10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
****
FORM 10-Q
****

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended May 31, 2003.

o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
For the transition period from       to      .

Commission File Number 0-10078

HEI, Inc.
(Exact name of Registrant as Specified in Its Charter)

Minnesota	41-0944876
(State or other jurisdiction	(I.R.S. Employer Identification No.)
of incorporation or organization)
1495 Steiger Lake Lane, Victoria, Minnesota	55386
(Address of principal executive offices)	(Zip Code)

(952) 443-2500
Registrant’s telephone number, including area code

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No    .

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes     No X

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: as of July 15, 2003, 7,045,791 shares of common stock, par value $.05.

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION
	Item 1. Financial Statements
		Consolidated Balance Sheets
		Consolidated Statements of Operations
		Consolidated Statements of Cash Flows
		Notes to Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II — OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
	Signatures
	Certifications
EX-10.1 Accounts Receivable Agreement
EX-10.2 Letter Re: Subordinated Promissory Note
EX-99.1 Section 906 Certification of CEO
EX-99.2 Section 906 Certification of CFO

Table of Contents			HEI, Inc.
Part I — Financial Information (unaudited)
	Item 1.	Financial Statements
		Consolidated Balance Sheets	3
		Consolidated Statements of Operations	4
		Consolidated Statements of Cash Flows	5
		Notes to Consolidated Financial Statements	6-13
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14-22
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
	Item 4.	Controls and Procedures	24
Part II — Other Information
	Item 1.	Legal Proceedings	24
	Item 6.	Exhibits and Reports on Form 8-K	24
	Signature		25
	Certifications		26-27

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

HEI, Inc.
Consolidated Balance Sheets (Unaudited)

(In thousands)
			May 31, 2003			August 31, 2002
Assets
Current assets:
	Cash and cash equivalents		$	27		$	2,372
	Restricted cash			—			1,000
	Accounts receivable, net			6,336			3,533
	Inventories, net			6,262			4,027
	Other current assets			410			383
Total current assets				13,035			11,315
Property and equipment:
	Land			216			216
	Building and improvements			4,316			4,316
	Fixtures and equipment			23,383			21,259
	Accumulated depreciation			(16,487	)		(14,439	)
Net property and equipment				11,428			11,352
Developed technology, net				521			—
Security deposits				1,580			—
Other long-term assets				294			322
Total assets			$	26,858		$	22,989
Liabilities and Shareholders’ Equity
Current liabilities:
	Revolving line of credit		$	—		$	1,589
	Current maturities of long-term debt			227			2,441
	Accounts payable			4,629			1,815
	Warranty reserve			416			200
	Accrued liabilities			2,146			901
Total current liabilities				7,418			6,946
Other long-term liabilities, less current maturities:
		Other long-term liabilities		2,703			—
		Long-term debt		2,729			1,473
Total other long-term liabilities, less current maturities				5,432			1,473
Total liabilities				12,850			8,419
Shareholders’ equity:
	Undesignated stock; 5,000 shares authorized; none issued			—			—
	Common stock, $.05 par; 10,000 shares authorized; 7,012 and 6,012 shares issued and outstanding			405			301
	Paid-in capital			18,899			16,349
	Accumulated deficit			(4,616	)		(814	)
	Notes receivable			(680	)		(1,266	)
Total shareholders’ equity				14,008			14,570
Total liabilities and shareholders’ equity			$	26,858		$	22,989

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.
Consolidated Statements of Operations (Unaudited)
(In thousands, except per share amounts)

				Three Months Ended						Nine Months Ended
				May 31, 2003			June 1, 2002			May 31, 2003			June 1, 2002
Net sales				$	12,517		$	8,500		$	26,151		$	22,424
Cost of sales					9,983			6,346			22,143			18,346
		Gross profit			2,534			2,154			4,008			4,078
Operating expenses:
		Selling, general and administrative			2,178			1,369			5,047			3,976
		Research, development and engineering			745			579			1,832			1,945
		Operating loss			(389	)		206			(2,871	)		(1,843	)
Other expenses:
		Former officer note write off			(681	)		—			(681	)		—
		Bank fees			(165	)		(8	)		(181	)		(29	)
		Other expense, net			(78	)		(19	)		(90	)		(80	)
	Income (loss) before income taxes				(1,313	)		179			(3,823	)		(1,952	)
Income tax benefit (expense)					2			(64	)		21			663
		Net Income (loss)			($1,311	)	$	115			($3,802	)		($1,289	)
Net Income (loss) per common share:
		Basic			($0.19	)	$	0.02			($0.59	)		($0.22	)
		Diluted			($0.19	)	$	0.02			($0.59	)		($0.22	)
Weighted average common shares outstanding:
			Basic		7,029			5,999			6,488			5,985
			Diluted		7,029			6,032			6,488			5,985

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.
Consolidated Statements of Cash Flows (Unaudited)
(In thousands)

		Nine Months Ended
		May 31, 2003			June 1, 2002
Cash flow from operating activities:
	Net loss		($3,802	)		($1,289	)
	Depreciation and amortization		2,256			2,155
	Deferred income tax benefit		—			(395	)
	Allowance for note receivable		587			—
Changes in operating assets and liabilities, net of affects of acquisition:
	Accounts receivable		(2,503	)		512
	Inventories		619			319
	Other current assets		83			(326	)
	Other assets		64			97
	Accounts payable		2,517			(160	)
	Accrued liabilities		(152	)		(216	)
Net cash flow provided by (used for) operating activities			(331	)		697
Cash flow from investing activities:
	Additions to property and equipment		(224	)		(2,200	)
	Additions to patents		(89	)		(87	)
	AMD acquisition costs paid		(1,198	)		—
	Cash acquired from CMED		1,215			—
Net cash flow used for investing activities			(296	)		(2,287	)
Cash flow from financing activities:
	Issuance of common stock		54			265
	Proceeds from long-term debt		204			—
	Promissory note payable		2,600			—
	Repayment of long-term debt		(3,895	)		(1,313	)
	Deferred financing costs		(92	)		(25	)
	Restricted cash		1,000			—
	Net borrowings (repayments) on revolving line of credit		(1,589	)		1,745
Net cash flow provided by (used for) financing activities			(1,718	)		672
Net decrease in cash and cash equivalents			(2,345	)		(918	)
Cash and cash equivalents, beginning of period			2,372			4,393
Cash and cash equivalents, end of period		$	27		$	3,475
Supplemental disclosures of cash flow information:
Interest paid		$	224		$	262
Income taxes received			(21	)		(268	)
Supplemental disclosures of non-cash investing and financing activities:
As more fully described in Note # 1 and 15, the Company issued 1,000,000 shares of its common stock valued at $2,600 in connection with the AMD acquisition.

See accompanying notes to unaudited consolidated financial statements.

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share amounts)

(1) Basis of Financial Statement Presentation

The accompanying unaudited interim consolidated financial statements have been prepared by HEI, Inc. pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These financial statements contain all normal recurring adjustments, which are, in our opinion, necessary for a fair presentation of the financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. We believe, however, that the disclosures are adequate to make the information presented not misleading. The year-end balance sheet data was derived from audited financial statements but does not include all disclosures required by GAAP. These unaudited interim consolidated financial statements should be read in conjunction with the financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2002, as amended by Amendment No. 1, filed with the SEC on December 20, 2002, and Amendment No. 2, filed with the SEC on January 7, 2003. Interim results of operations for the three- and nine-month periods ended May 31, 2003, may not necessarily be indicative of the results to be expected for the full year.

The unaudited interim consolidated financial statements include our acquisition on January 24, 2003, of certain assets and liabilities of Colorado MEDtech, Inc.’s (“CMED”) Colorado Operations (a business unit of CMED) or Advanced Medical Division (“AMD”), in a business combination accounted for as a purchase. The accompanying unaudited interim consolidated financial statements have been prepared on the basis of assumptions discussed in Note 15, including a preliminary allocation of the consideration paid for the assets and liabilities of AMD based on valuations of its fair value.

The unaudited interim consolidated financial statements include our accounts and the accounts of our wholly owned subsidiary. All significant intercompany transactions and balances have been eliminated in consolidation.

Our quarterly periods end on the Saturday closest to the end of each quarter of our fiscal year ending August 31.

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(2) Stock Based Compensation

We apply the intrinsic-value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for the issuance of stock incentives to employees and directors. No compensation expense related to employees’ and directors’ stock incentives has been recognized in the financial statements, as all options granted under stock incentive plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had we applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123, “Accounting for Stock-Based Compensation,” to stock based employee compensation, our net loss per share would have increased to the pro forma amounts indicated below:

	Three Months Ended						Nine Months Ended
	May 31, 2003			June 1, 2002			May 31, 2003			June 1, 2002
Net income (loss)	$	(1,311	)	$	115		$	(3,802	)	$	(1,289	)
Deduct: Total stock-based employee compensation income (expense) determined under fair value based method for all awards		(461	)		(344	)		(1,351	)		(1,058	)
Net income (loss) pro forma	$	(1,772	)	$	(229	)	$	(5,153	)	$	(2,347	)
Basic and diluted net Income (loss) per share as reported		(0.19	)		0.02			(0.59	)		(0.22	)
Stock-based compensation income (expense)		(0.06	)		(0.06	)		(0.20	)		(0.17	)
Basic and diluted net income (loss) per share pro forma	$	(0.25	)	$	(0.04	)	$	(0.79	)	$	(0.39	)

There were 145,000 options granted under our stock option plans during the three-months ended May 31, 2003.

(3) Inventories

Inventories are stated at the lower of cost, using the average cost method, or market and include materials, labor and overhead costs. Inventories consist of the following:

	May 31,		August 31,
	2003		2002
Purchased parts	$	3,899	$	1,944
Work in process		748		597
Finished goods		1,615		1,486
Total inventories	$	6,262	$	4,027

(4) Deferred Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The significant components of our deferred tax assets and liabilities consist of timing differences related to allowance for doubtful accounts, depreciation, reserves for excess and obsolete inventory, accrued warranty reserves, and the future benefit associated with Federal and state net operating loss carryforwards. A valuation allowance has been set at approximately $4,800 and $3,400, at May 31, 2003, and August 31, 2002, respectively, because of uncertainties related to the ability to utilize certain Federal and state net loss carryforwards as determined in accordance with GAAP. The valuation allowance is based on estimates of taxable income by jurisdiction and the period over which our deferred tax assets are recoverable.

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(5) Accrued Liabilities

	May 31,		August 31,
	2003		2002
Accrued employee related costs	$	499	$	655
Contractual manufacturing obligations		600		—
Customer deposits		407		—
Current portion of long-term liabilities		80		—
Other accrued liabilities		560		246
Total accrued liabilities	$	2,146	$	901

(6) Long-Term Debt

Our long-term debt consists of the following:

	May 31,		August 31,
	2003		2002
Subordinated promissory note	$	2,708	$	—
Industrial development revenue bonds		—		1,735
Commercial loan		248		104
Capital expenditure note		—		2,075
Total		2,956		3,914
Less current maturities		227		2,441
Total long-term debt	$	2,729	$	1,473

In April 1996, we issued Industrial Development Revenue Bonds (“IDRBs”) in connection with the construction of a new addition to our manufacturing facility in Victoria, Minnesota, and the purchase of production equipment. On March 14, 2003, an aggregate of approximately $1,735 of the debt proceeds from the Subordinated Promissory Note (as defined below) was used to repay the outstanding principal and interest on the IDRBs.

In connection with the purchase of AMD, we issued a Subordinated Promissory Note to CMED in the principal amount of $2,628 (the “Subordinated Promissory Note”). The terms of the Subordinated Promissory Note include an interest rate of 10% (increasing to 12% and 14% in July 2003 and January 2004, respectively) and a due date for all principal and interest on September 30, 2004. There are no prepayment penalties associated with this Subordinated Promissory Note. We also recorded a net $132 premium on the Subordinated Promissory Note, reflecting the difference between existing market rates of interest and the Subordinated Promissory Note interest rate.

On May 8, 2003, the Subordinated Promissory Note was sold by CMED to Whitebox Hedged High Yield Partners (“Whitebox”) for $1,820.

We used the proceeds from the Subordinated Promissory Note to retire our remaining indebtedness including our IDRBs and capital expenditure notes with LaSalle Business Credit LLC. The Subordinated Promissory Note continues with the same terms as the original agreement with CMED until August 15, 2003. To encourage early repayment, the terms of the Subordinated Promissory Note were modified on May 16, 2003 on the Subordinated Promissory Note; Whitebox will discount the face value of the Subordinated Promissory Note by $410 if paid by July 15, 2003, or $390 if paid by August 15, 2003. The principal prepayment would include all accrued interest through the payment date. In the event that we do not prepay the Subordinated Promissory Note in full by August 8, 2003, the following terms and conditions will apply to the ongoing obligation:

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• We will grant a first priority mortgage on our facility in Victoria, Minnesota.

• Accrued and unpaid interest will be capitalized as part of the Subordinated Promissory Note.

• We will issue 400,000 warrants that are exercisable over the next five years at an exercise price of 10% above the closing price of our common stock at August 15, 2003, as a form of prepayment of interest through September 30, 2004.

• At our option, we will have the right to extend the Subordinated Promissory Note to March 31, 2005, at a 12% annual rate.

• We will retain the right to prepay the Subordinated Promissory Note at any time without premium or penalty.

There was no accounting consequence from the modification of the Subordinated Promissory Note.

On May 29, 2003, we entered into an Accounts Receivable Agreement (the “Credit Agreement”) with Beacon Bank of Shorewood, Minnesota for a period of twelve months. The Credit Agreement is an accounts receivables backed facility and has inventory, intellectual property and other general intangibles as additional collateral. The Credit Agreement replaced our revolving line of credit with LaSalle Business Credit, LLC and is not subject to any restrictive financial covenants. We have a maximum of $3,000 available under the Credit Agreement, with the actual lending amount based on accounts receivable invoice factoring. As of May 31, 2003, there were no borrowings under the Credit Agreement. Effective May 29, 2003, the Credit Agreement bears a immediate processing fee of 0.50% of each assigned amount, a per diem equal to 1/25% on any assigned amount that remains uncollected and a monthly minimum of $1.5 in processing fees for the first six months the Credit Agreement is in place. The effected interest rate based on our average DSO of 43 days would be 18.6% annualized.

(7) Other long-term liabilities

	May 31,		August 31,
	2003		2002
Remaining lease obligation less estimated sublease proceeds	$	2,010	$	—
Unfavorable operating lease, net		773		—
Total		2,783		—
Less current maturities		80		—
Total long-term liabilities	$	2,703	$	—

The allocation of the purchase price for AMD included $2,010 for future estimated lease payments ($5,910 for future lease obligations less estimated sublease payments of $3,900 on excess manufacturing capacity for which we are in the process of reviewing alternative uses) and a net accrual of $773 related to an unfavorable operating lease.

(8) Net Income (Loss) Per Weighted Average Common Share

Basic income loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted income (losses) per share are computed by dividing net income (loss) by the weighted average number of common shares outstanding assuming the exercise of dilutive stock options. The dilutive effect of stock options is computed using the average market price per share during each period

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under the treasury stock method. In periods where losses have occurred, options are considered anti-dilutive and have not been included in the diluted loss per share calculations.

	Three Months Ended				Nine Months Ended
	May 31, 2003		June 1, 2002		May 31, 2003		June 1, 2002
Basic common shares		7,029		5,999		6,488		5,985
Dilutive effect of stock options and warrants		—		33		—		—
Fully diluted shares		7,029		6,032		6,488		5,985

(9) Workforce Reductions

With the continued sluggish economy in all markets, revenues continue to be unpredictable and unstable, although we noted some improvement in this third quarter. In our continued effort to size our cost structure with anticipated revenues, we reduced our workforce by 28 employees at the end of the first quarter of fiscal 2003, an additional 15 employees in the second quarter and 18 employees were reduced at our AMD Colorado division in the third quarter of 2003, for a total of 61 positions and accumulated savings of $737 during the first three quarters of fiscal 2003. Annualized wages and salaries for the 61 positions that were eliminated was $2,853. The breakdown by employee category (with annualized wages and salaries in parentheses) was: 25 direct labor ($670), 17 manufacturing ($783), 11 engineering ($703), and 8 administrative positions ($697). The amount of savings from workforce reductions are affected by the timing of reductions within the quarter and the amount of associated severance cost. A total of $184 in severance costs was paid during the first nine months of fiscal 2003. Substantially all of the severance charges were paid in the same period the charges were recorded.

We continue to evaluate further reductions along with other cost containment measures as revenues fluctuate. At the same time, we seek to balance our ongoing development of new products, increased sales and marketing focus, and to maintain our ability to react quickly to favorable market demands and opportunities. In addition, these costs savings will not be realized in their entirety if increased production demand requires the hiring of additional personnel.

(10) Intangible Assets

Information regarding intangible assets acquired in the AMD transaction follows:

	May 31, 2003						August 31, 2002
	Carrying		Accumulated				Carrying		Accumulated
	Value		Amortization		Net		Value		Amortization		Net
Developed technology	$	584	$	63	$	521	$	—	$	—	$	—

Amortization expense for years ending August 31, 2003, 2004, 2005, 2006 and 2007 will be $111, $190, $190, $87, and $6, respectively.

(11) Warranty Guarantees

Sales of our products are subject to limited warranty guarantees. Product guarantees typically extend for a period of twelve months from the date of manufacture. Warranty terms are included in customer contracts under which we are obligated to repair or replace any components or assemblies it deems defective due to workmanship or materials. We do, however, reserve the right to reject warranty claims where we determine that failure is due to normal wear, customer modifications, improper maintenance, or misuse. Warranty provisions are based on an estimated returns and warranty expenses applied to current period revenue and historical warranty incidence over the preceding twelve-month period. Both the experience and the warranty liability are evaluated on an ongoing basis for adequacy. Warranty provisions and claims for the nine-month period ended May 31, 2003, are as follows:

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August 31, 2002	$	200
Balance assumed from AMD acquisition		376
Provisions		—
Claims		(160	)
May 31, 2003	$	416

(12) Significant Customers

The table below sets forth the approximate percentage of net sales to major customers that represented over 10% of our revenue.

	Three Months Ended						Nine Months Ended
	May 31, 2003			June 1, 2002			May 31, 2003			June 1, 2002
Customer A		14.9	%		30.4	%		19.2	%		29.3	%
Customer B		20.4	%		—			14.2	%		—
Customer C		9.4	%		29.4	%		13.9	%		37.3	%
Total		44.7	%		59.8	%		47.3	%		66.6	%

Customer A has verbally advised us that it intends to discontinue a significant program with us in order to place it offshore. This program discontinuance will reduce but not eliminate sales stream from this customer.

Accounts receivable from these customers represented 34% and 50%, respectively, of the total accounts receivable at May 31, 2003, and August 31, 2002, respectively.

(13) Note Receivable

The outstanding Directors and Officers loans dated April 2, 2001, as amended on July 17, 2002, in the aggregate amount of $1,266, required an interest only payment to be made to us on April 2, 2003. All interest only payments were made, except that Mr. Anthony Fant, a current director and our former Chairman of the Board, Chief Executive Officer and President, failed to make his payment of approximately $10. As of July 15, 2003, Mr. Fant has not paid the interest payment and remains in default. Despite repeated requests, Mr. Fant has failed to provide any financial information that is necessary in order for us to determine the collectibility of his debt. Due to the lack of cooperation from Mr. Fant and his unknown financial position, we have fully reserved in our third quarter ending May 31, 2003 all amounts due from Mr. Fant in the amount of $681. This amount is reflected in the Other Expenses of our Unaudited Consolidated Statements of Operations.

(14) Litigation

Subsequent to the end of our third quarter, on June 30, 2003, we commenced litigation against Mr. Fant in the State of Minnesota, Hennepin County District Court, Fourth Judicial District. The complaint alleges breach of contract, conversion, breach of fiduciary duty, unjust enrichment and corporate waste resulting from, among other things, Mr. Fant’s default on his promissory note to us and other loans from us in the total amount of approximately $681, and certain other matters. In the lawsuit, we are seeking recovery of all amounts owed to us on the promissory note and the other loans, certain expenses incurred by us on behalf of Mr. Fant, and litigation costs and expenses.

(15) Pro Forma Financial Information

The pro forma information below includes our acquisition of AMD in a business combination accounted for as a purchase, which was consummated on January 24, 2003. The accompanying pro forma information has been prepared on the basis of assumptions noted below, including a preliminary allocation of the consideration paid for the assets and liabilities of AMD based on valuations of its fair value. This

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allocation includes an accrual of $800 related to an unfavorable operating lease; $2,010 for future estimated lease payments ($5,910 for future lease obligations less estimated sublease payments of $3,900 on excess manufacturing capacity for which we are in the process of reviewing alternative uses); and a $600 accrual to fulfill estimated contractual manufacturing obligations. The final allocation of the consideration to be paid may differ from those assumptions reflected in the accompanying unaudited interim consolidated financial statements. In our opinion, all adjustments necessary to present fairly such financial statements have been made based on the terms and structure of the AMD acquisition. We continue the process of gathering information to complete our analysis of the excess lease capacity, the value of intellectual property and the contractual manufacturing obligations. Any reductions in these liabilities or increases in assets will result in a decrease in the carrying value of the intangible assets and fixed assets. Conversely, an increase in these liabilities or decreases in assets will increase the carrying values of long-lived assets. At May 31, 2003, the carrying value of long-lived assets has been reduced by a net of $3,200 by the allocation of negative goodwill.

Our purposes for acquiring AMD were to immediately gain access to the more stable medical sector, to consolidate marketing and sales efforts, and to expand our resources to become more full service or “one stop shop” to all our customers and target markets. The design, development and manufacturing capabilities for medical devices at AMD coupled with our microelectronic design, development and manufacturing improves our offerings to the market to retain and gain customers.

The following pro forma information gives affect to the acquisition of AMD in a business combination accounted for as a purchase, which was closed on January 24, 2003. In exchange for certain assets of AMD, we issued 1,000,000 shares of our common stock and assumed approximately $900 of AMD liabilities, as well as AMD operating lease and other contractual commitments.

	Three Months Ended			Nine Months Ended
	June 1, 2002			May 31, 2003			June 1, 2002
Net sales	$	20,431		$	42,421		$	59,659
Net loss		(3,481	)		(6,714	)		(11,153	)
Net loss per share	$	(0.18	)	$	(0.34	)	$	(.59	)

As AMD had a June 30 year-end and we have an August 31 fiscal year-end, the pro forma information reflects the combination of different periods for us and AMD. The Company reported results for the quarter ended May 31, 2003 include the results of HEI and AMD The nine-month 2003 and 2002 pro forma information includes unaudited results of operations for the nine-month periods ended May 31, 2003 and June 1, 2002, respectively, for us and unaudited results of operations for the nine-month periods ended March 31, 2003 and 2002 for AMD, respectively. The 2002 three-month pro forma information includes unaudited results of operations for the three-month period ended June 1, 2002 for us and unaudited results of operations for the three-month period ended March 31, 2002 for AMD.

The unaudited pro forma amounts have been derived by applying pro forma adjustments to the historical consolidated financial information of us and AMD. However this pro forma information is not necessarily indicative of what the actual operating results or financial position would have been for the combined company had the transaction taken place on August 31, 2001, and do not purport to indicate the results of future operations.

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Below is a table of the estimated acquisition consideration, purchase price allocation and annual amortization of the intangible assets and goodwill acquired:

					Amortization
		Amount			Period
Purchase price allocation:
	Cash	$	1,215
	Accounts receivable		300
	Inventory		2,854
	Property and equipment		1,900		3-10 years
	Prepaids, deposits and other assets		1,690
	Developed technology		584		3-4 years
	Customer deposits and other reserves		(1,638	)
	Operating lease reserves		(2,810	)
	Accrued transaction costs		(1,495	)
	Total purchase price	$	2,600

We anticipate completing the purchase price allocation in the quarter ending August 31, 2003.

The estimation of intangible asset values for the developed technology was determined utilizing discounted cash flow analyses. The discounted cash flow analyses were based upon three to five-year cash flow projections. The expected future cash flows attributable to existing technologies were discounted to present value at discount rates ranging from 23% to 40%, taking into account risks related to the characteristics and applications of the developed technology, our anticipated courses of business activities, historical financial market rates of return, and assessments of the stage of the technology’s life cycle. The analyses resulted in a valuation for developed technologies that had reached technological feasibility and therefore were capitalized.

The cash flow projections were based on estimates and assumptions about circumstances and events that have not yet taken place. Such estimates and assumptions are inherently subject to significant economic and competitive uncertainties and contingencies beyond our control, including, but not limited to, those with respect to the future courses of our business activity. Accordingly, there will usually be differences between projected and actual results because events and circumstances frequently do not occur as expected, and those differences may be material.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
(in thousands, except share and per share amounts)

THREE AND NINE MONTHS ENDED MAY 31, 2003 AND JUNE 1, 2002

The following discussion highlights the significant factors affecting the changes in financial condition and results of operations. This review should be read in conjunction with the Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K, as amended, for the fiscal year ended August 31, 2002.

OVERALL

On January 24, 2003, we acquired certain assets and liabilities of Colorado MEDtech, Inc.’s (“CMED”) Colorado Operations (a business unit of CMED) or (the Advance Medical Division (“AMD”)) in a business combination accounted for as a purchase. In connection with this acquisition, we issued 1,000,000 shares of our common stock and assumed approximately $900 of AMD liabilities, as well as an operating lease and other contractual commitments. The purchase price of AMD was $2,600 based upon the closing market price of a share of our common stock the day the acquisition was finalized and consummated, as quoted on the NASDAQ National Market. The excess of the fair value of net assets over the purchase price in the amount of $3,200 has been allocated to reduce the carrying value of identifiable long-lived tangible and intangible assets.

Net sales in the third quarter were $12,517, $4,017 or 47% higher than the comparable quarter last year. Net sales for the nine months ended May 31, 2003, were $26,151, $3,727 or 17% higher than the first nine-months of last year. The third quarter and year-to-date increase is mainly related to $6,240 and $9,049, respectively, in net sales generated by AMD, which was acquired in January 2003.

We acquired a significant number of new customers and improved current customer activity in the third quarter of fiscal 2003. New customer activity included new contracts with four new top 10 hearing original equipment manufacturers (“OEMs”) for multiple programs with sales volume anticipated to begin in the fourth quarter of fiscal 2003. In addition, a new medical implantable OEM was added with multiple programs, which is anticipated to begin in volume in fiscal 2004. Two new medical imaging programs were added from the customers acquired in the second quarter of fiscal 2003. AMD added a new large OEM customer for its Link-it connectivity system and two new large software solutions customers in the third quarter of fiscal 2003. Business with current customers continued to pickup in hearing, medical and broadband market sectors contributing to the growth in sales. We expect these successes will contribute greatly to increased sales for fiscal 2004 and we anticipate that we will diversify our customer base and reduce customer concentration. However 45% of our net sales came from our top three customers for the third quarter of fiscal 2003 and 47% of our net sales came from our top three customers during the nine-months ended May 31, 2003. A significant customer has verbally advised us that it intends to discontinue a significant program with us in order to place it offshore. This program discontinuance will reduce but not eliminate sales stream from this customer.

In our continued effort to size our cost structure with anticipated revenues, we reduced our workforce by 28 employees at the end of the first quarter of fiscal 2003, an additional 15 employees in the second quarter of fiscal 2003 and 18 employees were reduced at our AMD Colorado division in the third quarter of 2003, for a total of 61 positions and accumulated savings of $737 during the first three quarters of fiscal 2003. As of May 31, 2003, we had 281 employees, compared to 209 employees as of June 1, 2002, including as of May 31, 2003, a net of 123 were added in connection with the acquisition of AMD.

We intend to reduce and contain costs as revenues fluctuate while balancing our ongoing development of new products, increase marketing/sales efforts and maintaining our ability to react quickly to favorable market demands and opportunities. These cost savings, however, will not be realized in their entirety if increased production demand requires the re-hiring of additional personnel.

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CRITICAL ACCOUNTING POLICIES

The accompanying consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States (“GAAP”), which require estimates and assumptions about future events that may affect the amounts reported in these financial statements and the accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to the financial statements. We believe that the following accounting policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from reported results.

Revenue recognition, Sales returns and Warranty

The SEC’s Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition” provides guidance on the application of GAAP to selected revenue recognition issues, and our revenue recognition policies are in compliance with SAB No. 101. We recognize revenue upon shipment of products to customers when all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. In fiscal 2002, a consignment program was established with a significant customer where revenue is recognized when the customer uses the inventory. Sales, payment terms and pricing extended to customers are governed by the respective contract agreements or binding purchase orders for each transaction and provide no right of return outside of contractual warranty terms. Payment terms are seven days for consignment program sales and four to 45 days for other customers.

We record provisions against net sales for estimated product returns. These estimates are based on factors that include, but are not limited to, historical sales returns, analyses of credit memo activities, current economic trends and changes in the demands of our customers. Provisions are also recorded for warranty claims that are based on historical trends and known warranty claims. Should actual product returns exceed estimated allowances, additional reductions to our net sales would result. As of May 31, 2003, and August 31, 2002, warranty and product reserves were $416 and $200, respectively.

Allowance for uncollectible accounts

We estimate the collectibility of trade receivables and notes receivable which requires considerable amount of judgment in assessing the realization of these receivables, including the current credit-worthiness of each customer and related aging of the past due balances. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to a deterioration of its financial viability, credit ratings or bankruptcy. The reserve requirements are based on the best facts available to us and reevaluated and adjusted as additional information is received. We are not able to predict changes in the financial condition of our customers, and if circumstances related to our customers deteriorate, our estimates of the recoverability of our receivables could be materially affected and it may be required to record additional allowances for uncollectable accounts. Alternatively, if we provide more allowances than we need, we may reverse a portion of such provisions in future periods based on changes in estimates from our actual collection experience. As of May 31, 2003, and August 31, 2002, we had accounts receivable allowances of $62 and $85, respectively.

Inventories

We record inventories at the lower of cost, using the average cost method or market value. Generally all inventory purchases are for customized parts for customer specific program. Contractual arrangements are typically agreed to with the customer prior to ordering customized parts to protect us in cases where the demand decreases, as often times the parts cannot be consumed in other programs. Even though contractual arrangements may be in place, we are still required to assess the utilization of inventory. In assessing the ultimate realization of inventories, judgments as to future demand requirements are made and compared to the current or committed inventory levels and contractual inventory holding requirements. Reserve requirements generally increase as projected demand requirements decrease due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. We have experienced significant changes in required reserves in recent periods due primarily to declining market conditions. It is possible that significant changes in

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required inventory reserves may continue to occur in the future if there is a further decline in market conditions. As of May 31, 2003, and August 31, 2002, we had reserves for excess and obsolete inventory of $368 and $311, respectively.

Long-lived assets

We continually evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets may warrant revision, or that the remaining balance of these assets may not be recoverable. We evaluate the recoverability of our long-lived assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” which we adopted on July 1, 2002. SFAS No. 144 superseded SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”. When deemed necessary, we complete this evaluation by comparing the carrying amount of the assets against the estimated undiscounted future cash flows associated with them. If such evaluations indicate that the future undiscounted cash flows of long-lived assets are not sufficient to recover the carrying value of such assets, the assets are adjusted to their estimated fair values. The adoption of SFAS No. 144 did not have a material impact on our reported results of operations.

Valuation of Deferred Taxes

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We record a current provision for income taxes based on amounts payable or refundable. Deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The overall change in deferred tax assets and liabilities for the period measures the deferred tax expense or benefit for the period. We recognize a valuation allowance for deferred tax assets when it is more likely than not that deferred assets are not recoverable.

We recorded valuation allowances of approximately $4,800 and $3,400, respectively, at May 31, 2003, and August 31, 2002, due to uncertainties as measured by GAAP related to our ability to utilize certain Federal and state net income tax loss carryforwards.

Purchase Accounting

The accompanying statements reflect a preliminary allocation of the purchase price of AMD. This allocation includes an accrual of $800 related to an unfavorable operating lease; $2,010 for future estimated lease payments ($5,910 for future lease obligations less estimated sublease payments of $3,900 on excess manufacturing capacity for which we are in the process of reviewing alternative uses); and a $600 accrual to fulfill estimated contractual manufacturing obligations. We continue the process of gathering information to complete our analysis of the excess lease capacity and the contractual manufacturing obligations. Any reductions in these liabilities will result in a decrease in the carrying value of the intangible assets and fixed assets. Conversely, an increase in these liabilities will increase the carrying values of long-lived assets. At May 31, 2003, the carrying value of long-lived and intangible assets has been reduced by $3,200 due to the allocation of negative goodwill.

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RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, FASB issued Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements, Including Guarantees of Indebtedness of Others.” FIN No. 45 requires that upon issuance of certain types of guarantees, a guarantor recognize and account for the fair value of the guarantee as a liability. FIN No. 45 contains exclusions to this requirement, including the exclusion of a parent’s guarantee of its subsidiaries’ debt to a third party. The initial recognition and measurement provisions of FIN No. 45 should be applied on a prospective basis for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements of both interim and annual periods ending after December 31, 2002, which we adopted in the quarter ended March 1, 2003. The adoption of FIN 45 did not have a material impact on our financial position, results of operations or cash flows.

In November 2002, Emerging Issues Task Force (“EITF”) finalized its tentative consensus on EITF Issue 21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on the timing of revenue recognition for sales undertakings to deliver more that one product or service. We are required to adopt EITF 21 on transactions occurring after June 2003 and we are currently analyzing the impact of its adoption on our financial statements.

In January 2003, FASB issued FIN No. 46, “Consolidation of Variable Interest Entities,” which addresses accounting for special-purpose and variable interest entities. We are required to adopt this guidance for financial statements issued after December 31, 2002, which we adopted in the quarter ended March 1, 2003. The adoption of FIN 46 did not have a material impact on our financial position, results of operations or cash flows.

In December 2002, FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”. This statement, which is an amendment of SFAS No. 123, provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported financial results. We currently account for stock-based compensation using the intrinsic value method defined in Accounting Principles Board No. 25 and do not currently intend to voluntarily change to the fair value method described in SFAS No. 123. As a result, we does not expect the new guidelines found in SFAS No. 148 will have a material effect upon our financial statements at its adoption. The new interim reporting requirements are effective for interim periods beginning after December 15, 2002. We have adopted our disclosure provisions. (See note 2 “Stock Based Compensation”).

In April 2003, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging,” which amends and clarifies financial accounting and reporting for derivative instruments. We are required to adopt this statement for transactions occurring after June 2003, and we are currently analyzing the impact of its adoption on our financial statements.

On May 15, 2003, the Financial Accounting Standards Board issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial instruments that embody obligations for the issuer. Generally, the Statement is effective for financial instruments entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. We will adopt the provisions of the Statement on October 1, 2003. We did not enter into any financial instruments within the scope of the Statement during the month of June, 2003. We are currently analyzing the impact of its adoption on our financial statements.

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FINANCIAL CONDITION AND LIQUIDITY

Our cash and cash equivalents totaled approximately $27 at May 31, 2003, and $2,372 at August 31, 2002. We had $3,000 available under the Credit Agreement at May 31, 2003.

In connection with the purchase of AMD, we issued a Subordinated Promissory Note to CMED in the amount of $2,628 (the “Subordinated Promissory Note”). The terms of the Subordinated Promissory Note include an interest rate of 10% (increasing to 12% and 14%, respectively, in July 2003 and January 2004, respectively) and a due date for all principal and interest on September 30, 2004. There are no prepayment penalties associated with the Subordinated Promissory Note. During the second quarter of fiscal 2003, the Subordinated Promissory Note, and approximately $1,215 in cash acquired from CMED, was used to (i) pay equipment loans of $844, (ii) pay transaction costs of $1,198 related to the AMD acquisition (iii) repay the outstanding Industrial Development Revenue Bonds (“IDRBs”) totaling $1,735.

On May 8, 2003, the Subordinated Promissory Note was sold by CMED to Whitebox Hedged High Yield Partners (“Whitebox”) for $1,820. To encourage us to prepay the Subordinated Promissory Note, Whitebox will discount the face value of the Subordinated Promissory Note by $410 if paid by July 15, 2003, or $390 if paid by August 15, 2003. In the event we do not prepay the Subordinated Promissory Note in full by August 15, 2003, the following terms and conditions will apply to the on going obligation:

• We will grant a first priority mortgage on our facility in Victoria, Minnesota.

• Accrued and unpaid interest will be capitalized as part of Subordinated Promissory Note.

• We will issue 400,000 warrants that are exercisable over the next five years at an exercise price of 10% above the closing price of our common stock at August 15, 2003, as a form of prepayment of interest through September 30, 2004.

• At our option, we will have the right to extend the Subordinated Promissory Note to March 31, 2005, at a 12% annual rate.

• We will retain the right to prepay the Subordinated Promissory Note at any time without premium or penalty.

Operating activities utilized cash of $331 during the nine months ended May 31, 2003, and provided $697 in cash during the nine months ended June 1, 2002. Cash used by operating activities for the nine months ended May 31, 2003, resulted primarily from a net loss of $3,802, offset by depreciation, a decrease in inventory and increase in accounts payable. The increases in accounts receivable and accounts payable are primarily a result of the acquisition of AMD. The accounts receivable average days outstanding improved to 43 days at May 1, 2003, from 53 days as of August 31, 2002. This improvement resulted from the contractual arrangements for a large, newly acquired AMD customer that calls for payment within four business days, which is much faster than our other customers.

Investing activities utilized cash of $296 and $2,287, for the nine months ended May 31, 2003 and June 1, 2002, respectively. Cash used by investing activities during the nine months ended May 31, 2003, was primarily attributed to equipment additions of $224 and payment of $1,198 in transaction costs related to the acquisition of AMD, offset by the $1,215 in cash acquired in connection with the acquisition of AMD.

Financing activities utilized $1,718 in cash during the nine months ended May 31, 2003, and provided $672 during the nine months ended June 1, 2002. The fiscal 2003 activity reflects the payoff of our equipment loan, IDRBs loan and net reductions in the revolving line of credit, offset by a decrease in restricted cash and the addition of the Subordinated Promissory Note.

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On May 29, 2003, we entered into an Accounts Receivable Agreement (the “Credit Agreement”) with Beacon Bank of Shorewood, Minnesota for a period of twelve months. The Credit Agreement is an accounts receivables backed facility and has inventory, intellectual property and other general intangibles as additional collateral. The Credit Agreement replaced our revolving line of credit with LaSalle Business Credit, LLC and is not subject to any restrictive financial covenants. We have a maximum of $3,000 available under the Credit Agreement, with the actual lending amount based on accounts receivable invoice factoring. As of May 31, 2003, there were no borrowings under the Credit Agreement. Effective May 29, 2003, the Credit Agreement bears a immediate processing fee of 0.50% of each assigned amount, a per diem equal to 1/25% on any assigned amount that remains uncollected and a monthly minimum of $1.5 in processing fees for the first six months the Credit Agreement is in place. The effected interest rate based on our average DSO of 43 days would be 18.6% annualized.

We believe that existing cash and cash equivalents, current lending capacity and cash generated from operations will provide sufficient cash flow to meet short- and long-term debt obligations and operating requirements. We are in the process of obtaining additional financing sources to refinance the Subordinated Promissory Note.

We originally issued IDRBs in April 1996 in connection with the construction of a new addition to our manufacturing facility in Victoria, Minnesota, and for the purchase of production equipment. On March 14, 2003, an aggregate of approximately $1,735 of debt proceeds from the Subordinated Promissory Note were used to fund the repayment of principal and interest on the IDRBs.

During fiscal 2003, we intend to expend no more than $500 for manufacturing and facility improvements and capital equipment, of which $224 has been expended during the first three quarters of fiscal 2003. The remaining additions will only be made to increase manufacturing capacity to the level sufficient to meet near-term production requirements and, if necessary, add technological capabilities and are expected to be funded from operations and available debt financing.

Giving effect to the acquisition of AMD and the assumed operating lease and other contractual commitments, including (i) the Subordinated Promissory Note and (ii) the rights and obligations of the operating leases including the facilities for AMD that has an original 10-year lease commitment, our contractual obligations at May 31, 2003 are summarized in the following table:

	Three
	Months		Fiscal		Fiscal
	Ending		Year		Year
	August 31,		Ending		Ending
	2003		2004		2005		Thereafter		Total
Long-term debt	$	111	$	144	$	2,621	$	—	$	2,876
Operating leases		718		2,831		2,654		17,406		23,609
Total contractual obligations	$	829	$	2,975	$	5,275	$	17,406	$	26,485

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RESULTS OF OPERATIONS

The following table indicates the dollars and percentages of total revenues represented by the selected items in our unaudited consolidated statements of operations:

Selected Operating Results:

	Three Months Ended										Nine Months Ended
	May 31, 2003					June 1, 2002					May 31, 2003					June 1, 2002
Net sales	$	12,517		100	%	$	8,500		100	%	$	26,151		100	%	$	22,424		100	%
Cost of sales		9,983		80	%		6,346		75	%		22,143		85	%		18,346		82	%
Gross profit		2,534		20	%		2,154		25	%		4,008		15	%		4,078		18	%
Operating expenses		2,923		23	%		1,948		23	%		6,879		26	%		5,921		26	%
Operating income (loss)		(389	)	(3	)%		206		2	%		(2,871	)	(11	)%		(1,843	)	(8	)%
Other expense		(924	)	(7	)%		(27	)	—	%		(952	)	(4	)%		(109	)	—	%
Income (loss) before income taxes		(1,313	)	(10	)%		179		2	%		(3,823	)	(15	)%		(1,952	)	(9	)%
Income tax (expense) benefit		2		—	%		(64	)	(1	)%		21		—	%		663		3	%
Net Income (loss)	$	(1,311	)	(10	)%	$	115		1	%	$	(3,802	)	(15	)%	$	(1,289	)	(6	)%

Net Sales

Our sales fluctuate based on changing product mix and market instability and are dependent on the level and timing of customer business and other matters such as customer concentration.

Net sales in the third quarter were $12,517, $4,017 or 47% higher that the comparable quarter last year. Net sales for the nine months ended May 31, 2003, were $26,151, $3,727 or 17% higher than the first nine months of last year. The third quarter and year to date increase mainly related to $6,240 and $9,049, respectively, in net sales generated by the AMD business, which we acquired in January 2003.

The communications and RFID markets remain soft as customers are awaiting market acceptance of new products and increased demand for existing products. As the demand for these products increases, we believe that we are well positioned for an increase in sales in these markets. We are also experiencing continued external interest in our proprietary products, for which we are working on new designs, qualification testing and prototype orders with numerous customers.

Because sales are generally tied to the customers’ projected sales and production of the related product, our sales are subject to uncontrollable fluctuations. To the extent that sales to any one customer represent a significant portion of sales, any change in the sales levels to that customer can have a significant impact on total sales. In addition, production from one customer may conclude while production for a new customer may not have begun or is not yet at full volume. We have significant customer concentration with 45% of net sales in the third quarter of fiscal 2003 being generated by three customers. Net sales generated by these customers amounted to 60% for the third quarter of last year.

At May 31, 2003, our backlog for future orders was approximately $22,037, compared to approximately $5,387 at August 31, 2002. This increase in backlog relates to the acquisition of AMD, which had a backlog of $15,100 at May 31, 2003. The AMD backlog includes customer commitments that have longer terms, as compared to our historical customer commitments. Our backlog is not necessarily a firm commitment from our customers and can change, in some cases materially, beyond our control.

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Net sales by market for the three and nine months ended May 31, 2003, and June 1, 2002, respectively, are as follows:

	Three Months Ended				Nine Months Ended
	May 31, 2003		June 1, 2002		May 31, 2003		June 1, 2002
Medical	$	7,203	$	658	$	11,870	$	1,446
Hearing		3,337		5,444		9,358		15,494
RFID/Communications		1,551		1,996		3,801		4,719
Industrial/HDI		426		402		1,122		765
Total Net Sales	$	12,517	$	8,500	$	26,151	$	22,424

Net sales analysis by market follows:

Medical: The acquisition of the AMD business accounted for the majority of the $6,545 and $10,424 increase in medical sales for the three- and nine-month periods ended May 31, 2003, and June 1, 2002, respectively.

Hearing: We continue to experience fluctuations in demand for our hearing products. Hearing sales for the three- and nine-month periods ended May 31, 2003, and June 1, 2002, decreased 39% and 40%, respectively, to $3,337 and $9,358, respectively. These decreases are mainly due to excess inventory positions at significant hearing customers and reflect the general economic slowdown, which continue to negatively impact the hearing contract manufacturing markets. During the latter part of fiscal 2002, a major customer’s internal manufacturing capabilities increased, which are expected to reduce annual revenues for fiscal 2003 by approximately $3,000. Also a significant customer has verbally advised us that it intends to discontinue a significant program with us in order to place it offshore. This program discontinuance will reduce but not eliminate sales stream from this customer

RFID/Communications: Net sales to Radio Frequency Identification (“RFID”) and Communication customers decreased by $445 or 22% and $918 or 19% for the three- and nine-month periods ended May 31, 2003, and June 1, 2002, respectively. This decrease is driven by a significant drop in orders from a major customer that, in 2002, sold one division and terminated operations of another. We are also experiencing significant competition from overseas manufacturers in this market. New products have been developed and capabilities have been expanded to improve revenue; however, the actual level of market acceptance of these initiatives is currently unknown.

Industrial/HDI: Net sales to industrial and High Density Interconnect (“HDI”) customers for the three-month and nine-month period ended May 31 2003, increased 6% and 47%, respectively, to $426 and $1,122 respectively. HDI represents net sales of flexible circuit boards. The overall market remains depressed, however, demand from a few of our customers increased this quarter and increased activity is seen in this market with low volume purchase orders.

Gross Profit

Gross profit was $2,534 (20% of net sales) and $4,008 (15%) for the three- and nine-months ended May 31, 2003, respectively, compared to $2,154 (25%) and $4,078 (18%) for the three- and nine-months ended June 1, 2002, respectively. An unfavorable mix of revenue from lower margin manufacturing programs coupled with lower manufacturing yields drove the decreases in gross margin. Our gross margins are heavily impacted by fluctuations in revenue, due to the fixed nature of many of our manufacturing costs.

Operating Expenses

Operating expenses increased by $975 or 50% and by $958 or 16% for the three- and nine-month periods ended May 31, 2003, and June 1, 2002, respectively. The increase for the three months ended May 31, 2003, related to the AMD business acquired in January 2003, representing $1,137 for this period. As a percentage of net sales, operating expenses in total were 23% and 26%, respectively, for the three and nine-month periods ended May 31, 2003, respectively, compared to 23% and 26%, respectively, for the comparable periods last year. Factors having an impact on these expenses include our past cost containment measures, which, in addition to staff reductions, include decreased insurance, legal and depreciation costs. These reductions were mitigated by increases in advertising, travel and severance costs. Overall expenses continue to decline as a result of our continued effort to right-size the business balanced with our commitment to maintain our research and development efforts and continued sales and marketing focus.

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Other Income (Expense), net

We recorded $924 and $952 in net other expenses during the three- and nine-month periods ended May 31, 2003, respectively, and $27 and $109 in net other expenses during the three- and nine-month ended June 1, 2002, respectively. Unusual expenses during the three-month period ended May 31, 2003, were non-cash write off of bank fees of $165 related to the terminated revolving line of credit with LaSalle Business Credit, and a reserve of $681 for Mr. Fant’s promissory note to us and other loans to Mr. Fant from us due to the uncollectible nature of the note from Mr. Fant, a current director and our former Chairman of the Board, Chief Executive Officer and President. Interest expense was $105 and $224 during the three- and nine-month periods ended May 31, 2003, respectively, and $88 and $262 during the three- and nine-month ended June 1, 2002, respectively. The improvement for the nine month period relates to the reduction in our debt.

Income Taxes

We established a valuation allowance of approximately $4,800 and $3,400, respectively, at May 31, 2003, and August 31, 2002, respectively, to fully reserve the deferred tax assets because of uncertainties related to our ability to utilize certain federal and state loss carryforwards as measured by GAAP. This allowance is based on estimates of taxable income by jurisdiction during the period over which its deferred tax assets are recoverable. The economic benefits of our net operating loss carryforwards to future years will continue until expired. At May 31, 2003, we had Federal net operating loss carryforwards of $10,761 that expire at various dates ranging from 2013 through 2022.

Forward-Looking Statements

Information in this document, which is not historical, includes forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, from time to time, we or our representatives have made or may make forward-looking statements orally or in writing. These statements are made based on our current views and assumptions regarding technology, markets, growth and earnings expectations, and all of such forward-looking statements involve a number of risks and uncertainties. There are certain important factors that can cause actual results to differ materially from the forward-looking statements, including, without limitation, continuing adverse business and market conditions, our ability to secure and satisfy customers, the availability and cost of materials from our suppliers, adverse competitive developments, changes in or cancellations of customer requirements, integration of AMD, collection of outstanding debt, our ability to succeed on the merits and defend against litigation, and other factors discussed from time to time in our filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on forward-looking statements and holders of our securities are specifically referred to such documents with regard to factors and conditions that may affect future results. We undertake no obligation to update these statements to reflect ensuing events or circumstances, or subsequent actual results.

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Item 3. Qualitative and Quantitative Disclosures About Market Risk
(in thousands, except share and per share amounts)

We are not exposed to certain market risks with the Credit Agreement and capital expenditure commercial loans. At May 31, 2003, the outstanding balance on the Credit Agreement and capital expenditure commercial loans were $0, and $248, respectively. Effective May 29, 2003, the Credit Agreement bears a immediate processing fee of 0.50% of each assigned amount, a per diem equal to 1/25% on any assigned amount that remains uncollected and a monthly aggregate minimum of $1.5 in processing fees for the first six months the Credit Agreement is in place.

On January 24, 2003, we acquired AMD from CMED in a business combination accounted for as a purchase. In connection with this acquisition, we issued 1,000,000 shares of our common stock and assumed approximately $900 of AMD liabilities, as well as AMD operating lease and other contractual commitments. The purchase price of AMD was $2,600 based upon the closing market price of a share of our common stock the day the merger was consummated on January 24, 2003, as quoted on the NASDAQ National Market. The excess of the fair value of net assets over the purchase price has been allocated to identifiable, long-lived tangible and intangible assets.

In connection with the AMD acquisition, we issued a Subordinated Promissory Note to CMED in the principal amount of $2,628 (the “Subordinated Promissory Note”). The terms of the Subordinated Note include an interest rate of 10% (increasing to 12% and 14%, in July 2003 and January 2004, respectively), and a due date for all principal and interest of September 30, 2004. On May 8, 2003, the Subordinated Promissory Note was sold by CMED to Whitebox Hedged High Yield Partners (“Whitebox”) for $1,820.

We used the proceeds from the Subordinated Promissory Note to retire our remaining indebtedness including our IDRBs and capital expenditure notes with LaSalle Business Credit LLC. The Subordinated Promissory Note continues with the same terms as the original agreement with CMED until August 15, 2003. To encourage early repayment the terms of the Subordinated Promissory Note were modified on May 16, 2003 on the Subordinated Promissory Note, Whitebox will discount the face value of the Subordinated Promissory Note by $410 if paid by July 15, 2003, or $390 if paid by August 15, 2003. The principal prepayment will include all accrued interest through the payment date. In the event that we do not prepay the Subordinated Promissory Note in full by August 8, 2003, the following terms and conditions will apply to the ongoing obligation:

• We will grant a first priority mortgage on our facility in Victoria, Minnesota.

• Accrued and unpaid interest will be capitalized as part of Subordinated Promissory Note.

• We will issue 400,000 warrants that are exercisable over the next five years at an exercise price of 10% above the closing price of our common stock at August 15, 2003, as a form of prepayment of interest through September 30, 2004.

• At our option, we will have the right to extend the Subordinated Promissory Note to March 31, 2005, at a 12% annual rate.

• We will retain the right to prepay the Subordinated Promissory Note at any time without premium or penalty.

We are exposed to market risk associated with the fair value of our common stock related to the potential issuance of the above noted warrant for 400,000 shares of common stock. For example, if on August 15, 2003, the closing price of the Company’s common stock is $2.50 (based on the high stock price for the last six months) and $1.75, (based on the low stock price for the last six months) the Company will recognize interest expense of $607 or $425, respectively, from that date to September 30, 2004.

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Item 4. Controls and Procedures

Based on their evaluation, as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer believe that our disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Exchange Act) are effective in timely alerting management to material information required to be included in this Form 10-Q and other Exchange Act filings.

There were no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of our evaluation, and there were no significant deficiencies or material weaknesses that required corrective actions.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     Subsequent to the end of our third quarter, on June 30, 2003, we commenced litigation against Anthony Fant, a current director and our former Chairman of the Board, Chief Executive Officer and President, in the State of Minnesota, Hennepin County District Court, Fourth Judicial District. The complaint alleges breach of contract, conversion, breach of fiduciary duty, unjust enrichment and corporate waste resulting from, among other things, Mr. Fant’s default on his promissory note to us and other loans from us in the total amount of approximately $681, and certain other matters. In the lawsuit, we are seeking recovery of all amounts owed to us on the promissory note and the other loans, certain expenses incurred by us on behalf of Mr. Fant, and litigation costs and expenses.

Item 6. Exhibits and Reports on Form 8-K

a)	Exhibits
	10.1	Accounts receivable agreement dated May 29, 2003 between HEI Inc. and Beacon Bank
	10.2	Letter confirming the understanding between HEI Inc. and Whitebox Hedged High Yield Partners relating to the Subordinated Promissory Note.
	99.1	Section 906 Certification of the Chief Executive Officer
	99.2	Section 906 Certification of the Chief Financial Officer
b)	Reports on Form 8-K

On March 20, 2003, we filed a Current Report on Form 8-K reporting, under Item 5 — Other Events, certain information relating to the election of directors and certain changes regarding our management structure.

On April 10, 2003, we filed a Current Report on Form 8-K reporting, under Item 7 — Financial Statements and Exhibits, the audited and unaudited financial statements for AMD. This filing was an amendment to our previously filed Current Report on Form 8-K, dated January 24, 2003, regarding our acquisition of AMD.

On April 22, 2003, we filed a Current Report on Form 8-K reporting, under Item 5 — Other Events, certain information regarding the appointment of Mack V. Traynor, III, as our Chief Executive Officer and President.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized

	HEI, Inc.
Date:    07/15/03	/s/ Douglas J. Nesbit           Douglas J. Nesbit Chief Financial Officer

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CERTIFICATIONS

I, Mack V. Traynor, III, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of HEI, Inc.;
2.	Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.	Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)	designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c)	presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a)	all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

/s/ Mack V. Traynor, III

Mack V. Traynor, III
Chief Executive Officer and President

Date: July 15, 2003

26

I, Douglas J. Nesbit, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of HEI, Inc.;
2.	Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.	Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)	designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c)	presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a)	all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

/s/ Douglas J. Nesbit

Douglas J. Nesbit
Chief Financial Officer

Date: July 15, 2003

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Exhibit Index

10.1	Accounts receivable agreement dated May 29, 2003 between HEI Inc. and Beacon Bank
10.2	Letter confirming the understanding between HEI Inc. and Whitebox Hedged High Yield Partners relating to the Subordinated Promissor
99.1	Section 906 Certification of the Chief Executive Officer
99.2	Section 906 Certification of the Chief Financial Officer

EX-10.1 3 c78181exv10w1.txt EX-10.1 ACCOUNTS RECEIVABLE AGREEMENT EXHIBIT 10.1 ACCOUNTS RECEIVABLE AGREEMENT This Agreement entered into as of May 29, 2003 by and among HEI, Inc. (herein called "Client"), a Minnesota corporation, whose addresses are 1495 Steiger Lake Lane, Victoria, MN 55386 and 610 S Rockford Drive, Tempe, AZ 85281 and 4801 N 63rd Street, Boulder, CO 80301 and Beacon Bank (herein called "Purchaser"), whose address is 19765 Highway 7, Shorewood, MN 55331. In consideration of the mutual covenants set forth herein, Client and Purchaser agree as follows: I. DEFINITIONS "ACCOUNT" means a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of, (ii) for services rendered or to be rendered, (iii) for a policy of insurance issued or to be issued, (iv) for a secondary obligation incurred or to be incurred, (v) for energy provided or to be provided, (vi) for the use or hire of a vessel under a charter or other contract, or (vii) arising out of the use of a credit or charge card or information contained on or for use with the card and any and all the proceeds therefrom. The term does not include (i) rights to payment evidenced by chattel paper or an instrument, (ii) commercial tort claims, (iii) deposit accounts, (iv) investment property, (v) letter of credit rights or letters of credit, or (vi) rights to payment for money or funds advanced or sold, other than rights arising out of the use of a credit or charge card or information contained on or for use with the card. "AFFILIATE" means, with respect to the Client, any person which directly or indirectly controls, is controlled by, or is under common control with the Client. The Client shall be deemed to control another person if the Client owns directly or indirectly 5% or more of any class of voting stock of the controlled person or possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of the controlled person, whether through ownership of stock, by contract or otherwise. In addition, the Client's Affiliates shall include the Client's officers, directors, joint venturers and partners and any person controlled by any such officer, director, joint venturer partner. "COLLATERAL" means all of the property, real or personal, tangible or intangible, given as security pursuant to Section 7.01 hereof for the obligations of Client under this agreement. "CREDIT PROBLEM" means a Customer is unable to pay its debts because of insolvency, the dissolution, termination of existence, or business failure of the Customer, the voluntary filing of a petition of bankruptcy, or the commencement of any proceeding under the Bankruptcy Code or any other bankruptcy or insolvency laws by or against Customer such that payment on the Account is or will be impaired. "CUSTOMER" means Client's customer or the account debtor. "CUSTOMER DISPUTE" means any claim by a Customer against Client, valid or invalid, now existing or hereafter arising (including, but not limited to, a claim for credit or refund due to a return of goods which gave rise to an Account, but excluding discounts, credits, allowances and adjustments accepted by Purchaser in determining the Eligible Amount of an Account), and which the Customer claims or may otherwise result in any reduction in the amount to be paid by the Customer under any Account or Accounts. The foregoing notwithstanding, a dispute with a Customer involving a Customer Dispute and/or a Credit Problem shall be deemed a Customer Dispute. "DAILY RATE" means the amount per diem equal to 1/25th of 1% (one twenty-fifth of one percent) of the Eligible Amount for each day an Account assigned herein remains unpaid. "ELIGIBLE AMOUNT" means the gross face amount of the Account less (i) any partial payments under the Account and (ii) any trade or cash discounts, credits or allowances, or any adjustments to the Account taken by the Customer. "PURCHASER'S DISCOUNT" means for each Account purchased by Purchaser in accordance with the terms hereof, the difference between the Eligible Amount of such Account and the Purchase Price of such Account, the Purchase Price determined as of the date that the Eligible Amount is paid in full, whether by the Customer or Client. "INSOLVENT" means, with respect to any person or entity, that such person's or entity's liabilities exceed such person's or entity's assets and/or such person or entity is not generally paying its debts as they become due and means "insolvent" as that term is used and defined in Section 101(32) of the United States Bankruptcy Code and Section 2 of the Uniform Fraudulent Transfer Act. II. PURCHASE OF ACCOUNTS RECEIVABLE 2.01 ASSIGNMENT/PURCHASE. Client hereby assigns and sells to Purchaser as absolute owner with recourse all Accounts approved and deemed acceptable by Purchaser, and represented by Client to be bona fide existing obligations of its Customers arising out of, and acquired by it, in the ordinary course of its business, which Accounts are or will be due and owing to Client without defense, offset or counterclaim. 2.02 PURCHASER'S DISCRETION. Purchaser shall purchase only such Accounts hereunder as Purchaser may select and approve in its sole and absolute discretion. Purchaser shall not have any liability to Client or any of Client's Customers for any failure or refusal by Purchasers to purchase any Account. 2.03 ASSIGNMENT DOCUMENTS. Client will provide Purchaser with an assignment of Accounts, in a form(s) satisfactory to Purchaser (including any notices of assignment as may be required by Purchaser), together with the original invoice or a true copy of each invoice and/or statement, as may be specified by Purchaser, including evidence of shipment, or other instruments or papers that Purchaser may require. 2.04 STAMPING. At Purchaser's request, Client will place a sticker on, or stamp, each original invoice being sold to Purchaser, in a form acceptable to Purchaser, indicating that the Account has been sold to Purchaser and that payment must be made directly to Purchaser. If for any reason Client fails to provide an Account with proper notification, Purchaser will charge a missing notation fee of 3% of the Eligible Amount. This requirement of stamping does not apply to any Accounts purchased by Purchaser that have been invoiced by Client prior to the date hereof. 2.05 NOTIFICATION. Client agrees to provide Purchaser a sufficient number of Notice of Assignment of Account forms, in a form satisfactory to Purchaser, signed by an authorized representative of Client, which may, at Purchaser's sole discretion, be distributed by Purchaser to each Customer whose Account is assigned and sold to Purchaser by Client. If Purchaser so requires, it shall be Client's obligation to ensure that the Notice of Assignment of Accounts form be duly executed by an authorized representative of the Customer and returned to Purchaser. 2.06 PART PAYMENT. Upon approval and acceptance by Purchaser of an Account, Purchaser shall pay to Client part payment of the Purchase Price in an amount not exceeding 80% (eighty percent) of the Eligible Amount. 2.07 PROCESSING FEE. For each Account approved and accepted by Purchaser hereunder, Purchaser shall receive from Client and Client shall be obligated to pay to Purchaser a processing fee equal to .50% (fifty hundredths percent) of the Eligible Amount. 2.08 PURCHASE PRICE. The purchase price payable by Purchaser to Client for each Account shall be equal to 100% (one hundred percent) of the Eligible Amount reduced by the Daily Rate beginning as of the date that Purchaser makes part payment as to such Account and continuing for each day thereafter that such Account remains unpaid (the "Purchase Price") payable as provided in Section 2.10 hereof. 2.09 COLLECTED RESERVE. Purchaser may hold in a reserve account all collections of purchased and non-purchased Accounts ("Collected Reserve"). The Collected Reserve may be held by Purchaser as security against charge-backs or any other obligations of Client to Purchaser and may be applied by Purchaser against such charge-backs or other obligations. Client hereby transfers and assigns to Purchaser all of its right, title and interest in and to the Collected Reserve, except as any portion of the Collected Reserve is released by Purchaser to Client as provided in Section 2.10 below. 2.10 RETURN OF COLLECTED RESERVE. Purchaser will return to Client that portion or all of the sums in the Collected Reserve on Friday as of Wednesday of each week only if and to the extent, in Purchaser's sole and absolute discretion, Purchaser has determined that Client has complied with all of the terms and conditions of this Agreement, including, without limitation, that no events of default as defined in Article VIII below have occurred and that Client acknowledges to Purchaser that there are no offsets or claims against or customer disputes relating to any Account purchased by Purchaser. However, if the Collected Reserve has a deficit balance at any time, Client shall be obligated to immediately pay to Purchaser, with or without demand, the amount of such deficit. 2.11 CUSTOMER DISPUTES. Upon the occurrence of any Customer Dispute, whether valid or invalid, Client will immediately pay to Purchaser, on the Account purchased by Purchaser subject to the Customer Dispute, the amount of any Part Payment made on the Account by Purchaser plus the Purchaser's Discount. Further, notwithstanding the payment obligation set forth herein, Purchaser may, in addition to any other remedies available to Purchaser under this Agreement, immediately charge-back the Account purchased by Purchaser, which is subject to the Customer Dispute, to Client and provide notice thereof to Client. Where the Purchaser charges back an Account subject to a Customer Dispute or where the Client makes payment to Purchaser as to such an Account, then upon the Purchaser's receipt of the Part Payment plus the Purchaser's Discount due thereon, the Client shall have and be entitled to exercise all rights of and as the owner of such Account subject to the Purchaser's security interest therein as set forth herein. Client shall notify Purchaser immediately of any disputes between Customer and Client. Purchaser may, but is not obligated to, settle any Customer Dispute directly with Customer. Such settlement does not relieve Client of final responsibility for payment of any such Account purchased by Purchaser. 2.12 CLIENT'S OBLIGATION. Until all Accounts purchased by Purchaser are paid or declared in Purchaser's own judgment to be uncollectible due to a Credit Problem, and the Client has satisfied its obligation to pay Purchaser as set forth in Section paragraph 2.11 above, the amount paid for the Account together with the Purchaser's Discount shall be and remain an obligation of Client to Purchaser. 2 III. WARRANTIES AND REPRESENTATIONS OF CLIENT In order to induce Purchaser to enter into this Agreement and purchase Accounts under the terms hereof, and with full knowledge that the truth and accuracy of the warranties and representations set forth in this Agreement are being relied upon by Purchaser, because, among other reasons, time is of the essence and a substantial delay in the purchase of Accounts by Purchaser could be caused by a complete credit investigation of each Customer, Client warrants and represents to Purchaser now, and during the term of this Agreement, that: 3.01 CLIENT ORGANIZATION; ETC. Client: (a) is duly organized, validly existing and in good standing under the laws of the State of Minnesota; (b) has the power and authority to own its properties and carry on its business as it is now being conducted, and is to be conducted following consummation of the transactions contemplated by this Agreement. (c) is qualified to do business in every jurisdiction where such qualification is necessary; (d) is duly authorized to conduct such business under the name of HEI, Inc. and such trade name has been properly registered as required by the laws of the State of Minnesota; and (e) has the power to execute and deliver this Agreement and to execute and deliver to Purchaser any and all documents required to be executed and delivered hereunder. 3.02 CUSTOMER SOLVENCY. To the best knowledge of Client, no Customer of Client whose Accounts are to be assigned to and purchased by Purchaser, is Insolvent. 3.03 TITLE TO ASSETS. Client has good title to all inventory (other than consigned inventory) and Accounts, free and clear of all mortgages, liens and encumbrances, covenants or restrictions, other than the security interest granted by this Agreement. 3.04 VALIDITY OF ACCOUNTS; ETC. Each Account offered for sale to Purchaser: (a) is an accurate and undisputed (without claim of offset, defense or counterclaim) statement of indebtedness by Customer to Client, for a sum certain, which is due and payable within forty-five days or less, or within such time as is agreed to, in writing, by Purchaser and Client; and (b) arises out of a bona fide absolute sale, delivery and acceptance of goods (not on consignment, or on approval, or on hold basis, or subject to any other contingency), or rendition of service by Client to Customer, made in the ordinary course of Client's business. 3.05 TITLE TO ACCOUNTS; ETC. None of the Accounts being sold to Purchaser have heretofore been sold or assigned to any person, firm or corporation, nor has any security interest in such Accounts been granted to any person, firm or corporation, or are owed by a Customer who is one of Client's Affiliates, other than the security interest granted by this Agreement. 3.06 NO CONTRAVENING AGREEMENTS. There are no agreements, verbal or written, between Client and Customer, or any other party, which would prohibit the sale of the Customer Account by Client to Purchaser. 3.07 AUTHORIZATION; ETC. The execution and performance by Client of the terms and provisions of this Agreement and the execution and delivery of any other documents required to be executed and delivered hereunder have been duly authorized by all requisite company action, and neither the execution and performance of this Agreement or any other documents required to be delivered hereunder, will violate any provision of law, any order of any court or other agency of government, the articles of organization or agreement of partnership, if any, of Client, or any indenture, agreement or other instrument to which Client is a party, or by which Client is bound, or be in conflict with, result in breach of, or constitute (with due notice or lapse of time or both) a default under, or result in the creation or imposition of any lien, charge or encumbrance of any nature whatsoever upon any of the property or assets of Client pursuant to, any such indenture, agreement or instrument, except as provided in this Agreement. 3.08 NO LITIGATION. Except as disclosed in writing by Client to Purchaser, there is no action, suit or proceeding at law or in equity or by or before any governmental instrumentality or other agency now pending or, to the knowledge of Client, threatened against or affecting Client which, if adversely determined, would have a material adverse effect on the business, operations, properties, assets or condition, financial or otherwise, of Client. 3.09 NO ADVERSE AGREEMENTS. Client is not a party to any material agreement or instrument or subject to any restriction adversely affecting its business, properties or assets, operations or condition, financial or otherwise. Client is not in default in the performance, observance or fulfillment of any agreement or instrument to which it is a party which materially adversely affects the business, operations, affairs or condition of Client or any of its properties. 3 3.10 NO ADVERSE EVENT. Except as disclosed in writing to Purchaser, there is no fact known to Client which materially adversely affects the business, operations, affairs or condition of Client or any of its properties. 3.11 TAXES. Client has filed all tax returns required by law to be filed and has paid all taxes, assessments and other governmental charges levied upon its properties, assets and income, other than those not yet delinquent. There are no unpaid assessments for additional taxes or any basis therefor. 3.12 COMPLIANCE WITH LAWS. Client is in full compliance in all material respects with all state and federal laws relating to the conduct of its business. IV. CONDITIONS TO PURCHASER'S OBLIGATIONS HEREUNDER 4.01 CONDITIONS PRECEDENT. Except as to those obligations of Purchaser that are discretionary as set forth herein, the obligations of Purchaser to perform its obligations hereunder is subject to the conditions precedent that the representations and warranties set forth in Article III hereof shall be true and correct on and as of the date hereof, and on the date each Account is offered to Purchaser for sale pursuant to this Agreement; and no Event of Default as specified in Article VIII hereof, nor any event which upon notice or lapse of time or both would constitute such an Event of Default, shall have occurred and be continuing; and each offer of an Account for sale to Purchaser shall constitute a certification by Client to such effect as of the date of such offer. V. AFFIRMATIVE COVENANTS BY CLIENT Client covenants and agrees that, from the date hereof and until termination of this Agreement and performance of all of Client's obligations hereunder, Client will, unless otherwise agreed to in writing by Purchaser: 5.01 INSPECTION OF RECORDS. Promptly, from time to time, permit Purchaser to inspect its books and records, at reasonable business hours, and to make copies of abstracts thereof, and furnish such other information regarding its operations, assets, business affairs and financial condition, as Purchaser may request. 5.02 NOTICES. Promptly notify Purchaser of: (a) any developments which would materially adversely affect the business of Client, its properties or affairs or the ability of Client to perform its obligations under this Agreement, or any other documents delivered in connection herewith; (b) any material adverse change in Client's condition, financial or otherwise; (c) the occurrence of any Event of Default by Client as defined in Article VIII hereof, and of the occurrence of any event which upon notice or lapse of time, or both, would constitute such an Event of Default; or (d) any change of address of Client. 5.03 TAXES. Pay all taxes or fees in relation to the Accounts, goods sold or services rendered, giving rise to the Accounts. 5.04 PURCHASER'S PROPERTY. Immediately turn over to Purchaser and, until doing so, hold in trust and safekeeping separate and apart from Client's other property and as the sole and separate property of Purchaser any payment on an Account purchased by Purchaser whenever any such payment, whether cash, check (payable to Client, Purchaser or both), money order or other form of payment, comes into Client's possession, and all goods giving rise to Accounts purchased by Purchaser which are returned or rejected by, or repossessed from Customer(s). If Client fails to turn over payment on a purchased Account to Purchaser in the form received (except for the Client's endorsement when necessary) within two business days of client's receipt of such payments, Purchaser will charge a misdirected payment fee of 15% of the Eligible Amount and the Client shall be obligated to immediately pay such fee with or without demand by Purchaser. 5.05 BOOK ENTRIES. Upon the sale of any of its Accounts to Purchaser, Client will immediately make proper entries on its books and records recognizing and disclosing the sale of such Accounts to Purchaser. 5.06 REIMBURSEMENT OF EXPENSES; ETC. Reimburse the Purchaser for its reasonable expenses, fees and disbursements (including, without limitation, reasonable attorneys' fees and legal expenses and wire transfer fees), incurred in connection with (i) the preparation or administration of this Agreement or any other document relating hereto and (ii) the Purchaser's enforcement of the obligations of the Client under this Agreement or any other such document, whether or not suit is commenced, and which attorneys' fees and legal expenses shall include, but not be limited to, any attorneys' fees and legal expenses incurred in connection with any appeal of a lower court's judgment or order. The Purchaser is hereby authorized to charge from time to time against any reserve account (including, without limitation, the Collected Reserve) established by the Purchaser pursuant to this Agreement any obligation of Client to Purchaser hereunder when due and apply any collections or other proceeds of any Account or other Collateral received by 4 Purchaser first to the reimbursement of Client's obligation hereunder. 5.08 REPORTING TO PURCHASER. Client shall provide the financial information to Purchaser as follows: (a) Client's year end financials and/or audit reports shall be delivered by Client within 120 days of Client's respective year ends during the term of this Agreement; (b) Client's monthly financial statements, including Client's accounts receivable aging and account payable aging, shall be delivered by Client by the 20th day of the month immediately following the month end to which the financial statements relate. 5.09 INSURANCE. Maintain insurance of such types and in such amounts as are maintained by companies of similar size engaged in the same or similar businesses; provided, however, that each policy insuring any collateral securing any and all obligations of Client shall name Purchaser as the loss payee. VI. NEGATIVE COVENANTS Client covenants and agrees that, until termination of this Agreement and performance by Client of all of its obligations hereunder, unless Purchaser shall otherwise consent in writing, it will not directly or indirectly: 6.01 NO LIENS. Create, incur, assume or suffer to exist any pledge, lien, charge or other encumbrance of any nature whatsoever on any of its Accounts or inventory, now or hereafter owned, other than the security interest granted by this Agreement. 6.02 NO SALE OF ASSETS; ETC. Sell, lease, transfer or otherwise dispose of any of its business or assets, except such (i) sales, transfers or other dispositions (including, without limitation, dispositions of inventory and equipment and the licensing of general intangibles) in the ordinary course of its business and (ii) grants of security interests in equipment in connection with Client's purchase money financing of such equipment. 6.03 NO INTERFERENCE WITH PURCHASER'S RIGHTS. Interfere in any fashion or under any circumstances with any of Purchaser's rights under this Agreement. 6.04 NO OTHER SALE OF ACCOUNTS. Sell its Accounts except to Purchaser during the term of this Agreement. 6.05 NO CHANGE OF ACCOUNT TERMS. Change or modify the terms of the original Account with Customer. 6.06 NO PLEDGE OF PURCHASER'S CREDIT. Pledge the credit of Purchaser to any person or entity for any purpose whatsoever. 6.07 NO ALTERNATIONS OF PAYMENT SCHEDULE. Alter any Customer payment schedule. VII. SECURITY INTEREST 7.01 GRANT OF SECURITY INTEREST. As a further inducement for Purchaser to enter into this Agreement, Client hereby grants to Purchaser, as security for the repayment of any and all of Client's obligations hereunder, a security interest in all of Client's accounts and inventory, instruments, documents, contract rights, chattel paper, general intangibles and the proceeds thereof (including any insurance proceeds) now or hereafter owned by Client, or in which Client now or hereafter may have any rights, wherever situated and whenever acquired. Client agrees to execute, from time to time, and authorizes Purchaser to execute and file such financing statements, assignments, and other documents covering the Collateral, including Proceeds, to create, evidence, perfect, maintain or continue its security interest in the Collateral (including additional Collateral acquired by the Client after the date hereof). Client will pay the cost of filing the same in all public offices in which Purchaser may deem filing to be appropriate and will notify Purchaser promptly upon acquiring any additional Collateral that may require an additional filing. Upon the occurrence of and during the continuance of an Event of Default, Client appoints Purchaser irrevocably as Client's agent and attorney-in-fact to perform such tasks as Purchaser in the sole exercise of its discretion determines to undertake to protect and/or enforce its rights to recover all sums due under the Agreement including, without limitation, notifying the United States Postal Service to change the address for delivery of the Client's mail to any address designated by Purchaser, otherwise intercept Client's mail, and receive, open and dispose of the Client's mail. Upon request, Client will deliver to Purchaser all Client's Documents, Chattel Paper and Instruments constituting part of the Collateral. VIII. DEFAULTS 8.01 EVENTS OF DEFAULT. Upon the occurrence of any of the following events (each of which is herein sometimes called an "Event of Default"): (a) If Client shall fail to pay any of its obligations to Purchaser within three business days of the date when due; 5 (b) If Client confesses inability to continue performance in accordance with this Agreement; (c) If any representation or warranty made herein or in any report, assignment, certificate, financial statement or other instrument furnished in connection with this Agreement, shall prove to be false or misleading in any material respect; (d) If Client shall fail to perform any covenant, condition or agreement contained herein; (e) If Client or any other person liable in whole or in part for payment or performance of the obligations contained herein shall (i) apply for or consent to appointment of a receiver, trustee, custodian or liquidator of it or any of its property; (ii) admit in writing its inability to pay its debts as they mature, (iii) make a general assignment for the benefit of creditors, (iv) be adjudicated bankrupt or insolvent or be the subject of an order for relief under Title 7 or 11 of the United States Code or (v) file a voluntary petition in bankruptcy, or a petition or an answer seeking reorganization or an arrangement with creditors or to take advantage of any bankruptcy, reorganization, insolvency, readjustment of debt, dissolution or liquidation law or statute, or an answer admitting the material allegations of a petition filed against it in any proceeding under any such law, or if a corporate action shall be taken for the purpose of effecting any of the foregoing; (f) If any order, judgment or decree shall be entered, without the application, approval or consent of Client by any court or competent jurisdiction, approving a petition seeking reorganization of Client or appointing a receiver trustee, custodian or liquidator of Client, or of all or a substantial part of the assets of Client; (g) If there occurs any attachment on any deposits or other property of Client in the hands or possession of Purchaser; (h) If any "default" (however defined) shall occur under any guaranty of Client's obligations hereunder; then, and in every such Event of Default and at any time thereafter during the continuance of such event, Purchaser may take any action permitted in law or equity including, without limitation, any one or more of the following: (i) charge back to Client all outstanding Accounts and declare all obligations secured hereby immediately due and payable; (ii) enforce the security interest given hereunder pursuant to the Uniform Commercial Code or any other law; (iii) require Client to assemble the Collateral and the records pertaining to the Accounts and make them available to Purchaser at a place designated by Purchaser: (iv) enter the premises of Client and take possession of the Collateral and of the records pertaining to the Accounts and any other Collateral; (v) grant extensions, compromise claims and settle the Accounts for less than the face value, and without prior notice to Client; (vi) use, in connection with any assembly or disposition of the Collateral, a trademark, trade name, copyright, patent right or technical process used or utilized by Client without payment of any license fee or royalty to Client; (vii) retain any surplus realized to cover Client's obligations to Purchaser and hold Client liable for any deficiency as provided in the Uniform Commercial Code; (viii) offset any funds held by Purchaser in any reserve account for obligations of Client to Purchaser, including but not limited to legal fees or other costs associated with the collection of Accounts, or pursue any other remedy at law or equity which Purchaser may have; (ix) charge an Event of Default fee of $750.00 per occurrence. IX. MISCELLANEOUS 9.01 SURVIVAL OF AGREEMENT; ETC. This Agreement and all covenants, agreements, representations and warranties made herein, shall survive the purchase by Purchaser of the Accounts hereunder, and shall continue in full force and effect, so long as Client shall have any obligations to Purchaser hereunder. Whenever in this Agreement any of the parties hereto is referred to, such reference shall be deemed to include the successors and assigns of such parties; and all covenants, promises and agreements in this Agreement contained, by or on behalf of Client, shall inure to the benefit of the successors and assigns of Purchaser. 9.02 PURCHASER'S PROPERTY. Any payment or payment(s) due as to any Account purchased by or assigned to Purchaser are the sole property of Purchaser. 9.03 APPOINTMENT OF ATTORNEY-IN-FACT. In order to carry out this Agreement and avoid unnecessary notification to Customers, Client irrevocably appoints Purchaser, or any person designated by Purchaser, its special attorney in fact or agent, with power to: (a) Delete Client's address on all invoices and statements mailed to Customers and to substitute in its place Purchaser's address; (b) Receive, open and dispose of all mail addressed to Client or to Client's trade name at Purchaser's address; (c) Endorse the name of Client or Client's trade name on any checks or other evidences of payment that may come 6 into the possession of Purchaser with respect to any Collateral; (d) In Client's name, or otherwise, to demand, sue for, collect, receive and give acquittance for any and all monies due or to become due on Accounts purchased by Purchaser; (e) To settle, compromise, compound, prosecute or defend any action or proceeding with respect to said Accounts; (f) To extend the time of payment of any or all of the Accounts purchased by Purchaser and to make any allowances and other adjustments with reference thereto; (g) Offer discounts to Client's Customer exclusive of Client's normal business custom with said Customer where necessary to affect collection; and (h) To do any and all things necessary and proper to carry out the purpose of this Agreement. The authority granted pursuant to this power of attorney shall continue in full force and effect until all Accounts purchased by Purchaser have been paid in full. 9.04 OPEN ITEMS. Should Purchaser receive a double payment on an Account or other payment which is not identified, Purchaser shall carry such sums as open items and shall return such sum to Client or Customer, as appropriate, upon written request for payment actually received by Purchaser. 9.05 INDEMNIFICATIONS OF PURCHASER. Client shall hold Purchaser harmless against any Customer ill will arising from Purchaser's collecting or attempting to collect any Account. 9.06 TERM OF AGREEMENT. This Agreement shall continue in full force and effect until May 29, 2004 ("Initial Termination Date"). Purchaser may terminate this Agreement at any time. Absent termination of this Agreement by Purchaser, or as provided elsewhere in this Agreement, this Agreement shall automatically and continually renew for successive periods of six months (each such period referred to as a "Renewal Period") from the Initial Termination Date or the end of a Renewal Period unless, Client, no less than thirty (30) days prior to the Initial Termination Date or the expiration of a Renewal Period: (a) gives Purchaser written notice to terminate this Agreement; and (b) if such termination occurs on or before November 29, 2003 (the "Minimum Cutoff Date"), pays Purchaser as liquidated damages an amount equal to the Monthly Minimum as set forth in Section 9.07 for each month or part of a month between the stated termination date and the Minimum Cutoff Date. 9.07 MONTHLY MINIMUM. Client agrees to generate a minimum of fees, i.e. Processing Fees plus Purchaser's Discount to Purchaser in the amount of $1,500.00 per month for a period of six months from the date of this Agreement regardless of any earlier termination of this Agreement (such minimum fees to be referred to herein as the "Monthly Minimum"). Purchaser acknowledges receipt of Client's payment of $1,000 prior to the execution of this Agreement, and agrees to apply such amount against the Monthly Minimum that the Client is required to generate for the first month during the term of this Agreement. Should Purchaser not receive the Monthly Minimum for any month during the term of this Agreement, Client agrees to remit immediately to Purchaser the difference between the Monthly Minimum and the fees actually generated through financing for such month. Remittance of the difference to Purchaser shall be made as follows: by Purchaser's deducting the difference from the Part Payment for any Account, from any sum otherwise to be returned to Client from the Collected Reserve in accordance with the provisions of this Agreement and/or any collateral securing Client's obligations to Purchaser, or by Client's direct payment to Purchaser of such difference. 9.08 SURVIVAL OF SECURITY INTEREST; ETC. After termination of this Agreement, Client shall remain fully responsible to Purchaser for any Accounts purchased before such termination and Purchaser's security interest shall survive such termination until all of Client's obligations hereunder shall have been fully paid and/or satisfied and, further, Purchaser agrees to abide by any requirements set forth in Article 9 of the Uniform Commercial Code to terminate any security interest granted to it by Client herein. 9.09 BINDING EFFECT; ETC. This Agreement shall inure to the benefit of and be binding upon the heirs, executors, administrators, successors and assigns of the parties hereto. 9.10 RIGHTS AND REMEDIES. No failure on the part of Purchaser to exercise, and no delay in exercising, and no course of dealing with respect to, any right, power or remedy under this Agreement shall operate as a waiver thereof, nor shall any single or partial exercise by Purchaser of any right, power or remedy under this Agreement preclude any other right, power or remedy. The remedies in this Agreement are cumulative and are not exclusive of any other remedies provided by law. 9.11 GOVERNING LAW. This Agreement shall be construed in accordance with and governed by the laws of the State of Minnesota. Unless otherwise defined herein, or unless the context otherwise requires, all terms used herein which are defined in the Minnesota Uniform Commercial Code have the meanings therein stated. 9.12 CONSENT TO JURISDICTION; ETC. Client hereby consents to the jurisdiction of the courts of the State of Minnesota and the United States District Court for the District of Minnesota for the purpose of any suit, action or other proceeding arising out of any of 7 its obligations hereunder or with respect to the transactions contemplated hereby, and expressly waives any and all objections it may have as to venue in any of such courts. CLIENT AND PURCHASER ALSO WAIVE TRIAL BY JURY IN ANY ACTION BROUGHT ON OR WITH RESPECT TO THIS AGREEMENT. 9.13 PURCHASER'S CUSTOMER NOTIFICATION RIGHTS; ETC. Purchaser may in its sole discretion give notice of assignment to any and all Customers of Client and collect Accounts directly from such Customers. 9.14 NOTICES. All notices and communications hereunder shall be given or made to the parties at their respective addresses set forth in the first paragraph of this Agreement, or at such other address as the addressee may hereafter specify for the purpose by written notice to the other party hereto. Such notices and other communications will be effectively given only if and when given in writing and delivered at the address set forth herein or duly deposited in the mails with first-class postage prepaid, or delivered to a telegraph company with all charges prepaid, addressed as aforesaid. 9.15 SEPARABILITY. If any provision hereof is held invalid, illegal or unenforceable in any jurisdiction, for any reason whatsoever, the other provisions hereof shall remain in full force and effect in such jurisdiction and to that end provisions hereof are declared to be severable and the remaining provisions shall be liberally construed in favor of Purchaser. 9.16 HEADINGS. The various headings of this Agreement are inserted for convenience only and shall not affect the meaning or interpretation of this Agreement or any provision hereof. IN WITNESS WHEREOF, this Agreement has been executed by the parties hereto all as of the day and year first above written. BEACON BANK HEI, INC. By By /s/ Mack Traynor --------------------- -------------------------- Its Its President -------------------- ------------------------- By -------------------------- Its ------------------------- 8 EX-10.2 4 c78181exv10w2.txt EX-10.2 LETTER RE: SUBORDINATED PROMISSORY NOTE EXHIBIT 10.2 [HEI INC LETTERHEAD] May 16, 2003 Whitebox Hedged High Yield Partners c/o Andrew J. Redleaf Chief Executive Officer Whitebox Advisors, LLC 3033 Excelsior Boulevard Suite 300 Minneapolis, MN 55416 Dear Andy, This letter is written to confirm the understanding between HEI, Inc. ("HEI") and Whitebox Hedged High Yield Partners ("Whitebox") relating to the Subordinated Promissory Note (the "Note") of HEI dated January 24, 2003 payable to the order of Colorado Madtech, Inc. ("CMED") in the original principal amount of $2,600,000 (the "Face Value") of the Note. We understand that CMED sold the Note to Whitebox on May 8, 2003. The Note is subordinated to certain indebtedness (the "Senior Debt") of HEI to LaSalle Business Credit, Inc. ("LaSalle") in accordance with the terms of a Subordination Agreement (the "Subordination Agreement") dated January 24, 2003 executed by CMED in favor of LaSalle, which Subordination Agreement is binding upon Whitebox as the transferee of the Note. To encourage HEI to prepay the Note prior to its current maturity date, Whitebox has agreed to accept a discounted amount as payment in full of the outstanding principal amount of the Note if such payment is made on or before certain dates specified below (the discounted amount Whitebox will so accept as payment in full being determined by the date on which such payment is received). In addition, HEI and Whitebox have agreed to modify the Note in certain respects if the Note is not prepaid in full, in accordance with the provisions of the Note as modified hereby, on or before August 15, 2003. DISCOUNTS. Whitebox agrees that the Face Value of the Note will be reduced by the following amounts (each a "Discount Amount"), and that Whitebox will accept as payment in full of the outstanding principal amount of the Note an amount equal to the Face Value of the Note as so reduced by the applicable Discount Amount, if such prepayment of principal is made by the Payment Date specified below with respect to the applicable Discount Amount:

Payment Date Discount Amount - ------------ --------------- on or before June 16, 2003 $430,000 thereafter and on or before July 15, 2003 $410,000 thereafter and on or before August 15, 2003 $390,000

Any such principal payment shall be made together with a payment of all interest accrued on the Note through the Payment Date. (For example, in accordance with this provision, HEI shall be deemed to have prepaid the Note in full if, on July 15, 2003, HEI pays Whitebox an amount equal to $2,190,000, together with all interest accrued on the Note through such Payment Date.) Upon receipt of any payment so deemed to constitute prepayment in full of the Note, Whitebox shall be deemed to have waived the right to receive payment of the applicable Discount Amount (payment of which Whitebox shall be deemed to have forgiven), and Whitebox shall cancel the Note and return it promptly (and in any event within 10 days from and after the receipt of such prepayment) to HEI marked "Paid in Full." MODIFICATIONS. If HEI does not prepay the Note in full, in accordance with the provisions of the Note as modified hereby, on or before August 15, 2003, HEI and Whitebox will modify the Note (by an addendum to the Note or by issuance of an amended and restated promissory note issued in substitution for the Note, and by delivery of such additional documents and instruments as HEI and Whitebox may deem necessary, in each case in form and substance reasonably satisfactory to HEI and Whitebox) to incorporate the following terms: - To secure the Note, HEI will grant Whitebox a first priority mortgage on HEI's building and real estate located at 1495 Steiger Lake Lane, Victoria, Minnesota. - Accrued and unpaid interest on the Note through August 15, 2003, will be capitalized. Accordingly, the principal amount of the Note will be increased to an amount equal to the sum of (i) the outstanding principal amount of the Note as of August 15, 2003, plus (ii) accrued and unpaid interest on the Note through such date. - HEI shall prepay interest to accrue on the Note from and after August 15, 2003 through September 30, 2004 by issuing to Whitebox a warrant to purchase 400,000 shares of HEI common stock at an exercise price per share equal to 10% above the closing price of a share of HEI common stock on August 15, 2003. Such warrant will have a five-year term, expiring on August 15, 2008, and shall contain such other terms and conditions as to which HEI and Whitebox may agree, it being understood that the such warrant shall be in a form reasonably acceptable to both HEI and Whitebox. - HEI will be granted the right to extend, at its option, the maturity date of the Note from September 30, 2004 to March 31, 2005, provided that, in the event HEI exercises such option, the Note will bear interest during such extension period at an annual rate of 12%, payable monthly. - HEI will continue to have the right to prepay the Note at any time without premium or penalty. CONDITION. Notwithstanding anything herein to the contrary, HEI shall have no obligations hereunder unless and until HEI shall have prepaid the Senior Debt in full and, in connection with such prepayment, LaSalle shall have acknowledged the termination of the Subordination Agreement. OTHER AGREEMENTS. If this letter is in accordance with your understanding of our agreement, please indicate your acceptance by signing below and returning this letter to HEI. This letter may be executed by the parties hereto individually or in any combination, in one or more counterparts, each of which shall together constitute one and the same agreement. This letter shall be governed, construed and enforced in accordance with the internal laws of the State of Minnesota. The parties have executed this letter agreement as of the date set forth above. HEI, INC. By /s/ Mack V. Traynor ----------------------- Mack V. Traynor, President and Chief Executive Officer Accepted and agreed to as of the date first set forth above: WHITEBOX HEDGED HIGH YIELD PARTNERS By WHITEBOX ADVISORS, LLC, its general partner By /s/ Andrew J. Redleaf ----------------------- Andrew J. Redleaf, Chief Executive Officer EX-99.1 5 c78181exv99w1.txt EX-99.1 SECTION 906 CERTIFICATION OF CEO EXHIBIT 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SS.1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of HEI, Inc. (the "Company") on Form 10-Q for the quarter ended May 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Mack V. Traynor, Chief Executive Officer and President of the Company, certify, pursuant to 18 U.S.C. ss.1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act oF 2002, that to the best of my knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Mack V. Traynor, III ------------------------------------- Mack V. Traynor, III Chief Executive Officer and President Date: July 15, 2003 A signed original of this written statement required by Section 906 has been provided to HEI, Inc. and will be retained by HEI, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. EX-99.2 6 c78181exv99w2.txt EX-99.2 SECTION 906 CERTIFICATION OF CFO EXHIBIT 99.2 CERTIFICATION PURSUANT TO 18 U.S.C. SS.1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of HEI, Inc. (the "Company") on Form 10-Q for the quarter ended May 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Douglas J. Nesbit, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss.1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that tO the best of my knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Douglas J. Nesbit ----------------------- Douglas J. Nesbit Chief Financial Officer Date: July 15, 2003 A signed original of this written statement required by Section 906 has been provided to HEI, Inc. and will be retained by HEI, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----

EX-10.1

                                                                    EXHIBIT 10.1

                          ACCOUNTS RECEIVABLE AGREEMENT


This Agreement entered into as of May 29, 2003 by and among HEI, Inc. (herein
called "Client"), a Minnesota corporation, whose addresses are 1495 Steiger Lake
Lane, Victoria, MN 55386 and 610 S Rockford Drive, Tempe, AZ 85281 and 4801 N
63rd Street, Boulder, CO 80301 and Beacon Bank (herein called "Purchaser"),
whose address is 19765 Highway 7, Shorewood, MN 55331. In consideration of the
mutual covenants set forth herein, Client and Purchaser agree as follows:

                                 I. DEFINITIONS

"ACCOUNT" means a right to payment of a monetary obligation, whether or not
earned by performance, (i) for property that has been or is to be sold, leased,
licensed, assigned, or otherwise disposed of, (ii) for services rendered or to
be rendered, (iii) for a policy of insurance issued or to be issued, (iv) for a
secondary obligation incurred or to be incurred, (v) for energy provided or to
be provided, (vi) for the use or hire of a vessel under a charter or other
contract, or (vii) arising out of the use of a credit or charge card or
information contained on or for use with the card and any and all the proceeds
therefrom. The term does not include (i) rights to payment evidenced by chattel
paper or an instrument, (ii) commercial tort claims, (iii) deposit accounts,
(iv) investment property, (v) letter of credit rights or letters of credit, or
(vi) rights to payment for money or funds advanced or sold, other than rights
arising out of the use of a credit or charge card or information contained on or
for use with the card.

"AFFILIATE" means, with respect to the Client, any person which directly or
indirectly controls, is controlled by, or is under common control with the
Client. The Client shall be deemed to control another person if the Client owns
directly or indirectly 5% or more of any class of voting stock of the controlled
person or possesses, directly or indirectly, the power to direct or cause the
direction of the management and policies of the controlled person, whether
through ownership of stock, by contract or otherwise. In addition, the Client's
Affiliates shall include the Client's officers, directors, joint venturers and
partners and any person controlled by any such officer, director, joint venturer
partner.

"COLLATERAL" means all of the property, real or personal, tangible or
intangible, given as security pursuant to Section 7.01 hereof for the
obligations of Client under this agreement.

"CREDIT PROBLEM" means a Customer is unable to pay its debts because of
insolvency, the dissolution, termination of existence, or business failure of
the Customer, the voluntary filing of a petition of bankruptcy, or the
commencement of any proceeding under the Bankruptcy Code or any other bankruptcy
or insolvency laws by or against Customer such that payment on the Account is or
will be impaired.

"CUSTOMER" means Client's customer or the account debtor.

"CUSTOMER DISPUTE" means any claim by a Customer against Client, valid or
invalid, now existing or hereafter arising (including, but not limited to, a
claim for credit or refund due to a return of goods which gave rise to an
Account, but excluding discounts, credits, allowances and adjustments accepted
by Purchaser in determining the Eligible Amount of an Account), and which the
Customer claims or may otherwise result in any reduction in the amount to be
paid by the Customer under any Account or Accounts. The foregoing
notwithstanding, a dispute with a Customer involving a Customer Dispute and/or a
Credit Problem shall be deemed a Customer Dispute.

"DAILY RATE" means the amount per diem equal to 1/25th of 1% (one twenty-fifth
of one percent) of the Eligible Amount for each day an Account assigned herein
remains unpaid.

"ELIGIBLE AMOUNT" means the gross face amount of the Account less (i) any
partial payments under the Account and (ii) any trade or cash discounts, credits
or allowances, or any adjustments to the Account taken by the Customer.

"PURCHASER'S DISCOUNT" means for each Account purchased by Purchaser in
accordance with the terms hereof, the difference between the Eligible Amount of
such Account and the Purchase Price of such Account, the Purchase Price
determined as of the date that the Eligible Amount is paid in full, whether by
the Customer or Client.

"INSOLVENT" means, with respect to any person or entity, that such person's or
entity's liabilities exceed such person's or entity's assets and/or such person
or entity is not generally paying its debts as they become due and means
"insolvent" as that term is used and defined in Section 101(32) of the United
States Bankruptcy Code and Section 2 of the Uniform Fraudulent Transfer Act.

                       II. PURCHASE OF ACCOUNTS RECEIVABLE

2.01 ASSIGNMENT/PURCHASE. Client hereby assigns and sells to Purchaser as
absolute owner with recourse all Accounts approved and deemed acceptable by
Purchaser, and represented by Client to be bona fide existing obligations of its
Customers arising out of, and acquired by it, in the ordinary course of its
business, which Accounts are or will be due and owing to Client without defense,
offset or counterclaim.



2.02 PURCHASER'S DISCRETION. Purchaser shall purchase only such Accounts
hereunder as Purchaser may select and approve in its sole and absolute
discretion. Purchaser shall not have any liability to Client or any of Client's
Customers for any failure or refusal by Purchasers to purchase any Account.

2.03 ASSIGNMENT DOCUMENTS. Client will provide Purchaser with an assignment of
Accounts, in a form(s) satisfactory to Purchaser (including any notices of
assignment as may be required by Purchaser), together with the original invoice
or a true copy of each invoice and/or statement, as may be specified by
Purchaser, including evidence of shipment, or other instruments or papers that
Purchaser may require.

2.04 STAMPING. At Purchaser's request, Client will place a sticker on, or stamp,
each original invoice being sold to Purchaser, in a form acceptable to
Purchaser, indicating that the Account has been sold to Purchaser and that
payment must be made directly to Purchaser. If for any reason Client fails to
provide an Account with proper notification, Purchaser will charge a missing
notation fee of 3% of the Eligible Amount. This requirement of stamping does not
apply to any Accounts purchased by Purchaser that have been invoiced by Client
prior to the date hereof.

2.05 NOTIFICATION. Client agrees to provide Purchaser a sufficient number of
Notice of Assignment of Account forms, in a form satisfactory to Purchaser,
signed by an authorized representative of Client, which may, at Purchaser's sole
discretion, be distributed by Purchaser to each Customer whose Account is
assigned and sold to Purchaser by Client. If Purchaser so requires, it shall be
Client's obligation to ensure that the Notice of Assignment of Accounts form be
duly executed by an authorized representative of the Customer and returned to
Purchaser.

2.06 PART PAYMENT. Upon approval and acceptance by Purchaser of an Account,
Purchaser shall pay to Client part payment of the Purchase Price in an amount
not exceeding 80% (eighty percent) of the Eligible Amount.

2.07 PROCESSING FEE. For each Account approved and accepted by Purchaser
hereunder, Purchaser shall receive from Client and Client shall be obligated to
pay to Purchaser a processing fee equal to .50% (fifty hundredths percent) of
the Eligible Amount.

2.08 PURCHASE PRICE. The purchase price payable by Purchaser to Client for each
Account shall be equal to 100% (one hundred percent) of the Eligible Amount
reduced by the Daily Rate beginning as of the date that Purchaser makes part
payment as to such Account and continuing for each day thereafter that such
Account remains unpaid (the "Purchase Price") payable as provided in Section
2.10 hereof.

2.09 COLLECTED RESERVE. Purchaser may hold in a reserve account all collections
of purchased and non-purchased Accounts ("Collected Reserve"). The Collected
Reserve may be held by Purchaser as security against charge-backs or any other
obligations of Client to Purchaser and may be applied by Purchaser against such
charge-backs or other obligations. Client hereby transfers and assigns to
Purchaser all of its right, title and interest in and to the Collected Reserve,
except as any portion of the Collected Reserve is released by Purchaser to
Client as provided in Section 2.10 below.

2.10 RETURN OF COLLECTED RESERVE. Purchaser will return to Client that portion
or all of the sums in the Collected Reserve on Friday as of Wednesday of each
week only if and to the extent, in Purchaser's sole and absolute discretion,
Purchaser has determined that Client has complied with all of the terms and
conditions of this Agreement, including, without limitation, that no events of
default as defined in Article VIII below have occurred and that Client
acknowledges to Purchaser that there are no offsets or claims against or
customer disputes relating to any Account purchased by Purchaser. However, if
the Collected Reserve has a deficit balance at any time, Client shall be
obligated to immediately pay to Purchaser, with or without demand, the amount of
such deficit.

2.11 CUSTOMER DISPUTES. Upon the occurrence of any Customer Dispute, whether
valid or invalid, Client will immediately pay to Purchaser, on the Account
purchased by Purchaser subject to the Customer Dispute, the amount of any Part
Payment made on the Account by Purchaser plus the Purchaser's Discount. Further,
notwithstanding the payment obligation set forth herein, Purchaser may, in
addition to any other remedies available to Purchaser under this Agreement,
immediately charge-back the Account purchased by Purchaser, which is subject to
the Customer Dispute, to Client and provide notice thereof to Client. Where the
Purchaser charges back an Account subject to a Customer Dispute or where the
Client makes payment to Purchaser as to such an Account, then upon the
Purchaser's receipt of the Part Payment plus the Purchaser's Discount due
thereon, the Client shall have and be entitled to exercise all rights of and as
the owner of such Account subject to the Purchaser's security interest therein
as set forth herein. Client shall notify Purchaser immediately of any disputes
between Customer and Client. Purchaser may, but is not obligated to, settle any
Customer Dispute directly with Customer. Such settlement does not relieve Client
of final responsibility for payment of any such Account purchased by Purchaser.

2.12 CLIENT'S OBLIGATION. Until all Accounts purchased by Purchaser are paid or
declared in Purchaser's own judgment to be uncollectible due to a Credit
Problem, and the Client has satisfied its obligation to pay Purchaser as set
forth in Section paragraph 2.11 above, the amount paid for the Account together
with the Purchaser's Discount shall be and remain an obligation of Client to
Purchaser.

                                       2





                  III. WARRANTIES AND REPRESENTATIONS OF CLIENT

         In order to induce Purchaser to enter into this Agreement and purchase
Accounts under the terms hereof, and with full knowledge that the truth and
accuracy of the warranties and representations set forth in this Agreement are
being relied upon by Purchaser, because, among other reasons, time is of the
essence and a substantial delay in the purchase of Accounts by Purchaser could
be caused by a complete credit investigation of each Customer, Client warrants
and represents to Purchaser now, and during the term of this Agreement, that:

3.01   CLIENT ORGANIZATION; ETC.  Client:

                  (a)      is duly organized, validly existing and in good
                           standing under the laws of the State of Minnesota;

                  (b)      has the power and authority to own its properties and
                           carry on its business as it is now being conducted,
                           and is to be conducted following consummation of the
                           transactions contemplated by this Agreement.

                  (c)      is qualified to do business in every jurisdiction
                           where such qualification is necessary;

                  (d)      is duly authorized to conduct such business under the
                           name of HEI, Inc. and such trade name has been
                           properly registered as required by the laws of the
                           State of Minnesota; and

                  (e)      has the power to execute and deliver this Agreement
                           and to execute and deliver to Purchaser any and all
                           documents required to be executed and delivered
                           hereunder.

3.02 CUSTOMER SOLVENCY. To the best knowledge of Client, no Customer of Client
whose Accounts are to be assigned to and purchased by Purchaser, is Insolvent.

3.03 TITLE TO ASSETS. Client has good title to all inventory (other than
consigned inventory) and Accounts, free and clear of all mortgages, liens and
encumbrances, covenants or restrictions, other than the security interest
granted by this Agreement.

3.04 VALIDITY OF ACCOUNTS; ETC. Each Account offered for sale to Purchaser: (a)
is an accurate and undisputed (without claim of offset, defense or counterclaim)
statement of indebtedness by Customer to Client, for a sum certain, which is due
and payable within forty-five days or less, or within such time as is agreed to,
in writing, by Purchaser and Client; and (b) arises out of a bona fide absolute
sale, delivery and acceptance of goods (not on consignment, or on approval, or
on hold basis, or subject to any other contingency), or rendition of service by
Client to Customer, made in the ordinary course of Client's business.

3.05 TITLE TO ACCOUNTS; ETC. None of the Accounts being sold to Purchaser have
heretofore been sold or assigned to any person, firm or corporation, nor has any
security interest in such Accounts been granted to any person, firm or
corporation, or are owed by a Customer who is one of Client's Affiliates, other
than the security interest granted by this Agreement.

3.06 NO CONTRAVENING AGREEMENTS. There are no agreements, verbal or written,
between Client and Customer, or any other party, which would prohibit the sale
of the Customer Account by Client to Purchaser.

3.07 AUTHORIZATION; ETC. The execution and performance by Client of the terms
and provisions of this Agreement and the execution and delivery of any other
documents required to be executed and delivered hereunder have been duly
authorized by all requisite company action, and neither the execution and
performance of this Agreement or any other documents required to be delivered
hereunder, will violate any provision of law, any order of any court or other
agency of government, the articles of organization or agreement of partnership,
if any, of Client, or any indenture, agreement or other instrument to which
Client is a party, or by which Client is bound, or be in conflict with, result
in breach of, or constitute (with due notice or lapse of time or both) a default
under, or result in the creation or imposition of any lien, charge or
encumbrance of any nature whatsoever upon any of the property or assets of
Client pursuant to, any such indenture, agreement or instrument, except as
provided in this Agreement.

3.08 NO LITIGATION. Except as disclosed in writing by Client to Purchaser, there
is no action, suit or proceeding at law or in equity or by or before any
governmental instrumentality or other agency now pending or, to the knowledge of
Client, threatened against or affecting Client which, if adversely determined,
would have a material adverse effect on the business, operations, properties,
assets or condition, financial or otherwise, of Client.

3.09 NO ADVERSE AGREEMENTS. Client is not a party to any material agreement or
instrument or subject to any restriction adversely affecting its business,
properties or assets, operations or condition, financial or otherwise. Client is
not in default in the performance, observance or fulfillment of any agreement or
instrument to which it is a party which materially adversely affects the
business, operations, affairs or condition of Client or any of its properties.


                                       3





3.10 NO ADVERSE EVENT. Except as disclosed in writing to Purchaser, there is no
fact known to Client which materially adversely affects the business,
operations, affairs or condition of Client or any of its properties.

3.11 TAXES. Client has filed all tax returns required by law to be filed and has
paid all taxes, assessments and other governmental charges levied upon its
properties, assets and income, other than those not yet delinquent. There are no
unpaid assessments for additional taxes or any basis therefor.

3.12 COMPLIANCE WITH LAWS. Client is in full compliance in all material respects
with all state and federal laws relating to the conduct of its business.

               IV. CONDITIONS TO PURCHASER'S OBLIGATIONS HEREUNDER

4.01 CONDITIONS PRECEDENT. Except as to those obligations of Purchaser that are
discretionary as set forth herein, the obligations of Purchaser to perform its
obligations hereunder is subject to the conditions precedent that the
representations and warranties set forth in Article III hereof shall be true and
correct on and as of the date hereof, and on the date each Account is offered to
Purchaser for sale pursuant to this Agreement; and no Event of Default as
specified in Article VIII hereof, nor any event which upon notice or lapse of
time or both would constitute such an Event of Default, shall have occurred and
be continuing; and each offer of an Account for sale to Purchaser shall
constitute a certification by Client to such effect as of the date of such
offer.

                       V. AFFIRMATIVE COVENANTS BY CLIENT

         Client covenants and agrees that, from the date hereof and until
termination of this Agreement and performance of all of Client's obligations
hereunder, Client will, unless otherwise agreed to in writing by Purchaser:

5.01 INSPECTION OF RECORDS. Promptly, from time to time, permit Purchaser to
inspect its books and records, at reasonable business hours, and to make copies
of abstracts thereof, and furnish such other information regarding its
operations, assets, business affairs and financial condition, as Purchaser may
request.

5.02     NOTICES.  Promptly notify Purchaser of:

         (a)      any developments which would materially adversely affect the
                  business of Client, its properties or affairs or the ability
                  of Client to perform its obligations under this Agreement, or
                  any other documents delivered in connection herewith;

         (b)      any material adverse change in Client's condition, financial
                  or otherwise;

         (c)      the occurrence of any Event of Default by Client as defined in
                  Article VIII hereof, and of the occurrence of any event which
                  upon notice or lapse of time, or both, would constitute such
                  an Event of Default; or

         (d)      any change of address of Client.

5.03 TAXES. Pay all taxes or fees in relation to the Accounts, goods sold or
services rendered, giving rise to the Accounts.

5.04 PURCHASER'S PROPERTY. Immediately turn over to Purchaser and, until doing
so, hold in trust and safekeeping separate and apart from Client's other
property and as the sole and separate property of Purchaser any payment on an
Account purchased by Purchaser whenever any such payment, whether cash, check
(payable to Client, Purchaser or both), money order or other form of payment,
comes into Client's possession, and all goods giving rise to Accounts purchased
by Purchaser which are returned or rejected by, or repossessed from Customer(s).
If Client fails to turn over payment on a purchased Account to Purchaser in the
form received (except for the Client's endorsement when necessary) within two
business days of client's receipt of such payments, Purchaser will charge a
misdirected payment fee of 15% of the Eligible Amount and the Client shall be
obligated to immediately pay such fee with or without demand by Purchaser.

5.05 BOOK ENTRIES. Upon the sale of any of its Accounts to Purchaser, Client
will immediately make proper entries on its books and records recognizing and
disclosing the sale of such Accounts to Purchaser.

5.06 REIMBURSEMENT OF EXPENSES; ETC. Reimburse the Purchaser for its reasonable
expenses, fees and disbursements (including, without limitation, reasonable
attorneys' fees and legal expenses and wire transfer fees), incurred in
connection with (i) the preparation or administration of this Agreement or any
other document relating hereto and (ii) the Purchaser's enforcement of the
obligations of the Client under this Agreement or any other such document,
whether or not suit is commenced, and which attorneys' fees and legal expenses
shall include, but not be limited to, any attorneys' fees and legal expenses
incurred in connection with any appeal of a lower court's judgment or order. The
Purchaser is hereby authorized to charge from time to time against any reserve
account (including, without limitation, the Collected Reserve) established by
the Purchaser pursuant to this Agreement any obligation of Client to Purchaser
hereunder when due and apply any collections or other proceeds of any Account or
other Collateral received by

                                       4





Purchaser first to the reimbursement of Client's obligation hereunder.

5.08 REPORTING TO PURCHASER. Client shall provide the financial information to
Purchaser as follows:

         (a)      Client's year end financials and/or audit reports shall be
                  delivered by Client within 120 days of Client's respective
                  year ends during the term of this Agreement;

         (b)      Client's monthly financial statements, including Client's
                  accounts receivable aging and account payable aging, shall be
                  delivered by Client by the 20th day of the month immediately
                  following the month end to which the financial statements
                  relate.

5.09     INSURANCE. Maintain insurance of such types and in such amounts as are
         maintained by companies of similar size engaged in the same or similar
         businesses; provided, however, that each policy insuring any collateral
         securing any and all obligations of Client shall name Purchaser as the
         loss payee.

                             VI. NEGATIVE COVENANTS

         Client covenants and agrees that, until termination of this Agreement
and performance by Client of all of its obligations hereunder, unless Purchaser
shall otherwise consent in writing, it will not directly or indirectly:

6.01 NO LIENS. Create, incur, assume or suffer to exist any pledge, lien, charge
or other encumbrance of any nature whatsoever on any of its Accounts or
inventory, now or hereafter owned, other than the security interest granted by
this Agreement.

6.02 NO SALE OF ASSETS; ETC. Sell, lease, transfer or otherwise dispose of any
of its business or assets, except such (i) sales, transfers or other
dispositions (including, without limitation, dispositions of inventory and
equipment and the licensing of general intangibles) in the ordinary course of
its business and (ii) grants of security interests in equipment in connection
with Client's purchase money financing of such equipment.

6.03 NO INTERFERENCE WITH PURCHASER'S RIGHTS. Interfere in any fashion or under
any circumstances with any of Purchaser's rights under this Agreement.

6.04 NO OTHER SALE OF ACCOUNTS. Sell its Accounts except to Purchaser during the
term of this Agreement.

6.05 NO CHANGE OF ACCOUNT TERMS. Change or modify the terms of the original
Account with Customer.

6.06 NO PLEDGE OF PURCHASER'S CREDIT. Pledge the credit of Purchaser to any
person or entity for any purpose whatsoever.

6.07 NO ALTERNATIONS OF PAYMENT SCHEDULE. Alter any Customer payment schedule.

                             VII. SECURITY INTEREST

7.01 GRANT OF SECURITY INTEREST. As a further inducement for Purchaser to enter
into this Agreement, Client hereby grants to Purchaser, as security for the
repayment of any and all of Client's obligations hereunder, a security interest
in all of Client's accounts and inventory, instruments, documents, contract
rights, chattel paper, general intangibles and the proceeds thereof (including
any insurance proceeds) now or hereafter owned by Client, or in which Client now
or hereafter may have any rights, wherever situated and whenever acquired.
Client agrees to execute, from time to time, and authorizes Purchaser to execute
and file such financing statements, assignments, and other documents covering
the Collateral, including Proceeds, to create, evidence, perfect, maintain or
continue its security interest in the Collateral (including additional
Collateral acquired by the Client after the date hereof). Client will pay the
cost of filing the same in all public offices in which Purchaser may deem filing
to be appropriate and will notify Purchaser promptly upon acquiring any
additional Collateral that may require an additional filing. Upon the occurrence
of and during the continuance of an Event of Default, Client appoints Purchaser
irrevocably as Client's agent and attorney-in-fact to perform such tasks as
Purchaser in the sole exercise of its discretion determines to undertake to
protect and/or enforce its rights to recover all sums due under the Agreement
including, without limitation, notifying the United States Postal Service to
change the address for delivery of the Client's mail to any address designated
by Purchaser, otherwise intercept Client's mail, and receive, open and dispose
of the Client's mail. Upon request, Client will deliver to Purchaser all
Client's Documents, Chattel Paper and Instruments constituting part of the
Collateral.

                                 VIII. DEFAULTS

8.01 EVENTS OF DEFAULT. Upon the occurrence of any of the following events (each
of which is herein sometimes called an "Event of Default"):

         (a)      If Client shall fail to pay any of its obligations to
                  Purchaser within three business days of the date when due;


                                       5

         (b)      If Client confesses inability to continue performance in
                  accordance with this Agreement;

         (c)      If any representation or warranty made herein or in any
                  report, assignment, certificate, financial statement or other
                  instrument furnished in connection with this Agreement, shall
                  prove to be false or misleading in any material respect;

         (d)      If Client shall fail to perform any covenant, condition or
                  agreement contained herein;

         (e)      If Client or any other person liable in whole or in part for
                  payment or performance of the obligations contained herein
                  shall (i) apply for or consent to appointment of a receiver,
                  trustee, custodian or liquidator of it or any of its property;
                  (ii) admit in writing its inability to pay its debts as they
                  mature, (iii) make a general assignment for the benefit of
                  creditors, (iv) be adjudicated bankrupt or insolvent or be the
                  subject of an order for relief under Title 7 or 11 of the
                  United States Code or (v) file a voluntary petition in
                  bankruptcy, or a petition or an answer seeking reorganization
                  or an arrangement with creditors or to take advantage of any
                  bankruptcy, reorganization, insolvency, readjustment of debt,
                  dissolution or liquidation law or statute, or an answer
                  admitting the material allegations of a petition filed against
                  it in any proceeding under any such law, or if a corporate
                  action shall be taken for the purpose of effecting any of the
                  foregoing;

         (f)      If any order, judgment or decree shall be entered, without the
                  application, approval or consent of Client by any court or
                  competent jurisdiction, approving a petition seeking
                  reorganization of Client or appointing a receiver trustee,
                  custodian or liquidator of Client, or of all or a substantial
                  part of the assets of Client;

         (g)      If there occurs any attachment on any deposits or other
                  property of Client in the hands or possession of Purchaser;

         (h)      If any "default" (however defined) shall occur under any
                  guaranty of Client's obligations hereunder;

         then, and in every such Event of Default and at any time thereafter
         during the continuance of such event, Purchaser may take any action
         permitted in law or equity including, without limitation, any one or
         more of the following: (i) charge back to Client all outstanding
         Accounts and declare all obligations secured hereby immediately due and
         payable; (ii) enforce the security interest given hereunder pursuant to
         the Uniform Commercial Code or any other law; (iii) require Client to
         assemble the Collateral and the records pertaining to the Accounts and
         make them available to Purchaser at a place designated by Purchaser:
         (iv) enter the premises of Client and take possession of the Collateral
         and of the records pertaining to the Accounts and any other Collateral;
         (v) grant extensions, compromise claims and settle the Accounts for
         less than the face value, and without prior notice to Client; (vi) use,
         in connection with any assembly or disposition of the Collateral, a
         trademark, trade name, copyright, patent right or technical process
         used or utilized by Client without payment of any license fee or
         royalty to Client; (vii) retain any surplus realized to cover Client's
         obligations to Purchaser and hold Client liable for any deficiency as
         provided in the Uniform Commercial Code; (viii) offset any funds held
         by Purchaser in any reserve account for obligations of Client to
         Purchaser, including but not limited to legal fees or other costs
         associated with the collection of Accounts, or pursue any other remedy
         at law or equity which Purchaser may have; (ix) charge an Event of
         Default fee of $750.00 per occurrence.

                                IX. MISCELLANEOUS

9.01 SURVIVAL OF AGREEMENT; ETC. This Agreement and all covenants, agreements,
representations and warranties made herein, shall survive the purchase by
Purchaser of the Accounts hereunder, and shall continue in full force and
effect, so long as Client shall have any obligations to Purchaser hereunder.
Whenever in this Agreement any of the parties hereto is referred to, such
reference shall be deemed to include the successors and assigns of such parties;
and all covenants, promises and agreements in this Agreement contained, by or on
behalf of Client, shall inure to the benefit of the successors and assigns of
Purchaser.

9.02 PURCHASER'S PROPERTY. Any payment or payment(s) due as to any Account
purchased by or assigned to Purchaser are the sole property of Purchaser.

9.03 APPOINTMENT OF ATTORNEY-IN-FACT. In order to carry out this Agreement and
avoid unnecessary notification to Customers, Client irrevocably appoints
Purchaser, or any person designated by Purchaser, its special attorney in fact
or agent, with power to:

         (a)      Delete Client's address on all invoices and statements mailed
                  to Customers and to substitute in its place Purchaser's
                  address;

         (b)      Receive, open and dispose of all mail addressed to Client or
                  to Client's trade name at Purchaser's address;

         (c)      Endorse the name of Client or Client's trade name on any
                  checks or other evidences of payment that may come

                                       6

                  into the possession of Purchaser with respect to any
                  Collateral;

         (d)      In Client's name, or otherwise, to demand, sue for, collect,
                  receive and give acquittance for any and all monies due or to
                  become due on Accounts purchased by Purchaser;

         (e)      To settle, compromise, compound, prosecute or defend any
                  action or proceeding with respect to said Accounts;

         (f)      To extend the time of payment of any or all of the Accounts
                  purchased by Purchaser and to make any allowances and other
                  adjustments with reference thereto;

         (g)      Offer discounts to Client's Customer exclusive of Client's
                  normal business custom with said Customer where necessary to
                  affect collection; and

         (h)      To do any and all things necessary and proper to carry out the
                  purpose of this Agreement. The authority granted pursuant to
                  this power of attorney shall continue in full force and effect
                  until all Accounts purchased by Purchaser have been paid in
                  full.

9.04 OPEN ITEMS. Should Purchaser receive a double payment on an Account or
other payment which is not identified, Purchaser shall carry such sums as open
items and shall return such sum to Client or Customer, as appropriate, upon
written request for payment actually received by Purchaser.

9.05 INDEMNIFICATIONS OF PURCHASER. Client shall hold Purchaser harmless against
any Customer ill will arising from Purchaser's collecting or attempting to
collect any Account.

9.06 TERM OF AGREEMENT. This Agreement shall continue in full force and effect
until May 29, 2004 ("Initial Termination Date"). Purchaser may terminate this
Agreement at any time. Absent termination of this Agreement by Purchaser, or as
provided elsewhere in this Agreement, this Agreement shall automatically and
continually renew for successive periods of six months (each such period
referred to as a "Renewal Period") from the Initial Termination Date or the end
of a Renewal Period unless, Client, no less than thirty (30) days prior to the
Initial Termination Date or the expiration of a Renewal Period: (a) gives
Purchaser written notice to terminate this Agreement; and (b) if such
termination occurs on or before November 29, 2003 (the "Minimum Cutoff Date"),
pays Purchaser as liquidated damages an amount equal to the Monthly Minimum as
set forth in Section 9.07 for each month or part of a month between the stated
termination date and the Minimum Cutoff Date.

9.07 MONTHLY MINIMUM. Client agrees to generate a minimum of fees, i.e.
Processing Fees plus Purchaser's Discount to Purchaser in the amount of
$1,500.00 per month for a period of six months from the date of this Agreement
regardless of any earlier termination of this Agreement (such minimum fees to be
referred to herein as the "Monthly Minimum"). Purchaser acknowledges receipt of
Client's payment of $1,000 prior to the execution of this Agreement, and agrees
to apply such amount against the Monthly Minimum that the Client is required to
generate for the first month during the term of this Agreement. Should Purchaser
not receive the Monthly Minimum for any month during the term of this Agreement,
Client agrees to remit immediately to Purchaser the difference between the
Monthly Minimum and the fees actually generated through financing for such
month. Remittance of the difference to Purchaser shall be made as follows: by
Purchaser's deducting the difference from the Part Payment for any Account, from
any sum otherwise to be returned to Client from the Collected Reserve in
accordance with the provisions of this Agreement and/or any collateral securing
Client's obligations to Purchaser, or by Client's direct payment to Purchaser of
such difference.

9.08 SURVIVAL OF SECURITY INTEREST; ETC. After termination of this Agreement,
Client shall remain fully responsible to Purchaser for any Accounts purchased
before such termination and Purchaser's security interest shall survive such
termination until all of Client's obligations hereunder shall have been fully
paid and/or satisfied and, further, Purchaser agrees to abide by any
requirements set forth in Article 9 of the Uniform Commercial Code to terminate
any security interest granted to it by Client herein.

9.09 BINDING EFFECT; ETC. This Agreement shall inure to the benefit of and be
binding upon the heirs, executors, administrators, successors and assigns of the
parties hereto.

9.10 RIGHTS AND REMEDIES. No failure on the part of Purchaser to exercise, and
no delay in exercising, and no course of dealing with respect to, any right,
power or remedy under this Agreement shall operate as a waiver thereof, nor
shall any single or partial exercise by Purchaser of any right, power or remedy
under this Agreement preclude any other right, power or remedy. The remedies in
this Agreement are cumulative and are not exclusive of any other remedies
provided by law.

9.11 GOVERNING LAW. This Agreement shall be construed in accordance with and
governed by the laws of the State of Minnesota. Unless otherwise defined herein,
or unless the context otherwise requires, all terms used herein which are
defined in the Minnesota Uniform Commercial Code have the meanings therein
stated.

9.12 CONSENT TO JURISDICTION; ETC. Client hereby consents to the jurisdiction of
the courts of the State of Minnesota and the United States District Court for
the District of Minnesota for the purpose of any suit, action or other
proceeding arising out of any of

                                       7





its obligations hereunder or with respect to the transactions contemplated
hereby, and expressly waives any and all objections it may have as to venue in
any of such courts. CLIENT AND PURCHASER ALSO WAIVE TRIAL BY JURY IN ANY ACTION
BROUGHT ON OR WITH RESPECT TO THIS AGREEMENT.

9.13 PURCHASER'S CUSTOMER NOTIFICATION RIGHTS; ETC. Purchaser may in its sole
discretion give notice of assignment to any and all Customers of Client and
collect Accounts directly from such Customers.

9.14 NOTICES. All notices and communications hereunder shall be given or made to
the parties at their respective addresses set forth in the first paragraph of
this Agreement, or at such other address as the addressee may hereafter specify
for the purpose by written notice to the other party hereto. Such notices and
other communications will be effectively given only if and when given in writing
and delivered at the address set forth herein or duly deposited in the mails
with first-class postage prepaid, or delivered to a telegraph company with all
charges prepaid, addressed as aforesaid.

9.15 SEPARABILITY. If any provision hereof is held invalid, illegal or
unenforceable in any jurisdiction, for any reason whatsoever, the other
provisions hereof shall remain in full force and effect in such jurisdiction and
to that end provisions hereof are declared to be severable and the remaining
provisions shall be liberally construed in favor of Purchaser.

9.16 HEADINGS. The various headings of this Agreement are inserted for
convenience only and shall not affect the meaning or interpretation of this
Agreement or any provision hereof.

IN WITNESS WHEREOF, this Agreement has been executed by the parties hereto all
as of the day and year first above written.

BEACON BANK                                        HEI, INC.

By                                                 By /s/ Mack Traynor
  ---------------------                              --------------------------
Its                                                Its President
   --------------------                               -------------------------

                                                   By
                                                     --------------------------
                                                   Its
                                                      -------------------------








                                       8

EX-10.2

                                                                    EXHIBIT 10.2

                              [HEI INC LETTERHEAD]

May 16, 2003

Whitebox Hedged High Yield Partners
c/o Andrew J. Redleaf
Chief Executive Officer
Whitebox Advisors, LLC
3033 Excelsior Boulevard
Suite 300
Minneapolis, MN  55416


Dear Andy,

This letter is written to confirm the understanding between HEI, Inc. ("HEI")
and Whitebox Hedged High Yield Partners ("Whitebox") relating to the
Subordinated Promissory Note (the "Note") of HEI dated January 24, 2003 payable
to the order of Colorado Madtech, Inc. ("CMED") in the original principal amount
of $2,600,000 (the "Face Value") of the Note. We understand that CMED sold the
Note to Whitebox on May 8, 2003. The Note is subordinated to certain
indebtedness (the "Senior Debt") of HEI to LaSalle Business Credit, Inc.
("LaSalle") in accordance with the terms of a Subordination Agreement (the
"Subordination Agreement") dated January 24, 2003 executed by CMED in favor of
LaSalle, which Subordination Agreement is binding upon Whitebox as the
transferee of the Note.

To encourage HEI to prepay the Note prior to its current maturity date, Whitebox
has agreed to accept a discounted amount as payment in full of the outstanding
principal amount of the Note if such payment is made on or before certain dates
specified below (the discounted amount Whitebox will so accept as payment in
full being determined by the date on which such payment is received). In
addition, HEI and Whitebox have agreed to modify the Note in certain respects if
the Note is not prepaid in full, in accordance with the provisions of the Note
as modified hereby, on or before August 15, 2003.

DISCOUNTS. Whitebox agrees that the Face Value of the Note will be reduced by
the following amounts (each a "Discount Amount"), and that Whitebox will accept
as payment in full of the outstanding principal amount of the Note an amount
equal to the Face Value of the Note as so reduced by the applicable Discount
Amount, if such prepayment of principal is made by the Payment Date specified
below with respect to the applicable Discount Amount:



Payment Date                                   Discount Amount
- ------------                                   ---------------
                                            
on or before June 16, 2003                        $430,000
thereafter and on or before July 15, 2003         $410,000
thereafter and on or before August 15, 2003       $390,000



Any such principal payment shall be made together with a payment of all
interest accrued on the Note through the Payment Date. (For example, in
accordance with this provision, HEI shall be deemed to have prepaid the Note in
full if, on July 15, 2003, HEI pays Whitebox an amount equal to $2,190,000,
together with all interest accrued on the Note through such Payment Date.)

Upon receipt of any payment so deemed to constitute prepayment in full of the
Note, Whitebox shall be deemed to have waived the right to receive payment of
the applicable Discount Amount (payment of which Whitebox shall be deemed to
have forgiven), and Whitebox shall cancel the Note and return it promptly (and
in any event within 10 days from and after the receipt of such prepayment) to
HEI marked "Paid in Full."

MODIFICATIONS. If HEI does not prepay the Note in full, in accordance with the
provisions of the Note as modified hereby, on or before August 15, 2003, HEI and
Whitebox will modify the Note (by an addendum to the Note or by issuance of an
amended and restated promissory note issued in substitution for the Note, and
by delivery of such additional documents and instruments as HEI and Whitebox
may deem necessary, in each case in form and substance reasonably satisfactory
to HEI and Whitebox) to incorporate the following terms:

         -   To secure the Note, HEI will grant Whitebox a first priority
             mortgage on HEI's building and real estate located at 1495 Steiger
             Lake Lane, Victoria, Minnesota.

         -   Accrued and unpaid interest on the Note through August 15, 2003,
             will be capitalized. Accordingly, the principal amount of the Note
             will be increased to an amount equal to the sum of (i) the
             outstanding principal amount of the Note as of August 15, 2003,
             plus (ii) accrued and unpaid interest on the Note through such
             date.

         -   HEI shall prepay interest to accrue on the Note from and after
             August 15, 2003 through September 30, 2004 by issuing to Whitebox a
             warrant to purchase 400,000 shares of HEI common stock at an
             exercise price per share equal to 10% above the closing price of a
             share of HEI common stock on August 15, 2003. Such warrant will
             have a five-year term, expiring on August 15, 2008, and shall
             contain such other terms and conditions as to which HEI and
             Whitebox may agree, it being understood that the such warrant shall
             be in a form reasonably acceptable to both HEI and Whitebox.

         -   HEI will be granted the right to extend, at its option, the
             maturity date of the Note from September 30, 2004 to March 31,
             2005, provided that, in the event HEI exercises such option, the
             Note will bear interest during such extension period at an annual
             rate of 12%, payable monthly.

         -   HEI will continue to have the right to prepay the Note at any time
             without premium or penalty.

CONDITION. Notwithstanding anything herein to the contrary, HEI shall have no
obligations hereunder unless and until HEI shall have prepaid the Senior Debt
in full and,

in connection with such prepayment, LaSalle shall have acknowledged the
termination of the Subordination Agreement.

OTHER AGREEMENTS. If this letter is in accordance with your understanding of
our agreement, please indicate your acceptance by signing below and returning
this letter to HEI. This letter may be executed by the parties hereto
individually or in any combination, in one or more counterparts, each of which
shall together constitute one and the same agreement. This letter shall be
governed, construed and enforced in accordance with the internal laws of the
State of Minnesota.

The parties have executed this letter agreement as of the date set forth above.

                                                 HEI, INC.

                                                 By /s/ Mack V. Traynor
                                                    -----------------------
                                                    Mack V. Traynor, President
                                                    and Chief Executive Officer

Accepted and agreed to as of
the date first set forth above:

WHITEBOX HEDGED HIGH YIELD PARTNERS

By WHITEBOX ADVISORS, LLC,
     its general partner

By /s/ Andrew J. Redleaf
   -----------------------
   Andrew J. Redleaf, Chief
   Executive Officer

EX-99.1

                                                                    EXHIBIT 99.1




                            CERTIFICATION PURSUANT TO
                               18 U.S.C. SS.1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002


In connection with the Quarterly Report of HEI, Inc. (the "Company") on Form
10-Q for the quarter ended May 31, 2003, as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), I, Mack V. Traynor, Chief
Executive Officer and President of the Company, certify, pursuant to 18 U.S.C.
ss.1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act oF 2002,
that to the best of my knowledge:

         (1) The Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934; and

         (2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.

                                         /s/ Mack V. Traynor, III
                                         -------------------------------------

                                         Mack V. Traynor, III
                                         Chief Executive Officer and President

Date: July 15, 2003



A signed original of this written statement required by Section 906 has been
provided to HEI, Inc. and will be retained by HEI, Inc. and furnished to the
Securities and Exchange Commission or its staff upon request.

EX-99.2

                                                                    EXHIBIT 99.2

                            CERTIFICATION PURSUANT TO
                               18 U.S.C. SS.1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002


In connection with the Quarterly Report of HEI, Inc. (the "Company") on Form
10-Q for the quarter ended May 31, 2003, as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), I, Douglas J. Nesbit,
Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss.1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that tO
the best of my knowledge:

          (1) The Report fully complies with the requirements of Section 13(a)
or 15(d) of the Securities Exchange Act of 1934; and

          (2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.

                                                   /s/ Douglas J. Nesbit
                                                   -----------------------

                                                   Douglas J. Nesbit
                                                   Chief Financial Officer
Date: July 15, 2003



A signed original of this written statement required by Section 906 has been
provided to HEI, Inc. and will be retained by HEI, Inc. and furnished to the
Securities and Exchange Commission or its staff upon request.