The number of shares of common stock that each underwriter has agreed to purchase is set forth opposite its name below.
--------- Number of Shares --------- J.P. Morgan Securities Inc...................................... Needham & Company, Inc.......................................... A.G. Edwards & Sons, Inc........................................ --------- Total........................................................... 3,120,000 =========
The underwriters are offering the common stock subject to their acceptance of the common stock and subject to prior sale. The underwriting agreement provides that the obligations of the underwriters to purchase shares of common stock are subject to the approval of certain legal matters by counsel and to certain other conditions. If any of the shares of common stock are purchased by the underwriters pursuant to the underwriting agreement, all of the shares, other than the shares of common stock covered by the over-allotment option described below, must be purchased. The underwriters propose to offer the shares of common stock directly to the public at the public offering price set forth on the cover page of this prospectus and to dealers at such price less a concession not in excess of $ per share. The underwriters may allow, and such dealers may reallow, a concession not in excess of $ per share to other dealers. After the initial public offering of the common stock, the offering price and other selling terms may be changed from time to time by the underwriters. We and certain selling stockholders have granted to the underwriters an option to purchase up to 468,000 additional shares of common stock on the same terms and conditions solely to cover over-allotments. We have agreed to sell up to 37,288 additional shares and the selling stockholders have agreed to sell up to 430,712 additional shares. The option may be exercised during the 30-day period after the date of this prospectus. If the underwriters' option is exercised in full, the total price to public would be $ , the total underwriting discounts and commissions would be $ , and total proceeds to us would be $ , before deducting $ in expenses. We and the selling stockholders have agreed to indemnify the underwriters against specified liabilities, including liabilities under the Securities Act, and to contribute to payments that the underwriters may be required to make in connection with such liabilities. We, our officers, directors and stockholders holding an aggregate of 7,277,419 shares of common stock will agree not to, without the prior written consent of J.P. Morgan Securities Inc., (1) offer, pledge, announce the intention to sell, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant to purchase or otherwise transfer or dispose of, directly or indirectly, any shares of common stock or any securities of Cortelco which are substantially similar to the common stock, including but not limited to any securities that are convertible into or exercisable or exchangeable for, or that represent the right to receive common stock or any such substantially similar securities or (2) enter into any swap, option, future, forward or other agreement that transfers, in whole or in part, any of the economic consequences of ownership of common stock or any securities 56 substantially similar to the common stock. We may, however, issue shares of common stock upon the exercise of stock options that are currently outstanding, and may grant additional options under our stock option plans, provided that, without the prior written consent of J.P. Morgan Securities Inc., such additional options shall not be exercisable during such period. In connection with the offering, the underwriters may engage in transactions that stabilize, maintain or otherwise affect the price of the common stock. Specifically, the underwriters may over-allot the offering, creating a syndicate short position. In addition, the underwriters may bid for, and purchase, shares of common stock in the open market to cover syndicate short positions or to stabilize the price of the common stock. Finally, the underwriting syndicate may reclaim selling concession allowed for distributing the common stock in the offering, if the syndicate repurchases previously distributed common stock in syndicate covering transactions, in stabilization transactions or otherwise. Any of these activities may stabilize or maintain the market price of the common stock above independent market levels. The underwriters are not required to engage in these activities, and may end any of these activities at any time. Prior to this offering, there has been no public market for our common stock. The initial public offering price for the shares of common stock offered in this offering will be determined by negotiation among Cortelco, the selling stockholders and the underwriters. Among the factors to be considered in determining the initial public offering price are our revenue and earnings, market valuations of other companies engaged in activities similar to ours, estimates of our business potential and prospects, the present state of our business operations, our management, the general condition of the securities markets at the time of the offering and other factors deemed relevant. The estimated initial public offering price range set forth on the cover of this preliminary prospectus is subject to change as a result of market conditions and other factors. There can be no assurance that an active trading market will develop for our common stock or that our common stock will trade in the public market at or above the initial public offering price. 57 Legal Matters The validity of the shares of common stock offered hereby will be passed upon for Cortelco by Cooley Godward LLP, Palo Alto, California. Certain legal matters in connection with this offering will be passed upon for the underwriters by Davis Polk & Wardwell, New York, New York. Experts The consolidated financial statements of Cortelco Systems, Inc., (except for Cortelco Puerto Rico Inc. for the year ended July 31, 1996) as of July 31, 1997 and 1998 and for each of the three years in the period ended July 31, 1998, included in this prospectus and the related financial statements included elsewhere in this registration statement have been audited by Deloitte & Touche LLP, independent auditors, as stated in their reports appearing herein and elsewhere in this registration statement. The 1996 financial statements of Cortelco Puerto Rico, Inc. (consolidated with those of Cortelco) have been audited by PricewaterhouseCoopers LLP, as stated in their report included herein. The financial statements of Cortelco and its consolidated subsidiaries are included in this prospectus in reliance upon the reports of Deloitte & Touche LLP and are given based upon their authority as experts in accounting and auditing. The financial statements of Cortelco Puerto Rico, Inc., not separately presented in this prospectus, have been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon appears herein. Such financial statements, to the extent they have been included in the financial statements of Cortelco Systems, Inc., have been so included in reliance on their report given on the authority of said firm as experts in auditing and accounting. The financial statements of BCS Technologies, Inc. as of July 31, 1997 and 1998 and for the year ended July 31, 1998 and the eleven months ended July 31, 1997 included in this prospectus have been audited by Brock and Company, CPA's, P.C., independent auditors, as stated in their report appearing in this prospectus and have been included in reliance upon the report of that firm given upon their authority as experts in accounting and auditing. Additional Information A registration statement on Form S-1, relating to the common stock offered has been filed by with the SEC. This prospectus, which constitutes a part of the registration statement, does not contain all of the information set forth in the registration statement and the exhibits and schedules thereto. Statements contained in this prospectus as to the contents of any contract or other document referred to are not necessarily complete. If a contract of document has been filed as an exhibit to the registration statement, we refer you to the copy of such contract or other document that has been filed. Each statement in this prospectus relating to a contract or document filed as an exhibit is qualified in all respects by the filed exhibit. For further information with respect to our company and the common stock offered by this prospectus, we refer you to the registration statement, exhibits and schedules that we have filed. A copy of the registration statement may be inspected by anyone without charge at the public reference facilities maintained by the SEC at 450 Fifth Street, N.W., Judiciary Plaza, Washington, D.C. 20549, and copies of material filed may be obtained from the SEC upon the payment of certain fees prescribed by the SEC. The SEC also maintains a World Wide Web site that contains registration statements, reports, proxy and information statements and other information regarding registrants that file electronically. The address of the site is www.sec.gov. As a result of this offering, we will become subject to the information and reporting requirements of the SEC and will be required to file periodic reports, proxy statements and other information with the SEC. 58 Index to Financial Statements
Page ---- Cortelco Systems, Inc. and Subsidiaries: Independent Auditors' Report.............................................. F-2 Report of Independent Accountants......................................... F-3 Consolidated Balance Sheets at July 31, 1997 and 1998..................... F-4 Consolidated Statements of Operations for the Years Ended July 31, 1996, 1997 and 1998............................................................ F-5 Consolidated Statements of Cash Flows for the Years Ended July 31, 1996, 1997 and 1998............................................................ F-6 Consolidated Statements of Stockholders' Equity (Deficit) for the Years Ended July 31, 1996, 1997 and 1998....................................... F-7 Notes to Consolidated Financial Statements for the Years Ended July 31, 1996, 1997 and 1998...................................................... F-8 Consolidated Balance Sheets at July 31, 1998 and April 30, 1999 (Unaudited).............................................................. F-21 Consolidated Statements of Operations for the Nine Months Ended April, 1998 (Unaudited) and 1999 (Unaudited).................................... F-22 Consolidated Statements of Cash Flows for the Nine Months Ended April, 1998 (Unaudited) and 1999 (Unaudited).................................... F-23 Notes to Consolidated Financial Statements for the Nine Months Ended April, 1998 (Unaudited) and 1999 (Unaudited)............................. F-24 BCS Technologies, Inc.: Independent Auditors' Report.............................................. F-27 Balance Sheets at July 31, 1997 and 1998 and April 12, 1999 (Unaudited)... F-28 Statements of Operations for the Eleven Months Ended July 31, 1997, the Year Ended July 31, 1998, the Nine Months Ended April 30, 1998 (Unaudited) and the Period from August 1, 1998 through April 12, 1999 (Unaudited).............................................................. F-29 Statements of Cash Flows for the Eleven Months Ended July 31, 1997, the Year Ended July 31, 1998, the Nine Months Ended April 30, 1998 (Unaudited) and the Period from August 1, 1998 through April 12, 1999 (Unaudited).............................................................. F-30 Statements of Stockholders' Equity (Deficit) for the Eleven Months Ended July 31, 1997, the Year Ended July 31, 1998 and the Period from August 1, 1998 through April 12, 1999 (Unaudited).................................. F-31 Notes to Financial Statements............................................. F-32 Unaudited Pro Forma Consolidated Financial Information: Unaudited Pro Forma Consolidated Financial Information.................... F-39 Pro Forma Consolidated Balance Sheet at April 30, 1999 (Unaudited)........ F-40 Pro Forma Consolidated Statement of Operations for the Year Ended July 31, 1998 (Unaudited) ........................................................ F-41 Pro Forma Consolidated Statement of Operations for the Nine Months Ended April 30, 1998 and 1999 (Unaudited) ..................................... F-42 Notes to Pro Forma Consolidated Financial Statements (Unaudited).......... F-43 .
F-1 Independent Auditors' Report To the Board of Directors and Stockholders of Cortelco Systems, Inc. We have audited the accompanying consolidated balance sheets of Cortelco Systems, Inc. and subsidiaries (the "Company"), a 97% owned subsidiary of Cortelco Systems Holding Corporation, as of July 31, 1997 and 1998 and the related consolidated statements of operations, cash flows, and stockholders' equity (deficit) for each of the three years in the period ended July 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the statements of operations and cash flows of Cortelco Puerto Rico, Inc. (a consolidated subsidiary) for the year ended July 31, 1996, which statements reflect total revenues constituting 39.7% of the related consolidated total for that year. Those statements were audited by other auditors whose report has been furnished to us and our opinion, insofar as it relates to the amounts included for Cortelco Puerto Rico, Inc. for the year ended July 31 1996, is based solely on the report of such other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Cortelco Systems, Inc. and its subsidiaries at July 31, 1997 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended July 31, 1998 in conformity with generally accepted accounting principles. Deloitte & Touche LLP Memphis, Tennessee April 9, 1999 F-2 Report of Independent Accountants To the Board of Directors and Stockholders of Cortelco Puerto Rico, Inc. In our opinion, the statements of income and cash flows of Cortelco Puerto Rico, Inc. for the year ended July 31, 1996 (not presented separately herein) present fairly, in all material respects, the results of its operations and its cash flows for the year ended July 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. We have not audited the financial statements of Cortelco Puerto Rico, Inc. for any period subsequent to July 31, 1996. /s/ PricewaterhouseCoopers LLP PRICEWATERHOUSECOOPERS LLP San Juan, Puerto Rico September 17, 1996 Stamp 1392003 of the P.R. Society of Certified Public Accountants has been Affixed to the file copy of this report F-3 Cortelco Systems, Inc. and Subsidiaries Consolidated Balance Sheets At July 31, 1997 and 1998
-------------------- At July 31, -------------------- 1997 1998 --------- --------- Dollars in thousands ASSETS: Current assets: Cash and cash equivalents.............................. $ 320 $ 126 Trade accounts receivable, net of allowance for doubtful accounts of $3,090 and $1,880................ 8,295 7,109 Current portion of investment in sales-type leases..... 146 150 Inventories............................................ 5,849 6,256 Current portion of cellular telephone equipment deferred acquisition costs, net....................... 546 269 Other current assets................................... 539 802 --------- --------- Total current assets................................. 15,695 14,712 Certificate of deposit--restricted....................... 174 Property and equipment, net.............................. 1,322 1,317 Receivable from parent................................... 355 656 Receivable (payable) from affiliate...................... (172) 1 Other assets: Investment in joint venture............................ 67 67 Cellular telephone equipment deferred acquisition costs, net............................................ 172 -- Investment in sales-type leases, noncurrent............ 72 106 Intangible assets, net of accumulated amortization of $0 and $4............................................. 315 327 Notes receivable from employees........................ -- 138 Deferred financing costs, net of accumulated amortization of $0 and $91............................ 417 511 --------- --------- Total other assets................................... 1,043 1,149 --------- --------- Total assets......................................... $ 18,417 $ 17,835 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT): Current liabilities: Dividend payable....................................... $ -- $ 2,667 Checks outstanding..................................... 1,615 55 Note payable to related party.......................... -- 250 Current portion of long-term debt...................... 129 32 Notes payable under revolving line of credit........... 2,941 2,739 Trade accounts payable................................. 2,294 2,603 Accounts payable to CMC Industries, Inc................ 2,936 2,205 Amounts payable to minority stockholder of consolidated joint venture......................................... -- 403 Accrued expenses and other............................. 1,270 1,429 --------- --------- Total current liabilities............................ 11,185 12,383 Note payable to parent................................... 750 359 Long-term debt........................................... 4,871 6,041 Minority interest ....................................... -- 174 Commitments and contingencies............................ -- -- Stockholders' equity (deficit): Series A convertible preferred stock, $.001 par value, (10,000,000 shares authorized, none outstanding)...... -- -- Common stock, $.001 par value (50,000,000 shares authorized, 3,629,224 and 3,920,252 shares issued and outstanding).......................................... 4 4 Additional paid-in capital............................. 9,217 8,324 Accumulated deficit.................................... (4,176) (6,266) Note receivable from officer/director.................. (250) -- Note receivable from parent............................ (3,184) (3,184) --------- --------- Total stockholders' equity (deficit)................. 1,611 (1,122) --------- --------- Total liabilities and stockholders' equity........... $ 18,417 $ 17,835 ========= =========
See notes to consolidated financial statements. F-4 Cortelco Systems, Inc. and Subsidiaries Consolidated Statements of Operations Years Ended July 31, 1996, 1997 and 1998
------------------------------------- Year Ended July 31, ------------------------------------- 1996 1997 1998 ----------- ----------- ----------- Dollars in thousands, except per share data Net revenues............................ $ 38,518 $ 35,635 $ 30,949 Cost of revenues........................ 26,742 24,153 18,504 ----------- ----------- ----------- Gross profit........................... 11,776 11,482 12,445 Operating expenses: Selling, general and administrative.... 7,853 10,103 10,045 Research and development............... 1,256 1,310 1,407 ----------- ----------- ----------- Total operating expenses.............. 9,109 11,413 11,452 ----------- ----------- ----------- Income from operations.................. 2,667 69 993 Interest expense........................ 1,004 915 826 Management fee expense, net............. 178 406 185 Other expense (income), net............. (54) 272 61 ----------- ----------- ----------- Income (loss) from continuing operations before income taxes and minority interest.............................. 1,539 (1,524) (79) Income tax expense...................... 607 -- -- ----------- ----------- ----------- Income (loss) from continuing operations before minority interest... 932 (1,524) (79) Minority interest....................... -- -- (54) ----------- ----------- ----------- Income (loss) from continuing operations............................ 932 (1,524) (133) Discontinued operations--loss from operations of Cortelco, Inc . (less applicable income tax benefit of $607 in 1996)............................... (1,207) (515) -- ----------- ----------- ----------- Net loss.............................. $ (275) $ (2,039) $ (133) =========== =========== =========== Net income (loss) per common share-- basic and diluted: Income (loss) from continuing operations............................ $ 0.24 $ (0.40) $ (0.03) Income (loss) from discontinued operations............................ (0.31) (0.13) -- ----------- ----------- ----------- Net loss per common share--basic and diluted............................... $ (0.07) $ (0.53) $ (0.03) =========== =========== ===========
See notes to consolidated financial statements. F-5 Cortelco Systems, Inc. and Subsidiaries Consolidated Statements of Cash Flows Years Ended July 31, 1996, 1997 and 1998
----------------------------- Year Ended July 31, ----------------------------- 1996 1997 1998 Dollars in thousands -------- --------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss....................................... $ (275) $ (2,039) $ (133) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation.................................. 474 368 343 Amortization of intangibles................... -- -- 113 Amortization of deferred acquisition costs.... 1,104 1,143 638 Provision for the allowance for doubtful accounts..................................... 82 985 65 Loss from discontinued operations............. 1,814 515 -- Write-off of purchased software............... 108 -- -- Loss on sales of property and equipment....... -- -- 2 Minority interest ............................ -- -- 54 Changes in net assets and liabilities: Trade accounts receivable.................... (1,508) 976 1,438 Investment in sales-type leases, net......... 793 424 (38) Accounts receivable from/payable to affiliates.................................. 814 (465) (474) Inventories.................................. (779) 726 73 Deferred acquisition costs................... (863) (1,302) (189) Other current assets......................... (98) 37 (190) Trade accounts payable....................... (778) 606 (10) Accounts payable to CMC Industries, Inc...... 511 (903) (731) Amounts payable to minority stockholder of consolidated joint venture.................. -- -- 403 Accrued expenses and other................... 250 78 (259) -------- --------- -------- Net cash provided by operating activities... 1,649 1,149 1,105 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment............ (472) (537) (263) Purchase of patents, trademarks and software technology.................................... -- (315) (15) Maturities of certificates of deposit.......... (5) (6) 174 Net repayments (advances) under notes receivable from employees..................... -- -- (138) -------- --------- -------- Net cash used in investing activities....... (477) (858) (242) CASH FLOWS FROM FINANCING ACTIVITIES: Net borrowings (repayments) under revolving line of credit................................ 850 (3,232) (202) Increase (decrease) in checks outstanding...... -- 1,615 (1,560) Repayments of long-term debt................... (2,007) (1,120) 1,073 Proceeds from issuance of note payable to related party................................. -- -- 250 Proceeds from issuance of subordinated note.... 92 3,000 -- Repayment of note payable to parent company.... -- -- (391) Debt issuance costs............................ -- (417) (227) -------- --------- -------- Net cash used in financing activities....... (1,065) (154) (1,057) -------- --------- -------- Net increase (decrease) in cash and cash equivalents.................................... 107 137 (194) Cash and cash equivalents, beginning of year.... 76 183 320 -------- --------- -------- Cash and cash equivalents, end of year.......... $ 183 $ 320 $ 126 ======== ========= ======== Supplemental cash flow information: Interest paid.................................. $ 994 $ 923 $ 585 Income taxes paid.............................. -- -- 86 Noncash activity: 1996 and 1997: All noncash transactions, primarily transfers of assets to/from companies affiliated through common ownership, are discussed in the accompanying notes. 1998: The Company issued 95,343 shares of common stock in exchange for a 55% interest in a joint venture in mainland China (see Note 9). Additionally, the Company entered into a barter transaction whereby they exchanged inventory and installation services valued at approximately $135,000 for advertising and promotional services.
See notes to consolidated financial statements. F-6 Cortelco Systems, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity (Deficit) Years Ended July 31, 1996, 1997 and 1998 -----------------------------------------------------------------------------
Note Common Stock Receivable From Total ---------------- Additional ----------------- Stockholders' Paid- Accumulated Officer/ Equity Shares Amount in Capital Deficit Director Parent (Deficit) Dollars in thousands --------- ------ ---------- ----------- -------- ------- ------------- Balance at July 31, 1995 3,629,224 $ 4 $ 9,217 $ (612) $ (250) $(3,184) $ 5,175 Net loss................ -- -- -- (275) -- -- (275) --------- ---- -------- -------- ------- ------- --------- Balance at July 31, 1996 3,629,224 4 9,217 (887) (250) (3,184) 4,900 Distribution of Cortelco, Inc. common stock........... -- -- -- (1,250) -- -- (1,250) Net loss................ -- -- -- (2,039) -- -- (2,039) --------- ---- -------- -------- ------- ------- --------- Balance at July 31, 1997 3,629,224 4 9,217 (4,176) (250) (3,184) 1,611 Issuance of common stock to acquire interest in joint venture.......... 95,343 -- 67 -- -- -- 67 Net loss................ -- -- -- (133) -- -- (133) Stock dividend.......... 195,685 -- 1,957 (1,957) -- -- -- Dividend declaration (CSI).................. -- -- (2,217) -- 250 -- (1,967) Dividend declaration (CSPR)................. -- -- (700) -- -- -- (700) --------- ---- -------- -------- ------- ------- --------- Balance at July 31, 1998 3,920,252 $ 4 $ 8,324 $ (6,266) $ -- $(3,184) $ (1,122) ========= ==== ======== ======== ======= ======= =========
See notes to consolidated financial statements. F-7 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements Years Ended July 31, 1996, 1997 and 1998 1. Description of Business and Organization Description of Business--Cortelco Systems, Inc. (the "Company" or "CSI") designs, develops and markets integrated enterprise communications systems for routing and controlling the voice, video and data communications of businesses and other organizations. In addition to selling Millennium systems and related systems products, Cortelco also resells cellular airtime, cellular telephones and third-party voice communications systems in Puerto Rico. Organization--Effective July 31, 1993, the telecommunications business of CMC Industries, Inc. ("CMC") was spun-off to Cortelco Systems Holding Corporation ("CSHC", the parent company). From August 1, 1993 to July 31, 1995, CSHC combined the operations of the Company (the "Systems" and "Automatic Call Distributor" product lines) with the operations related to another product line, single line telephones, and accounted for these product lines as a single business unit. Effective August 1, 1995, CSHC contributed the assets of the "Systems" and "Automatic Call Distributor" product lines to the Company. The assets were recorded at historical book value. 2. Basis of Presentation Basis of Presentation--The Company was a 97% owned subsidiary of CSHC through April 1999. The consolidated financial statements of CSI include the accounts of its wholly-owned subsidiaries, Cortelco Puerto Rico, Inc. for all periods presented and Cortelco, Inc. (the "Automatic Call Distributor" product line) through March 31, 1997, at which time Cortelco, Inc. was spun-off to CSHC (see Note 4). The consolidated financial statements also include the accounts of its 55% owned joint venture in mainland China since the date of acquisition (see Note 9). Minority interest is recognized for the remaining 45% interest in the financial position and operations of the joint venture. All significant intercompany balances have been eliminated. The Company is also affiliated with the following entities through common stockholder ownership: Cortelco International, Inc. ("CII", subsidiary of CSHC) Cortelco Puerto Rico, Inc. ("CPR", subsidiary of CSHC) Cortelco Canada ("CC", subsidiary of CSHC) BCS Technologies, Inc. CMC Industries, Inc. The Company also has two inactive subsidiaries, Cortelco Holding Corp. and CTC Holding Corp. In April 1999 a series of transactions occurred whereby CSHC distributed the common stock of the Company to the CSHC stockholders and CPR formed a new wholly-owned subsidiary in the Commonwealth of Puerto Rico, Cortelco Systems Puerto Rico, Inc. ("CSPR"), in contemplation of a merger between the Company and the newly formed subsidiary. Previous to the merger, CPR contributed substantially all of the operations and certain assets and liabilities to the newly formed CSPR. Cortelco Puerto Rico, Inc. retained certain real estate assets and the related mortgage note payable. On April 8, 1999, CPR transferred all issued and outstanding stock of CSPR to CSHC, the Company issued 553,880 shares of common stock to CSHC in exchange for an 100% interest in CSPR and CSPR assumed the CPR Credit Facility described in Note 11. As the business combination was between entities under common control, the merger has been accounted for in a manner similar to a pooling of interests and accordingly, all periods presented in the accompanying financial statements reflect the results of operations on an "as if pooled" basis. The common stock issued to effect the business combination has been reflected as outstanding for all periods presented. 3. Summary of Significant Accounting Policies Cash and Cash Equivalents--All highly liquid investments with a maturity of three months or less are considered to be cash equivalents. F-8 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 The Company provides a centralized cash management function whereby all cash receipts on customer accounts are processed through a lockbox arrangement and swept daily to paydown the line of credit agreement discussed in Note 11. All cash disbursements are handled through daily draws on the line of credit to cover the Company's outstanding checks. Inventories--Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out ("LIFO") method for approximately 81% and 72% of the inventories at July 31, 1997 and 1998, respectively. The first-in, first-out ("FIFO") method is principally used for the remainder. Property and Equipment--Property and equipment are stated at cost. Depreciation is provided using the straight-line method for financial reporting purposes and accelerated method for income tax reporting purposes over the estimated useful lives of the assets, generally five to thirty years. Investments--Investments in affiliates and corporate joint ventures which represent a 20% to 50% equity interest are accounted for under the equity method. Investments representing less than a 20% interest are carried at the lower of cost or net realizable value. Intangible Assets--Intangible assets primarily represent costs incurred to acquire and/or establish patents, trademarks and software technology. These costs are being amortized on a straight-line basis over the estimated useful lives of the assets, generally five years. The amortization period begins with the initial introduction of the underlying product to the market in order to properly match revenue and expense. The Company reviews the carrying value of intangible assets for impairment based on undiscounted cash flows whenever events or changes in circumstances occur which might indicate that the carrying amount might not be recoverable. Deferred Financing Costs--Deferred financing costs represent costs associated with the issuance of debt. These costs are being amortized using the effective interest method over the life of the related debt issue. Product Warranties--The Company provides the customer with a warranty from the date of purchase. Estimated warranty obligations are recorded based on actual claims experience. Income Taxes--Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company's results are included in the consolidated U.S. income tax return of Cortelco Systems Holding Corporation. Income taxes are not provided on the unremitted earnings of the Company's foreign subsidiaries and foreign joint ventures since it is the Company's intention to continue to reinvest these earnings. Revenue Recognition--Revenues are recognized at the time products are shipped or when title passes. Net sales is comprised of sales reduced by related sales allowances. Revenues from cellular airtime are recognized when earned based on cellular airtime contracts. The Company receives sales commissions on certain transactions with the Puerto Rico Telephone Company. These commissions are recorded as cellular airtime in the accompanying financial statements. Cellular Telephone Equipment Deferred Acquisition Costs--The Company offers commissions to dealers, and discounts to customers, on the sale of cellular telephone equipment that is part of a simultaneous leasing of cellular telephone service. These commissions and discounts are deferred and amortized to income over the life of each contract, which usually ranges from one to three years. Allocation of Certain Shared Expenses--The accompanying financial statements include the assets, liabilities, revenues and expenses specifically identifiable with the Company as well as certain allocated expenses for services provided by CSHC and CII. The costs have been allocated using formulas including estimates of effort expended and sales and management believes the allocation method to be reasonable. The financial statements may not necessarily reflect the assets and liabilities and results of operations of the Company had it been operated as a stand-alone entity. Management estimates that the costs that would have been incurred on a stand alone basis would have approximated $120,000, $390,000, and $100,000 for the years ended July 31, 1996, 1997, and 1998. Medical Care and Disability Benefit Plans--The Company is self-insured with respect to certain medical and disability benefits offered to substantially all employees through participation in an insurance plan with an affiliated company. These F-9 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 costs are charged against earnings in the period in which claims are incurred. The Company does not provide benefits to retired employees. Foreign Currency Translation--The assets and liabilities of the foreign joint venture are translated at current exchange rates with the related translation adjustments reported as a separate component of stockholders equity. Income statement accounts are translated at the average exchange rate during the period. Earnings Per Share--The Company follows Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings Per Share," which requires disclosure of basic and diluted earnings per share ("EPS"). Basic EPS is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted EPS is similar to basic EPS except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares, such as options, had been issued. Reverse Stock Split--On February 24, 1999, the Company's board of directors authorized a 1 for 10 reverse stock split of its common and preferred stock effective for stockholders of record on March 1, 1999. The Company's board of directors also approved an amendment to the Company's certificate of incorporation to decrease the authorized common and preferred shares to 50,000,000 and 10,000,000, respectively, and to increase the par value per common share from $.0001 to $.001. Shares outstanding and all per share amounts in the accompanying financial statements have been restated to give effect to the reverse stock split. Fair Value of Financial Instruments--The carrying amounts of financial instruments such as cash, accounts receivable, accounts payable and the outstanding borrowings under the revolving credit agreement approximate their fair value due to the short term nature of the instruments. Additionally, the carrying value of the Company's investment in the foreign joint venture discussed in Note 9 approximates fair value. As determined by an independent third-party, the fair value of the Company's subordinated convertible debt could not be practicably determined due to the lack of a quoted market and the complex features of the security. Additional information pertinent to the debt agreement is contained in Note 11. Estimates--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications--Certain amounts in the 1997 financial statements have been reclassified to conform with the 1998 presentation. New Accounting Standards--In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS 130, "Reporting Comprehensive Income," which established standards for reporting and display of comprehensive income and its components and requires a separate statement to report the components of comprehensive income for each period reported. The provisions of this statement are effective for fiscal years beginning after December 15, 1997. Management believes this statement may require expanded disclosure in the Company's financial statements. In June 1998, FASB issued SFAS 133, "Accounting for Derivative Instruments and Hedging," which established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The provisions of this statement are effective for fiscal years beginning after June 15, 1999. Management has not evaluated what impact, if any, the adoption of this statement will have on the disclosures in the Company's financial statements. F-10 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 4. Discontinued Operations Effective March 31, 1997 the Company distributed all of the outstanding common stock of its subsidiary in the automatic call distribution business to the CSHC stockholders. The net assets, results of operations and cash flows of Cortelco, Inc. have been reported as discontinued operations in the accompanying financial statements. Summarized financial information of the discontinued operations is presented as follows:
------------------- Eight Year Months Ended Ended July 31, March 31, 1996 1997 -------- --------- Dollars in thousands Net revenues.............................................. $ 6,063 $ 2,512 Cost of revenues.......................................... 4,631 1,321 -------- -------- Gross profit............................................. 1,432 1,191 Operating expenses........................................ 3,158 1,620 -------- -------- Loss from operations..................................... (1,726) (429) Interest expense.......................................... 158 48 Other expense (income), net............................... (70) 38 -------- -------- Loss before income taxes................................. (1,814) (515) Income tax benefit........................................ 607 -------- -------- Loss from discontinued operations....................... $ (1,207) $ (515) ======== ========
As of the date of the spin-off, the net assets of the Company's subsidiary in the automatic call distributor business totalled $1,250,000 and this amount was charged against retained earnings in the accompanying 1997 balance sheet to reflect the distribution of the subsidiary's stock. 5. Major Customers and Concentrations of Credit Risk Financial instruments which potentially subject the Company to a concentration of credit risk consist principally of cash, trade accounts receivable and notes receivable. The Company maintains its cash balances with large regional or national financial institutions and has not experienced losses. The Company's products are sold principally to dealers, value added resellers, national accounts and the U.S. government. Approximately 38% of the Company's revenues are generated within the Commonwealth of Puerto Rico. The Company's credit risk is limited principally to trade accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. No additional risk beyond amounts provided for collection losses is believed inherent in the Company's trade accounts receivable. 6. Inventories Inventories consist of the following:
------------------ 1997 1998 -------- -------- Dollars in thousands Raw materials and purchased components...................... $ 910 $ 819 Finished goods.............................................. 5,137 5,551 LIFO reserve................................................ (198) (114) -------- -------- Total inventories......................................... $ 5,849 $ 6,256 ======== ========
In 1997, the liquidation of LIFO inventories decreased cost of revenues and therefore decreased the net loss from continuing operations before taxes by $200,000. In 1998, the liquidation of LIFO inventories decreased cost of revenues and therefore decreased the net loss from continuing operations before taxes by $84,000. F-11 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 7. Investment in Sales-Type Leases The Company's net investment in sales-type lease contracts consists of:
-------------------- 1997 1998 --------- --------- Dollars in thousands Future minimum lease contract receivables................ $ 255 $ 326 Less unearned interest income............................ (37) (70) --------- --------- Total investment in sales-type leases.................. 218 256 Less current portion..................................... (146) (150) --------- --------- Investment in sales-type leases, non-current........... $ 72 $ 106 ========= =========
Annual future minimum lease contract gross receivables under sales-type lease contracts are as follows: Dollars in thousands 1999................................................................. $ 150 2000................................................................. 67 2001................................................................. 58 2002................................................................. 44 2003 and thereafter.................................................. 7 --------- Total.............................................................. $ 326 =========
8. Property and Equipment Property and equipment consists of the following:
-------------------- 1997 1998 --------- --------- Dollars in thousands Building improvements.................................... $ 900 $ 1,000 Machinery and equipment.................................. 744 891 Furniture and fixtures................................... 729 802 Automobiles.............................................. 25 73 Construction in progress................................. 42 10 --------- --------- Total.................................................. 2,440 2,776 Less accumulated depreciation............................ (1,118) (1,459) --------- --------- Property and equipment, net............................ $ 1,322 $ 1,317 ========= =========
9. Investment in Joint Ventures The Company has a $67,000 investment representing a 10% equity interest in a Poland-based company (DTS/ZWUT) which will manufacture, sell and distribute products designed and marketed by the Company. The Company accounts for its interest in the joint venture at the lower of cost or net realizable value. During 1996, the Company entered into an acquisition agreement with a Taiwanese company ("Sea Union") whereby the Company has the option to acquire controlling interests in several telecommunications joint ventures in mainland China over an extended period of time in exchange for Company stock. On August 11, 1997, the Company exercised its option to acquire a controlling interest in one of the joint ventures. The Company acquired a 55% interest in Heilongjiang Longhai Telecommunication Equipment Co., Ltd. ("Longhai") in exchange for 95,343 shares of the Company's common stock valued at $67,000. The acquisition was recorded under the F-12 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 purchase method of accounting and accordingly, the results of operations have been included in the consolidated financial statements since the date of acquisition. The purchase price has been allocated to the assets acquired and liabilities assumed based on their estimated fair market value at the date of acquisition. 10. Accrued Expenses and Other Accrued expenses and other consists of the following:
------------------- 1997 1998 --------- --------- Dollars in thousands Employee compensation...................................... $ 128 $ 152 Commissions................................................ 96 85 Vacation................................................... 267 259 Warranty................................................... 340 250 Interest................................................... -- 263 Financing costs............................................ 195 -- Other...................................................... 244 420 --------- --------- Total.................................................... $ 1,270 $ 1,429 ========= =========
11. Debt Cortelco Systems, Inc. Revolving Credit Facility--On July 31, 1997, CSI entered into a new loan and security agreement with Foothill Capital (the "CSI Credit Facility") which provides for borrowings based upon an asset formula involving eligible accounts receivable and inventories, up to a maximum of $7,500,000, including letters of credit, and expires in July 2001. At July 31, 1998, CSI had outstanding borrowings under this facility of $2,353,000. The Company had no outstanding letters of credit at July 31, 1998. The borrowings are collateralized by substantially all the assets of the Company. The CSI Credit Facility provides for interest at the reference rate plus the margin in effect, which fluctuates during the term of the CSI Credit Facility, based on the Company's satisfaction of certain minimum income requirements. At July 31, 1998 the effective interest rate was 8.875% (prime rate of 8.5% plus a margin of 0.375%). The CSI Credit Facility also provides for an annual facility fee equal to 0.125% of the maximum borrowing base and an annual unused line fee equal to 0.375% based upon the average unused portion of the available credit. The CSI Credit Facility also contains covenants which, among other matters, limit the ability of the Company to incur indebtedness; merge, consolidate or acquire or sell assets; pay dividends; or redeem or exchange capital stock. At July 31, 1998 the Company was not in compliance with certain covenants contained in the CSI Credit Facility. On March 30, 1999, the Company received a waiver related to the covenants previously in default. On April 8, 1999, the CSI Credit Facility was amended to pledge the outstanding common stock of CSPR. Cortelco Puerto Rico, Inc. ("CPR") Revolving Credit Facility--On August 29, 1997, CPR entered into a new revolving line of credit agreement with Foothill Capital (the "CPR Credit Facility") under which CPR may borrow up to $1,500,000. The agreement provides for interest at a variable rate plus 1.25% (9.75% at July 31, 1998). The CPR Credit Facility contains various restrictive covenants and is secured by liens on accounts receivable and inventories as well as a pledge of CPR's stock. At July 31, 1998, CPR had outstanding borrowings under this facility of $386,000. The CPR Credit Facility contains covenants which, among other matters limit the ability of CPR to incur indebtedness; merge, consolidate or acquire or sell assets; pay dividends; or redeem or exchange capital stock. At July 31, 1998, CPR was not in compliance with certain covenants contained in the CPR Credit Facility. On March 30, 1999, CPR received a waiver related to the covenants previously in default. On April 8, 1999, in connection with the assumption of the CPR Credit Facility by CSPR (see Note 2), the CPR Credit Facility was amended to include as an event of default a failure by CSHC to pledge the outstanding stock of CII to the lender on or before May 28, 1999, as contemplated by CII's credit facility with the lender. F-13 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 Long-term debt consists of the following:
-------------------- 1997 1998 --------- --------- Dollars in thousands Subordinated note (1).................................... $ 3,000 $ 3,000 Note payable to bank by CPR (2).......................... 2,000 3,073 --------- --------- Total.................................................. 5,000 6,073 Less amounts payable within one year..................... (129) (32) --------- --------- Long-term debt, less current portion................... $ 4,871 $ 6,041 ========= =========
- ------------------- (1) The outstanding balance of $3,000,000 represents borrowings under a subordinated note agreement dated July 31, 1997 with ChinaVest IV, L.P. The note matures on July 31, 2002 and is convertible into shares of the Company's Series A Convertible Preferred Stock based on a conversion price determined by a formula defined in the agreement, which is based on the Company's audited net income for the fiscal year ended July 31, 1998. Based on the conversion price formula, the holder can convert $686,000 of principal to 1,463,206 shares of Series A Convertible Preferred Stock. The holder has the option to convert the note at any time subsequent to July 31, 1998. The agreement provides for interest at the rate of 8% annually. Upon conversion, the accrued interest on the principal amount converted by the holder is payable within sixty days following the date of conversion. The Company's Series A Convertible Preferred Stock has full voting rights and is convertible into common shares at any time. The agreement also contains covenants which, among other matters, limit the ability of the Company to merge, consolidate, acquire, or sell assets. At July 31, 1998, the Company was not in compliance with a covenant contained in the agreement. On April 5, 1999, the Company received a waiver related to the covenant previously in default. Additionally on April 5, 1999, the holder of the subordinated note provided their consent to a series of transactions, including the merger with CSPR and the reverse stock split discussed in Note 1 and the repurchase of common stock from CSHC in partial settlement of the outstanding note receivable (see Note 15). (2) The outstanding balance at July 31, 1997 represents borrowings by CPR under a term loan agreement bearing interest at an annual rate of 9.85%. On August 29, 1997, the agreement was refinanced. The new agreement bears interest at a fixed rate of 10% and is due in monthly installments of principal and interest totalling $28,170 through September 1, 2002. Subsequent to September 1, 2002, the remaining principal balance will be negotiated for a period of five additional years. The agreement is collateralized by certain property. The fair value of the term loan was estimated by discounting future cash flows using rates currently available for debt with similar terms and remaining maturities. The fair value was estimated to be $3,318,000 at July 31, 1998. The scheduled repayment of long-term debt is as follows:
Dollars in thousands 1999................................................................. $ 32 2000................................................................. 35 2001................................................................. 39 2002................................................................. 3,043 2003 and thereafter.................................................. 2,924 --------- Total................................................................ $ 6,073 =========
F-14 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 12. Lease Commitments The Company leases its primary warehouse and office facilities, as well as certain office equipment, under operating leases. The following is a schedule of future minimum lease payments required under operating leases that have remaining initial or remaining noncancellable lease terms in excess of one year as of July 31, 1998: Dollars in thousands 1999..................................................................... $ 443 2000..................................................................... 177 2001..................................................................... 174 2002..................................................................... 179 2003 and thereafter...................................................... 154 ------ Total.................................................................... $1,127 ======
Rent expense for the years ended July 31, 1996, 1997, and 1998 totaled $540,000, $526,000, and $446,000, respectively, which included $46,000, $137,000, and $137,000, respectively, rent charged by CII for the sharing of warehouse space. 13. Income Taxes The Company's current taxable income has historically been included in the consolidated income tax return of CSHC. There does not currently exist a tax sharing agreement for allocating income taxes. The consolidated provision or benefit is allocated proportionately between the subsidiaries of CSHC based on the contribution of each company in the consolidated federal tax return as if each company calculated its tax on a separate return basis. The financial statements of the Company do not include a provision (benefit) for income taxes for 1997 and 1998 due to cumulative net operating losses. The components of income tax expense attributable to continuing operations for 1996 are as follows: Dollars in thousands Current: Federal................................................................. $534 State................................................................... 73 ---- Total current............................................................. 607 Deferred: Federal................................................................. -- State................................................................... -- ---- Total deferred............................................................ -- ---- Total income tax expense.................................................. $607 ====
F-15 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 A reconciliation between the income tax expense from continuing operations recognized in the Company's consolidated statement of operations and the income tax expense computed by applying the domestic federal statutory income tax rate to income from continuing operations before income taxes is as follows:
------------------------------- 1996 1997 1998 --------- --------- --------- Dollars in thousands Income tax at statutory rate (35%)........... $ 539 $ (533) $ (29) State income taxes, net of federal benefit... 47 -- -- Additional taxes on foreign income........... 5 (30) (2) Foreign earnings not repatriated............. -- -- (23) Change in valuation allowance................ (7) 524 5 Other, net................................... 23 39 49 --------- --------- --------- Total income tax expense................... $ 607 $ -- $ -- ========= ========= =========
Income taxes are not provided for the undistributed earnings of the foreign joint venture as such earnings are intended to be permanently reinvested. Such earnings would become taxable upon the sale or liquidation or upon the remittance of dividends. Accumulated undistributed earnings on which U.S. taxes have not been provided are approximately $66,000. The deferred tax effects of the Company's principal temporary differences at July 31, 1997 and 1998 are as follows:
--------------------------------- Assets Liabilities Total Dollars in thousands --------- ----------- --------- 1997 - ---- Allowance for doubtful receivables......... $ 888 $ -- $ 888 Inventories................................ 444 (207) 237 Basis difference in property and equipment................................. 184 -- 184 Accrued warranty costs..................... 54 -- 54 Accrued expenses and other................. 20 -- 20 Deferred costs............................. -- (280) (280) Other...................................... 115 -- 115 Net operating loss carryforwards........... 255 -- 255 Minimum tax credits........................ 154 -- 154 Valuation allowance........................ (1,627) -- (1,627) --------- --------- --------- Total deferred asset (liability)......... $ 487 $ (487) $ -- ========= ========= ========= 1998 - ---- Allowance for doubtful receivables......... $ 574 $ -- $ 574 Inventories................................ 350 (78) 272 Basis difference in property and equipment................................. 157 -- 157 Accrued warranty costs..................... 54 -- 54 Accrued expenses and other................. 47 -- 47 Deferred costs............................. -- (106) (106) Other...................................... 88 -- 88 Net operating loss carryforwards........... 392 -- 392 Minimum tax credits........................ 154 -- 154 Valuation allowance........................ (1,632) -- (1,632) --------- --------- --------- Total deferred asset (liability)......... $ 184 $ (184) $ -- ========= ========= =========
At July 31, 1998 the Company's allocated portion of the consolidated net operating loss carryforward is approximately $334,000, which expires at various dates through 2013. During the year ended July 31, 1996, the Company utilized F-16 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 approximately $2,554,000 of net operating loss carryforwards. The provision for income taxes for 1996 includes a benefit of approximately $893,900 related to the utilization of these carryforwards. 14. Stock Options During 1998, the Board of Directors approved the adoption of the 1997 Equity Incentive Plan (the "Plan") which permits the granting of incentive stock options, supplemental stock options, stock bonuses, and restricted stock purchase agreements to officers, directors and key employees of the Company and to non-employee consultants. At July 31, 1998, 250,000 shares of the Company's common stock were reserved for issuance under the terms of the Plan. Incentive stock options are granted only to employees and are issued at prices not less than 100% of the fair market value of the stock at the date of grant. The options vest over a four-year period and the term of any option shall not be greater than ten years from the date of grant. Stock bonuses and restricted stock purchase agreements are granted only to directors, officers, or employees of or consultants to the Company and are issued at prices not less than 85% of the fair market value of the stock at the date of grant. During 1998, 139,311 options were granted with exercise prices ranging from $.70 to $1.00 per share and remain outstanding at July 31, 1998. No compensation expense related to stock option grants was recorded during 1998 as the option exercise prices were equal to or greater than fair market value on the date of grant. The status of the Company's stock option plan is as follows:
------------------- Weighted Average Number Exercise of Shares Price --------- --------- Granted.................................................... 139,311 $ 0.885 Exercised.................................................. -- N/A Cancelled.................................................. -- N/A --------- --------- Outstanding at July 31, 1998............................... 139,311 $ 0.885 ========= ========= Options exercisable at July 31, 1998....................... 7,904 $ 0.945 ========= =========
The options outstanding at July 31, 1998 are exercisable at prices ranging from $.70 to $1.00 per share. The weighted average remaining contractual life of all outstanding options was 9.81 years at July 31, 1998. The Company accounts for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," under which no compensation cost for stock options is recognized for options granted at or above fair market value. Had compensation expense been determined based upon fair values at the grant dates in accordance with SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income and earnings per share would not have been different as the fair value of the options was determined to be zero on the applicable dates of grant. 15. Related Parties As discussed in Note 1, certain expenses reflected in the financial statements include allocations of expenses from CSHC and CII. These allocations include: insurance, computer maintenance, general warehousing expenses, and salesmen expenses. During 1997, CSHC incurred certain costs on behalf of CSHC's subsidiaries. Management of CSHC allocated these costs proportionately among the subsidiaries based on estimates of effort expended and sales. As a result, the Company incurred management fee expense of $406,000 for the year ended July 31, 1997. During 1998, certain costs were incurred by CSI on behalf of CSHC and the consolidated group. The costs incurred by CSI related to certain administrative functions, such as administration of insurance and benefit plans, handling of legal and accounting matters, etc. As a result, CSI recognized management fee income of $80,000 for the year ended July 31, 1998. During 1998, CPR received various administrative services from CSHC and incurred management fee expense of $265,000 for the year ended July 31, 1998. F-17 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 At July 31, 1997 and 1998, the Company's accounts include a receivable of $355,000 and $656,000, respectively, due from CSHC. The amount in 1998 includes an intercompany tax receivable of $86,000. Additionally, CPR has a non-interest bearing demand note payable with CSHC. At July 31, 1997 and 1998, the balance outstanding totaled $750,000 and $359,000, respectively. This note is subordinate to the CPR revolving credit facility discussed in Note 11. The Company also has a $3,184,000 note receivable from CSHC that has been reflected as a reduction of stockholders' equity in the accompanying balance sheets as of July 31, 1997 and 1998. The note matures on or before December 31, 2002, subject to CSHC's ability to repay the $3,600,000 note payable to corporation discussed in Note 18. During 1996, 1997, and 1998 the Company recognized sales to a company affiliated through common stockholder ownership (CII) totalling $519,000, $65,000, and $85,000, respectively. The Company also had inventory purchases from this affiliate totalling $1,165,000, $692,000, and $188,000, respectively. At July 31, 1997 and 1998, the Company's accounts include a $172,000 payable to and a $1,000 receivable from CII, respectively. The Company has a manufacturing services agreement with CMC (primary contract electronic manufacturer), an affiliate through common stockholder ownership. During 1996, 1997, and 1998 the Company purchased approximately $14,892,000, $10,663,000, and $9,351,000, respectively, under the agreement. Additionally the Company recognized sales to CMC during 1996, 1997, and 1998 of approximately $767,000, $128,000, and $154,000, respectively, in component parts. The agreement expired during 1997, however, subsequent to July 31, 1998 the Company renewed the agreement. At July 31, 1998, the Company had a $250,000 non-interest bearing demand note payable to a stockholder of CSHC. Subsequent to year-end, the note payable was paid in full. At July 31, 1997 and 1998, the Company's trade accounts receivable include $124,000 and $95,000, respectively, due from a company affiliated through common stockholder ownership (BCS Technologies, Inc.). Sales to this affiliate totaled approximately $975,000, $392,000, and $353,000 during the years ended July 31, 1996, 1997, and 1998, respectively. At July 31, 1998, the Company's accounts include $403,000 due to the minority stockholder of Longhai for expenses paid by the stockholder on behalf of the joint venture. 16. Employee Savings Plan Substantially all employees of the Company can participate in the Cortelco International, Inc. Profit Sharing Plan, which is qualified under Section 401 of the Internal Revenue Code. Under the provisions of the plan, all participants may contribute up to 16% of their compensation, subject to limitations established by the Internal Revenue Service. The Company may contribute a matching contribution of not less than 50% of the employee contributions up to 6% of the employee's compensation. The Company may also provide special discretionary contributions equal to a percentage of an employee's annual compensation and/or an amount determined by management. During 1996, 1997, and 1998 contributions allocated to the Company totaled $115,000, $119,000, and $110,000, respectively. 17. Segment Information In June 1997, SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," was issued effective for fiscal years beginning after December 15, 1997. The statement allows, and the Company has chosen, the early adoption of this statement for the year ended July 31, 1998. The Company's reportable segments are communications systems, China operations--Longhai and cellular airtime services, each of which offers different products and services. Each segment requires different technology and marketing strategies. The communication systems solutions segment offers communications solutions that address the voice, video, and data network switching requirements of small and medium sized installations. The Company's cellular airtime services segment offers cellular airtime and cellular telephones through CPR. The China Operations--Longhai segment represents the Company's 55% ownership of a Chinese telecommunications equipment company. F-18 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 The accounting policies of the segments are those described in the summary of significant accounting policies. Management evaluates performance based on operating income.
--------------------------------------------------- China Cellular Dollars in thousands Communications Operations - Airtime Consolidated 1996 Systems Longhai Services Total - -------------------- -------------- ------------ --------- ------------ Revenues.................. $ 28,334 N/A $ 10,184 $ 38,518 Operating income.......... 2,634 N/A 33 2,667 Total assets.............. 14,616 N/A 3,560 18,176 Capital expenditures...... 470 N/A 2 472 Depreciation and amortization............. 467 N/A 7 474 1997 - ---- Revenues.................. $ 25,838 N/A $ 9,797 $ 35,635 Operating income.......... 311 N/A (242) 69 Total assets.............. 14,981 N/A 3,436 18,417 Capital expenditures...... 370 N/A 167 537 Depreciation and amortization............. 354 N/A 14 368 1998 - ---- Revenues.................. $ 23,464 $ 777 $ 6,708 $ 30,949 Operating income.......... 755 138 100 993 Total assets.............. 14,566 1,269 2,000 17,835 Capital expenditures...... 249 8 6 263 Depreciation and amortization............. 414 18 24 456
Following is a reconciliation of profits from operating segments to income before income taxes for the years ended July 31, 1996, 1997, and 1998:
------------------------------- 1996 1997 1998 --------- --------- --------- Total for reportable segments $ 2,667 $ 69 $ 993 Unallocated: Interest expense............................ 1,004 915 826 Management fee income (expense)............. 178 406 185 Other, net.................................. (54) 272 61 --------- --------- --------- Income before income taxes................ $ 1,539 $ (1,524) $ (79) ========= ========= =========
Financial information relating to the Company's revenues by geographic area was as follows:
----------------------------- 1996 1997 1998 Dollars in thousands --------- --------- --------- United States................................... $ 37,784 $ 34,994 $ 29,404 Central America................................. 161 324 256 Europe.......................................... 136 29 42 South America................................... 409 168 184 Saudi Arabia.................................... -- 119 128 South Africa.................................... -- -- 44 China........................................... 28 1 782 Taiwan.......................................... -- -- 109 --------- --------- --------- Consolidated.................................. $ 38,518 $ 35,635 $ 30,949 ========= ========= =========
F-19 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements--(Continued) Years Ended July 31, 1996, 1997 and 1998 18. Commitments and Contingencies At July 31, 1998 the stock of the Company was pledged as collateral under a $3,600,000 note payable from CSHC to a corporation. The note matured in September 1998 and was secured by the outstanding common stock of the Company and a personal guaranty of the single largest stockholder of CSHC. CSHC did not make the scheduled payment due in September 1998. On February 25, 1999, CSHC entered a consent agreement with the corporation whereby the stock of CSI was released from the original pledge agreement in order to allow the CSI spin-off discussed in Note 2. Additionally, the corporation agreed not to declare an event of default. In exchange for the corporation's consent, CSHC remitted $1,000,000 of the amount outstanding and agreed to a revised repayment schedule. In connection with the transaction, CSHC's single largest stockholder loaned CSHC $1,000,000. The Company is involved in various matters of litigation, claims, and assessments arising in the ordinary course of business. In the opinion of management, the eventual disposition of these matters will not have a material adverse effect on the financial statements. 19. Earnings Per Share The computations of basic and diluted earnings per share for each year were as follows:
------------------------------- 1996 1997 1998 --------- --------- --------- Dollars in thousands, except per share data Income (loss) from continuing operations...... $ 932 $ (1,524) $ (133) Discontinued operations....................... (1,207) (515) -- --------- --------- --------- Income (loss) available to common shareholders................................ (275) (2,039) (133) Weighted average shares outstanding........... 3,825 3,825 3,918 --------- --------- --------- Basic and diluted earnings per share......... $ (0.07) $ (0.53) $ (0.03) ========= ========= =========
Options to purchase 139,311 shares of common stock were outstanding at July 31, 1998 but were not included in the computation of the diluted earnings per share because the options' exercise price was equal to or greater than the average market price of the common shares. Additionally, at July 31, 1997 and 1998, $686,000 of convertible subordinated debt was convertible into 1,463,206 shares of convertible preferred stock which was convertible into 1,434,894 shares of common stock. All of these potential common shares were excluded from the computation of diluted earnings per share for 1997 and 1998 because their inclusion would have had an antidilutive effect on earnings per share. 20. Subsequent Events On February 24, 1999, the Company's Board of Directors declared a dividend of $2,216,514 payable to the stockholders (CSHC and Sea Union) of record on February 26, 1999. Approximately $1,957,000 of the dividend declared is payable upon certain events occurring in the future. The remaining amount of the dividend declaration primarily relates to the distribution of the non-interest bearing note receivable from an officer/director to CSHC. As the Company has a retained deficit, the dividend is recorded as a return of capital. The dividend has been reflected in the financial statements as if declared on July 31, 1998. On April 5, 1999, the Company's Board of Directors declared a stock dividend of 195,685 shares of the Company's common stock to stockholders of record on April 5, 1999. The dividend was charged to the accumulated deficit in the amount of $1,956,850, which was based on the fair value of the Company's common stock as determined by the Board of Directors. The stock dividend has been reflected in the financial statements as if declared on July 31, 1998. On April 5, 1999, the Company received 250,000 shares of its common stock from CSHC in exchange for a $2,500,000 reduction of the outstanding note receivable balance. On April 8, 1999, previous to the merger discussed in Note 1, CSPR declared a dividend of $700,000 payable to the stockholder (CSHC) of record on April 8, 1999, payable upon certain events occurring in the future. The dividend has been reflected in the financial statements as if declared on July 31, 1998. Subsequent to year-end, the Company entered into a letter of intent agreement to merge with an affiliated company, BCS Technologies, Inc. F-20 Cortelco Systems, Inc. and Subsidiaries Consolidated Balance Sheets (Unaudited) At July 31, 1998 and April 30, 1999
-------------------- July 31, April 30, 1998 1999 --------- --------- Dollars in thousands ASSETS Current assets: Cash and cash equivalents............................... $ 126 $ 1,822 Trade accounts receivable, net of allowance for doubtful accounts of $1,880 and $1,453.......................... 7,109 10,866 Current portion of investment in sales-type leases...... 150 70 Inventories............................................. 6,256 7,597 Current portion of cellular telephone deferred acquisition costs, net................................. 269 69 Other current assets.................................... 802 648 --------- --------- Total current assets................................... 14,712 21,072 Property and equipment, net.............................. 1,317 1,116 Receivable (payable) from affiliate...................... 657 -- Other assets: Investment in joint venture............................. 67 67 Investment in sales-type leases, noncurrent............. 106 79 Intangible assets, net of accumulated amortization of $4 and $15 327 316 Notes receivable from employees......................... 138 90 Deferred financing costs, net of accumulated amortization of $91 and $157........................... 511 246 Other assets............................................ -- 638 Deferred tax asset...................................... -- 116 Goodwill................................................ -- 11,266 --------- --------- Total other assets..................................... 1,149 12,818 --------- --------- Total assets........................................... $ 17,835 $ 35,006 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY: Current liabilities: Dividends payable....................................... $ 2,667 $ 2,667 Short-term debt......................................... -- 16 Checks outstanding...................................... 55 -- Note payable to related party........................... 250 -- Payable to affiliate.................................... -- 79 Current portion of long-term debt....................... 32 -- Notes payable under revolving line of credit............ 2,739 2,552 Trade accounts payable.................................. 2,603 4,523 Accounts payable to CMC Industries, Inc................. 2,205 1,988 Amounts payable to minority stockholder of consolidated joint venture.......................................... 403 -- Accrued expenses and other.............................. 1,429 2,713 Income tax payable...................................... -- 1,352 --------- --------- Total current liabilities.............................. 12,383 15,890 Note payable to parent................................... 359 -- Long-term debt........................................... 6,041 2,314 Minority interest ....................................... 174 188 Commitments and contingencies............................ -- -- Stockholders' equity (deficit): Series A convertible preferred stock, $.001 par value, (10,000,000 shares authorized, 1,463,206 outstanding).. -- 660 Common stock, $.001 par value (50,000,000 shares authorized, 3,920,252 and 7,639,932 shares issued and outstanding)........................................... 4 8 Additional paid-in capital.............................. 8,324 24,148 Accumulated deficit..................................... (6,266) (5,568) Note receivable from affiliate (former parent).......... (3,184) (2,634) --------- --------- Total stockholders' equity (deficit)................... (1,122) 16,614 --------- --------- Total liabilities and stockholders' equity............. $ 17,835 $ 35,006 ========= =========
See notes to consolidated financial statements (unaudited). F-21 Cortelco Systems, Inc. and Subsidiaries Consolidated Statements of Operations (Unaudited) Nine Months Ended April 30, 1998 and 1999
-------------------- Nine Months Ended April 30, -------------------- 1998 1999 --------- --------- Dollars in thousands, except per share data Net revenues............................................. $ 22,812 $ 27,626 Cost of revenues......................................... 13,472 15,837 --------- --------- Gross profit............................................ 9,340 11,789 Operating expenses: Selling, general and administrative..................... 7,760 8,795 Research and development................................ 1,038 1,489 Amortization expense.................................... -- 28 --------- --------- Total operating expenses............................... 8,798 10,312 --------- --------- Income from operations................................... 542 1,477 Interest expense......................................... 633 584 Management fee expense (income), net..................... 148 23 Other expense (income), net.............................. 101 85 --------- --------- Income (loss) from continuing operations before income taxes and minority interest............................ (340) 785 Income tax expense....................................... -- 81 --------- --------- Income (loss) from operations before minority interest.. (340) 704 Minority interest........................................ (49) (6) --------- --------- Net income (loss) and comprehensive income (loss)....... $ (389) $ 698 ========= ========= Net income (loss), per common share: Basic................................................... $ (0.10) $ 0.17 Diluted................................................. $ (0.10) $ 0.13
See notes to consolidated financial statements (unaudited). F-22 Cortelco Systems, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended April 30, 1998 and 1999
-------------------- 1998 1999 --------- --------- Dollars in thousands CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)....................................... $ (389) $ 698 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization.......................... 246 185 Amortization of deferred acquisition costs............. 331 200 Amortization of intangibles............................ 2 11 Provision for the allowance for doubtful accounts...... 194 196 Minority interest...................................... 49 6 Changes in net assets and liabilities, net of effect of business acquisitions: Trade accounts receivable............................. 2,415 (1,549) Investment in sales-type leases, net.................. (48) 107 Accounts receivable from/payable to affiliates........ (574) (87) Inventories........................................... (1,144) 750 Other current assets.................................. 83 106 Deferred assets....................................... -- 9 Other assets.......................................... -- (638) Trade accounts payable................................ 19 1,288 Accounts payable to CMC Industries, Inc............... 35 (217) Accrued expenses and other............................ (16) 31 Income taxes payable.................................. -- 78 --------- --------- Net cash provided by operating activities............ 1,203 1,174 CASH FLOWS FROM INVESTING ACTIVITIES: Net cash acquired from business acquisitions............ 36 3,126 Purchases of property and equipment..................... (258) (328) Purchase of patents, trademarks, and software technology............................................. (239) -- Net repayments (advances) under notes receivable from employees.............................................. (170) 48 Maturities of certificates of deposit................... 174 -- --------- --------- Net cash provided by (used in) investing activities.. (457) 2,846 CASH FLOWS FROM FINANCING ACTIVITIES: Net repayments under revolving line of credit........... (162) (187) Decrease in checks outstanding.......................... (1,615) (55) Repayments of long-term debt............................ (2,051) (21) Repayment of note payable to parent company............. (250) (100) Repayment of note payable to related party.............. 250 (250) Proceeds from term debt................................. 3,100 -- Debt issuance costs..................................... (127) 239 Loan to affiliate....................................... -- (1,950) --------- --------- Net cash used in financing activities................ (855) (2,324) --------- --------- Net increase (decrease) in cash and cash equivalents.... (109) 1,696 Cash and cash equivalents, beginning of period.......... 320 126 --------- --------- Cash and cash equivalents, end of period................ $ 211 $ 1,822 ========= =========
See notes to consolidated financial statements (unaudited). F-23 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Unaudited) Nine Months Ended April 30, 1998 and 1999 1. Financial Statement Presentation The accompanying consolidated financial statements have been prepared by the Company, without audit. It is management's opinion that these statements include all adjustments, consisting of only normal recurring adjustments, necessary to present fairly the financial position, results of operations, and cash flows as of April 30, 1999 and for all periods presented. The results for the nine months ended April 30, 1998 and 1999 are not necessarily indicative of the results that may be expected for the full year. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto as of July 31, 1997 and 1998 and for each of the three years in the period ended July 31, 1998. In June 1997, the Financial Accounting Standards Board issued SFAS 130, "Reporting Comprehensive Income," which established standards of reporting and display of comprehensive income and its components and requires a separate statement to report the components of comprehensive income for each period reported. For the nine months ended April 30, 1998 and 1999 net income (loss) equaled comprehensive income (loss). 2. Acquisition of BCS Technologies, Inc. On April 12, 1999, the Company acquired BCS Technologies, Inc. ("BCS") in exchange for 3,969,680 common shares. The purchase price was determined based on an independent valuation of the fair value of the BCS equity. The acquisition was accounted for using the purchase method and the purchase price of $16,840,000 was preliminarily allocated as follows: Dollars in thousands Current assets...................................................... $ 8,025 Fixed assets........................................................ 293 Goodwill............................................................ 11,294 Current liabilities assumed......................................... (2,772) --------- Net assets acquired............................................... $ 16,840 =========
The Company has not completed the determination of fair values and the allocation of purchase price may change. The results of the acquired business have been included in the consolidated financial statements since the acquisition date. Goodwill is being amortized on a straight-line basis over twenty years. F-24 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Unaudited)--(Continued) Nine Months Ended April 30, 1998 and 1999 3. Earnings Per Share The computations of basic and diluted earnings per share were as follows:
---------------------------- Nine Months Ended April 30, ---------------------------- 1998 1999 ------------- ------------- Dollars in thousands, except per share data Basic earnings per share: Income (loss) from operations................... $ (389) $ 698 Weighted average shares outstanding--basic...... 3,910 4,159 ------------- ------------- Basic earnings per share...................... $ (0.10) $ 0.17 ============= ============= Diluted earnings per share: Income: Income (loss) from operations................... $ (389) $ 698 Interest on 8% convertible subordinated debt.... -- 38 ------------- ------------- Income (loss) available to common shareholders................................. (389) 736 Weighted average shares: Outstanding..................................... 3,910 4,159 Assumed conversion of preferred stock........... -- 1,435 Dilutive effect of stock options................ -- 175 ------------- ------------- Weighted average shares outstanding--diluted.. 3,910 5,769 ------------- ------------- Diluted earnings per share.................... $ (0.10) $ 0.13 ============= =============
4. Inventories Inventories consist of the following:
-------------------- July 31, April 30, 1998 1999 --------- --------- Dollars in thousands Raw materials and purchased components................... $ 819 $ 1,910 Finished goods........................................... 5,551 5,801 LIFO reserve............................................. (114) (114) --------- --------- Total inventories...................................... $ 6,256 $ 7,597 ========= =========
5. Segment Information
-------------------------------------------------------------- China Cellular Automatic Communication Operations Airtime Call Consolidated Systems --Longhai Services Distribution Total ------------- ---------- --------- ------------ ------------ Dollars in thousands Nine months ended April 30, 1998: External revenue...... $ 16,964 $ 630 $ 5,218 -- $ 22,812 Intersegment reserve.. -- -- -- -- -- Income (loss) from operations........... 631 119 (208) -- 542 Nine months ended April 30, 1999: External revenue...... 22,250 453 3,838 $ 1,085 27,626 Intersegment reserve.. -- -- -- -- -- Income (loss) from operations........... 598 (4) 406 477 1,477
F-25 Cortelco Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Unaudited)--(Continued) Nine month periods ended April 30, 1998 and 1999 Following is a reconciliation of profits from operating segments to income before income taxes for the nine month periods ended April 30, 1998 and 1999:
-------------------- 1998 1999 --------- --------- Dollars in thousands Total for reportable segments.......................... $ 542 $ 1,477 Unallocated: Interest expense..................................... 633 584 Management fee (income) expense...................... 148 23 Other, net........................................... 101 85 --------- --------- Income (loss) before income taxes.................. $ (340) $ 785 ========= =========
There have been no differences from the last annual financial statements in the basis of measuring segment profit or loss. There have been no material changes in the amount of assets for any operating segment since the last annual financial statements, except for the acquisition of the automatic call distribution business. 6. Changes In Stockholders' Equity The following represents the changes in stockholders' equity for the nine months ended April 30, 1999:
----------------------------------------------------------------------------------------------- Preferred Stock Common Stock Additional Note Total ------------------- -------------------- Paid in Accumulated Receivable Stockholders' Dollars in thousands, Shares Amount Shares Amount Capital Deficit from Parent Equity (Deficit) except share data --------- --------- --------- --------- ---------- ----------- ----------- ---------------- Balance at July 31, 1998................... 3,920,252 $ 4 $ 8,324 $ (6,266) $ (3,184) $ (1,122) Investment in BCS....... 3,969,680 4 16,796 16,800 Capital contribution from parent............ 1,528 1,528 Conversion of debt to preferred stock........ 1,463,206 $ 660 660 Shares in exchange for note retirement........ (250,000) (2,500) 2,500 Loan to affiliate....... (1,950) (1,950) Consolidated net income................. 698 698 --------- --------- --------- --------- ---------- ----------- ----------- ---------------- Balance at April 30, 1999................... 1,463,206 $ 660 7,639,932 $ 8 $ 24,148 $ (5,568) $ (2,634) $ 16,614 ========= ========= ========= ========= ========== =========== =========== ================
F-26 Independent Auditors' Report Board of Directors and Stockholders BCS Technologies, Inc. Englewood, Colorado We have audited the accompanying balance sheets of BCS Technologies, Inc. as of July 31, 1997 and 1998, and the related statements of operations, changes in stockholders' equity and cash flows for the eleven months ended July 31, 1997 and the year ended July 31, 1998. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of BCS Technologies, Inc. as of July 31, 1997 and 1998, and the results of its operations and its cash flows for the eleven months ended July 31, 1997 and the year ended July 31, 1998 in conformity with generally accepted accounting principles. Brock and Company, CPAs, P.C. Certified Public Accountants Littleton, Colorado March 5, 1999 F-27 BCS Technologies, Inc. Balance Sheets
------------------------------- At July 31, ------------------ At April 1997 1998 12, 1999 ------- --------- ----------- Dollars in thousands (Unaudited) ASSETS: Current assets: Cash and cash equivalents.................... $ 927 $ 406 $ 3,126 Accounts receivable--trade................... 865 2,073 2,404 Inventories.................................. 1,134 1,257 2,091 Prepaid expenses and other current assets.... 104 90 279 Deferred income tax asset.................... -- 69 125 ------- --------- ----------- Total current assets........................ 3,030 3,895 8,025 Property and equipment, at cost: Leasehold improvements....................... 16 20 23 Machinery and equipment...................... 420 496 564 Furniture and fixtures....................... 77 96 111 Computer software............................ 29 32 59 Vehicle...................................... 8 8 8 ------- --------- ----------- Total property and equipment, at cost....... 550 652 765 Less accumulated depreciation................ (310) (396) (472) ------- --------- ----------- Net property and equipment.................. 240 256 293 ------- --------- ----------- Total assets................................ $ 3,270 $ 4,151 $ 8,318 ======= ========= =========== LIABILITIES AND STOCKHOLDERS' EQUITY: Current liabilities: Short-term debt.............................. $ 102 $ 28 $ 16 Accounts payable............................. 202 328 632 Accounts payable--affiliates................. 137 183 -- Prepaid maintenance contracts................ 254 296 368 Income taxes payable--current................ 17 223 1,274 Accrued liabilities: Compensation................................ 101 256 349 Warranty.................................... 70 55 45 Other....................................... 24 20 88 Current portion of capital lease obligations................................. 5 -- -- ------- --------- ----------- Total current liabilities................... 912 1,389 2,772 Stockholders' Equity: Common stock, par value $.000001, 24,386,775 shares authorized, 23,814,706 shares issued and outstanding in 1997 and 1998 and 23,602,242 shares issued in 1999............ -- -- -- Treasury stock, at cost...................... -- -- (157) Additional paid-in capital................... 2,298 2,298 2,298 Retained earnings............................ 60 464 3,405 ------- --------- ----------- Total stockholders' equity.................. 2,358 2,762 5,546 ------- --------- ----------- Total liabilities and stockholders' equity.. $ 3,270 $ 4,151 $ 8,318 ======= ========= ===========
The accompanying notes are an integral part of the financial statements. F-28 BCS Technologies, Inc. Statements of Operations
---------------------------------------------------------- Period from Eleven Months Year Nine Months August 1, 1998 Ended Ended Ended through July 31, 1997 1998 April 30, 1998 April 12, 1999 -------------- ----------- --------------- -------------- (Unaudited) (Unaudited) Dollars in thousands, except per share data Revenues................ $ 3,924 $ 6,799 $ 3,642 $ 12,239 Cost of revenues........ 1,538 2,465 1,363 4,167 ---------- ----------- ----------- ----------- Gross profit........... 2,386 4,334 2,279 8,042 Operating expenses: Selling, general and administrative........ 1,810 3,095 2,256 3,111 Research and development........... 235 704 521 610 ---------- ----------- ----------- ----------- Total operating expenses............. 2,045 3,799 2,777 3,721 ---------- ----------- ----------- ----------- Income (loss) from operations............. 341 535 (498) 4,321 Other Income: Interest income........ 14 26 22 50 Gain on sale of equipment............. 63 -- -- -- ---------- ----------- ----------- ----------- Total other income.... 77 26 22 50 ---------- ----------- ----------- ----------- Income (loss) before income taxes........... 418 561 (476) 4,371 Income tax expense (benefit).............. 17 157 -- 1,430 ---------- ----------- ----------- ----------- Net income (loss)...... $ 401 $ 404 $ (476) $ 2,941 ========== =========== =========== =========== Pro forma information (unaudited): Net income before income taxes.......... $ 418 Income tax expense..... 152 ---------- Pro forma net income... $ 266 ========== Earnings (loss) per common share: Basic:................. Net income (loss)..... $ 0.03 $ 0.02 $ (0.02) $ 0.12 Weighted average number of common shares............... 8,701,076 23,814,706 23,814,706 23,717,891 Diluted:............... Net income (loss)..... $ 0.03 $ 0.02 $ (0.02) $ 0.12 Weighted average number of common shares............... 8,763,810 24,046,252 24,078,289 24,072,891
The accompanying notes are an integral part of the financial statements. F-29 BCS Technologies, Inc. Statements of Cash Flows Increase (Decrease) in Cash and Cash Equivalents
--------------------------------------------------------- Period from Nine Months August 1, 1998 Eleven Months Year Ended Ended through April Ended July 31, July 31, April 30, 12, 1997 1998 1998 1999 -------------- ---------- ----------- -------------- Dollars in thousands (Unaudited) (Unaudited) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)...... $ 401 $ 404 $ (476) $ 2,941 Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Depreciation.......... 44 87 60 75 Gain on sale of equipment............ (63) -- -- -- Increase (decrease) from changes in assets and liabilities, net of effects from acquisition: Accounts receivable... 14 (1,208) 227 (331) Inventories........... 134 (123) (74) (834) Prepaid expenses and other current as- sets................. (1) 14 3 (199) Deferred income tax asset................ -- (69) -- (56) Accounts payable...... (204) 126 (44) 304 Accounts payable-- affiliates........... 137 46 (103) (183) Prepaid maintenance contracts............ 74 42 25 72 Income taxes payable-- current.............. 17 206 (19) 1,051 Accrued liabilities... (99) 136 (23) 151 --------- --------- ----------- ----------- Net cash provided (used) by operating activities........... 454 (339) (424) 3,001 --------- --------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Cash received from acquisition........... 500 -- -- -- Proceeds from sale of equipment............. 75 2 -- 1 Purchases of property and equipment......... (73) (105) (82) (113) --------- --------- ----------- ----------- Net cash provided (used) by investing activities........... 502 (103) (82) (112) --------- --------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Subchapter S dividend.. (412) -- -- -- Loan principal payments.............. -- (79) (39) (12) Proceeds from exercise of stock options...... 19 -- -- -- Repurchase of common stock................. -- -- -- (157) --------- --------- ----------- ----------- Net cash used by financing activities........... (393) (79) (39) (169) --------- --------- ----------- ----------- Net increase (decrease) in cash and cash equivalents............ 563 (521) (545) 2,720 Cash and cash equivalents, beginning of period............. 364 927 927 406 --------- --------- ----------- ----------- Cash and cash equivalents, end of period................ $ 927 $ 406 $ 382 $ 3,126 ========= ========= =========== ===========
The accompanying notes are an integral part of the financial statements. F-30 BCS Technologies, Inc. Statements of Stockholders' Equity (Deficit)
----------------------------------------------------------------- Common Stock Treasury Stock Additional ------------------ ---------------- Paid-In Retained Dollars in thousands, Shares Amount Shares Amount Capital Earnings Total except share data ---------- ------ -------- ------ ---------- -------- ------ Balance, September 1, 1996................... 74,900 $ 51 -- $ -- $ -- $ 597 $ 648 ---------- ------ -------- ------ -------- ------- ------ Dividends............... -- -- -- -- -- (460) (460) Recapitalization of common stock, conversion Of Subchapter S retained earnings to additional paid-in capital and change in par value of common stock........... 12,850,090 (51) -- -- 529 (478) -- Issuance of common stock in connection with merger................. 10,675,850 -- -- -- 1,750 -- 1,750 Exercise of common stock purchase options....... 213,866 -- -- -- 19 -- 19 Net income for the eleven months ended July 31, 1997.......... -- -- -- -- -- 401 401 ---------- ------ -------- ------ -------- ------- ------ Balance, July 31, 1997.. 23,814,706 -- -- -- 2,298 60 2,358 ---------- ------ -------- ------ -------- ------- ------ Net income for the year ended July 31, 1998.... -- -- -- -- -- 404 404 ---------- ------ -------- ------ -------- ------- ------ Balance, July 31, 1998.. 23,814,706 -- -- -- 2,298 464 2,762 ---------- ------ -------- ------ -------- ------- ------ Treasury stock purchased (unaudited)............ (226,676) -- (226,676) (157) -- -- (157) Net income for the period August 1, 1998 to April 12, 1999 (unaudited)............ -- -- -- -- -- 2,941 2,941 ---------- ------ -------- ------ -------- ------- ------ Balance, April 12, 1999 (unaudited)............ 23,588,030 $ -- (226,676) $ (157) $ 2,298 $ 3,405 $5,546 ========== ====== ======== ====== ======== ======= ======
The accompanying notes are an integral part of the financial statements. F-31 BCS Technologies, Inc. Notes to Financial Statements Year Ended July 31, 1998 and Unaudited Nine Months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999 1. Organization Organization Organization--BCS Technologies, Inc. is an organization formed by a series of transactions between the following entities: Cortelco Holding Corporation (CHC) Cortelco Systems Holding Corporation (CSHC) Cortelco, Inc. (CI) Cortelco Systems, Inc. (CSI) Business Communication Systems, Inc. (BCS) CHC, CSHC, CI and CSI are all entities related through common stockholder ownership. BCS was a closely held corporation not related to CHC, CSHC, CI and CSI. The culmination of the series of transactions was a merger of BCS and CI with BCS being the accounting acquirer. BCS then changed its name to BCS Technologies, Inc. (the Company). The stockholders of BCS own 53% of the common stock of the Company after the merger. Before the merger of BCS and CI, CI was a wholly-owned subsidiary of CHC, which was a wholly-owned subsidiary of CSI. CHC had no active operations. CSI was a wholly-owned subsidiary of CSHC. At the time the merger agreement was signed, CSHC owned 100% of CSI, which owned 100% of CI. Before the merger agreement was signed, CSI owned 100% of CHC which owned 100% of CI. On March 27, 1997 CHC was merged into CI. On April 1, 1997, CI was spun off by CSHC to its stockholders. Immediately following the spin off of CI, on April 2, 1997, CI was merged into BCS with BCS as the accounting acquirer. BCS changed its name to BCS Technologies, Inc. Description of Business The Company was originally founded in 1985 and operates from offices in Englewood, Colorado and a 23,000 square foot facility located in Georgia. The Company is engaged in the development, sales, manufacturing and distribution of electronic communication devices throughout the United States. Business Activities The Company is a corporation organized under the laws of the State of Delaware for the purpose of the sale and servicing of electronic communication devices throughout the United States. 2. Summary of Significant Accounting Policies Use of Estimates in Preparing Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents For purposes of the statement of cash flows, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and temporary cash investments. At times, cash balances held at financial institutions were in excess of FDIC insurance limits. The Company limits the amount of credit exposure to any one financial institution. The Company believes no significant concentration of credit risk exists with respect to these cash investments. Revenue Recognition The Company recognizes revenues from system and product sales when title passes to the customer. Revenues from prepaid maintenance contracts are recognized ratably over the terms of the contracts. Revenues from the sales of systems accounted for approximately 32%, 53%, 38%, and 78% for the eleven months ended July 31, 1997, the year ended July 31, 1998, and the nine months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999. The Company generates the remainder of its revenue from parts sales and system maintenance. Accounts Receivable The Company charges off all known uncollectible accounts on a current basis. No reserve for uncollectible accounts is required, as any accounts which are considered doubtful are not considered material to the financial statements. F-32 BCS Technologies, Inc. Notes to Financial Statements--(Continued) Inventories The Company uses the lower of first-in, first-out ("FIFO") cost or market in valuing inventories. Depreciation The Company provides for depreciation of property and equipment using straight- line and accelerated methods for financial and income tax reporting purposes over the estimated useful lives of the assets, which is generally fifteen years for leasehold improvements, five years for machinery and equipment, five to seven years for furniture and fixtures and vehicles and three years for computer software. Product Warranties The Company provides the customer with a warranty from the date of purchase. Estimated warranty obligations are recorded based on actual claims experience. Income Taxes Income tax expense is based on reported income before income taxes. Deferred income taxes reflect the temporary difference between assets and liabilities recognized for financial reporting and such amounts recognized for tax purposes which requires recognition of deferred income tax assets and liabilities. Deferred income tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is recognized if it is anticipated that some or all of a deferred income tax asset may not be realized. Advertising Advertising costs are charged to operations in the year incurred. The Company expended $170,426 for the eleven months ended July 31, 1997, $117,912 for the year ended July 31, 1998, and $91,077 for the nine months ended April 30, 1998 and $97,271 for the period August 1, 1998 through April 12, 1999. Interim Financial Statements The financial statements for the six months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999 are unaudited, but in the opinion of management, include all adjustments necessary to fairly state the results therein, such adjustments being of a normal, recurring nature. Operating results for the period August 1, 1998 through April 12, 1999 are not necessarily indicative of the results that may be expected for the fiscal year ending July 31, 1999. All April 30, 1998 and April 12, 1999 data presented in these footnotes is unaudited. Stock Option Plans The Company utilizes Statement of Financial Accounting Standards No. 123 (FAS 123), "Accounting for Stock-Based Compensation". The Statement defines a fair value based method of accounting for stock options or similar equity instrument. FAS 123 allows an entity to continue to measure compensation cost for employee stock option plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion (APB) No. 25, which was elected by the Company. Accordingly, the Company must make certain pro forma disclosures as if the fair value based method had been applied. Earnings (Loss) Per Common Share Basic earnings per share is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Dilutive earnings per share reflects the potential dilution that could occur if dilutive securities, stock options, were exercised. F-33 BCS Technologies, Inc. Notes to Financial Statements--(Continued) 3. Business Acquisition On April 2, 1997, the Company acquired the net assets of Cortelco, Inc., which had a fair value of $1,750,000, in exchange for 10,675,850 shares of common stock. The acquisition was accounted for as a reverse acquisition using the purchase method of accounting, and the results of CI's operations were included in the Company's financial statements from the date of acquisition. The Company acquired cash of $500,000, accounts receivable of $509,523, inventory of $1,054,028, prepaid expenses of $70,185, property and equipment of $183,333, and current liabilities of $567,069 in the purchase of Cortelco, Inc. The following unaudited pro forma information presents the results of operations as if the acquisition had occurred at September 1, 1996 and the Company had revoked its subchapter S election on such date and was taxed as a Subchapter C corporation for the entire period.
----------- Eleven months ended July 31, Dollars in thousands, except per share data 1997 ----------- Net sales.......................................................... $ 5,761 Net income......................................................... 89 Earnings per common share: Basic and diluted................................................ $ 0.00
The unaudited pro forma information is not necessarily indicative of the combined results that would have occurred had the acquisition been effected on the assumed date, nor is it indicative of the results that may occur in the future. 4. Inventories Inventories consist of the following:
----------------------------- At July 31, Dollars in thousands ------------------- April 12, 1997 1998 1999 --------- --------- --------- Raw materials and purchased components.......... $ 223 $ 225 $ 502 Finished goods.................................. 911 1,032 1,589 --------- --------- --------- Total inventories............................. $ 1,134 $ 1,207 $ 2,091 ========= ========= =========
5. Short-Term Debt Short-term debt consists of following:
----------------------------- At July 31, Dollars in thousands ------------------- April 12, 1997 1998 1999 --------- --------- --------- Amount payable to affiliate--excess of net worth of CI for the merger with BCS. To be reduced by any uncollectible receivables, or other items that would reduce the net worth of CI at the date of merger...................... $ 54 $ 28 $ 16 Notes payable to stockholder, unsecured and due on demand..................................... 48 -- -- --------- --------- --------- Total.......................................... $ 102 $ 28 $ 16 ========= ========= =========
6. Capitalized Leases The Company leased certain equipment under long term leases. During the year ended July 31, 1998 the leases terminated and the Company purchased the equipment for a nominal cost. F-34 BCS Technologies, Inc. Notes to Financial Statements--(Continued) 7. Operating Leases and Rent Expense The Company leases its office facilities in Englewood, Colorado and Dallas, Texas under noncancellable lease agreements which expire in July 2001 and December 1998, respectively. Additionally, the Company leases its primary warehouse facility in Kennesaw, Georgia and certain office equipment under noncancellable leases. At July 31, 1998, future minimum lease payments required under the noncancelable operating leases are as follows:
Dollars in thousands --------- Year Ending July 31, Amount - ----------- --------- 1999................................................................. $ 178 2000................................................................. 100 2001................................................................. 98 --------- Total................................................................ $ 376 =========
Rent expense under all operating leases in effect during the eleven months ended July 31, 1997 was $148,246, during the year ended July 31, 1998 was $308,164, during the nine months ended April 30, 1998 was $230,828 and during the period August 1, 1998 through April 12, 1999 was $236,788. 8. Related Party Transactions During the eleven months ended July 31, 1997, the year ended July 31, 1998, and the nine months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999, the Company purchased inventory from affiliates totaling $391,568, $353,023, $400,165, and $1,130,063, respectively. During the year ended July 31, 1998 the Company, through a related party, was awarded a GSA contract. The contract is invoiced through the related party who remits the amount collected to the Company when received from the government. At July 31, 1998 and April 12, 1999 the Company was due $856,259 and $1,991,360, respectively, from the related party for amounts invoiced on the contract. These amounts are included in trade accounts receivable at July 31, 1998 and April 12, 1999. The Company's payable to affiliated companies' stockholders consists of:
----------------------------- July 31, ------------------- April 12, 1997 1998 1999 Dollars in thousands --------- --------- --------- Payable to CSHC................................. $ 16 $ 105 $ -- Payable to CSI.................................. 120 78 -- Payable to stockholders......................... 1 -- -- --------- --------- --------- Net accounts payable--affiliates................ $ 137 $ 183 $ -- ========= ========= =========
9. Employee Savings Plan Substantially all employees of the Company can participate in the Dean Witter Reynolds, Inc. Savings Incentive Match Plan, which is qualified under Section 408(p) of the Internal Revenue Code. Under the provisions of the plan, all participants may contribute the lesser of 100% of their compensation or $6,000. The Company may contribute a matching contribution equal to the lesser of the employee contributions or 3% of the employee's compensation. During the eleven months ended July 31, 1997, the year ended July 31, 1998, and the nine months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999, the Company contributed $7,265, $48,602, $26,350, and $56,458 to the plan, respectively. F-35 BCS Technologies, Inc. Notes to Financial Statements--(Continued) 10. Stock Option Plans The Company currently has three stock option plans. Under the terms of the first plan, certain employees may purchase common stock of the Company at prices ranging from $.04 to $.34 per share. This plan is an exchange of options in the pre-merger company for options in the merged company. The number of options outstanding under this plan and the number of common shares reserved for issuance upon the exercise of those options is 558,928. The other two plans grant certain employees options to purchase common stock of the Company held by two major stockholders for prices ranging from nominal amounts to $.65 per share. These options are exercisable upon the achievement of certain conditions or a lapse of ten years. The number of shares subject to option under these plans are 1,355,306. The following is a summary of transactions:
-------------------- Weighted Average Exercise Shares Price --------- --------- Outstanding, September 1, 1996 (None vested).......................................... 7,490 $ 8.01 Granted (weighted average of fair value of $0.03 per share)................................................ 2,223,162 0.22 Canceled............................................... (174,964) 0.47 Exercised.............................................. (213,866) 0.09 --------- Outstanding, July 31, 1997 (402,072 vested at a weighted average price of $0.23 per share)..................................... 1,841,822 0.24 Canceled............................................... (83,144) 0.48 --------- Outstanding, July 31, 1998 (393,928 vested at a weighted average price of $0.23 per share)..................................... 1,758,678 0.23 Granted (weighted average fair value of $0.09 per share)................................................ 290,000 0.37 Canceled............................................... (134,444) 0.0001 --------- Outstanding, April 12, 1999 (393,928 vested at a weighted average price of $0.13 per share)..................................... 1,914,234 $ 0.27 =========
Additional information regarding options outstanding at January 31, 1999 is as follows:
----------------------------------------------------- Options Outstanding Vested Options --------------------------------- ----------------- Weighted Average Weighted Weighted Remaining Average Average Exercise Number Contractual Exercise Number Exercise Price Outstanding Life Price Vested Price - -------- ----------- ----------- --------- ------- --------- $0.0001.................. 480,306 7.9 $ 0.0001 -- $ -- 0.04..................... 81,499 2.4 0.04 81,499 0.04 0.14..................... 293,637 2.4 0.14 293,637 0.14 0.25..................... 400,000 8.2 0.25 -- -- 0.34..................... 183,792 8.6 0.34 18,792 0.34 0.65..................... 475,000 8.1 0.65 -- -- - ------------------------- --------- --------- --------- ------- --------- $0.0001-$0.65 1,914,234 7.0 years $ 0.27 393,328 $ 0.23 ========================= ========= ========= ========= ======= =========
Additional Stock Plan Information. Since the Company continues to account for its stock-based awards to employees using the intrinsic value method in accordance with APB No. 25, FAS 123, "Accounting for Stock-Based Compensation," requires the disclosure of pro forma net income (loss) and earnings (loss) per share had the Company adopted the fair value method as of the beginning of 1995. Under FAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options F-36 BCS Technologies, Inc. Notes to Financial Statements--(Continued) without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company's fair value calculations on stock-based awards under the stock plans were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 8 years from the date of grant in 1997 and 10 years from the date of grant in 1999; stock volatility, 0% in 1997 and in 1999; risk-free interest rate, 6.75% in 1997 and 5.0% in 1999 and no dividends during the expected term. The Company's calculations are based on a single option award valuation approach, and forfeitures are recognized as they occur. If the computed fair values of the 1997 and 1999 awards had been amortized to expense over the vesting period of the awards, the effect on pro forma net income (loss) would have been insignificant. 11. Income Taxes The provision for income taxes consists of the following:
-------------------- At July 31, -------------------- 1997 1998 Dollars in thousands --------- --------- Current: Federal............................................... $ 13 $ 219 State................................................. 4 7 Deferred: Federal............................................... (34) (23) State................................................. (7) (5) Valuation allowance................................... 41 (41) --------- --------- Total income tax expense................................ $ 17 $ 157 ========= =========
Income tax effects of deferred income tax assets are comprised of the following future deductible amounts:
-------------------- At July 31, -------------------- 1997 1998 Dollars in thousands --------- --------- Allowance for warranties and sales returns................ $ 23 $ 19 Accrued compensated absences.............................. 18 27 Uniform inventory capitalization.......................... -- 23 --------- --------- Subtotal.................................................. 41 69 Valuation allowance....................................... (41) -- --------- --------- Net deferred income tax asset............................. $ -- $ 69 ========= =========
Prior to April 2, 1997, the Company had elected under Subchapter S of the Internal Revenue Code to have its income taxed directly to its stockholders. The 1997 provision for income taxes includes only the taxable income from April 2, 1997 through July 31, 1997. Pro forma net income and earnings per share have been determined assuming the Company had been taxed under Subchapter C of the Internal Revenue Code for federal and state purposes for 1997. The following table reconciles the provision for income taxes at the U.S. Statutory rate to that in the financial statements for 1998: Income taxes at statutory rate........................................... 34.0% State income taxes, net of federal benefit............................... 0.1 Uniform inventory capitalization......................................... 4.6 Change in valuation allowance and other.................................. (10.7) ----- 28.0% =====
F-37 BCS Technologies, Inc. Notes to Financial Statements--(Continued) As a result of the merger, the Company has a net operating loss carryforward of approximately $8,250,000 available to offset Georgia state income taxes. The financial statements and disclosures do not include recognition of approximately $495,000 of deferred income tax benefit due to the significant uncertainty of its future realization. 12. Earnings (Loss) Per Common Share Outstanding stock options to purchase 1,383,542, 1,364,750, 1,364,750 and 1,489,750 shares of common stock were not included in the computation of diluted earnings (loss) per common share for the eleven months ended July 31, 1997, the year ended July 31, 1998, and the nine months ended April 30, 1998 and the period August 1, 1998 through April 12, 1999. The effect of including the stock options would be antidilutive or the stock options were exercisable from shares owned by existing stockholders. A summary of the diluted weighted average number of common shares is as follows:
------------------------------------------------ Period from August 1, Nine Months 1998 Eleven Months Year Ended Ended through Ended July 31, July 31, April 30, April 12 1997 1998 1998 1999 -------------- ---------- ----------- ---------- Weighted average number of common shares outstanding... 8,701,076 23,814,706 23,814,706 23,717,891 Dilutive effect of stock options..................... 62,734 231,546 263,342 355,000 ------------ ---------- ---------- ---------- Diluted weighted average number of common shares outstanding................. 8,763,810 24,046,252 24,078,048 24,072,891 ============ ========== ========== ==========
13. Major Customer The Company had one major customer which accounted for 22% of revenues for the year ended July 31, 1998, and 80% of revenues for the period August 1, 1998 through April 12, 1999. 14. Supplemental Cash Flow Information The Company paid cash for income taxes totaling $17,000 during the year ended July 31, 1998 and for the nine month period ended April 30, 1998. Cash totaling $327,446 was paid for income taxes during the period August 1, 1998 through Apri 12, 1999. No income taxes were paid during the eleven months ended July 31, 1997. F-38 Unaudited Pro Forma Consolidated Financial Information The following pro forma consolidated statements of operations data for the year ended July 31, 1998 and the nine month periods ended April 30, 1998 and 1999 represent the unaudited pro forma operating results as if the acquisition of BCS Technologies, Inc. had occurred as of August 1, 1997. The following pro forma consolidated balance sheet data presents the unaudited pro forma financial condition of the Company as if the acquisition of BCS Technologies, Inc. had occurred as of April 30, 1999. The pro forma financial data reflects adjustments to the historical financial statements of Cortelco and BCS Technologies, Inc., that (1) reflect the purchase method of accounting for the acquisition of BCS, and (2) eliminate the results of operations and related assets and liabilities not acquired from the merger with Cortelco Systems Puerto Rico. The historical consolidated balance sheet at April 30, 1999 reflects the acquisition of BCS and the merger with Cortelco Systems Puerto Rico in April 1999, therefore only pro forma offering adjustments are required to be presented. The pro forma, as adjusted, financial information gives effect, additionally, to (1) the conversion of convertible preferred stock into 1,434,894 shares of common stock upon the closing of this offering, and (2) this offering and the uses of proceeds from this offering. The pro forma financial data does not purport to represent what the company's financial position or results of operations actually would have been had the transactions occurred on the dates indicated, or to project the company's financial position or results of operations at any future date or for any future period. The following pro forma financial data should be read in conjunction with the Company's consolidated financial statements and related notes, BCS Technologies' financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" which is included elsewhere. F-39 Pro Forma Consolidated Balance Sheet (Unaudited)
------------------------------------- At April 30, 1999 ------------------------------------- Actual --------- Pro Forma Offering Adjustments Pro Forma CSI (Note 3) As Adjusted Dollars in thousands --------- ----------- ----------- ASSETS Cash and cash equivalents............... $ 1,822 $ 23,247 (a) $ 19,878 (5,191)(b) Trade accounts receivable............... 10,866 10,866 Inventories............................. 7,597 7,597 Other current assets.................... 787 787 Property and equipment, net............. 1,116 1,116 Other assets............................ 1,552 (622)(e) 930 Goodwill................................ 11,266 11,266 --------- --------- --------- Total assets.......................... $ 35,006 $ 17,434 $ 52,440 ========= ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Dividends payable....................... $ 2,667 2,667 Current portion of long-term debt....... 16 16 Notes payable under revolving line-of- credit................................. 2,552 (2,552)(b) -- Accounts payable........................ 4,523 4,523 Accrued expenses........................ 2,713 (325)(b) 2,388 Income tax payable...................... 1,352 1,352 Accounts payable to related parties..... 1,988 1,988 Payable to affiliate.................... 79 79 Long-term debt.......................... 2,314 (2,314)(b) -- Minority interest....................... 188 188 Preferred stock......................... 660 (660)(c) -- Common shareholders' equity............. 15,954 23,247 (a) 39,239 660 (c) (622)(e) --------- --------- --------- Total liabilities and stockholders' equity............................... $ 35,006 $ 17,434 $ 52,440 ========= ========= =========
See notes to pro forma consolidated financial statements (unaudited). F-40 Pro Forma Consolidated Statement of Operations Data (Unaudited)
---------------------------------------------------------------- Year Ended July 31, 1998 ---------------------------------------------------------------- Pro Forma Actual Pro Forma Offering --------------- Adjustments Adjustments Pro Forma Dollars in thousands, CSI BCS (Note 2) Pro Forma (Note 3) As Adjusted except per share data ------- ------ ----------- --------- ----------- ----------- Net revenues............ $30,949 $6,799 $(353)(a) $37,395 $37,395 Cost of revenues........ 18,504 2,466 (322)(a) 20,648 20,648 ------- ------ ----- ------- ---- ------- Gross profit........... 12,445 4,333 (31) 16,747 16,747 Operating expenses: Selling, general and administrative......... 10,045 3,095 304 (c) 13,347 13,347 -- -- (97)(e) -- -- Research and development............ 1,407 704 -- 2,111 2,111 Amortization of goodwill............... -- -- 565 (d) 565 565 ------- ------ ----- ------- ---- ------- Total operating expenses............. 11,452 3,799 772 16,023 16,023 ------- ------ ----- ------- ---- ------- Income (loss) from operations.............. 993 534 (803) 724 724 Interest expense....... 826 -- (327)(f) 499 (499)(d) -- Management fee expense, net........... 185 -- -- 185 185 Other expense (income), net.......... 61 (26) 478 (b) 513 513 ------- ------ ----- ------- ---- ------- Income (loss) from continuing operations before income taxes and minority interest....... (79) 560 (954) (473) 499 26 Income tax expense (benefit).............. -- 157 (157)(g) -- 9 (f) 9 ------- ------ ----- ------- ---- ------- Income (loss) from operations before minority interest...... (79) 403 (797) (473) 490 17 Minority interest...... (54) -- -- (54) (54) ------- ------ ----- ------- ---- ------- Net income (loss)...... $ (133) $ 403 $(797) $ (527) 490 $ (37) ======= ====== ===== ======= ==== ======= Net income (loss) per common share: Basic.................. $ (0.03) $ (0.06) $ 0.00 Diluted................ $ (0.03) $ (0.06) $ 0.00
See notes to pro forma consolidated financial statements (unaudited). F-41 Pro Forma Consolidated Statement of Operations Data (Unaudited)
------------------------------------------------------------------------------------------------------- Nine Months Ended April 30, ------------------------------------------------------------------------------------------------------- 1998 1999 ----------------------------------------------------------------- ------------------------------------- Actual Pro Forma Actual ------------- -------------------------------------------------- ---------------------- Offering Dollars in Adjustments Pre- Adjustments BCS Through Adjustments thousands, except CSI BCS (Note 2) Offering (Note 3) As Adjusted CSI April 12, 1999 (Note 2) per share data ------ ----- ----------- --------- ----------- ----------- ------ -------------- ----------- Net revenues....... 22,812 3,641 (247)(a) 26,206 26,206 27,626 12,239 (987)(a) Cost of revenues... 13,472 1,338 (243)(a) 14,567 14,567 15,837 4,197 (852)(a) ------ ----- --------- --------- ---- ------ ------ ------------ --------- Gross profit...... 9,340 2,303 (4) 11,639 11,639 11,789 8,042 (135) Operating expenses: Selling, general, and administrative.... 7,760 2,281 228 (c) 10,196 10,196 8,795 3,054 207 (c) (73)(e) -- (68)(e) Research and development....... 1,038 521 -- 1,559 1,559 1,489 667 -- Amortization of goodwill.......... -- -- 424 (d) 424 424 28 -- 396 (d) ------ ----- --------- --------- ---- ------ ------ ------------ --------- Total operating expenses........ 8,798 2,802 579 12,179 12,179 10,312 3,721 535 ------ ----- --------- --------- ---- ------ ------ ------------ --------- Income (loss) from operations......... 542 (499) (583) (540) (540) 1,477 4,321 (670) Interest expense........... 633 -- (239)(f) 394 (394)(d) -- 584 -- (276)(f) Management fee expense, net...... 148 -- -- 148 148 23 -- -- Other expense (income), net..... 101 (22) 359 (b) 438 438 85 (50) 359 (b) ------ ----- --------- --------- ---- ------ ------ ------------ --------- Income (loss) from continuing operations before income taxes and minority interest........... (340) (477) (703) (1,520) 394 (1,126) 785 4,371 (753) Income tax expense (benefit)......... -- -- -- -- -- -- 81 1,430 -- ------ ----- --------- --------- ---- ------ ------ ------------ --------- Income (loss) from operations before minority interest.......... (340) (477) (703) (1,520) 394 (1,126) 704 2,941 (753) Minority interest.......... (49) -- -- (49) -- (49) (6) -- -- ------ ----- --------- --------- ---- ------ ------ ------------ --------- Net income (loss)............ (389) (477) (703) (1,569) 394 (1,175) 698 2,941 (753) ====== ===== ========= ========= ==== ====== ====== ============ ========= Net income (loss) per common share: Basic............. $(0.10) $ (0.19) $(0.10) $(0.17) Diluted........... $(0.10) $ (0.19) $(0.10) $(0.13) Pro Forma ----------------------------------- Offering Dollars in Pre- Adjustments thousands, except Offering (Note 3) As Adjusted per share data ---------- ------------ ----------- Net revenues....... 38,878 38,878 Cost of revenues... 19,182 19,182 ---------- ------------ ----------- Gross profit...... 19,696 19,696 Operating expenses: Selling, general, and administrative.... 11,988 11,988 -- Research and development....... 2,156 2,156 Amortization of goodwill.......... 424 424 ---------- ------------ ----------- Total operating expenses........ 14,568 14,568 ---------- ------------ ----------- Income (loss) from operations......... 5,128 5,128 Interest expense........... 308 (308)(d) -- Management fee expense, net...... 23 23 Other expense (income), net..... 394 394 ---------- ------------ ----------- Income (loss) from continuing operations before income taxes and minority interest........... 4,403 308 4,711 Income tax expense (benefit)......... 1,511 105 (f) 1,616 ---------- ------------ ----------- Income (loss) from operations before minority interest.......... 2,892 203 3,095 Minority interest.......... (6) (6) ---------- ------------ ----------- Net income (loss)............ 2,886 203 3,089 ========== ============ =========== Net income (loss) per common share: Basic............. $ (0.35) $ .27 Diluted........... $ (0.30) $ .26
See notes to pro forma consolidated financial statements (unaudited). F-42 Notes to Pro Forma Consolidated Financial Information (Unaudited) 1. Basis of Presentation The pro forma consolidated statements of operations data for the year ended July 31, 1998 and the nine month periods ended April 30, 1998 and 1999 represent the unaudited pro forma operating results as if the acquisition of BCS Technologies, Inc. ("BCS") had occurred as of August 1, 1997. The pro forma financial data reflects adjustments to the historical financial statements of Cortelco Systems ("the Company") and BCS, that (1) reflect the purchase method of accounting for the acquisition of BCS, and (2) eliminate the results of operations and related assets and liabilities not acquired from the merger with Cortelco Systems Puerto Rico. The historical consolidated balance at April 30, 1999 reflects the acquisition of BCS and the merger with Cortelco Systems Puerto Rico in April 1999, therefore only pro forma offering adjustments are required to be presented. The pro forma, as adjusted, financial information gives effect, additionally, to (1) the conversion of convertible preferred stock debt into 1,434,894 shares of common stock upon the closing of the offering, and (2) the offering and the uses of proceeds thereof. The pro forma financial data does not purport to represent what the Company's financial position or results of operations actually would have been had the transactions occurred on the dates indicated, or to project the Company's financial position or results of operations at any future date or for any future period. The following pro forma financial data should be read in conjunction with Cortelco's consolidated financial statements and related notes, BCS' financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" which is included elsewhere. 2. Pro Forma Adjustments (a) To reflect the elimination of revenues and cost of revenues and balances between Cortelco Systems, Inc. and BCS. (b) To reflect the elimination of rental income related to the building retained by Cortelco Puerto Rico, Inc. and not acquired by the Company. (c) To reflect the rental expense to be incurred by the Company in connection with lease agreement negotiated by Cortelco Puerto Rico, Inc. for building space. (d) To reflect the goodwill amortization related to the BCS acquisition, goodwill is amortized over a 20 year life, resulting in annual amortization of $565,000 and nine month amortization of $424,000. (e) To reflect the elimination of the depreciation for building improvements not acquired from Cortelco Puerto Rico, Inc. (f) To reflect the elimination of interest expense and amortization of deferred financing costs related to the mortgage payable not assumed from Cortelco Puerto Rico, Inc. Interest expense totaled $283,000 for the year ended July 31, 1998 and $206,000 and $230,000 for the nine months ended April 30, 1998 and 1999, respectively. The amortization of deferred financing costs totaled $44,000 for the year ended July 31, 1998 and $33,000 and $46,000 for the nine months ended April 30, 1998 and 1999, respectively. (g) To eliminate income tax expense for the year ended July 31, 1998 as the Company would have had a consolidated net loss on a pro forma basis. 3. Pro Forma Offering Adjustments (a) To record the proceeds ($23.2 million) from the issuance of 2,300,000 shares of the Company's common stock, net of $2.1 million underwriting discounts and commissions and estimated offering expenses, including accounting and legal fees, filing and listing fees and priority expenses. (b) To record the repayment of $4.9 million in debt and $0.3 million of related accrued interest from offering proceeds. (c) To record the conversion of convertible preferred stock into 1,434,894 common shares. F-43 Notes to Pro Forma Consolidated Financial Information (Unaudited)--(continued) (d) To record the decrease in interest expense, including the amortization of deferred financing costs, resulting from the repayment of the subordinated note and bank debt and the conversion of debt to common stock. (e) To record the write-off of deferred financing costs related to the repayment of $4.9 million of debt on the balance sheet. This expense has been appropriately excluded from the pro forma consolidated statement of operations but will be reflected in the Company's historical consolidated financial statements in 1999 as an extraordinary loss on extinguishment of debt. (f) To record the income tax effect of the above adjustments at 34%, the Company's estimated effective tax rate. 4. Pro Forma Earnings Per Share Data The computation of basic and diluted earnings per share were as follows:
--------------------------------------------------------------------- Nine Months Ended April 30, Year Ended --------------------------------------------- July 31, 1998 1998 1999 ---------------------- ---------------------- --------------------- Pro Forma Pro Forma Pro Forma Dollars in thousands, Pro Forma As Adjusted Pro Forma As Adjusted Pro Forma As Adjusted except per share data --------- ----------- --------- ----------- --------- ----------- Basic earnings per share: Income (loss) from continuing operations............ $ (527) $ (37) $ (1,569) $ (1,175) $ 2,886 $ 3,089 Weighted average shares outstanding--basic: Historical shares outstanding........... 3,918 3,918 3,910 3,910 4,159 4,159 Stock issued to acquire BCS................... 3,970 3,970 3,970 3,970 3,708 3,708 Stock issued to pay dividend declared..... 267 -- 267 -- 267 -- Stock issued in offering.............. -- 2,300 -- 2,300 -- 2,300 Conversion of preferred stock................. -- 1,435 -- 1,435 -- 1,435 Weighted average shares outstanding-- basic................ 8,155 11,623 8,147 11,615 8,134 11,602 --------- ----------- --------- ----------- --------- ----------- Basic earnings (loss) per share............ $ (0.06) $ 0.00 $ (0.19) $ (0.10) $ 0.35 $ 0.27 ========= =========== ========= =========== ========= =========== Diluted earnings (loss) per share: Income (loss) from continuing operations............ $ (527) $ (37) $ (1,569) $ (1,175) $ 2,886 $ 3,089 Interest on 8% convertible subordinated debt..... -- -- -- -- 38 -- --------- ----------- --------- ----------- --------- ----------- Income (loss) available to common shareholders......... (527) (37) (1,569) (1,175) 2,924 3,089 Weighted average shares--basic.......... 8,155 11,623 8,147 11,615 8,134 11,602 Assumed conversion of 8% convertible subordinated debt...... -- -- -- -- 1,435 -- Dilutive effect of stock options................ -- -- -- -- 175 175 --------- ----------- --------- ----------- --------- ----------- Weighted average shares outstanding-- diluted.............. 8,155 11,623 8,147 11,615 9,744 11,777 --------- ----------- --------- ----------- --------- ----------- Diluted earnings (loss) per share..... $ (0.06) $ 0.00 $ (0.19) $ (.10) $ 0.30 $ 0.26 ========= =========== ========= =========== ========= ===========
F-44 Cortelco Platforms -- Versatile By Design Communications Interface Flexible bus and software architecture provide direct links to virtually any type of communications device and to other networked Cortelco platforms. System Controller Our software takes advantage of a real-time operating system and the speed and capacity of today's microprocessors and computer memory. External Computer Inter- Computer and telephony functions are efficiently face integrated through standards-based interfaces to the system controller.
[LOGO FOR CORTELCO SYSTEMS, INC. APPEARS HERE] Part II Information not required in Prospectus Item 13. Other Expenses of Issuance and Distribution. The following table sets forth all expenses, other than the underwriting discounts and commissions, payable by Cortelco in connection with the sale of the common stock being registered. All the amounts shown are estimates except for the registration fee and the NASD filing fee. Registration fee................................................. $ 9,730 NASD filing fee.................................................. 4,000 Nasdaq application fee........................................... 53,750 Blue sky qualification fee and expenses.......................... 5,000 Printing and engraving expenses.................................. 225,000 Legal fees and expenses.......................................... 375,000 Accounting fees and expenses..................................... 275,000 Directors and officers' insurance................................ 153,000 Transfer agent and registrar fees................................ 750 Miscellaneous.................................................... 8,770
---------- Total............................................................ $1,110,000
Item 14. Indemnification of Officers and Directors. Under Section 145 of the Delaware General Corporation Law, we have broad powers to indemnify our directors and officers against liabilities they may incur in such capacities, including liabilities under the Securities Act. Our certificate of incorporation provides for the elimination of liability for monetary damages for breach of the directors' fiduciary duty of care to Cortelco and its stockholders. These provisions do not eliminate the directors' duty of care and, in appropriate circumstances, equitable remedies such as injunctive or other forms of non-monetary relief will remain available under Delaware law. In addition, each director will continue to be subject to liability for breach of the director's duty of loyalty to Cortelco, for acts or omissions not in good faith or involving intentional misconduct, for knowing violations of law, for any transaction from which the director derived an improper personal benefit, and for payment of dividends or approval of stock repurchases or redemptions that are unlawful under Delaware law. The provision does not affect a director's responsibilities under any other laws, such as the federal securities laws or state or federal environmental laws. We expect to enter into agreements with our directors and officers that require us to indemnify such persons against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred (including expenses of a derivative action) in connection with any proceeding, whether actual or threatened, to which any such person may be made a party by reason of the fact that such person is or was a director or officer of Cortelco or any of its affiliated enterprises, provided such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of Cortelco and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The indemnification agreements also set forth certain procedures that will apply in the event of a claim for indemnification thereunder. The Underwriting Agreement filed as Exhibit 1.1 to this registration statement provides for indemnification by the underwriters of Cortelco and its officers and directors for certain liabilities arising under the Securities Act or otherwise. II-1 Item 15. Recent Sales of Unregistered Securities. Since April 1996, we have sold and issued the following unregistered securities: (1) In July 1997, we issued a convertible promissory note in the aggregate principal amount of $3,000,000 to ChinaVest IV, L.P. (2) In August 1997, we issued 95,343 shares of common stock to an investor in exchange for an interest in the Longhai joint venture. (3) In April 1999, we issued 3,969,681 shares of common stock to stockholders of BCS Technologies, Inc. and assumed options covering 94,279 shares of common stock under the BCS 1997 Incentive Plan in connection with the acquisition of BCS. We issued 553,880 shares of common stock to Cortelco Systems Holding Corporation in connection with the merger with Cortelco Systems Puerto Rico. (4) Since April 1998, we have granted incentive stock options to employees, directors and consultants under our 1997 Equity Incentive Plan covering an aggregate of 333,505 shares of common stock, at an average exercise price of $3.76. No options have been exercised under the 1997 Equity Incentive Plan. (5) Since April 1999, we have granted incentive stock options to employees, directors and consultants under our 1999 Equity Incentive Plan covering an aggregate of 987,982 shares of common stock, at an average exercise price of $9.73. No options have been exercised under the 1999 Equity Incentive Plan. The sales and issuances of securities in the transactions described in paragraphs (1) through (3) were deemed to be exempt from registration under the Securities Act by virtue of Section 4(2) and/or Regulation D promulgated under the Securities Act. The purchasers in each case represented their intention to acquire the securities for investment only and not with a view to the distribution thereof. Appropriate legends are affixed to the stock certificates issued in such transactions. Similar legends were imposed in connection with any subsequent sales of any such securities. All recipients either received adequate information about Cortelco or had access, through employment or other relationships, to such information. The sales and issuance of securities in the transaction described in paragraphs (4) and (5) above were deemed to be exempt from registration under the Securities Act by virtue of Rule 701 promulgated thereunder in that they were offered and sold either pursuant to written compensatory benefit plans or pursuant to a written contract relating to compensation, as provided by Rule 701. II-2 Item 16. Exhibits. (a)
Exhibit Number Description of Document ------- ----------------------- 1.1* Form of Underwriting Agreement. 3.1+ Amended and Restated Certificate of Incorporation of Cortelco as currently in effect. 3.2+ Amended and Restated Certificate of Incorporation of Cortelco to be in effect immediately following the closing of the offering. 3.3 Bylaws of Cortelco as currently in effect. 3.4+ Amended and Restated Bylaws of Cortelco to be in effect immediately following the closing of the offering. 4.1+ Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4. 4.2+ Investor Rights Agreement between Cortelco, Cortelco Systems Holding Corporation and ChinaVest, dated as of July 31, 1997. 4.3+ Registration Rights Agreement between CMC Industries, Inc. and Cortelco, dated as of March 15, 1999. 5.1* Opinion of Cooley Godward LLP. 10.1+ Loan and Security Agreement between Cortelco and Foothill Capital Corporation, dated as July 31, 1997. 10.2+ Convertible Subordinated Note issued by Cortelco in favor of ChinaVest IV, L.P., dated as of July 31, 1997. 10.3+ Promissory Note issued by Cortelco Systems Holding Corporation in favor of Cortelco, dated as of July 31, 1997. 10.4+ Promissory Note issued by J. Michael O'Dell in favor of Cortelco, dated as of November 11, 1997. 10.5+ Assumption Agreement between Cortelco Puerto Rico, Inc. and Cortelco Systems Puerto Rico, Inc., dated as of April 12, 1999, and Loan and Security Agreement between Cortelco Puerto Rico, Inc. and Foothill Capital Corporation, dated as August 28, 1997. 10.6 Promissory Note issued by Cortelco Systems Holding Corporation in favor of BCS Technologies, Inc., dated as of May 28, 1999. 10.7+ Form of Indemnity Agreement to be entered into between Cortelco and its officers and directors. 10.8+ Manufacturing Agreement between Cortelco and CMC Manufacturing, Inc., dated as of August 1, 1998. 10.9+ Lease Agreement between Cortelco and Willow Lake Associates, dated as of July 24, 1989, as amended on April 6, 1998. 10.10+ Industrial Lease Agreement between BCS Technologies, Inc. and Industrial Developments International (Georgia), L.P., dated as of March 1, 1999. 10.11+ Lease Agreement between Cortelco Systems Puerto Rico, Inc. and Cortelco Puerto Rico, Inc. dated as of March 1, 1999. 10.12+ Employment Agreement, dated as of April 12, 1999, by and between Cortelco and each of David M. Fredrick and Frank Naso. 10.13+ Cortelco's 1999 Equity Incentive Plan and related documents. 10.14+ Cortelco's 1999 Employee Stock Purchase Plan and related documents. 11.1 Computation of Net Loss Per Share. 21.1 List of Subsidiaries of Registrant. 23.1 Consent of Deloitte & Touche LLP. 23.2 Consent of PricewaterhouseCoopers LLP.
II-3 23.3 Consent of Brock and Company, CPA's, P.C. 23.4* Consent of Cooley Godward LLP. (See ) 24.1+ Power of Attorney. 27.1 Financial Data Schedule.
- ------------------- * To be filed by amendment. + Previously filed. (b) Schedule II--Valuation and Qualifying Accounts
Item 17. Undertakings. We undertake to provide to the underwriters at the closing specified in the Underwriting Agreement certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of Cortelco pursuant to the foregoing provisions or otherwise, Cortelco has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by Cortelco of expenses incurred or paid by a director, officer or controlling person of Cortelco in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, Cortelco will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. We hereby undertake that: (i) for purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by Cortelco pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time the Commission declared it effective, and (ii) for the purpose of determining any liability under the Securities Act, each post- effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment to Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Memphis, State of Tennessee, on the 11th day of June, 1999. Cortelco Systems, Inc. /s/ J. Michael O'Dell By: ____________________________________ J. Michael O'Dell President and Chief Executive Officer In accordance with the requirements of the Securities Act of 1933, as amended, this Amendment to Registration Statement has been signed below by the following persons in the capacities and on the dates stated.
Signature Title Date --------- ----- ---- /s/ J. Michael O'Dell President, Chief Executive June 11, 1999 ______________________________________ Officer and Director J. Michael O'Dell (Principal Executive Officer) /s/ Stephen N. Samp Vice President of Finance June 11, 1999 ______________________________________ and Administration, Chief Stephen N. Samp Financial Officer and Secretary (Principal Financial and Accounting Officer) /s/ David S. Lee Chairman of the Board June 11, 1999 ______________________________________ David S. Lee /s/ Stephen R. Bowling Director June 11, 1999 ______________________________________ Stephen R. Bowling * Director June 11, 1999 ______________________________________ Robert P. Dilworth * Director June 11, 1999 ______________________________________ W. Frank King /s/ Jenny Hsui Theleen Director June 11, 1999 ______________________________________ Jenny Hsui Theleen
/s/ J. Michael O'Dell *By: ___________________ J. Michael O'Dell Attorney-in-fact II-5 Cortelco Systems, Inc. Schedule II--Valuation and Qualifying Accounts - ------------------------------------------------------------------------------
Column A Column B Column D Column E - -------- ---------- Column C ---------- ---------- Additions Balance at Charged to Charged to Balance Beginning Costs and Other at End Description of Period Expenses Accounts Deductions of Period - ----------- ---------- ---------- ---------- ---------- ---------- 1996 Allowance for doubtful accounts and sales allowance $1,722,136 $1,011,283 -- $ 668,395 $2,065,024 Warranty reserve 170,373 605,957 -- 447,524 328,806 1997 Allowance for doubtful accounts and sales allowance 2,065,024 2,101,157 -- 1,076,419 3,089,762 Warranty reserve 328,806 481,921 -- 470,099 340,628 1998 Allowance for doubtful accounts and sales allowance 3,089,762 3,045 -- 1,212,927 1,879,880 Warranty reserve 340,628 231,257 -- 322,275 249,610
S-1 EXHIBIT INDEX
Exhibit Number Description of Document ------- ----------------------- 1.1* Form of Underwriting Agreement. 3.1+ Amended and Restated Certificate of Incorporation of Cortelco as currently in effect. 3.2+ Amended and Restated Certificate of Incorporation of Cortelco to be in effect immediately following the closing of the offering. 3.3 Bylaws of Cortelco as currently in effect. 3.4+ Amended and Restated Bylaws of Cortelco to be in effect immediately following the closing of the offering. 4.1+ Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4. 4.2+ Investor Rights Agreement between Cortelco, Cortelco Systems Holding Corporation and ChinaVest, dated as of July 31, 1997. 4.3+ Registration Rights Agreement between CMC Industries, Inc. and Cortelco, dated as of March 15, 1999. 5.1* Opinion of Cooley Godward LLP. 10.1+ Loan and Security Agreement between Cortelco and Foothill Capital Corporation, dated as July 31, 1997. 10.2+ Convertible Subordinated Note issued by Cortelco in favor of ChinaVest IV, L.P., dated as of July 31, 1997. 10.3+ Promissory Note issued by Cortelco Systems Holding Corporation in favor of Cortelco, dated as of July 31, 1997. 10.4+ Promissory Note issued by J. Michael O'Dell in favor of Cortelco, dated as of November 11, 1997. 10.5+ Assumption Agreement between Cortelco Puerto Rico, Inc. and Cortelco Systems Puerto Rico, Inc., dated as of April 12, 1999, and Loan and Security Agreement between Cortelco Puerto Rico, Inc. and Foothill Capital Corporation, dated as August 28, 1997. 10.6 Promissory Note issued by Cortelco Systems Holding Corporation in favor of BCS Technologies, Inc., dated as of May 28, 1999. 10.7+ Form of Indemnity Agreement to be entered into between Cortelco and its officers and directors. 10.8+ Manufacturing Agreement between Cortelco and CMC Manufacturing, Inc., dated as of August 1, 1998. 10.9+ Lease Agreement between Cortelco and Willow Lake Associates, dated as of July 24, 1989, as amended on April 6, 1998. 10.10+ Industrial Lease Agreement between BCS Technologies, Inc. and Industrial Developments International (Georgia), L.P., dated as of March 1, 1999. 10.11+ Lease Agreement between Cortelco Systems Puerto Rico, Inc. and Cortelco Puerto Rico, Inc. dated as of March 1, 1999. 10.12+ Employment Agreement, dated as of April 12, 1999, by and between Cortelco and each of David M. Fredrick and Frank Naso. 10.13+ Cortelco's 1999 Equity Incentive Plan and related documents. 10.14+ Cortelco's 1999 Employee Stock Purchase Plan and related documents. 11.1 Computation of Net Loss Per Share. 21.1 List of Subsidiaries of Registrant. 23.1 Consent of Deloitte & Touche LLP. 23.2 Consent of PricewaterhouseCoopers LLP. 23.3 Consent of Brock and Company, CPA's, P.C. 23.4* Consent of Cooley Godward LLP. (See ) 24.1+ Power of Attorney. 27.1 Financial Data Schedule.
- ------------------- * To be filed by amendment. + Previously filed. EX-3.3 2 BYLAWS OF CORTELCO EXHIBIT 3.3 BYLAWS OF CORTELCO INVESTMENT CORP. (a Delaware corporation) TABLE OF CONTENTS
PAGE ARTICLE I. Offices Section 1. Registered Office..................................................................... 1 Section 2. Other Offices......................................................................... 1 ARTICLE II. Corporate Seal Section 3. Corporate Seal........................................................................ 1 ARTICLE III. Stockholders' Meetings Section 4. Place of Meetings..................................................................... 1 Section 5. Annual Meeting........................................................................ 1 Section 6. Special Meetings...................................................................... 1 Section 7. Notice of Meetings.................................................................... 2 Section 8. Quorum................................................................................ 2 Section 9. Adjournment and Notice of Adjourned Meetings.......................................... 2 Section 10. Voting Rights......................................................................... 3 Section 11. Beneficial Owners of Stock............................................................ 3 Section 12. List of Stockholders.................................................................. 3 Section 13. Action without Meeting................................................................ 4 ARTICLE IV. Directors Section 15. Number and Term of Office............................................................. 4 Section 16. Powers................................................................................ 4 Section 17. Vacancies............................................................................. 4 Section 18. Resignation........................................................................... 5 Section 19. Removal............................................................................... 5 Section 20. Meetings.............................................................................. 5 Section 21. Quorum and Voting..................................................................... 6 Section 22. Action without Meeting................................................................ 6 Section 23. Fees and Compensation................................................................. 6 Section 24. Committees............................................................................ 7
TABLE OF CONTENTS (CONTINUED)
PAGE Section 25. Organization......................................................................... 8 ARTICLE V. Officers Section 26. Officers Designated.................................................................. 8 Section 27. Tenure and Duties of Officers........................................................ 8 Section 28. Delegation of Authority.............................................................. 10 Section 29. Resignations......................................................................... 10 Section 30. Removal.............................................................................. 10 ARTICLE VI. Execution of Corporate Instruments and Voting of Securities Owned by the Corporation Section 31. Execution of Corporate Instruments................................................... 10 Section 32. Voting of Securities Owned by the Corporation........................................ 11 ARTICLE VII. Shares of Stock Section 33. Form and Execution of Certificates................................................... 11 Section 34. Lost Certificates.................................................................... 11 Section 35. Transfers............................................................................ 12 Section 36. Fixing Record Dates.................................................................. 12 Section 37. Registered Stockholders.............................................................. 13 ARTICLE VIII. Other Securities of the Corporation Section 38. Execution of Other Securities........................................................ 13 ARTICLE IX. Dividends Section 39. Declaration of Dividends............................................................. 13 Section 40. Dividend Reserve..................................................................... 14 ARTICLE X. Fiscal Year Section 41. Fiscal Year.......................................................................... 14 ARTICLE XI. Indemnification
TABLE OF CONTENTS (CONTINUED)
PAGE Section 42. Indemnification of Directors, Officers, Employees and Other Agents.................... 14 ARTICLE XII. Notices Section 43. Notices............................................................................... 17 ARTICLE XIII. Amendments Section 44. Amendments............................................................................ 19 ARTICLE XIV. Loans to Officers Section 45. Loans to Officers..................................................................... 19 ARTICLE XV. Miscellaneous Section 46. Annual Report......................................................................... 20
EXHIBIT 3.3 BYLAWS OF CORTELCO INVESTMENT CORP. (a Delaware corporation) ARTICLE I Offices ------- Section 1. Registered Office. The registered office of the ----------------- corporation in the State of Delaware shall be in the City of Dover, County of Kent. [Del. Code Ann., tit. 8, (S)131] Section 2. Other Offices. The corporation shall also have and ------------- maintain an office or principal place of business in Memphis, Tennessee, at such place as may be fixed by the Board of Directors, and may also have offices at such other places, both within and without the State of Delaware as the Board of Directors may from time to time determine or the business of the corporation may require. [Del. Code Ann., tit. 8, (S)122(8)] ARTICLE II Corporate Seal -------------- Section 3. Corporate Seal. At the discretion of the Board of -------------- Directors, the corporation shall have a corporate seal which shall consist of a die bearing the name of the corporation and the inscription, "Corporate Seal Delaware." Said seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced or otherwise. [Del. Code Ann., tit. 8, (S)122 (3)] ARTICLE III Stockholders' Meetings ---------------------- Section 4. Place of Meetings. Meetings of the stockholders of the ----------------- corporation shall be held at such place, either within or without the State of Delaware, as may be designated from time to time by the Board of Directors, or, if not so designated, then at the office of the corporation required to be maintained pursuant to Section 2 hereof. [Del. Code Ann., tit. 8, (S)211(a)] Section 5. Annual Meeting. The annual meeting of the stockholders of -------------- the corporation, for the purpose of election of Directors and for such other business as may lawfully come before it, shall be held on such date and at such time as may be designated from time to time by the Board of Directors. [Del. Code Ann., tit. 8, (S)211(b)] 1. Section 6. Special Meetings. Special meetings of the stockholders of ---------------- the corporation may be called, for any purpose or purposes, by (a) the Chairman of the Board, (b) the President, (c) the Board of Directors pursuant to a resolution adopted by a majority of the total number of authorized directors (whether or not there exist any vacancies in previously authorized directorships at the time any such resolution is presented to the Board for adoption, or (d) by the holders of shares entitled to cast not less than ten percent (10%) of the votes at the meeting, and shall be held at such place, on such date, and at such time as they or he shall fix; provided, however, that following registration of any of the classes of equity securities of the corporation pursuant to the provisions of the Securities Exchange Act of 1934, as amended, special meetings of the stockholders may only be called by the Board of Directors pursuant to a resolution adopted by a majority of the total number of authorized Directors. Section 7. Notice of Meetings. Except as otherwise provided by law ------------------ or the Certificate of Incorporation, written notice of each meeting of stockholders shall be given not less than ten (10) nor more than sixty (60) days before the date of the meeting to each stockholder entitled to vote at such meeting, such notice to specify the place, date and hour and purpose or purposes of the meeting. Notice of the time, place and purpose of any meeting of stockholders may be waived, in writing, signed by the person entitled to notice thereof, either before or after such meeting, and will be waived by any stockholder by his attendance thereat in person or by proxy, except when the stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. Any stockholder so waiving notice of such meeting shall be bound by the proceedings of any such meeting in all respects as if due notice thereof had been given. [Del. Code Ann., tit. 8, (S)(S)222, 229] Section 8. Quorum. At all meetings of stockholders, except where ------ otherwise provided by statute or by the Certificate of Incorporation, or by these Bylaws, the presence, in person or by proxy duly authorized, of the holders of a majority of the outstanding shares of stock entitled to vote shall constitute a quorum for the transaction of business. Any shares, the voting of which at said meeting has been enjoined, or which for any reason cannot be lawfully voted at such meeting, shall not be counted to determine a quorum at such meeting. In the absence of a quorum any meeting of stockholders may be adjourned, from time to time, by vote of the holders of a majority of the shares represented thereat, but no other business shall be transacted at such meeting. The stockholders present at a duly called or convened meeting at which a quorum is present may continue to transact business until adjournment, notwithstanding the withdrawal of enough stockholders to leave less than a quorum. Except as otherwise provided by law, the Certificate of Incorporation or these Bylaws, all action taken by the holders of a majority of the voting power represented at any meeting at which a quorum is present shall be valid and binding upon the corporation; provided, however, that Directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of Directors. Where a separate vote by a class or classes is required, a majority of the outstanding shares of such class or classes, present in person or represented by proxy, shall constitute a quorum entitled to take action with respect to that vote on that matter and the affirmative vote of the majority (plurality, in the case of the election of Directors) of shares of such class or classes present in person or represented by proxy at the meeting shall be the act of such class. [Del. Code Ann., tit. 8, (S)216] 2. Section 9. Adjournment and Notice of Adjourned Meetings. Any meeting -------------------------------------------- of stockholders, whether annual or special, may be adjourned from time to time by the vote of a majority of the shares represented thereat. When a meeting is adjourned to another time or place, notice need not be given of the adjourned meeting if the time and place thereof are announced at the meeting at which the adjournment is taken. At the adjourned meeting the corporation may transact any business which might have been transacted at the original meeting. If the adjournment is for more than thirty (30) days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting. [Del. Code Ann., tit. 8, (S)222 (c)] Section 10. Voting Rights. For the purpose of determining those ------------- stockholders entitled to vote at any meeting of the stockholders, except as otherwise provided by law, only persons in whose names shares stand on the stock records of the corporation on the record date, as provided in Section 12 of these Bylaws, shall be entitled to vote at any meeting of stockholders. Except as may be otherwise provided in the Certificate of Incorporation or these Bylaws, each stockholder shall be entitled to one vote for each share of capital stock held by such stockholder. Every person entitled to vote or execute consents shall have the right to do so either in person or by an agent or agents authorized by a written proxy executed by such person or his duly authorized agent, which proxy shall be filed with the Secretary at or before the meeting at which it is to be used. An agent so appointed need not be a stockholder. No proxy shall be voted after three (3) years from its date of creation unless the proxy provides for a longer period. All elections of Directors shall be by written ballot, unless otherwise provided in the Certificate of Incorporation. [Del. Code Ann., tit. 8, (S)(S)211(e), 212(b)] Section 11. Beneficial Owners of Stock. (a) If shares or other -------------------------- securities having voting power stand of record in the names of two (2) or more persons, whether fiduciaries, members of a partnership, joint tenants, tenants in common, tenants by the entirety, or otherwise, or if two (2) or more persons have the same fiduciary relationship respecting the same shares, unless the Secretary is given written notice to the contrary and is furnished with a copy of the instrument or order appointing them or creating the relationship wherein it is so provided, their acts with respect to voting shall have the following effect: (a) if only one (1) votes, his act binds all; (b) if more than one (1) votes, the act of the majority so voting binds all; (c) if more than one (1) votes, but the vote is evenly split on any particular matter, each faction may vote the securities in question proportionally, or may apply to the Delaware Court of Chancery for relief as provided in the General Corporation Law of Delaware, Section 217(b). If the instrument filed with the Secretary shows that any such tenancy is held in unequal interests, a majority or even-split for the purpose of this subsection (c) shall be a majority or even-split in interest. [Del. Code Ann., tit. 8, (S)217(b)] (b) Persons holding stock in a fiduciary capacity shall be entitled to vote the shares so held. Persons whose stock is pledged shall be entitled to vote, unless in the transfer by the pledgor on the books of the corporation he has expressly empowered the pledgee to vote thereon, in which case only the pledgee, or his proxy, may represent such stock and vote thereon. [Del. Code Ann., tit. 8, (S)217(a)] Section 12. List of Stockholders. The Secretary shall prepare and -------------------- make, at least ten (10) days before every meeting of stockholders, a complete list of the stockholders entitled to 3. vote at said meeting, arranged in alphabetical order, showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten (10) days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not specified, at the place where the meeting is to be held. The list shall be produced and kept at the time and place of meeting during the whole time thereof, and may be inspected by any stockholder who is present. [Del. Code Ann., tit. 8, (S)219(a)] Section 13. Action without Meeting. (a) Any action required by ---------------------- statute to be taken at any annual or special meeting of the stockholders, or any action which may be taken at any Annual or special meeting of the stockholders, may be taken, without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, are signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted. (b) Every written consent shall bear the date of signature of each stockholder who signs the consent, and no written consent shall be effective to take the corporate action referred to therein unless, within sixty (60) days of the earliest dated consent delivered to the Corporation in the manner herein required, written consents signed by a sufficient number of stockholders to take action are delivered to the corporation by delivery to its registered office in the State of Delaware, its principal place of business or an officer or agent of the corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Deliver made to a corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. [Del. Code Ann., tit. 8, (S)228] (c) Prompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders who have not consented in writing. If the action which is consented to is such as would have required the filing of a certificate under any section of the General Corporation Law of Delaware if such action had been voted on by stockholders at a meeting thereof, then the certificate filed under such section shall state, in lieu of any statement required by such section concerning any vote of stockholders, that written notice and written consent have been given as provided in Section 228 of the General Corporation Law of Delaware. Section 14. Organization. (a) At every meeting of stockholders, the ------------- Chairman of the Board of Directors, or, if a Chairman has not been appointed or is absent, the President, or, if the President is absent, the most senior Vice President present, or in the absence of any such officer, a chairman of the meeting chosen by a majority in interest of the stockholders entitled to vote, present in person or by proxy, shall act as chairman. The Secretary, or, in his absence, an Assistant Secretary directed to do so by the President, shall act as secretary of the meeting. (b) The Board of Directors of the corporation shall be entitled to make such rules or regulations for the conduct of meetings of stockholders as it shall deem necessary, appropriate or convenient. Subject to such rules and regulations of the Board of Directors, if any, the chairman of the meeting shall have the right and authority to prescribe such rules, regulations and procedures and to do all such acts as, in the judgment of such chairman, are necessary, appropriate or convenient for the proper conduct of the meeting, including, without limitation, establishing an agenda or order of business for the meeting, rules and procedures for maintaining order at the meeting and the safety of those present, limitations on participation in such meeting to stockholders of record of the corporation and their duly authorized and constituted proxies, and such other persons as the chairman shall permit, restrictions on entry to the meeting after the time fixed for the commencement thereof, limitations on the time allotted to questions or comments by participants and regulation of the opening and closing of the polls for balloting on matters which are to be voted on by ballot. Unless, and to the extent determined by the Board of Directors or the chairman of the meeting, meetings of stockholders shall not be required to be held in accordance with rules of parliamentary procedure. ARTICLE IV Directors --------- Section 15. Number and Term of Office. The number of Directors which ------------------------- shall constitute the whole of the Board of Directors shall be five (5). The number of authorized Directors may be modified from time to time by amendment of this Section 15 in accordance with the provisions of Section 44 hereof. Except as provided in Section 17, the Directors shall be elected by the stockholders at their annual meeting in each year and shall hold office until the next annual meeting and until their successors shall be duly elected and qualified. Directors need not be stockholders unless so required by the Certificate of Incorporation. If for any cause the Directors shall not have been elected at an annual meeting, they may be elected as soon thereafter as convenient at a special meeting of the stockholders called for that purpose in the manner provided in these Bylaws. [Del. Code Ann., tit. 8, (S)(S)141(b), 211(b), (c)] Section 16. Powers. The powers of the corporation shall be ------ exercised, its business conducted and its property controlled by the Board of Directors, except as may be otherwise provided by statute or by the Certificate of Incorporation [Del. Code Ann., tit. 8, (S)141(a) ] 4. Section 17. Vacancies. Unless otherwise provided in the Certificate --------- of Incorporation, vacancies and newly created directorships resulting from any increase in the authorized number of Directors may be filled by a majority of the Directors then in office, although less than a quorum, or by a sole remaining Director, and each Director so elected shall hold office for the unexpired portion of the term of the Director whose place shall be vacant and until his successor shall have been duly elected and qualified. A vacancy in the Board of Directors shall be deemed to exist under this Section 17 in the case of the death, removal or resignation of any Director, or if the stockholders fail at any meeting of stockholders at which Directors are to be elected (including any meeting referred to in Section 19 below) to elect the number of Directors then constituting the whole Board of Directors. [Del. Code Ann., tit. 8, (S)223(a), (b)] Section 18. Resignation. Any Director may resign at any time by ----------- delivering his written resignation to the Secretary, such resignation to specify whether it will be effective at a particular time, upon receipt by the Secretary or at the pleasure of the Board of Directors. If no such specification is made, it shall be deemed effective at the pleasure of the Board of Directors. When one or more Directors shall resign from the Board of Directors, effective at a further date, a majority of the Directors then in office, including those who have so resigned, shall have power to fill such vacancy or vacancies, the vote thereon to take effect when such resignation or resignations shall become effective, and each Director so chosen shall hold office for the unexpired portion of the term of the Director whose place shall be vacated and until his successor shall have been duly elected and qualified. [Del. Code Ann., tit. 8, (S)(S)141(b) , 223 (d)] Section 19. Removal. At a special meeting of stockholders called for ------- the purpose in the manner hereinabove provided, subject to any limitations imposed by law or the Certificate of Incorporation, the Board of Directors, or any individual Director, may be removed from office, with or without cause, and a new Director or Directors elected by a vote of stockholders holding a majority of the outstanding shares entitled to vote at an election of Directors. [Del. Code Ann., tit. 8, (S)141(k)] Section 20. Meetings. -------- (a) Annual Meetings. The annual meeting of the Board of Directors --------------- shall be held immediately after the annual meeting of stockholders and at the place where such meeting is held. No notice of an annual meeting of the Board of Directors shall be necessary and such meeting shall be held for the purpose of electing officers and transacting such other business as may lawfully come before it. (b) Regular Meetings. Except as hereinafter otherwise provided, ---------------- regular meetings of the Board of Directors shall be held in the office of the corporation required to be maintained pursuant to Section 2 hereof. Unless otherwise restricted by the Certificate of Incorporation, regular meetings of the Board of Directors may also be held at any place within or without the State of Delaware which has been determined by the Board of Directors. [Del. Code Ann., tit. 8, (S)141(g)] (c) Special Meetings. Unless otherwise restricted by the Certificate ---------------- of Incorporation, special meetings of the Board of Directors may be held at any time and place 5. within or without the State of Delaware whenever called by the President or a majority of the Directors. [Del. Code Ann., tit. 8, (S)141(g)] (d) Telephone Meetings. Any member of the Board of Directors, or of ------------------ any committee thereof,, may participate in a meeting by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and participation in a meeting by such means shall constitute presence in person at such meeting. [Del. Code Ann., tit. 8, (S)141(i)] (e) Notice of Meetings. Written notice of the time and place of all ------------------ special meetings of the Board of Directors shall be given at least one (1) day before the date of the meeting. Notice of any meeting may be waived in writing at any time before or after the meeting and will be waived by any Director by attendance thereat, except when the Director attends the meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. [Del. Code Ann., tit. 8, (S)229] (f) Waiver of Notice. The transaction of all business at any meeting ---------------- of the Board of Directors, or any committee thereof, however called or noticed, or wherever held, shall be as valid as though had at a meeting duly held after regular call and notice, if a quorum be present and if, either before or after the meeting, each of the Directors not present shall sign a written waiver of notice, or a consent to holding such meeting, or an approval of the minutes thereof. All such waivers, consents or approvals shall be filed with the corporate records or made a part of the minutes of the meeting. [Del. Code Ann., tit. 8, (S)229] Section 21. Quorum and Voting. (a) Unless the Certificate of ----------------- Incorporation requires a greater number and except with respect to indemnification questions arising under Section 42 hereof, for which a quorum shall be one-third (1/3) of the exact number of Directors fixed from time to time in accordance with Section 15 hereof, but not less than one (1), a quorum of the Board of Directors shall consist of a majority of the exact number of Directors fixed from time to time in accordance with Section 15 of these Bylaws, but not less than one (1); provided, however, at any meeting whether a quorum be present or otherwise, a majority of the Directors present may adjourn from time to time until the time fixed for the next regular meeting of the Board of Directors, without notice other than by announcement at the meeting. [Del. Code Ann., tit. 8, (S)141(b)] (b) At each meeting of the Board of Directors at which a quorum is present all questions and business shall be determined by a vote of a majority of the Directors present, unless a different vote be required by law, the Certificate of Incorporation or these Bylaws. [Del. Code Ann., tit. 8, (S)141(b)] Section 22. Action without Meeting. Unless otherwise restricted by ---------------------- the Certificate of Incorporation or these Bylaws, any action required or permitted to be taken at any meeting of the Board of Directors or of any committee thereof may be taken without a meeting, if all members of the Board of Directors or committee, as the case may be, consent thereto in writing, and such writing or writings are filed with the minutes of proceedings of the Board of Directors or committee. [Del. Code Ann., tit. 8, (S)141(f)] 6. Section 23. Fees and Compensation. Directors shall be entitled to --------------------- such compensation for their services as may be approved by the Board of Directors, including, if so approved, by resolution of the Board of Directors, a fixed sum and expenses of attendance, if any, for attendance at each regular or special meeting of the Board of Directors and at any meeting of a committee of the Board of Directors. Nothing herein contained shall be construed to preclude any Director from serving the corporation in any other capacity as an officer, agent, employee, or otherwise and receiving compensation therefor. [Del. Code Ann., tit. 8, (S)141(h)] Section 24. Committees. ---------- (a) Executive Committee. The Board of Directors may by resolution ------------------- passed by a majority of the whole Board of Directors, appoint an Executive Committee to consist of one (1) or more members of the Board of Directors. The Executive Committee, to the extent permitted by law and specifically granted by the Board of Directors, shall have and may exercise when the Board of Directors is not in session all powers of the Board of Directors in the management of the business and affairs of the corporation, including, without limitation, the power and authority to declare a dividend or to authorize the issuance of stock, except such committee shall not have the power or authority to amend the Certificate of Incorporation, to adopt an agreement of merger or consolidation, to recommend to the stockholders the sale, lease or exchange of all or substantially all of the corporation's property and assets, to recommend to the stockholders of the corporation a dissolution of the corporation or a revocation of a dissolution or to amend these Bylaws. [Del. Code Ann., tit. 8, (S)141(c)] (b) Other Committees. The Board of Directors may, by resolution ---------------- passed by a majority of the whole Board of Directors, from time to time appoint such other committees as may be permitted by law. Such other committees appointed by the Board of Directors shall consist of one (1) or more members of the Board of Directors, and shall have such powers and perform such duties as may be prescribed by the resolution or resolutions creating such committees, but in no event shall such committee have the powers denied to the Executive Committee in these Bylaws. [Del. Code Ann., tit. 8, (S)141(c)] (c) Term. The members of all committees of the Board of Directors ---- shall serve a term coexistent with that of the Board of Directors which shall have appointed such committee. The Board of Directors, subject to the provisions of subsections (a) or (b) of this Section 24, may at any time increase or decrease the number of members of a committee or terminate the existence of a committee. The membership of a committee member shall terminate on the date of his death or voluntary resignation from the committee or from the Board of Directors. The Board of Directors may at any time for any reason remove any individual committee member and the Board of Directors may fill any committee vacancy created by death, resignation, removal or increase in the number of members of the committee. The Board of Directors may designate one or more Directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee, and, in addition, in the absence or disqualification of any member of a committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not he or they constitute a quorum, may unanimously appoint another member of the Board of Directors to act at the meeting in the place of any such absent or disqualified member. [Del. Code Ann., tit. 8, (S)141 (c)] 7. (d) Meetings. Unless the Board of Directors shall otherwise provide, -------- regular meetings of the Executive Committee or any other committee appointed pursuant to this Section 24 shall be held at such times and places as are determined by the Board of Directors, or by any such committee, and when notice thereof has been given to each member of such committee, no further notice of such regular meetings need be given thereafter. Special meetings of any such committee may be held at any place which has been determined from time to time by such committee, and may be called by any Director who is a member of such committee, upon written notice to the members of such committee of the time and place of such special meeting given in the manner provided for the giving of written notice to members of the Board of Directors of the time and place of special meetings of the Board of Directors. Notice of any special meeting of any committee may be waived in writing at any time before or after the meeting and will be waived by any Director by attendance thereat, except when the Director attends such special meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. A majority of the authorized number of members of any such committee shall constitute a quorum for the transaction of business, and the act of a majority of those present at any meeting at which a quorum is present shall be the act of such committee. [Del. Code Ann., tit. 8, (S)(S)141(c), 229] Section 25. Organization. At every meeting of the Directors, the ------------ Chairman of the Board of Directors, or, if a Chairman has not been appointed or is absent, the President, or if the President is absent, the most senior Vice President, or, in the absence of any such officer, a chairman of the meeting chosen by a majority of the Directors present, shall preside over the meeting. The Secretary, or in his absence, an Assistant Secretary directed to do so by the President, shall act as secretary of the meeting. ARTICLE V Officers -------- Section 26. Officers Designated. The officers of the corporation ------------------- shall be the Chairman of the Board of Directors, the President, one or more Vice Presidents, the Secretary and the Chief Financial Officer or Treasurer, all of whom shall be elected at the annual organizational meeting of the Board of Directors. The order of the seniority of the Vice Presidents shall be in the order of their nomination, unless otherwise determined by the Board of Directors. The Board of Directors may also appoint one or more Assistant Secretaries, Assistant Treasurers, and such other officers and agents with such powers and duties as it shall deem necessary. The Board of Directors may assign such additional titles to one or more of the officers as it shall deem appropriate. Any one person may hold any number of offices of the corporation at any one time unless specifically prohibited therefrom by law. The salaries and other compensation of the officers of the corporation shall be fixed by or in the manner designated by the Board of Directors. [Del. Code Ann., tit. 8, (S)(S)122(5), 142(a), (b) ] Section 27. Tenure and Duties of Officers. ----------------------------- (a) General. All officers shall hold office at the pleasure of the ------- Board of Directors and until their successors shall have been duly elected and qualified, unless sooner removed. Any officer elected or appointed by the Board of Directors may be removed at any 8. time by the Board of Directors. If the office of any officer becomes vacant for any reason, the vacancy may be filled by the Board of Directors. [Del. Code Ann., tit. 8, (S)141(b), (e) ] (b) Duties of Chairman of the Board of Directors. The Chairman of the -------------------------------------------- Board of Directors, when present, shall preside at all meetings of the stockholders and the Board of Directors. The Chairman of the Board of Directors shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. If there is no President, then the Chairman of the Board of Directors shall also serve as the Chief Executive Officer of the corporation and shall have the powers and duties prescribed in paragraph (c) of this Section 27. [Del. Code Ann., tit. 8, (S)142(a)] (c) Duties of President. The President shall preside at all meetings ------------------- of the stockholders and at all meetings of the Board of Directors, unless the Chairman of the Board of Directors has been appointed and is present. The President shall be the Chief Executive Officer of the corporation and shall, subject to the control of the Board of Directors, have general supervision, direction and control of the business and officers of the corporation. The President shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. [Del. Code Ann., tit. 8, (S)142(a)] (d) Duties of Vice Presidents. The Vice Presidents, in the order of ------------------------- their seniority, may assume and perform the duties of the President in the absence or disability of the President or whenever the office of President is vacant. The Vice Presidents shall perform other duties commonly incident to their office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. [Del. Code Ann., tit. 8, (S)142(a)] (e) Duties of Secretary. The Secretary shall attend all meetings of ------------------- the stockholders and of the Board of Directors, and shall record all acts and proceedings thereof in the minute book of the corporation. The Secretary shall give notice in conformity with these Bylaws of all meetings of the stockholders, and of all meetings of the Board of Directors and any committee thereof requiring notice. The Secretary shall perform all other duties given him in these Bylaws and other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. The President may direct any Assistant Secretary to assume and perform the duties of the Secretary in the absence or disability of the Secretary, and each Assistant Secretary shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. [Del. Code Ann., tit. 8, (S)142 (a) ] (f) Duties of Chief Financial Officer or Treasurer. The Chief ---------------------------------------------- Financial Officer or Treasurer shall keep or cause to be kept the books of account of the corporation in a thorough and proper manner, and shall render statements of the financial affairs of the corporation in such form and as often as required by the Board of Directors or the President. The Chief Financial Officer or Treasurer, subject to the order of the Board of Directors, shall have the custody of all funds and securities of the corporation. The Chief Financial Officer or Treasurer 9. shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. The President may direct any Assistant Treasurer to assume and perform the duties of the Chief Financial Officer or Treasurer in the absence or disability of the Chief Financial Officer or Treasurer, and each Assistant Treasurer shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. [Del. Code Ann., tit. 8, (S)142(a)] Section 28. Delegation of Authority. The Board of Directors may from ----------------------- time to time delegate the powers or duties of any officer to any other officer or agent, notwithstanding any provision hereof. Section 29. Resignations. Any officer may resign at any time by ------------ giving written notice to the Board of Directors or to the President or to the Secretary. Any such resignation shall be effective when received by the person or persons to whom such notice is given, unless a later time is specified therein, in which event the resignation shall become effective at such later time. Unless otherwise specified in such notice, the acceptance of any such resignation shall not be necessary to make it effective. Any resignation shall be without prejudice to the rights, if any, of the corporation under any contract with the resigning officer. [Del. Code Ann., tit. 8, (S)142(b)] Section 30. Removal. Any officer may be removed from office at any ------- time, either with or without cause, by the vote or written consent of a majority of the Directors in office at the time, or by any committee or superior officers upon whom such power of removal may have been conferred by the Board of Directors. ARTICLE VI Execution of Corporate Instruments and Voting ---------------------------------------------- of Securities Owned by the Corporation -------------------------------------- Section 31. Execution of Corporate Instruments. The Board of ---------------------------------- Directors may, in its discretion, determine the method and designate the signatory officer or officers, or other person or persons, to execute on behalf of the corporation any corporate instrument or document, or to sign on behalf of the corporation the corporate name without limitation, or to enter into contracts on behalf of the corporation, except where otherwise provided by law or these Bylaws, and such execution or signature shall be binding upon the corporation. [Del. Code Ann., tit. 8, (S)(S)103(a), 142(a), 158] Unless otherwise specifically determined by the Board of Directors or otherwise required by law, promissory notes, deeds of trust, mortgages and other evidences of indebtedness of the corporation, and other corporate instruments or documents requiring the corporate seal, and certificates of shares of stock owned by the corporation, shall be executed, signed or endorsed by the Chairman of the Board of Directors, or the President or any Vice President, and by the Secretary or Chief Financial Officer or Treasurer or any Assistant Secretary or Assistant Treasurer. All other instruments and documents requiring the corporate signature, but not requiring the corporate seal, may be executed as aforesaid or in such other manner as may be directed by the Board of Directors. [Del. Code Ann., tit. 8, (S)(S)103(a), 142(a), 158] 10. All checks and drafts drawn on banks or other depositaries on funds to the credit of the corporation or in special accounts of the corporation shall be signed by such person or persons as the Board of Directors shall authorize so to do. Unless authorized or ratified by the Board of Directors or within the agency power of an officer, no officer, agent or employee shall have any power or authority to bind the corporation by any contract or engagement or to pledge its credit or to render it liable for any purpose or for any amount. [Del. Code Ann., tit. 8, (S)(S)103(a), 142(a), 158] Section 32. Voting of Securities Owned by the Corporation. All stock --------------------------------------------- and other securities of other corporations owned or held by the corporation for itself, or for other parties in any capacity, shall be voted, and all proxies with respect thereto shall be executed, by the person authorized so to do by resolution of the Board of Directors, or, in the absence of such authorization, by the Chairman of the Board of Directors, the President, or any Vice President. [Del. Code Ann., tit. 8, (S)123] ARTICLE VII Shares of Stock --------------- Section 33. Form and Execution of Certificates. Certificates for the ---------------------------------- shares of stock of the corporation shall be in such form as is consistent with the Certificate of Incorporation and applicable law. Every holder of stock in the corporation shall be entitled to have a certificate signed by or in the name of the corporation by the Chairman of the Board of Directors, or the President or any Vice President and by the Treasurer or Assistant Treasurer or the Secretary or Assistant Secretary, certifying the number of shares owned by him in the corporation. Where such certificate is countersigned by a transfer agent other than the corporation or its employee, or by a registrar other than the corporation or its employee, any other signature on the certificate may be a facsimile. In case any officer, transfer agent, or registrar who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer, transfer agent, or registrar before such certificate is issued, it may be issued with the same effect as if he were such officer, transfer agent, or registrar at the date of issue. Each certificate shall state upon the face or back thereof, in full or in summary, all of the designations, preferences, limitations, restrictions on transfer and relative rights of the shares authorized to be issued. [Del. Code Ann., tit. 8, (S)158] Section 34. Lost Certificates. A new certificate or certificates ----------------- shall be issued in place of any certificate or certificates theretofore issued by the corporation alleged to have been lost, stolen, or destroyed, upon the making of an affidavit of that fact by the person claiming the certificate of stock to be lost, stolen, or destroyed. The corporation may require, as a condition precedent to the issuance of a new certificate or certificates, the owner of such lost, stolen, or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require or to give the corporation a surety bond in such form and amount as it may direct as indemnity against any claim that may be made against the corporation with respect to the certificate alleged to have been lost, stolen, or destroyed. [Del. Code Ann., tit. 8, (S)167] 11. Section 35. Transfers. (a) Transfers of record of shares of stock of --------- the corporation shall be made only upon its books by the holders thereof, in person or by attorney duly authorized, and upon the surrender of a properly endorsed certificate or certificates for a like number of shares. [Del. Code Ann., tit. 8, (S)201; Del. Code Ann., Tit. 6, article 8 subtit. I] (b) The corporation shall have power to enter into and perform any agreement with any number of stockholders of any one or more classes of stock of the corporation to restrict the transfer of shares of stock of the corporation of any one or more classes owned by such stockholders in any manner not prohibited by the General Corporation Law of Delaware. [Del. Code Ann., tit. 8, (S)160 (a)] Section 36. Fixing Record Dates. (a) In order that the corporation ------------------- may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which record date shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting. If no record date is fixed by the Board of Directors, the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or if notice is waived, at the close of business on the day next preceding the day on which the meeting is held. A determination of stockholders of records entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. (b) In order that the corporation may determine the stockholders entitled to consent to corporate action in writing without a meeting, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which date shall not be more than ten (10) days after the date upon which the resolution fixing the record date is adopted by the Board of Directors. If no record date has been fixed by the Board of Directors, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting, when no prior action by the Board of Directors is required by law, shall be the first date on which a signed written consent setting forth the action taken or proposed to be taken is delivered to the corporation by delivery to its registered office in the State of Delaware, its principal place of business or an officer or agent of the corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to a corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. If no record date has been fixed by the Board of Directors and prior action by the Board of Directors is required by law, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting shall be at the close of business on the day on which the Board of Directors adopts the resolution taking such prior action. (c) In order that the corporation may determine the stockholders entitled to receive payment of any dividend or other distribution or allotment of any rights or the stockholders entitled to exercise any rights in respect of any change, conversion or exchange of stock, or for the purpose of any other lawful action, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the 12. record date is adopted, and which record date shall be not more than sixty (60) days prior to such action. If no record date is fixed, the record date for determining stockholders for any such purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. [Del. Code Ann., tit. 8, (S)213] Section 37. Registered Stockholders. The corporation shall be ----------------------- entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware. [Del. Code Ann., tit. 8, (S)(S)213(a), 219] ARTICLE VIII Other Securities of the Corporation ----------------------------------- Section 38. Execution of Other Securities. All bonds, debentures and ----------------------------- other corporate securities of the corporation, other than stock certificates (covered in Section 33), may be signed by the Chairman of the Board of Directors, the President or any Vice President, or such other person as may be authorized by the Board of Directors, and the corporate seal (if any) impressed thereon or a facsimile of such seal, imprinted thereon and attested by the signature of the Secretary or an Assistant Secretary, or the Chief Financial Officer or Treasurer or an Assistant Treasurer; provided, however, that where any such bond, debenture or other corporate security shall be authenticated by the manual signature of a trustee under an indenture pursuant to which such bond, debenture or other corporate security shall be issued, the signatures of the persons signing and attesting the corporate seal on such bond, debenture or other corporate security may be the imprinted facsimile of the signatures of such persons. Interest coupons appertaining to any such bond, debenture or other corporate security, authenticated by a trustee as aforesaid, shall be signed by the Treasurer or an Assistant Treasurer of the corporation or such other person as may be authorized by the Board of Directors, or bear imprinted thereon the facsimile signature of such person. In case any officer who shall have signed or attested any bond, debenture or other corporate security, or whose facsimile signature shall appear thereon or on any such interest coupon, shall have ceased to be such officer before the bond, debenture or other corporate security so signed or attested shall have been delivered, such bond, debenture or other corporate security nevertheless may be adopted by the corporation and issued and delivered as though the person who signed the same or whose facsimile signature shall have been used thereon had not ceased to be such officer of the corporation. ARTICLE IX Dividends --------- Section 39. Declaration of Dividends. Dividends upon the capital ------------------------ stock of the corporation, subject to the provisions of the Certificate of Incorporation, if any, may be declared by the Board of Directors pursuant to law at any regular or special meeting. Dividends may be paid in cash, in property, or in shares of the capital stock, subject to the provisions of the Certificate of Incorporation. [Del. Code Ann., tit. 8, (S)(S)170, 173] 13. Section 40. Dividend Reserve. Before payment of any dividend, there ---------------- may be set aside out of any funds of the corporation available for dividends such sum or sums as the Board of Directors from time to time, in their absolute discretion, think proper as a reserve or reserves to meet contingencies, or for equalizing dividends, or for repairing or maintaining any property of the corporation, or for such other purpose as the Board of Directors shall think conducive to the interests of the corporation, and the Board of Directors may modify or abolish any such reserve in the manner in which it was created. [Del. Code Ann., tit. 8, (S)171] ARTICLE X Fiscal Year ----------- Section 41. Fiscal Year. The fiscal year of the corporation shall be ----------- fixed by resolution of the Board of Directors. ARTICLE XI Indemnification --------------- Section 42. Indemnification of Directors, Officers, Employees and ----------------------------------------------------- Other Agents. - ------------ (a) Directors and Executive Officers. The corporation shall indemnify -------------------------------- its Directors and executive officers to the fullest extent not prohibited by the Delaware General Corporation Law; provided, however, that the corporation may -------- ------- limit the extent of such indemnification by individual contracts with its Directors and executive officers; and, provided, further, that the corporation -------- ------- shall not be required to indemnify any Director or executive officer in connection with any proceeding (or part thereof) initiated by such person or any proceeding by such person against the corporation or its Directors, officers, employees or other agents unless (i) such indemnification is expressly required to be made by law, (ii) the proceeding was authorized by the Board of Directors of the corporation, or (iii) such indemnification is provided by the corporation, in its sole discretion, pursuant to the powers vested in the corporation under the Delaware General Corporation Law. (b) Other Officers Employees and Other Agents. The corporation shall ----------------------------------------- have power to indemnify its other officers, employees and other agents as set forth in the Delaware General Corporation Law. (c) Good Faith. (i) For purposes of any determination under this ---------- Bylaw, a Director or executive officer shall be deemed to have acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, to have had no reasonable cause to believe that his conduct was unlawful, if his action is based on information, opinions, reports and statements, including financial statements and other financial data, in each case prepared or presented by: (A) one or more officers or employees of the corporation whom the Director or executive officer believed to be reliable and competent in the matters presented; 14. (B) counsel, independent accountants or other persons as to matters which the Director or executive officer believed to be within such person's professional competence; and (C) with respect to a Director, a committee of the Board upon which such Director does not serve, as to matters within such committee's designated authority, which committee the Director believes to merit confidence; so long as, in each case, the Director or executive officer acts without knowledge that would cause such reliance to be unwarranted. (ii) The termination of any proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere or its equivalent shall not, of itself, create a presumption that the person did not act in good faith and in a manner which he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal proceeding, that he had reasonable cause to believe that his conduct was unlawful. (iii) The provisions of this paragraph (c) shall not be deemed to be exclusive or to limit in any way the circumstances in which a person may be deemed to have met the applicable standard of conduct set forth by the Delaware General Corporation Law. (d) Expenses. The corporation shall advance, prior to the final -------- disposition of any proceeding, promptly following request therefor, all expenses incurred by any Director or executive officer in connection with such proceeding upon receipt of an undertaking by or on behalf of such person to repay said amounts if it should be determined ultimately that such person is not entitled to be indemnified under this Bylaw or otherwise. Notwithstanding the foregoing, unless otherwise determined pursuant to paragraph (e) of this Bylaw, no advance shall be made by the corporation if a determination is reasonably and promptly made (1) by the Board of Directors by a majority vote of a quorum consisting of Directors who were not parties to the proceeding, or (2) if such quorum is not obtainable, or, even if obtainable, a quorum of disinterested directors so directs, by independent legal counsel in a written opinion, that the facts known to the decision making party at the time such determination is-made demonstrate clearly and convincingly that such person acted in bad faith or in a manner that such person did not believe to be in or not opposed to the best interests of the corporation. (e) Enforcement. Without the necessity of entering into an express ----------- contract, all rights to indemnification and advances to Directors and executive officers under this Bylaw shall be deemed to be contractual rights and be effective to the same extent and as if provided for in a contract between the corporation and the Director or executive officer. Any right to indemnification or advances granted by this Bylaw to a Director or executive officer shall be enforceable by or on behalf of the person holding such right in any court of competent jurisdiction if (i) the claim for indemnification or advances is denied, in whole or in part, or (ii) no disposition of such claim is made within ninety (90) days of request therefor. The claimant in such enforcement action, if successful in whole or in part, shall be entitled to be paid also the expense of prosecuting his claim. The corporation shall be entitled to raise as a defense to any 15. such action that the claimant has not met the standards of conduct that make it permissible under the Delaware General Corporation Law for the corporation to indemnify the claimant for the amount claimed. Neither the failure of the corporation (including its Board of Directors, independent legal counsel or its stockholders) to have made a determination prior to the commencement of such action that indemnification of the claimant is proper in the circumstances because he has met the applicable standard of conduct set forth in the Delaware General Corporation Law, nor an actual determination by the corporation (including its Board of Directors, independent legal counsel or its stockholders) that the claimant has not met such applicable standard of conduct, shall be a defense to the action or create a presumption that claimant has not met the applicable standard of conduct. (f) Non-Exclusivity of Rights. The rights conferred on any person by ------------------------- this bylaw shall not be exclusive of any other right which such person may have or hereafter acquire under any statute, provision of the Certificate of Incorporation, Bylaws, agreement, vote of stockholders or disinterested Directors or otherwise, both as to action in his official capacity and as to action in another capacity while holding office. The corporation is specifically authorized to enter into individual contracts with any or all of its Directors, officers, employees or agents respecting indemnification and advances, to the fullest extent not prohibited by the Delaware General Corporation Law. (g) Survival of Rights. The rights conferred on any person by this ------------------ Bylaw shall continue as to a person who has ceased to be a Director, officer, employee or other agent and shall inure to the benefit of the heirs, executors and administrators of such a person. (h) Insurance. To the fullest extent permitted by the Delaware --------- General Corporation Law, the corporation, upon approval by the Board of Directors, may purchase insurance on behalf of any person required or permitted to be indemnified pursuant to this Bylaw. (i) Amendments. Any repeal or modification of this Bylaw shall only ---------- be prospective and shall not affect the rights under this Bylaw in effect at the time of the alleged occurrence of any action or omission to act that is the cause of any proceeding against any agent of the corporation. (j) Saving Clause. If this Bylaw or any portion hereof shall be ------------- invalidated on any grounds by any court of competent jurisdiction, then the corporation shall nevertheless indemnify each Director and executive officer to the full extent not prohibited by any applicable portion of this Bylaw that shall not have been invalidated, or by any other applicable law. (k) Certain Definitions. For the purposes of this Bylaw, the ------------------- following definitions shall apply: (i) The term "proceeding" shall be broadly construed and shall include, without limitation, the investigation, preparation, prosecution, defense, settlement, arbitration and appeal of, and the giving of testimony in, any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative. 16. (ii) The term "expenses" shall be broadly construed and shall include, without limitation, court costs, attorneys' fees, witness fees, fines, amounts paid in settlement or judgment and any other costs and expenses of any nature or kind incurred in connection with any proceeding. (iii) The term the "corporation" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers, and employees or agents, so that any person who is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under the provisions of this Bylaw with respect to the resulting or surviving corporation as he would have with respect to such constituent corporation if its separate existence had continued. (iv) References to a "director," "officer," "employee," or "agent" of the corporation shall include, without limitation, situations where such person is serving at the request of the corporation as a director, officer, employee, trustee or agent of another corporation, partnership, joint venture, trust or other enterprise. (v) References to "other enterprises" shall include employee benefit plans; references to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to serving at the request of the corporation" shall include any service as a director, officer, employee or agent of the corporation which imposes duties on, or involves services by, such director, officer, employee, or agent with respect to an employee benefit plan, its participants, or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "not opposed to the best interests of the corporation" as referred to in this Bylaw. ARTICLE XII Notices ------- Section 43. Notices. ------- (a) Notice to Stockholders. Whenever, under any provisions of these ---------------------- Bylaws, notice is required to be given to any stockholder, it shall be given in writing, timely and duly deposited in the United States mail, postage prepaid, and addressed to his last known post office address as shown by the stock record of the corporation or its transfer agent. [Del. Code Ann., tit. 8, (S)222] 17. (b) Notice to Directors. Any notice required to be given to any ------------------- Director may be given by the method stated in subsection (a), or by facsimile, telex or telegram, except that such notice other than one which is delivered personally shall be sent to such address as such Director shall have filed in writing with the Secretary, or, in the absence of such filing, to the last known post office address of such Director. (c) Address Unknown. If no address of a stockholder or Director be --------------- known, notice may be sent to the office of the corporation required to be maintained pursuant to Section 2 hereof. (d) Affidavit of Mailing. An affidavit of mailing, executed by a duly -------------------- authorized and competent employee of the corporation or its transfer agent appointed with respect to the class of stock affected, specifying the name and address or the names and addresses of the stockholder or stockholders, or Director or Directors, to whom any such notice or notices was or were given, and the time and method of giving the same shall be conclusive evidence of the statements therein contained. [Del. Code Ann., tit. 8, (S)222] (e) Time Notices Deemed Given. All notices given by mail, as above ------------------------- provided, shall be deemed to have been given as at the time of mailing and all notices given by facsimile, telex or telegram shall be deemed to have been given as of the sending time recorded at time of transmission. (f) Methods of Notice. It shall not be necessary that the same method ----------------- of giving notice be employed in respect of all Directors, but one permissible method may be employed in respect of any one or more, and any other permissible method or methods may be employed in respect of any other or others. (g) Failure to Receive Notice. The period or limitation of time ------------------------- within which any stockholder may exercise any option or right, or enjoy any privilege or benefit, or be required to act, or within which any Director may exercise any power or right, or enjoy any privilege, pursuant to any notice sent him in the manner above provided, shall not be affected or extended in any manner by the failure of such stockholder or such Director to receive such notice. (h) Notice to Person with Whom Communication Is Unlawful. Whenever ---------------------------------------------------- notice is required to be given, under any provision of law or of the Certificate of Incorporation or Bylaws of the corporation, to any person with whom communication is unlawful, the giving of such notice to such person shall not be required and there shall be no duty to apply to any governmental authority or agency for a license or permit to give such notice to such person. Any action or meeting which shall be taken or held without notice to any such person with whom communication is unlawful shall have the same force and effect as if such notice had been duly given. In the event that the action taken by the corporation is such as to require the filing of a certificate under any provision of the Delaware General Corporation Law, the certificate shall state, if such is the fact and if notice is required, that notice was given to all persons entitled to receive notice except such persons with whom communication is unlawful. 18. (i) Notice to Person with Undeliverable Address. Whenever notice is ------------------------------------------- required to be given, under any provision of law or the Certificate of Incorporation or Bylaws of the corporation, to any stockholder to whom (i) notice of two consecutive annual meetings, and all notices of meetings or of the taking of action by written consent without a meeting to such person during the period between such two consecutive annual meetings, or (ii) all, and at least two, payments (if sent by first class mail) of dividends or interest on securities during a twelve (12) month period have been mailed addressed to such person at his address as shown on the records of the corporation and have been returned undeliverable, the giving of such notice to such person shall not be required. Any action or meeting which shall be taken or held without notice to such person shall have the same force and effect as if such notice had been duly given. If any such person shall deliver to the corporation a written notice setting forth his then current address, the requirement that notice be given to such person shall be reinstated. In the event that the action taken by the corporation is such as to require the filing of a certificate under any provision of the Delaware General Corporation Law, the certificate need not state that notice was not given to persons to whom notice was not required to be given pursuant to this paragraph. [Del. Code Ann., tit. 8, (S)230] ARTICLE XIII Amendments ---------- Section 44. Amendments. Except as otherwise set forth in paragraph ---------- (i) of Section 42 of these Bylaws, these Bylaws may be amended or repealed and new Bylaws adopted by the stockholders entitled to vote. The Board of Directors shall also have the power, if such power is conferred upon the Board of Directors by the Certificate of Incorporation, to adopt, amend or repeal Bylaws (including, without limitation, the amendment of any Bylaw setting forth the number of Directors who shall constitute the whole Board of Directors). [Del. Code Ann., tit. 8, (S)(S)109(a), 122 (6)] ARTICLE XIV Loans to Officers ----------------- Section 45. Loans to Officers. The corporation may lend money to, or ----------------- guarantee any obligation of, or otherwise assist any officer or other employee of the corporation or of its subsidiaries, including any officer or employee who is a Director of the corporation or its subsidiaries, whenever, in the judgment of the Board of Directors, such loan, guarantee or assistance may reasonably be expected to benefit the corporation. The loan, guarantee or other assistance may be with or without interest and may be unsecured, or secured in such manner as the Board of Directors shall approve, including, without limitation, a pledge of shares of stock of the corporation. Nothing in this Section 45 shall be deemed to deny, limit or restrict the powers of guaranty or warranty of the corporation at common law or under any statute. [Del. Code Ann., tit. 8, (S)143] 19. ARTICLE XV Miscellaneous ------------- Section 46. Annual Report. (a) Subject to the provisions of Section ------------- 46(b) below, the Board of Directors shall cause an annual report to be sent to each stockholder of the corporation not later than one hundred twenty (120) days after the close of the corporation's fiscal year. Such report shall include a balance sheet as of the end of such fiscal year and an income statement and statement of changes in financial position for such fiscal year, accompanied by any report thereon of independent accountants or, if there is no such report, the certificate of an authorized officer of the corporation that such statements were prepared without audit from the books and records of the corporation. Such report shall be sent to stockholders at least fifteen (15) days prior to the next annual meeting of stockholders after the end of the fiscal year to which it relates. (b) If and so long as there are fewer than 100 holders of record of the corporation's share, the requirement of sending of an annual report to the stockholders of the corporation is hereby expressly waived. 20. EX-10.6 3 PROMISSORY NOTE ISSUED BY CORTELCO Exhibit 10.6 PROMISSORY NOTE --------------- Principal amount: $2,600,000 Date: May 28, 1999 For value received, CORTELCO SYSTEMS HOLDING CORP., a Delaware corporation ("Borrower"), hereby promises to pay to BCS TECHNOLOGIES, INC. or its assigns ("Holder") in immediately available funds, the principal sum of $2,600,000 (the "Loan") with interest on the unpaid principal balance of this note (the "Note") at the rate set forth below, from the date of this Note until this Note is paid in full. 1. Principal Repayment. The outstanding principal amount of the Loan -------------------- shall be due and payable on demand after September 15, 1999. Each payment shall be credited first to accrued interest, then to unpaid principal, and interest shall then cease on the portion of principal credited. All payments shall be made in lawful money of the United States of America, without offset, deduction or counterclaim of any kind. 2. Interest Rate. Borrower further promises to pay interest in the -------------- outstanding principal amount hereof from the date hereof until payment in full, which interest shall be payable at the rate per annum equal to the prime rate plus one and one-half percent (prime + 1.5%). Accrued interest shall be computed on the basis of a 365-day year, based on the actual number of days elapsed. 3. Place of Payment. All amounts payable hereunder shall be payable at ----------------- the office of Holder, 8400 E. Prentice Avenue #1320, Englewood, Colorado, or such other place as Holder may from time to time designate in writing. 4. Prepayment. Borrower may prepay this Note, in whole or part, on any ----------- date, without premium or penalty. Any partial payment shall be credited first to accrued interest, and thereafter to the outstanding principal balance hereof. Prepayments shall then be applied to the next principal payment that becomes due. 5. Default. In the event of default hereunder, Borrower shall pay all -------- reasonable attorneys' fees and court costs incurred by Holder in enforcing and collecting this Note. 6. Successors and Assigns. This Note shall inure to the benefit of and be ----------------------- enforceable by Holder, its successors and assigns, and shall be binding upon and enforceable against Borrower and its successors and assigns, provided that neither party shall have the right to assign any rights or obligations hereunder without the express written consent of the other. 7. Waiver; Representations. Presentment for payment, demand, notice of ------------------------ dishonor, protest, notice of protest, stay of execution and all other defenses to payment generally and notices in connection with the deliver, acceptance, performance, default or enforcement of the payment of this Note are hereby waived by Borrower and its successors and assigns. 8. Waivers and Amendments. Neither this Note nor any provision hereof ----------------------- may be changed, waived, discharged, terminated, modified or amended except upon the written consent of Borrower and Holder. 9. Headings. The headings of the various sections of this Note have been --------- inserted for convenience of reference only and shall not be deemed to be part of this Note. 10. Governing Law. This Note shall be governed by and construed in ------------- accordance with the laws of the State of Colorado. 11. Entire Agreement. This Note constitutes the full and entire ----------------- understanding and agreement between the parties with regard to the subjects hereof and thereof. 12. Payment of Fees and Expenses. If any action at law or in equity is ----------------------------- necessary to enforce or interpret the terms of this Note, the prevailing party shall be entitled to reasonable attorneys' fees, costs and necessary disbursements in addition to any other relief to which such party may be entitled. 1 IN WITNESS WHEREOF, Borrower has caused this Note to be duly executed and delivered as of the date first written above. Borrower: Cortelco Systems Holding Corp. By: /s/ Stephen R. Bowling __________________________________________ Stephen R. Bowling President Agreed to and accepted: Holder: BCS Technologies, Inc. By: /s/ David M. Fredick __________________________________________ David M. Fredrick VP & General Manager of ACD Operations EX-11.1 4 COMPUTATION OF NET LOSS PER SHARE EXHIBIT 11.1 CORTELCO SYSTEMS, INC. STATEMENT REGARDING COMPUTATION OF NET LOSS PER SHARE
------------------------------ 1996 1997 1998 ------------------------------ In thousands, except per share data Basic: Income available to common shareholders......... $ (275) $(2,039) $ (133) Weighted average share outstanding.............. 3,825 3,825 3,918 ------- -------- ------- Basic loss per share............................ $(0.07) $ (0.53) $(0.03) ------- -------- ------- Diluted: Income available to common shareholders......... $ (275) $(2,039) $ (133) Interest on convertible debt.................... 55 ------- -------- ------- Income available after assumed conversion....... (275) (2,039) (78) Weighted average shares--basic.................. 3,825 3,825 3,918 Assumed conversion of convertible debt 1,435 ------- -------- ------- Weighted average shares--diluted................ 3,825 3,825 5,353 ------- -------- ------- Diluted loss per share.......................... $(0.07) $ (0.53) $(0,02) ======= ======== =======
EX-21.1 5 LIST OF SUBSIDIARIES Exhibit 21.1 List of Subsidiaries
State or Jurisdiction Entity Name of Incorporation - ----------- --------------------- BCS Technologies, Inc. Delaware Cortelco Systems Puerto Rico, Inc. Puerto Rico
EX-23.1 6 CONSENT OF DELOITTE & TOUCHE LLP Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULE To the Board of Directors and Stockholders of Cortelco Systems, Inc. We consent to the use in this Registration Statement of Cortelco Systems, Inc. on Form S-1 of our report dated April 9, 1999, appearing in the Prospectus, which is a part of this Registration Statement, and to the reference to us under the headings "Selected Financial Data" and "Experts" in such Prospectus. Our audits of the financial statements referred to in our aforementioned report also included the consolidated financial statement schedule of Cortelco Systems, Inc. and subsidiaries, listed in Item 16(b). This financial statement schedule is the responsibility of Cortelco Systems, Inc.'s management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche LLP /s/ Deloitte & Touche LLP Memphis, Tennessee June 10, 1999 EX-23.2 7 CONSENT OF PRICEWATERHOUSECOOPERS LLP Exhibit 23.2 Consent of Independent Accountants We hereby consent to the use in the Prospectus constituting part of this Registration Statement on Form S-1 of our report dated September 17, 1996, relating to the financial statements of Cortelco Puerto Rico, Inc. which appears in such Prospectus. /s/ PricewaterhouseCoopers LLP PRICEWATERHOUSECOOPERS LLP San Juan, Puerto Rico June 9, 1999 EX-23.3 8 CONSENT OF BROCK AND COMPANY EXHIBIT 23.3 INDEPENDENT AUDITOR'S CONSENT - ----------------------------- We consent to the use in this Registration Statement of Cortelco Systems, Inc. on Form S-1 of our report on the financial statements of BCS Technologies, Inc., dated March 5, 1999, appearing in the Prospectus, which is part of this Registration Statement. We also consent to the reference to us under the headings "Experts" in such Prospectus. /s/ BROCK AND COMPANY, CPAs, P.C. ------------------------------------------- BROCK AND COMPANY, CPAs, P.C. Certified Public Accountants Littleton, Colorado June 11, 1999 EX-27.1 9 FINANCIAL DATA SCHEDULE
5 1,000 YEAR 9-MOS JUL-31-1998 APR-30-1999 AUG-01-1997 AUG-01-1998 JUL-31-1998 APR-30-1999 126 1,822 0 0 8,989 12,319 (1,880) (1,453) 6,256 7,597 14,712 21,072 1,317 1,116 0 0 17,835 35,006 12,383 15,890 0 0 0 0 0 0 (1,122) 16,614 0 0 17,835 35,006 30,949 27,626 30,949 27,626 18,504 15,837 11,452 10,312 246 108 0 0 826 584 (79) 785 0 81 0 704 0 0 0 0 (54) (6) (133) (698) (0.03) 0.17 (0.03) 0.13
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