-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SGdENog3KJ+/xNRi91WPzjYtDwUluOioiGI6LCsualJB6KMdIyL/Mg7FXyKsnn2q IIFHtW5TGOVnjXMm03TPXw== 0001047469-97-006963.txt : 19971208 0001047469-97-006963.hdr.sgml : 19971208 ACCESSION NUMBER: 0001047469-97-006963 CONFORMED SUBMISSION TYPE: S-3/A PUBLIC DOCUMENT COUNT: 10 FILED AS OF DATE: 19971205 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: INCOMNET INC CENTRAL INDEX KEY: 0000353356 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 952871296 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-3/A SEC ACT: SEC FILE NUMBER: 333-16629 FILM NUMBER: 97733436 BUSINESS ADDRESS: STREET 1: 21031 VENTURA BLVD STREET 2: STE 1100 CITY: WOODLAND HILLS STATE: CA ZIP: 91364 BUSINESS PHONE: 8188873400 MAIL ADDRESS: STREET 1: 21031 VENTURA BLVD STREET 2: SUITE 1100 CITY: WOODLAND HILLS STATE: CA ZIP: 91364 FORMER COMPANY: FORMER CONFORMED NAME: INTELLIGENT COMMUNICATIONS NETWORKS INC DATE OF NAME CHANGE: 19860805 S-3/A 1 FORM S-3/A AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON DECEMBER 5, 1997 REGISTRATION NO. 333-16629 --------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- PRE-EFFECTIVE AMENDMENT NO. 3 TO THE FORM S-3 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ----------------- INCOMNET, INC. - -------------------------------------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) CALIFORNIA 7375 95-2871296 - ---------------------------- ---------------------------- ------------- (State or Other Jurisdiction (Primary Standard Industrial (IRS Employer of Incorporation or Classification Code Number) Identification Organization) Number) 21031 VENTURA BOULEVARD, SUITE 1100 WOODLAND HILLS, CALIFORNIA 91364 (818) 887-3400 (ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES) -------------------- MELVYN REZNICK, PRESIDENT INCOMNET, INC. 21031 VENTURA BOULEVARD, SUITE 1100 WOODLAND HILLS, CALIFORNIA 91364 (818) 887-3400 (NAME, ADDRESS, INCLUDING ZIP CODE AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF AGENT FOR SERVICE) COPIES TO: MARK J. RICHARDSON, ESQ. 1299 OCEAN AVENUE, SUITE 900 SANTA MONICA, CALIFORNIA 90401 (310) 393-9992 ----------------------- APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE OF SECURITIES TO THE PUBLIC: AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT IS DECLARED EFFECTIVE. IF ANY OF THE SECURITIES BEING REGISTERED ON THIS FORM ARE BEING OFFERED ON A DELAYED OR CONTINUOUS BASIS PURSUANT RULE 415 UNDER THE SECURITIES ACT OF 1933, CHECK THE FOLLOWING BOX: /X/ ----------------------- CALCULATION OF REGISTRATION FEE
- -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- TITLE OF EACH CLASS AMOUNT TO BE PROPOSED PROPOSED MAXIMUM AMOUNT OF OF SECURITIES TO BE REGISTERED(1) MAXIMUM OFFERING AGGREGATE OFFERING REGISTRATION FEE REGISTERED PRICE PER SHARE PRICE - -------------------------------------------------------------------------------------------------- Common Stock . . . . . . 920,751 $ 2.75 2,532,065 $ 858.33 - -------------------------------------------------------------------------------------------------- Common Stock Underlying Warrants to Purchase Common Stock(1). . . . . 360,000 3.75 1,350,000 457.63 - -------------------------------------------------------------------------------------------------- Common Stock Underlying Warrants to Purchase Common Stock(1). . . . . 12,500 2.94 36,500 12.37 - -------------------------------------------------------------------------------------------------- Common Stock Underlying Warrants to Purchase Common Stock(1). . . . . 50,000 5.26 263,000 89.15 - -------------------------------------------------------------------------------------------------- Common Stock Underlying Warrants to Purchase Common Stock(1). . . . . 55,000 3.00 165,000 55.93 - -------------------------------------------------------------------------------------------------- Common Stock Underlying Convertible Preferred Stock(1) . . . . . . . . 1,278,030 2.40 3,067,272 1,039.75 - -------------------------------------------------------------------------------------------------- Total . . . . . . 2,676,281 - $ 7,413,837 $ 2,513.16* - -------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------
- ------------------------- (1) Pursuant to Rule 416, there are also being registered such additional shares of Common Stock as may become issuable pursuant to the anti-dilution provisions of the Warrants or the Series B Convertible Preferred Stock. * $2,025.40 of this fee has already been paid. THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE SECURITIES AND EXCHANGE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE. PROSPECTUS SUBJECT TO COMPLETION, DATED DECEMBER 5, 1997 INCOMNET, INC. 2,676,281 SHARES OF COMMON STOCK The shares covered by this Prospectus are comprised of (i) 477,500 shares of the Common Stock of Incomnet, Inc., a California corporation (the "Company") which may be purchased upon the exercise of 477,500 warrants (the "Warrants") which were issued to certain affiliates of Rapid Cast, Inc. (in which the Company has a minority interest) and other private investors (the "Warrantholders"), (ii) 170,751 shares of the Common Stock of the Company (the "Outstanding Shares") which were issued to several investors upon the prior conversion by them of Series A 2% Convertible Preferred Stock ("Series A Preferred") and in a private placement, (iii) 1,100,000 shares of the Common Stock of the Company which may be issued upon the conversion of 2,434 shares of Series B 6% Convertible Preferred Stock ("Series B Preferred"), (iv) 178,030 shares of the Common Stock of the Company which may be issued upon the exercise of an option to purchase up to 450 additional shares of Series B Preferred and the conversion of those additional shares into Common Stock, and (v) 750,000 shares of the Company's Common Stock (the "Shares"), some or all of which may be issued upon the conversion of outstanding Series A Preferred (up to 125 shares of Series A Preferred only, since the holders of all other Series A Preferred waived their registration rights), or Series B Preferred, or offered and sold from time to time at the prevailing market price through a registered member of the National Association of Securities Dealers, Inc. (the "Underwriter"). The Underwriter for the offer and sale of the Shares is Continental Pacific Securities, Inc. The shares of Common Stock issuable upon the exercise of the Warrants or the conversion of Series B Preferred are referred to herein as the "Underlying Shares." The holders of the Underlying Shares, when issued, and the Outstanding Shares are herein referred to as the "Shareholders." The Outstanding and Underlying Shares are being offered for resale by the Shareholders and not pursuant to an initial issuance of stock by the Company. The Warrants and Series B Preferred have not been separately registered and are not offered by this Prospectus. The Warrants, Outstanding Shares, Series A Preferred and Series B Preferred were issued in private placements pursuant to Section 4(2) of the Securities Act of 1933, as amended. See "DESCRIPTION OF CAPITAL STOCK" and "SELLING SECURITY HOLDERS." The Company's Common Stock is traded on the NASDAQ Small Capital Market ("NASDAQ/Small Cap") under the symbol "ICNT." The last reported sale price of the Common Stock on the NASDAQ/Small Cap on November 26, 1997 was $2.90 per share. See "PRICE RANGE OF COMMON STOCK AND DIVIDENDS." ---------- See "RISK FACTORS" for certain factors that should be considered by prospective investors. ----------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
- ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Price Underwriting Proceeds to Discounts and to Public Commissions(1) Company - ---------------------------------------------------------------------------------------------------------- PER UNDERLYING SHARE-WARRANTS (2). . . . . . . . . $ 3.75 $ 0 $ 1,350,000 - ---------------------------------------------------------------------------------------------------------- PER UNDERLYING SHARE-SERIES B PREFERRED (2). . . . $ 3.97 $ 0 $ 2,248,000 - ---------------------------------------------------------------------------------------------------------- PER UNDERLYING SHARE-WARRANTS(2) . . . . . . . . . $ 2.94 $ 0 $ 36,500 - ---------------------------------------------------------------------------------------------------------- PER UNDERLYING SHARE-WARRANTS(2) . . . . . . . . . $ 5.26 $ 0 $ 263,000 - ---------------------------------------------------------------------------------------------------------- PER UNDERLYING SHARE-WARRANTS(2) . . . . . . . . . $ 3.00 $ 0 $ 165,000 - ---------------------------------------------------------------------------------------------------------- PER SHARE (3). . . . . . . . . . . . . . . . . . . $ --- $ --- $ --- - ---------------------------------------------------------------------------------------------------------- TOTAL (4). . . . . . . . . . . . . . . . . . . . . $ --- $ --- $ 4,062,500 - ---------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------
- ------------------------- (1) No underwriters will be involved in the exercise of Warrants or the conversion of Series B Preferred, nor were any underwriters involved in the issuance of the Warrants, the Outstanding Shares, the Series A Preferred or the Series B Preferred. A referral fee equal to 5% of the gross proceeds of the placement of the Series A Preferred was paid by the Company to an unaffiliated referral source. A total referral fee of $186,000 (ie. $152,000 in cash and 34 shares of Series B Preferred with a value of $1,000 per share) was paid by the Company to an unaffiliated referral source for the placement of the Series B Preferred. The Shareholders do not have any specific plan of distribution with respect to the Outstanding Shares or Underlying Shares. The sale of the Outstanding Shares and Underlying Shares may be made in the open market through broker-dealers or in individual negotiated transactions. -1- (2) The price per share for the Underlying Shares relating to the Warrants reflects the exercise price of the Warrants. The price per share for the Underlying Shares relating to the Series B Preferred reflects the maximum average conversion price at which the Series B Preferred is convertible. The conversion price may be less depending on the average bid price for the Company's Common Stock on the public trading market for the five trading days immediately preceding the conversion date. See "THE COMPANY - Issuance of Convertible Preferred Stock - Conversion." The Company received net proceeds of $2,248,000 from the issuance of the Series B Preferred covered by this Prospectus. The table does not include up to 450 additional shares of Series B Preferred which may be issued in the future pursuant to the exercise of an option to purchase Series B Preferred at a price of $1,000 per share. The maximum conversion price for those shares is therefore not known at this time. See "THE COMPANY - Issuance of Convertible Preferred Stock - Warrants and Options." (3) Those Shares which are not issued upon the conversion of outstanding Series B Preferred may be issued from time to time at the prevailing market price through the Underwriter. The price per Share and underwriting commission are therefore undetermined at this time. (4) The total proceeds to the Company will equal the aggregate exercise price of 477,500 Warrants and the original issuance price of the Series B Preferred and the Shares. The proceeds from the sale of the Shares is not known at this time since (a) the number of Shares remaining after the conversion of all outstanding Series B Preferred and up to 125 shares of Series A Preferred is not yet known, (b) the market price at which the remaining Shares, if any, are sold through the Underwriter is not yet known, and (c) the amount of underwriting discounts and commissions on the sale of the Shares is not known at this time. See "THE COMPANY - Issuance of Convertible Preferred Stock." The Shareholders will receive all net proceeds from the sale of their respective Outstanding Shares and Underlying Shares. AVAILABLE INFORMATION Incomnet, Inc. is subject to the information requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance therewith file reports, proxy statements and other information with the Securities and Exchange Commission (the "SEC"). Copies of such reports, proxy statements and other information can be obtained, upon payment of prescribed fees, from the SEC at Room 1024, 450 Fifth Street, N.W., Judiciary Plaza, Washington, D.C. 20549. In addition, such reports, proxy statements and other information can be inspected at the SEC's facilities referred to above and at the SEC's Regional Office at 5670 Wilshire Boulevard, 11th Floor, Los Angeles, California 90036-3648. The Company's Common Stock is reported on the National Association of Securities Dealers Automated Quotation Small Capital System and such reports, proxy statements and other information regarding Incomnet are available for inspection and copying at 33 Whitehall, New York, New York 10004. The Company has filed with the SEC a Registration Statement on Form S-3 (together with any amendments thereto, the "Registration Statement") under the Securities Act of 1933, as amended (the "Securities Act"), with respect to the Underlying Shares. This Prospectus does not contain all the information set forth in the Registration Statement. Such additional information may be obtained from the SEC's principal office in Washington, D.C. Statements contained in this Prospectus or in any document incorporated by reference in this Prospectus as to the contents of any contract or other document referred to herein or therein are not necessarily complete, and in each instance reference is made to the copy of such contract or other document filed as an exhibit to the Registration Statement or such other document, each such statement being qualified in all respects by such reference. INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE The following documents filed with the SEC are incorporated in this Prospectus by reference: (a) The Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996 filed on April 15, 1997, as amended by Form 10-KA filed on May 23, 1997 (provided that the information referred to in Item 402(a)(8) of Regulation S-K shall not be deemed to be specifically incorporated herein). -2- (b) The Company's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1997 filed on November 14, 1997. (c) The Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1997 filed on August 13, 1997. (d) The Company's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1997 filed on May 15, 1997. (e) The Company's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1996 filed on November 14, 1996. (f) The Company's Quarterly Report on Form 10-QA for the fiscal quarter ended September 30, 1997 filed on December 3, 1997. (g) The Company's Quarterly Report on Form 10-QA for the fiscal quarter ended June 30, 1997 filed on December 3, 1997. (h) The Company's Quarterly Report on Form 10-QA for the fiscal quarter ended March 31, 1997 filed on December 3, 1997. (i) The Company's Annual Report on Form 10-KA for the fiscal year ended December 31, 1996 filed on December 3, 1997. (j) The Company's Current Report on Form 8-K filed on February 8, 1995, its Current Report on Form 8-K filed on July 25, 1995, its Current Report on Form 8-K filed on August 18, 1995, its Current Report on Form 8-K filed on November 15, 1995, its Current Report on Form 8-K filed on November 30, 1995, its Current Report on Form 8-K filed on February 9, 1996, its Current Report on Form 8-K filed on April 29, 1996, its Current Report on Form 8-K filed on June 7, 1996, its Current Report on Form 8-K filed on August 8, 1996, its Current Report on Form 8-K filed on January 28, 1997, its Current Report on Form 8-K filed on February 7, 1997, its Current Report on Form 8-K filed on April 10, 1997, its Current Report on Form 8-K filed on May 13, 1997, and its Current Report on Form 8-K filed on August 20, 1997. (k) The Company's definitive Proxy Statement on Schedule 14A, dated November 17, 1997 and filed with the Securities and Exchange Commission on November 7, 1997. (l) All documents filed by the Company pursuant to Section 13(a), 13(c), 14 or 15(d) of the Exchange Act after the date of this Prospectus. Any statement contained in a document incorporated herein by reference will be deemed to be modified or superseded for the purpose of this Prospectus to the extent that a statement contained herein or in a subsequently filed document modifies or supersedes such statement. Any such statement so modified or superseded will not be deemed, except as so modified or superseded, to constitute a part of this Prospectus. This Prospectus incorporates documents by reference which are not presented herein or delivered with this Prospectus. Such documents relating to the Company are available without charge upon request made to Incomnet, Inc., 21031 Ventura Boulevard, Suite 1100, Woodland Hills, California 91364 (telephone (818) 887- 3400), attention: Melvyn Reznick, President. No person is authorized to give any information or to make any representations other than as contained herein and, if given or made, such information or representations must not be relied upon as having been authorized. This Prospectus does not constitute an offer or solicitation by anyone in any jurisdiction in which such offer or solicitation is not authorized or in which the person making such an offer or solicitation is not qualified to do so or to any person to whom it is unlawful to make such offer or solicitation. Neither the delivery of this Prospectus nor any distribution of securities made hereunder shall under any circumstances create an implication that there has been no change in the affairs of the Company since the date hereof or that the information herein is correct as of any time subsequent to the date of this Prospectus. -3- PROSPECTUS SUMMARY THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED INFORMATION AND FINANCIAL STATEMENTS APPEARING ELSEWHERE OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS. THE COMPANY Incomnet, Inc. (the "Company" or "Incomnet") and its two wholly owned subsidiaries, National Telephone & Communications, Inc. ("NTC") and GenSource Corporation ("GenSource"), are engaged in three types of businesses: (i) interactive computer networking products and services, (ii) discount long distance telephone communications services to residential and commercial customers in the United States, and (iii) the development and marketing of software that is utilized to process insurance-related claims, including workers compensation, disability, general medical, and property and casualty claims. The Company also owns approximately 29% (22% on a fully diluted basis) of Rapid Cast, Inc. ("RCI"), which is engaged in the business of manufacturing and marketing the Fast Cast-TM- LenSystem that allows retail optical stores and wholesale optical lens manufacturing laboratories to produce single vision, flat-top bifocal and progressive multifocal lenses rapidly on demand. Incomnet, Inc. was incorporated under the laws of the State of California on January 31, 1974. The Company acquires and develops computer hardware and software for interactive communications networks. It currently operates a communications network under the tradename "AutoNETWORK" for several hundred automobile dismantling companies in California, Colorado, Nevada, Arizona, Oregon and Washington. The network permits the subscribers to share information simultaneously and to communicate electronically on a real-time basis through individual computer workstations linked by the Company's proprietary software, central message switching computer and front-end network processor. The Company is evaluating other business applications for its communications technology in order to establish more subscriber-based communications networks. The Company's principal executive office is located at 21031 Ventura Boulevard, Suite 1100, Woodland Hills, California, 91364. Its telephone number is (818) 887-3400. National Telephone Communications, Inc. was incorporated under the laws of the State of Nevada on September 6, 1984. Since July 1989 NTC has operated as an inter-exchange carrier and reseller of long distance telephone service, providing nationwide long distance telephone access to its residential and commercial customers. NTC purchases large blocks of time from long distance national and regional telecommunications carriers at rates based upon high volume usage. NTC resells the time to its customers at discounted telecommunications retail rates. In general, NTC provides its customers with rates that are 5% to 50% below the published retail rates of major national carriers like AT&T and MCI with complete domestic and international coverage. NTC's products include (i) fixed rate per minute services called Call$aver, (ii) a prepaid calling card product, Sure$aver, which eliminates calling card surcharges such as those imposed by AT&T, MCI and Sprint, and (iii) a measured rate Dial-1 service that is interconnected to local telephone companies throughout the United States. NTC is licensed to provide telecommunication services by the Public Utilities Commissions of numerous states. NTC markets its services through referral marketing agents and affinity groups on a nationwide basis. NTC's offices are located at 2801 North Main Street, Irvine, California, 92714. Its telephone number is (714) 251-8000. GenSource Corporation was incorporated under the laws of the State of California in 1977. The Company acquired 100% of the issued and outstanding stock of GenSource on May 2, 1997. GenSource develops and markets a trademarked line of software products designed to process insurance-related claims. Its software is licensed to companies which provide their own insurance and claims administration, to insurance companies, and to third party administrators who process claims for either self-insured companies or for insurance companies. The insurance related products include GenCOMP-TM-, GenMED-TM-, GenDIS-TM-, GenPAC-TM-, GenRISK-TM-, GenTRIS-TM- and Top Rate-TM-. In addition, GenSource offers several computer and service-related products including GenARS-TM-, which is an optical disk-based information storage and retrieval system, and GenSERVE-TM-, which is a maintenance and service program for customers. GenSource's offices are located at 25572 Avenue Stanford, Valencia, California 91355. Its telephone number is (805) 294-1300. Rapid Cast, Inc. was incorporated under the laws of the State of Delaware on February 12, 1994. RCI owns 100% of the issued and outstanding stock of Q2100, Inc. ("Q2100"), which it acquired from Pearle, Inc. on February 8, 1995. The Company acquired 51% of the issued and outstanding stock of RCI on February 8, 1995, as well. The Company's percentage ownership of RCI was reduced to approximately 35% of its total issued and outstanding stock on January 16, 1997 when RCI issued 8,000,000 shares of 7% Convertible Preferred Stock in a private placement to certain unaffiliated institutional investors. In September 1997, the Company's percentage ownership in RCI was reduced further to approximately 29% when RCI issued 8,000,000 more shares of Common Stock to its existing shareholders in a private placement in which the Company elected not to participate. See "THE COMPANY - Recent Capitalization of RCI." Q2100 owns certain -4- domestic and foreign patents and patent applications relating to a new technology, commonly known as Thick Film Radiation Cured Polymer Technology, which enables retail optical stores, small to mid-sized wholesale optical lens manufacturing laboratories and other dispensers of prescription ophthalmic lenses to produce lenses on site rapidly and at a cost generally lower than if they were purchased from third party manufacturers and distributors. RCI is currently manufacturing and marketing this technology through the sale of casting machines and liquid monomer under the name Rapid Cast or the Fast Cast Lensystem. RCI's principal executive office is located at 10100 Bluegrass Parkway, Louisville, Kentucky 40299, and its telephone number is (502) 458-5500. THE OFFERING Type of Security Registered. . . . Common Stock, no par value. Number of Outstanding Shares . . . 170,751 Number of Underlying Shares-Warrants . . . . 477,500 Minimum Number of Underlying Shares-Series B Preferred. . . . . . . . . . . . 627,503(1) Number of Shares . . . . . . . . . 750,000 Selling Security Holders . . . . . The Outstanding Shares are held by (a) three investors who purchased shares of Series A Preferred in September 1996 and converted a portion of them on December 31, 1996 into 10,826 shares of Common Stock, (b) certain affiliates of RCI who purchased 33,000 shares of Common Stock in a private placement in January 1997, and (c) five investors who purchased Series A Preferred in October 1996 and converted them on November 4, 1997 into 126,925 shares of Common Stock. The Underlying Shares are issuable upon the exercise of 477,500 Warrants held by (i) certain affiliates of RCI, (ii) a consultant who assisted the Company in placing the Series B Preferred, and (iii) other private investors. The Underlying Shares are also issuable upon the conversion of 2,434 outstanding shares of Series B Preferred issued by the Company in July and November 1997. See "SELLING SECURITY HOLDERS." Terms of the Warrants. . . . . . . The Warrants include (a) 360,000 Warrants which entitle those Warrantholders to purchase 360,000 shares of the Company's Common Stock at an exercise price of $3.75 per share, exercisable until December 9, 1999, (b) 12,500 Warrants which entitle those Warrantholders to purchase 12,500 shares of the Company's Common Stock at a purchase price of $2.94 per share, exercisable at any time until December 16, 2001, (c) 50,000 Warrants which entitle those Warrantholders to purchase 50,000 shares of the Company's Common Stock at a purchase price of $5.26 per share, exercisable at any time until July 29, 1999, and (d) 55,000 Warrants which entitle those Warrantholders to purchase 55,000 shares of the Company's Common Stock at a purchase price of $3.00 per share, exercisable at any time until November 3, 1999. See "SELLING SECURITY HOLDERS." (1) The number of Underlying Shares indicated assumes an average conversion price of approximately $3.97 per share, which is the maximum average conversion price under the terms and conditions of the Series B Preferred. Accordingly, the Underlying Shares indicated are the minimum number of Underlying Shares which will be issued by the Company upon the conversion of 2,434 Outstanding Shares of Series B Preferred. In the registration statement encompassing this Prospectus, the Company has registered an additional 472,497 shares which, in combination with 750,000 shelf shares covered by this Prospectus, will provide a pool of registered shares to issue upon the conversion of outstanding Series B Preferred to the extent that the average conversion price is less than $3.97 per share, and up to 125 shares of Series A Preferred. See "THE COMPANY - Issuance of Convertible Preferred Stock." -5- Terms of the Series B Preferred. . The Series B Preferred entitles the holders to convert their Preferred Stock into the Company's Common Stock at any time upon the earlier of (i) the effective date of the registration statement covering the Underlying Shares, or (ii) 120 days after the date that the Series B Preferred is issued. The conversion ratio is equal to the lesser of (i) 80% of the average bid price of the Company's Common Stock on the public trading market on the five trading days immediately preceding the conversion date, divided by the original purchase price of the Series B Preferred, or (ii) the bid price of the Company's Common Stock on the date that the Series B Preferred is issued, divided by the original purchase price of the Series B Preferred. The cumulative 6% per annum dividend is also payable on the conversion date. The bid price on the date of funding of the Series B Preferred covered by this Prospectus ranges from $3.00 to $4.29 per share. See "THE COMPANY - Issuance of Convertible Preferred Stock." Issuance of Shares . . . . . . . . The unissued Shares (not including the Underlying Shares which are reserved for issuance upon the exercise of Warrants and the conversion of Series B Preferred) are reserved for issuance from time to time through the Underwriter in open market transactions in accordance with Rule 415, or upon the conversion of Series A Preferred (only with respect to 125 shares) or Series B Preferred, if necessary. The amount of net proceeds to be received by the Company from the sale of the Shares, if any, is not known at this time because it depends on the number of unissued Shares remaining after the conversion of Series A Preferred (up to 125 shares) and Series B Preferred, the prevailing market price of the Company's Common Stock on the dates that it elects to sell the Shares, if any, and the amount of the Underwriter's discounts and commissions. Shares of Common Stock to be Outstanding After Issuance of Shares, Conversion of Series B Preferred and Exercise of Warrants . . . . . . . . . . . . . 15,861,796(2) Voting Rights. . . . . . . . . . . Each Share and Underlying Share of Common Stock will have one vote per share, if and when issued, and each Outstanding Share has one vote. The Warrants and Series B Preferred do not have any voting rights associated with them. Use of Proceeds. . . . . . . . . . The Company would receive net proceeds of $1,814,500 from the exercise of all 477,500 (2) The total number of shares of the Company's Common Stock to be outstanding after the issuance of Shares, the exercise of Warrants and the conversion of the Series B Preferred assumes an average conversion price for the Series B Preferred of approximately $3.97 per share, which is the maximum average conversion price under the terms and conditions of the Series B Preferred. If the average conversion price of the Series B Preferred is less than approximately $3.97 per share, then the number of shares outstanding after the offering and the conversion of the Series B Preferred would be higher. See "THE COMPANY - Issuance of Convertible Preferred Stock." The outstanding shares include 1,500,000 shares of the Company's Common Stock reserved for issuance to the class plaintiffs pursuant to the settlement of the class action lawsuit known as SAUNDRA GAYLES, ET AL. VS. INCOMNET, INC. AND SAM D. SCHWARTZ. See "THE COMPANY - Settlement of the Class Action Lawsuit." -6- Warrants. The Company has received net proceeds of $36,000 from the issuance of the Warrants and $2,248,000 from the issuance of the Series B Preferred covered by this Prospectus. The amount of net proceeds to be received by the Company from the sale of the Shares, if any, is not known at this time. The Company will not receive any proceeds from the sale of the Outstanding Shares or the Underlying Shares. The Company expects to use the net proceeds from the exercise of the Warrants and sale of Shares, if any, for general working capital purposes. There is no assurance that the Warrants will be exercised or that any Shares will be sold by the Company through the Underwriter. See "USE OF PROCEEDS." NASDAQ Symbol. . . . . . . . . . . ICNT -7- SUMMARY CONSOLIDATED FINANCIAL DATA INCOMNET, INC., NATIONAL TELEPHONE COMMUNICATIONS, INC. AND GENSOURCE CORPORATION
NINE MONTHS ENDED SEPTEMBER 30 YEAR ENDED DECEMBER 31 -------------------------------- ------------------------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- ---- ---- STATEMENT OF REVENUES Revenues $99,341,000 $77,296,000 $106,905,000 $86,564,917 $46,815,057 $11,298,972 $5,534,874 Income (Loss) before income taxes and and minority interest (7,886,000) (11,202,000) (43,705,000) 856,543 4,000,242 (1,606,844) (2,264,597) Income (Loss) before minority interest (7,207,000) (10,523,000) (36,799,000) 1,366,025 3,999,187 (1,606,844) (2,461,697) Net Income (Loss) (7,207,000) (8,615,000) (37,676,000) 1,366,025 4,071,194 948,769 (2,021,333) PER COMMON SHARE DATA Net Income (Loss) (0.53) (0.65) (2.82) .11 .42 (.12) (.28) Cash Dividends 0 0 0 0 0 0 0 Book Value .81 2.59 .65 3.21 1.58 .48 .13 Number of Shares 14,006,793(1) 13,268,050 13,369,681 13,262,648 10,482,854 8,183,877 7,189,671 BALANCE SHEET DATA Total Assets 48,652,000 69,564,043 40,587,000 74,105,629 26,158,346 8,665,839 6,744,994 Long-Term Debt 6,955,000 8,708,181(2) 1,040,000 8,459,772(2) 900 20,000 176,000 Shareholders' Equity 11,413,000 34,414,968 8,626,000 42,548,056 16,535,153 3,929,148 1,047,125
- ------------------------------ (1) Includes 1,500,000 shares of the Company's Common Stock reserved for issuance to the class plaintiffs pursuant to the settlement of the lawsuit SAUNDRA GAYLES, ET AL. VS. INCOMNET, INC. AND SAM D. SCHWARTZ. See "THE COMPANY - Settlement of the Class Action Lawsuit." (2) Long term liabilities include approximately $8,459,772 of deferred tax liability at December 31, 1995 and $8,055,562 of deferred tax liability at September 30, 1996 arising from the nondeductibility of the RCI patent rights. The deferred tax liability was eliminated when the RCI patent amortization schedule was accelerated and the related intangible asset was written off entirely. -8- RISK FACTORS Prospective investors should consider carefully, in addition to the other information contained in this Prospectus, the following factors before purchasing the Shares, the Outstanding Shares or the Underlying Shares. OVERVIEW - CAUTIONARY STATEMENTS The following are cautionary statements made pursuant to the Private Securities Litigation Reform Act of 1995 in order for the Company to avail itself of the "safe harbor" provisions of the Reform Act. The discussions and information in this Prospectus may contain both historical and forward-looking statements. To the extent that the Prospectus contains forward-looking statements regarding the financial condition, operating results, business prospects or any other aspect of the Company and its subsidiaries, please be advised that the Company's and its subsidiaries' actual financial condition, operating results and business performance may differ materially from that projected or estimated by the Company in forward-looking statements. The differences may be caused by a variety of factors, including but not limited to adverse economic conditions, intense competition, including intensification of price competition and entry of new competitors and products, adverse federal, state and local government regulation, inadequate capital, unexpected costs and operating deficits, increases in general and administrative costs, lower sales and revenues than forecast, loss of customers, disadvantageous currency exchange rates, termination of contracts, loss of supplies, technological obsolescence of the Company's products, price increases for supplies and components, inability to raise prices, failure to obtain new customers, litigation and administrative proceedings involving the Company, including the pending lawsuits and SEC investigation, the possible acquisition of new businesses that result in operating losses or that do not perform as anticipated, resulting in unanticipated losses, the possible fluctuation and volatility of the Company's operating results, financial condition and stock price, losses incurred in litigating and settling cases, dilution in the Company's ownership of its subsidiaries and businesses, adverse publicity and news coverage, inability to carry out marketing and sales plans, challenges to the Company's patents, loss or retirement of key executives, changes in interest rates, inflationary factors, and other specific risks that may be alluded to in this Prospectus or in other reports issued by the Company. RISKS RELATING TO INCOMNET, INC. AND ITS SUBSIDIARIES POSSIBLE DEFICIENCIES IN CARRIER SERVICE. The telecommunications business is extremely competitive and its success depends upon several factors, including high quality technology, effective marketing, accurate billing and responsive customer service. As a "switchless" reseller of long distance telephone service registered with the Federal Communications Commission and state public utility commissions, the Company provides billing and customer service directly. The Company is, however, dependent upon services provided to it and its customers by telecommunications carriers. The Company has the right to provide long distance telephone service to its customers through any telecommunications carriers that it chooses. At present, the Company has contracts with several carriers. The two main carriers which provide service to the Company are Wiltel, which handles most calls in the mainland United States, and U.S. Sprint, which handles calls from Hawaii to the United States. The Company is subject to the risk that its carriers may not provide high quality telephone service to the Company's customers, along with accurate, timely billing records of that service to the Company. RISK OF TERMINATION OF CARRIER SERVICE. The Company's newest contract with Wiltel commenced on June 17, 1996 as an amendment to the contract entered into on September 15, 1995 (service had been provided under a prior arrangement since July 1992). The Wiltel Carrier Switched Services Agreement expires by its terms on June 15, 2001. Wiltel may terminate its carrier agreement with the Company or modify the charges upon 60 days prior written notice to the Company. The -9- Company may not terminate the new Wiltel contract without a cancellation charge (the cancellation charge would be 100% of the minimum purchase requirement for the remaining term of the agreement) unless Wiltel increases its rates under the agreement by an amount the effect of which would be to cause total charges for the three months immediately preceding the rate increase to be 5% greater than they were with the original discounts. The Sprint contract commenced on April 7, 1993 and is terminable by either party upon 30 days prior notice. The termination of the contracts with either of these carriers or an increase in rates would have an adverse impact on the Company's financial condition and operating results if the Company could not replace either carrier with similar service at an equivalent price. The Company could lose its carrier contracts for reasons beyond its control. While the Company has the right to switch its customers to other carriers in its discretion, there is no assurance that the Company could replace its carrier contracts on substantially similar terms if its current contracts were terminated or were not renewed upon their expiration. Should the Company lose its contracts and not be able to replace them, it would have a significant adverse impact on both the Company's telephone and marketing related revenues because the Company would not be able to sign on new customers. There is also no assurance that the Company will continue to have the capital available and retain the qualified personnel that are required to maintain a satisfactory level of services to its customers. See "THE COMPANY" and "Item 1. Business" in the Company's 1996 Form 10-K. MINIMUM PURCHASE REQUIREMENT. Pursuant to its new Carrier Service Agreement with Wiltel, the Company is obligated to purchase a minimum amount of telephone time on a "take-or-pay" basis. If the Company is not able to use the minimum amount of telephone time under the new agreement, then it must pay to Wiltel the difference between the actual usage and the minimum usage requirement in cash. The Company could experience operating losses as the result of the minimum purchase requirement in the new carrier contract. The Company currently relies on purchases by an unaffiliated party under the Wiltel agreement (at no profit to the Company) in order to meet the minimum purchase requirement. If the unaffiliated co-purchaser ceases to purchase telephone time under the agreement, the Company could experience significant operating losses. See "Item 1. Business - Contract with Wiltel" in the Company's 1996 Form 10-K." SEC INVESTIGATION AND RELATED LAWSUITS. In August 1994, the Company was notified by the Pacific regional office of the Securities and Exchange Commission that the Commission had initiated a confidential investigation of the Company. In September 1994 the Commission issued a formal order of private investigation. The Commission stated in its correspondence to the Company that the investigation "should not be construed as an adverse reflection on any person, entity or security, or as an indication by the Commission or its staff that any violation of law has occurred." In August and September 1994, the Company supplied copies of its books and records to the Commission, and the Company's present and prior independent certified public accounting firms submitted their working papers pursuant to the Commission's subpoena. In February 1995, the Company provided to the Commission pursuant to its subpoena additional documents associated with NTC's regulatory authorizations and with the Company's recent acquisition of a controlling interest in RCI. The Company continues to fully cooperate with the Commission. While the Company believes that the outcome of the fact finding investigation will not have a material adverse effect on the financial condition or operating results of the Company, no assurance can be given on this matter until the investigation is concluded. See "Item 3. Legal Proceedings - Securities and Exchange Commission Investigation" in the Company's 1996 Form 10-K, as updated in the Company's Form 10-Q for the quarter ended September 30, 1997 under "Item 1. Legal Proceedings - Securities and Exchange Commission Investigation." On January 20, 1995, a class action lawsuit was filed in the United States District Court of the Central District of California against Incomnet, Inc. and Sam D. Schwartz, known as SAUNDRA GAYLES VS. INCOMNET, INC AND SAM D. SCHWARTZ, alleging violations of federal securities laws. In particular, the suit alleges that the defendants violated Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, by not disclosing in August 1994 that the Securities and Exchange Commission had -10- initiated a confidential investigation of the Company. The suit also alleges that the Company issued false and misleading press releases on January 17, 1995 and January 18, 1995. On October 17, 1995, the complaint was amended to add claims that the Company and its former Chairman, Sam D. Schwartz, violated federal and state securities laws because Mr. Schwartz did not disclose purchases and sales of the Company's stock made in the open market by him and his affiliates. Two additional civil lawsuits were filed in federal district court in Georgia making similar claims and allegations, both of which have been transferred to the same California court as the SAUNDRA GAYLES case. On July 22, 1996, the Company was served with a complaint in the lawsuit CHARLES STEVENS VS. SAM D. SCHWARTZ AND INCOMNET, INC., Civil Action No. 96-4906 RMT (VAPx), filed in the United States District Court for the Central District of California, Western Division. The complaint alleges that the Company and its former Chairman, Sam D. Schwartz, violated Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and Section 25400 of the California Corporations Code, as a result of false and misleading statements made by defendants and undisclosed trading in the Company's stock engaged in by Mr. Schwartz and his affiliates. The Company has settled the class action lawsuit, the two Georgia lawsuits and the STEVENS case, although the class action settlement is subject to court approval and possible plaintiff disapprovals. See "THE COMPANY - Settlement of the Class Action Lawsuit", "THE COMPANY - Settlement of The Atlanta Lawsuits" and THE COMPANY-Settlement of the Stevens Lawsuit." In October 1996, the Company was served with a complaint in the lawsuit entitled SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLIANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York. The complaint states that the plaintiff was a purchaser of the Company's stock in July 1995. The complaint alleges that the Company and its former Chairman violated Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, as a result of false and misleading statements made by the defendants and undisclosed trading in the Company's stock engaged in by Mr. Schwartz and his affiliate. The plaintiff also alleges that Mr. Schwartz and his affiliate owed a fiduciary duty to the plaintiff and breached it by their conduct, and that these defendants committed common law fraud. The complaint also alleges other causes of action against other unrelated defendants. The suits seek recision and damages on behalf of the plaintiffs. On July 22, 1997, the Company was named in a lawsuit known as JAMES A. BELTZ, ET AL. VS SAMUEL D. SCHWARTZ and RITA SCHWARTZ, husband and wife, STEPHEN A. CASWELL, JOEL W. GREENBERG, INCOMNET, INC., DAVID BODNER and MURRAY HUBERFELD, in the United States District Court in the District of Minnesota. This lawsuit was filed by 17 individuals who were allowed to opt out of the class action lawsuit to pursue a separate lawsuit with similar claims. The lawsuit alleges losses by the plaintiffs of approximately $1.5 million and seeks unspecified damages. Litigation has been threatened by other potential claimants. There is no assurance that these pending and threatened lawsuits will not have a material adverse effect on the Company and its financial condition and operating results. See "Item 3. Legal Proceedings" in the Company's 1996 Form 10-K, as updated under "Item 1. Legal Proceedings - Class Action and Related Lawsuits" in the Company's Form 10-Q for the quarter ended September 30, 1997. RISKS INHERENT IN NETWORK MARKETING PROGRAMS. The Company sells its telephone service through a network marketing program in which independent sales representatives sign up both new independent sales representatives and telecommunications customers. The independent sales representatives pay all their own expenses and are treated by the Company as independent contractors. New independent representatives purchase sales materials, training and limited product inventories from the Company. As the representatives sign up new representatives, who themselves also sign up new representatives, the initial representative builds a "downline" of representatives that can reach through multiple levels. The Company's marketing plan allows a representative to build a network down to seven levels. Representatives do not receive commissions for bringing in new representatives. Representatives only receive commissions, overrides and bonuses based on bringing telephone customers and revenues to the Company. While the development of a strong network marketing program can result in a stable base of independent sales representatives who generate revenues from signing up both new customers and new representatives, there are risks inherent in network marketing. Because the representatives are structured in downlines, there is a much higher risk associated with competitive programs designed to attract the Company's existing base of representatives. If representatives decide to leave the Company's -11- program for a competitive program, there is a strong incentive for those representatives to bring other representatives in their downlines to the new program, all of whom will also try to move their telephone customers to the new program. As the momentum of representatives switching to new programs builds, the Company would experience a substantial loss of both representatives and customers. As a result, a sales force based upon network marketing has the inherent risk of eroding more rapidly than would otherwise occur if the Company operated through a base of representatives who worked directly for the Company. There are no assurances that the Company can keep its marketing plan competitive against competitive plans. Consequently, there is a risk that the Company's base of representatives and customers could decline in a manner that would have a serious impact on the Company's revenues and earnings. LOSS OF INDEPENDENT SALES REPRESENTATIVES. In February 1994, a group of approximately ten independent sales representatives in Northern California left the Company to market a competitive telephone service using a multi-level marketing approach. These representatives attempted to recruit other representatives and telephone customers away from the Company to their competitive program. The Company believes that these representatives took proprietary lists of the Company's representatives and customers with the intention of soliciting them to join their program, which was in direct violation of contracts that these representatives signed when they joined the Company's marketing program. As a result, the Company has filed suit against the representatives for damages of $500,000 for the loss of customers who were obtained through the taking of proprietary lists from the Company. The Company also sought and received a temporary restraining order against the representatives from continuing to use the Company's proprietary materials to solicit customers from the Company. The Company estimates that it has lost under 100 representatives and under 1,000 customers as a result of actions by the former marketing representatives. The Company's request for a permanent injunction was denied by the court on the grounds that the Company had not sustained enough continuing damages to warrant a permanent injunction. There are no assurances that the losses will remain at the current level. The defendants have filed a cross-complaint against NTC and the Company claiming that NTC failed to meet its contractual obligations to the defendants, and that the actions taken by the defendants were legal. The cross-complaint seeks compensatory and special damages, along with general and punitive damages. There is no assurance that the Company will prevail in its lawsuit to recover damages or that it may not lose more representatives and customers in the future, or that the defendants will not be successful with their cross- complaint. See "Item 3. Legal Proceedings - Legal Action Against Prior Representatives" in the Company's 1996 Form 10-K, as updated under "Item 1. Legal Proceedings - Legal Action Against Prior Representatives" in the Company's Form 10-Q for the quarter ended September 30, 1997. RISKS OF BILLING THROUGH LOCAL EXCHANGE CARRIERS. NTC previously offered a long distance telephone service called Easy-1 pursuant to which customers receive a single bill from their local telephone company for both local and long distance telephone service (NTC offers only long distance service). As a result, on Easy-1 accounts the local exchange carriers handle NTC's long distance billings and collections. Theoretically, billing through the local exchange carrier is supposed to enhance collection rates and lower NTC's billing costs, while offering a convenience for customers. The local exchange carriers charge a fee for their billing and collection services. NTC recently discontinued the Easy-1 service and all billings through local exchange carriers for new accounts. The cost savings and collections from the services provided by local exchange carriers did not seem to justify the charges being incurred by NTC for those services, and NTC experienced longer than expected delays in receiving its cash flow from Easy-1 accounts. NTC now utilizes direct billing on all new long distance telephone accounts. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." CONTENTS OF PRIOR AUDIT REPORTS. The reports of the independent certified public accountants with respect to the Company's financial statements for the fiscal year ending December 31, 1995 include an "emphasis of the matter" paragraph with respect to uncertainties related to the pending shareholders' class action matter. The reports of the independent certified public accountants with respect to the Company's financial statements for the fiscal years ending December 31, 1992 and 1993 raised substantial -12- doubts regarding the Company's ability to continue as going concerns because the current liabilities of the Company exceeded current assets by a significant margin. In addition, the scope of Grant Thornton's audit report with respect to Incomnet for the fiscal year ending December 31, 1990 was limited to the extent that it was not able to verify certain amounts with respect to Incomnet's investment in Incomnet, India, Ltd. In 1991 Incomnet wrote-off its entire investment in Incomnet India, Ltd. POSSIBLE NEED FOR ADDITIONAL FINANCING - DILUTION OF OWNERSHIP IN RCI. The Company may need additional capital in order to finance its anticipated growth, especially the growth of its subsidiaries, NTC and RCI. NTC has constructed a conference center in Honolulu, Hawaii for the independent sales representatives to conduct marketing meetings and seminars, and may construct more conference centers in the future. Unforeseen events such as the unexpected loss of customers or expenditures which were not budgeted could also require the Company to seek additional capital. In 1996 and early 1997, the Company and certain of its affiliates made substantial loans to RCI, most of which were repaid in January 1997, and a portion of which were converted into RCI common stock. In September 1997, the Company's ownership of RCI was further diluted when it elected not to participate in a private placement of RCI securities to its existing shareholders to raise additional capital. If RCI needs additional financing and the Company does not have the funds available to make its pro rata share of the advances, the Company's percentage ownership in RCI could be significantly diluted. Furthermore, if RCI needs additional financing or capital and cannot obtain it, its operations could be severely hampered, resulting in a material adverse impact on the operating results and financial condition of the Company. There is no assurance that the Company or its subsidiaries can obtain additional capital or financing, if necessary, or obtain it on acceptable terms. The shareholders of the Company may experience substantial dilution in their ownership of the Company as a result of financings or capitalizations done by the Company in order to obtain necessary funding. See "RISK FACTORS - General Risks - Adverse Effects of Issuance of Preferred Stock." Furthermore, as a result of the issuance of convertible preferred stock, warrants and stock options by RCI since the acquisition of a controlling interest in it by the Company on February 8, 1995, partially to raise capital, the Company's ownership interest in RCI has been reduced to approximately 29% on a current basis and approximately 22% on a fully diluted basis. Recent investors in RCI have an option to purchase more of RCI's 7% convertible preferred stock, which would further dilute the Company's ownership of RCI. See "THE COMPANY - Recent Capitalization of RCI." NO ASSURANCE OF PROFITABILITY - RECENT LOSSES. In the past the Company and its wholly owned subsidiary, NTC, have incurred substantial operating losses and have only recently achieved profitability. RCI and its wholly owned subsidiary, Q2100, have only recently emerged from the development stage and have incurred substantial operating losses since their inception. See "RISK FACTORS - Risks Relating to RCI - Recent Emergence From Development Stage." There is no assurance that the Company's consolidated revenues will continue to grow or be earned at current levels, or that the Company will be profitable. For the fiscal year ending December 31, 1996 the Company had a net loss of approximately $37,676,000 on a consolidated basis and NTC had a net after tax income of approximately $2,895,000. For the nine months ended September 30, 1997 the Company had a net loss of approximately $7,207,458 on a consolidated basis and NTC had a net after tax income of approximately $1,933,210. As of December 31, 1996, NTC had an accumulated shareholders' deficit of approximately $2,710,000 and RCI had an accumulated shareholders' deficit of approximately $19,048,000. As of September 30, 1997, NTC had an accumulated shareholder's deficit of approximately $776,901. There is no assurance that RCI will ever be profitable, or that NTC will continue to be profitable. There is no assurance that the Company will not incur operating deficits in the future. See "SELECTED CONSOLIDATED FINANCIAL INFORMATION", "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS", and "Item 14. Financial Statements" in the Company's 1996 Form 10-K, and the Company's Form 10-Q for the quarter ended March 31, 1997. -13- COMPETITION. The telephone and telecommunications industries are extremely competitive, especially the provision of long distance telephone services. In its long distance telephone business, the Company competes with several long distance carriers such as AT&T, MCI, Sprint and others, which have substantially greater financial, marketing and other resources than the Company. The Company depends on independent marketing representatives in order to obtain customers for its long distance telephone services. Several other network marketing firms also utilize independent marketing representatives to sell long distance telephone services, and may compete with the Company for marketing representatives. Independent marketing representatives may leave the Company to work for competitors from time to time, adversely affecting the Company's business. The Company's network telecommunications business is also subject to competition, and both business segments may experience competition from new competitors in the future. Many of the Company's competitors have higher national, regional and local recognition than the Company. There is no assurance that the Company will be able to continue to successfully compete in the long distance telephone or network telecommunications businesses. See "THE COMPANY" and "Item 1. Business - Operations" in the Company's 1996 Form 10-K. ADVERSE IMPACT OF GOVERNMENT REGULATION. The Company's businesses are subject to government regulation in several respects which could cause additional operating costs and which must be monitored for compliance. In particular, federal and state law prohibits the practice known as "slamming", whereby telephone companies switch a customer's carrier without the customer's permission. In June 1997, the California Public Utility Commission and the California Attorney General initiated an investigation of NTC for alleged "slamming" incidences by certain NTC independent sales representatives. On October 28, 1997, NTC settled a civil consumer protection lawsuit filed against it by the State of California, without admitting or denying wrongdoing. In November 1997, NTC settled the related administrative action by the California Public Utilities Commission. Pursuant to the settlements, NTC paid a total of approximately $1,600,600 in penalties and restitution, and agreed to implement new safeguards and policies to prevent "slamming" in the future. There is no assurance that NTC will not be penalized again for possible "slamming" practices by its independent marketing representatives in the future, despite NTC's new safeguards, and that such penalty, whether in the form of a fine or a suspension of its right to conduct business, will not have a material adverse impact on the Company's and NTC's financial condition, operating results and business performance. See "THE COMPANY - Settlement of Civil Consumer Protection Lawsuits With the State of California." NTC must also comply with advertising and disclosure rules relating to its sale of long distance telephone services to the public. Its retail marketing program utilizing independent representatives to recruit retail customers and additional representatives is subject to state laws regulating network marketing programs. NTC must be registered with the public utility commissions of most states in order to provide telephone service in those states. While NTC's registrations are effective in most of those states, it continues to operate through agency contracts in certain states where its registrations are pending. The Company is also subject to federal, state and local government regulations relating to health, safety, employment, wages and working conditions. There is no assurance that government regulations will not have a material adverse impact on the Company's and its subsidiaries' financial condition, operating results and business performance. NO DIVIDENDS ON COMMON STOCK. The Company has not paid dividends on its Common Stock in the past and does not anticipate the payment of any cash dividends in the near future. The payment of cash dividends on the Common Stock is restricted pursuant to the terms and conditions of the outstanding Series A Preferred and Series B Preferred. See "THE COMPANY - Issuance of Convertible Preferred Stock" and "PRICE RANGE OF COMMON STOCK AND DIVIDENDS." CONTROL BY THE PRINCIPAL STOCKHOLDERS. The principal stockholders own in the aggregate approximately 16.7% of the combined voting power of the Company's Common Stock (18.7% when not accounting for 1,500,000 shares of the Company's Common Stock reserved for issuance to the plaintiffs in the recently settled class action lawsuit), not including those shares owned by the Company's prior Chairman and President, Sam D. Schwartz (who owns approximately 6% of the outstanding shares). Accordingly, the principal stockholders are able to exercise significant control of the vote on matters submitted to a vote of the Company's stockholders. Such control by the principal stockholders may have the effect of discouraging certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of Common Stock might otherwise receive a premium for their shares over then current market prices. See "PRINCIPAL STOCKHOLDERS." RISKS RELATING TO GENSOURCE. On May 2, 1997, the Company acquired 100% of the total issued and outstanding stock of GenSource Corporation (previously known as California Interactive Computing, Inc.). GenSource Corporation is engaged in the business of developing, marketing, maintaining and enhancing computer software for the processing of insurance and insurance-related claims. The computer software industry is extremely competitive. The Company's software products are subject to technological obsolescence and other risks inherent in the computer software business, including but not limited to the inability to protect or utilize its proprietary rights, the failure of its technology to perform as anticipated, the loss of key technical and marketing personnel, and other risks. See "RISK FACTORS - Cautionary Statements." Incomnet, Inc. plans to invest in excess of one million dollars of new capital into GenSource Corporation to assist it in upgrading its software products for windows applications and to strengthen its marketing capabilities. A substantial portion of this capital investment has already been made. There is no assurance that the new products will be successful, that the investment in GenSource Corporation will be justified, or that GenSource Corporation will continue to be profitable, increase its profitability, or that it will not incur operating losses in the future. Furthermore, the Company purchased GenSource Corporation by assuming five year promissory notes and by assuming certain notes payable to the prior shareholders of GenSource Corporation. There is no assurance that the Company will be able to pay those notes. The notes are secured by the stock of GenSource Corporation. If the Company defaults on the payment of the notes, the holders of the notes could foreclose on the stock securing the notes and reacquire ownership of GenSource Corporation from the Company. See "THE COMPANY - Acquisition of California Interactive Computing, Inc." -14- RISKS RELATING TO RCI RECENT EMERGENCE FROM DEVELOPMENT STAGE. RCI recently emerged from its development stage. RCI was incorporated in February 1994 and did not commence marketing its products until after a controlling interest in it was acquired by the Company on February 8, 1995. RCI has a limited operating history and only began shipping its products in April 1995. RCI and Q2100 have incurred substantial operating losses since their inception. As of December 31, 1996, they had a consolidated shareholders' deficiency accumulated during their development stage of $19,048,000. The likelihood of RCI's success must be considered in light of the foregoing facts, together with the expenses, difficulties, uncertainties and delays frequently encountered in connection with the early phases of a new business. Unanticipated difficulties relating to marketing, manufacturing or competition, for instance, could materially adversely affect RCI's ability to achieve its business objectives. Certain of RCI's customers have experienced technical and mechanical difficulties with the casting machines. RCI has had to make service calls on those machines and is making design modifications to its equipment and components. There is no assurance that design modifications will solve problems that have arisen and that may arise in the future. Furthermore, there is no assurance that RCI will not experience a high number of returns which would adversely affect the operating results, financial condition and business performance of RCI and the Company. See "Item 1. Business - Rapid Cast, Inc" in the Company's 1996 Form 10-K. RISK OF UNCERTAIN MARKET ACCEPTANCE; COST OF LENSYSTEM. RCI's success depends substantially upon the acceptance of the LenSystem as an alternative to traditional methods of purchasing and fabricating eyeglass lenses. Factors that may adversely affect market acceptance include potential customers' unfamiliarity with the Company's relatively new technology, lens making processes, products, lens designs and materials, their reluctance to change current methods of purchasing and fabricating lenses, and the initial capital investment in purchasing the LenSystem. Furthermore, potential customers may be reluctant to purchase the LenSystem because it cannot currently manufacture all possible prescriptions and lens types. In addition, lens dispensers can obtain single vision lenses (approximately 50% of the lens type dispensed) at prices competitive with or lower than the cost of producing such lenses utilizing the LenSystem. After LenSystems are purchased, there can be no assurance that customers will continue to use their LenSystem to fabricate lenses. Consequently, there can be no assurance that customers will accept RCI's products as an alternative to traditional methods of purchasing and fabricating optical lenses. Moreover, market acceptance of the LenSystem will depend, in large part, upon its pricing (of both the LenSystem and the Rapid Cast Liquid Monomer) and RCI's ability to demonstrate the advantages of the LenSystem over competing products, technologies, and current distribution channels. See "Item 1. Business - Rapid Cast, Inc." in the Company's 1996 Form 10-K. OPERATING LOSSES; NEED FOR ADDITIONAL FINANCING; UNCERTAINTY OF ADDITIONAL FINANCING. RCI's operations to date have consumed substantial amounts of capital, and RCI expects its capital and operating expenditures to increase in the next few years. Such operating expenses are currently, and may continue to, exceed RCI's revenues. RCI has not been profitable since its inception. While RCI recently received a substantial capital investment from a group of private institutional investors, these investors are not obligated to invest additional capital in RCI and there is no assurance that the capital invested to date will be adequate for RCI's needs. See "THE COMPANY - Recent Capitalization of RCI." There is no assurance that RCI will be able to obtain additional financing or capital from any other source. RCI's need for additional financing will depend upon numerous factors, including, but not limited to, the extent that and duration of RCI's future operating losses, the level and timing of future revenues and expenditures, market acceptance of new products, the results of ongoing research and development projects, competing technologies, market developments, and the ability of RCI to maintain and develop additional collaborative arrangements and international distribution agreements. To the extent that existing resources are insufficient to fund RCI's activities, RCI may seek to raise additional funds through public or private financings. There can be no assurances that additional financing will be available or, if available, that it will be available on acceptable terms. If additional funds are raised by issuing equity securities, further dilution to the existing stockholders may result. If adequate funds are not available, RCI's results of operation may be adversely affected. See "Item 1. Business - Rapid Cast, Inc." in the Company's 1996 Form 10-K. -15- COMPETITION. The vision care industry is subject to intense competition from a variety of sources. RCI competes with conventional channels of distribution, including lens manufacturers and wholesale lens laboratories and, to a lesser extent, with manufacturers of point of sale lens fabrication systems, manufacturers of contact lenses and providers of equipment related to medical treatments to correct refractive disorders. Many of RCI's competitors have significantly greater financial, technological, marketing and other resources than RCI, which could enable such competitors to develop new processes or products that could render RCI's products obsolete or less competitive. In addition, many of RCI's competitors have significantly greater experience than RCI in developing new lenses, lens materials and fabrication technologies, and there can be no assurance that RCI will be able to compete effectively with such competitors. The effects of such competition could have a material adverse effect on RCI's financial condition and results of operations. RAPID TECHNOLOGICAL CHANGE. The potential market for the LenSystem is one characterized by rapidly changing technology, and many of RCI's competitors have substantially greater resources for the research and development of new technologies than RCI will have for such purposes. There can be no assurance that technologies or medical advances, including, without limitation, laser vision correction, Radial Keratotomy (RK) and new ophthalmic drugs which could obviate the need for prescription lenses, will not render the LenSystem uncompetitive or obsolete. RCI's ability to anticipate changes in technology, and then to improve the Technology or development or acquire new technologies in response to such changes, will therefore be a critical factor affecting RCI's ability to grow and become profitable. There accordingly can be no assurance that the Technology will not be subject to the development or widespread acceptance of any new processes or products that cause the Technology to become noncompetitive, incompatible, or result in early product obsolescence, or that RCI's business will not be materially adversely affected as a result. Substantial research and development is being conducted by competitors and others with respect to lens fabrication systems that could enable eyewear dispensers to fabricate plastic eyeglass lenses at the point of sale. RCI believes that this research and development will continue and may intensify and accelerate. The development or widespread acceptance of any new process or products, including new lens shapes, sizes, coatings and materials that cause RCI's products to become obsolete, noncompetitive or incompatible, would have a material adverse effect on RCI's financial condition and results of operations. THE OPTICAL MARKETPLACE. RCI's success will depend, in significant part, on its ability to anticipate trends and changes in the optical marketplace and to develop or acquire technology capable of satisfying the demands of the marketplace in connection with such trends and changes. Among the factors RCI must be aware of are fashion, lens material, lens coatings and treatments. Some or all of the changes required to be made in response to these factors may not be adaptable to an onsite lens manufacturing environment and could have a material adverse effect on RCI's financial condition and results of operations. PATENTS AND PROPRIETARY RIGHTS. In February 1995, RCI acquired all of the capital stock of Q2100 and thus all of Q2100's issued patents and patent applications that relate to the Technology. As of the date of this Prospectus, five United States patents have issued, eight United States patent applications are pending, and over 20 foreign applications are pending. RCI's success depends, in significant part, on its ability to obtain patent protection for its products, both in the United States and in other countries, to preserve its intellectual property rights and to operate without infringing on the rights of third parties. There can be no assurances that RCI will be able to protect its intellectual property rights adequately, that competitors will not be able to develop similar technology independently, that the claims allowed on any patents held by RCI will be sufficiently broad to protect RCI's technology or that RCI's patents will provide a significant competitive advantage for its products. Moreover, RCI believes that obtaining foreign patents may be more difficult than obtaining domestic patents because of differences in patent laws. In addition, the protection provided by foreign patents, once they are obtained, may be weaker than the protection provided by United States patents. The failure by RCI to -16- protect adequately its intellectual property rights could have a material adverse effect on RCI's financial condition and results of operations. RCI has been the subject certain legal disputes involving the intellectual property rights of others. See "Item 3. Legal Proceedings - Patent Infringement Lawsuit" in the Company's 1996 Form 10-K. The patent infringement suit entitled RONALD BLUM O.D. VS. RAPID CAST, INC., ET AL. has been settled. See "THE COMPANY - Settlement of Patent Infringement Lawsuit by RCI." Any litigation in the future to enforce patents issued to RCI, to protect trade secrets or know-how possessed by RCI or to defend RCI against claimed infringement of the rights of others would be time-consuming and costly, and could have a material adverse effect on RCI's financial condition and results of operations. Additionally, the manufacture and sale of products that RCI develops or markets may involve the use of processes, products or information, the rights to which may be held by others. There can be no assurance that RCI will be able, for financial reasons or otherwise, to obtain ownership or license rights with regard to the use of such processes, products or information or, if obtained, that the use of such rights will be on terms favorable to RCI. Failure to obtain such rights, if any, could have a material adverse effect upon the financial condition and results of operations of RCI. RCI also relies, and will continue to rely, on trade secrets and proprietary know-how which it seeks to protect, in part, by secrecy agreements with its employees, consultants, licensees, potential strategic partners and others. There can be no assurance that any such agreements will not be breached, that RCI would have adequate remedies for any such breach, or that RCI's trade secrets are not already known to, or will not otherwise become known to, or be independently developed by, RCI's competitors. To the extent that consultants, licensees or other third parties (such as prospective joint venture partners or subcontractors engaged to manufacture the LenSystem) participate in RCI's projects, technological information independently developed by them or by others may be the subject of disputes as to the proprietary rights to such information, which disputes may not be resolved in favor of RCI. The LenSystem uses as its raw material the Rapid Cast Liquid Monomer, which is injected into a lens mold and then cured (i.e., hardened) into a finished lens. The Rapid Cast Liquid Monomer is a proprietary trade secret which is not protected by any issued patents nor the subject of any patent applications. RCI does not currently intend to seek patent protection for the Rapid Cast Liquid Monomer. See "Item 1. Business - Rapid Cast, Inc. - Technical Overview of the Rapid Cast LenSystem" in the Company's 1996 Form 10-K. MANUFACTURING UNCERTAINTIES. RCI currently does not have the facilities to manufacture the LenSystem's equipment components and raw materials (i.e., the Rapid Cast Liquid Monomer) and has no plans to develop its own manufacturing capabilities. RCI engages subcontractors and licensees to produce such components and raw materials. RCI is at present substantially dependent upon four suppliers from which it purchases different components and the Rapid Cast Liquid Monomer. RCI believes that it could take in excess of six months to secure alternatives for its suppliers in the event of the loss of RCI's current suppliers. The glass molds utilized by the LenSystem to produce a specific progressive multifocal design are available from only one supplier. Alternative suppliers for those glass molds or any other component of the LenSystem may not be available. RCI has certain of its components and tooling manufactured abroad and may have additional components provided by foreign suppliers in the future. The loss of a supplier for any material or component used by RCI or the inability of a supplier to fulfill RCI's requirements might cause significant delays in deliveries and the incurrence of additional costs. Such delays or increased costs could have a material adverse effect on RCI's financial condition and results of operations. MARKETING UNCERTAINTIES, DOMESTIC. RCI's marketing efforts in the United States have relied primarily on trade journals, trade shows and conventions to present its products to the marketplace. RCI has not expended significant funds on direct or other marketing campaigns and has a dedicated sales and marketing staff of four persons. There can be no assurance that the implementation of RCI's future marketing plans will be effective or that RCI will not be required to expend more than it currently anticipates in order to market its products. -17- MARKETING UNCERTAINTIES; INTERNATIONAL. RCI generally markets its LenSystem internationally through exclusive local distributors and has entered into several exclusive distribution agreements worldwide. There can be no assurance that the purchase commitments and other obligations contained in these agreements will be honored. Nor can there be any assurance that suitable distributors for other countries to which RCI is not currently distributing will be found. Laws and regulations imposed by foreign countries may also adversely affect the marketing or commercial viability of the LenSystem and the Rapid Cast Liquid Monomer. Additionally, significant fluctuations in the value of the United States dollar could adversely affect future demand for the LenSystem in foreign countries. PRODUCT LIABILITY CLAIMS AND UNINSURED RISKS. The manufacturing, marketing and sale of prescription ophthalmic lenses entail the inherent risk of exposure to product liability claims. These claims might be made by, among others, consumers who purchase lenses manufactured by, or businesses that utilize, the Lensystem. Currently, RCI maintains product liability insurance which provides coverage of $6,000,000 per occurrence and $7,000,000 in the aggregate. There can be no assurance that RCI will be able to maintain such insurance at commercially reasonable rates, if at all, or that the coverage provided thereby is sufficient to fully protect RCI against liability. RCI's inability or failure to protect itself adequately against such liabilities could have a material adverse effect upon its prospects, financial condition and results of operations. EQUIPMENT INSTALLATION AND SERVICE. RCI does not presently have any contracts or arrangements with qualified companies to install and service the LenSystem, currently relying on its staff of installers and technicians. Furthermore, equipment malfunctions have caused and may in the future cause RCI to incur unanticipated operating expenses that may not be covered by component manufacturers' warranties. See "RISK FACTORS - Risks Relating to RCI - Recent Emergence From Development Stage." DEPENDENCE UPON KEY PERSONNEL. The success of RCI will be largely dependent upon the continuing services and efforts of certain of its directors and executive officers. The loss of the services of Frank Pipp, John Vidovich, or certain other officers or consultants could have a material adverse effect upon RCI's ability to achieve its business objectives. RCI expects that its ability to achieve its business objectives will also depend in large part upon its ability to attract and retain highly qualified management personnel in the future, including sales, marketing and scientific staff. There can be no assurance that RCI will be able to attract and retain personnel with the requisite skills and experience necessary to successfully manage RCI's business and operations. REGULATORY CONSIDERATIONS. The lenses produced by the LenSystem are regarded by the United States Food and Drug Administration (the "FDA") as medical "devices" within the meaning of the Federal Food, Drug, and Cosmetic Act (the "Food and Drug Act"), but the lenses may be marketed without pre-market notification, review, approval or clearance by the FDA. Other requirements, principally those concerning impact resistance, current good manufacturing practices, labeling and reporting of certain allegedly device-related adverse effects will apply. RCI believes that the LenSystem, as manufacturing equipment, is itself not a "medical device" under the Food and Drug Act. If the LenSystem is itself a medical device, RCI believes that LenSystem may be marketed without premarket notification, review, approval, or clearance by the FDA, although other requirements, principally those concerning current good manufacturing practices, labeling, and reporting of certain allegedly device- related adverse affects, and of device malfunctions in certain circumstances, would apply. In any event, certain state and local government authorities (such as the State of California) also regulate medical device manufacturers. Depending upon where LenSystem equipment is manufactured, RCI may be subject to such additional state regulations. Although there can be no assurance in this regard, RCI does not anticipate that compliance with such governmental regulation will have an adverse effect upon its -18- business. Failure to comply with FDA, and in some cases, the state requirements, could result in civil sanctions, e.g., product seizure, injunction versus product manufacturing or distribution, or criminal prosecution and conviction. In addition, certain legal impediments and foreign regulatory restrictions may affect the sale and exportation of the LenSystem to countries other than the United States. PAYMENT OF ACQUISITION PRICE OF RCI. The Company issued 600,000 shares of restricted Common Stock to the founding shareholders of RCI to complete the payment of the purchase price of 51% of RCI in lieu of issuing up to 750,000 shares of performance based stock. RCI's financial performance during the twelve month period ending March 31, 1996 indicates that the founding shareholders of RCI would not have been issued any additional shares of the Company's common stock under the original stock purchase agreement. See "Item 1. Business -Acquisition of Rapid Cast, Inc." in the Company's 1996 Form 10-K. NO ANTICIPATED DIVIDENDS. Since inception, RCI has not declared or paid any cash dividends on its common stock and does not anticipate paying any cash or other dividends on its common stock in the foreseeable future. The declaration and payment of any cash dividends in the future will be determined solely by the Board of Directors of RCI (which will, for the foreseeable future, be elected by RCI's current stockholders, including the Company). AUTHORIZATION AND ISSUANCE OF ADDITIONAL SECURITIES. RCI's Certificate of Incorporation authorizes the issuance of up to 60,000,000 shares of common stock and 42,500,000 shares of preferred stock. RCI's Board of Directors has the power to issue any and all of such shares without stockholder approval. RCI may issue a substantial number of additional shares in the future including additional shares of convertible preferred stock to existing investors, not including the Company, who have an option to purchase more shares of RCI's preferred stock. See "THE COMPANY - Recent Capitalization of RCI.". Furthermore, there are outstanding a substantial number of warrants and options to purchase a substantial number of additional shares of the common stock of RCI, the exercise of which would result in a significant dilution of the Company's ownership in RCI. To the extent that additional shares of common or preferred stock are issued, dilution of the interests of RCI's stockholders, including the Company, will occur. OPTION PLAN. Pursuant to its stock option plan, RCI may grant options to purchase up to 4,514,732 shares of its common stock to directors, officers and employees of, and consultants to, RCI. RCI has issued options to purchase 3,260,000 shares of common stock under the option plan. During the respective exercise periods of the above-mentioned options, the holders thereof are given an opportunity to profit from a rise in the market price of the common stock (if RCI's stock becomes publicly traded), with a resultant dilution of the interests of the then existing stockholders. As a result, the terms upon which RCI may obtain additional equity financing during such periods could be adversely affected. These holders may be expected to exercise their rights to acquire common stock at a time when RCI would, in all likelihood, be able to obtain needed capital through a new offering of securities on terms more favorable than those provided by these options. See "THE COMPANY - Recent Capitalization of RCI." GENERAL RISKS BUSINESS DEPENDENT ON KEY PERSONNEL. The Company's business is partially dependent upon the performance of certain key individuals, including its President and Chief Executive Officer, and certain executives of its wholly-owned subsidiaries, NTC and GenSource. The Company has entered into an employment agreement (expiring on June 30, 2002) with Melvyn Reznick, its President and Chief Executive Officer, and an employment agreement expiring on December 31, 1999 with Stephen A. Caswell, its Secretary and Vice-President. NTC has entered into employment agreements with Edward R. Jacobs, the Chief Executive Officer of NTC (i.e. expiring on July 25, 1999), and James R. Quandt, a new President of NTC (i.e. expiring January 6, 2000). RCI has -19- entered into employment agreements with several of its executives. The Company and its subsidiaries do not anticipate a termination of their employment relationships with any of their key executives. RCI does not yet have a permanent Chief Executive Officer and is utilizing the services of an independent consultant and its newly appointed Chairman of the Board to fill that role until a permanent Chief Executive Officer is hired. While the independent consultant to RCI is currently its acting Chief Executive Officer, there is no assurance that RCI will be able to hire a permanent Chief Executive Officer, or that the absence of a permanent Chief Executive Officer will not have a material adverse effect on RCI's financial condition or results of operation. Furthermore, the loss of one or more key executives of the Company, NTC or GenSource could have an adverse impact on the Company's and its subsidiaries' business. See "Item 1. Business - Employees" in the Company's 1996 Form 10-K. DILUTION CAUSED BY FUTURE SALES OF SHARES. As of November 30, 1997, the Company has approximately 3,707,200 shares of Common Stock (not including the Shares, the Underlying Shares or outstanding shares of Series A Preferred or Series B Preferred) issued and outstanding which may be deemed "restricted securities" as that term is defined under Rule 144 of the Securities Act of 1933, as amended (the "Securities Act"). The restricted securities may be sold in the future in compliance with Rule 144 or Regulation S of the Securities Act. Ordinarily, under Rule 144 a person who is an affiliate of the Company (as that term is defined in Rule 144) and has beneficially owned restricted securities for a period of two years may, every three months, sell in brokerage transactions an amount that does not exceed the greater of (i) 1% of the outstanding class of such securities or (ii) the average weekly trading volume in such securities on all national exchanges or reported through the automated quotation system of a registered securities association during the four weeks prior to the filing of a notice of sale by a securities holder. A person who is not an affiliate of the Company who beneficially owns restricted securities is also subject to the foregoing volume limitations but may, after the expiration of three years, sell unlimited amounts of such securities under certain circumstances. Pursuant to Regulation S, foreign shareholders may resell their shares without restriction after the expiration of 40 days from the date of the sale of the stock to them. The Company can make no prediction as to the effect, if any, that sales of shares of Common Stock, or the availability of shares for future sale, will have on the market price of the Common Stock prevailing from time to time. Sales of substantial amounts of Common Stock (including the Shares and the Underlying Shares) in the public market, or the perception that such sales could occur, could depress prevailing market prices for the Company's Common Stock. Such sales may also make it more difficult for the Company to sell equity securities or equity-related securities in the future at a time and price which it deems appropriate. DILUTION CAUSED BY FUTURE ISSUANCES OF STOCK BY THE COMPANY. The Company's Certificate of Incorporation, as amended, authorizes the issuance of 20,000,000 shares of Common Stock and 100,000 shares of preferred stock. The Company currently has approximately 14,006,793 shares of Common Stock outstanding (including 1,500,000 shares reserved for issuance to the class plantiffs pursuant to the settlement of SAUNDRA GAYLES vs. INCOMNET, INC. AND SAM D. SCHWARTZ), 1,825 shares of the Series A Preferred Stock and 2,434 shares of Series B Preferred Stock outstanding. Assuming the issuance of all of the Shares covered by this Prospectus, and the issuance of the number of Underlying Shares based on the exercise of all Warrants and the conversion of Series A Preferred at the maximum average conversion price of approximately $4.44 per share, and the conversion of 2,434 shares of Series B Preferred at a maximum average conversion price of approximately $3.97 per share, the Company would have 16,272,832 shares of its Common Stock outstanding, not including shares issuable upon the exercise of other outstanding options and warrants. The remaining shares of Common Stock not issued or reserved for specific purposes may be issued without any action or approval of the Company's stockholders. Any such issuance could be used as a method of discouraging, delaying or preventing a change in control of the Company or could dilute the public ownership of the Company. There can be no assurance that the Company will not undertake to issue such shares if it deems it appropriate to do so. See "RISK FACTORS - Possible Effect of Reverse Stock Split or Business Combinations" and "DESCRIPTION OF CAPITAL STOCK." -20- POSSIBLE ADVERSE EFFECTS OF ISSUANCE OF PREFERRED STOCK. The Company's Certificate of Incorporation, as amended, authorizes the issuance of a maximum of 100,000 shares of Preferred Stock on terms that may be established by the Company's Board of Directors without further stockholder action. In September and October 1996 the Company issued $2,440,000 of Series A 2% Convertible Preferred Stock which is convertible into the Company's Common Stock based on a price equal to the lesser of the bid price of the Company's Common Stock on the date of funding (i.e. ranging from $4.125 to $4.75 per share), or 80% of the average bid price during the five trading days immediately preceding the date of the conversion. In July and again in November 1997, The Company issued a total of $2,434,000 of Series B 6% Convertible Preferred Stock which is also convertible into the Company's Common Stock based on a price equal to the lesser of the bid price of the Company's Common Stock on the date of funding (i.e. ranging from $3.00 to $4.29 per share) or 80% of the average bid price during the five trading days immediately preceeding the date of conversion. Furthermore, options to purchase up to 450 additional shares of Series B Preferred have been granted. Consequently, the Common Stockholders will experience dilution from the conversion of the Preferred Stock. The dilution will be greater to the extent that the bid price of the Company's Common Stock is lower at the time of conversion, since more shares of Common Stock will be issued for each share of outstanding Series A Preferred and Series B Preferred. Furthermore, while the Preferred Stock remains outstanding, the Company is subject to certain restrictive covenants. See "THE COMPANY - Issuance of Convertible Preferred Stock." The terms of any other series of Preferred Stock, which may include priority claims to assets and dividends and special voting rights, could also adversely affect the rights of holders of the Common Stock. To date, no Preferred Stock other than the Series A Preferred and Series B Preferred have been issued by the Company, although the Company may issue more Series B Preferred in the future. The issuance of Preferred Stock could make the possible takeover of the Company or the removal of the Company's management more difficult, or otherwise dilute the rights of holders of Common Stock and the market price of the Common Stock. See "DESCRIPTION OF CAPITAL STOCK - Preferred Stock." POSSIBLE EFFECT OF REVERSE STOCK SPLIT OR BUSINESS COMBINATION. The number of shares of the Company's Common Stock outstanding or issuable upon the conversion or exercise of outstanding securities issued by the Company is approaching the total authorized number of shares of the Company's Common Stock. As a result, or in order to implement a business combination in the future or for others reasons, the Company may effect a reverse split of its outstanding stock. A reverse stock split may cause the market price of the Company's stock to decline, and may result in dilution of the existing shareholders' ownership of the Company if the reverse stock split is implemented in connection with a business combination with another entity. There is no assurance that a reverse split of the Company's outstanding stock or a business combination with another entity, if implemented, would not have a material adverse effect on the market price or value of the Company's stock, or on the operating results, financial condition or business performance of the Company. THE COMPANY GENERAL The Company and its wholly-owned subsidiaries, NTC and GenSource, are engaged in three businesses: (i) interactive communications networking services by the Company, (ii) the provision of long distance telephone services by NTC, and (iii) the development, marketing, maintenance, and enhancement of computer software for the processing of insurance and insurance - related claims. The Company provides interactive communications networking services using its proprietary communications software, a central message switching computer and front-end network processor. All subscribers to Incomnet's communications network can simultaneously access the information on the system, can communicate on the system on a real-time basis and can leave electronic messages. The technology is particularly well suited to networks of buyers and sellers because requests for quotes can be broadcast to all participants simultaneously, while responses and subsequent negotiations associated with the quote can be done privately. The Company's major network is the Auto Dismantler Network, known under the tradename "AutoNETWORK," which currently links several hundred licensed automobile dismantlers in California, Colorado, Nevada, Arizona, Oregon and Washington. AutoNETWORK is a monthly subscription service that automobile dismantlers utilize to buy, sell and trade used parts that have been salvaged from automobiles damaged in traffic collisions. The Company continually evaluates other applications for its telecommunications networking technology, including other industries where electronic broadcast and point-to-point communications would add value to the conduct of their business. See "Item 1. Business - AutoNETWORK" and "Item 1. Business - Network Services" in the Company's 1996 Form 10-K. -21- The Company was incorporated under the laws of the State of California in 1974. Its principal place of business is located at 21031 Ventura Boulevard, Suite 1100, Woodland Hills, California 91364. Its telephone number is (818) 887- 3400. Additional information about the Company is included in documents incorporated by reference in this Prospectus. See "AVAILABLE INFORMATION" and "INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE." The Company's wholly owned subsidiary, NTC, is an inter-exchange carrier and reseller of long distance telephone services and provides nationwide long distance telephone access to commercial and residential customers across the United States. Customers of NTC purchase and pay for specific amounts of time either through direct billing from NTC, billing from the customer's local telephone company, or by prepaying for the use of NTC calling cards. NTC's primary products are its Call $aver Calling Card, its Sure $aver Calling Card, and its Dial-1 Telephone Service. In order to provide these NTC services, NTC purchases large amounts of long distance time from national and regional carriers at rates based upon high volume usage. NTC then resells this time to customers at discounted retail rates. Its calling cards also eliminate the calling card surcharges generally imposed by AT&T, MCI and Sprint. NTC utilizes a multi-level marketing network of independent sales representatives to market its long distance telephone services to retail customers. NTC was incorporated under the laws of the State of Nevada on September 6, 1984. Its principal offices are located at 2801 North Main Street, Irvine, California 92714 and its telephone number is (714) 251-8000. See "Item 1. Business - Acquisition of National Telephone Communications, Inc. -Operations." See also "AVAILABLE INFORMATION" and "INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE." The Company's other wholly-owned subsidiary, GenSource (previously known as California Interactive Computing, Inc.) is engaged in the development and marketing of software that is used to process insurance-related claims, including workers compensation, disability, general medical, and property and casualty claims. Its software is licensed to companies which provide their own insurance and claims administration, to insurance companies, and to third-party administrators who process claims for either self-insured companies or for insurance companies. GenSource's trademarked line of software products include GenCOMP-TM-, GenMED-TM-, GenDIS-TM-, GenPAC-TM-, GenRISK-TM-, GenIRIS-TM- and Top Rate-TM-. In addition, GenSource also offers several computer and service-related products, including GenARS-TM-, which is an optical disk-based information storage and retrieval system, and GenSERVE-TM-, which is a maintenance and service program for customers. GenSource is currently in the process of enhancing its computer software products for windows applications utilizing new capital being invested into it by Incomnet, Inc. GenSource was incorporated in 1977 in California and has provided computer software for claims processing for 20 years. See "THE COMPANY - Acquisition of California Interactive Computing, Inc." The Company owns a minority interest in RCI. RCI manufactures and markets the Fast Cast-TM- LenSystem that allows retail optical stores and wholesale optical lens manufacturing laboratories to produce single vision, flat-top bifocal and progressive bifocal lenses on demand, and in minutes. The Fast Cast-TM-LenSystem uses a series of high-accuracy prescription glass molds that are filled with a proprietary liquid monomer (plastic). When exposed to ultraviolet light within the system's curing chamber, the monomer undergoes a chemical reaction that rapidly "cures" or hardens the lens in 15 minutes. RCI commenced assembling and marketing the Rapid Cast equipment, molds and liquid monomer for the Fast Cast-TM- LenSystem in February 1995, when it acquired 100% of the outstanding stock of Q2100, Inc. from Pearle, Inc., and when the Company acquired its ownership interest in RCI. See "Item 1. Business - Acquisition of Rapid Cast, Inc." and "Item 1. Business - Rapid Cast, Inc." in the Company's 1996 Form 10-K. APPOINTMENT OF NEW DIRECTORS BY THE COMPANY On January 20, 1997, the Company's Board of Directors appointed Dr. Howard Silverman to fill a vacancy and become a member of the Board of Directors. Since March 1996, Dr. Silverman has been consulting for various companies in the optical and financial areas, including Andrew, Alexander, Wise & Company in New York, and Rapid Cast, Inc. From August 1995 to March 1996, Dr. Silverman served as a Vice-President of Corporate Finance for Rickel & Associates, an investment banking firm. From 1991 until he joined Rickel & Associates in 1995, Dr. Silverman was an independent business consultant specializing in early stage and mid-size operating companies. From 1985 to 1991, Dr. Silverman was the founder and Chairman of the Board of Directors of Vision Sciences, Inc., a company that developed, manufactured and sold in-office lens casting systems, which enabled the optical retailer to cast his own finished plastic optical lenses. Dr. Silverman was a member of the Board of Directors and the director of business development for Staar Surgical Co., Inc., a publicly owned company, from 1984 to 1990. He was the co-founder and Chief Operating Officer of Hydro- Optics, Inc., a manufacturer of hydrophilic contact lens, from 1974 until 1984. Dr. Silverman has also been the Vice President and Chief Operating Officer of Diversified Health Industries, Inc. and the President and Chief Executive Officer of Precision Contact Lens, Inc. Dr. Silverman had a private optometric practice in New York City from 1968 to 1972, specializing in contact lenses. Dr. Silverman earned a Bachelor of Science in Chemical Engineering from the College of the City of New York in 1965 and a Doctor of Optometry from Illinois College of Optometry in 1968. See the Company's Report on Form 8-K, dated January 20, 1997. On August 13, 1997, the Company's Board of Directors appointed three more members to the Board, David Wilstein, Richard M. Horowitz and Stanley Weinstein. See the Proxy Statement for the 1997 Annual Meeting of the Shareholders of the Company and the Company's Report on Form 8-K, dated August 13, 1997. Richard M. Horowitz, 56, has served as President of Management Brokers Insurance Agency (Beverly Hills, California) since 1974. He also serves as Chairman of Leviathan Corporation, a computer sales, consulting and software company, and Chairman of Dial 800, Inc., a telecommunication company. Since 1990, he has been a member of the Board of Directors of Trio-Tech International, a company that produces environmental testing equipment. He has an MBA from Pepperdine University. Stanley C. Weinstein, 65, is a co-founder and the Managing Shareholder of Weinstein Spira & Company, P.C., Certified Public Accountants, which was established in 1962 in Houston, Texas. His expertise includes diverse business consulting, executive recruitment and compensation, and the development and utilization of marketing strategies. Mr. Weinstein attended Rutgers University and obtained a B.B.A. from Upsala College. He is a member of the American Institute of Certified Public Accountants (AICPA) and the Texas Society of Certified Public Accountants (TSCPA). David Wilstein, 69, is the President and Chairman of the Board of the Realtech Group, a real estate development and management firm in Los Angeles, California, which he founded in 1968. He is also the Chairman of the Board of Aero Products Research, a company that develops plastic products, and is a member of the Board of C. L. Systems, a company that develops electro-optical test equipment. Mr. Wilstein has a B.S. in civil-structural engineering from the University of Pittsburgh. -22- APPOINTMENT OF NEW EXECUTIVE OFFICER OF NTC On January 6, 1997, NTC entered into an employment agreement with James R. Quandt pursuant to which Mr. Quandt is serving as the President of NTC's newly formed operating division, and will be nominated to become a member of NTC's Board of Directors. The employment agreement contemplates that Mr. Quandt will eventually become the Chief Executive Officer of NTC upon the retirement of Edward Jacobs, the current Chief Executive Officer, which is presently scheduled for January 1, 1999. Mr. Quandt's employment agreement commenced on January 6, 1997 and has a term of three years. The employment agreement provides for Mr. Quandt to implement a separation of the functions of the Company into an operating division, with primary responsibility for the telephone business, and a marketing division, with primary responsibility for the independent sales representatives. Until Mr. Quandt becomes the Chief Executive Officer of NTC (which is contemplated but not guaranteed), he and the President of the newly formed marketing division will report to Mr. Jacobs. The employment agreement recites that Mr. Jacobs also contemplates retiring as the Chairman of the Board of Directors of NTC on July 25, 1999, although such retirement is not contractually mandated. The employment agreement contemplates that Mr. Quandt may be nominated to become the Chairman of the Board of Directors of NTC upon Mr. Jacobs' retirement from that position. Pursuant to the employment agreement, Mr. Quandt is entitled to the following compensation: (1) A base salary of $40,000 per month, (2) an incentive bonus equal to one and one-half (1.5%) of the quarterly net profit earned by NTC, provided that the quarterly net profit is at least $1,250,000, the payment of the bonus does not cause the quarterly net profit of NTC to be less than $1,250,000, and NTC's pretax profit for the succeeding calendar quarter is reasonably expected to exceed the minimum quarterly net profit of $1,250,000, and (3) nonqualified stock options to purchase 600,000 shares of the common stock of NTC. The stock options will have an exercise price determined by the Board of Directors of NTC in accordance with the NTC Stock Option Plan, but in no event greater than the higher of $5.00 per share or the fair market value of NTC's stock at the time of the grant. See "THE COMPANY - Amendment to NTC Management Incentive Agreement." The stock options will have an exercise period of five years from the date of grant. The stock options will vest as follows: (1) 250,000 stock options will vest upon Mr. Quandt completing 15 months of employment for NTC under the employment agreement, and (2) 350,000 stock options will vest only in the event NTC achieves cumulative pretax profits which total a minimum of $10,000,000 in any four contiguous calendar quarters prior to January 1, 1998. In addition to the base salary, regular bonus and stock options, Mr. Quandt will earn a hiring bonus equal to $225,000, payable if NTC's quarterly net profits exceed $1,250,000, but in any event no later than December 31, 1997 with respect to $150,000 of the guaranteed hiring bonus, and the balance by no later than June 30, 1998. The hiring bonus will be paid at the rate of 1.5% of quarterly pre-tax profits of NTC in excess of $1,250,000, and if not earned in that manner, will be paid in full in two installments as follows: $150,000 by December 31, 1997 and the balance by June 30, 1998. To the extent that the regular bonus and guaranteed hiring bonuses are paid to Mr. Quandt pursuant to his employment agreement, Mr. Jacobs has agreed to waive any remaining portion of the quarterly incentive bonus payable by NTC to Mr. Jacobs (i.e. 1.5% of the pre-tax net profits in excess of $1,250,000 of net profits of NTC per calendar quarter) pursuant to Mr. Jacobs' current employment agreement with NTC. Under the employment agreement, Mr. Quandt is entitled to a significant severance payment if his employment terminates prior to the agreement's termination date because of his death, disability, or for a reason other than cause, or because of a voluntary resignation by Mr. Quandt for "good cause", as defined in the employment agreement. Mr. Quandt has agreed not to compete with NTC during the term of his employment agreement and for a period of one year after the agreement terminates for any -23- reason. The effectiveness of Mr. Quandt's employment agreement is conditioned on its approval by the NTC Board of Directors, which is expected to be given in the near future. Prior to assuming his executive position with NTC, Mr. Quandt was the Chairman of the Board of Directors of Global Financial Information Corporation, a privately held group of companies in the financial information and technology industry. Global Financial Information Corporation operates from a base of 27 offices internationally, with a staff of approximately 840 professionals. From 1991 to 1995, Mr. Quandt was the President and Chief Executive Officer of Standard & Poors Financial Information Services, a subsidiary of McGraw Hill Corporation in New York, New York. At Standard & Poors, Mr. Quandt was responsible for all executive, administrative and operational functions of nine domestic and international companies that comprised the Standard & Poors Group. From 1980 to 1991, Mr. Quandt was an executive officer in various capacities with Security Pacific Bank in Los Angeles, California. Mr. Quandt was the Senior Vice President and Group Division Head of Security Pacific Bank's Financial Management & Trust Services Group from 1988 to 1991. From 1983 to 1990, Mr. Quandt was the President and Chief Executive Officer of Security Pacific Brokerage, Inc., a subsidiary of Security Pacific Bank, for which he negotiated the sale in 1990 to Fidelity Investments. Mr. Quandt was Group Vice President of Security Pacific Financial Management Centers from 1980 to 1983. From 1976 to 1980, Mr. Quandt was a Second Vice President with Smith, Barney, Harris, Upham & Co. in Los Angeles, California, and from 1972 to 1976, he was a Senior Account Executive with the Bank of America. Mr. Quandt earned a Bachelor of Science in Economic and Business Administration from Saint Mary's College of California in 1971 and completed the program at the Graduate School of Business, Management Policy Institute, at the University of Southern California. Mr. Quandt is a member of the Board of Regents of Saint Mary's College of California and the Alumni Council Board of the American Bankers Association. Mr. Quandt is also a member of the New York Municipal Forum. REINCORPORATION OF NTC AND RESIGNATION OF DIRECTOR On March 20, 1997, NTC reincorporated under the laws of the State of Delaware. On March 21, 1997, Jerry Ballah resigned as an officer and director of NTC, which was accepted by the NTC Board of Directors. The Board of Directors of NTC authorized NTC to enter into a consulting agreement with Mr. Ballah pursuant to which he would provide marketing consulting services to NTC for $150,000 per year in consulting fees. The NTC Board of Directors also authorized NTC to make a one year loan of up to $600,000 to Mr. Ballah bearing interest at the applicable federal rate, evidenced by a promissory note payable to NTC. The outstanding balance of the loan is approximately $550,000 as of November 30, 1997. AMENDMENTS TO BYLAWS On June 8, 1997, the Board of Directors of the Company adopted an amendment to the Company's Bylaws relating to the procedures for nominating candidates for election as directors of the Company. The amendment states as follows: "Section 3.A. NOMINATION OF DIRECTORS. Only persons who are nominated in accordance with the procedures set forth in this Section 3A shall be eligible for election as, and to serve as, directors. Nominations of persons for election to the Board of Directors may be made at a meeting of the stockholders at which directors are to be elected (i) by or at the direction of the Board of Directors or (ii) by any stockholder of the Corporation who is a stockholder of record at the time of the giving of such stockholder's notice provided for in this Section 3A, who shall be entitled to vote at such meeting in the election of directors and who complies with the requirements of this Section 3A. Such nominations, other than those made by or at the direction of the Board of Directors, shall be preceded by timely advance notice in writing to the Secretary of the Corporation. To be timely, a stockholders' notice shall be delivered to, or mailed and received at, the principal executive offices of the Corporation (i) with respect to an election to be held at the annual meeting of the stockholders of the Corporation, not later than the close of business on the 90th day prior to the first anniversary of the preceding year's annual meeting; PROVIDED, HOWEVER, that with respect to the annual meeting of stockholders to be held in 1997 or in the event that the date of the annual meeting is more than 30 days before or more than 60 days after such anniversary date, notice by the stockholder to be timely must be so delivered not later than the close of business on the later of the 90th day prior to such annual meeting or the 10th day following the day on which public announcement of the date of such meeting is first made by the Corporation; and (ii) with respect to an election to be held at a special meeting of stockholders of the Corporation for the election of directors, not later than the close of business on the tenth day following the day on which notice of the date of the special meeting was mailed to stockholders of the Corporation or public disclosure of the date of the special meeting was made, whichever first occurs. Any such stockholder's notice to the Secretary of the Corporation shall set forth (x) as to each person whom the stockholder proposes to nominate for election or re-election as a director (i) the name, age, business address and residence address of such person, (ii) the principal occupation or employment of such person, (iii) the number of shares of each class of capital stock of the Corporation beneficially owned by such person, (iv) the written consent of such person to having such person's name placed in nomination at the meeting and to serve as a director if elected and (v) any other information relating to such person that is required to be disclosed in solicitations of proxies for election of directors, or is otherwise required, pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and (y) as to the stockholder giving the notice, (i) the name and address, as they appear on the Corporation's books, of such stockholder and (ii) the number of shares of each class of voting stock of the Corporation which is then beneficially owned by such stockholder. The presiding officer of the meeting of stockholders shall determine whether the requirements of this Section 3A have been met with respect to any nomination or intended nomination. If the presiding officer determines that any nomination was not made in accordance with the requirements of this Section 3A, he shall so declare at the meeting and the defective nomination shall be disregarded. Notwithstanding the foregoing provisions of this Section 3A, a stockholder shall also comply with all applicable requirements of the Exchange Act and the rules and regulations thereunder with respect to the matters set forth in this Section 3A." On August 13, 1997, the Board of Directors of the Company adopted an amendment to the Company's Bylaws providing that the fixed number of directors of the Company will be seven members rather than six members, within a range of permitted directors numbering a minimum of five and a maximum of nine. On November 17, 1997, the Board of Directors adopted an amendment to the Company's Bylaws providing for the requirement that any resolution to be adopted by the Company's Board of Directors must be approved by a majority of the directors comprising a quorum plus one. Accordingly, if seven members of the Board are present, the approval of five is required to adopt a resolution. A quorum is present for meetings of the Company's Board of Directors if a majority of the Board is present. GRANT OF STOCK OPTIONS AND OTHER COMPENSATION BY THE COMPANY The Company's Board of Directors approved the following executive compensation for the President and Secretary of the Company at its Board meeting on January 21, 1997, pursuant to the recommendation of the Company's Compensation Committee: (1) Melvyn Reznick's annual salary for the twelve month period commencing on December 1, 1996 and ending on December 1, 1997 was increased to $250,000. Mr. Reznick was granted a cash bonus of $40,000. He was also granted options to purchase a certain number of shares of NTC common stock from the Company. The number of options to purchase NTC stock would have been equal to $135,000 divided by the fair market value of each share of NTC stock on December 31, 1996. The exercise price would have been equal to the fair market value of NTC stock and the term of the options would have been three years. In June 1997, Mr. Reznick elected to accept his bonus in cash in lieu of options to purchase NTC stock from the Company. The Company's Compensation Committee also recommended that Mr. Reznick's bonus for 1997 be $100,000, subject to the approval of the Company's Board of Directors early next year, provided that the Board determines that Mr. Reznick satisfies the following criteria: The Company completes the spin-off of 10% of the common stock of NTC that it owns, the pending investigation of the Company by the Securities and Exchange Commission is settled and terminated, the Company's legal and regulatory issues are under control and, if possible, resolved, the Company expands its corporate communications activities so that its stock is presented properly to the investment community, the Company develops a new source of revenues and profits so that Incomnet, Inc. has a clear potential to cover its costs independent of NTC and RCI, and there is significant appreciation in the value of the Company's stock. -24- (2) Stephen A. Caswell's annual salary for the twelve month period commencing on January 1, 1997 was increased to $115,000. Mr. Caswell was granted a cash bonus of $10,000. He was also granted options to purchase a certain number of shares of NTC common stock from the Company, which would have been calculated in the same manner as for Mr. Reznick, except that the dollar amount of options is $40,000 rather than $135,000. In June 1997, Mr. Caswell elected to accept his bonus in cash in lieu of options to purchase NTC stock from the Company. The Compensation Committee recommended and the Board of Directors approved a potential cash bonus of $35,000 for Mr. Caswell for 1997, provided that the Company achieves the same goals as are applicable to Mr. Reznick's potential 1997 bonus. On January 21, 1997, the Board of Directors granted the following stock options to the following officers, directors and consultants to the Company. The options granted to the directors of the Company were not granted pursuant to and are not covered by the provisions of Incomnet, Inc.'s 1996 Stock Option Plan:
Number Potential Realizable Value of Stock Exercise at Assumed Annual Rates of Stock Name Options Price Date of Expiration Price Appreciation for Term (3) - ---- -------- -------- ------------------ -------------------------------- 5% 10% ---- ------- Howard Silverman 35,000 $4.25 1/21/2002 $ 0 $ 14,700 Albert Milstein 35,000 $4.25 1/21/2002 $ 0 $ 14,700 Nancy Zivitz 35,000 $4.25 1/21/2002 $ 0 $ 14,700 Stephen Caswell 40,000(1) $4.25 1/21/2002 $ 0 $ 16,800 Mark Richardson(2) 20,000 $4.25 1/21/2002 $ 0 $ 8,400
- ------------------------------ (1) These stock options are pledged to the Company as additional collateral to secure the nonrecourse loan by the Company to Mr. Caswell made on November 15, 1995, which is also secured by 20,000 shares of the Company's Common Stock owned by Mr. Caswell. The current outstanding balance of the loan is approximately $340,000. (2) Mr. Richardson is corporate legal counsel to the Company. See "LEGAL MATTERS." (3) The assumed appreciation is calculated from the last sale price of the Company's Common Stock on the NASDAQ over-the-counter market on November 26, 1997, which was $2.90 per share. The members of the Compensation Committee are Albert Milstein, Nancy Zivitz and Dr. Howard Silverman. Dr. Silverman joined the Compensation Committee upon his appointment as a director on January 20, 1997. He did not participate in the issuance of the report by the Compensation Committee relating to the recommendations for compensation for Mr. Reznick and Mr. Caswell, as described above, which were adopted by the full Board of Directors on January 21, 1997. Mr. Caswell was a member of the Compensation Committee until he resigned from it on June 27, 1997. Mr. Caswell did not vote on the recommendations of the Compensation Committee relating to his compensation from the Company. In approving the recommendations to the Board of Directors for Mr. Reznick's and Mr. Caswell's compensation, the Compensation Committee in its report noted extraordinary work performed by these executives under difficult conditions. Mr. Reznick performed an important role in financing and procuring the equity financing for Rapid Cast, Inc., one of the Company's subsidiaries. Mr. Reznick personally made and guaranteed bridge loans to Rapid Cast, Inc. as well as coordinating negotiations with J.P. Morgan and The Clipper Group to complete the institutional financing of Rapid Cast, Inc. Mr. Reznick is serving a key role on the Board of Directors, Audit -25- Committee and Compensation Committee for Rapid Cast, Inc. He also works extensively with the research and development department of Rapid Cast, Inc. The Compensation Committee and the Board of Directors believes that the institutional financing of Rapid Cast, Inc. may not have been accomplished without the financial and managerial involvement of Mr. Reznick. The Compensation Committee noted that Mr. Reznick was also instrumental in resolving the issues with National Telephone & Communications, Inc., the Company's 100% owned subsidiary, including initiating the procedures necessary to accomplish the eventual spin-off of a portion of the Company's NTC shares. The current management incentive agreement with NTC provides Incomnet, Inc. with a reliable source of working capital in 1997. The Compensation Committee also noted that Mr. Reznick served as an effective leader in resolving and making progress in resolving difficult legal and regulatory issues affecting the Company. The Compensation Committee made a comparative analysis of Mr. Reznick's annual salary in relation to the salaries of chief executive officers of public companies of approximately the same size, as well as the salaries of the chief executive officers of NTC and RCI, and determined that the recommendation for Mr. Reznick's compensation was fair and reasonable. The Compensation Committee also issued a report with respect to Mr. Caswell which noted his valuable work in providing support for the Company's litigation tasks, including his assistance in the pending legal action for the recovery of short swing profits for the Company in MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ. Mr. Caswell performed critical tasks in connection with the Company raising $2,440,000 in the private placement of the Series A 2% Convertible Preferred Stock. Mr. Caswell was also instrumental in establishing an investor relations program for the Company including the hiring of Fi.Comm, Ltd., the Company's investor relations firm. The Compensation Committee made a comparative analysis of Mr. Caswell's annual salary in relation to the salaries of corporate secretaries of public companies of approximately the same size, and determined that the recommendation for Mr. Caswell's compensation was fair and reasonable. APPOINTMENT OF COMMITTEE MEMBERS The current members of the Audit Committee of the Company's Board of Directors are Albert Milstein, Nancy Zivitz and Dr. Howard Silverman. The current members of the Compliance Committee of the Company's Board of Directors are Melvyn Reznick, Mark Richardson, Albert Milstein and Nancy Zivitz. The current members of the Compensation Committee of the Company's Board of Directors are Albert Milstein, Nancy Zivitz, and Dr. Howard Silverman. EMPLOYMENT AGREEMENTS WITH COMPANY MANAGEMENT On June 8, 1997, the Company's Board of Directors approved an extension of the employment agreement with Melvyn Reznick, the President and Chairman of the Board of the Company, and a new employment agreement with Stephen A. Caswell, the Company's Secretary and Vice-President. The existing employment agreement with Mr. Reznick was extended until the earlier of (i) June 30, 2002, or (ii) six months after the date that 100% of the Company's holdings of NTC stock are sold, conveyed or otherwise distributed but no sooner than December 31, 1999 ("Early Termination Date"). The annual salary was established to be $250,000 for the term of the contract. In the event of an improper termination of the agreement by the Company for any reason, Mr. Reznick is entitled (i) to be paid a lump sum amount equal to his annual salary during the remaining term of his agreement plus his annual salary for three additional years, plus accrued bonus, if any, (ii) to receive all of his benefits during such period, and (iii) to exercise all of his vested stock options at any time during the remaining term of the options. In the event of an early termination because of the disposition of 100% of the Company's NTC stock, then the Company has agreed to pay Mr. Reznick a lump sum amount equal to the sum of the annual compensation and accrued but unpaid bonus (if any, with respect to the bonus) which would be payable to him for one additional year after the Early Termination Date, but not beyond June 30, 2002, as well as to provide his benefits during that period and to permit him to exercise his vested stock options during the remaining term of the options. Mr. Caswell's employment agreement has a term which expires on the earlier of (i) December 31, 1999, or (ii) six months after the date that 100% of the Company's holdings of NTC stock are sold, conveyed or otherwise distributed. His annual salary is $115,000 during the term of the contract. In the event of an improper termination of Mr. Caswell's employment agreement by the Company for any reason, Mr. Caswell is entitled (i) to be paid a lump sum amount equal to his annual salary during the remaining term of his agreement plus his annual salary for 15 additional months, (ii) to receive all of his benefits during that period, and (iii) to exercise all of his vested stock options at any time during the remaining term of the options. In the event of an early termination because of the disposition of 100% of the Company's NTC stock, then the Company has agreed to pay Mr. Caswell a lump sum amount equal to the sum of the annual compensation and accrued bonus (if any, with respect to the bonus) which would be payable to him for one additional year after the Early Termination Date, but not beyond December 31, 1999, as well as to provide his benefits during such period and to permit him to exercise his vested stock options during the remaining term of the options. On October 30, 1997, NTC entered into a new employment agreement with Edward R. Jacobs, who had been the Chairman and Chief Executive Officer of NTC under a previous employment agreement from December 28, 1994 to July 25, 1997. Pursuant to the new agreement, Mr. Jacobs' employment with NTC was extended until July 25, 1999. The terms and conditions of the extended employment agreement are described in "Item 5. Other Information - Employment Agreement Between Incomnet, Inc. and Edward R. Jacobs" in the Company's Form 10-Q for the quarter ended September 30, 1997 and in the Company's Proxy Statement for the 1997 Annual Meeting of the Company's Shareholders. FILING OF SCHEDULE 13D On May 5, 1997, four shareholders representing to own a total of 1,119,094 shares of the Company's Common Stock filed a Schedule 13D with the Securities and Exchange Commission. The shareholders are David Wilstein, his brother, Leonard Wilstein, Richard M. Horowitz and Jack Gilbert. An amended Schedule 13D was subsequently filed by the group adding Robert Epstein, who owns 325,000 shares of the Company's Common Stock. The shareholders, acting in concert, stated that they were considering various courses of action, including but not limited to acquiring additional shares of the Company's stock and seeking representation on the Company's Board of Directors by proposing nominees for election to the Board at the Company's annual meeting of the shareholders or otherwise. On August 13, 1997, the Company's Board of Directors appointed David Wilstein and Richard M. Horowitz, two members of the group, to fill existing vacancies on the Board. The Board also amended the Bylaws to create an additional vacancy and appointed Stanley Weinstein as the seventh director of the Company. See "THE COMPANY - Appointment of New Directors." ACQUISITION OF CALIFORNIA INTERACTIVE COMPUTING, INC. On May 2, 1997, the Company acquired 100% of the issued and outstanding capital stock of California Interactive Computing, Inc. ("CIC"), a private California corporation engaged in the business of developing and marketing computer software that is used to process insurance related claims, including workers compensation, disability, general medical, and property and casualty claims. CIC's computer software is licensed to companies which provide their own insurance and claims administration, to insurance companies, and to third party administrators who process claims for either self-insured companies or insurance companies. CIC was incorporated in 1977 and has provided software for claims processing for 20 years. CIC's name was changed to GenSource Corporation on October 15, 1997. The total purchase price for CIC was $2,176,829 payable over a five year period, comprised of a total of $1,758,302 payable in cash to the shareholders of CIC for their stock and the assumption of approximately $418,527 of loans payable by CIC to two of its prior shareholders. In addition, CIC entered into a two year employment agreement with Jerry Buckley, CIC's prior President and Chairman of the Board of Directors, pursuant to which CIC is paying Mr. Buckley $10,000 per month in consideration for his services as the Director of Strategic Planning for CIC. See "Item 13 - Certain Relationships and Related Transactions - Acquisition of California Interactive Computing, Inc." in the Company's 1997 Form 10-KA. See also the Company's Report on Form 8-K, dated May 2, 1997, and "Item 5 - Other Information -Acquisition of California Interactive Computing, Inc." in the Company's Form 10-Q for the quarter ended March 31, 1997. AGREEMENTS WITH NTC AND ITS MANAGEMENT In November 1996 the Company entered into a new management incentive agreement with NTC pursuant to which the Company agreed to spin-off 10% of the shares it owns in NTC, to establish stock option programs for the senior executives, employees and key independent sales representatives of NTC, and to vote its shares for NTC management's slate of director nominees. The new management incentive agreement entirely superseded the incentive agreement entered into by the Company with NTC in February 1996. See "Item 5. Other Information - Agreement with NTC Management" in the Company's Form 10-Q for the quarter ended September 30, 1996 as updated under "Item 1. Business - National Telephone and Communications Inc. - Management Incentive Agreement" in the Company's 1996 Form 10-K. The Company also entered into settlement agreements with Edward Jacobs, the Chairman of the Board Directors and President of NTC, and Jerry Ballah, the Executive Vice President and a director of NTC, pursuant to which mutual general releases were given. The Company agreed to assume certain debt obligations of Mr. Jacobs and Mr. Ballah to NTC, as well as to make a cash payment to them to cover their tax liabilities from the debt forgiveness. See "Item 5. Other Information - Settlement Agreement with NTC Directors" in the Company's Form 10-Q for the quarter ended September 30, 1996 as updated under "Item 1. Business - National Telephone and Communications Inc. - Management Incentive Agreement" in the Company's 1996 Form 10-K. -26- On January 28, 1997, the Company entered into an amended and restated management incentive agreement with NTC which entirely supersedes the agreement entered into in November 1996. The amended and restated management incentive agreement essentially contains the same terms and conditions as the agreement entered into in November 1996, except as follows: The Company and NTC agree that the Company, as the owner of 100% of the total issued and outstanding stock of NTC, owns ten million shares of NTC. The three NTC stock option plans previously agreed to have been revised. The Company and NTC have now agreed that there will be three stock option plans and one convertible debt plan. The exercise price of all stock options issued under the option plans will not be less than the fair market value of NTC common stock on the date of the grant, and the conversion price of the convertible debt issued under the convertible debt plan will not be less than the fair market value of NTC common stock on the date of the issuance of the convertible debenture. Shares issuable pursuant to the plans are expected to be registered with the Securities and Exchange Commission no later than at the time of NTC's planned public offering. Upon the creation of the plans and first grant of options and convertible debt units pursuant to the plans, Edward Jacobs will waive his rights to all remaining outstanding unexercised warrants and options issued to him by the Company pursuant to his employment agreement, dated December 28, 1994. See "Item 1. Business - National Telephone and Communications, Inc. - Management Incentive Agreement" in the Company's 1996 Form 10-K. The amended and restated management incentive agreement was amended on April 7, 1997 to reflect minor adjustments in the terms and conditions of the NTC stock option and convertible debt plans. Those adjustments are reflected in the discussion in the following paragraphs. The first stock option plan is the one for key independent sales representatives. A total of 2,884,615 shares are reserved for issuance under this plan. Options to purchase 961,538 shares of NTC common stock were granted to key independent sales representatives who are Corporate Team members, 480,769 of which will vest on June 30, 1998, subject to acceleration if NTC's public offering occurs prior to January 1, 1998. Options to purchase the other 480,769 shares will vest on June 30, 1999. In connection with this grant, NTC expects to recognize approximately $150,000 of compensation expense in the period March 1997 to June 1999, assuming all 961,538 options granted vest. The exercise price of these options is $3.50 per share and the exercise term is five years from the date of grant (i.e. they expire on March 20, 2002). The remaining 1,923,077 shares reserved for issuance pursuant to stock options granted under this plan may be granted to key independent sales representatives after each of June 30, 1997, December 31, 1997, June 30, 1998 and December 31, 1998 if NTC's gross revenues for the three month periods ending on each of such dates exceed NTC's gross revenues for the corresponding three month periods ending December 31, 1996, June 30, 1997, December 31, 1997 and June 30, 1998, by the percentage amounts indicated on the following table: Percentage Increase in NTC Gross Revenues Number of Options Available For Grant In Comparative Three Month Periods At End of Each Period(1) - ----------------------------------------- ------------------------------------- 30% 125,000 40% 250,000 50% 500,000(1) - ------------------------------ (1) Stock options in the amount indicated may be granted at the end of each of the four comparative three month periods. If the percentage increase for all four of the comparative periods is 50% or more, then the total stock options available for grant in the fourth period would be 423,077 instead of 500,000 because there are 1,923,077 (not 2,000,000) options available for grant under this portion of the key independent sales representatives' stock option plan. These stock options, once granted, will vest in four equal annual installments on each anniversary date after the stock option grant date. The exercise price for these stock options will equal the greater of $3.50 per share or the fair market value of NTC common stock on the date of grant. The NTC Board of Directors will determine when and to whom these stock options will be granted. -27- The second stock option plan is the one for NTC executives, employees and key consultants. A total of 3,705,001 shares are reserved for issuance under this plan. Options representing 1,446,026 of these reserved shares will be subject only to a time-in-service vesting requirement, but in no event will such options vest prior to January 1, 1998. Options representing 1,682,051 of the reserved shares will vest in four equal annual installments on each anniversary date of the option grant date, subject to the acceleration of vesting in the event that NTC achieves certain income targets in 1997, to be determined by the NTC Board of Directors. An amount equal to 480,770 of the 1,682,051 shares issuable pursuant to options granted under this plan are reserved for issuance to Edward Jacobs and Jerry Ballah, allocated 240,385 to Mr. Jacobs and 240,385 to Mr. Ballah. An amount equal to 576,924 of the 3,705,001 shares issuable pursuant to options granted under this plan are also reserved for issuance to Mr. Jacobs and Mr. Ballah, allocated 288,462 to Mr. Jacobs and 288,462 to Mr. Ballah. These stock options have been granted but will not vest until January 31, 2002, except that the vesting of these stock options will accelerate if NTC achieves certain revenue goals prior to January 1, 2000. On March 20, 1997, options to purchase 2,437,094 shares of NTC common stock were granted under the second option plan to a total of 263 employees and consultants of NTC, including the aboved described 480,770 and 567,924 stock options granted to Mr. Jacobs and Mr. Ballah. On April 11, 1997, options to purchase an additional 735,000 shares of NTC common stock were granted to a total of 18 key consultants of NTC. The exercise price of the 2,437,094 stock options is $3.50 per share and the exercise price of the 735,000 stock options is $3.75 per share. The exercise period is ten years from the date of grant, regardless of when they vest. In the future, and prior to NTC becoming a publicly traded company, the exercise price of any new options granted under this plan will be the higher of the latest Duff & Phelps appraisal of each share of NTC common stock or $3.50 per share. After NTC becomes a publicly traded company, the exercise price of any stock options granted under this plan will not be less than the fair market value of NTC's stock on the date of the grant or, in the case of stock options granted to affiliates of NTC, 110% of the fair market value of NTC's stock. The third stock option plan is the one for members of NTC's Board of Directors. A total of 300,000 shares are reserved for issuance under this plan. Each director of NTC will receive an option to purchase 25,000 shares of NTC common stock which will vest in four equal annual installments on each anniversary date of the option grant date. The fourth option plan is the Senior Executive and Consultant Convertible Debt Plan for Edward Jacobs and Jerry Ballah. A total of 2,664,231 shares are reserved for issuance under this plan. Mr. Jacobs and Mr. Ballah have collectively received convertible debt units which may be converted into 2,664,231 shares of NTC common stock, allocated 1,407,115 to Mr. Jacobs and 1,257,116 to Mr. Ballah. These convertible debt units were issued by NTC on April 11, 1997. In connection with the issuance of the convertible debt units, Mr. Jacobs and Mr. Ballah issued convertible debentures to NTC at the rate of $3.00 per conversion share (i.e. an aggregate of $7,992,693 in debentures payable to NTC), bearing fixed simple interest at the rate of 6.49% per annum and payable in full on the earlier of (a) the date five years from the date of grant (i.e. April 11, 2002), or (b) the conversion date. The convertible debentures are full recourse obligations of Mr. Jacobs and Mr. Ballah. Each convertible debt unit is convertible into one share of NTC common stock at a conversion price equal to the outstanding principal and interest balance of the convertible debentures plus $.01 per share. A portion of the convertible debt units granted under this plan may be assignable. The vesting of all stock options and convertible debt units is dependent upon the grantee being a director, officer, employee or key consultant of NTC at the time of vesting. All nonvested stock options expire automatically upon the termination or severance of a grantee from employment or service with NTC. Furthermore, grantees of the stock options generally have a period of 90 days (30 days in the case of consultants) after a severance from NTC in which to exercise vested stock options (this provision is not applicable to convertible debt units). The following table lists the stock options and convertible debt units issued to the directors and executive officers of NTC as of November 30, 1997. These stock options do not include any that have been granted to the independent sales representatives of NTC or other employees or consultants of NTC.
- ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Grantee Type Number Exercise or Date of Value at Assumed Annual Conversion Expiration Rates of Stock Price Price Appreciation For Term(10) 5% 10% --- --- Edward R. Jacobs(1) Stock Options 240,385 $3.50 3/20/2007(8) $ 333,338 $1,029,143 Stock Options 288,462 $3.50 3/20/2007(9) $ 400,004 $1,234,617 Convertible Debt Units 1,407,115 $3.01 4/11/2002 $1,170,167 $2,585,764 James R. Quandt(2) Stock Options 300,000 $3.50 3/20/2007(7) $ 416,000 $1,284,000 Stock Options 300,000 $3.50 3/20/2007(8) $ 416,000 $1,284,000 Michael Keebaugh(3) Stock Options 50,000 $3.50 3/20/2007(7) $ 69,334 $ 214,000 Stock Options 50,000 $3.50 3/20/2007(8) $ 69,334 $ 214,000 Victor C. Streufert(4) Stock Options 75,000 $3.50 3/20/2007(7) $ 104,001 $ 321,000 Stock Options 50,000 $3.50 3/20/2007(8) $ 69,334 $ 214,000 Deborah Chuckas(5) Stock Options 50,000 $3.50 3/20/2007(7) $ 69,334 $ 214,000 Stock Options 50,000 $3.50 3/20/2007(8) $ 69,334 $ 214,000 Louis Cheng(6) Stock Options 50,000 $3.50 3/20/2007(7) $ 69,334 $ 214,000 Stock Options 50,000 $3.50 3/20/2007(8) $ 69,334 $ 214,000 - ----------------------------------------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------------------------------------
(1) Mr. Jacobs is the Chief Executive Officer and Chairman of the Board of Directors of NTC. The conversion price of $3.01 per share for the convertible debt units does not include accrued interest on the outstanding debentures. The terms of Jerry Ballah's stock options and convertible debt units are the same as Mr. Jacobs'. Mr. Ballah resigned as an officer and director of NTC on March 21, 1997. (2) Mr. Quandt is the President and a director of NTC. (3) Mr. Keebaugh is the Vice-President of Operations of NTC. (4) Mr. Streufert is the Chief Financial Officer of NTC. (5) Ms. Chuckas is the Vice President of Marketing Support for NTC. (6) Mr. Cheng is the Vice President of Information Systems for NTC. (7) These stock options vest and are exercisable on the later of (i) 15 months after the employee's date of hire or 15 months after the employee's date of promotion to the employee's current position, whichever is later, or (ii) 180 days after the first sale by NTC of common stock shares in a bona fide underwriting pursuant to a registration statement under the Securities Act of 1933, as amended (an "Underwriting"). (8) These stock options vest and are exercisable in accordance with the following schedule, subject to acceleration as described after the vesting schedule: (a) 25% on the later of the first anniversary of each employee' date of grant or 180 days after an Underwriting, (b) 25% on the second anniversary of each employee's date of grant, (c) 25% on the third anniversary of each employee's date of grant, and (d) 25% on the fourth anniversary of each employee's date of grant. In the event that the total of NTC's net income plus income and franchise taxes paid or accrued during each fiscal quarter exceeds $10,000,000 in any four consecutive calendar quarters up to and including the fourth calendar quarter of 1997, the vesting of these outstanding stock options would accelerate so that all shares subject to such options would vest on the later to occur of (i) 45 days after the last day of the fourth consecutive calendar quarter on which the total of NTC's net income plus income and franchise taxes exceeded $10,000,000, or (ii) 180 days after an Underwriting. In the event that the total net income plus income and franchise taxes paid or accrued during each fiscal quarter of 1997 does not exceed $10,000,000 but total net income plus income and franchise taxes paid or accrued during 1998 is more than twice NTC's total net income plus income and franchise taxes paid or accrued during 1997, the vesting of these stock options would accelerate so that all shares subject to such options would vest on the later of (i) February 15, 1999, or (ii) 180 days after an Underwriting. (9) These stock options vest on January 31, 2002, subject to acceleration according to the following schedule: In the event that the sales of NTC exceed the amounts set forth below in any calendar quarter up to and including the fourth calendar quarter of 1999, the vesting of these stock options would accelerate so that the following number of shares subject to such options would vest: SALES IN CALENDAR QUARTER NUMBER OF SHARES VESTING ------------------------- ------------------------ $100,000,000 192,308 $125,000,000 384,616 $180,000,000 576,924 (10) Assumes a current value of $3.00 per share for each share of NTC common stock. The amended and restated NTC management incentive agreement provides that, until four additional independent directors are appointed to the NTC Board of Directors, if a vacancy is created on the NTC Board of Directors by reason of the death, resignation or removal, with or without cause, of Mr. Jacobs, then the Company has agreed to vote its shares for the individual nominated by the remaining NTC management director. In addition to the regular members of the NTC Board of Directors, a key independent sales representative may be nominated and elected to the NTC Board of Directors on a rotating basis, such that the same sales representative cannot serve consecutive terms. NTC has agreed to make total cash payments to the Company on or before December 31, 1997 equal to $2,200,000, of which a net total of $775,000 has already been paid as of June 27, 1997. The cash payments of up to $2,200,000 by NTC to Incomnet, Inc. will be treated as a return of capital to the -28- Company. NTC may make advances to Incomnet, Inc. in excess of its cash payment obligation of $2,200,000, which Incomnet, Inc. will be obligated to repay with interest upon demand. Any charge to earnings or taxable income associated with advances made by NTC to Incomnet, Inc. or costs incurred in the spin-off of NTC shares will be incurred by Incomnet, Inc. for financial reporting purposes, rather than by NTC. SETTLEMENT WITH RCI PARTIES As of December 9, 1996, the Company entered into a Settlement and Mutual Release Agreement with Robert Cohen, Alan Cohen, Jeff Rubin, Jeff Cohen, Broadway Partners, a partnership comprised of the children of Alan and Robert Cohen, and Lenore Katz (the "RCI Parties"). Robert Cohen is a director and shareholder of Rapid Cast, Inc. and Jeff Rubin is a director, shareholder and executive officer of Rapid Cast, Inc. Jeff Cohen is the son-in-law of Robert Cohen. See "SELLING SECURITY HOLDERS." Pursuant to the settlement agreement, the RCI Parties purchased 360,000 Warrants entitling them to purchase 360,000 shares of the Common Stock of the Company for an exercise price of $3.75 per share at any time until December 9, 1999. The RCI Parties paid a total of $36,000 in cash to the Company for the Warrants. Certain of the RCI Parties also purchased a total of 33,000 shares of the Common Stock of the Company for an aggregate purchase price of $100,000. The Company is registering those shares and the shares issuable upon the exercise of the Warrants pursuant to the registration statement encompassing this Prospectus in accordance with its agreement to do so in the Settlement and Mutual Release Agreement. See "SELLING SECURITY HOLDERS." The Company and the RCI Parties also mutually released each other from all claims, if any, which they may have had against each other, and the RCI Parties assigned all of the claims which they may have against Sam and Rita Schwartz, prior directors of the Company, to the Company. SETTLEMENT OF THE CLASS ACTION LAWSUIT Counsel for the plaintiffs in the class action lawsuit known as SAUNDRA GAYLES VS. INCOMNET, INC. AND SAM D. SCHWARTZ entered into a settlement agreement with the Company on October 7, 1997. The settlement, which is subject to court approval, consists of a payment of $500,000 in cash plus securities with a value of $8.15 million for a total settlement value of $8.65 million. The securities consist of 1,500,000 shares of the Company's Common Stock, plus a number of warrants to be determined if the value of the Common Stock does not equal at least $8.15 million after the settlement is approved by the court. See "Part II. Item 1. Legal Proceedings - Class Action and Related Lawsuits" in the Company's Form 10-Q for the quarter ended September 30, 1997. STATUS OF OPT-OUT LAWSUIT In May 1997 the court in the class action lawsuit ruled that approximately 20 former shareholders of the Company are permitted to "opt-out" of the class and file a separate lawsuit against the Company, Sam Schwartz and other defendants which they may name. On July 22, 1997, the Company was named in the lawsuit known as JAMES A BELTZ, ET AL. VS. SAMUEL D. SCHWARTZ and RITA SCHWARTZ, husband and wife; STEPHEN A. CASWELL; JOEL W. GREENBERG; INCOMNET, INC., a California corporation; DAVID BODNER and MURRAY HUBERFELD, in the United States District Court, District of Minnesota. The lawsuit was filed by 17 individuals who were allowed to opt out of the class action lawsuit to pursue a lawsuit on their own. The lawsuit alleges that Mr. Schwartz and the other defendants created a fraudulent scheme to inflate the price of the Company's stock in violation of federal securities law. The lawsuit alleges losses by the plaintiffs of approximately $1.5 million and seeks unspecified damages. See "Part II. Item 1. Legal Proceedings - Class Action and Related Lawsuits" in the Company's Form 10-Q for the quarter ended September 30, 1997. STATUS OF SILVA RUN LAWSUIT The status of the pending lawsuit described in the Company's Form 10-Q for its second quarter ending June 30, 1997, known as SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York and transferred in March 1997 to the same court in California which is hearing the pending class action lawsuit, has not materially changed since the filing of the Company's Form 10-Q for the third quarter ending September 30, 1997. STATUS OF SECTION 16(b) ACTION On February 21, 1997, the plaintiffs and Sam Schwartz in the lawsuit entitled RICHARD MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ, entered into a stipulated settlement pursuant to which Mr. Schwartz agreed to pay $4,250,000 to the Company as full payment of his short swing profit obligation to the Company. Under the stipulated settlement, the disgorgement of short-swing profits was paid $600,000 in cash and the balance by cancellation of shares of the Company's Common Stock owned by Mr. Schwartz, based on 90% of the average between the bid and the asked price of the Company's Common Stock on the NASDAQ market during the 30 calendar days immediately preceding the date that the court enters an order approving the settlement. On June 9, 1997, the court entered an order approving the settlement and awarded attorneys' fees and costs of $600,000 and $26,450, respectively, which has been paid by the Company. The number of shares tendered by Mr. Schwartz to the Company for cancellation pursuant to the settlement was 1,047,966, which were cancelled in July 1997. SETTLEMENT OF CIVIL CONSUMER PROTECTION LAWSUITS WITH THE STATE OF CALIFORNIA On October 28, 1997, the Company announced that its NTC subsidiary reached a settlement of a civil consumer protection lawsuit with the State of California. In the settlement, which NTC reached without admitting any wrongdoing, NTC agreed to a court order requiring it to implement policies to prevent the practice of slamming (i.e. switching customers' long distance telephone service without their permission or knowledge) by its independent sales representives or employees, and agreed to pay $1,250,600 in costs and penalities. NTC also agreed to institute sagegaurds to prevent slamming violations from occuring in the future. Among those safeguards, NTC agreed to wait 24 hours after the consumer agrees to switch his telephone company to NTC before calling the customer to confirm that the consumer really wants to switch to NTC. The lawsuit was brought through the California Attorney General's Office and the Orange County District Attorney Office. The California Public Utility Commission was the investigative agency. As part of a related administrative action, restitution to consumers was being sought by the Consumer Services Division of the California Public Utility Commission. On November 17, 1997, NTC reached a settlement with the California Public Utility Commission pursuant to which it agreed to pay to total of approximately $350,000 to the Commission for customer restitution, educational brochures and investigative costs. The terms of the settlement with the Commission require the resignation in 1998 of the directors of NTC who were directors prior to January 1, 1997. See "Part II. Item 1. Legal Procedings - Civil Consumer Protection Lawsuit With The State of California." -29- LAWSUIT AGAINST SAM D. SCHWARTZ On April 25, 1997, the Company filed a lawsuit against Sam D. Schwartz, its prior President and Chairman of the Board, alleging fraud, breach of fiduciary duty, negligence, and breach of contract, and seeking declaratory relief and the imposition of a constructive trust. The lawsuit was filed in the Superior Court of California in the County of Los Angeles. In the lawsuit, the Company alleges that Mr. Schwartz failed to disclose to the Company or its Board of Directors that he would obtain a direct financial benefit in connection with certain transactions considered and/or entered into by the Company during the period from 1993 to 1995. The Company further alleges that Mr. Schwartz fraudulently induced the Company to enter into a Severance Agreement between him and the Company on November 27, 1995, and that he breached his fiduciary duty to the Company by self dealing, acting in bad faith and concealing material facts. The Company seeks payment from Mr. Schwartz of the actual damages incurred by it as a result of Mr. Schwartz's conduct, as well as interest, punitive damages, attorney's fees and costs, and reimbursement of all payments previously made to Mr. Schwartz pursuant to the Severance Agreement. Furthermore, the Company seeks a declaratory order that Mr. Schwartz committed acts or omissions involving known misconduct, the absence of good faith, an improper personal benefit, a reckless disregard of his duties to the Company and its shareholders, an unexcused pattern of inattention, and a violation of Sections 310 and 316 of the California Corporations Code. On June 24, 1997, Mr. Schwartz answered the Company's lawsuit against him denying the allegations and counterclaiming for (i) enforcement of any payments due under his Severance Agreement with the Company, (ii) indemnification against third party claims, and (iii) payment of the same settlement to him as was paid to the prior noteholders who purchased convertible notes from the Company on February 8, 1995 (Mr. Schwartz also purchased convertible notes from the Company on February 8, 1995), even though the Company's settlement with those prior noteholders was based on the misconduct of Mr. Schwartz. See "THE COMPANY - Settlement with Prior Noteholders." The Company intends to vigorously assert its claims against Mr. Schwartz, including possible contribution claims with respect to the Company's proposed settlement payments to the plaintiffs in the class action lawsuit, and to vigorously defend against Mr. Schwartz's counterclaims. The lawsuit against Mr. Schwartz has entered the discovery phase and there is no assurance regarding its outcome. There is no assurance that the case will not have a material adverse impact on the financial condition, operating results and business performance of the Company or its subsidiaries. See "Item 1. Legal Proceedings - INCOMNET, INC. VS. SAM D. SCHWARTZ" in the Company's Form 10-Q for the quarter ended March 31, 1997, and "Item 3. Legal Proceedings - Settlement with Prior Noteholders" in the Company's 1996 Form 10-K. SETTLEMENT OF THE ATLANTA LAWSUITS In February 1997, the Company completed a settlement and release agreement with the plaintiffs in the pending lawsuits entitled HERBERT M. SCHWARTZ ET AL. VS. INCOMNET, INC., SAM D. SCHWARTZ AND KALIBER MANAGEMENT CORP. and BRENT ABRAHM ET AL. VS. INCOMNET, INC., SAM D. SCHWARTZ AND KALIBER MANAGEMENT CORP. pursuant to which the lawsuit against the Company is being dismissed and an order is being entered barring indemnification or contribution between the Company and Sam D. Schwartz. In consideration for the payment of $400,000 in cash and the issuance of a note in the principal amount of $400,000 to the plaintiffs, the plaintiffs have released the Company from all claims and dismissed their lawsuits against the Company with prejudice. The $400,000 note was issued as of January 1, 1997 and bears interest at the rate of 12% per annum from January 1, 1997 to January 22, 1997, and 8% per annum thereafter until December 31, 1997, when the note is due and payable in full. The note is secured by a certificate of deposit in the amount of $415,000 purchased by the Company, which the Company has the right to replace with a number of registered shares of its Common Stock equivalent in value to the certificate of deposit as collateral for the note. The Company may use a portion of the shelf shares covered by this Prospectus to pledge as collateral for the note in place of the $415,000 certificate of deposit. The Company's settlement did not include Sam D. Schwartz. SETTLEMENT OF THE STEVENS LAWSUIT In January 1997, the Company entered into a Settlement Agreement and Mutual Release of all claims in the pending lawsuit entitled CHARLES STEVENS VS. SAM D. SCHWARTZ AND INCOMNET, INC. Pursuant to the settlement, the Company paid $7,500 in cash to the plaintiff and issued 12,500 Warrants to purchase 12,500 shares of the Company's Common Stock at an exercise price of $2.94 per share, exercisable at any time until December 17, 2001. The Company agreed to register the shares underlying the 12,500 Warrants issued to Mr. Stevens and his legal counsel. In consideration for the issuance of Warrants and payment of cash, the plaintiff released the Company from all claims and dismissed the lawsuit against the Company with prejudice. The settlement did not include Sam D. Schwartz. SETTLEMENT WITH PRIOR NOTEHOLDERS Commencing in January 1996 the Company entered into a series of settlement agreements with certain prior holders of 8% convertible promissory notes issued by the Company on February 8, 1995 to finance the acquisition of 51% of RCI. See "Item 1. Business - Acquisition of RCI" in the Company's 1995 Form 10-K. Settlement agreements have been executed by all seven of the prior noteholders who held $825,000 of convertible notes. The registration statement covering the prior noteholders' outstanding shares and newly issued settlement shares issued pursuant to the settlement agreements was declared effective by the Securities and Exchange Commission on October 31, 1996. See also "Item 3. Legal Proceedings - Claims by Prior Noteholders" in the Company's 1996 Form 10-K. SETTLEMENT WITH PRICE INTERNATIONAL In August 1996, the Company entered into a settlement agreement with Price International pursuant to which the Company agreed to lower the exercise price of Price International's 75,000 warrants from $11.25 per share to $4.50 per share, and to extend the expiration date of the warrants from -30- November 15, 1997 until December 31, 1998. The Company also agreed to register the 75,000 shares issuable upon the exercise of the warrants. Those shares were registered by the Company in the registration statement which was declared effective by the Securities and Exchange Commission on October 31, 1996. In consideration for the modification to the terms and conditions of the warrants, Price International agreed that (a) it would be required to exercise at least 25,000 of the warrants once the trading price of the Company's stock averages $5.30 per share during any 30 day period, and (b) it releases and forever discharges the Company from all claims it may have had against the Company for events occurring prior to the date of the settlement agreement. Price International has not yet exercised any of the warrants issued to it in its settlement agreement with the Company. ISSUANCE OF CONVERTIBLE PREFERRED STOCK Series A Preferred. From September 20, 1996 to October 25, 1996, the Company issued 2,440 shares of Series A 2% Convertible Preferred Stock to 12 accredited investors in a private placement pursuant to Regulation D of the Securities Act of 1933, as amended. The shares of Series A 2% Convertible Preferred Stock were purchased by four affiliated individuals and eight unaffiliated investors. The Company raised $2,440,000 in capital from the issuance of the Preferred Stock, a portion of which it utilized to repay advances made to it by Melvyn Reznick, the Company's Chairman and Chief Executive Officer, who in turn owed approximately $723,000 to a bank on a loan with a maturity date of September 16, 1996. Mr. Reznick had borrowed these funds from the bank in order to make a substantial portion of his loan to the Company, which enabled the Company to make its pro rata share of loans to RCI. See "Item 5. Other Information - Loan to Company By Melvyn Reznick" in the Company's Form 10-Q for the fiscal quarter ending September 30, 1996. The balance of the proceeds is being utilized for general working capital and to pay the costs of settling pending litigation. The Company paid a referral fee to Newport Capital Partners, an unaffiliated financial consultant, equal to 5% of the capital raised through its referrals, which was $1,700,000. The Company has therefore paid $85,000 of referral fees to Newport Capital Partners. The basic terms and conditions of the Series A 2% Convertible Preferred Stock are described in "Item 1. Business - Issuance of Convertible Preferred Stock" in the Company's 1996 Form 10-K. On November 7, 1997, 1,700 shares of the Series A Preferred was purchased from four institutional investors, who were original purchasers of the Series A Preferred, for $1.7 million by 12 individual accredited investors. These individuals have agreed to waive all registration rights and liquidated damage rights associated with the Series A Preferred. They have agreed that they will convert their Series A Preferred into shares subject to Rule 144 of the Securities Act of 1933, as amended, instead of shares that will be registered by the Company. The Company has paid total liquidated damages of $540,000 in cash to the four original purchasers of the Series A Preferred conveyed to the new buyers. On November 3, 1997, three other individuals converted $225,000 of the Series A Preferred (i.e. the original investment amount) into the Company's Common Stock, subject to Rule 144. These three individuals received liquidated damages of $67,500 paid in additional shares of Common Stock at a price of $3.00 per share. As of November 7, 1997, 125 shares of original Series A Preferred with registration rights remain outstanding. These shares are held by Dr. Robert Cohen and Lenore Katz. These individuals are owed liquidated damages of approximately $45,000 as of November 30, 1997. See "Item 5. Other Information - Conveyence of Series A 2% Convertible Preferred Stock and Issuance of Series B 6% Convertible Preferred Stock" in the Company's Form 10-Q for the quarter ended September 30, 1997. Series B Preferred. In July 1997, the Company's Board of Directors approved the issuance of up to 2,990 shares of Series B 6% Convertible Preferred Stock (the "Series B Preferred"), at a price of $1,000 per share, with each share convertible into shares of the Company's Common Stock at a conversion ratio to be determined. At that time, the Company raised $1.8 million (less a cash referral fee of $92,000) by selling 1,800 shares of the authorized Series B Preferred and issuing an additional 34 shares of Series B Preferred as referral compensation. The Company also issued 50,000 Warrants and options to purchase up to 125 additional shares of Series B Preferred to the individual who arranged for the placement of the Series B Preferred in July 1997. See "SELLING SECURITY HOLDERS" and "Item 5. Other Information - Issuance of 6% Convertible Preferred Stock" in the Company's Form 10-Q for the second quarter ended June 30, 1997. On November 4, 1997, the Company issued 600 additional shares of Series B Preferred, raising an additional $600,000, less a cash referral fee of $60,000 to the individual who arranged the sale (the same individual arranged the sale of the 1,800 shares of Series B Preferred in July 1997). In connection with this new issuance of the Series B Preferred, the Company also issued Warrants to the referring individual to purchase 55,000 shares of the Company's Common Stock at an exercise price of $3.00 per share for a period of two years, an option to the individual to acquire an additional 125 shares of Series B Preferred convertible at 88% of the average bid price of the Company's Common Stock quoted on the five trading days immediately preceding the date of issuance of the additional Series B Preferred, and the right for one year for the individual to purchase an additional $200,000 in Series B Preferred. The cash fee, Warrants and options paid and issued, respectively, to the individual were contingent upon the referring individual placing $1.7 million of Series A Preferred being sold by four original institutional purchasers who owned the Series A Preferred, to 12 new individuals who would waive all associated registration rights. On November 7, 1997, this contingency was met. See "THE COMPANY - Issuance of Convertible Preferred Stock - Series A Preferred." The basic terms and conditions of the Series B Preferred are as follows: VOTING. The Series B 6% Convertible Preferred Stock does not have voting rights. DIVIDEND. The Series B 6% Convertible Preferred Stock has a cumulative noncompounded annual dividend of 6% payable in cash or stock at the Company's option upon conversion of the Preferred Stock into Common Stock, and prior to the payment of any dividends on the Common Stock. No dividends may be declared or paid on the Series B Preferred until all cumulative unpaid dividends have been declared and paid on the outstanding Series A Preferred. LIQUIDATION PREFERENCE. The Series B 6% Convertible Preferred Stock has a liquidation preference of $1,000 per share plus all cumulative unpaid dividends, whether or not declared by the Company's Board of Directors. Upon any liquidation or change of control of the Company (i.e. transfer of more than 50% of its voting stock), the Preferred Stockholders are entitled to the second priority in payment from the Company's assets, before any payments are made on the Company's Common Stock, until the liquidation preference is paid in full. The Series B Preferred is junior in preference to the Series A Preferred. No liquidation preference may be paid to the holders of the Series B Preferred until the full liquidation preference has been paid to the holders of the outstanding Series A Preferred. CONVERSION. The Preferred Stockholders may convert each share of Series B 6% Convertible Preferred Stock into the number of shares of the Company's Common Stock calculated as follows, at any time upon the earlier of (i) 120 days after the issuance of the Preferred Stock, or (ii) when the shares of Common Stock underlying the Preferred Stock are registered with the Securities and Exchange Commission. The conversion price (the "Conversion Price") for each share of Series B 6% Convertible Preferred Stock is equal to the lesser of (a) 80% of the average bid price for the Company's Common Stock on the public trading market for the five trading days immediately preceding the conversion date, as specified by the Preferred Stockholder, or (b) the bid price of the Company's Common Stock on the funding date (i.e. the issuance date of the Series B Preferred). (The bid price of the Company's Common Stock was $4.29 per share when the 1,800 shares of Series B Preferred was issued on July 29, 1997 and was $3.00 per share when the 600 shares of Series B Preferred was issued on November 4, 1997.) To calculate the number of shares of Common Stock issuable upon the conversion of the Preferred Stock, the Conversion Price is multiplied -31- by a ratio, the numerator of which is the sum of 1,000 and the accrued but unpaid dividends, and the denominator of which is the Conversion Price. If for any reason a registration statement covering the shares of Common Stock issuable upon the conversion of the Preferred Stock is not in effect with the Securities and Exchange Commission at the time of a valid conversion by a Preferred Stockholder, then the Conversion Price is reduced by 3% per month for each of the first three months that the effectiveness of the registration is late. REDEMPTION. The Company has the right to redeem the Preferred Stock for its issuance price plus cumulative unpaid dividends if the Company's stock trades at a price which averages $2.00 per share or less for any period of five consecutive trading days after the Preferred Stock is issued. REGISTRATION RIGHTS. Pursuant to a Registration Rights Agreement entered into by the Company with each purchaser of the Series B 6% Convertible Preferred Stock, the Company is obligated to file a registration statement with the Securities and Exchange Commission covering the shares of Common Stock underlying the Preferred Stock within 30 days after the Preferred Stock is issued, and to have the registration statement declared effective within 120 days after it is filed. ANTIDILUTION PROVISION. The Certificate of Determination for the Series B 6% Convertible Preferred Stock contains comprehensive provisions for adjustments to the Conversion Price and the conversion ratio of the Preferred Stock in the event of stock dividends, asset distributions, reorganizations, recapitalizations, mergers, stock splits or similar transactions by the Company, in order to protect the Preferred Stock from dilution as a result of such transactions. RESTRICTIVE COVENANTS. During the first 90 days after the Series B 6% Convertible Preferred Stock is issued, the Company is not permitted to issue any other securities, except in limited circumstances, including pursuant to the exercise of outstanding options or warrants or pursuant to existing settlement agreements, without first notifying the Preferred Stockholders and giving them a right of first refusal to purchase the securities themselves. While the Series B 6% Convertible Preferred Stock is outstanding or until it is converted into Common Stock, the Company is not permitted to engage in certain transactions, such as the redemption or purchase of its own Common Stock (except in connection with the collection of Section 16(b) short-swing profits), without the prior consent of the Preferred Stockholders. Furthermore, the Company is not permitted to pay cash dividends on its Common Stock unless all cumulative unpaid dividends on the Series B 6% Convertible Preferred Stock is paid. The Company cannot take any action which would modify the rights of the Preferred Stockholders under the Certificate of Determination without the prior consent of the Preferred Stockholder being affected by the modification. RECENT CAPITALIZATION OF RCI On January 16, 1997, Rapid Cast, Inc., a minority owned subsidiary of the Company, issued 8,000,000 shares of Series A and Series B 7% Convertible Preferred Stock to institutional investors in a private placement pursuant to Regulation D of the Securities Act of 1933, as amended. The investors contributed $12,000,000 in capital in consideration for the issuance of 7,275,000 shares of voting Series A 7% Convertible Preferred Stock and 725,000 shares of nonvoting Series B 7% Convertible Preferred Stock. The investors also have the option to purchase up to an additional 6,666,666 shares of voting or nonvoting 7% Convertible Preferred Stock from RCI for a purchase price $1.50 per share, exercisable with respect to 3,333,333 of the shares upon the sooner to occur of (i) the appointment of a permanent -32- Chief Executive Officer of RCI, or (ii) July 16, 1997, or the option relating to those shares will expire unexercised. The option with respect to the remaining 3,333,333 shares must be exercised on or before July 16, 1998, or the option with respect to those shares will expire unexercised. (In July 1997, the RCI shareholders agreed, in lieu of having the institutional investors exercise their option to acquire additional shares of Series A and Series B 7% Convertible Preferred Stock, to raise $8,000,000 of additional capital by offering 8,000,000 new shares of Common Stock to all of the RCI shareholders on a pro rata basis at a price of $1.00 per share. In September 1997, the $8,000,000 private placement to existing RCI shareholders was fully subscribed. The Company elected not to participate in the private placement.) Frank Pipp, the new Chairman of the Board of Directors of RCI, also has an option to purchase up to 1,333,333 shares of Series A 7% Preferred Stock at any time until July 16, 1998 for a price of $1.50 per share. The proceeds of the first issuance of the Series A and Series B 7% Convertible Preferred Stock were utilized by RCI (i) to repay short-term bridge loans made to RCI by its shareholders, including Incomnet, Inc., in the approximate total amount of $3,705,430; (ii) to repurchase 1,200,000 shares of RCI common stock from Dr. Larry Joel for a redemption price of $1.28 per share; (iii) to make the final settlement payment of $325,000 on the patent infringement lawsuit known as RONALD BLUM, O.D. VS. RAPID CAST, INC., ET AL., which has been dismissed; (iv) to repay the bank line of credit with Bank Leumi in the approximate outstanding amount of $500,000 plus interest; (v) to pay placement costs of approximately $500,000; (vi) to pay all trade payables in the approximate outstanding amount of $2,000,000, and (vii) the balance for working capital. The outstanding RCI founder loans in the approximate outstanding balance of $1,680,000 on the date of the closing, the other RCI shareholder bridge loans which were not repaid from the proceeds of the private placement of the Series A and Series B 7% Convertible Preferred Stock, and the outstanding 8% convertible notes in the approximate outstanding balance of $648,000 (which were convertible into RCI common stock at a price of $.80 per share), were all converted into newly issued RCI common stock and Series C 7% Convertible Preferred Stock as follows: No. of Shares of Series C No. of Shares Name of RCI Shareholder Preferred Stock(1) of Common Stock (2) - ----------------------- ------------------ ------------------- Robert Cohen 121,543 260,708(3) Alan Cohen 120,194 260,708(5) Jeff Rubin 122,260 45,752 Sean Zimberg 111,781 135,252 Dr. Larry Joel(6) 0 255,099 Huberfeld Bodner Partnership 0 543,390 Martin Price 27,485 53,856 Incomnet, Inc. 0 428,570 - ------------------------------ (1) Issued at a price of $1.50 per share. (2) Issued at a price of $.80 per share with respect to the conversion of the outstanding principal balance of the 8% convertible promissory notes, and $1.28 with respect to the conversion of the RCI founder loans and the accrued but unpaid interest on the 8% convertible promissory notes. (3) Includes 36,602 shares issued in the name of Robert Cohen's children. (4) Includes 120,194 shares issued in the name of Alan Cohen's children. (5) Includes 36,602 shares issued in the name of Alan Cohen's children. (6) In September 1996 Dr. Joel surrendered 142,222 shares of RCI common stock to RCI as the settlement payment for $448,000 of liabilities owed by Dr. Joel to RCI. -33- From the proceeds of the capitalization of RCI on January 16, 1997, Incomnet, Inc. was repaid $2,647,348 of principal and accrued interest on its short term bridge loans which it made to RCI during the period from April 1996 through January 1997. RCI also issued 428,570 shares of its common stock to Incomnet, Inc. in exchange for the conversion by Incomnet, Inc. of $326,400 of 8% convertible promissory notes purchased by it from RCI in January 1996. Incomnet, Inc. now owns 10,628,570 shares of RCI common stock. Melvyn Reznick was repaid $80,000 plus interest at the rate of 10% per annum for the loan he made to RCI in late December 1996, and Stephen Caswell was repaid $12,500 plus interest at the rate of 10% per annum for the loan he made to RCI in early January 1997. Pursuant to its Amended and Restated Certificate of Incorporation filed on January 16, 1997, RCI is authorized to issue a total of 60,000,000 shares of common stock, 22,000,000 shares of which are nonvoting common stock, and 42,500,000 shares of preferred stock, all having a par value of $.001 per share. As of March 17, 1997, RCI has a total of 22,091,113 shares of common stock issued and outstanding, 10,628,570 of which are owned by Incomnet, Inc., 7,275,000 shares of voting Series A 7% Convertible Preferred Stock, 725,000 shares of nonvoting Series B 7% Convertible Preferred Stock, and 503,264 voting Series C 7% Convertible Preferred Stock. Incomnet, Inc. does not own any outstanding RCI preferred stock. Each share of issued and outstanding Series A, Series B and Series C Preferred Stock is convertible into one share of RCI common stock (subject to adjustment) at any time at the option of the preferred stockholder, and automatically upon the occurrence of a "qualified public offering" by RCI, as that term is defined in the Certificate of Determination of Rights, References and Privileges for all outstanding series of RCI preferred stock. The terms of conversion and other rights of the outstanding RCI preferred stock are all subject to customary adjustments and antidilution provisions in the event of stock splits, certain stock dividends, stock combinations, reorganizations, recapitalizations and similar events. A "qualified public offering" by RCI occurs when RCI makes a public offering of its securities having gross proceeds of at least $20,000,000 and an offering price of at least $1.90 per share if it occurs on or prior to December 31, 1997, $2.14 per share if it occurs on or prior to June 30, 1998, $2.40 per share if it occurs on or prior to December 31, 1998, $2.69 per share if it occurs on or prior to June 30, 1999, $3.02 per share if it occurs on or prior to December 31, 1999, $3.40 per share it occurs on or prior to June 30, 2000, $3.81 per share if it occurs on or prior to December 31, 2000, $4.29 per share if it occurs on or prior to June 30, 2001, $4.82 per share if it occurs on or prior to December 31, 2001, $5.41 per share it if occurs on or prior to June 30, 2002, and $6.08 per share if it occurs after June 30, 2002, in each case as adjusted for stock splits, certain stock dividends, stock combinations and similar events. The Series A, Series B and Series C 7% Convertible Preferred Stock have a liquidation preference of $1.50 per share. All outstanding RCI preferred stock have a cumulative noncompounded dividend of 7% per annum which must be declared and paid in full before any dividends may be declared or paid on the RCI common stock. All dividends on outstanding RCI preferred stock, regardless of whether Series A, Series B or Series C, must be declared and paid ratably on all such outstanding preferred stock. Each holder of outstanding RCI preferred stock has the right to be paid the 7% dividend, when declared, either in cash, in shares of Series A, Series B or Series C Preferred Stock (at a price of $1.50 per preferred share, subject to adjustment), or in a combination of cash and preferred stock. The cumulative unpaid dividend on the outstanding RCI preferred stock must be paid in full in shares of RCI common stock (at a price of $1.50 per common share, subject to adjustment) or in cash, at the option of the preferred stockholder, upon the conversion of the preferred stock into common stock. The preferred stockholder may require RCI to redeem the outstanding preferred stock beginning after January 1, 2003 if the preferred stock has not otherwise been converted. The redemption price would equal the original issue price plus cumulative unpaid dividends. The Certificate of Determination for the outstanding RCI preferred stock contains numerous restrictive covenants applicable to RCI with respect to the incurrence of debt, sale of assets, issuance of shares, mergers, reorganizations, recapitalizations, affiliate transactions, and similar transactions by RCI. -34- In connection with the issuance of the preferred stock by RCI, RCI and its shareholders entered into a Registration Rights Agreement, a Shareholders Agreement and related agreements governing the outstanding RCI shares and the management of RCI. Pursuant to the Registration Rights Agreements, the Series A and Series B Preferred Stockholders have priority demand and piggyback registration rights with respect to the shares of RCI common stock issuable upon the conversion of the preferred stock, and issuable upon the exercise of warrants held by them. The Series A and Series B Preferred Stockholders are the only RCI shareholders with demand registration rights, of which they have three for less than $5,000,000 of proposed sales and an unlimited number of proposed sales in excess of $5,000,000. With respect to piggyback registration rights, the holders of Series A and Series B Preferred Stock are entitled to 80% of the available registration of shares for selling security holders on a pro rata basis, and the other existing RCI shareholders are entitled to 20% of the available share registration for selling security holders on a pro rata basis, subject to other conditions and limitations. Pursuant to the RCI Shareholders Agreement, the RCI shareholders and RCI are granted certain first rights of refusal to purchase RCI stock proposed for sale by other RCI shareholders. The RCI Shareholders Agreement imposes certain other restrictions on the transferability of RCI shares, except for Rule 144 sales, a sale of shares in a public offering pursuant to the Registration Rights Agreement, and a transfer to RCI. The RCI shareholders also agree to vote their shares so that (i) the RCI Board of Directors will consist of nine members, (ii) subject to certain conditions, the RCI Board of Directors will consist of two members designated by J.P.Morgan Investment Corporation and its related investors, two members designated by Clipper Capital Associates, L.P. and its related investors, one member designated by Incomnet, Inc., provided, that if Incomnet, Inc. undergoes a "change of control" (defined as the cessation of Melvyn Reznick's service on the RCI Board of Directors for any reason or certain other changes in the Incomnet, Inc. Board of Directors or the stock ownership of Incomnet, Inc.), then the Incomnet designee must be approved by a majority of the other members of the RCI Board of Directors, one member designated by Jeff Rubin, one member designated by Robert Cohen, one member (initially Frank Pipp) designated by a majority of the RCI Board of Directors who qualify as outside directors and approved by a majority of the RCI shareholders, and one member who is the interim or permanent Chief Executive Officer of RCI. RCI has established Executive, Audit and Compensation Committees. The following persons are the current members of the RCI Board of Directors and its Committees: I. BOARD OF DIRECTORS(1) Molly F., Ashby (J.P. Morgan Designee) Robert Cohen Patrick H. Ganett (J.P. Morgan Designee) Kevin A. Macdonald (Clipper Designee) Frank Pipp (Chairman and Interim Chief Executive Officer)(2) Melvyn Reznick (Incomnet Designee) Jeff Rubin II. EXECUTIVE COMMITTEE Molly F., Ashby (Chairman) Kevin A. Macdonald Frank Pipp -35- III. COMPENSATION COMMITTEE Patrick H. Ganett (Chairman) Kevin A. Macdonald Frank Pipp Melvyn Reznick IV. AUDIT COMMITTEE Melvyn Reznick (Chairman) Patrick H. Ganett Kevin A. Macdonald - ------------------------------ (1) The Board of Directors currently has one vacancy which is reserved for the permanent Chief Executive Officer when he is hired. (2) John L. Vidovich is currently a consultant and acting co-Chief Executive Officer of RCI with Frank Pipp. Mr. Vidovich may become the permanent Chief Executive Officer of RCI. The permanent Chief Executive Officer of RCI is expected to join the RCI Board of Directors and may join one or more of its Committees. Upon the completion of a "qualified public offering" by RCI, as that term is defined in the Certificate of Determination for the outstanding RCI preferred stock and as described above, the voting and transferability restrictions in the RCI Shareholders Agreement generally terminate, except that the RCI shareholders agree to vote for one director designee each for J.P. Morgan and Clipper after the "qualified public offering" as long as their investors hold a specified minimum number of shares of RCI. The RCI Shareholders Agreement grants the RCI shareholders pro rata preemptive rights to purchase new securities proposed to be issued by RCI, except in circumstances such as when RCI makes a public offering, issues stock to acquire another company in a purchase, merger or other reorganization, issues stock pursuant to outstanding conversion rights, options or warrants, issues up to 120,000 shares to John L. Vidovich or 450,000 shares to Frank Pipp, implements a stock split or stock dividend, or issues stock after a "qualified public offering" by RCI. In connection with the short term bridge loans made to RCI from April 1996 to January 1997 and the issuance of the preferred stock by RCI on January 16, 1997, RCI issued options and warrants to purchase its common stock, and amended and restated its 1994 Stock Option Plan. The RCI 1994 Stock Option Plan was amended to authorize and reserve up to 4,514,732 shares of its common stock for issuance upon the exercise of stock options granted and which may be granted by the RCI Board of Directors in the future. Under the RCI 1994 Stock Option Plan, a total of 3,260,000 stock options have been granted to various officers, directors, employees and key consultants of RCI. The exercise price of 908,000 of the stock options is $2.25 per share and the exercise price of 1,842,000 of the stock options is $2.00 per share. These stock options have vested (subject to continued employment) and are exercisable at any time from the date of grant until dates ranging from November 1, 2005 until July 31, 2006. Melvyn Reznick was granted 100,000 of these options by RCI, having an exercise price of $2.25 per share and exercisable at any time until July 31, 2006. Frank Pipp was granted 450,000 of these stock options to purchase a total of 450,000 shares of RCI common stock at any time until January 20, 2007, 225,000 to which may be purchased at an exercise price of $1.28 per share and 225,000 of which may be purchased at an exercise price of $4.00 per share. RCI also granted to John L. Vidovich 60,000 of these stock options to purchase 60,000 common stock at any time until January 20, 2007 at an exercise price of $1.28 per share. -36- RCI issued to the purchasers of the Series A and Series B Preferred Stock warrants to purchase 1,400,000 shares of RCI common stock at an exercise price of $1.74 per share, exercisable at any time until January 16, 2004. The holders of these warrants have certain registration rights under the Registration Rights Agreement described above, and customary adjustment and antidilution protection. In connection with short term bridge loans made to RCI by its shareholders and others during the period from April 1996 until early January 1997, RCI issued a total of 4,441,933 warrants to purchase 4,441,933 shares of RCI common stock at any time until dates ranging from September 30, 2003 to December 31, 2003. The exercise price of 1,853,683 of the warrants is $2.25 per share, the exercise price of 302,500 of the warrants is $1.28 per share, and the exercise price of 2,285,750 of the warrants is $.75 per share. Incomnet, Inc. holds 841,416 of these warrants to purchase 841,416 shares of RCI common stock at an exercise price of $2.25 per share at any time until September 30, 2003, 480,000 of these warrants to purchase 480,000 shares of RCI common stock at an exercise price of $.75 per share at any time until December 30, 2003, 150,000 of these warrants to purchase 150,000 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003, and 1,090,000 of these warrants to purchase 1,090,000 shares of RCI common stock at an exercise price of $.75 per share at any time until November 30, 2003. In consideration for personal loans and loan guarantees, Melvyn Reznick holds 175,000 of these warrants to purchase 175,000 shares of RCI common stock from the Company at an exercise price of $2.25 per share at any time until September 30, 2003, and 160,000 of these warrants to purchase 160,000 shares of RCI common stock from RCI at an exercise price of $.75 per share at any time until December 31, 2003. In consideration for personal loans to RCI, Albert Milstein was issued 25,000 warrants to purchase 25,000 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003. In consideration for personal loans to RCI, Steve Caswell was issued 12,500 of these warrants to purchase 12,500 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003. RCI also has a total of 1,000,000 additional warrants outstanding which entitle their holders to purchase a total of 1,000,000 shares of RCI common stock at an exercise price equal to 50% of the average of the last reported sales price of RCI shares during the first 30 business days after the shares of RCI first become publicly traded, provided that they become publicly traded on or before December 31, 1998. If RCI becomes publicly traded on or before December 31, 1998, these warrants are then exercisable for a period of 180 days after the public trading commencement date. These 1,000,000 RCI warrants were issued on February 8, 1995 in connection with the issuance of 8% convertible promissory notes by Incomnet, Inc. on that date to finance its acquisition of a controlling interest in RCI. See "Item 1. Business - Acquisition of Rapid Cast, Inc." in the Company's Form 10-K for the fiscal year ending December 31, 1995. SETTLEMENT OF RCI PATENT INFRINGEMENT CASE On January 16, 1997, RCI completed the settlement of the lawsuit entitled RONALD BLUM, O.D. VS. RAPID CAST, INC., ET AL. and the lawsuit has been dismissed. In consideration for a total cash payment of $525,000 in cash to Dr. Blum and the release by RCI of all claims which it may have had against Dr. Blum, RCI received a release of all claims by Dr. Blum. See "Item 1. Legal Proceedings - Patent Infringement Lawsuit" in the Company's Form 10-Q for the fiscal quarter ending September 30, 1996. RCI - LIMITATION OF LIABILITY AND INDEMNIFICATION MATTERS As permitted by the Delaware General Corporation Law (the "Delaware Law"), RCI's Certificate of Incorporation includes a provision that eliminates, to the maximum extent permitted by the Delaware Law, any director's personal liability to RCI or its stockholders for monetary damages in respect of any breach by such director of his fiduciary duty. The Delaware Law does not permit a director's personal liability to be eliminated (i) for any breach of a director's duty of loyalty to RCI or -37- its stockholders, (ii) for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law, (iii) for unlawful payments of dividends or unlawful stock repurchases or redemptions, as provided in Section 174 of the Delaware Law, or (iv) for any transaction from which the director derived an improper personal benefit. In addition, as permitted by Section 145 of the Delaware Law, the By-Laws of RCI provide that RCI shall indemnify its directors and executive officers to the fullest extent permitted by the Delaware Law, including those circumstances in which indemnification would otherwise be discretionary, subject to certain exceptions. The By-Laws also provide that RCI will advance expenses to directors and executive officers incurred in connection with an action or proceeding as to which they may be entitled to indemnification, subject to certain exceptions. RCI currently carries director and officer liability insurance. RCI has entered or will enter into indemnity agreements with each of its directors and executive officers that provide the maximum indemnity allowed to directors and executive officers by the Delaware Law and RCI's By-Laws, subject to certain exceptions, as well as certain additional procedural protection. In addition, the indemnity agreements provide generally that RCI will advance expenses incurred by directors and executive officers in any action or proceeding as to which they may be entitled to indemnification, subject to certain exceptions. RCI currently carries director and officer liability insurance. RCI - ANTI-TAKEOVER PROVISIONS OF DELAWARE LAW RCI is a Delaware corporation and thus subject to Section 203 of the Delaware General Corporation Law ("Section 203"), which is generally viewed as an anti-takeover statute. In general, Section 203 prohibits a Delaware corporation from engaging in any "business combination" (as defined) with any "interested stockholder" (as defined) for a period of three years following the date that such stockholder became an interested stockholder, unless (i) prior to such date, the board of directors of the corporation approved either the business combination or the transaction which resulted in the stockholder becoming an interested stockholder; (ii) upon consummation of the transaction which resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding for purposes of determining the number of shares outstanding those shares owned (a) by persons who are directors and also officers and (b) by employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or (iii) on or subsequent to such date, the business combination is approved by the board of directors and authorized at an annual or special meeting stockholders, and not by written consent, by the affirmative vote of at least 66-2/3% of the outstanding voting stock which is not owned by the interested stockholder. In general, Section 203 defines a "business combination" to include: (i) any merger or consolidation involving the corporation and the interested stockholder; (ii) any sale, transfer, pledge or other disposition involving the interested stockholder of 10% or more of the assets of the corporation; (iii) (subject to certain exceptions) any transaction which results in the issuance or transfer by the corporation of any stock of the corporation to the interested stockholder; (iv) any transaction involving the corporation which has the effect of increasing the proportionate share of the stock of any class or series of the corporation beneficially owned by the interested stockholder; or (v) the receipt by the interested stockholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or through the corporation. In general, Section 203 defines an "interested stockholder" as (a) any entity or person beneficially owning 15% or more of the outstanding voting stock of the corporation or (b) any entity or person affiliated with or controlling or controlled by such entity or person. The existence of Section 203 would be expected to have the effect of discouraging takeover attempts involving RCI, including attempts that might result in a premium over the market price of RCI's common stock (if it is then publicly traded). -38- USE OF PROCEEDS The Company will not receive any net proceeds from the sale of the Outstanding Shares or the Underlying Shares, if and when issued. The Company would receive $1,814,500 of net proceeds from the exercise of the Warrants, if and when they are exercised, and has received net proceeds of $2,248,000 from the issuance of the Series B Preferred covered by this Prospectus. The amount of net proceeds to be received from the sale of Shares by the Company is uncertain and depends on (i) whether any Shares are sold and if so, how many Shares are sold, (ii) the price at which Shares are sold through the Underwriter in the NASDAQ over-the-counter market from time to time, (iii) the conversion price of the Series B Preferred (and 125 shares of Series A Preferred), and the extent to which Shares are needed to cover conversions, and (iv) the amount of commissions and discounts paid to the Underwriter in connection with the sale of the Shares. The net proceeds received from the sale of the Shares and the exercise of the Warrants, if any, will be used by the Company for general working capital purposes. See "DESCRIPTION OF CAPITAL STOCK." PRICE RANGE OF COMMON STOCK AND DIVIDENDS The Company's Common Stock is quoted on the NASDAQ Small Capital Market System under the symbol "ICNT." The following table sets forth, for the calendar quarters indicated, the actual high and low sale prices of the Company's Common Stock as reported on the NASDAQ/Small Capital Market commencing for the first quarter of 1994. The approximate number of record holders of Common Stock on November 30, 1997 was 797. HIGH LOW LAST SALE ---- --- --------- 1994 First Quarter 7.25 6.00 6.75 Second Quarter 11.12 6.37 9.75 Third Quarter 12.50 8.00 11.37 Fourth Quarter 14.62 9.94 13.25 1995 First Quarter 16.25 12.25 14.25 Second Quarter 15.87 11.25 15.25 Third Quarter 23.50 15.25 22.25 Fourth Quarter 11.25 2.50 4.56 1996 First Quarter 6.20 4.25 5.12 Second Quarter 6.25 4.37 4.75 Third Quarter 5.31 4.50 4.75 Fourth Quarter 4.75 4.12 4.43 1997 First Quarter 5.06 2.87 3.00 Second Quarter 5.37 2.81 4.87 Third Quarter 5.19 2.94 3.62 Fourth Quarter(a) 3.81 2.18 2.90 - ------------------------------ (a) Through November 26, 1997. -39- A recent closing sale price for the Common Stock as reported in published financial sources is set forth on the cover page of this Prospectus. There is no public trading market for the Warrants or the Series A Preferred or Series B Preferred, nor is one expected to develop. The Company intends to retain future earnings for use in its business and does not anticipate paying any dividends on shares of its Common Stock in the foreseeable future. Furthermore, pursuant to the Certificates of Determination for the Series A Preferred and Series B Preferred, no cash dividends or cash distributions may be made on the Company's Common Stock unless all cumulative unpaid dividends on the Series A Preferred and Series B Preferred are paid. CAPITALIZATION The following table sets forth the actual capitalization of the Company at September 30, 1997 and the capitalization of the Company reflecting (i) the issuance of 477,500 Underlying Shares assuming the exercise of all 477,500 Warrants, (ii) the issuance of 627,503 Underlying Shares pursuant to the conversion of 2,434 outstanding shares of the Series B Preferred, (iii) the issuance of 40,686 Shares upon the conversion of 125 shares of Series A Preferred at a conversion price of $4.25 per share (less the impact of liquidated damages for late registration and the 2% per annum cumulative dividend), which is the maximum conversion price of those shares, and (iv) no other issuance of Shares.
September 30, 1997 -------------------------- Actual As Adjusted(2) ------ -------------- Long-Term Debt:(1) $ 3,355,000 $ 3,355,000 Minority Interest $ 0 $ 0 Stockholders' Equity (Deficiency) Preferred Stock, no par value; 100,000 shares authorized, 3,909 shares issued and outstanding 3,698,000 4,048,000 (4,259 as adjusted) Common Stock, no par value; 20,000,000 shares $69,972,000 $71,786,500 authorized, 14,006,793 shares issued and outstanding (15,152,482 as adjusted)(3) Additional paid in capital 36,000 36,000 Retained earnings (accumulated deficit) (56,765,000) (56,765,000) Treasury Stock (5,491,845) (5,491,845) ------------ ------------ Total stockholders' equity (deficiency) 11,413,000 13,613,655 ------------ ------------ Total capitalization $ 14,768,000 $ 16,968,655 ------------ ------------ ------------ ------------
- ------------------------------ (1) The long-term debt does not include liabilities of RCI in excess of assets totalling $3,600,000. (2) The "as adjusted" column does not reflect the sale of any Shares through the Underwriter because the price and amount of such sales, and the underwriting commissions and discounts applicable to such sales, are too uncertain at this time. The "as adjusted" column also assumes that no shares are needed to be issued in excess of the 627,503 Underlying Shares reserved for issuance upon the conversion of the 2,434 outstanding shares of Series B Preferred, and 40,686 Shares upon the conversion of 125 outstanding shares of Series A Preferred which still have registration rights. The sale of Shares through the Underwriter would increase the amount of stockholders' equity by the net proceeds received by the Company from the sale, after the deduction of underwriting commissions and discounts. The issuance of additional shares upon the conversion of Series A Preferred or Series B Preferred, if necessary, would not increase stockholders' equity. See "THE COMPANY - Issuance of Convertible Preferred Stock." (3) Assumes a total of 477,500 Underlying Shares of the Company's Common Stock is issued pursuant to the exercise of the Warrants, a total of 627,503 Underlying Shares of the Company's Common Stock is issued pursuant to the conversion of 2,434 shares of the outstanding Series B Preferred (including payment -40- of the 6% cumulative dividend in Common Stock), and a total of 40,686 Shares of the Company's Common Stock is issued upon the conversion of 125 outstanding shares of Series A Preferred which still have registration rights (including payment in Common Stock of the liquidated damages through November 30, 1997 and the 2% per annum cumulative dividend). Includes $36,000 paid for the Warrants. See "THE COMPANY - Settlement with RCI Parties." The adjusted shares of Common Stock assume that 2,434 shares of Series B Preferred are converted into Common Stock at an average conversion price of approximately $3.97 per share. The average conversion price may be less, depending on the average bid price of the Company's Common Stock prior to the conversion date. If the average conversion price of the Series B Preferred is less than $3.97 per share (or if the average conversion price of the 125 outstanding shares of Series A Preferred with registration rights is less than $4.25 per share), more dilution would be incurred by the existing Common Stockholders. See "THE COMPANY - Issuance of Convertible Preferred Stock" and "RISK FACTORS - Possible Adverse Effects of Issuance of Preferred Stock." DILUTION As of September 30, 1997, the net tangible book value of the Company was approximately $8,119,000 or approximately $.58 per share of Common Stock. Net tangible book value per share consists of total assets less intangible assets and liabilities, divided by the total number of shares of Common Stock outstanding. Without giving effect to any changes in such net tangible book value after September 30, 1997, other than to give effect to the exercise of the 477,500 Warrants and the conversion of the 2,434 outstanding shares of Series B Preferred at an average conversion price of approximately $3.97 per Underlying Share, the PRO FORMA net tangible book value at September 30, 1997 would have been $10,319,655 or approximately $.68 per share. Thus, as of September 30, 1997, the net tangible book value per share of Common Stock owned by the Company's current stockholders would have increased by approximately $.10 without any additional investment on their part. The holders of the 360,000 Warrants will incur an immediate dilution of approximately $3.07 per share from their Warrant exercise price. The holders of the 12,500 Warrants will incur an immediate dilution of approximately $2.26 per share from their Warrant exercise price. The holders of 50,000 of the Warrants will incur an immediate dilution of approximately $4.58 per share from their Warrant exercise price. The holders of 55,000 of the Warrants will incur an immediate dilution of approximately $2.32 per share from their Warrant exercise price. The holders of the Series B Preferred will incur an immediate average dilution of approximately $3.29 per share from their average conversion price, assuming a maximum average conversion price of approximately $3.97 per share. "Dilution" means the difference between the public offering price and the PRO FORMA net tangible book value per share after giving effect to the offering. Holders of the Common Stock may be subjected to additional dilution if any additional securities are issued as compensation or to raise additional financing. The following table illustrates the dilution which investors participating in this offering will incur and the benefit to current stockholders as a result of this offering.
EXERCISE OF EXERCISE OF EXERCISE OF EXERCISE OF CONVERSION OF SERIES 360,000 WARRANTS 12,500 WARRANTS 50,000 WARRANTS 55,000 WARRANTS B PREFERRED SHARES ---------------- --------------- --------------- --------------- --------------------- Price per share(1) $3.75 $2.94 $5.26 $3.00 $3.97 Net tangible book value per share before offering $ .58 $ .58 $ .58 $ .58 $ .58 Increase in net tangible book value per share attributable to shares offered hereby $ .10 $ .10 $ .10 $ .10 $ .10 Pro forma net tangible book value per share after offering $ .68 $ .68 $ .68 $ .68 $ .68 Dilution of net tangible book value per share to purchasers in this offering $3.07 $2.26 $4.58 $2.32 $3.29
(1) The price per share represents the exercise price of the Warrants in the case of the Warrants, and the maximum average conversion price in the case of the Series B 6% Convertible Preferred Stock. If the average conversion price is less than approximately $3.97 per share, then the average dilution to the holders of the Series B Preferred would be less than $3.29 per share. SELECTED CONSOLIDATED FINANCIAL INFORMATION The selected consolidated financial information for the Company presented under the captions "Statement of Operations Data" and "Balance Sheet Data" for, and as of the end of, each of the years in the five-year period ended December 31, 1996, and the nine months ended September 30, 1997, is derived from the Company's Consolidated Financial Statements. The Company's Consolidated Financial Statements as of December 31, 1994, 1995 and 1996 and for each of the years in the three-year period ended December 30, 1996, and the report thereon, and as of September 30, 1996 and September 30, 1997 and for the nine months ended September 30, 1996 and September 30, 1997, have been incorporated in this Prospectus by reference. This selected consolidated financial information should be read in conjunction with the Company's Consolidated Financial Statements and the related notes thereto included in the Company's 1996 Form 10-K and the Company's Form 10-Q for the fiscal quarter ended September 30, 1997, incorporated herein by reference, and with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" in this Prospectus. -41- INCOMNET, INC. STATEMENT OF OPERATIONS DATA:
Nine Months Ended September 30 Year Ended December 31 ------------------------------ --------------------------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- ---- ---- Revenues $99,341,000 $77,296,000 $106,905,000 $86,564,917 $46,815,057 $11,298,972 $5,534,874 Income (Loss) before income taxes, extra- ordinary items and minority interest (7,886,000) (11,202,000) (51,517,000) 957,044 4,000,242 (1,606,844) (2,264,597) Income (Loss) before extra- ordinary item and minority interest (7,207,000) (10,523,000) (43,705,000) 856,543 3,999,187 (1,606,844) (2,461,697) Minority Interest 0 1,908,000 6,906,000 509,482 - - - Net Income (Loss) (7,207,000) (8,615,000) (37,676,000) 1,366,025 4,071,194 (948,769) (2,021,333) Net Income (Loss) per share before extraordinary items (0.53) (0.65) (2.75) 0.11 0.42 (0.20) (0.34) Net Income (Loss) per share (0.53) (0.65) (2.82) 0.11 0.42 (0.12) (0.28) Cash dividends per common share 0 0 0 0 0 0 0 Weighted average number of shares 13,687,977 13,244,674 13,370,000 12,706,401 9,593,207 8,183,877 7,189,671 BALANCE SHEET DATA: At September 30 At December 31 -------------------------- -------------------------------------------------------- 1997 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- ---- Total assets $48,652,000 $69,564,043 $74,105,629 $26,158,346 $8,665,839 $6,744,944 Long-term obligations 6,955,000 8,708,181(2) 8,459,772(2) 900 20,000 176,000
- ------------------------------ (1) Includes accounting for 1,500,000 shares of the Company's Common Stock reserved in September 1997 for future issuance to the class plaintiffs pursuant to the settlement of the lawsuit SAUNDRA GAYLES, ET AL. vs. INCOMNET, INC. and SAM D. SCHWARTZ. See "THE COMPANY - Settlement of the Class Action Lawsuit." (2) These long term obligations include $8,459,772 as of December 31, 1995 and $8,055,562 as of September 30, 1996 relating to the net deferred tax liability arising from the nondeductibility of the RCI patent rights, which were eliminated when the RCI patent amortization schedule was accelerated and the related intangible asset was written off entirely. -42- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED RESULTS OF OPERATIONS GENERAL Gross revenues from NTC's operations have been increasing steadily since the Company acquired a controlling interest and commenced advancing working capital to NTC in early 1992. Upon acquiring control of NTC, the Company implemented a new marketing plan for NTC pursuant to which compensation payments to the independent marketing representatives were calculated and paid on a more timely basis. NTC uses a network marketing program of independent representatives to sell its telecommunications-related services to retail customers. The growth in NTC's telecommunications-related revenues is directly tied to its network marketing program. NTC's independent representatives typically purchase materials, training and services from NTC to assist them in selling new retail customers and enrolling other representatives in the NTC program. NTC pays the independent representatives a residual monthly commission on the telecommunications revenue. In addition, the network marketing program pays various bonuses and overrides when and if new representatives obtain a minimum number of new telephone customers, typically 10, within a 30 to 60 day period. This program has been designed to bring NTC new retail telephone customers even if little or no growth occurs in the marketing program revenues itself. The new telecommunications revenue generally lags the marketing program revenues by one to six weeks. When the marketing program revenues increase, an increase in NTC's telecommunications-related revenues is expected to follow. As part of NTC's new management program, the billing system was enhanced to allow for multiple billing cycles each month. NTC still establishes significant reserves for its direct-billed Dial-one receivables. NTC believes that the pre-paid calling card products now offered by it significantly reduce losses due to uncollectible accounts receivable. NTC's long distance telephone services and marketing programs subject the Company to the regulatory control of the Federal Communications Commission and various state regulatory agencies, including but not necessarily limited to state Public Utility Commissions or equivalent, state attorney general offices, and state consumer relations and protection offices. See "THE COMPANY - Settlement of Civil Consumer Protection Lawsuits With The State of California" and "RISK FACTORS - Adverse Impact of Government Regulation." The Company's current emphasis with respect to NTC is to continue to ensure that (i) processing capacity is maintained and increased to handle growing sales, (ii) the independent marketing force continues to expand, resulting in a growing base of telephone customers, and (iii) the business is operated efficiently with reliable reporting. While the improved computer processing system is expected to reduce operating expenses as a percentage of gross revenues due in part to increased speed and decreased errors, on-going costs in 1997 for expansion of NTC's infrastructure and more emphasis on local exchange carrier billing may result in expenses in 1997 which are comparable to or higher than expenses in 1996 and 1995, as a percentage of gross revenues, depending upon the rate of NTC's growth. On May 2, 1997, the Company acquired 100% of the total issued and outstanding capital stock of California Interactive Computing, Inc., which changed its name to GenSource Corporation in October 1997. The financial condition and operating results of this 100% owned subsidiary will commence being reflected in the consolidated financial condition and operating results of the Company in its Form 10-Q to be filed for the quarter ended June 30, 1997. See the Company's Report on Form 8-K, dated May 2, 1997. -43- THREE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1996 SALES - Sales of $33.3 million in the third quarter ended September 30, 1997 increased 21% over sales of $27.6 million in the third quarter ended September 30, 1996. The majority of this increase was attributable to NTC's sales increase to $32.3 million in the three months ended September 30, 1997 from $25.8 million in the three months ended September 30, 1996, respectively. The following table summarizes the Company's sales performance by subsidiary and segment during the comparable third quarters in 1997 and 1996: $ in millions ------------------ Subsidiary Segment 1997 1996 - -------------- --------------------------------------- ------ ------ NTC Telephone (telecommunications services) $ 28.7 $ 21.1 NTC Telephone (marketing programs) 3.6 4.7 RCI Optical -- 1.4 GenSource Software 0.6 -- AutoNETWORK Network 0.4 0.4 ------ ------ Total Company Sales $ 33.3 $ 27.6 ------ ------ ------ ------ COST OF SALES - Total Company cost of sales increased to $23.4 million or 70% of sales during the quarter ending September 30, 1996 verses $17.7 million or 64% of sales during the comparable prior year quarter. The quarter-to-quarter increase in cost of sales resulted largely from the increase in carrier costs associated with increased telephone service sales by NTC. The increase in the percentage of overall sales to 70% in the third quarter of 1997 from 64% in the third quarter of 1996 was due primarily to a percentage increase in NTC's carrier costs in the third quarter of 1997 versus the third quarter of 1996. The following table summarizes the Company's changes in three major cost components in the third quarter ended September 30, 1997 and 1996, respectively: $ in millions ---------------------- September September 30, 1997 30, 1996 --------- --------- Commissions paid to NTC independent sales reps $ 4.4 $ 5.0 Carrier costs for NTC's long distance telephone service 17.8 11.0 All other costs of sales 1.2 1.8 ------ ------ Total Company Cost of Sales $ 23.4 $ 17.8 ------ ------ ------ ------ NTC's total commission expense decreased to $4.4 million in the third quarter of 1997 compared to $5.0 million in the same quarter of 1996. NTC's carrier costs to deliver long distance telephone service to its telephone customers increased to $17.8 million in the third quarter of 1997 compared to $11.0 million in the third quarter of 1996. This increase in carrier costs reflects a decline in the gross margin of carrier-related sales. In the third quarter of 1996, gross margin was 48%, or $11.0 million in carrier costs on $21.1 million in carrier sales, while in the third quarter of 1997, gross margin declined to 38%, or $17.8 million in carrier costs on $28.7 million in carrier sales. The third cost component shown in the table above is "all other costs of sales" which represents: (1) NTC's costs of producing sales materials for its independent sales representatives, (2) GenSource's cost of producing software products and related services, and (3) AutoNETWORK's costs of providing communications network products and services. GENERAL & ADMINISTRATIVE - Total general and administrative costs decreased to $6.7 million or 20% of sales in the quarter ending September 30, 1996 compared to $8.3 million or 30% of sales in the same prior year quarter. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. The decrease in general and administrative expense is associated with improved efficiencies at NTC and by no longer consolidating the financial statements of RCI. DEPRECIATION & AMORTIZATION - Total Company depreciation and amortization expense was $821,409 in the third quarter of 1997 verses $501,787 in the third quarter of 1996. This increase was caused primarily by continuing investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its anticipated expansion in sales. BAD DEBT EXPENSE - Total Company bad debt expense increased to $1.6 million in the third quarter of 1997 from $1.3 million in the third quarter of 1996. The increase in bad debt was associated with an increase in total sales at NTC in the third quarter of 1997 versus the third quarter of 1996. OTHER INCOME & EXPENSE - The Company's other income and expense was an expense of $11.2 million in the third quarter of 1997 compared to other expense of $10.7 million in the third quarter of 1996. The $11.2 million in other expenses consists primarily of: (1) an $8.7 million reserve for the settlement of the class action lawsuit against the Company, (2) a $1.6 million reserve for the settlement of a civil consumer protection lawsuit by the State of California against the Company's NTC subsidiary and approximately $600,000 in additional legal expenses associated with related lawsuits and administrative matters. NET INCOME - The Company incurred a net income loss of $9.6 million in the third quarter of 1997 compared to a loss of $9.3 million in the third quarter of 1997. The net loss was due primarily to the reserves taken for legal settlements, including $8.65 million to settle the class action lawsuit against the Company and $1.6 million for NTC to settle a civil consumer protection lawsuit with the State of California. Without the reserves for legal settlements and associated expenses, the Company had net operating income of approximately $806,397 in the third quarter ended September 30, 1997. -44- YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 AND YEAR ENDED DECEMBER 31, 1994 SALES. For 1996, 1995 and 1994, the Company's net sales totaled approximately $106.9 million, $86.6 million and $46.8 million, respectively. The increases in sales in 1996 compared with 1995 and 1995 compared with 1994 were attributable principally to increased sales at NTC. The following table summarizes the Company's year-to-year sales performance by subsidiary and segment:
Subsidiary Segment $ In Millions 1996 1995 1994 ---- ---- ---- NTC Telephone (telecommunications services) $ 83.7 $70.0 $34.2 NTC Telephone (marketing programs) 17.1 13.1 11.4 RCI Optical 4.7 2.0 --- AutoNETWORK Network 1.4 1.5 1.2 -------------------------- TOTAL COMPANY NET SALES $106.9 $86.6 $46.8 -------------------------- --------------------------
NTC's net sales increase was driven largely by continued expansion of the customer base for its telecommunications services. As a result of this continuing expansion, NTC's telecommunication service revenues represented 83.0%, 84.2% and 75.0% of NTC's total revenues for 1996, 1995 and 1994, respectively, with the remaining 17.0%, 15.8% and 25.0% generated by sales of NTC's marketing programs for 1996, 1995 and 1994, respectively. Revenues from the optical segment may decline in 1997 because the Company's percentage ownership in RCI is lower than in 1995 and 1996, and machine orders at RCI have declined while RCI implements design modifications and improvements. See "Item 1. Business - Rapid Cast, Inc. - Technical Overview of the Rapid Cast LenSystem" in the Company's 1996 Form 10-K. COST OF SALES. Total Company cost of sales for 1996, 1995 and 1994 were approximately $68.6 million, $57.9 million and $31.2 million, respectively. The increases in cost of sales were attributed principally to the increase in carrier costs associated with increased telephone service sales by NTC and a volume related rise in RCI cost of sales. Gross margin when stated as a percentage of net sales was 35.9%, 33.1% and 33.3% for 1996, 1995 and 1994, respectively. The increase in gross margin in 1996 was attributable principally to reductions in NTC's telecommunication service cost of sales resulting from: (1) lower long-distance transport costs charged by NTC's carriers, and (2) continuing improvements in the mix of sales in the higher profit product lines. The following table summarizes the Company's year-to-year changes in three major cost components: $ In Millions 1996 1995 1994 ---- ---- ---- Carrier costs for NTC's long distance telephone service $44.7 $40.4 $21.3 Commissions paid to NTC independent sales representatives 18.0 14.2 7.7 All other costs of sales 5.9 3.3 2.2 ------------------- TOTAL COMPANY NET SALES $68.6 $57.9 $31.2 ------------------- ------------------- NTC's total commission expenses for 1996, 1995 and 1994 were $18.0 million, $14.2 million and $7.7 million, respectively. The increases were attributed principally to the residual monthly sales commissions and various bonuses and overrides paid to sales representatives on increased marketing and telephone service revenues. The third cost component shown in the table above is "all other costs of sales" which represents: (1) NTC's costs of producing sales materials for its independent sales representatives, (2) RCI's costs of producing optical systems and ancillary goods, and (3) AutoNETWORK's costs of providing communications network products and services. GENERAL AND ADMINISTRATIVE. Total general and administrative costs for 1996, 1995 and 1994 were approximately $36.9 million, $19.8 million and $9.4 million, respectively. General and administrative expenses represented 34.57%, 22.9% and 20.2% of net sales in 1996, 1995 and 1994, respectively. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. NTC's general and administrative costs increased to 24.5% of sales in 1996 from 20.3% of sales in 1995. This increase was due principally to: (1) increases in fees paid to local exchange carriers (LECs) to process NTC's billing and collection of its LEC-billed long distance telephone service, and (2) increases in compensation and fringe benefits expended as NTC continues to build infrastructure to support anticipated future sales growth. RCI's general and administrative costs continue to reflect the startup nature of its operations. DEPRECIATION AND AMORTIZATION. The Company's depreciation and amortization expense totaled $2.0 million, $1.0 million and $0.4 million for 1996, 1995 and 1994, respectively. These increases were caused by the continuing investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its expansion in sales. BAD DEBT EXPENSE. The Company's bad debt expense totaled $6.1 million, $4.1 million and $1.8 million for 1996, 1995 and 1994, respectively. Bad debt expense represented 5.7%, 4.8% and 3.8% of net sales in 1996, 1995 and 1994, respectively. The increase in bad debt was caused primarily by increased provisioning of NTC's LEC billed receivables which currently carry a higher than estimated bad debt provision, and direct billed collection agency write-offs. OTHER (INCOME) AND EXPENSE. The Company's other (income) and expense totaled $3.4 million, $1.0 million and $(0.3) million for 1996, 1995 and 1994, respectively. The increase in 1996 was attributable in large part to settlement costs of $2.0 million associated with claims by officers against the Company. The increase in 1995 was attributed principally to: (1) a $0.4 million settlement with convertible noteholders relating to the acquisition of RCI, (2) a $0.2 million settlement with a former Company officer, and (3) a $0.3 million write-off of marketable securities by NTC. CHARGE FOR ASSET IMPAIRMENT. The charge for asset impairment totaled $39.1 million for 1996 for the devaluation of the Company's investment in RCI. There was no impairment in 1995 and 1994. MINORITY INTEREST. Beginning on July 1, 1995, the Company converted from the equity method to the consolidated method of accounting for its 51% ownership in RCI. As a result, 49% of RCI's losses from July 1 through December 31, 1995 (the "minority interest") were eliminated from the Company's "Consolidated Statements of Operations" for 1995. NET INCOME (LOSS). The Company's net income (loss) totaled ($37.7) million, $1.4 million and $4.1 million for 1996, 1995 and 1994, respectively. Net income (loss) represented (35.2%), 1.6% and 8.7% of net sales for 1996, 1995 and 1994, respectively. The decreases were attributed principally to: (1) higher losses at RCI in 1996 due to the devaluation of patent rights and significantly increased operating costs incurred to build infrastructure for future potential sales growth, and (2) higher losses at the Company's headquarters which were caused by the establishment of reserves for devaluation of the Company's investment in RCI and for settlement costs. EMPLOYMENT. Employment of the Company totaled 288 at December 31, 1996, not including independent sales representatives of NTC, who are classified as independent contractors and not as employees of the Company. -45- LIQUIDITY AND CAPITAL RESOURCES AS OF SEPTEMBER 30, 1997 Overall, the Company had negative cash flows of $1.1 million during the first nine months of 1997 resulting from negative cash flows from operations of $13.1 million and negative cash flows from investing activities of $2.4 million, which were offset by positive cash flows from investing activities of $14.4 million. The Company expects that its operating and investing activities will continue to experience negative cash flows due to (1) anticipated cash costs associated with the class action lawsuit, related lawsuits and other legal and regulatory issues and (2) anticipated funding requirements of approximately $1.2 million through fiscal year 1998 associated with the operation and acquisition of GenSource (see the Company's Report on Form 10-Q for the second quarter ended June 30, 1997). To endeavor to meet these anticipated funding needs, the Company has issued options to acquire up to 250,000 shares of Series B Preferred with a conversion rate at 88% of the market value of the Company's Common Stock on the date of conversion, the right to acquire 200 additional shares of Series B Preferred with an 80% conversion ratio, and warrants to acquire 105,000 shares of the Company's Common Stock. There is no assurance that these options will be exercised and therefore management is not certain that its liquidity and capital resources will be sufficient to fund its activities in 1998. The Company's cash flows are discussed below, as follows: CASH FLOW FROM OPERATIONS - The Company experienced $13.1 million in negative cash flow from operations during the first nine months of 1997 compared to $5.8 million in negative cash flow from operations during the prior year's comparable period. This year-to-year decrease in cash flow from operations resulted primarily from: (1) a net loss from operating activities of $7.2 million, which includes reserves of $8.65 million and $1.6 million for anticipated legal settlements, (2) an increase in operating assets, primarily accounts receivable of $5.7 million and (3) a decrease in operating liabilities of $2.7 million. CASH FLOW FROM INVESTING - The Company experienced negative cash flows from investing activities of $ 2.3 million in the first nine months of 1997 as compared with a positive cash flow of $2.9 million in the first nine months of 1996. The negative cash flow in the first nine months of 1997 resulted primarily from $3.7 million used to acquire plant and equipment, primarily by NTC, and by $2.2 million for the acquisition of GenSource, reduced by a $3.6 million liability in excess of assets arising from changing to the equity method of accounting for RCI. CASH FLOW FROM FINANCING - Positive cash flows from financing activities totaled $14.4 million during the first nine months of 1997 compared with $2.7 million during the first nine months of 1996. The positive cash flow during the first nine months of 1997 resulted primarily from (1) issuance of $8.65 million of common stock primarily to settle the class action lawsuit against the Company, (2) net sales of $1.3 million worth of convertible preferred stock, (3) increased borrowings under NTC's line of credit, and (4) assumption of $2.2 million in obligations associated with the acquisition of GenSource. LITIGATION. The Company is subject to pending litigation and an investigation by the Securities and Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and the results of its operations. Management does not believe that the investigation by the Securities and Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Part II. Item 1. Legal Proceedings" in the Company's Form 10-Q for the quarter ended September 30, 1997. LIQUIDITY AND CAPITAL RESOURCES AS OF DECEMBER 31, 1996 GENERAL. Overall, the Company achieved slightly positive cash flows of $0.6 million during 1996 resulting from positive cash flows from operating activities of $3.0 million and from financing activities of $5.2 million, which were almost entirely offset by negative cash flows from investing activities of $7.6 million. The Company may need to raise additional capital in 1997 to fund settlement costs relating to pending litigation or to make a business acquisition, although specific needs had not yet been identified as of December 31, 1996. Pursuant to its management incentive agreement with NTC, the Company receives cash distributions from NTC on a periodic basis, which are scheduled to be made until December 31, 1997. See "Item 1. Business - National Telephone & Communications, Inc. - Management Incentive Agreement" in the Company's 1996 Form 10-K. The Company does not expect to have to make loans to RCI in 1997, and RCI's capital needs in the short-term have been met through its private placement of preferred stock and warrants in January 1997. See "Item 1. Business - The Recent Capitalization of RCI" in the Company's 1996 Form 10-K. The Company may, however, be presented with an option to purchase additional convertible preferred stock in RCI in July 1997 if J.P. Morgan or The Clipper Group do not exercise their options to purchase up to $5,000,000 of additional preferred stock. RCI is incurring net operating deficits and will need additional capital to continue its business. If the Company elects to contribute additional capital to RCI, it will need to raise funds through the sale of stock or otherwise. There is no assurance that it will be able to raise such capital or financing, or that its ownership of RCI will not be further diluted. NTC is expected to have sufficient capital or financing to fund its requirements in 1997, including funds required for the establishment of its branch marketing offices, one of which is currently being built in leased premises in Honolulu, Hawaii. There is no assurance that the cash distributions by NTC to the Company or the cash flow from AutoNETWEORK will be sufficient to meet the Company's future funding requirements, or that RCI or NTC will have sufficient capital or financing to meet their needs. CASH FLOW FROM OPERATIONS. Net cash provided by operating activities of $3.0 million in 1996 was primarily attributable to the operating loss for 1996 of $37.7 million and non-cash items, principally from a devaluation of the Company's investment in RCI, of $39.1 million, as well as depreciation and amortization of $4.3 million, and changes in operating assets and liabilities of $11.7 million. With regard to the collection of accounts receivable, the Company increased its allowance for doubtful accounts to 13.2% of gross receivables as of December 31, 1996 compared to 8.0% of gross receivables as of December 31, 1995. This increased provisioning reflects NTC's reserves for all direct-billed Dial-one receivables which have been submitted to collection agencies for collection, and a modest improvement in collection rates for LEC-billed and calling card products. CASH FLOW FROM INVESTING. Net cash used in investing activities of $7.6 million in 1996 was attributable principally to the Company's additions to property, plant and equipment of $7.2 million and additions to patents of $0.7 million. CASH FLOW FROM FINANCING. Net cash provided by financing activities of $5.2 million in 1996 was attributable principally to changes in shorter-term debt of $2.9 million, proceeds of $2.3 million from the issuance of preferred stock, and additions to long-term debt of $1.3 million, partially offset by a reduction of long term debt of $1.8 million. In addition, positive cash flow resulted primarily from RCI entering into various loan agreements to finance the building of infrastructure to support its anticipated future sales growth. In September 1996, the Company also raised $0.4 million from the sale of 365 shares of Series A 2% Convertible Preferred Stock, and raised an additional $2.1 million in October 1996 through the placement of additional shares of Series A 2% Convertible Preferred Stock. The Company paid aggregate referral fees equal to approximately 5% of the capital raised from the placement of the Series A 2% Convertible Preferred Stock. Cash paid to reduce debt totaled $1.2 million, $0.0 million and $0.3 million during 1996, 1995 and 1994, respectively. The Company had material commitments for capital expenditures of $1.5 million in tenant improvements for its Honolulu, Hawaii office space at December 31, 1996, and expects to continue making improvements to the NTC headquarters building and purchasing additional equipment commensurate with the expansion of its business. During 1996, the company had capital expenditures of $7.2 million for plant and equipment. At December 31, 1996, the Company had net operating loss carryforwards for federal income tax purposes of approximately $22.6 million, which are expected to be available to offset taxable income for the next several years. LITIGATION. The Company is subject to pending litigation and an investigation by the Securities and Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and results of operations. Management does not believe that the investigation by the Securities and Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Item 3. Legal Proceedings" in the Company's 1996 Form 10-K. -46- LIQUIDITY AND CAPITAL RESOURCES AS OF DECEMBER 31, 1995. For the year ended December 31, 1995, the Company had a net profit of $1,366,025 and, at that date, current assets exceeded current liabilities by $1,440,515. Since the Company acquired a controlling interest in NTC in early 1992, the Company's capital needs have primarily been satisfied from outside sources such as the private placement of securities, the exercise of warrants and options, and loans and bank credit lines guaranteed by its principal shareholders. Cash flow from operations did not provide net working capital to the Company during the period from February 1992 to May 1994. While cash flow from operations on a consolidated basis has generally been positive since June 1994, the increasing capital needs of RCI and legal costs may require the Company to raise additional capital from outside sources in the future. The Company had net working capital of $1,440,515 at December 31, 1995, compared to net working capital of $8,798,793 at December 31, 1994. During 1995, net cash flow from operations was $1,378,839 compared to net cash flow from operations of $3,083,887 in 1994. During 1995, the Company's allowance for doubtful accounts increased to 20.6% of gross accounts receivable from 15.1% in the prior year. This increased provisioning related primarily to slower collections of NTC's direct-billed and LEC-billed Dial-one products which was partially offset by improved collections of NTC's calling card business. During 1995, the Company's cash requirements were met through a combination of a cash flow from operations, exercise of warrants to purchase the Company's common stock and private placements of its Common Stock. In 1995, the Company raised $29,058,773 in either private placements or from the exercise of warrants. On February 5, 1996, Melvyn Reznick, the President and a director of the Company, personally guaranteed and arranged for a $500,000 bank line of credit for the Company, which was eventually expanded to $700,000. Mr. Reznick also loaned the Company an additional amount of approximately $320,000. The Company had no material commitments for capital expenditures at December 31, 1995, but does expect to continue expanding the NTC headquarters building and purchasing additional equipment commensurate with the requirements of its customer base. During 1995, the Company had capital expenditures of $7,389,419 for plant and equipment. At December 31, 1995, the Company had net operating loss carryforwards for federal income tax purposes of approximately $16,800,000, which are expected to be available to offset taxable income in future years. The Company and its subsidiaries are engaged in legal proceedings where the ultimate outcome cannot presently be determined. Furthermore, the Company is subject to an investigation by the Securities & Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and results of operations. Management does not believe that the investigation by the Securities & Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Item 3. Legal Proceedings" in the Company's 1995 Form 10-K. -47- PRINCIPAL STOCKHOLDERS The following table sets forth information concerning the beneficial ownership of the Company's Common Stock as of November 26, 1997. Persons and groups named in the table represent (i) each person known by the Company to own beneficially more than 5% of the Company's Common Stock, (ii) each director of the Company or its wholly-owned subsidiaries, (iii) each executive officer of the Company or its wholly-owned subsidiaries, and (iv) all directors and executive officers of the Company and its wholly-owned subsidiaries as a group.
NAME AND ADDRESS OF AMOUNT AND NATURE OF PERCENTAGE OF SHARES OF BENEFICIAL OWNER BENEFICIAL OWNERSHIP(1) COMMON STOCK OUTSTANDING(11) - ------------------- ----------------------- ---------------------------- Melvyn Reznick 305,300(2) 2.0% 21031 Ventura Boulevard Suite 1100 Woodland Hills, CA 91364 David Wilstein 539,379(3) 3.54% 2080 Century Park East - Penthouse Los Angeles, CA 90067 Richard Horowitz 373,530(3) 2.45% 9301 Wilshire Blvd Suite 206 Beverly Hills, CA 90210 Robert Epstein 325,000(3) 2.13% 5000 Plaza on the Lake Suite 180 Austin, Texas 78735 Jack Gilbert 201,500(3) 1.32% 15456 Coutolene Road Magalia, CA 95954 Leonard Wilstein 166,779(3) 1.1% 11201 Hindry Avenue Los Angeles, CA 90045 Sam D. Schwartz 835,444(4) 5.49% 16032 Valley Meadow Place Encino, CA 91364 Nancy Zivitz 729,300(5) 4.79% 7234 Silverbell Drive Sarasota, Florida 34241 Stanley Weinstein 140,550(6) 0.92% Weinstein Spira & Co. 5 Greenway Plaza, #2200 Houston, Texas 77046 Albert Milstein 125,000(7) 0.82% 21031 Ventura Boulevard Suite 1100 Woodland Hills, CA 91364 Howard Silverman 35,000(8) 0.23% 21031 Ventura Boulevard Suite 1100 Woodland Hills, CA 91364 Edward R. Jacobs 0 0.0% 2801 Main Street Irvine, CA 92715 Stephen A. Caswell 20,000(9) 0.13% 21031 Ventura Boulevard Suite 1100 Woodland Hills, CA 91364 James R. Quandt 0 0% 2801 Main Street Irvine, California 92715 Victor C. Streufert 0 0% 2801 Main Street Irvine, California 92715 Michael J. Keebaugh 0 0% 2801 Main Street Irvine, California 92715 Deborah A. L. Chuckas 0 0% 2801 Main Street Irvine, California 92715 Louis W. Cheng 0 0% 2801 Main Street Irvine, California 92715 Jerry C. Buckley 25572 Avenue Stanford Valencia, California 91355 0 0% Eric Hoffberg 25572 Avenue Stanford Valencia, California 91355 0 0% All directors and officers as 2,408,609(10) 15.8% a group (16 persons)
-48- - ------------------------------ (1) See the Company's Proxy Statement for the 1997 Annual Meeting of the Shareholders for additional information regarding outstanding stock options and warrants to purchase the Company's Common Stock. (2) Includes stock options to purchase 25,000 shares at an exercise price of $4.87 per share, exercisable at any time until February 28, 2001, stock options to purchase 25,000 shares at an exercise price of $4.87 per share, exercisable at any time until May 31, 2001, stock options to purchase 25,000 shares at an exercise price of $4.87 per share, exercisable at any time until August 31, 2001, stock options to purchase 25,000 shares at an exercise price of $4.87 per share exercisable at any time until November 30, 2001, and stock options to purchase 150,000 shares at an exercise price of $4.37 per share, exercisable at any time until April 5, 2001 with respect to 100,000 of those options, February 28, 2002 with respect to 25,000 of those options, and May 31, 2002 with respect to 25,000 of those options. Does not include stock options to purchase 200,000 shares at an exercise price of $4.87 per share, which do not vest until RCI achieves certain financial performance goals, and stock options to purchase 50,000 shares at an exercise price of $4.37 per share, which do not vest until RCI becomes a public company. See "Ratification of 1996 Stock Option Program for Directors, Officers and Key Consultants" in the Company's Proxy Statement for its 1996 Annual Meeting of the Shareholders. (3) All of these individuals filed a Schedule 13D/A on August 15, 1997 in which they stated that although they have not entered into any written agreement relating to the voting of their shares or relating to any particular course of action concerning the voting of their shares, they have deemed themselves to be a group pursuant to Rule 13d-5(b)(1) of the Securities Exchange Act of 1934, as amended. As a group, they own a total of 1,606,188 shares or approximately 10.55% of the outstanding shares of the Company (assuming 15,223,773 shares outstanding.) Mr. Wilstein and Mr. Horowitz are directors of the Company. (4) Excludes 90,000 shares owned by Rita L. Schwartz, which are her sole and separate property, in which Mr. Schwartz disclaims any beneficial interest. Includes 90,000 shares acquired upon the conversion of 8% convertible promissory notes. Reflects the tender by Mr. Schwartz of 1,047,966 shares of the Company's Common Stock to the Company as part of his disgorgement of short swing profits to the Company pursuant to Section 16(b) of the Securities Exchange Act of 1934, as amended, in compliance with the court order issued on June 9, 1997 in the lawsuit MORALES VS. INCOMNET, INC. AND SAM SCHWARTZ. See "THE COMPANY - Status of Section 16(b) Action." (5) Includes 644,300 shares owned by Clarence R. Zivitz, Nancy Zivitz' husband, and stock options to purchase 85,000 shares owned by Nancy Zivitz, a member of the Company's Board of Directors, 50,000 of which have an exercise price of $4.37 per share and 35,000 of which have an exercise price of $4.25 per share. The stock options are exercisable as follows: 25,000 at any time until February 28, 2001, 25,000 at any time until January 1, 2002, and 35,000 at any time until January 22, 2002. (6) Mr. Weinstein was appointed as a director of the Company on August 13, 1997 to fill a vacancy on the Company's Board of Directors. See "THE COMPANY - Appointment of New Directors of the Company. (7) Includes stock options to purchase 25,000 shares at an exercise price of $4.37 per share exercisable at any time until April 5, 2001, stock options to purchase 25,000 at an exercise price of $4.37 per share exercisable at any time until January 1, 2002, and stock options to purchase 35,000 shares at an exercise price of $4.25 per share exercisable at any time January 22, 2002. (8) Reflects 35,000 stock options to purchase 35,000 shares of the Company's Common Stock at an exercise price of $4.25 per share, exercisable at any time until January 22, 2002. (9) Does not include stock options to purchase 50,000 shares at an exercise price of $4.37 per share, which do not vest until RCI achieves certain financial performance goals, and stock options to purchase 40,000 shares at an exercise price of $4.25 per share, exercisable at any time until January 22, 2002, which are pledged to the Company as additional collateral for a nonrecourse loan previously made to Mr. Caswell. See "THE COMPANY - Grant of Stock Options by the Company." (10) Does not include any shares held by members of the group of shareholders who filed the Schedule 13D/A on August 15, 1997 who are not actually officers or directors of the Company. (11) Assumes 15,223,773 shares outstanding, including 1,500,000 shares reserved for issuance to the class action plaintiffs and 1,217,500 shares issuable upon the exercise of stock options and warrants which have vested, but which do not include any Shares or Underlying Shares. Based upon the Company's review of Forms 3, 4 and 5 and any amendments thereto furnished to the Company in compliance with Section 16 of the Securities Exchange Act of 1934, as amended, all of such Forms were filed on a timely basis by such reporting persons, other than reports on Form 4 and Form 5 of transactions occurring from January -49- 1993 until July 1995 which were reported late by Sam D. Schwartz, the Company's former Chairman, President and Chief Executive Officer. DESCRIPTION OF CAPITAL STOCK The following summaries of certain provisions of the Articles of Incorporation, as amended, and Bylaws of the Company do not purport to be complete and are qualified in their entirety by reference to such instruments, each of which is incorporated by reference as an exhibit to the Registration Statement of which this Prospectus is a part. See "AVAILABLE INFORMATION." GENERAL The Company's authorized capital stock consists of 20,000,000 shares of Common Stock and 100,000 shares of Preferred Stock, without par value. As of November 26, 1997, there were 14,006,793 shares of the Company's Common Stock outstanding, including 1,500,000 shares reserved for future issuance to the class action plaintiffs pursuant to the settlement of SAUNDRA GAYLES VS INCOMNET, INC. and SAM D. SCHWARTZ, but excluding any Shares or Underlying Shares issuable upon the exercise of Warrants or the conversion of outstanding Series A Preferred and Series B Preferred. As of November 26, 1997, 4,259 shares of the Company's Preferred Stock were issued and outstanding and no Common Stock or Preferred Stock was held as treasury stock. See "THE COMPANY - Issuance of Convertible Preferred Stock." COMMON STOCK DIVIDENDS. Subject to the rights of holders of the Company's Preferred Stock, if any, to receive certain dividends prior to the declaration of dividends on shares of the Company's Common Stock, when and as dividends are declared by the Company's Board of Directors payable in cash, stock or other property, the holders of the Company's Common Stock are entitled to share ratably in such dividends. VOTING RIGHTS. Each holder of the Company's Common Stock has one vote for each share held on matters presented for consideration by the shareholders. PREEMPTIVE RIGHTS. The holders of the Company's Common Stock have no preemptive rights to acquire any additional shares of the Company. ISSUANCE OF STOCK. Under California law the Company's Board of Directors generally may issue authorized shares of the Company's Common Stock or Preferred Stock without shareholder approval. LIQUIDATION RIGHTS. In the event of the liquidation, dissolution or winding-up of the Company, whether voluntary or involuntary, the holders of the Company's Common Stock will be entitled to share ratably in any of its assets or funds that are available for distribution to its shareholders after the satisfaction of its liabilities (or after adequate provision is made therefor) and after payment of the liquidation preferences of outstanding Preferred Stock, if any. PREFERRED STOCK The Company's authorized Preferred Stock may be issued from time to time as a class without series, or if so determined by the Board of Directors, in one or more series. The voting rights, dividend rights, conversion rights, redemption rights and liquidation preferences of any Preferred Stock, the number of shares constituting any such series and the terms and conditions of the issue of the Preferred Stock may be fixed by resolution of the Company's Board of Directors. The Company's Preferred Stock, -50- as, if and when issued, has and will have a preference over the Company's Common Stock with respect to the payment of dividends and the distribution of assets in the event of the liquidation of the Company, and such other preferences as may be fixed by the Board of Directors. See "THE COMPANY - Issuance of Convertible Preferred Stock." WARRANTS AND OPTIONS In November 1994, the Company approved the Incomnet 1994 Stock Option Plan for the directors, employees and key outside consultants of the Company and its subsidiaries, which provided for the issuance of stock options covering up to 1,500,000 shares of the Company's Common Stock. In November 1994, options to purchase 1,200,000 shares of the Company's Common Stock were granted at an exercise price of $10 per share provided, that the stock options vest and become exercisable only upon NTC earning at least $15 million in pre-tax profits during any continuous four audited quarterly periods until December 31, 1997. See footnote 6, "Shareholders' Equity - Stock Options" in the Consolidated Financial Statements of the Company included in "Item 8. Financial Statements" in the Company's 1995 Form 10-K. On February 6, 1996, the Company entered into a Management Incentive Agreement pursuant to which Edward R. Jacobs, the grantee of the 1,200,000 stock options issued under the 1994 Stock Option Plan, agreed to cancel all of those options upon adoption of a new stock option plan for NTC, to be effective once NTC becomes a publicly traded company. No additional stock options are intended to be issued under the 1994 Stock Option Plan. On November 30, 1995, the Company issued 300,000 stock options to Melvyn Reznick, the President and Chief Executive Officer of the Company, pursuant to the Employment Agreement entered into by the Company and Mr. Reznick on that date. See "Item 1. Business -Employees, Officers and Directors - Officers" in the Company's 1996 Form 10-K. On February 5, 1996, as modified on March 13, 1996, April 25, 1996 and June 11, 1996, the Company's Board of Directors adopted the Incomnet 1996 Stock Option Plan for the directors, officers and key outside consultants of the Company pursuant to which an aggregate of 1,500,000 stock options are authorized to be granted, 780,000 of which have been granted (480,000 of which are vested and 300,000 of which are not yet vested), including the 300,000 stock options issued pursuant to Mr. Reznick's Employment Agreement. The Company's 1996 Stock Option Plan was ratified by the Company's Shareholders at their annual meeting on July 29, 1996. See "Ratification of 1996 Stock Option Program for Directors, Officers and Key Consultants" in the Company's Proxy Statement for the 1996 Annual Meeting of the Shareholders. On January 21, 1997, the Company granted a total of 165,000 additional stock options to certain directors, officers, and consultants, 105,000 of which were not granted under the Company's 1996 Stock Option Plan. See also "THE COMPANY - Grant of Stock Options by the Company." The holders of warrants and options do not have any voting rights until they exercise the warrants or options and receive voting shares of Common Stock pursuant to such exercise. The number of shares of Common Stock which can be purchased upon the exercise of the warrants and options and the exercise price are subject to adjustment in certain events, such as a stock split, reverse stock split, stock dividend or similar event, in order to prevent dilution to the warrant and option holders under those circumstances. SIZE OF BOARD OF DIRECTORS The Company's Bylaws provide that the Company's Board of Directors will consist of no fewer than five and no more than nine members, with the number currently fixed at seven members. The Company's Board of Directors presently has seven directors and there are no vacancies. CUMULATIVE VOTING Pursuant to the Company's Bylaws and in accordance with the California Corporations Code, each shareholder is entitled to one vote for each share of the Company's Common Stock held, and such holders may be entitled to cumulative voting rights in the election of directors. Under the California -51- Corporations Code, cumulative voting is not required unless, at the annual meeting and prior to the voting, at least one shareholder gives notice of his intention to cumulate his votes. If one shareholder give notice of an intention to cumulate votes, then all shareholders have cumulative voting rights in the election of directors. If no such notice is given, voting for directors is noncumulative, which means that a simple majority of the shares voting may elect all of the directors. Under cumulative voting, each shareholder entitled to vote has the right to give one candidate a number of votes equal to the number of authorized directors multiplied by the number of votes to which his shares are entitled, or to distribute his votes on the same principle among as many candidates as he desires. As a result, each share of the Company's Common Stock has a number of votes equal to the number of authorized directors. The California cumulative voting law applies only to the election of directors and not to any other matters as to which shareholders may vote. DIRECTOR'S LIABILITY The California Corporations Code and the Company's Bylaws provide that a director of the Company will have no personal liability to the Company or its shareholders for monetary damages for breach of fiduciary duty as a director except (i) for acts or omissions that involve intentional misconduct or a knowing and culpable violation of law, (ii) for acts or omissions that a director believes to be contrary to the best interests of the corporation or its shareholders or that involve the absence of good faith on the part of the director, (iii) for any transaction from which a director derived an improper personal benefit, (iv) for acts or omissions that show a reckless disregard for the director's duty to the corporation or its shareholders in circumstances in which the director was aware, or should have been aware, in the ordinary course of performing a director's duties, of a risk of serious injury to the corporation or its shareholders, (v) for acts or omissions that constitute an unexcused pattern of inattention that amounts to an abdication of the director's duty to the corporation or its shareholders, or (vi) for an unlawful dividend, distribution, stock repurchase or redemption. This provision would generally absolve directors of personal liability for negligence in the performance of duties, including gross negligence. INDEMNIFICATION The Company's Bylaws and Sections 204 and 317 of the California Corporations Code contain comprehensive provisions for indemnification of directors, officers and agents of California corporations against expenses, judgments, fines and settlements in connection with litigation. The Company has a policy of providing indemnification for its executive officers, directors and members of its Committees, within the scope of the California Corporations Code. It has entered into indemnification agreements with its executive officers, directors and committee members. Under the California Corporations Code, other than an action brought by or in the right of the Company, such indemnification is available if it is determined that the proposed indemnitee acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the Company and, with respect to any criminal action or proceeding, has no reasonable cause to believe his conduct was unlawful. In actions brought by or in the right of the Company, such indemnification is limited to expenses (including attorneys' fees) actually and reasonably incurred if the indemnitee acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the Company. No indemnification may be made, however, in respect of any claim, issue or matter as to which such person is adjudged to be liable to the Company unless and only to the extent that the court in which the action was brought determines that in view of all the circumstances of the case, the person is fairly and reasonably entitled to indemnity for such expenses as the court deems proper. To the extent that the proposed indemnitee has been successful in defense of any action, suit or proceeding, he must be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by him in connection with the action. The Company's Articles of Incorporation, as amended, provide for indemnification of the directors and officers of the Company against liabilities to the maximum extent provided by California law. -52- Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers or persons controlling the Company pursuant to the foregoing provisions, the Company has been informed that in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Act and is therefore unenforceable. AMENDMENT OF CERTIFICATE OF INCORPORATION AND BYLAWS Under the California Corporations Code, a corporation's certificate of incorporation can be amended by the affirmative vote of the holders of a majority of the outstanding shares entitled to vote, and a majority of the outstanding stock of each class entitled to vote as a class, unless the certificate requires the vote of a larger portion of the stock. The Company's Articles of Incorporation, as amended, do not require a larger percentage affirmative vote. As is permitted by the California Corporations Code, the Company's Bylaws give its Board of Directors the power to adopt, amend or repeal the Company's Bylaws. The Company's shareholders entitled to vote have concurrent power to adopt, amend or repeal the Company's Bylaws. DIVIDENDS The California Corporations Code provides that, subject to any restrictions in the corporation's articles of incorporation, dividends may be declared from the corporation's surplus or, if there is no surplus, from its net profits for the fiscal year in which the dividend is declared and the preceding fiscal year. Dividends may not be declared, however, if the corporation's capital has been diminished to an amount less than the aggregate amount of all capital represented by the issued and outstanding stock of all classes having a preference upon the distribution of assets. TRANSFER AGENT The Transfer Agent and Registrar for the capital stock of the Company is American Stock Transfer Company. SELLING SECURITY HOLDERS THE WARRANTHOLDERS. The selling security holders include the individuals and entities listed on the table below who purchased 360,000 Warrants for a price of $.10 per Warrant in connection with a settlement agreement entered into with the Company on December 9, 1996. See "THE COMPANY - Settlement with RCI Parties." Three individuals were also issued 105,000 additional warrants to purchase 105,000 shares of the Company's Common Stock as compensation for services in assisting the Company to place 2,434 shares of Series B Preferred. See "THE COMPANY - Issuance of Convertible Preferred Stock - Series B Preferred." The selling security holders also include Charles Stevens and his legal counsel, who were issued a total of 12,500 Warrants in connection with the settlement of the lawsuit known as CHARLES STEVENS V. INCOMNET, INC. AND SAM D. SCHWARTZ. See "THE COMPANY - Settlement of the Stevens Lawsuit." They are also listed on the following table: -53-
NUMBER OF NUMBER OF UNDERLYING NAME OF WARRANTHOLDER WARRANTS SHARES EXERCISE PRICE EXERCISE PERIOD Dr. Robert Cohen(1) 100,000 100,000 $3.75 12/9/96 - 12/9/99 Dr. Alan Cohen(3) 100,000 100,000 $3.75 12/9/96 - 12/9/99 Jeff Cohen(3) 50,000 50,000 $3.75 12/9/96 - 12/9/99 Stefanie Rubin(2) 10,000 10,000 $3.75 12/9/96 - 12/9/99 Lenore Katz 10,000 10,000 $3.75 12/9/96 - 12/9/99 Allyson Cohen(4) 50,000 50,000 $3.75 12/9/96 - 12/9/99 Broadway Partners(5) 40,000 40,000 $3.75 12/9/96 - 12/9/99 Charles Stevens 9,375 9,375 $2.94 12/17/96 - 12/17/01 Peter Dion-Kindem(7) 3,125 3,125 $2.94 12/17/96 - 12/17/01 Stefanie Rubin(2) 16,666 16,666 $5.26 7/29/97 - 7/29/99 Lemone Katz 16,666 16,666 $5.26 7/29/97 - 7/29/99 Charles Shapiro 16,667 16,667 $5.26 7/29/97 - 7/29/99 Stefanie Rubin 55,000 55,000 $3.00 11/3/97 - 11/3/99
- ------------------------------ (1) Dr. Robert Cohen is a shareholder and director of Rapid Cast, Inc. (2) Stefanie Rubin is the wife of Jeff Rubin, who is a director of Rapid Cast, Inc. Stefanie Rubin is a shareholder of Rapid Cast, Inc. (3) Dr. Alan Cohen and Dr. Robert Cohen are brothers. (4) Jeff Cohen is the son of Dr. Robert Cohen. (5) Allyson Cohen is Dr. Robert Cohen's daughter. (6) Broadway Partners is a partnership composed of the children of Drs. Robert and Alan Cohen. (7) Mr. Dion-Kindem is legal counsel to Charles Stevens. These Underlying Shares are therefore being offered for resale by the Warrantholders if and when they exercise their Warrants and not pursuant to an initial issuance of stock by the Company. THE SERIES B PREFERRED HOLDERS. The selling security holders include a total of 14 individuals and entities which purchased a total of 2,434 shares of Series B Preferred, 1,834 of which were issued on July 29, 1997 and 600 of which were issued on November 3, 1997. The following table sets forth the name of each Series B Preferred holder, the number of shares of Series B Preferred owned by the holder, the amount of their investment, and the number of shares of the Company's Common Stock into which the Series B Preferred is convertible assuming that the average bid price of the Company's Common Stock for the five trading days immediately preceding the conversion date for each holder is at least 20% higher than the bid price on the date of the issuance of the Series B Preferred (i.e., the highest possible conversion price resulting in the minimum number of shares of Common Stock issuable upon the conversion of the Series B Preferred). If the average bid price prior to the conversion date is less than that amount, then more shares of the Company's Common Stock would be issued upon the conversion of the Series B Preferred, causing more dilution to the Company's Common Stockholders. See "RISK FACTORS - General Risks - Possible Adverse Effects of Issuance of Preferred Stock." -54-
Minimum Number of Number of Shares of Common Name of Series B Series B Preferred Amount of Stock Issuable Preferred Holder Shares Investment Upon Conversion - ----------------------------------------------------------------------------------------- Broadway Partners 200 $ 200,000 46,620 Ellen Cohen 100 $ 100,000 23,310 S&R Holdings 200 200,000 46,620 Gary Kaplowitz 450 450,000 104,895 Allen Rothstein 450 450,000 104,895 Stefanie Rubin(1) 134(4) 100,000 31,235 Dr. Robert Cohen(2) 200 200,000 46,620 Lenore Katz 100 100,000 23,310 Stefanie Rubin(1) 100 100,000 33,333 Dr. Alan Cohen(3) 100 100,000 33,333 Meryl Cohen 100 100,000 33,333 Jeffrey Cohen 100 100,000 33,333 Allyson Cohen 100 100,000 33,333 Ellen Cohen 100 100,000 33,333 ---------- ---------- ---------- TOTAL 2,434 $2,400,000 627,503 ---------- ---------- ---------- ---------- ---------- ----------
- ------------------------------ (1) Stefanie Rubin is the wife of Jeff Rubin. (2) Dr. Robert Cohen is a director and shareholder of Rapid Cast, Inc. (3) Dr. Alan Cohen is the brother of Dr. Robert Cohen. (4) Reflects 34 shares of referral consideration. THE HOLDERS OF OPTIONS TO PURCHASE SERIES B PREFERRED. The selling shareholders include the designee of a consultant who was issued options to purchase up to 450 additional shares of Series B Preferred in consideration for assisting the Company with the placement of the outstanding 2,434 shares of Series B Preferred. This Prospectus covers the Underlying Shares issuable upon the conversion of the 450 additional shares of Series B Preferred, if the option to acquire such Series B Preferred is exercised. The following table summarizes the options to purchase up to 450 additional shares of Series B Preferred:
Name of Option Number of Shares Total Purchase Price Exercise Conversion Holder of Series B Preferred of Series B Preferred Period Ratio(2) - -------------- --------------------- --------------------- -------------------- ---------- Stefanie Rubin 250 $ 250,000 7/29/97 - 11/3/98(1) 88% Stefanie Rubin 200 $ 200,000 11/3/97 - 11/3/98 80%
- -------------------------- (1) The exercise period is the one year period ending July 29, 1998 with respect to 125 of these shares and the one year period ending November 3, 1998 with respect to the other 125 of these shares of Series B Preferred. (2) The Conversion Ratio equals the percentage of the average closing bid price of the Company's Common Stock for the five trading days immediately preceding the conversion date, which is divided into the original investment amount plus the 6% per annum cumulative unpaid dividend to determine the number of shares of the Company's Common Stock issuable upon the conversion of the Series B Preferred. Accordingly, the number of shares of Common Stock issuable upon the conversion of these shares of Series B Preferred is not known at this time. See "THE COMPANY - Issuance of Convertible Preferred Stock - Series B Preferred." THE OUTSTANDING SHAREHOLDERS. The selling shareholders include (i) three investors who purchased 365 shares of Series A Preferred in September 1996 and converted them into a total of 150,826 shares of Common Stock on December 31, 1996, 140,000 of which were registered with the Securities and Exchange Commission on October 31, 1996, and the balance of which are covered by this Prospectus, and (ii) four investors who purchased 250 shares of Series A Preferred in October 1996 and converted them into a total of 126,925 shares on November 3, 1997. The selling shareholders also include two investors who purchased 30,000 shares of the Company's Common Stock for $3.03 per share in January 1997 in connection with the settlement agreement made between the Company and certain affiliates of Rapid Cast, Inc. See "THE COMPANY - Settlement with RCI Parties." The following table lists the selling security holders who are Outstanding Shareholders and the number of Outstanding Shares owned by them. -55- NAME OF OUTSTANDING SHAREHOLDER NUMBER OF SHARES ------------------------------- ---------------- Stefanie Rubin(1) 19,552 Dr. Robert Cohen(2) 25,000 Jack Gilbert(3) 8,927 Mark Richardson(4) 742 Charles Shapiro(5) 12,948 Leonard Wilstein(6) 51,791 David Wilstein(7) 51,791 - ------------------------------ (1) Stefanie Rubin is the wife of Jeff Rubin, who is a director of RCI. Ms. Rubin purchased 65 shares of Series A Preferred and converted them into 26,924 shares of the Company's Common Stock, 11,552 of which are covered by this Prospectus. Ms. Rubin also purchased 8,000 shares of the Company's Common Stock in January 1997 in a private placement for $3.03 per share, which are also covered by this Prospectus. See "THE COMPANY - Settlement with RCI Parties." (2) Dr. Robert Cohen is a director of RCI. These shares were purchased from the Company for a price of $3.03 per share in a private placement in January 1997. See "THE COMPANY - Settlement with RCI Parties." (3) Jack Gilbert purchased 300 shares of Series A Preferred and converted them into 123,967 shares of the Company's Common Stock, 8,927 of which are covered by this Prospectus. (4) Mark Richardson purchased 25 shares of Series A Preferred Stock and converted them into 10,331 shares of the Company's Common Stock, 742 of which are covered by this Prospectus. Mr. Richardson is corporate counsel to the Company. See "LEGAL MATTERS." (5) Charles Shapiro purchased 25 shares of Series A Preferred and converted them into 12,948 shares of the Company's Common Stock on November 3, 1997. (6) Leonard Wilstein purchased 100 shares of Series A Preferred and converted them into 51,791 shares of the Company's Common Stock on November 3, 1997. (7) David Wilstein is a director of the Company. Mr. Wilstein purchased 100 shares of Series A Preferred and converted them into 51,791 shares of the Company's Common Stock on November 3, 1997. See "PRINCIPAL STOCKHOLDERS." SHARES ELIGIBLE FOR FUTURE SALE As of November 26, 1997, the Company has approximately 3,707,200 shares of its Common Stock (not including the Shares or the Underlying Shares issuable upon the exercise of the Warrants or the Series B Preferred covered by this Prospectus, but including all other shares of the Company's Common Stock which can be acquired pursuant to the exercise of other vested outstanding warrants and options) issued and outstanding which may be deemed to be "restricted securities" as that term is defined in Rule 144 of the Securities Act. These restricted securities may be sold in the future in compliance with Rule 144 or Regulation S of the Securities Act. The Company can make no prediction as to the effect, if any, that sales of shares of Common Stock, or the availability of shares for future sale, will have on the market price of the Common Stock prevailing from time to time. Sales of substantial amounts of Common Stock (including shares issued upon the exercise of warrants or options) in the public market, or the perception that such sales could occur, could depress the prevailing market price for the Common Stock. Such sales may also make it more difficult for the Company to sell equity securities or equity-related securities in the future at a time and price which it deems appropriate. See "RISK FACTORS -General Risks - Dilution Caused by Future Sales of Shares." -56- LEGAL MATTERS The validity of the issuance of the shares of Common Stock covered by this Prospectus will be passed upon for the Company by Mark J. Richardson, Esq., counsel to the Company, 1299 Ocean Avenue, Suite 900, Santa Monica, California, 90401. In consideration for certain legal services, the Company has issued to Mr. Richardson options to purchase 50,000 shares of the Company's Common Stock, 30,000 of which are exercisable at a purchase price of $4.37 per share, and 20,000 of which are exercisable at a purchase price of $4.25 per share. The stock options are exercisable as follows: 15,000 at any time until April 5, 2001, 15,000 at any time until January 1, 2002, and 20,000 at any time until January 22, 2002. Mr. Richardson also purchased 25 shares of the Company's Series A 2% Convertible Preferred Stock for $25,000 in cash on the same terms and conditions as the other purchasers of the Preferred Stock. See "THE COMPANY - - Issuance of Convertible Preferred Stock." EXPERTS The financial statements of the Company, included and incorporated by reference from the Company's Annual Report (Form 10-K) for the years ended December 31, 1996, 1995 and 1994, have been audited by Stonefield Josephson, independent auditors, as set forth in their reports thereon and incorporated herein by reference. Such financial statements are incorporated herein by reference in reliance upon such reports given upon the authority of such firms as experts in accounting and auditing. -57- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NO DEALER, SALESMAN OR ANY OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRE-SENTATIONS NOT CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY UNDERWRITER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER OF ANY SECURITIES OTHER THAN THOSE TO WHICH IT RELATES OR AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, TO ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF. --------------- TABLE OF CONTENTS AVAILABLE INFORMATION 2 INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE 2 PROSPECTUS SUMMARY 4 RISK FACTORS 9 THE COMPANY 21 USE OF PROCEEDS 39 PRICE RANGE OF COMMON STOCK AND DIVIDENDS 39 CAPITALIZATION 40 DILUTION 41 SELECTED CONSOLIDATED FINANCIAL INFORMATION 41 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 43 PRINCIPAL STOCKHOLDERS 48 DESCRIPTION OF CAPITAL STOCK 50 SELLING SECURITY HOLDERS 53 SHARES ELIGIBLE FOR FUTURE SALE 56 LEGAL MATTERS 57 EXPERTS 57 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2,676,281 SHARES INCOMNET, INC. COMMON STOCK ---------------- PROSPECTUS DECEMBER 3, 1997 ---------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- -58- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 14. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION The following table sets forth the expenses (other than underwriting discounts and commissions) expected to be incurred in connection with the offering described in this Registration Statement. All amounts are estimated except the registration fees. Registration Fee $ 2,513.16 Printing Costs for Registration Statement, Prospectus and related documents $ 15,000.00 Accounting Fees and Expenses $ 20,000.00 Legal Fees and Expenses $ 50,000.00 Blue Sky Fees and Expenses $ 5,000.00 ----------- Total $ 92,513.16 ----------- ----------- ---------- ITEM 15. INDEMNIFICATION OF DIRECTORS AND OFFICERS. See "DESCRIPTION OF CAPITAL STOCK - Indemnification" in the Prospectus. ITEM 16. EXHIBITS. Exhibit No. Description - --- ----------- 3.1 The Articles of Incorporation, as amended, of Incomnet, Inc. (A) 3.2 The Bylaws of Incomnet, Inc. (A) 3.3 Certificate of Determination for Series A 2% Convertible Preferred Stock. (M) 3.4 Amendment to Bylaws of Incomnet, Inc., dated June 8, 1997.(R) 3.5 Amendment to Bylaws of Incomnet, Inc., dated August 13, 1997. 3.6 Amendment to Bylaws of Incomnet, Inc., dated November 5, 1997. 3.7 Certificate of Determination for Series B 6% Convertible Preferred Stock. 4.1 Warrant to Purchase 500,000 Shares of Incomnet, Inc., dated January 17, 1994. (C) 4.2 Warrant to Purchase 500,000 Shares of Incomnet, Inc., dated May 27, 1994. (D) 4.3 Form of Warrant to Purchase 986,667 Shares of Incomnet, Inc. (E) 4.4 Form of Warrant to Purchase 75,000 Shares of Incomnet, Inc. (I) 4.5 Form of Warrant to Purchase 510,000 Shares of RCI Common Stock with Registration Rights Agreement, dated April 19, 1996. (I) 4.6 Form of Warrant to Purchase RCI Common Stock, dated February 8, 1995. (I) 4.7 Form of Warrant to Purchase 360,000 Shares of Incomnet, Inc. (N) 4.8 Form of Warrant to Purchase 12,500 Shares of Incomnet, Inc. (N) II-1 5.1 Form of Legal Opinion and Consent of Mark J. Richardson, Esq. with respect to securities being registered. 10.1 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated February 14, 1994. (C) 10.2 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated May 10, 1994. (C) 10.3 Agreement and Plan of Exchange by and between Incomnet, Inc. and National Telephone Communications, Inc., dated May 12, 1994. (B) 10.4 Consulting Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated January 17, 1994. (C) 10.5 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated August 17, 1994. (C) 10.6 Carrier Switched Services Agreement with Wiltel, Inc., dated September 30, 1993. (B)(1) 10.7 Network Wats Enrollment Form with U.S. Sprint, dated April 7, 1993. (B) 10.8 Carrier Switched Services Agreement with Wiltel, Inc., dated November 15, 1994. (D)(1) 10.9 The Stock Purchase Agreement for the acquisition of RCI, dated January 18, 1995. (F) 10.10 The Stock Purchase Agreement for the acquisition of Q2100, dated October 29, 1994. (F) 10.11 Stock Pledge Agreement, dated February 8, 1995. (F) 10.12 Form of 8% Convertible Secured Promissory Note, dated February 8, 1995. (F) 10.13 Agreement for Promotion of Pagers between NTC and Page Prompt.(I) 10.14 Carrier Switched Services Agreement Wiltel, Inc, dated September 15, 1995. (I)(1) 10.15 Amendment to Stock Purchase Agreement Between Incomnet, Inc. and Rapid Cast, Inc., Dated June 15, 1995. (I) 10.16 Agreement for Promotion of Internet Access Services Between NTC and EarthLink Network. (I) 10.17 Severance Agreement Between Incomnet, Inc. and Sam D. Schwartz, dated November 30, 1995. (G) 10.18 Employment Agreement Between Incomnet, Inc. and Melvyn Reznick, dated November 30, 1995. (G) 10.19 Management Incentive Agreement, dated February 6, 1996, between Incomnet, Inc. and National Telephone Communications, Inc. (H) II-2 10.20 Settlement Agreements and Proposed Settlement Agreements With Prior Noteholders. (I) 10.21 Form of 8% Convertible Note Issued By RCI in January 1996. (I) 10.22 Form of Short-Term 10% Note Issued By RCI in April 1996. (I) 10.23 Amended Carrier Switched Services Agreement with Wiltel, Inc., dated June 17, 1996.(K)(1) 10.24 Settlement Agreement Between Joel Greenberg and Incomnet, Inc., dated as of May 9, 1996 and executed on June 6, 1996. (J) 10.25 Form of Registration Rights Agreement Between Incomnet, Inc. and Purchasers of Series A Convertible Preferred Stock.(K) 10.26 Form of Purchase Agreement for the Series A 2% Convertible Preferred Stock.(K) 10.27 Management Incentive Agreement With NTC, dated October 14, 1996.(M) 10.28 Settlement Agreements With Edward Jacobs and Jerry Ballah, dated November 14, 1996.(M) 10.29 Shareholders Agreement for Rapid Cast, Inc., dated January 16, 1997.(N) 10.30 Registration Rights Agreement for Rapid Cast, Inc., dated January 16, 1997.(N) 10.31 Amended and Restated Management Incentive Agreement Between NTC and Incomnet, Inc., dated January 28, 1997.(N) 10.32 Employment Agreement Between NTC and James R. Quandt, dated January 6, 1997.(N) 10.33 Settlement Agreement and Mutual Release Between Incomnet, Inc. and the RCI Parties, dated December 9, 1996.(N) 10.34 Stock Option and Convertible Debt Plans Adopted By National Telephone & Communications, Inc. (R) 10.35 Form of Stock Purchase Agreement for the acquisition of California Interactive Computing, Inc., dated May 2, 1997(O) 10.36 Amendment to Employment Agreement Between Incomnet, Inc. and Melvyn H. Reznick, dated June 8, 1997.(R) 10.37 Employment Agreement Between Incomnet, Inc. and Stephen A. Caswell, dated June 8, 1997.(R) 10.38 Employment Agreement Between NTC and Edward R. Jacobs, dated October 30, 1997.(Q) 13.1 The Annual Report on Form 10-K for the fiscal year ending December 31, 1996 for Incomnet, Inc. (P) 13.2 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996 for Incomnet, Inc., filed on May 23, 1997. (P) 13.3 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996, filed on July 9, 1997. (P) 13.4 The Quarterly Report on Form 10-Q for the fiscal quarter ending March 31, 1997 for Incomnet, Inc. (P) II-3 13.5 The Quarterly Report on Form 10-QA for the fiscal quarter ending March 31, 1997 for Incomnet, Inc., filed on July 9, 1997 (P) 13.6 The Quarterly Report on Form 10-Q for the fiscal quarter ending September 30, 1996 for Incomnet, Inc. (L) 13.7 The Quarterly Report on Form 10-QA for the fiscal quarter ending September 30, 1996 for Incomnet, Inc. (N) 13.8 The Quarterly Report on Form 10-Q for the fiscal quarter ending June 30, 1997 for Incomnet, Inc.(P) 13.9 The Quarterly Report on Form 10-Q for the fiscal quarter ending September 30, 1997 for Incomnet, Inc.(P) 13.10 The definitive Proxy Statement, dated November 17, 1997, for the 1997 Annual Meeting of the Shareholders of Incomnet, Inc.(P) 13.11 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996 for Incomnet, Inc., filed on December 5, 1997. 13.12 The Quarterly Report on Form 10-QA for the fiscal quarter ending March 31, 1997 for Incomnet, Inc., filed on December 5, 1997. 13.13 The Quarterly Report on Form 10-QA for the fiscal quarter ending June 30, 1997 for Incomnet, Inc., filed on December 5, 1997. 13.14 The Quarterly Report on Form 10-QA for the fiscal quarter ending September 30, 1997 for Incomnet, Inc., filed on December 5, 1997. II-4 16. Letter re Change in Certifying Accountant. (B) 21. Subsidiaries of the Registrant. (A) 23.1 Consent of Stonefield Josephson, independent Certified Public Accountants, relating to the financial statements. 23.2 Consent of Mark J. Richardson, Esq. is included in his opinion. 24. Power of Attorney is included on the signature page of this Registration Statement. - ------------------------- (1) Certain information has been deleted from this agreement pursuant to a request for confidential treatment under Rule 406. (A) Incorporated by reference from Incomnet, Inc.'s Annual Report on Form 10- K for the year ending December 31, 1994. (B) Incorporated by reference from Incomnet Inc.'s Registration Statement on Form S-4 filed with the Securities and Exchange Commission on May 12, 1994, and declared effective on October 27, 1994. (C) Incorporated by reference from the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on June 17, 1994 and declared effective on October 27, 1994. (D) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on December 12, 1994 and declared effective on December 22, 1994. (E) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on January 5, 1995 and declared effective on January 9, 1995. (F) Incorporated by reference from the Company's Report on Form 8-K, dated February 8, 1995, relating to the Company's acquisition of a controlling interest in RCI. (G) Incorporated by reference from the Company's Report on Form 8-K dated November 30, 1995, relating to the resignation of Sam D. Schwartz and employment of Melvyn Reznick. (H) Incorporated by reference from the Company's Report on Form 8-K, dated February 9, 1996, relating to the management incentive agreement between Incomnet and NTC. (I) Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996. (J) Incorporated by reference from the Company's Report on Form 8-K, dated June 7, 1996, relating to the settlement agreement with Joel W. Greenberg and his resignation as a director of the Company. II-5 (K) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. (L) Incorporated by reference from the filing of the Form 10-Q for the fiscal quarter ending September 30, 1996, as filed with the Securities and Exchange Commission on November 14, 1996. (M) Incorporated by reference from the original filing of this Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996. (N) Incorporated by reference from Amendment Number One to the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997. (O) Incorporated by reference from the Company's Report on Form 8-K, dated May 2, 1997, relating to the acquisition of California Interactive Computing, Inc. (P) Incorporated by reference from filings made under the Securities and Exchange Act of 1934, as amended. (Q) Incorporated by reference from the Company's filing of the Form 10-Q for the fiscal quarter ending September 30, 1997, as filed with the Securities and Exchange Commission on November 14, 1997. (R) Incorporated by reference from Amendment Number Two to the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on July 9, 1997. ITEM 17. UNDERTAKINGS. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the provision described in Item 15 above, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. RULE 430A UNDERTAKINGS. The undersigned registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of Prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of Prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act 1933 shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. RULE 415 UNDERTAKINGS. The undersigned registrant hereby undertakes: (1) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) To include any prospectus required by Section 10(a)(3) of the Securities Act of 1933; (ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement; II-6 (iii) To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement; PROVIDED, HOWEVER, that paragraphs (a)(1)(i) and (a)(1)(ii) do not apply if the information required to be included in a post- effective amendment by those paragraphs is contained in periodic reports filed by the registrant pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934 that are incorporated by reference in the registration statement; (2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof; and (3) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. The undersigned registrant hereby undertakes that, for purposes of determining any liability under the Securities Act of 1933, each filing of the registrant's annual report pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 (and, where applicable, each filing of an employee benefit plan's annual report pursuant to Section 15(d) of the Securities Exchange Act of 1934) that is incorporated by reference in the registration statement shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets the requirements for filing on Form S-3 and has duly caused this Registration Statement to be signed on its behalf by the undersigned, the President of the Registrant duly thereunto authorized, in the City of Woodland Hills, State of California, on the 3rd day of December, 1997. INCOMNET, INC. Registrant By:/s/ Melvyn Reznick ---------------------------------------- Melvyn Reznick, President and Chief Executive Officer II-7 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Mark J. Richardson his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Registration Statement, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might do in person, hereby ratifying and confirming all that said attorneys-in- fact and agents of each of them, or their or his substitutes, may lawfully do or cause to be done by virtue thereof. Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed below on the 3rd day of December, 1997, by the following persons in the capacities indicated. Signatures Title - ---------- ----- /s/ Melvyn Reznick President, Chief Executive - ------------------------------ Officer and Director Melvyn Reznick (Chief Executive Officer and Principal Financial Officer) /s/ Stephen A. Caswell Vice President of Information Systems, - ------------------------------ Secretary (Principal Accounting Officer) Stephen A. Caswell /s/ Albert Milstein Director - ------------------------------ Albert Milstein /s/ Nancy Zivitz Director - ------------------------------ Nancy Zivitz /s/ Howard Silverman Director - ------------------------------ Howard Silverman /s/ David Wilstein Director - ------------------------------ David Wilstein /s/ Richard Horowitz Director - ------------------------------ Richard Horowitz /s/ Stanley Weinstein Director - ------------------------------ Stanley Weinstein II-8 INDEX TO THE EXHIBIT VOLUME TO REGISTRATION STATEMENT ON FORM S-3 Exhibit No. Description - ------- ----------- 3.1 The Articles of Incorporation, as amended, of Incomnet, Inc. (A) 3.2 The Bylaws of Incomnet, Inc. (A) 3.3 Certificate of Determination for Series A 2% Convertible Preferred Stock. (M) 3.4 Amendment to Bylaws of Incomnet, Inc., dated June 8, 1997. (R) 3.5 Amendment to Bylaws of Incomnet, Inc., dated August 13, 1997. 3.6 Amendment to Bylaws of Incomnet, Inc., dated November 5, 1997. 3.7 Certificate of Determination for Series B 6% Convertible Preferred Stock. 4.1 Warrant to Purchase 500,000 Shares of Incomnet, Inc., dated January 17, 1994. (C) 4.2 Warrant to Purchase 500,000 Shares of Incomnet, Inc., dated May 27, 1994. (D) 4.3 Form of Warrant to Purchase 986,667 Shares of Incomnet, Inc. (E) 4.4 Form of Warrant to Purchase 75,000 Shares of Incomnet, Inc. (I) 4.5 Form of Warrant to Purchase 510,000 Shares of RCI Common Stock with Registration Rights Agreement, dated April 19, 1996. (I) 4.6 Form of Warrant to Purchase RCI Common Stock, dated February 8, 1995. (I) 4.7 Form of Warrant to Purchase 360,000 Shares of Incomnet, Inc. (N) 4.8 Form of Warrant to Purchase 12,500 Shares of Incomnet, Inc. (N) 5.1 Form of Legal Opinion and Consent of Mark J. Richardson, Esq. with respect to securities being registered. 10.1 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated February 14, 1994. (C) 10.2 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated May 10, 1994. (C) 10.3 Agreement and Plan of Exchange by and between Incomnet, Inc. and National Telephone Communications, Inc., dated May 12, 1994. (B) 10.4 Consulting Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated January 17, 1994. (C) 10.5 Agreement by and between Broad Capital Associates, Inc. and Incomnet, Inc., dated August 17, 1994. (C) 10.6 Carrier Switched Services Agreement with Wiltel, Inc., dated September 30, 1993. (B)(1) 10.7 Network Wats Enrollment Form with U.S. Sprint, dated April 7, 1993. (B) 10.8 Carrier Switched Services Agreement with Wiltel, Inc., dated November 15, 1994. (D)(1) 10.9 The Stock Purchase Agreement for the acquisition of RCI, dated January 18, 1995. (F) 10.10 The Stock Purchase Agreement for the acquisition of Q2100, dated October 29, 1994. (F) 10.11 Stock Pledge Agreement, dated February 8, 1995. (F) 10.12 Form of 8% Convertible Secured Promissory Note, dated February 8, 1995. (F) 10.13 Agreement for Promotion of Pagers between NTC and Page Prompt.(I) 10.14 Carrier Switched Services Agreement Wiltel, Inc, dated September 15, 1995. (I)(1) 10.15 Amendment to Stock Purchase Agreement Between Incomnet, Inc. and Rapid Cast, Inc., Dated June 15, 1995. (I) 10.16 Agreement for Promotion of Internet Access Services Between NTC and EarthLink Network. (I) 10.17 Severance Agreement Between Incomnet, Inc. and Sam D. Schwartz, dated November 30, 1995. (G) 10.18 Employment Agreement Between Incomnet, Inc. and Melvyn Reznick, dated November 30, 1995. (G) 10.19 Management Incentive Agreement, dated February 6, 1996, between Incomnet, Inc. and National Telephone Communications, Inc. (H) 10.20 Settlement Agreements and Proposed Settlement Agreements With Prior Noteholders. (I) 10.21 Form of 8% Convertible Note Issued By RCI in January 1996. (I) 10.22 Form of Short-Term 10% Note Issued By RCI in April 1996. (I) 10.23 Amended Carrier Switched Services Agreement with Wiltel, Inc., dated June 17, 1996. (K)(1) 10.24 Settlement Agreement Between Joel Greenberg and Incomnet, Inc., dated as of May 9, 1996 and executed on June 6, 1996. (J) 10.25 Form of Registration Rights Agreement Between Incomnet, Inc. and Purchasers of Series A Convertible Preferred Stock. (K) 10.26 Form of Purchase Agreement for the Series A 2% Convertible Preferred Stock. (K) 10.27 Management Incentive Agreement With NTC, dated October 14, 1996. (M) 10.28 Settlement Agreements With Edward Jacobs and Jerry Ballah, dated November 14, 1996. (M) 10.29 Shareholders Agreement for Rapid Cast, Inc., dated January 16, 1997. (N) 10.30 Registration Rights Agreement for Rapid Cast, Inc., dated January 16, 1997. (N) 10.31 Amended and Restated Management Incentive Agreement Between NTC and Incomnet, Inc., dated January 28, 1997. (N) 10.32 Employment Agreement Between NTC and James R. Quandt, dated January 6, 1997. (N) 10.33 Settlement Agreement and Mutual Release Between Incomnet, Inc. and the RCI Parties, dated December 9, 1996. (N) 10.34 Stock Option and Convertible Debt Plans Adopted By National Telephone & Communications, Inc. (R) 10.35 Form of Stock Purchase Agreement for the acquisition of California Interactive Computing, Inc., dated May 2, 1997. (O) 10.36 Amendment to Employment Agreement Between Incomnet, Inc. and Melvyn H. Reznick, dated June 8, 1997. (R) 10.37 Employment Agreement Between Incomnet, Inc. and Stephen A. Caswell, dated June 8, 1997. (R) 10.38 Employment Agreement Between NTC and Edward R. Jacobs, dated October 30, 1997. (Q) 13.1 The Annual Report on Form 10-K for the fiscal year ending December 31, 1996 for Incomnet, Inc. (P) 13.2 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996 for Incomnet, Inc., filed on May 23, 1997. (P) 13.3 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996, filed on July 9, 1997. (P) 13.4 The Quarterly Report on Form 10-Q for the fiscal quarter ending March 31, 1997 for Incomnet, Inc. (P) 13.5 The Quarterly Report on Form 10-QA for the fiscal quarter ending March 31, 1997 for Incomnet, Inc., filed on July 9, 1997. (P) 13.6 The Quarterly Report on Form 10-Q for the fiscal quarter ending September 30, 1996 for Incomnet, Inc. (L) 13.7 The Quarterly Report on Form 10-QA for the fiscal quarter ending September 30, 1996 for Incomnet, Inc. (N) 13.8 The Quarterly Report on Form 10-Q for the fiscal quarter ending June 30, 1997 for Incomnet, Inc. (P) 13.9 The Quarterly Report on Form 10-Q for the fiscal quarter ending September 30, 1997 for Incomnet, Inc. (P) 13.10 The definitive Proxy Statement, dated November 17, 1997, for the 1997 Annual Meeting of the Shareholders of Incomnet, Inc. (P) 13.11 The Annual Report on Form 10-KA for the fiscal year ending December 31, 1996 for Incomnet, Inc., filed on December 5, 1997. 13.12 The Quarterly Report on Form 10-QA for the fiscal quarter ending March 31, 1997 for Incomnet, Inc., filed on December 5, 1997. 13.13 The Quarterly Report on Form 10-QA for the fiscal quarter ending June 30, 1997 for Incomnet, Inc., filed on December 5, 1997. 13.14 The Quarterly Report on Form 10-QA for the fiscal quarter ending September 30, 1997 for Incomnet, Inc., filed on December 5, 1997. 16. Letter re Change in Certifying Accountant. (B) 21. Subsidiaries of the Registrant. (A) 23.1 Consent of Stonefield Josephson, independent Certified Public Accountants, relating to the financial statements. 23.2 Consent of Mark J. Richardson, Esq. is included in his opinion. 24. Power of Attorney is included on the signature page of this Registration Statement. - ------------------------- (1) Certain information has been deleted from this agreement pursuant to a request for confidential treatment under Rule 406. (A) Incorporated by reference from Incomnet, Inc.'s Annual Report on Form 10-K for the year ending December 31, 1994. (B) Incorporated by reference from Incomnet Inc.'s Registration Statement on Form S-4 filed with the Securities and Exchange Commission on May 12, 1994, and declared effective on October 27, 1994. (C) Incorporated by reference from the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on June 17, 1994 and declared effective on October 27, 1994. (D) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on December 12, 1994 and declared effective on December 22, 1994. (E) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on January 5, 1995 and declared effective on January 9, 1995. (F) Incorporated by reference from the Company's Report on Form 8-K, dated February 8, 1995, relating to the Company's acquisition of a controlling interest in RCI. (G) Incorporated by reference from the Company's Report on Form 8-K dated November 30, 1995, relating to the resignation of Sam D. Schwartz and employment of Melvyn Reznick. (H) Incorporated by reference from the Company's Report on Form 8-K, dated February 9, 1996, relating to the management incentive agreement between Incomnet and NTC. (I) Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996. (J) Incorporated by reference from the Company's Report on Form 8-K, dated June 7, 1996, relating to the settlement agreement with Joel W. Greenberg and his resignation as a director of the Company. (K) Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. (L) Incorporated by reference from the filing of the Form 10-Q for the fiscal quarter ending September 30, 1996, as filed with the Securities and Exchange Commission on November 14, 1996. (M) Incorporated by reference from the original filing of this Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996. (N) Incorporated by reference from Amendment Number One to the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997. (O) Incorporated by reference from the Company's Report on Form 8-K, dated May 2, 1997, relating to the acquisition of California Interactive Computing, Inc. (P) Incorporated by reference from filings made under the Securities and Exchange Act of 1934, as amended. (Q) Incorporated by reference from the Company's filing of the Form 10-Q for the fiscal quarter ending September 30, 1997, as filed with the Securities and Exchange Commission on November 14, 1997. (R) Incorporated by reference from Amendment Number Two to the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on July 9, 1997. EX-3.5 2 EXHIBIT 3.5 EXHIBIT 3.5 - AMENDMENT TO THE BYLAWS OF INCOMNET, INC., DATED AUGUST 13, 1997 On August 13, 1997, the Board of Directors of the Company adopted an amendment to Article III. Section 2 of the Company's Bylaws providing that the fixed number of directors of the Company will be seven (7) members, rather than six (6) members, within a range of permitted directors numbering a minimum of five (5) and a maximum of nine (9). The amended Article II. Section 2 of the Bylaws now reads as follows: Section 2. NUMBER OF DIRECTORS. The number of directors of the corporation shall not be less than five (5) nor more than nine (9). The exact number of directors shall be seven (7) until changed, within the limits specified above, by a Bylaw amending this Section 2, duly adopted by the Board of Directors or by the shareholders. Such indefinite number of directors may be changed, or a definite number fixed without provision for an indefinite number, by a duly adopted amendment to the Articles of Incorporation or by an amendment to this bylaw duly adopted by the vote or written consent of holders of a majority of the outstanding shares entitled to vote; provided, however, that an amendment reducing the number or the minimum number of directors to a number less than five cannot be adopted if the votes cast against its adoption at a meeting of the shareholders, or the shares not consenting in the case of action by written consent, are equal to more than 16-2/3% of the outstanding shares entitled to vote. No amendment may change the stated maximum number of authorized directors to number greater than two times the stated minimum number of directors minus one. EX-3.6 3 EXHIBIT 3.6 EXHIBIT 3.6 - AMENDMENT TO THE BYLAWS OF INCOMNET, INC., DATED NOVEMBER 5, 1997 On November 5, 1997, the Board of Directors of the Company adopted an amendment to Article III. Section 10 of the Company's Bylaws providing that all formal resolutions, acts or decisions of the Board must be approved by a majority vote, plus one additional vote, of the directors present at a meeting duly held at which a quorum is present. Article III. Section 10 of the Bylaws now states as follows: Section 10. QUORUM. A majority of the authorized number of directors shall constitute a quorum for the transaction of business, except to adjourn as hereinafter provided. Every act or decision done or made by a majority vote, plus one additional vote, of the directors present at a meeting duly held at which a quorum is present shall be regarded as the act of the Board of Directors, subject to the provisions of Section 310 of the Corporations Code of California (approval of contracts or transactions in which a director has a direct or indirect material financial interest), Section 311 (appointment of committees), and Section 317(e) (indemnification or directors). A meeting at which a quorum is initially present may continue to transact business notwithstanding the withdrawal of directors, if any action taken is approved by at least a majority vote, plus one additional vote, of the required quorum for such meeting. EX-3.7 4 EXHIBIT 3.7 EXHIBIT 3.7 -- CERTIFICATE OF DETERMINATION OF CONVERTIBLE SERIES B PREFERRED STOCK OF INCOMNET, INC., DATED JULY 29, 1997 The undersigned, Melvyn Reznick and Stephen Caswell, hereby certify that: I. They are the duly elected and acting President and Secretary, respectively, of Incomnet, Inc., a California corporation (the "Company"). II. The Articles of Incorporation of the Company authorizes 100,000 shares of preferred stock, no par value per share. The number of shares of Convertible Series A Preferred Stock authorized is 4,000, of which 2,075 are issued and outstanding. The number of shares of Convertible Series B Preferred Stock authorized herein is 2,900, none of which have been issued. III. The following is a true and correct copy of resolutions duly adopted by the Board of Directors at a meeting duly held on Thursday, July 13, 1997, which constituted all requisite action on the part of the Company for adoption of such resolutions. RESOLUTIONS WHEREAS, the Board of Directors of the Company (the "Board of Directors") is authorized to provide for the issuance of the shares of Preferred Stock in series, and by filing a certificate pursuant to the applicable law of the State of California, to establish from time to time the number of shares to be included in each such series, and to fix the designations, powers, preferences and rights of the shares of each such series and the qualifications, limitations or restrictions thereof. WHEREAS, the Board of Directors desires, pursuant to its authority as aforesaid, to designate a new series of preferred stock, set the number of shares constituting such series and fix the rights, preferences, privileges and restrictions of such series. NOW, THEREFORE, BE IT RESOLVED, that the Board of Directors hereby designates a new series of preferred stock and the number of shares constituting such series, and fixes the rights, preferences, privileges and restrictions relating to such series as follows: Section 1. DESIGNATION, AMOUNT AND PAR VALUE. The series of Preferred Stock shall be designated as the Convertible Series B Preferred Stock (the "Preferred Stock"), and the number of shares so designated shall be 2,900. The par value of each share of Preferred Stock shall be no par value. Each share of Preferred Stock shall have a stated value of $1,000.00 per share (the "Stated Value"). Section 2. DIVIDENDS. (a) Holders of Preferred Stock shall be entitled to receive, when and as declared by the Board of Directors out of funds legally available therefor, and the Company shall pay, cumulative dividends at the rate per share (as a percentage of the Stated Value per share) equal to 6% per annum, payable in cash or shares of Common Stock, in arrears on the Conversion Date (as hereinafter defined). Dividends on the Preferred Stock shall accrue daily commencing on the Original Issue Date (as defined in Section 6) and shall be deemed to accrue on such date whether or not earned or declared and whether or not there are profits, surplus or other funds of the Company legally available for the payment of dividends. The party that holds the Preferred Stock on an applicable record date for any dividend payment will be entitled to receive such dividend payment and any other accrued and unpaid dividends which accrued prior to such dividend payment date, without regard to any sale or disposition of such Preferred Stock subsequent to the applicable record date but prior to the applicable dividend payment date. Except as otherwise provided herein, if at any time the Company pays less than the total amount of dividends then accrued to any class of Preferred Stock, such payment shall be distributed ratably among the holders of such class based upon the number of shares held by each holder. No dividends may be declared or paid on the Convertible Series B Preferred Stock until all cumulative unpaid dividends have been declared and paid on the outstanding Convertible Series A Preferred Stock. (b) So long as any Preferred Stock shall remain outstanding, neither the Company nor any subsidiary thereof shall redeem, purchase or otherwise acquire directly or indirectly any Junior Securities (as defined in Section 6), except the redemption of shares in payment of short swing profits payable to the Company pursuant to Section 16(b) of the Securities Exchange Act of 1934, as amended, nor shall the Company directly or indirectly pay or declare any cash dividend or make any cash distribution (other than a dividend or distribution described in Section 4) upon, nor shall any cash distribution be made in respect of, any Junior Securities, nor shall any monies be set aside for or applied to the purchase or redemption (through a sinking fund or otherwise) of any Junior Securities, except as described above, unless all dividends on the Preferred Stock for all past dividend periods shall have been paid. Section 3. VOTING RIGHTS. Except as otherwise provided herein and as otherwise provided by law, the Preferred Stock shall have no voting rights. However, so long as any shares of Preferred Stock are outstanding, the Company shall not, without the affirmative vote of the holders of a majority of the shares of the Preferred Stock then outstanding, (i) alter or change adversely the powers, preferences or rights given to the Preferred Stock or (ii) authorize or create any class of stock ranking as to dividends or distribution of assets upon a Liquidation (as defined below) senior to, prior to or PARI PASSU with the Preferred Stock. Section 4. LIQUIDATION. Upon any liquidation, dissolution or winding-up of the Company, whether voluntary or involuntary (a "Liquidation"), the holders of shares of Preferred Stock shall be entitled to receive out of the assets of the Company, whether such assets are capital or surplus, for each share of Preferred Stock an amount equal to the Stated Value, plus an amount equal to accrued but unpaid dividends per share, whether declared or not, but without interest, before any distribution or payment shall be made to the holders of any Junior Securities, and if the assets of the Company shall be insufficient to pay in full such amounts, then the entire assets to be distributed shall be distributed among the holders of Preferred Stock ratably in accordance with the respective amounts that would be payable on such shares if all amounts payable thereon were paid in full. A sale, conveyance or disposition of all or substantially all of the assets of the Company or the effectuation by the Company of a transaction or series of related transactions in which more than 50% of the voting power of the Company is disposed of shall be deemed a Liquidation; PROVIDED that, a consolidation or merger of the Company with or into any other company or companies shall not be treated as a Liquidation, but instead shall be subject to the provisions of Section 5. The Company shall mail written notice of any such Liquidation, not less than 60 days prior to the payment date stated therein, to each record holder of Preferred Stock. No liquidation preference may be paid to the holders of the Convertible Series B Preferred Stock until the full liquidation preference has been paid to the holders of the outstanding Convertible Series A Preferred Stock. Section 5. CONVERSION. (a) Each share of Preferred Stock shall be convertible into shares of Common Stock, at the Conversion Ratio as defined in Section 6 hereof, at the option of the holder in whole or in part at any time after the expiration of the earlier to occur of (i) 120 days after the Original Issue Date or (ii) 60 days after the date that the Securities and Exchange Commission (the "Commission") declares effective under the Securities Act of 1933, as amended (the "Securities Act"), a registration statement (the "Registration Statement") covering the shares of Common Stock into which the Preferred Stock is convertible in accordance with the terms hereof. The holder shall effect conversions by surrendering the certificate or certificates representing the shares of Preferred Stock to be converted to the Company, together with a conversion notice (the "Holder Conversion Notice") in the manner set forth in Section 5(j) hereof. Each Holder Conversion Notice shall specify the number of shares of Preferred Stock to be converted and the date on which such conversion is to be effected, which date may not be prior to the date the Holder delivers such Notice by facsimile (the "Holder Conversion Date"). Each Holder Conversion Notice, once given, shall be irrevocable. If the holder is converting less than all shares of Preferred Stock represented by the certificate or certificates tendered by the holder with the Holder Conversion Notice, the Company shall promptly deliver to the holder a certificate for such number of shares as have not been converted. (b) Provided that ten (10) Trading Days (as defined in Section 6) shall have elapsed from the date the Commission declared the Registration Statement effective under the Securities Act, each share of the Preferred Stock shall automatically convert into shares of Common Stock at the Conversion Ratio after the expiration of one year after the Original Issue Date. Upon the conversion of shares of Preferred Stock pursuant Section 5(b) herein, the holders of the Preferred Stock shall surrender the certificates representing such shares at the office of the Company or of any transfer agent for the Preferred Stock or Common Stock. The date on which an automatic conversion occurs pursuant to Section 5(b) herein is referred to herein as the "Automatic Conversion Date." Each of a "Holder Conversion Date" and an "Automatic Conversion Date" is sometimes referred to herein as a "Conversion Date." (c) (i) If the average of the Per Share Market Value (as defined in Section 6) for the five (5) Trading Days immediately preceding the date that the Company receives any Holder Conversion Notice is less than $2.00, then the Company shall have the right, exercisable by notice to the tendering Holder by the close of business on the Business Day following the Company's receipt of such Conversion Notice, to redeem the Preferred Stock tendered for conversion pursuant to such Holder Conversion Notice at a price equal to the product of (i) the average of the Per Share Market Value for the five (5) Trading Days immediately preceding the Conversion Date, (ii) the number of shares of Preferred Stock which would then be converted but for this section, and (iii) the Conversion Ratio. Such redemption price will be paid by the Company within ten (10) Business Days of its receipt of such Holder Conversion Notice. If the Company fails for any reason to pay such redemption price within such period, the Company shall effect the conversion of Preferred Shares subject to such Holder Conversion Notice at the lesser of the Conversion Price measured on the Conversion Date indicated in the Holder Conversion Notice and the Conversion Price measured at the end of such ten (10) Business Day period. The Holder shall have the right, exercisable at any time when the Per Share Market Value is such that the Company would have the right of redemption contemplated in this section were it to receive a Holder Conversion Notice, to deliver to the Company (by facsimile) a letter inquiring whether the Company would exercise such redemption right if it received a Holder Conversion Notice within five (5) calendar days of its receipt of such letter, which such inquiry letter shall set forth the number of shares that would be subject to such Holder Conversion Notice. The Company shall respond to the inquiry letter (by facsimile) by the close of business on the Business Day after which it is received, which response shall be binding upon it with respect to the Conversion Notice that is subject to such inquiry letter. The Company shall be deemed to have waived its redemption right if it fails for any reason to respond by facsimile to the Holder delivering such inquiry letter by the close of business on the Business Day after its receipt of the inquiry letter. (ii) Not later than three (3) Trading Days after the Conversion Date, the Company will deliver to the holder (i) a certificate or certificates which shall be free of restrictive legends and trading restrictions (other than those then required by law and as set forth in the Purchase Agreement), representing the number of shares of Common Stock being acquired upon the conversion of shares of Preferred Stock and (ii) one or more certificates representing the number of shares of Preferred Stock not converted; provided, however that the Company shall not be obligated to issue certificates evidencing the shares of Common Stock issuable upon conversion of any shares of Preferred Stock until certificates evidencing such shares of Preferred Stock are either delivered for conversion to the Company or any transfer agent for the Preferred Stock or Common Stock, or the holder notifies the Company that such certificates have been lost, stolen or destroyed and provides a bond (or other adequate security reasonably acceptable to the Company) satisfactory to the Company to indemnify the Company from any loss incurred by it in connection therewith. The Company shall, upon request of the holder, use its best efforts to deliver any certificate or certificates required to be delivered by the Company under this Section 5(c) electronically through the Depository Trust Corporation or another established clearing corporation performing similar functions. In the case of a conversion pursuant to a Holder Conversion Notice, if such certificate or certificates are not delivered by the date required under this Section 5(c), the holder shall be entitled by written notice to the Company at any time on or before such holder's receipt of such certificate or certificates thereafter, to rescind such conversion, in which event the Company shall immediately return the certificates representing the shares of Preferred Stock tendered for conversion. (d) (i) The conversion price for each share of Preferred Stock (the "Conversion Price") in effect on any Conversion Date shall be the LESSER of X OR Y; where X is the GREATER of (a) [$(BID PRICE AT FUNDING) ] or (b) [ C ] / [ ( { C / F } + 1.50 ) / 2 ] where C = the average Per Share Market Value for the five (5) Trading Days immediately preceding the Conversion Date and F = the Per Share Market Value on the Trading Day immediately preceding the Original Issue Date; and Y = 80% of the average Per Share Market Value for the five (5) Trading Days immediately preceding the Conversion Date; provided, however, if the Registration Statement is not declared effective by the Commission for any reason by the Effective Date (as defined in the Registration Rights Agreement between the Company and the holder pursuant to which the Registration Statement is being prepared and filed), then for each of the first three months after such Effective Date that such registration statement shall not have been so declared effective, clause (a) and (b) above shall be decreased by 3% (i.e., a reduction of 3% at the end of the first such month and 6% at the end of the second such month). (ii) If the Company, at any time while any shares of Preferred Stock are outstanding, (a) shall pay a stock dividend or otherwise make a distribution or distributions on shares of its Junior Securities payable in shares of its capital stock (whether payable in shares of its Common Stock or of capital stock of any class), (b) subdivide outstanding shares of Common Stock into a larger number of shares, (c) combine outstanding shares of Common Stock into a smaller number of shares, or (d) issue by reclassification of shares of Common Stock any shares of capital stock of the Company, the Conversion Price designated in Section 5(d)(i) shall be multiplied by a fraction of which the numerator shall be the number of shares of Common Stock outstanding before such event and of which the denominator shall be the number of shares of Common Stock outstanding after such event. Any adjustment made pursuant to this Section 5(d)(ii) shall become effective immediately after the record date for the determination of stockholders entitled to receive such dividend or distribution and shall become effective immediately after the effective date in the case of a subdivision, combination or re-classification. (iii) If the Company, at any time while any shares of Preferred Stock are outstanding, shall issue rights or warrants to all holders of Common Stock entitling them to subscribe for or purchase shares of Common Stock at a price per share less than the Per Share Market Value of Common Stock at the record date mentioned below, the Conversion Price designated in Section 5(d)(i) shall be multiplied by a fraction, of which the denominator shall be the number of shares of Common Stock (excluding treasury shares, if any) outstanding on the date of issuance of such rights or warrants plus the number of additional shares of Common Stock offered for subscription or purchase, and of which the numerator shall be the number of shares of Common Stock (excluding treasury shares, if any) outstanding on the date of issuance of such rights or warrants plus the number of shares which the aggregate offering price of the total number of shares so offered would purchase at such Per Share Market Value. Such adjustment shall be made whenever such rights or warrants are issued, and shall become effective immediately after the record date for the determination of stockholders entitled to receive such rights or warrants. However, upon the expiration of any right or warrant to purchase Common Stock the issuance of which resulted in an adjustment in the Conversion Price designated in Section 5(d)(i) pursuant to this Section 5(d)(iii), if any such right or warrant shall expire and shall not have been exercised, the Conversion Price designated in Section 5(d)(i) shall immediately upon such expiration be recomputed and effective immediately upon such expiration be increased to the price which it would have been (but reflecting any other adjustments in the Conversion Price made pursuant to the provisions of this Section 5 after the issuance of such rights or warrants) had the adjustment of the Conversion Price made upon the issuance of such rights or warrants been made on the basis of offering for subscription or purchase only that number of shares of Common Stock actually purchased upon the exercise of such rights or warrants actually exercised. (iv) If the Company, at any time while shares of Preferred Stock are outstanding, shall distribute to all holders of Common Stock (and not to holders of Preferred Stock) evidences of its indebtedness or assets or rights or warrants to subscribe for or purchase any security (excluding those referred to in Section 5(d)(iii) above) then in each such case the Conversion Price at which each share of Preferred Stock shall thereafter be convertible shall be determined by multiplying the Conversion Price in effect immediately prior to the record date fixed for determination of stockholders entitled to receive such distribution by a fraction of which the denominator shall be the Per Share Market Value of Common Stock determined as of the record date mentioned above, and of which the numerator shall be such Per Share Market Value of the Common Stock on such record date less the then fair market value at such record date of the portion of such assets or evidence of indebtedness so distributed applicable to one outstanding share of Common Stock as determined by the Board of Directors in good faith; provided, however that in the event of a distribution exceeding ten percent (10%) of the net assets of the Company, such fair market value shall be determined by a nationally recognized or major regional investment banking firm or firm of independent certified public accountants of recognized standing (which may be the firm that regularly examines the financial statements of the Company) (an "Appraiser") selected in good faith by the holders of a majority in interest of the shares of Preferred Stock; and provided, further that the Company, after receipt of the determination by such Appraiser shall have the right to select an additional Appraiser, in which case the fair market value shall be equal to the average of the determinations by each such Appraiser. In either case the adjustments shall be described in a statement provided to all holders of Preferred Stock of the portion of assets or evidences of indebtedness so distributed or such subscription rights applicable to one share of Common Stock. Such adjustment shall be made whenever any such distribution is made and shall become effective immediately after the record date mentioned above. (v) All calculations under this Section 5 shall be made to the nearest cent or the nearest 1/100th of a share, as the case may be. (vi) Whenever the Conversion Price is adjusted pursuant to Section 5(d)(ii),(iii), (iv) or (v), the Company shall promptly mail to each holder of Preferred Stock, a notice setting forth the Conversion Price after such adjustment and setting forth a brief statement of the facts requiring such adjustment. (vii) In case of any reclassification of the Common Stock, any consolidation or merger of the Company with or into another person, the sale or transfer of all or substantially all of the assets of the Company or any compulsory share exchange pursuant to which the Common Stock is converted into other securities, cash or property, the holders of the Preferred Stock then outstanding shall have the right thereafter to convert such shares only into the shares of stock and other securities and property receivable upon or deemed to be held by holders of Common Stock following such reclassification, consolidation, merger, sale, transfer or share exchange, and the holders of the Preferred Stock shall be entitled upon such event to receive such amount of securities or property as the shares of the Common Stock of the Company into which such shares of Preferred Stock could have been converted immediately prior to such reclassification, consolidation, merger, sale, transfer or share exchange would have been entitled. The terms of any such consolidation, merger, sale, transfer or share exchange shall include such terms so as to continue to give to the holder of Preferred Stock the right to receive the securities or property set forth in this Section 5(d)(vii) upon any conversion following such consolidation, merger, sale, transfer or share exchange. This provision shall similarly apply to successive reclassifications, consolidations, mergers, sales, transfers or share exchanges. (viii) If: (a) the Company shall declare a dividend (or any other distribution) on its Common Stock; or (b) the Company shall declare a special nonrecurring cash dividend on or a redemption of its Common Stock; or (c) the Company shall authorize the granting to all holders of the Common Stock rights or warrants to subscribe for or purchase any shares of capital stock of any class or of any rights; or (d) the approval of any stockholders of the Company shall be required in connection with any reclassification of the Common Stock of the Company (other than a subdivision or combination of the outstanding shares of Common Stock), any consolidation or merger to which the Company is a party, any sale or transfer of all or substantially all of the assets of the Company, or any compulsory share exchange whereby the Common Stock is converted into other securities, cash or property; or (e) the Company shall authorize the voluntary or involuntary dissolution, liquidation or winding-up of the affairs of Company; then the Company shall cause to be filed at each office or agency maintained for the purpose of conversion of Preferred Stock, and shall cause to be mailed to the holders of Preferred Stock at their last addresses as they shall appear upon the stock books of the Company, at least 30 calendar days prior to the applicable record or effective date hereinafter specified, a notice stating (x) the date on which a record is to be taken for the purpose of such dividend, distribution, redemption, rights or warrants, or if a record is not to be taken, the date as of which the holders of Common Stock of record to be entitled to such dividend, distributions, redemption, rights or warrants are to be determined, or (y) the date on which such reclassification, consolidation, merger, sale, transfer, share exchange, dissolution, liquidation or winding-up is expected to become effective, and the date as of which it is expected that holders of Common Stock of record shall be entitled to exchange their shares of Common Stock for securities or other property deliverable upon such reclassification, consolidation, merger, sale, transfer, share exchange, dissolution, liquidation or winding-up; provided, however, that the failure to mail such notice or any defect therein or in the mailing thereof shall not affect the validity of the corporate action required to be specified in such notice. (e) If at any time conditions shall arise by reason of action taken by the Company which in the opinion of the Board of Directors are not adequately covered by the other provisions hereof and which might materially and adversely affect the rights of the holders of Preferred Stock (different than or distinguished from the effect generally on rights of holders of any class of the Company's capital stock) or if at any time any such conditions are expected to arise by reason of any action contemplated by the Company, the Company shall mail a written notice briefly describing the action contemplated and the material adverse effects of such action on the rights of the holders of Preferred Stock at least 30 calendar days prior to the effective date of such action, and an Appraiser selected by the holders of majority in interest of the Preferred Stock shall give its opinion as to the adjustment, if any (not inconsistent with the standards established in this Section 5), of the Conversion Price (including, if necessary, any adjustment as to the securities into which shares of Preferred Stock may thereafter be convertible) and any distribution which is or would be required to preserve without diluting the rights of the holders of shares of Preferred Stock; PROVIDED, however, that the Company, after receipt of the determination by such Appraiser, shall have the right to select an additional Appraiser, in which case the adjustment shall be equal to the average of the adjustments recommended by each such Appraiser. The Board of Directors shall make the adjustment recommended forthwith upon the receipt of such opinion or opinions or the taking of any such action contemplated, as the case may be; PROVIDED, however, that no such adjustment of the Conversion Price shall be made which in the opinion of the Appraiser(s) giving the aforesaid opinion or opinions would result in an increase of the Conversion Price to more than the Conversion Price then in effect. (f) The Company covenants that it will at all times reserve and keep available out of its authorized and unissued Common Stock solely for the purpose of issuance upon conversion of Preferred Stock as herein provided, free from preemptive rights or any other actual contingent purchase rights of persons other than the holders of Preferred Stock, such number of shares of Common Stock as shall be issuable (taking into account the adjustments and restrictions of Section 5(b) and Section 5(d) hereof) upon the conversion of all outstanding shares of Preferred Stock. The Company covenants that all shares of Common Stock that shall be so issuable shall, upon issue, be duly and validly authorized, issued and fully paid and nonassessable. (g) Upon a conversion hereunder the Company shall not be required to issue stock certificates representing fractions of shares of Common Stock, but may if otherwise permitted, make a cash payment in respect of any final fraction of a share based on the Per Share Market Value at such time. If the Company elects not, or is unable, to make such a cash payment, the holder of a share of Preferred Stock shall be entitled to receive, in lieu of the final fraction of a share, one whole share of Common Stock. (h) The issuance of certificates for shares of Common Stock on conversion of Preferred Stock shall be made without charge to the holders thereof for any documentary stamp or similar taxes that may be payable in respect of the issue or delivery of such certificate, provided that the Company shall not be required to pay any tax that may be payable in respect of any transfer involved in the issuance and delivery of any such certificate upon conversion in a name other than that of the holder of such shares of Preferred Stock so converted and the Company shall not be required to issue or deliver such certificates unless or until the person or persons requesting the issuance thereof shall have paid to the Company the amount of such tax or shall have established to the satisfaction of the Company that such tax has been paid. (i) Shares of Preferred Stock converted into Common Stock shall be canceled and shall have the status of authorized but unissued shares of preferred stock. (j) Each Holder Conversion Notice shall be given by facsimile and by mail, postage prepaid, addressed to the attention of the Secretary of the Company at the facsimile telephone number and address of the principal place of business of the Company. The notice of the Automatic Conversion Date shall be given by facsimile and by mail, postage prepaid, addressed to each holder of Preferred Stock at the facsimile telephone number and address of such holder appearing on the books of the Company or provided to the Company by such holder, or if no such facsimile telephone number or address appears or is so provided, at the principal place of business of the holder. Any such notice shall be deemed given and effective upon the earliest to occur of (i)(a) if such Conversion Notice is delivered via facsimile at the facsimile telephone number specified in this Section 5(j) prior to 4:30 p.m. (Eastern Standard Time) on any date, such date (or, in the case of a notice of Automatic Conversion, the next Trading Day) or such later date as is specified in the Conversion Notice, and (b) if such Conversion Notice is delivered via facsimile at the facsimile telephone number specified in this Section 5(j) after 4:30 p.m. (Eastern Standard Time) on any date, the next date (or, in the case of a notice of Automatic Conversion, the next Trading Day after such next day) or such later date as is specified in the Conversion Notice, (ii) five days after deposit in the United States mails or (iii) upon actual receipt by the party to whom such notice is required to be given. Section 6. DEFINITIONS. For the purposes hereof, the following terms shall have the following meanings: "Common Stock" means shares now or hereafter authorized of the class of Common Stock, no par value, of the Company and stock of any other class into which such shares may hereafter have been reclassified or changed. "Conversion Ratio" means, at any time, a fraction, of which the numerator is Stated Value plus accrued but unpaid dividends, and of which the denominator is the Conversion Price at such time. "Junior Securities" means the Common Stock and all other equity securities of the Company, except the Company's Convertible Series A Cumulative Preferred Stock and the Company's Convertible Series B Cumulative Preferred Stock. "Original Issue Date" shall mean the date of the first issuance of any shares of the Preferred Stock regardless of the number transfers of any particular shares of Preferred Stock and regardless of the number of certificates which may be issued to evidence such Preferred Stock. "Per Share Market Value" means on any particular date (a) the closing bid price per share of the Common Stock on such date on The NASDAQ Stock Market or other stock exchange on which the Common Stock has been listed or if there is no such price on such date, then the closing bid price on such exchange on the date nearest preceding such date, or (b) if the Common Stock is not listed on The NASDAQ Stock Market or any stock exchange, the closing bid for a share of Common Stock in the over-the-counter market, as reported by the NASD at the close of business on such date, or (c) if the Common Stock is not quoted on the NASD, the closing bid price for a share of Common Stock in the over-the-counter market as reported by the National Quotation Bureau Incorporated (or similar organization or agency succeeding to its functions of reporting prices), or (d) if the Common Stock is no longer publicly traded the fair market value of a share of Common Stock as determined by an Appraiser (as defined in Section 5(d)(iv) above) selected in good faith by the holders of a majority in interest of the shares of the Preferred Stock; PROVIDED, however, that the Company, after receipt of the determination by such Appraiser, shall have the right to select an additional Appraiser, in which case, the fair market value shall be equal to the average of the determinations by each such Appraiser. "Person" means a corporation, an association, a partnership, organization, a business, an individual, a government or political subdivision thereof or a governmental agency. "Purchase Agreement" means the Convertible Preferred Stock Purchase Agreement, dated as of the Original Issue Date, between the Company and the original holder of the Preferred Stock. "Trading Day" means (a) a day on which the Common Stock is traded on NASDAQ or principal stock exchange on which the Common Stock has been listed, or (b) if the Common Stock is not listed on NASDAQ or any stock exchange, a day on which the Common Stock is traded in the over-the-counter market, as reported by the NASD, or (c) if the Common Stock is not quoted on the NASD, a day on which the Common Stock is quoted in the over-the-counter market as reported by the National Quotation Bureau Incorporated (or any similar organization or agency succeeding its functions of reporting prices). Section 7. NOTICES. Any notice required by the provisions hereof to be given to the holders of shares of Preferred Stock shall be deemed given when personally delivered to such holder or five business days after the same has been deposited in the United States mail, certified or registered mail, return receipt requested, postage prepaid, and addressed to each holder of record at his address appearing on the books of the Company. Dated: July 29, 1997 /s/ MELVYN REZNICK ------------------------------------ Melvyn Reznick, President /s/ STEPHEN A. CASWELL ------------------------------------ Stephen A. Caswell, Secretary Melvyn Reznick and Stephen A. Caswell hereby declare under penalty of perjury under the laws of the State of California that they have read the foregoing certificate and know the contents thereof and that the same is true of their own knowledge. Dated: July 29, 1997 /s/ MELVYN REZNICK ------------------------------------ Melvyn Reznick, President /s/ STEPHEN A. CASWELL ------------------------------------ Stephen A. Caswell, Secretary EX-5.1 5 EXHIBIT 5.1 EXHIBIT 5.1 LAW OFFICES OF MARK J. RICHARDSON WILSHIRE PALISADES BUILDING 1299 OCEAN AVENUE SUITE 900 SANTA MONICA, CALIFORNIA 90401 TELEPHONE (310) 393-9992 FACSIMILE (310) 393-2004 December ____, 1997 Incomnet, Inc. 21031 Ventura Boulevard Suite 1100 Woodland Hills, California 91364 RE: INCOMNET, INC. - VALIDITY OF ISSUANCE OF SHARES ----------------------------------------------- Ladies and Gentlemen: We have acted as special counsel to you in connection with the registration on Form S-3 (File No. 333-16629 under the Securities Act of 1933, as amended ("Registration Statement"), of a total of 2,676,281 shares of the Common Stock of Incomnet, Inc., no par value, comprised of (i) 477,500 shares (the "Underlying Shares") issuable upon the exercise of 477,500 warrants (the "Warrants") to purchase Common Stock at an exercise price of $3.75 per share at any time until December 9, 1999, with respect to 360,000 of the Warrants, at an exercise price of $2.94 per share at any time until December 16, 2001, with respect to 12,500 of the Warrants, at an excercise price of $5.26 per share at any time until July 29, 1999, with respect to 50,000 of the Warrents, and at an exercise price of $3.00 per share at any time until November 3, 1999, with respect to 55,000 of the Warrants, (ii) 170,751 outstanding shares (the "Outstanding Shares") issued upon the conversion of Series A 2% Convertible Preferred Stock previously issued by the Company, or new stock issued in a private placement pursuant to Section 4(2) of the Securities Act of 1933, as amended (the "Act"), (iii) a minimum of 627,503 shares (also referred to herein as the "Underlying Shares") issuable upon the conversion of 2,434 outstanding shares of Series B 6% Convertible Preferred Stock, and (iv) up to 750,000 unissued shares (the "Shares") which may be issued in the future pursuant to the conversion of Series B 6% Convertible Preferred Stock, the conversion of up to 125 shares of Series A 2% Convertible Preferred Stock, or in open market sales under Rule 415 of the Act through a registered broker-dealer. You have requested our opinion in connection with the registration of the Shares, the Underlying Shares and the Outstanding Shares covered by the Prospectus, dated December 3, 1997 (the "Prospectus"). In connection with our acting as counsel, we have examined the laws of the State of California together with the forms of Warrants attached as Exhibits 4.7 and 4.8 to the Registration Statement, the Certificate of Determination for Series A 2% Convertible Preferred Stock attached as Exhibit 3.3 to the Registration Statement, the Certificate of Determination for Series B 6% Convertible Preferred Stock attached as Exhibit 3.7 to the Registration Statement, the Prospectus, and certain other documents and instruments prepared on behalf of Incomnet, Inc. as we have deemed necessary and relevant in the preparation of our opinion as hereinafter set forth. In our examination, we have assumed the genuineness of all signatures on original documents and the authenticity of all documents submitted to us as originals, the conformity to original documents of all documents submitted to us as certified, conformed or photostatic copies of originals, the authenticity of such latter documents, and the proper execution, delivery and filing of the documents referred to in this opinion. Based upon the foregoing, we are of the opinion that the Shares, the Outstanding Shares and the Underlying Shares issued and to be issued by Incomnet, Inc. pursuant to the exercise of the Warrants, the conversion of Series B 6% Convertible Preferred Stock, and the terms of the Prospectus have been and will be duly created and have been and will be validly issued shares of the Common Stock, no par value, of Incomnet, Inc. Upon payment for the Shares, the Outstanding Shares and the Underlying Shares and full compliance with all of the terms and conditions relating to the issuance of the Shares and the Underlying Shares and the sale of the Outstanding Shares set forth in the Prospectus and in the Warrants, the Shares, the Outstanding Shares and the Underlying Shares will be fully paid and nonassessable. For the purposes of this opinion, we are assuming the proper execution of all Warrants, the Certificates of Determination of Series A 2% Convertible Preferred Stock and the Series B 6% Convertible Preferred Stock, the Registration Rights Agreement relating to the Series B 6% Convertible Preferred Stock, the Purchase Agreement for the Series B 6% Convertible Preferred Stock, subscription agreements and conversion agreements, and that the appropriate certificates are duly filed and recorded in every jurisdiction in which such filing and recordation is required in accordance with the laws of such jurisdictions. We express no opinion as to the laws of any state or jurisdiction other than California. We consent to the use of this opinion as an exhibit to the Registration Statement, and we further consent to the use of our name in the Registration Statement and the Prospectus which is a part of said Registration Statement. Respectfully submitted, Mark J. Richardson, Esq. EX-13.11 6 EXHIBIT 13.11 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A AMENDMENT NO. 1 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 COMMISSION FILE NO. 0-12386 INCOMNET, INC. A California IRS Employer No. Corporation 95-2871296 21031 Ventura Blvd., Suite 1100 Woodland Hills, California 91364 Telephone no. (818) 887-3400 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:................................................................None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:..........................................Common Stock, No Par Value 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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO__ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Aggregate market value of voting common stock held by non-affiliates of the registrant (based upon the average of the closing bid and ask prices of $2 13/16 and $2 15/16 respectively, as reported by the NASDAQ System on March 21, 1997) $30,958,080 Number of shares of registrant's common stock outstanding as of March 21, 1997.................................................13,520,669 DOCUMENTS INCORPORATED BY REFERENCE: Portions of registrant's proxy statements relating to registrant's 1997 annual meeting of shareholders have been incorporated by reference into Part III hereof. 1 TABLE OF CONTENTS PAGE ---- INTRODUCTORY NOTE 7 PART I ITEM 1 - BUSINESS General 7 Telephone Services 7 Optical Systems 7 Network Products and Services 8 National Telephone & Communications, Inc. (NTC) 8 Products 8 Network Marketing Program 8 Disclosure of Independent Representative Organizations Related to NTC Executives 9 Wiltel Contract 9 Management Incentive Agreement 9 Reincorporation of NTC in Delaware 11 Rapid Cast, Inc. (RCI) 11 General 11 The Optical Marketplace 11 The Production and Dispensing of Prescription Eyeglass Lenses 12 The Fast Cast LenSystem 13 Technical Overview of the Rapid Cast LenSystem 13 Marketing and Pricing Strategy 14 Manufacturing Strategy 14 Research and Development Strategy 14 Maintenance, Warranty and Insurance 14 Competition 15 Patents and Proprietary Rights 15 Governmental Regulation 16 Recent Capitalization of Rapid Cast, Inc. (RCI) 16 Issuance of Convertible Preferred Stock 20 Agreement with Price International, Inc. 22 Network Services 22 Employees, Officers and Directors 22 Employees 22 Directors and Officers 23 Appointment of New Director by the Company 24 Appointment of Committee Members 24 2 TABLE OF CONTENTS (CONT'D) PAGE ---- ITEM 2 - PROPERTIES 24 ITEM 3 - LEGAL PROCEEDINGS 25 Class Action and Related Lawsuits 25 Settlement with RCI Parties 26 Settlement of Stevens Lawsuit 26 Settlement of the Atlanta Lawsuits 26 Section 16 (b) Lawsuit 26 Settlement of Patent Infringement Lawsuit 27 Legal Action Against Prior Representatives 27 Settlement With Prior Noteholders 27 Settlement with Price International 28 Potential Lawsuits 28 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 29 PART II ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS 29 Market Information 29 Dividends 29 ITEM 6 - SELECTED FINANCIAL DATA 29 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 30 Liquidity and Capital Resources 30 Results of Operations 31 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 33 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 33 PART III ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS OF THE REGISTRANT 33 ITEM 11 - EXECUTIVE COMPENSATION 33 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 34 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 34 PART IV ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K 34 Index to Financial Statements 34 Index to Exhibits 34 Signatures 37 Report of Independent Auditors 38 Consolidated Balance Sheet 39 Consolidated Statement of Operations 40 3 TABLE OF CONTENTS (CONT'D) PAGE ---- Consolidated Statement of Cash Flows 41 Consolidated Statement of Shareholders' Equity 42 Notes to Consolidated Financial Statements 43 Note 1 - Summary of Significant Accounting Policies 43 Note 2 - Funding of Marketing Commissions and Deferred Income 45 Note 3 - Related Party Transactions 45 Note 4 - Acquisition of Rapid Cast, Inc. 45 Note 5 - Property, Plant and Equipment 46 Note 6 - Patent Rights from Acquisition of RCI 46 Note 7 - Investments, Notes Receivable and Other Assets 46 Note 8 - Notes Payable 46 Note 9 - Income Taxes 47 Note 10 - Shareholders' Equity 48 Note 11 - Commitments, Contingencies and Other 51 Note 12 - Network Marketing Costs 53 Note 13 - Compensation of Independent Sales Representatives 53 Note 14 - Segment Information 53 Note 15 - Fourth Quarter Adjustments 55 Note 16 - Changes in Accounting 55 Note 17 - Subsequent Events 55 Schedule II - Valuation and Qualifying Accounts 56 Exhibit 3.1 - Certificate of Determination for Series A 2% Convertible Preferred Stock. (Incorporated by reference from Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996.) Exhibit 4.1 - Form of Warrant to Purchase 75,000 Shares of Incomnet, Inc. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 4.2 - Form of Warrant to Purchase 510,000 Shares of RCI Common Stock with Registration Rights Agreement, dated April 19, 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 4.3 - Form of Warrant to Purchase RCI Common Stock, dated February 8, 1995. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 4.4 - Form of Warrant to Purchase 360,000 Shares of Incomnet, Inc. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 4.5 - Form of Warrant to Purchase 12,500 Shares of Incomnet, Inc. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.1 - Employment Agreement with James Quandt, dated January 6, 4 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.2 - Amended and Restated Management Incentive Agreement Between NTC and Incomnet, Inc., dated January 28, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.3 - Settlement Agreements With Prior Noteholders. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 10.4 - Form of 8% Convertible Note Issued by RCI in January 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 10.5 - Form of Short-Term 10% Note Issued by RCI in April 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996.) Exhibit 10.6 - Amended Carrier Switched Services Agreement with Wiltel, Inc. dated June 17, 1996. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. Certain information has been deleted from this agreement pursuant to a request for confidential treatment pursuant to Rule 406.) Exhibit 10.7 - Settlement Agreement Between Joel W. Greenberg and Incomnet, Inc. (Incorporated by reference from the Company's Report on Form 8-K, dated June 7, 1996, relating to the settlement agreement with Joel W. Greenberg and his resignation as a director of the Company.) Exhibit 10.8 - Form of Registration Rights Agreement Between Incomnet, Inc. and Purchasers of Series A Convertible Preferred Stock. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended.) Exhibit 10.9 - Form of Purchase Agreement for the Series A 2% Convertible Preferred Stock. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended.) Exhibit 10.10 -Management Incentive Agreement with NTC, dated October 14, 1996. (Incorporated by reference from Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996.) Exhibit 10.11 -Settlement Agreements With Edward Jacobs and Jerry Ballah, dated November 14, 1996. (Incorporated by reference from 5 Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996.) Exhibit 10.12 - Shareholders Agreement for Rapid Cast, Inc., dated January 16, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.13 - Registration Rights Agreement for Rapid Cast, Inc., dated January 16, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.14 - Settlement Agreement and Mutual Release Between Incomnet, Inc. and the RCI Parties, dated January 9, 1996. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997.) Exhibit 10.15 - Lease Agreement By NTC for space in Honolulu, Hawaii. * Exhibit 10.16 - Credit Agreement dated March 27, 1997 between National Telephone & Communication, Inc. and First Bank & Trust, Irvine Regional office. * Exhibit 21 - Subsidiaries of the Registrant * Exhibit 27 - Financial Data Schedule * * Previously Filed on Form 10-K filed with the Securities and Exchange Commission on April 15, 1997 6 INTRODUCTORY NOTE This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends that such forward-looking statements be subject to the safe harbors created by such statutes. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties. Accordingly, to the extent that this Annual Report contains forward-looking statements regarding the financial condition, operating results, business prospects or any other aspect of the Company and its subsidiaries, please be advised that the Company and its subsidiaries' actual financial condition, operating results and business performance may differ materially from that projected or estimated by the Company in forward-looking statements. The differences may be caused by a variety of factors, including but not limited to adverse economic conditions, intense competition, including intensification of price competition and entry of new competitors and products, adverse federal, state and local government regulation, inadequate capital, unexpected costs and operating deficits, increases in general and administrative costs, lower sales and revenues than forecast, loss of customers, customer returns of products sold to them by the Company or its subsidiaries, disadvantageous currency exchange rates, termination of contracts, loss of supplies, technological obsolescence of the Company's products, technical problems with the Company's products, price increases for supplies and components, inability to raise prices, failure to obtain new customers, litigation and administrative proceedings involving the Company, including the pending class action and related lawsuits and SEC investigation, the possible acquisition of new businesses that result in operating losses or that do not perform as anticipated, resulting in unanticipated losses, the possible fluctuation and volatility of the Company's operating results, financial condition and stock price, losses incurred in litigating and settling cases, dilution in the Company's ownership of its subsidiaries and businesses, adverse publicity and news coverage, inability to carry out marketing and sales plans, challenges to the Company's patents, loss or retirement of key executives, changes in interest rates, inflationary factors, and other specific risks that may be alluded to in this Annual Report or in other reports issued by the Company. In addition, the business and operations of the Company are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements. In light of the significant uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. PART I ITEM 1. BUSINESS GENERAL: Incomnet, Inc. (the "Company") was incorporated under the laws of the State of California on January 31, 1974. The Company is engaged in the following businesses: TELEPHONE SERVICES- The Company, through its wholly-owned subsidiary, National Telephone & Communications,-Registered Trademark- Inc. (NTC), markets long distance telecommunications services to commercial and residential customers in the United States. Service is provided by procuring long distance telecommunications transmission services from long distance communication carriers at high volume wholesale rates and reselling those services at retail rates. NTC uses a network marketing program of independent representatives to sell its telecommunications-related services to retail customers. The growth in NTC's telecommunications-related revenues is directly tied to its network marketing program. NTC's independent representatives typically pay an annual fee for certain materials, training and services from NTC which are used by the independent representatives to sell new retail customers and enroll other representatives in the NTC program. NTC pays the independent representatives a residual monthly commission on the telecommunications revenue. In addition, the network marketing program pays various bonuses and overrides when and if representatives obtain a minimum number of new telephone customers within a specific 30 to 60 day period. This program has been designed to bring NTC new retail telephone customers even if little or no growth occurs in the marketing program revenues. The new telecommunications revenues generally lag the new marketing program revenues by one to three months. Sales from this segment accounted for 94.2% of the Company's total 1996 sales. 7 OPTICAL SYSTEMS- The Company, through its 35%-owned subsidiary Rapid Cast, Inc. (RCI), acquired in February 1995, manufactures and markets the FastCast-TM- LenSystem that allows retail optical stores and wholesale optical lens manufacturing laboratories to produce single vision, flat-top bifocal and progressive bifocal lenses on demand, in approximately 30 minutes. The FastCast-TM- LenSystem uses a series of high-accuracy prescription glass molds that are filled with a proprietary liquid monomer (plastic). When exposed to ultraviolet light within the system's curing chamber, the monomer undergoes a chemical reaction that rapidly "cures" or hardens the lens. Sales from this segment accounted for 4.4% of the Company's total 1996 sales. Rapid Cast's operating results are included in the accompanying financial statements. NETWORK PRODUCTS AND SERVICES- The Company acquires and/or develops hardware and software, primarily for interactive data communications networks. In this regard, the Company operates a communications network known under the tradename "AutoNETWORK" that services the automotive dismantling industry in California, Nevada, Arizona, Oregon and Washington. Sales from this segment accounted for 1.4% of the Company's total 1996 sales. NATIONAL TELEPHONE & COMMUNICATIONS, INC. (NTC): PRODUCTS - NTC is an inter-exchange carrier and reseller of long distance telephone services to residential and small business customers throughout the United States. NTC's primary product is its Dial-1 Telephone Service. Its other long distance telephone products are 800-Number Services and Calling Card Services, which include the Flag Card, Sure$aver Card, Sure$aver Gold Card, Global$aver Card, and Call$aver Card. In order to provide these products, NTC generally contracts to purchase long distance telephone time from national carriers at wholesale rates based upon high volume usage. NTC then resells this time to its customers at its own discounted retail rates which are generally 10% to 30% or more below AT&T's published, tariffed MTS rates. NTC's Dial-1 Service is transparent to its customers once a customer's long distance service has been converted to NTC. NTC's calling card products operate similarly to the calling card products offered by the major carriers. NTC's customers pay for their long distance calling usage either through direct billing from NTC , through billing from the customer's local exchange carrier ("LEC"), through direct billing by NTC of the customer's major credit card, or by prepaying for long distance time in the case of certain NTC calling card products. In certain states, NTC has an agency agreement with an unaffiliated company which bills customers' local intrastate calls through the local telephone company. Commencing in the second quarter of 1996, NTC increased its use of LECs to bill and collect telephone service accounts receivable. The increase in the use of LECs has increased the amount of time that it takes for NTC to receive payment on its accounts receivable. NETWORK MARKETING PROGRAM - NTC markets its products on a nationwide basis through a multi-level, network marketing program of independent sales representatives. NTC authorizes and trains the independent representatives to resell its services to residential and small business customers, and allows the individual representatives to build up their own "downline" sales force of other independent representatives. NTC currently has in excess of 40,000 independent representatives in its network marketing program. Once an independent representative has signed up a long distance telephone customer on one or more of NTC's services/products, the customer becomes an NTC customer. NTC takes over the servicing and billing of the customers as well as the collection of monies owed by the customers for their use of the NTC telephone services/products. NTC pays each independent representative a commission on the telephone usage monies billed to those retail telephone customers who are directly sourced by that representative. NTC also pays override commissions to each independent representative on the monies billed to those telephone customers sourced by the representative's downline as well as a bonus percentage of all telephone monies billed by NTC from the retail telephone customers collectively sourced by all independent representatives, if certain minimums of retail telephone business are personally achieved by the representative. In addition, NTC pays sales quota bonuses to independent representatives for assisting other representatives to obtain certain minimum quotas of new retail long distance telephone business. NTC does not pay any monies to independent representatives simply for recruiting other representatives into NTC's network marketing program. NTC generally maintains communications with its independent representatives through (1) NTC's proprietary communications systems, (2) NTC's internal personnel dedicated to the support of the independent representatives, (3) various NTC manuals, newsletters and other publications that are periodically and continually sent to the independent representatives, (4) NTC's network 8 of senior independent representatives, and (5) various training programs offered by NTC and its senior independent representatives throughout the United States. NTC believes it is in compliance with all State and Federal regulations governing multi-level marketing companies. However, to ensure the Company has objective and knowledgeable outside legal opinion in this area, NTC has formed a Regulatory Compliance Committee consisting of four former States Attorney General that periodically reviews NTC's marketing programs for such compliance. DISCLOSURE OF INDEPENDENT REPRESENTATIVE ORGANIZATIONS RELATED TO NTC EXECUTIVES - - In order to eliminate potential conflicts of interest, at the end of 1992, NTC implemented its current policy that no senior, decision-making NTC executive or officer may have a downline organization of independent representatives involved with the selling of NTC's long distance telephone services and/or marketing programs ("Executive Downlines"). Violation of this policy subjects such an NTC officer/executive to immediate termination and forfeiture of all past and future commissions from such disallowed Executive Downlines. To the best of the Company's knowledge, none of NTC's senior officers/executives have an Executive Downline, including Ed Jacobs (Chairman of the Board), James R. Quandt (President), Victor C. Streufert (Vice President of Finance and Administration and Chief Financial Officer), Debra Chuckas (Vice President-Marketing Support), Louis W. Cheng (Vice President-Information Services), and Michael A. Keebaugh (Vice President of Operations). In addition, NTC's current policy requires full disclosure by all senior NTC officers and executives of any NTC downline organizations headed by an immediate family member of such senior officer or executive as well as disclosure of the personal involvement of an immediate family member in the sale of NTC's long distance telephone services to retail customers ("Immediate Family Customers/Downlines"). To the best of the Company's knowledge, none of NTC's senior officers or executives have Immediate Family Customers/Downlines. WILTEL CONTRACT - In September 1995, NTC entered into a new carrier contract with Wiltel, Inc. of Tulsa, Oklahoma, a subsidiary of WorldCom, Inc., covering a potential volume purchase of $600 million of long distance telephone time over a five year period commencing in November 1995. Effective February 1996, NTC entered into a revised multiple-year $1.0 billion contract with Wiltel, Inc., which has a fixed term expiring January 2002. As in the prior carrier contract with Wiltel, Inc., NTC has committed to purchase the designated volume of telephone time in accordance with a schedule over the term of the contract. NTC currently relies in part on the purchases of another unaffiliated long distance telephone service provider to meet its volume purchase requirements under the new contract. MANAGEMENT INCENTIVE AGREEMENT - On January 28, 1997 the Company entered into an amended and restated management incentive agreement with NTC pursuant to which the Company agreed to spin-off 10% of the shares it owns in NTC, to establish stock option programs for the senior executives, employees and key independent sales representatives of NTC, and to vote its shares for NTC management's slate of director nominees. The new management incentive agreement entirely supersedes the incentive agreements entered into by the Company with NTC in February and November 1996. See "Item 5. Other Information - Agreement with NTC Management" in the Company's Form 10-Q for the quarter ended September 30, 1996. In November 1996 the Company also entered into settlement agreements with Edward Jacobs and Jerry Ballah (the former Executive Vice President and director of NTC, who is now the Executive Director, Global Marketing of NTC's network marketing program as a consultant to NTC), pursuant to which mutual general releases were given. The Company agreed to assume certain debt obligations of Mr. Jacobs and Mr. Ballah to NTC, as well as to make a cash payment to them to cover their tax liabilities from the debt forgiveness. See "Item 5. Other Information - Settlement Agreement with NTC Directors" in the Company's Form 10-Q for the quarter ended September 30, 1996. With respect to a potential spin-off of NTC shares by the Company, there is no assurance as to if or when a spin-off will occur, or whether or not NTC will make a public offering of its stock. 9 The amended and restated management incentive agreement essentially contains the same terms and conditions as the agreement entered into in November 1996, except as follows: The Company and NTC agree that the Company, as the owner of 100% of the total issued and outstanding stock of NTC, owns ten million shares of NTC. The three NTC stock option plans previously agreed to have been revised. The Company and NTC have now agreed that there will be three stock option plans and one convertible debt plan. The exercise price of all stock options issued under the option plans will not be less than the fair market value of NTC common stock on the date of the grant, and the conversion price of the convertible debt issued under the convertible debt plan will not be less than the fair market value of NTC common stock on the date of the issuance of the convertible debenture. Shares issuable pursuant to the plans are expected to be registered with the Securities and Exchange Commission no later than at the time of NTC's planned public offering. Upon the creation of the plans and first grant of options and convertible debt units pursuant to the plans, Edward Jacobs will waive his rights to all remaining outstanding unexercised warrants and options issued to him by the Company pursuant to his employment agreement, dated December 28, 1994. The first stock option plan is the one for key independent sales representatives. A total of 2,884,615 shares are reserved for issuance under this plan. Options to purchase 961,538 shares of NTC common stock have been granted to key independent sales representatives who are Corporate Team members, 480,769 of which will vest on June 30, 1998, subject to acceleration if NTC's public offering occurs prior to January 1, 1998. Options to purchase the other 480,769 shares will vest on June 30, 1999. The remaining 1,923,077 shares reserved for issuance pursuant to stock options granted under this plan may be granted to key independent sales representatives after each of June 30, 1997, December 31, 1997, June 30, 1998 and December 31, 1998 if NTC's gross revenues for the three month periods ending on each of such dates exceed NTC's gross revenues for the corresponding three month periods ending December 31, 1996, June 30, 1997, December 31, 1997 and June 30, 1998, by the percentage amounts indicated on the following table:
Percentage Increase in NTC Gross Revenues In Number of Options Available For Grant At End Comparative Three Month Period of Each Period(1) ------------------------------ ----------------- 30% 125,000 40% 250,000 50% 500,000(1)
- -------------------- (1) Stock options in the amount indicated may be granted at the end of each of the four comparative three month periods. If the percentage increase for all four of the comparative periods is 50% or more, then the total stock options available for grant in the fourth period would be 423,077 instead of 500,000 because there are 1,923,077 (not 2,000,000) options available for grant under this portion of the key independent sales representatives' stock option plan. These stock options, once granted, will vest in four equal annual installments on each anniversary date after the stock option grant date. The NTC Board of Directors will determine when and to whom these stock options will be granted. The second stock option plan is the one for NTC executives, employees and key consultants. A total of 3,705,001 shares are reserved for issuance under this plan. Options representing 1,446,076 of these reserved shares will be subject only to a time-in-service vesting requirement, but in no event will such options vest prior to January 1, 1998. Options representing 1,682,051 of the reserved shares will vest in four equal annual installments on each anniversary date of the option grant date, subject to the acceleration of vesting in the event that NTC achieves certain income targets in 1997, to be determined by the NTC Board of Directors. No more than 480,770 shares issuable pursuant to options granted under this plan may be issued to persons eligible to receive convertible debt units under the Senior Executive and Consultant Convertible Debt Plan described below in this section. The NTC Board of Directors will determine when and to whom these stock options will be granted. Options representing 576,924 shares will be reserved under this plan for issuance to persons eligible to receive convertible debt units under the Senior Executive and Consultant Convertible Debt Plan described below in this section in equal amounts. These options will be granted upon the creation of the plan but will not vest until January 31, 2002, except that the vesting of these options will accelerate in the following amounts if NTC achieves revenues which exceed the following amounts for any calendar quarter ending prior to January 1, 2000. QUARTERLY REVENUES NUMBER OF SHARES VESTING ------------------ ------------------------ $100 million 192,308 $125 million 192,308 $180 million 192,308 The third stock option plan is the one for members of NTC's Board of Directors. A total of 300,000 shares are reserved for issuance under this plan. Each director of NTC will receive an option to purchase 25,000 shares of NTC common stock which will vest in four equal annual installments on each anniversary date of the option grant date. 10 The fourth option plan is the Senior Executive and Consultant Convertible Debt Plan for Edward Jacobs and Jerry Ballah. A total of 2,664,231 shares are reserved for issuance under this plan to be allocated between Mr. Jacobs and Mr. Ballah as determined by the NTC Board of Directors. These units will vest upon grant. A portion of the convertible debt units granted under this plan may be assignable. The amended and restated NTC management incentive agreement provides that, until four additional independent directors are appointed to the NTC Board of Directors, if a vacancy is created on the NTC Board of Directors by reason of the death, resignation or removal, with or without cause, of Mr. Jacobs or Mr. Ballah, then the Company has agreed to vote its shares for the individual nominated by the remaining NTC management director. In addition to the regular members of the NTC Board of Directors, a key independent sales representative may be nominated and elected to the NTC Board of Directors on a rotating basis, such that the same sales representative cannot serve consecutive terms. NTC has agreed to make total cash payments to the Company on or before December 31, 1997 equal to $2,200,000, of which $1,200,000 of payments have already been made as of March 17, 1997. The cash payments of up to $2,200,000 by NTC to Incomnet, Inc. will be treated as a return of capital to the Company. NTC may make advances to Incomnet, Inc. in excess of its cash payment obligation of $2,200,000, subject to the limitations of its credit agreement, which Incomnet, Inc. will be obligated to repay with interest upon demand. Any charge to earnings or taxable income associated with advances made by NTC to Incomnet, Inc. or costs incurred in the spin-off of NTC shares will be incurred by Incomnet, Inc. for financial reporting purposes rather than by NTC. REINCORPORATION OF NTC IN DELAWARE Effective March 21, 1997, NTC, previously a Nevada corporation, reincorporated under the laws of the State of Delaware. Pursuant to its new Articles of Incorporation, NTC has authorized 100 million shares of common stock, par value $.01 per share, of which 10 million shares are issued and outstanding, all of which are held by Incomnet Inc., and 1.5 million shares of preferred stock, none of which are issued or outstanding. RAPID CAST, INC. (RCI): GENERAL - RCI is a Delaware corporation formed in February 1994 which acquired 100% of the outstanding capital stock of Q2100, Inc. ("Q2100") from Pearle, Inc., an unaffiliated subsidiary of Grand Metropolitan, Ltd., a United Kingdom conglomerate. Q2100 owns certain domestic and foreign patents and patent applications relating to a new technology, commonly known as Thick Film Radiation Cured Polymer Technology (the "Technology"), which enables retail optical stores and wholesale optical lens manufacturing laboratories to produce many prescription ophthalmic lenses on site at a cost generally lower than if they were purchased from third party manufacturers or distributors. RCI is marketing the Technology under the name Fast Cast-TM- LenSystem. THE OPTICAL MARKETPLACE - Nearly 60% of the United States population (approximately 151 million people) required some form of vision correction in 1992, according to CENSUS INTERNATIONAL '93: THE OPTICAL INDUSTRY FACT BOOK ("Census93"). It is estimated that, by the year 2000, the United States prescription eyewear population will rise to approximately 164 million people and that, in the following decade, over 180 million people will use prescription eyewear products. Census93 reports that, in the approximately $11.9 billion United States retail optical market in 1992, the average optical retailer's breakdown of dollar revenue by product category was: (a) approximately 47% (or nearly $5.6 billion) from the sale of eyeglass lenses and lens treatments (e.g., the application of scratch-resistant and ultraviolet 11 coatings), (b) approximately 38% from the sale of eyeglass frames and sunglasses, and (c) approximately 15% from the sale of contact lenses. Census93 reports that, out of the approximately 80 million pairs of prescription eyeglass lenses sold in the United States in 1992, an estimated 55% to 60% were single vision lenses, while an estimated 40% to 45% were multifocal lenses (i.e., bifocal, trifocal and cataract lenses). According to Census93, bifocal lenses currently constitute the substantial majority of consumer purchases of multifocal lenses, representing an estimated average of approximately 84% of all multifocal lenses purchased in the years 1987, 1989 and 1991. Multifocal lenses are produced as either "flat-top" or "progressive" lenses. Progressive lenses are distinguished from flat-top lens by the absence of visible horizontal lines separating the different corrective prescription areas. Census93 reports that, by the end of 1992, flat-top bifocal and trifocal lenses held approximately 79% of the multifocal market, while approximately 21% of this market consisted of progressive lenses. The LenSystem is capable of producing single vision, flat-top bifocal and progressive bifocal lenses. Although no assurance can be given in this regard, RCI believes that the market for progressive bifocal lenses offers particularly great opportunities, both because of the potential to convert persons currently wearing flat-top bifocals to the "no-line" option offered by progressive lenses, and because the bulk of the baby boomer generation (ages 30 to 49 in 1994) has not yet reached their early 40s, when people typically first experience the presbyopia that requires correction by bifocals. Single vision and multifocal prescription eyeglass lenses are currently manufactured using one of three basic types of materials. According to Census93, the two conventional materials, glass and hard-resin plastic, accounted respectively for approximately 13% and 64% of 1993 United States prescription lens sales, while the newer premium materials such as polycarbonates, high index plastic and high index glass, accounted for approximately 23% of such sales. Within the categories of single vision and multifocal lenses, there are many types of premium lenses (generally designed to be especially thin, strong, and light) that the LenSystem currently cannot manufacture: (a) high index plastic and high index glass lenses, which generally are very thin, lightweight lenses used to reduce the thickness of very high strength prescription lenses; (b) polycarbonate lenses, which are made from a material with superior impact resistance and are typically used for sports and other eye-safety purposes; and (c) aspheric lenses, which are made to have flatter curves than conventional spherical lenses, thereby improving visual acuity and the appearance of the eyes through the lenses. Census93 estimates that aspheric lenses represented about 1% of 1992 United States sales of prescription lenses. RCI anticipates that sales of high index lenses will continue to grow steadily over the next several years. During the years 1990 through 1992, the United States market of contact lens wearers remained basically flat, according to Census93, at approximately 25 million users. There can be no assurance, however, that technological developments, medical advances, changes in consumer tastes or other factors will not cause the use of contact lenses to grow significantly in the future at the expense of prescription eyeglass lenses. Census93 reports that, despite the recent flat rate of overall contact lens use, a Bausch & Lomb study has found that first-time usage of disposable contact lenses grew at a compounded annual growth rate of 47% from 1989 through 1992. THE PRODUCTION AND DISPENSING OF PRESCRIPTION EYEGLASS LENSES - As previously noted, approximately 77% of all conventional single vision and multifocal prescription eyeglass lenses are currently manufactured from glass or hard-resin plastic. According to Census93, during the years 1991 through 1993 hard-resin plastic was used in the manufacturing of approximately 82% of all prescription lenses made from conventional materials. Although there can be no assurance in this regard, RCI anticipates that the use of glass in manufacturing conventional lenses will decrease over time due to a variety of factors, including its relatively greater weight and inferior impact resistance. After being prescribed for an individual by his or her medical doctor (ophthalmologist) or optometrist, prescription eyeglass lenses reach the consumer through three traditional channels: independent dispensers (consisting of thousands of private sector optometrists, opticians and ophthalmologists), retail optical chain stores (i.e., retailers having at least four stores, including so-called "superoptical" stores or "superstores", mass merchandisers and warehouse membership clubs), and miscellaneous third party and other dispensers. Census93 estimates that independent dispensers accounted for approximately 62% of 1992 United States optical sales, retail optical chain stores accounted for approximately 33% of such sales, and third party and other dispensers accounted for approximately 5% of such sales. 12 The substantial majority of glass and hard-resin plastic prescription lenses purchased in the United States are currently obtained from lens dispensers (such as independent optometrists, opticians, ophthalmologists and retail chain stores) who do not manufacture the lenses on-site. They instead obtain lenses from third party manufacturers and distributors, including hundreds of large factories and large, mid-sized and small wholesale manufacturing laboratories. These manufacturers and distributors have invested in the space and equipment required to grind glass or plastic lenses into a specific prescription and then to finish (i.e., polish) the lenses in order to provide clarity. In the case of plastic lenses, these manufacturers additionally possess the molds and other machinery required in order to form and then "cure" (i.e., harden) such lenses. Conventional curing processes utilize heat-driven reactions to harden the plastic. Heat-curing processes are relatively time-consuming, generally requiring between approximately six and 16 hours, depending upon the specific type of plastic involved. In most cases, a retail lens dispenser who obtains finished lenses from third party manufacturers and distributors cannot offer consumers "same day" service unless that retailer maintains a relatively large, mostly idle and generally expensive inventory of lens blanks. This inventory generally has consisted principally of single vision and flat-top bifocal lenses, due to the historically greater demand for such lenses. Even a retailer who maintains a very extensive inventory of lens blanks typically must place special orders for the majority of lenses required to fill more complex prescriptions and for most premium lenses. Filling any such order generally takes one or more days. Largely as a result of these limitations in the ability of retail lens dispensers to provide consumers with same day service for certain lenses, full service eyeglass lens manufacturing began to move into retail optical outlets in the form of the so-called "superoptical store". Many of these superstores are operated by the large retail optical chain stores, such as LensCrafters, Opti-World and Pearle Express. A "superoptical store" is generally understood in the United States optical industry to be a retail store with the on-site equipment necessary to produce the great majority of finished prescription lenses in about one hour. The required equipment generally consists of a surfacing (or grinding) laboratory and a finishing machine. According to Census93, superoptical stores rarely fall below 1,900 square feet in total area. In addition to an investment in equipment and space, a superoptical store typically requires the maintenance of a largely idle inventory of semi-finished lens blanks. THE FAST CAST LENSYSTEM - The LenSystem incorporates a new technology called Thick Film Radiation Cured Polymer Technology, which uses ultraviolet light instead of heat to initiate the chemical reaction that hardens the Fast Cast Liquid Monomer into a plastic lens. The Technology resulted from a research program that was initially begun in 1985 by the University of Louisville. In 1988, Dr. Larry Joel, one of the RCI founding shareholders, and others formed ORGIC, which contracted with the University of Kentucky to sponsor and continue that research program in return for the ownership of all resulting patents and discoveries. By 1990, ORGIC (then majority-owned by Dr. Joel and the predecessor of Q2100) had developed and tested a new liquid monomer, an ultraviolet curing unit and a lens casting machine. ORGIC believed that equipment utilizing the Technology could permit on-site production of prescription eyeglass lenses at a low cost and in a very short amount of time. ORGIC also believed that, in order to commercialize the use of such equipment and effectively bring it to the marketplace, financial and other resources would be required that ORGIC did not possess. In 1991, ORGIC, with the Technology (together with all related issued patents and patent applications), was sold to Pearle and subsequently renamed Q2100, Inc. On February 8, 1995, RCI purchased 100% of Q2100 from Pearle, and the Company purchased 51% of RCI. See "Item 1. Business - Acquisition of Rapid Cast, Inc." in the Company's Form 10-K for the fiscal year ending December 31, 1995. TECHNICAL OVERVIEW OF THE FAST CAST LENSYSTEM - The Rapid Cast LenSystem consists of three primary components: The Fast Cast Mold and Gasket Library, the Fast Cast Liquid Monomer (the "Monomer"), and the Fast Cast Ultraviolet Curing Unit (the "Curing Unit"). The Fast Cast Mold and Gasket Library is used to create the actual mold assembly from which a lens will be made. Once the type of lens (i.e., single vision, flat-top bifocal or progressive bifocal) and prescription to be produced are known, a front mold and a back mold are selected from an easy to read wall chart. A gasket is used to hold the front and back molds in place, creating a mold assembly consisting of a hollow cavity. This cavity is then filled with the Fast Cast Liquid Monomer. The Fast Cast Liquid Monomer is a proprietary monomer that is injected in liquid form into the mold assembly using a standard squeeze bottle. This Monomer is a "thick film" monomer, meaning that its thickness is best measured in parts of centimeters (as opposed to thin film monomers, which are measured in parts of millimeters). The Fast Cast Liquid Monomer is chemically inert and, because it is cured by ultraviolet light, does not require the addition of a separate 13 chemical initiator for the hardening process. As a result of its chemical stability, the Fast Cast Liquid Monomer has a shelf-life of many years and does not require special shipping and storage precautions. These advantages are not generally realized by conventional lens manufacturing processes which use hard-resin monomers to produce plastic lenses. These conventional monomers (such as the CR-39 Monomer, which has long been the substance most commonly used in manufacturing plastic lenses) require the addition of chemical initiators prior to being cured, and those initiators are in some cases flammable or explosive prior to being mixed with the monomer. Temperature-controlled shipping and storage arrangements must accordingly be made, and cold storage facilities must be utilized even after the monomer and initiator are mixed, since the resulting substance hardens and becomes useless when exposed for an extended period to temperatures above approximately 25 degrees fahrenheit. The Curing Unit controls the chemical reaction that occurs when the Fast Cast Liquid Monomer is exposed to ultraviolet light. It monitors the exact temperature of the lens during this reaction, utilizing multiple cold air jets to control the temperature of each sector of a lens. The Curing Unit also continuously monitors the energy output of the ultraviolet light in order to maintain a constant output, even with fluctuations in electrical current. RCI currently intends to utilize two versions of the Curing Unit, which differ only in the quantity of the lenses that can be produced at one time. The Premier Curing Unit will cure two pairs of lenses within approximately 30 minutes. The smaller Deluxe Curing Unit will cure one pair of lenses in the same amount of time. In addition, the front mold assembly may be coated with a scratch resistant coating and then cured with high intensity UV light onto the mold surface. This coating then adheres to the lens during the curing process. A lens produced by the LenSystem can be subjected to the application of various additional treatments (such as scratch resistant, anti-reflective and ultraviolet coatings) using the same materials and process now employed to apply such coatings to conventional plastic lenses. Scratch resistant and ultraviolet coatings can generally be applied on site in under ten minutes, whereas the application of an anti-reflective coating requires that the lens be sent out to a third party service company. If inadequacies appear in the LenSystem during day to day operation, there is no assurance that any such inadequacies can be corrected at commercially acceptable cost, or at all. Certain RCI customers have experienced technical problems with the LenSystem, including the calibration of the molds, the generation of heat by the Curing Unit, and related problems. As a result, machine orders have declined significantly while RCI works on corrective measures. While RCI management believes that the design and functional problems can be corrected, there is no assurance that these problems will be resolved or that new problems will not arise. There is no assurance that the rate of machine orders received by RCI will stabilize or increase in the future. MARKETING AND PRICING STRATEGY - RCI expects that initially the bulk of RCI's revenues will be derived from sales of equipment and that as the installed base of equipment stabilizes, an increasing share of revenues will be derived from Monomer sales. RCI is initially seeking to market the LenSystem principally to operators of retail optical stores and small to mid-sized wholesale lens manufacturing laboratories, both inside and outside the United States. Currently the sale price for a single LenSystem with one set of molds is approximately $37,000 for a smaller unit and $43,000 for a larger unit. Operators may be able to lease RCI equipment from third party lessors for approximately $750 to $950 per month at current interest rates over a 60 month period. RCI expects that each purchaser or lessee of a LenSystem will at least initially use RCI's Fast Cast Liquid Monomer. RCI does not believe that, in the short term, marketing of the LenSystem will require the purchase of significant print, television, radio or other advertising. RCI instead anticipates that the LenSystem will receive a large amount of nonpaid publicity within trade magazines that regularly report on technological changes in the optical industry. RCI may nonetheless utilize limited print advertising in optical industry trade magazines for the purpose of highlighting the LenSystem's perceived advantages. RCI currently intends to focus its marketing resources in the short term on the introduction and demonstration of the LenSystem at one or more optical industry conventions and trade shows. RCI believes that such conventions will provide an attractive forum for exhibiting the LenSystem's limited space requirements, ease of use and high quality output. MANUFACTURING STRATEGY - RCI currently does not have the facilities or the experience to manufacture the components of the LenSystem and has no plans to develop its own manufacturing capabilities. RCI currently has such components manufactured through subcontractors. RESEARCH AND DEVELOPMENT STRATEGY - RCI anticipates that its research and development efforts will emphasize the further development and enhancement of the Technology and the LenSystem, generally in response to potential future changes in technologies, customer preferences and optical industry standards. Should RCI be unable to anticipate these changes (whether because of a lack of adequate research and development funding or otherwise) or fail to improve the LenSystem or develop new technologies in response to these changes, RCI's ability to grow and become profitable could be materially adversely affected. RCI has experienced several customer requests for service and replacement 14 parts due to problems with the design and functioning of certain aspects of the Fast Cast LenSystem. As a result, RCI is making design modifications and servicing these customers, which have resulted in increased costs and slower sales than anticipated. RCI believes that it will be able to satisfy these customers and make the necessary design modifications to solve the problems. There is no assurance, however, that RCI's design modifications will solve the current problems with the Fast Cast LenSystem or that future design and operating problems may not occur. More specifically, RCI believes that, in addition to single vision, flat-top bifocal and progressive bifocal lenses, the Technology could be enhanced to enable it to produce other existing types of prescription lenses as well as new lens designs that may be developed in the future. If and to the extent funds become available, RCI accordingly expects that it might seek to improve the LenSystem so as to broaden the range of low cost, high quality lenses it can produce. There can be no assurance, however, that RCI will in fact ever undertake to develop any such improvements or that any effort to do so would be successful or commercially viable. RCI does not currently anticipate that it will conduct future research and development relating to technologies or products that are not related to the on-site production of prescription eyeglass lenses. There can be no assurance that, if conducted in the future, any of RCI's research and development efforts will be successful, be completed in a timely manner, improve RCI's profitability, or enable it to respond effectively to technological or medical advances or new product developments by competitors. MAINTENANCE, WARRANTY AND INSURANCE - Initial sales of LenSystems are supported by sales and technical representatives who provide installation and training services. RCI provides its customers with a complete operations manual and training videos. RCI currently offers the LenSystem with a one year warranty for parts and labor. RCI currently maintains product liability insurance which provides coverage of $6,000,000 per occurrence and $7,000,000 in the aggregate. There can be no assurance that the coverage provided by those policies is sufficient to protect RCI against liability. RCI's inability or failure to protect itself adequately against such liabilities could have a material adverse effect upon its prospects, financial condition and results of operations. COMPETITION - The prescription ophthalmic lens industry is intensely competitive. Numerous manufacturers and distributors currently supply United States lens dispensers, including such dispensers as retail optical stores and small to mid-sized wholesale optical lens manufacturing laboratories. These are the customers to whom RCI initially intends to market the LenSystem. Many of these manufacturers and distributors are currently capable of supplying lenses to a lens dispenser within 24 hours after receipt of the dispenser's order, and, in many cases they can do so at prices competitive with the cost of producing such lenses utilizing the LenSystem. Innotech Corporation is one competitor of RCI which uses plastic to produce lenses. RCI believes that the LenSystem has superior quality (i.e. better durability) and equivalent pricing to other manufacturers of single vision lenses, and both superior quality and lower pricing with respect to flat-top bifocal and progressive bifocal lenses. If RCI is successful in marketing the LenSystem, it anticipates that other companies or entities will attempt to develop competitive lens casting systems capable of being placed in retail optical store locations. Potential competitors may include companies that own large optical lens manufacturing factories, owners of chains of retail optical stores, large wholesale optical lens manufacturing laboratories, mass merchandisers and warehouse membership clubs that have entered or may enter the retail optical industry, companies in the optical instrument business, companies in the contact lens industry, pharmaceutical and chemical companies that have entered or may enter the retail optical industry or the optical lens manufacturing industry, and universities and public research organizations. Many of these competitors have substantially greater financial, technological, research, product development, manufacturing, sales, marketing and human resources than RCI. There can be no assurance that one or more of these competitors will not develop a system for on-site production of prescription ophthalmic lenses which is competitive with or superior to the LenSystem, or that RCI will have the technological, marketing or financial resources or flexibility to respond to any such development. The development of such a system would, in all likelihood, exert adverse price pressures on the LenSystem and could render it obsolete and unmarketable. PATENTS AND PROPRIETARY RIGHTS - In February 1995 RCI acquired all of the capital stock of Q2100 and thus all of Q2100's issued patents and patent applications that relate to the Technology. RCI is not aware that any party, in the United States or elsewhere, has challenged the validity or enforceability of the issued patents relating to the 15 Technology, other than the patent dispute with Ronald D. Blum O.D., which was settled in January 1997. See "Item 3. Legal Proceedings - Settlement of Patent Infringement Lawsuit." The status of pending patent applications involves complex legal and factual questions, and the scope and breadth of claims to be allowed is uncertain. Accordingly, there can be no assurance that pending patent applications, or patent applications that may be filed by RCI in the future, will result in patents being issued, or that any patents that may be issued in the future will afford protection against competitors with similar technology. Patent applications in the United States are maintained in secrecy until patents are issued and, since publication of discoveries in the scientific or patent literature tends to lag behind actual discoveries by several months or even years, there can be no assurance with respect to pending patent applications that the covered inventions were not first created by other parties, or that such applications were the first to be filed on such inventions. In addition, patents relating to the Technology that have been or may be issued in some foreign countries may not afford the same protection to RCI as is provided under the patent laws of the United States. No assurance can be given that the issued patents relating to the Technology will afford protection against competitors with similar technology, or that any fo such patents will not be infringed, designed around by others or invalidated. Applications of the Technology (or future technologies RCI may develop) may infringe patents or proprietary rights of others. If any licenses are found to be required in order for RCI to use the Technology or other processes or products, such licenses may not be available on acceptable terms, if at all. Furthermore, there can be no assurance that challenges will not be instituted against the validity or enforceability of any patent owned by RCI or, if instituted, that such challenges will not be successful. The cost of litigation to uphold the validity and prevent infringement of a patent can be substantial and could have a material adverse effect upon RCI's financial condition and results of operations. In addition to potential patent protection, RCI will rely upon the laws of unfair competition and trade secrets to protect its proprietary rights. RCI currently intends to seek to protect its trade secrets and other proprietary information in part by entering into appropriate confidentiality and nondisclosure agreements with its future employees, consultants, suppliers, joint venturers, subcontractors, licensees, scientific collaborators, sponsored researchers and others. These agreements will generally provide that all confidential information developed by or made known to the other party during the course of the relationship with RCI is to be kept confidential and not disclosed to third parties, except in certain circumstances. In the case of employees, consultants, scientific collaborators and sponsored researchers, the agreements will generally provide that all inventions conceived by them relating to the business of RCI will be the exclusive property of RCI. There can be no assurance, however, that any such agreements will provide meaningful protection for RCI's trade secrets in the event of unauthorized use or disclosure of such information. Although RCI intends to protect its rights vigorously, there can be no assurance that trade secrets will be established or maintained, that secrecy, confidentiality or nondisclosure agreements will be honored, or that others will not independently develop similar or superior technologies. To the extent that employees, consultants or other third parties (such as prospective joint venturers or subcontractors) apply technological information to RCI's projects which has been independently developed by them or others, disputes may arise as to the proprietary rights to such information, which disputes may not be resolved in favor of RCI. RCI currently utilizes the tradenames and marks "Fast Cast," "Rapidcast," and "LenSystem." None of these marks have been federally registered. GOVERNMENTAL REGULATION - The lens produced by the LenSystem may be medical "devices" within the meaning of the Federal Food, Drug and Cosmetic Act (the "Food and Drug Act"), but management believes that the lenses may be marketed without pre-market notification, review, approval or clearance by the Federal Food and Drug Administration ("FDA"). Other requirements, principally those concerning impact resistance, good manufacturing practices, labeling and reporting of certain alleged adverse effects, apply to RCI's business. Although the FDA may disagree, RCI also believes that the LenSystem is itself not a "medical device" under the Food and Drug Act. Certain state and local governmental authorities (such as the State of California) also regulate medical device manufacturers. Depending upon where LenSystem equipment is manufactured, RCI may be subject to such additional regulations. Although there can be no assurance in this regard, RCI does not anticipate that compliance with such governmental regulation will have an adverse effect upon its business. 16 RECENT CAPITALIZATION OF RCI: On January 16, 1997, Rapid Cast, Inc., a minority owned subsidiary of the Company, issued 8,000,000 shares of Series A and Series B 7% Convertible Preferred Stock to institutional investors in a private placement pursuant to Regulation D of the Securities Act of 1933, as amended. The investors contributed $12,000,000 in capital in consideration for the issuance of 7,275,000 shares of voting Series A 7% Convertible Preferred Stock and 725,000 shares of nonvoting Series B 7% Convertible Preferred Stock. The investors also have the option to purchase up to an additional 6,666,666 shares of voting or nonvoting 7% Convertible Preferred Stock from RCI for a purchase price $1.50 per share, exercisable with respect to 3,333,333 of the shares upon the sooner to occur of (i) the appointment of a permanent Chief Executive Officer of RCI, or (ii) July 15, 1997, or the option relating to those shares will expire unexercised. The option with respect to the remaining 3,333,333 shares must be exercised on or before July 16, 1998, or the option with respect to those shares will expire unexercised. Frank Pipp, the new Chairman of the Board of Directors of RCI, also has an option to purchase up to 1,333,333 shares of Series A 7% Preferred Stock at any time until July 15, 1998 for a price of $1.50 per share. The Company's ownership of RCI will be diluted to the extent that those investors or Mr. Pipp exercise their options to purchase additional shares of Series A 7% Preferred Stock. The proceeds of the issuance of the Series A and Series B 7% Convertible Preferred Stock were utilized by RCI (i) to repay short-term bridge loans made to RCI by its shareholders, including Incomnet, Inc., in the approximate total amount of $3,705,430; (ii) to repurchase 1,200,000 shares of RCI common stock from Dr. Larry Joel for a redemption price of $1.28 per share; (iii) to make the final settlement payment and license new technology for $325,000 on the patent infringement lawsuit known as RONALD BLUM, O.D. VS. RAPID CAST, INC., ET AL., which has been dismissed; (iv) to repay the bank line of credit with Bank Leumi in the approximate outstanding amount of $500,000 plus interest; (v) to pay placement costs of approximately $700,000; (vi) to pay all overdue trade payables in the approximate outstanding amount of $1,700,000, and (vii) the balance for working capital. The outstanding RCI founder loans in the approximate outstanding principal balance of $1,205,000 on the date of the closing, the other RCI shareholder bridge loans which were not repaid from the proceeds of the private placement of the Series A and Series B 7% Convertible Preferred Stock, and the outstanding 8% convertible notes in the approximate outstanding balance of $648,000 (which were convertible into RCI common stock at a price of $.80 per share), were all converted into newly issued RCI common stock and Series C 7% Convertible Preferred Stock as follows:
No. of Shares of Series C No. of Shares Name of RCI Shareholder Preferred Stock(1) of Common Stock (2) - ----------------------- ------------------ ------------------- Robert Cohen 121,543 260,708(3) Alan Cohen 120,194 260,708(5) Jeff Rubin 122,260 45,752 Dr. Shawn Zimberg 111,781 135,252 Dr. Larry Joel(6) 0 255,099 Huberfeld Bodner Partnership 0 543,390 Martin Price 27,485 52,628 Incomnet, Inc. 0 428,570
- -------------------- (1) Issued at a price of $1.50 per share. (2) Issued at a price of $.80 per share with respect to the conversion of the outstanding principal balance of the 8% convertible promissory notes, and $1.28 with respect to the conversion of the RCI founder loans, the accrued but unpaid interest on the 8% convertible promissory notes, the unpaid bridge notes and accrued interest. (3) Includes 36,603 shares issued in the name of Robert Cohen's children. (4) Includes 120,194 shares issued in the name of Alan Cohen's children. (5) Includes 36,602 shares issued in the name of Alan Cohen's children. 17 (6) In September 1996 Dr. Joel surrendered 142,222 shares of RCI common stock to RCI as the settlement payment for $448,000 of liabilities owed by Dr. Joel to RCI. From the proceeds of the capitalization of RCI on January 15, 1997, Incomnet, Inc. was repaid $2,647,348 of principal and accrued interest on its short term bridge loans which it made to RCI during the period from April 1996 through January 1997. RCI also issued 428,570 shares of its common stock to Incomnet, Inc. in exchange for the conversion by Incomnet, Inc. of $326,400 of 8% convertible promissory notes purchased by it from RCI in January 1996. Incomnet, Inc. now owns 10,628,570 shares of RCI common stock. Melvyn Reznick was repaid $80,000 plus interest at the rate of 10% per annum for the loan he made to RCI in late December 1996, and Stephen Caswell was repaid $12,500 plus interest at the rate of 10% per annum for the loan he made to RCI in early January 1997. Pursuant to its Amended and Restated Certificate of Incorporation filed on January 15, 1997, RCI is authorized to issue a total of 60,000,000 shares of common stock, 22,000,000 shares of which are nonvoting common stock, and 42,500,000 shares of preferred stock, all having a par value of $.001 per share. As of March 17, 1997, RCI has a total of 22,233,335 shares of common stock issued and 20,891,113 outstanding, 10,628,570 of which are owned by Incomnet, Inc., 7,275,000 shares of voting Series A 7% Convertible Preferred Stock, 725,000 shares of nonvoting Series B 7% Convertible Preferred Stock, and 503,264 voting Series C 7% Convertible Preferred Stock. Incomnet, Inc. does not own any outstanding RCI preferred stock. Each share of issued and outstanding Series A, Series B and Series C Preferred Stock is convertible into one share of RCI common stock (subject to adjustment) at any time at the option of the preferred shareholder, and automatically upon the occurrence of a "qualified public offering" by RCI, as that term is defined in the Certificate of Determination of Rights, References and Privileges for all outstanding series of RCI preferred stock. The terms of conversion and other rights of the outstanding RCI preferred stock are all subject to customary adjustments and antidilution provisions in the event of stock splits, certain stock dividends, stock combinations, reorganizations, recapitalizations and similar events. A "qualified public offering" by RCI occurs when RCI makes a public offering of its securities having gross proceeds of at least $20,000,000 and an offering price of at least $1.90 per share if it occurs on or prior to December 31, 1997, $2.14 per share if it occurs on or prior to June 30, 1998, $2.40 per share if it occurs on or prior to December 31, 1998, $2.69 per share if it occurs on or prior to June 30, 1999, $3.02 per share if it occurs on or prior to December 31, 1999, $3.40 per share it occurs on or prior to June 30, 2000, $3.81 per share if it occurs on or prior to December 31, 2000, $4.29 per share if it occurs on or prior to June 30, 2001, $4.82 per share if it occurs on or prior to December 31, 2001, $5.41 per share it if occurs on or prior to June 30, 2002, and $6.08 per share if it occurs after June 30, 2002, in each case as adjusted for stock splits, certain stock dividends, stock combinations and similar events. The Series A, Series B and Series C 7% Convertible Preferred Stock have a liquidation preference of $1.50 per share. All outstanding RCI preferred stock have a cumulative noncompounded dividend of 7% per annum which must be declared and paid in full before any dividends may be declared or paid on the RCI common stock. All dividends on outstanding RCI preferred stock, regardless of whether Series A, Series B or Series C, must be declared and paid ratably on all such outstanding preferred stock. Each holder of outstanding RCI preferred stock has the right to be paid the 7% dividend, when declared, either in cash, in shares of Series A, Series B or Series C Preferred Stock (at a price of $1.50 per preferred share, subject to adjustment), or in a combination of cash and preferred stock. The cumulative unpaid dividend on the outstanding RCI preferred stock must be paid in full in shares of RCI common stock (at a price of $1.50 per common share, subject to adjustment) or in cash, at the option of the preferred shareholder, upon the conversion of the preferred stock into common stock. The preferred shareholder may require RCI to redeem the outstanding preferred stock beginning after January 1, 2003 if the preferred stock has not otherwise been converted. The redemption price would equal the original issue price plus cumulative unpaid dividends. The Certificate of Determination for the outstanding RCI preferred stock contains numerous restrictive covenants applicable to RCI with respect to the incurrence of debt, sale of assets, issuance of shares, mergers, reorganizations, recapitalizations, affiliate transactions, and similar transactions by RCI. In connection with the issuance of the preferred stock by RCI, RCI and its shareholders entered into a Registration Rights Agreement, a Shareholders Agreement and related agreements governing the outstanding RCI shares and the management of RCI. 18 Pursuant to the Registration Rights Agreements, the Series A and Series B Preferred Shareholders have priority demand and piggyback registration rights with respect to the shares of RCI common stock issuable upon the conversion of the preferred stock, and issuable upon the exercise of warrants held by them. The Series A and Series B Preferred Shareholders are the only RCI shareholders with demand registration rights, of which they have three for less than $5,000,000 of proposed sales and an unlimited number of proposed sales in excess of $5,000,000. With respect to piggyback registration rights, the holders of Series A and Series B Preferred Stock are entitled to 80% of the available registration of shares for selling security holders on a pro rata basis, and the other existing RCI shareholders are entitled to 20% of the available share registration for selling security holders on a pro rata basis, subject to other conditions and limitations. Pursuant to the RCI Shareholders Agreement, the RCI shareholders and RCI are granted certain first rights of refusal to purchase RCI stock proposed for sale by other RCI shareholders. The RCI Shareholders Agreement imposes certain other restrictions on the transferability of RCI shares, except for Rule 144 sales, a sale of shares in a public offering pursuant to the Registration Rights Agreement, and a transfer to RCI. The RCI shareholders also agree to vote their shares so that (i) the RCI Board of Directors will consist of nine members, (ii) subject to certain conditions, the RCI Board of Directors will consist of two members designated by J.P.Morgan Investment Corporation and its related investors, two members designated by Clipper Capital Associates, L.P. and its related investors, one member designated by Incomnet, Inc., provided, that if Incomnet, Inc. undergoes a "change of control" (defined as the cessation of Melvyn Reznick's service on the RCI Board of Directors for any reason or certain other changes in the Incomnet, Inc. Board of Directors or the stock ownership of Incomnet, Inc.), then the Incomnet designee must be approved by a majority of the other members of the RCI Board of Directors, one member designated by Jeff Rubin, one member designated by Robert Cohen, one member (initially Frank Pipp) designated by a majority of the RCI Board of Directors who qualify as outside directors and approved by a majority of the RCI shareholders, and one member who is the interim or permanent Chief Executive Officer of RCI. RCI has established Executive, Audit and Compensation Committees. The following persons are the current members of the RCI Board of Directors and its Committees: I. BOARD OF DIRECTORS(1) Molly F., Ashby (J.P. Morgan Designee) Robert Cohen Patrick H. Garrett (J.P. Morgan Designee) Kevin A. Macdonald (Clipper Designee) Frank Pipp (Chairman and Interim Chief Executive Officer)(2) Melvyn Reznick (Incomnet Designee) Jeff Rubin II. EXECUTIVE COMMITTEE Molly F., Ashby (Chairman) Kevin A. Macdonald Frank Pipp III. COMPENSATION COMMITTEE Patrick H. Garrett (Chairman) Kevin A. Macdonald Frank Pipp Melvyn Reznick IV. AUDIT COMMITTEE Melvyn Reznick (Chairman) Patrick H. Garrett 19 Kevin A. Macdonald - -------------------- (1) The Board of Directors currently has one vacancy which is reserved for the permanent Chief Executive Officer when he is hired. (2) John L. Vidovich is currently a consultant and acting co-Chief Executive Officer of RCI with Frank Pipp. Mr. Vidovich may become the permanent Chief Executive Officer of RCI. The permanent Chief Executive Officer of RCI is expected to join the RCI Board of Directors and may join one or more of its Committees. Upon the completion of a "qualified public offering" by RCI, as that term is defined in the Certificate of Determination for the outstanding RCI preferred stock and as described above, the voting and transferability restrictions in the RCI Shareholders Agreement generally terminate, except that the RCI shareholders agree to vote for one director designee each for J.P. Morgan and Clipper after the "qualified public offering" as long as their investors hold a specified minimum number of shares of RCI. The RCI Shareholders Agreement grants the RCI shareholders pro rata preemptive rights to purchase new securities proposed to be issued by RCI, except in circumstances such as when RCI makes a public offering, issues stock to acquire another company in a purchase, merger or other reorganization, issues stock pursuant to outstanding conversion rights, options or warrants, issues up to 120,000 shares to John L. Vidovich or 450,000 shares to Frank Pipp, implements a stock split or stock dividend, or issues stock after a "qualified public offering" by RCI. In connection with the short term bridge loans made to RCI from April 1996 to January 1997 and the issuance of the preferred stock by RCI on January 16, 1997, RCI issued options and warrants to purchase its common stock, and amended and restated its 1994 Stock Option Plan. The RCI 1994 Stock Option Plan was amended to authorize and reserve up to 4,514,732 shares of its common stock for issuance upon the exercise of stock options granted and which may be granted by the RCI Board of Directors in the future. Under the RCI 1994 Stock Option Plan, a total of 3,260,000 stock options have been granted to various officers, directors, employees and key consultants of RCI. The exercise price of 1,408,000 of the stock options is $2.25 per share and the exercise price of 1,342,000 of the stock options is $2.00 per share. These stock options have vested (subject to continued employment) and are exercisable at any time from the date of grant until dates ranging from November 1, 2005 until July 31, 2006. Melvyn Reznick was granted 100,000 of these options by RCI, having an exercise price of $2.25 per share and exercisable at any time until July 31, 2006. Frank Pipp was granted 450,000 of these stock options to purchase a total of 450,000 shares of RCI common stock at any time until January 20, 2007, 225,000 to which may be purchased at an exercise price of $1.28 per share and 225,000 of which may be purchased at an exercise price of $4.00 per share. RCI also granted to John L. Vidovich 60,000 of these stock options to purchase 60,000 common stock at any time until January 20, 2007 at an exercise price of $1.28 per share. RCI issued to the purchasers of the Series A and Series B Preferred Stock warrants to purchase 1,400,000 shares of RCI common stock at an exercise price of $1.74 per share, exercisable at any time until January 16, 2004. The holders of these warrants have certain registration rights under the Registration Rights Agreement described above, and customary adjustment and antidilution protection. In connection with short term bridge loans made to RCI by its shareholders and others during the period from April 1996 until early January 1997, RCI issued a total of 4,441,933 warrants to purchase 4,441,933 shares of RCI common stock at any time until dates ranging from September 30, 2003 to December 31, 2003. The exercise price of 1,853,683 of the warrants is $2.25 per share, the exercise price of 302,500 of the warrants is $1.28 per share, and the exercise price of 2,285,750 of the warrants is $.75 per share. Incomnet, Inc. holds 841,416 of these warrants to purchase 841,416 shares of RCI common stock at an exercise price of $2.25 per share at any time until September 30, 2003, 480,000 of these warrants to purchase 480,000 shares of RCI common stock at an exercise price of $.75 per share at any time until December 30, 2003, 150,000 of these warrants to purchase 150,000 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003, and 1,090,000 of these warrants to purchase 1,090,000 shares of RCI common stock at an exercise price of $.75 per share at any time until November 30, 2003. In consideration for personal loans and loan guarantees, Melvyn Reznick holds 175,000 of these warrants to purchase 175,000 shares of RCI common stock at an exercise price of $2.25 per share at any time 20 until September 30, 2003, and 160,000 of these warrants to purchase 160,000 shares of RCI common stock at an exercise price of $.75 per share at any time until December 31, 2003. In consideration for personal loans to RCI, Albert Milstein was issued 25,000 warrants to purchase 25,000 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003. In consideration for personal loans to RCI, Steve Caswell was issued 12,500 of these warrants to purchase 12,500 shares of RCI common stock at an exercise price of $1.28 per share at any time until December 31, 2003. RCI also has a total of 1,000,000 additional warrants outstanding which entitle their holders to purchase a total of 1,000,000 shares of RCI common stock at an exercise price equal to 50% of the average of the last reported sales price of RCI shares during the first 30 business days after the shares of RCI first become publicly traded, provided that they become publicly traded on or before December 31, 1998. If RCI becomes publicly traded on or before December 31, 1998, these warrants are then exercisable for a period of 180 days after the public trading commencement date. These 1,000,000 RCI warrants were issued on February 8, 1995 in connection with the issuance of 8% convertible promissory notes by Incomnet, Inc. on that date to finance its acquisition of a controlling interest in RCI. See "Item 1. Business - Acquisition of Rapid Cast, Inc." in the Company's Form 10-K for the fiscal year ending December 31, 1995. ISSUANCE OF CONVERTIBLE PREFERRED STOCK: From September 20, 1996 to October 25, 1996, the Company issued 2,440 shares of Series A 2% Convertible Preferred Stock to 12 accredited investors in a private placement pursuant to Regulation D of the Securities Act of 1933, as amended. The shares of Series A 2% Convertible Preferred Stock were purchased by four affiliated individuals and eight unaffiliated investors. The Company raised $2,440,000 in capital from the issuance of the Preferred Stock, a portion of which it utilized to repay advances made to it by Melvyn Reznick, the Company's Chairman and Chief Executive Officer, who in turn owed approximately $723,000 to a bank on a loan with a maturity date of September 16, 1996. Mr. Reznick had borrowed these funds from the bank in order to make a substantial portion of his loan to the Company, which enabled the Company to make its pro rata share of loans to RCI. See "Item 5. Other Information - Loan to Company By Melvyn Reznick" in the Company's Form 10-Q for the fiscal quarter ending September 30, 1996. The balance of the proceeds is being utilized and is expected to be utilized for general working capital and to pay the costs of settling pending litigation. The Company paid a referral fee to Newport Capital Partners, an unaffiliated financial consultant, equal to 5% of the capital raised through its referrals, which was $1,700,000. The Company has therefore paid $85,000 of referral fees to Newport Capital Partners. The basic terms and conditions of the Series A 2% Convertible Preferred Stock are described in the following paragraphs: VOTING - The Series A 2% Convertible Preferred Stock does not have voting rights. DIVIDEND - The Series A 2% Convertible Preferred Stock has a cumulative noncompounded annual dividend of 2% payable in cash or stock at the Company's option upon conversion of the Preferred Stock into Common Stock, and prior to the payment of any dividends on the Common Stock. LIQUIDATION PREFERENCE - The Series A 2% Convertible Preferred Stock has a liquidation preference of $1,000 per share plus all cumulative unpaid dividends, whether or not declared by the Company's Board of Directors. Upon any liquidation or change of control of the Company (i.e. transfer of more than 50% of its voting stock), the Preferred Shareholders are entitled to the first priority in payment from the Company's assets, before any payments are made on the Company's Common Stock, until the liquidation preference is paid in full. CONVERSION - The Preferred Shareholders may convert each share of Series A 2% Convertible Preferred Stock into the number of shares of the Company's Common Stock calculated as follows, at any time upon the earlier of (i) 90 days after the issuance of the Preferred Stock, or (ii) 60 days after the shares of Common Stock underlying the Preferred Stock are registered with the Securities and Exchange Commission: The conversion price (the "Conversion Price") for each share of Series A 2% Convertible Preferred Stock is equal to the LESSER of (a) 80% of the average bid price for the Company's Common Stock on the public trading market for the five trading days immediately preceding the conversion date, as specified by the Preferred Shareholder, or (b) the bid price of the Company's Common Stock on the funding date (i.e. the issuance date of the Preferred Stock). To calculate the number of shares of Common Stock issuable upon the conversion of the Preferred Stock, the Conversion Price is multiplied by a ratio, the numerator of which is the sum of 1,000 and the accrued but unpaid dividends, and the denominator of which is the Conversion Price. If for any reason a registration statement covering the shares of Common Stock issuable upon the conversion of the Preferred Stock is not in effect with the Securities and Exchange Commission at the time of a valid conversion by a Preferred Shareholder, 21 then the Conversion Price is reduced by 3% per month for each of the first three months that the effectiveness of the registration is late. The Company has the right to cause a conversion of the Preferred Stock into Common Stock on the same terms at any time after one year after the Preferred Stock is issued. REDEMPTION - The Company has the right to redeem the Preferred Stock for its issuance price plus cumulative unpaid dividends if the Company's stock trades at a price which averages $2.00 per share or less for any period of five consecutive trading days after the Preferred Stock is issued. REGISTRATION RIGHTS - Pursuant to a Registration Rights Agreement entered into by the Company with each purchaser of the Series A 2% Convertible Preferred Stock, the Company is obligated to file a registration statement with the Securities and Exchange Commission covering the shares of Common Stock underlying the Preferred Stock within 30 days after the Preferred Stock is issued, and to have the registration statement declared effective within 75 days after it is filed. The Underlying Shares issuable upon the conversion of the first 365 shares of Series A 2% Convertible Preferred Stock were covered by a prior registration statement declared effective by the Securities and Exchange Commission on October 31, 1996. The balance of the shares of Common Stock issuable upon the conversion of outstanding Series A 2% Convertible Preferred Stock are covered by this Prospectus. ANTIDILUTION PROVISION - The Certificate of Determination for the Series A 2% Convertible Preferred Stock contains comprehensive provisions for adjustments to the Conversion Price and the conversion ratio of the Preferred Stock in the event of stock dividends, asset distributions, reorganizations, recapitalizations, mergers, stock splits or similar transactions by the Company, in order to protect the Preferred Stock from dilution as a result of such transactions. RESTRICTIVE COVENANTS - During the first 90 days after the Series A 2% Convertible Preferred Stock is issued, the Company is not permitted to issue any other securities, except in limited circumstances, including pursuant to the exercise of outstanding options or warrants or pursuant to existing settlement agreements, without first notifying the Preferred Shareholders and giving them a right of first refusal to purchase the securities themselves. While the Series A 2% Convertible Preferred Stock is outstanding or until it is converted into Common Stock, the Company is not permitted to engage in certain transactions, such as the redemption or purchase of its own Common Stock (except in connection with the collection of Section 16(b) short-swing profits), without the prior consent of the Preferred Shareholders. Furthermore, the Company is not permitted to pay cash dividends on its Common Stock unless all cumulative unpaid dividends on the Series A 2% Convertible Preferred Stock is paid. The Company cannot take any action which would modify the rights of the Preferred Shareholders under the Certificate of Determination without the prior consent of the Preferred Shareholder being affected by the modification. AGREEMENT WITH PRICE INTERNATIONAL, INC.: On October 27, 1994, the Company entered into an exclusive agreement with Price International, Inc. ("PRI") of Boca Raton, FL, to provide production, management and marketing services for sports-oriented private label and collectible telephone calling cards. In June 1996, the license with the NHLPA expired and was not renewed. PRI and Incomnet also agreed to end their relationship in providing telephone calling cards. Incomnet has also decided, at this point in time, not to issue additional cards to the ones issued under the agreement. In August 1996, the Company entered into a settlement agreement with PRI pursuant to which the Company agreed to lower the exercise price of PRI's 75,000 warrants from $11.25 to $4.50 per share, and to extend the expiration date of the warrants from November 15, 1997 until December 31, 1998. The Company also registered the 75,000 shares issuable upon the exercise of the warrants in a registration statement with the Securities & Exchange Commission declared effective on October 31, 1996 (see Item 3. Legal Proceedings - "Settlement With Price International, Inc."). NETWORK SERVICES: The Company's major network service is the Auto Dismantler Network (known under the tradename "AutoNETWORK") that currently links several hundred licensed automobile dismantlers in California, Nevada, Arizona, Utah, Oregon and Washington. AutoNETWORK is a monthly subscription service that auto dismantlers utilize to buy, sell and trade used parts that have been salvaged from automobiles damaged in traffic collisions. The Company evaluates on a continual basis other applications that could use the Company's broadcast and point-to-point business communications technologies. 22 AutoNETWORK allows automobile dismantlers to buy, sell and trade used automobile parts. By entering a parts request into a personal computer, the request is transmitted to the communications message switching system, which in turn broadcasts the request within seconds to every dismantler on the network or to a selected local or regional subgroup of dismantlers. Those dismantlers who have the requested part in stock and wish to sell it then transmit private messages and enter into private negotiations to sell the part. Generally, a dismantler using AutoNETWORK can locate a part, if available, within minutes of entering his request. The majority of dismantlers on the network generate substantially increased parts sales per month using the network. During September 1989, the Company agreed to a joint venture with Dismantlers Exchange, a privately-owned, Fairfield, California-based operator of voice telephone hotlines used by more than 200 auto dismantlers to locate auto parts throughout Central and Northern California, Oregon and Washington. Under the joint venture agreement, Dismantlers Exchange markets its own version of the Company's computerized parts locator network in its marketing area under the tradename "DX PC Network". Although both companies operate their networks separately, customers of each network are able to receive appropriate parts requests and send private messages to each other. Dismantlers Exchange also operates a central clearinghouse so that customers of either network can search for parts on each network as required. In February 1997, the Company agreed with Dismantlers Exchange to end the joint venture. Incomnet has taken over the customer base serviced by Dismantler's Exchange. In 1997, the Company intends to invest approximately $5,000 into the AutoNETWORK business to enhance the services provided to the automobile dismantlers in the network. EMPLOYEES, OFFICERS AND DIRECTORS: EMPLOYEES - As of December 31, 1996, the Company, including its subsidiaries, NTC and RCI, employed 288 full-time people, consisting of 73 general and administrative, 46 marketing and sales, and 169 operations and customer service personnel. None of the Company's employees are subject to a collective bargaining agreement, and the Company has not experienced any slow-downs, strikes or work stoppages due to labor difficulties. The Company considers its employee relations to be satisfactory. DIRECTORS AND OFFICERS - The success of the Company is heavily dependent on the Company's President and Chief Executive Officer, Melvyn Reznick, and the Chief Executive Officer and President of the Company's NTC subsidiary, Edward R. Jacobs and James R. Quandt, respectively. The Company has a three-year employment contract with Mr. Jacobs that expires on July 25, 1997. Should Mr. Jacobs become unavailable or incapable of performing his duties and functions, the Company could suffer material adverse consequences. There can be no assurance that the Company would be able to attract a competent replacement on a timely basis should the Company find it necessary to replace Mr. Jacobs. On January 6, 1997, NTC entered into an employment agreement with James R. Quandt pursuant to which Mr. Quandt is serving as NTC's President and is a member of NTC's Board of Directors. The employment agreement contemplates that Mr. Quandt will eventually become the Chief Executive Officer of NTC upon the retirement of Edward Jacobs, the current Chief Executive Officer, which is presently scheduled for January 1, 1999. Mr. Quandt's employment agreement commenced on January 6, 1997 and has a term of three years. The employment agreement recites that Mr. Jacobs also contemplates retiring as the Chairman of the Board of Directors of NTC on July 25, 1999, although such retirement is not contractually mandated. The employment agreement contemplates that Mr. Quandt may be nominated to become the Chairman of the Board of Directors of NTC upon Mr. Jacobs' retirement from that position. 23 Pursuant to the employment agreement, Mr. Quandt is entitled to the following compensation: (1) A base salary of $40,000 per month, (2) an incentive bonus equal to one and one-half (1.5%) of the quarterly net profit earned by NTC, provided that the quarterly net profit is at least $1,250,000, and the payment of the bonus does not cause the quarterly net profit of NTC to be less than $1,250,000, and NTC's pretax profit for the succeeding calendar quarter is reasonably expected to exceed the minimum quarterly net profit of $1,250,000, and (3) nonqualified stock options to purchase 600,000 shares of the common stock of NTC. The stock options will have an exercise price determined by the Board of Directors of NTC in accordance with the NTC Stock Options Plan, but in no event greater than the higher of $5.00 per share or the fair market value of NTC's stock at the time of the grant. See "THE COMPANY - Amendment to NTC management Incentive Agreement." The stock options will have an exercise period of five years from the date of grant. The stock options will vest as follows: (1) 300,000 stock options will vest upon Mr. Quandt completing 15 months of employment for NTC under the employment agreement, and (2) 350,000 stock options will vest only in the event NTC achieves certain pretax profits goals prior to January 1, 1998 or prior to January 1, 1999 whichever first occurs. In addition to the base salary, regular bonus and stock options, Mr. Quandt will earn a hiring bonus equal to $225,000, payable if NTC's quarterly net profits exceed $1,250,000, but in any event no later than December 31, 1997 with respect to $150,000 of the guaranteed hiring bonus, and the balance by no later than June 30, 1998. The hiring bonus will be paid at the rate of 1.5% of quarterly pre-tax profits of NTC in excess of $1,250,000, and if not earned in that manner, will be paid in full in two installments as follows: $150,000 by December 31, 1997 and the balance by June 30, 1998. To the extent that the regular bonus and guaranteed hiring bonuses are paid to Mr. Quandt pursuant to his employment agreement, Mr. Jacobs has agreed to waive any remaining portion of the quarterly incentive bonus payable by NTC to Mr. Jacobs (i.e. 1.5% of the pre-tax net profits in excess of $1,250,000 of net profits of NTC per calendar quarter) pursuant to Mr. Jacobs' current employment agreement with NTC. Under the employment agreement, Mr. Quandt is entitled to a significant severance payment if his employment terminates prior to the agreement's termination date because of his death, disability, or for a reason other than cause, or because of a voluntary resignation by Mr. Quandt for "good cause", as defined in the employment agreement. Mr. Quandt has agreed not to compete with NTC during the term of his employment agreement and for a period of one year after the agreement terminates for any reason. Prior to assuming his executive position with NTC, Mr. Quandt was the Chairman of the Board of Directors of Global Financial Information Corporation, a privately held group of companies in the financial information and technology industry. Global Financial Information corporation operates from a base of 27 offices internationally, with a staff of approximately 840 professionals. From 1991 to 1995, Mr. Quandt was the President and Chief Executive Officer of Standard & Poors Financial Information Services, a subsidiary of McGraw Hill Corporation in New York, New York. At Standard & Poors, Mr. Quandt was responsible for all executive, administrative and operational functions of nine domestic and international companies that comprised the Standard & Poors Group. From 1980 to 1991, Mr. Quandt was an executive officer in various capacities with Security Pacific Bank in Los Angeles, California. Mr. Quandt was the Senior Vice President and Group Division Head of Security Pacific Bank's Financial Management & Trust Services Group from 1988 to 1991. From 1983 to 1990, Mr. Quandt was the President and Chief Executive Officer of Security Pacific Brokerage, Inc., a subsidiary of Security Pacific Bank. Effective April 8, 1997, James R. Quandt was elected to be a member of the Board of Directors of NTC to replace Jerry Ballah, who resigned as a director and as an officer of NTC. Mr. Ballah is now a marketing consultant to NTC. Effective January 17, 1997, the Company entered into an Amendment to the Employment Agreement with Melvyn Reznick pursuant to which the term of Mr. Reznick's Employment Agreement has been extended for two additional years, until November 30, 1999. Mr. Reznick is also a director and a member of several committees of the Board of Directors of RCI, as well as being a director of NTC. APPOINTMENT OF NEW DIRECTOR BY THE COMPANY - On January 20, 1997, the Company's Board of Directors appointed Dr. Howard Silverman to fill a vacancy and become a member of the Board of Directors. Since March 1996, Dr. Silverman has been consulting for various companies in the optical and financial areas, including Andrew, Alexander, Wise & Company in New York, and Rapid Cast, Inc. From August 1995 to March 1996, Dr. Silverman served as a Vice President of Corporate Finance for Rickel & Associates, an investment banking firm. From 1991 until he joined Rickel & Associates in 1995, Dr. Silverman was an independent business consultant specializing in early stage and mid-size operating companies. From 1985 to 1991, Dr. Silverman was the founder and Chairman of the Board of Directors of Vision Sciences, Inc., a company that developed, manufactured and sold in-office lens casting systems, which enabled the optical retailer to cast his own finished plastic optical lenses. Dr. Silverman was a member of the Board of Directors and the director of business development for Staar Surgical Co., Inc., a publicly owned company, from 1984 to 1990. He was the co-founder and Chief Operating Officer of Hydro-Optics, Inc., a manufacturer of hydrophilic contact lens, from 1974 until 1984. Dr. Silverman has also been the Vice President and Chief Operating Officer of Diversified Health Industries, Inc. and the President and Chief Executive Officer of Precision Contact Lens, Inc. Dr. Silverman had a private optometric practice in New York City from 1968 to 1972, specializing in contact lenses. Dr. Silverman earned a Bachelor of Science in Chemical Engineering from the College of the City of New York in 1965 and a Doctor of Optometry form Illinois College of Optometry in 1968. See the Company's Report on Form 8-K, dated January 20, 1997. 24 APPOINTMENT OF COMMITTEE MEMBERS - The current members of the Audit Committee of the Company's Board of Directors are Albert Milstein, Nancy Zivitz and Dr. Howard Silverman. The current members of the Compliance Committee of the Company's Board of Directors are Melvyn Reznick, Mark Richardson, Albert Milstein and Nancy Zivitz. The current members of the Compensation Committee of the Company's Board of Directors are Albert Milstein, Nancy Zivitz, Stephen Caswell and Dr. Howard Silverman. ITEM 2. PROPERTIES The Company does not own any real estate. The Company leases approximately 6,224 square feet of office facilities at 21031 Ventura Boulevard, Suite 1100, Woodland Hills, California 91364. The Company has been obligated to make lease payments at the rate of $8,713 per month from May 1995 through July 1998. The Company's subsidiary, NTC, currently leases approximately 64,000 square feet of office space in Irvine, California at a rate of approximately $52,000 per month. NTC has entered into an agreement to extend the lease on its headquarters building at 2801 Main Street, Irvine, California. According to the terms of this agreement, NTC would be obligated to pay formula based monthly lease payments estimated to be approximately $57,000 per month during 1997 and increasing to approximately $72,000 per month for the remainder of the initial five year lease term. In addition, in February 1997, NTC entered into a ten year lease for office space in Honolulu, Hawaii, with the lease expiring in 2007. The monthly payments on the lease in Honolulu, Hawaii commence at $36,698 per month in 1997 and 1998, and increase on a bi-annual basis through the term of the lease to $43,536 per month in 2006 and 2007. The Company's other subsidiary, Rapid Cast, Inc., has entered into a lease on approximately 12,250 square feet of office, research and development space for its facilities in Louisville, Kentucky, expiring on May 30, 2000. RCI is obligated to make lease payments at the rate of $8,167 per month through December 31, 1997, $8,322 per month in 1998, and $8,433 per month from January 1999 through May 2000. RCI also leases approximately 2,850 square feet of office space in East Meadow, New York, for $2,417 per month with annual escalations. ITEM 3. LEGAL PROCEEDINGS SECURITIES AND EXCHANGE COMMISSION INVESTIGATION: In August 1994, the Company was notified by the Pacific Regional Office of the Securities and Exchange Commission that the Commission had initiated an informal inquiry of the Company. In September 1994 the Commission issued a formal order of private investigation. The Commission stated in its correspondence to the Company that the investigation "should not be construed as an adverse reflection on any person, entity or security, or as an indication by the Commission or its staff that any violation of law has occurred." In August and September 1994, the Company supplied copies of its books and records to the Commission, and the Company's present and prior independent certified public accounting firms submitted their working papers pursuant to the Commission's subpoena. In February 1995, the Company provided to the Commission pursuant to its subpoena additional documents associated with NTC's regulatory authorizations and with the Company's recent acquisition of a controlling interest in RCI. The Company continues to fully cooperate with the Commission. While the Company believes that the outcome of the fact finding investigation will not have a material adverse effect on the financial condition or operating results of the Company, no assurance can be given on this matter until the investigation is concluded. See "Item 3. Legal Proceedings - Securities and Exchange Commission Investigation" in the Company's 1995 Form 10-K, as updated in the Company's Form 10-Q for the quarter ended September 30, 1996 under "Item 1. Legal Proceedings - Securities and Exchange Commission Investigation." CLASS ACTION AND RELATED LAWSUITS: On October 17, 1995, the Company was served with an amended complaint in the class action lawsuit entitled SANDRA GAYLES; THOMAS COMISKEY, AS TRUSTEE FBO THOMAS COMISKEY, IRA; CHARLES KOWAL; ARTHUR KALTER; MATTHEW G. HYDE; ARTHUR WIRTH; AND ISABEL SPERBER, VS. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 AWT (BQRx), filed in the United States District Court for the Central District of California, Western Division, which was originally filed in January 1995. The amended complaint retains the claim alleging that the Company violated Sections (10)b and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated under Section 10(b) of the Exchange Act, because it did not disclose and falsely denied the existence of the non-public investigation of the Company commenced by the Securities and Exchange Commission in August 1994. The complaint adds claims that the Company and its former Chairman, Sam D. Schwartz, violated Sections 10, 16(a), 25 20(a) and 23(a) of the Exchange Act, and Section 25400 of the California Corporations Code, because they did not disclose until August 1995 purchases and sales of the Company's stock made in the open market by an affiliate of Mr. Schwartz between September 1994 and August 1995. The amended complaint seeks (i) certification of the class, (ii) compensatory damages, (iii) damages pursuant to Section 25500 of the California Corporations Code, (iv) interest and attorneys' fees and costs, and (v) other extraordinary, equitable and injunctive relief as may be appropriate. On January 11, 1996, the case was certified as a class action pursuant to the parties' stipulation. The Company has answered the complaint and the lawsuit is currently in the discovery phase. The plaintiffs in the class action lawsuit SAUNDRA GAYLES VS. INCOMNET, INC. AND SAM D. SCHWARTZ have conducted written discovery and taken the deposition of the Company's custodian of records. The discovery phase of the case is currently scheduled to close on May 31, 1997. A hearing is expected to be held on May 5, 1997 to determine whether a specific group of investors who filed a motion to elect not to be part of the class will be entitled to opt-out of the class action lawsuit and commence their own lawsuit. The plaintiffs and the Company have filed motions opposing the request for opt-out status by those investors, who filed their election forms after the deadline established for such elections. Several other parties have timely filed elections to be separate from the class, but none have filed separate lawsuits to date. The Company is not certain whether any of those potential plaintiffs will file separate lawsuits against the Company or any of the other defendants. The Company and the class plaintiffs have and continue to engage in settlement discussions. No assurance can be given that a settlement will be reached, or the terms of such settlement, if any. The Company has been served with a complaint in the lawsuit entitled SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLIANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York. The complaint states that the plaintiff was a purchaser of the Company's stock in July 1995. The complaint alleges that the Company and it's former Chairman, Sam D. Schwartz, violated Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and committed common law fraud, as a result of false and misleading statements made by the defendants and undisclosed trading in the Company's stock engaged in by Mr. Schwartz and his affiliate. The plaintiff also alleges that Mr. Schwartz and his affiliate owed a fiduciary duty to the plaintiff that was breached by their conduct. The complaint also alleges other causes of action against other unrelated defendants. The Company answered the complaint in November 1996 and moved to have it transferred to California. In March 1997, the claims relating to the Company and Sam Schwartz was ordered severed and transferred from the court in New York to the same court in California which is hearing the pending class action lawsuit. See "Part II, Item 1. Legal Proceedings - Class Action and Related Lawsuits" in the company's Form 10-Q for the fiscal quarter ending September 30, 1996. SETTLEMENT WITH RCI PARTIES As of December 9, 1996, the Company entered into a Settlement and Mutual Release Agreement with Robert Cohen, Alan Cohen, Jeff Rubin, Jeff Cohen, Broadway Partners, a partnership comprised of the children of Alan and Robert Cohen, and Lenore Katz (the "RCI Parties"). Robert Cohen is a director and shareholder of Rapid Cast, Inc. and Jeff Rubin is a director, shareholder and executive officer of Rapid Cast, Inc. Jeff Cohen is the son-in-law of Robert Cohen. Pursuant to the settlement agreement, the RCI Parties purchased 360,000 Warrants entitling them to purchase 360,000 shares of the Common Stock of the Company for an exercise price of $3.75 per share at any time until December 9, 1999. The RCI Parties paid a total of $36,000 in cash to the Company for the warrants. Certain of the RCI Parties also purchased a total of 33,000 shares of the Common Stock of the Company for an aggregate purchase price of $100,000. The Company is registering those shares and the shares issuable upon the exercise of the warrants pursuant to a registration statement pending with the Securities and Exchange Commission in accordance with its agreement to do so in the Settlement and Mutual Release Agreement. The Company and the RCI Parties also mutually released each other from all claims, if any, which they may have had against each other, and the RCI Parties assigned all of the claims which they may have against Sam and Rita Schwartz, prior directors of the Company, to the Company. SETTLEMENT OF THE STEVENS LAWSUIT In January 1997, the Company entered into a Settlement Agreement and Mutual Release of all claims in the pending lawsuit entitled CHARLES STEVENS VS. SAM D. SCHWARTZ AND INCOMNET, INC. Pursuant to the settlement, the Company paid $7,500 in cash to the plaintiff and issued 12,500 warrants to purchase 12,500 shares of the Company's Common Stock at an exercise price of $2.94 per share, exercisable at any time until December 16, 2001. The Company agreed to register the shares underlying the 12,500 warrants issued to Mr. Stevens and his legal counsel. In consideration for the 26 issuance of warrants and payment of cash, the plaintiff released the Company from all claims and dismissed the lawsuit against the Company with prejudice. The settlement did not include Sam D. Schwartz. SETTLEMENT OF THE ATLANTA LAWSUITS In February 1997, the Company entered into a settlement and release agreement with the plaintiffs in the lawsuits entitled HERBERT M. SCHWARTZ ET AL. VS. INCOMNET, INC., SAM D. SCHWARTZ AND KALIBER MANAGEMENT CORP. and BRENT ABRAHM ET AL. VS. INCOMNET, INC., SAM D. SCHWARTZ AND KALIBER MANAGEMENT CORP. pursuant to which the lawsuit against the Company were dismissed and an order was entered barring indemnification or contribution between the Company and Sam D. Schwartz. In consideration for the payment of $400,000 in cash and the issuance of a note in the principal amount of $400,000 to the plaintiffs, the plaintiffs released the Company from all claims and dismissed their lawsuits against the Company with prejudice. The $400,000 note was issued as of January 1, 1997 and bears interest at the rate of 12% per annum from January 1, 1997 to January 22, 1997, and 8% per annum thereafter until December 31, 1997, when the note is due and payable in full. The note is secured by a certificate of deposit in the amount of $415,000 purchased by the Company, which the Company has the right to replace with a number of registered shares of its Common Stock equivalent in value to the certificate of deposit as collateral for the note. SECTION 16(b) LAWSUIT: In January 1996, the Company was served with a derivative shareholders lawsuit entitled RICHARD MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ, 96 Civil 0225 in the United States District Court for the Southern District of New York, alleging violations of Section 16(b) of the Securities Exchange Act of 1934, as amended, and demanding that the Company assert claims against Mr. Schwartz for the payment of short-swing profits plus interest. Mr. Schwartz has retained separate counsel for this action. In early July 1996, Mr. Schwartz deposited 800,000 shares of his Incomnet, Inc. Common Stock into a court-approved escrow account with the Company's New York counsel as security for his obligation to pay short swing profits. In early February 1997, plaintiff's counsel prepared a motion for summary judgment in the case seeking $5,050,000 in short swing profits from Mr. Schwartz plus pre-judgment interest. On February 21, 1997, the plaintiffs and Sam Schwartz entered into a stipulated settlement pursuant to which Mr. Schwartz agreed to pay $4,250,000 to the Company as full payment of his short swing profit obligation to the Company. The plaintiff's lawyer indicated that he would request a fee of $850,000 plus reimbursement of $65,000 of expenses, to be paid by the Company from the proceeds of the recovery. Under the stipulated settlement, the disgorgement of short-swing profits would be payable $600,000 in cash and the balance by tender to the Company of shares of the Company's Common Stock owned by Mr. Schwartz, based on 90% of the average between the bid and the asked price of the Company's Common Stock on the NASDAQ market during the 30 calendar days immediately preceding the date that the court enters an order approving the settlement. Pursuant to the agreement, Mr. Schwartz has deposited $600,000 in cash and has agreed to deposit additional shares of the Company's common stock into a separate escrow account from the one which already contains 800,000 shares of the Company's stock owned by him or his affiliates. The Company intends to oppose the amount of plaintiff's attorney's fees sought. The Company does not otherwise intend to oppose the proposed settlement. On April 11, 1997, a revised stipulation was filed containing the same economic terms. Notice of the settlement is to be given to the shareholders by April 21, 1997. Any opposition to the settlement is due by May 16, 1997, and a hearing to approve the settlement is to be held on May 30, 1997. There is no assurance that the Company will recover the short-swing profits from Mr. Schwartz. SETTLEMENT OF PATENT INFRINGEMENT LAWSUIT: In July 1995 Rapid Cast, Inc. was served with a lawsuit entitled RONALD D. BLUM, O.D. VS. RAPID CAST, INC., Case No. 95-CV5113, filed in the United States District Court in the Southern District of New York. The complaint alleges that Rapid Cast, Inc. has infringed on the plaintiff's patent for curing plastic lenses by virtue of employing its technology in the FastCastTM LenSystem. On January 16, 1997, RCI settled the lawsuit and the lawsuit has been dismissed. In consideration for a total cash payment of $525,000 in cash to Dr. Blum and the release by RCI of all claims which it may have had against Dr. Blum, RCI received a release of all claims by Dr. Blum. See "Item 1. Legal Proceedings - Patent Infringement Lawsuit" in the Company's Form 10-Q for the fiscal quarter ending September 30, 1996. LEGAL ACTION AGAINST PRIOR REPRESENTATIVES: 27 On July 28, 1994, NTC filed a lawsuit against six prior independent marketing representatives who terminated their relationship with NTC on March 31, 1994. The lawsuit alleges that the defendants breached their agreements with NTC after terminating their representative status by (i) soliciting NTC's customers to leave NTC and sign up with a competitor, (ii) soliciting NTC's other independent marketing representatives to leave NTC and work for a competitor, (iii) misappropriating and failing to return the NTC customer and independent sales representative lists, (iv) disclosing NTC's customers, representatives and other trade secrets to a competitor and (v) willfully and maliciously conspiring to injure NTC's business in order to improve their own business. The causes of action against the defendants are breach of contract, misappropriation of trade secrets and intentional interference with NTC's economic relationships. NTC sought injunctive relief and is seeking monetary damages of at least $500,000, as well as punitive damages in an unspecified amount. On August 31, 1994, the court awarded NTC a temporary injunction against the defendants, enjoining them from disclosing or utilizing any of NTC's trade secrets, including its list of customers and independent sales representatives. A permanent injunction was subsequently denied by the court on the basis that NTC had failed to demonstrate irreparable harm. All of the defendants were located in Northern California. The Company believes that as a result of the defendants' wrongful actions, NTC lost independent marketing representatives in Northern California and retail customers. While these actions slowed the growth rate of NTC's customers and marketing representatives in the spring of 1994, growth is continuing. The rate at which NTC is signing new representatives, especially from other parts of the United States, is also increasing, which may result in an increased rate of growth in the customer base in the future. On August 30, 1994, the defendants filed a cross-complaint against NTC and the Company, claiming that NTC failed to meet its contractual obligations to the defendants and that actions taken by the defendants as a result were proper and legal. The cross complainants are seeking compensatory and special damages, along with general and punitive damages. Management cannot predict the ultimate resolution of the lawsuit or its impact on the Company at this time. SETTLEMENT WITH PRIOR NOTEHOLDERS: In January 1996 a civil action was filed against the Company and Sam D. Schwartz in the United States District Court for the Eastern District of New York, entitled JULES NORDLICHT VS. INCOMNET, INC. AND SAM D. SCHWARTZ, Case No. CV 95-5134, alleging breach of contract and material misrepresentations and nondisclosures in connection with the issuance and conversion of promissory notes by the Company in a private placement. The complaint sought damages of $750,000. In early February 1996 the Company entered into a settlement agreement with Mr. Nordlicht pursuant to which the Company agreed to issue to Mr. Nordlicht and register 31,000 shares of the Company's common stock, repay the outstanding balance of his note (i.e. $500,000 plus interest), and issue him 5,000 additional warrants to purchase shares of Rapid Cast, Inc. (if and when it goes public) which the Company had received pursuant to the redemption of another convertible promissory note previously issued by the Company. The settlement agreement has been filed with the court and the case has been dismissed with prejudice. Commencing in March 1996 the Company entered into a series of settlement agreements with six other prior holders of a total of $325,000 in principal amount of 8% convertible promissory notes issued by the Company on February 8, 1995 to finance the acquisition of 51% of RCI. See "Item 1. Business - Acquisition of RCI" in the Company's 1995 Form 10-K. Pursuant to the settlement agreements with Mr. Nordlicht and the six other noteholders, the Company issued a total of 74,917 new shares and registered a total of 138,417 outstanding and newly issued shares, including the 74,917 newly issued settlement shares. The registration statement covering the prior noteholders' outstanding shares and newly issued settlement shares issued pursuant to the settlement agreements was declared effective by the Securities and Exchange Commission on October 31, 1996. See also "Item 3. Legal Proceedings - Claims by Prior Noteholders" in the Company's 1995 Form 10-K and "Part II, Item 1. Legal Proceedings - Claims By Prior Noteholders" in the Company's Form 10-Q for the fiscal quarter ended September 30, 1996. SETTLEMENT WITH PRICE INTERNATIONAL: Price International, Inc. (PRI) asserted a claim for breach of contract and federal securities laws violations in connection with the exercise of 25,000 warrants at $11.25 per share by it allegedly based on statements made to it by the Company (See Agreement with Price International, Inc.). PRI asserted this claim in a letter written to the Company by its counsel in October 1995. In August 1996, the Company entered into a settlement agreement with Price International pursuant to which the Company agreed to lower the exercise price of Price International's 75,000 warrants from $11.25 per share to $4.50 per share, and to extend the expiration date of the warrants from November 15, 1997 until December 31, 1998. The Company also agreed to register the 75,000 shares issuable upon the exercise of the warrants. Those shares were registered by the Company in the registration statement which was declared effective by the Securities and Exchange Commission on October 31, 1996. In consideration for the modification to the terms and conditions of the warrants, Price International agreed that (a) it would be required to exercise at least 25,000 of the warrants once the trading price 28 of the Company's stock averages $5.30 per share during any 30 day period, and (b) it releases and forever discharges the Company from all claims it may have had against the Company for events occurring prior to the date of the settlement agreement. Price International has not yet exercised any of the warrants issued to it in its settlement agreement with the Company. POTENTIAL LAWSUITS: There is no assurance that claims similar to those asserted in the pending class action and related lawsuits, or other claims, will not be asserted against the Company by new parties in the future. In this regard, potential plaintiffs have from time to time orally asserted claims against the Company and its prior directors. Several members of the class in the pending class action lawsuit against the Company have opted out, and certain other class members are attempting to opt out even though they did not file their elections in a timely manner. See "Legal Proceedings - Class Action and Related Lawsuits." Sam Schwartz may file claims against the Company for indemnification and payments under his Severance Agreement with the Company. See "Item 1. Business - Employees, Officers and Directors - Officers" in the Company's 1995 Form 10-K. If such claims are filed as legal complaints, the Company will seek to have them consolidated with other pending lawsuits, if appropriate, or will defend them separately. From time to time, the Company is also involved in litigation arising from the ordinary course of business, the ultimate resolution of which management believes will not have a material adverse effect on the financial condition or results of operations of the Company. See "Part II, Item 1. Legal Proceedings - Potential Lawsuits" in the Company's Form 10-Q for the fiscal quarter ended September 30, 1996. From time to time, the Company is involved in litigation arising from the ordinary course of business, the ultimate resolution of which management believes will not have a material adverse effect on the financial condition or results of operations of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1996. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS MARKET INFORMATION: The Company's common stock trades on the NASDAQ Small-Cap Market under the symbol "ICNT". The following table sets forth the range of bid prices for the common stock during the periods indicated. Prices represent the actual high and low sale prices of the Company's stock as provided by NASDAQ real-time pricing information. YEAR ENDED DECEMBER 31, 1996: Quarter High Low Last Sale ------- ---- --- --------- 4 5 2 7/8 2 31/32 3 5 5/16 4 3/16 4 5/16 2 6 1/4 4 3/8 4 3/4 1 6 3/16 4 3/8 5 3/8 YEAR ENDED DECEMBER 31, 1995: Quarter High Low Last Sale ------- ---- --- --------- 4 11 1/4 2 1/2 4 9/16 29 3 24 1/2 9 11 2 16 3/8 10 7/8 15 1 14 5/8 8 1/4 14 3/8 On March 21, 1997, the last sales price per share of the Company's common stock, as reported by the NASDAQ Stock Market, was $2 15/16. On March 21, 1997, the Company's 13,520,669 shares of common stock outstanding were held by approximately 797 shareholders of record. DIVIDENDS: The Company has not paid cash dividends on its common stock since inception. Payment of dividends is within the discretion of the Company's Board of Directors and will depend, among other factors, on earnings, capital requirements and the operating and financial condition of the Company. Furthermore, the payment of dividends on the Company's common stock is subject to the payment in full of all accrued but unpaid dividends on its outstanding Series A 2% Convertible Preferred Stock. See "Item 1. Business - Issuance of Convertible Preferred Stock." At the present time, the Company's anticipated working capital requirements are such that it intends to follow a policy of retaining earnings in order to finance the development of its business. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.") ITEM 6. SELECTED FINANCIAL DATA A summary of selected financial data for the five years ended December 31, 1996, 1995, 1994, 1993, and 1992, is presented below, and should be read in conjunction with the audited consolidated financial statements for the years ended December 31, 1996, 1995 and 1994 at "Item 8. Financial Statements and Supplementary Data." Segment information is presented at "Item 1. Business segment information" (In thousands, except per share amounts).
FOR THE YEAR: 1996(2) 1995(2) 1994(2) 1993(1,2) 1992(2) ------ ------ ------ -------- ------- Sales $106,905 $86,565 $46,815 $11,299 $5,535 Income (loss) before income taxes, minority interest and extraordinary items (51,517) 957 4,000 (1,607) (2,265) Income (loss) before minority interest and extraordinary items (43,705) 857 3,999 (1,607) (2,462) Net Income (37,676) 1,366 4,071 (949) (2,021) PER SHARE: Net income (loss) before extraordinary items (2.75) 0.11 0.42 (0.20) (0.34) Net income (loss) (2.82) 0.11 0.42 (0.12) (0.28) AT YEAR END: Total assets $40,587 $74,106 $26,158 $8,666 $6,745 Long-term obligations 1,040 8,460 1 20 176
- ------------------------- (1) In 1992, the Company acquired a controlling interest in National Telephone & Communications, Inc. This information is described in "Item 1. Business - Acquisition of National Telephone & Communications, Inc. (NTC)" in the Company's 1995 Form 10-K. (2) The Company is engaged in legal proceedings where the ultimate outcome cannot presently be determined. This information is described at "Item 3. Legal Proceedings." ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW: 30 The following is management's discussion and analysis of certain significant factors which have affected the results of operations and financial condition of the Company during the period included in the accompanying financial statements. This discussion should be read in conjunction with the financial statements and associated notes. The discussion herein is qualified by reference to the Introductory Note. LIQUIDITY AND CAPITAL RESOURCES: GENERAL - Overall, the Company achieved slightly positive cash flows of $0.6 million during 1996 resulting from positive cash flows from operating activities ($3.0 million) and from financing activities ($5.2 million), which were almost entirely offset by negative cash flows from investing activities ($7.6 million). The Company may need to raise additional capital in 1997 to fund settlement costs relating to pending litigation or to make a business acquisition, although specific needs have not yet been identified. Pursuant to its management incentive agreement with NTC, the Company receives cash distributions from NTC on a periodic basis, which are scheduled to be made until December 31, 1997. See "Item 1. Business - National Telephone & Communications, Inc. - Management Incentive Agreement." The Company does not expect to have to make loans to RCI in 1997, and RCI's capital needs in the short-term have been met through its private placement of preferred stock and warrants in January 1997. See "Item 1. Business - The Recent Capitalization of RCI." NTC is expected to have sufficient capital and financing to fund its requirements in 1997, including funds required for the establishment of its branch marketing offices, one of which is currently being built on leased premises in Honolulu, Hawaii. There is no assurance that the cash distributions by NTC to the Company or the cash flow from AutoNETWORK will be sufficient to meet the Company's future funding requirements, or that RCI or NTC will have sufficient capital or financing to meet their needs. CASH FLOW FROM OPERATIONS - Net cash provided by operating activities of $3.0 million in 1996 was primarily attributable to the operating loss for 1996 ($37.7 million) and non-cash items principally from a devaluation of the Company's investment in RCI ($39.1 million), depreciation and amortization ($4.3 million), and changes in operating assets and liabilities ($11.7 million). With regard to the collection of accounts receivable, the Company increased its allowance for doubtful accounts to 13.2% of gross receivables as of December 31, 1996 compared to 8.0% of gross receivables as of December 31, 1995. This increased provisioning reflects NTC's reserves for all direct-billed Dial-one receivables which have been submitted to collection agencies for collection and a modest improvement in collection rates for LEC-billed and calling card products. CASH FLOW FROM INVESTING - Net cash used in investing activities of $7.6 million in 1996 was attributable principally to the Company's additions to property, plant and equipment ($7.2 million) and additions to patents ($0.7 million). CASH FLOW FROM FINANCING - Net cash provided by financing activities of $5.2 million in 1996 was attributable principally to changes in short-term debt ($2.9 million), proceeds from the issuance of preferred stock ($2.3 million) and additions to long-term debt ($1.3 million), partially offset by reduction of long-term debt ($1.8 million). In addition, positive cash flow resulted primarily from RCI entering into various loan agreements to finance the building of infrastructure to support its anticipated future sales growth. In September 1996, the Company also raised $0.4 million from the sale of 365 shares of Series A 2% Convertible Preferred Stock, and raised an additional $2.1 million in October 1996 through the placement of additional shares of Series A 2% Convertible Preferred Stock. The Company paid aggregate referral fees equal to approximately 5% of the capital raised from the placement of the Series A 2% Convertible Preferred Stock. Cash paid to reduce debt totaled $1.2 million, $0.0 million and $0.3 million during 1996, 1995 and 1994, respectively. The Company had material commitments for capital expenditures of $1.5 million in tenant improvements for its Honolulu, Hawaii office space at December 31, 1996, and expects to continue making improvements to the NTC headquarters building and purchasing additional equipment commensurate with the expansion of its business. During 1996, the Company had capital expenditures of $7.2 million for plant and equipment. 31 At December 31, 1996, the Company had net operating loss carryforwards for federal income tax purposes of approximately $22.6 million, which are expected to be available to offset taxable income for the next several years. LITIGATION - The Company is subject to pending litigation and an investigation by the Securities and Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and results of operations. Management does not believe that the investigation by the Securities and Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Item 3. Legal Proceedings." RESULTS OF OPERATIONS: FINANCIAL ANALYSIS- SALES - For 1996, 1995 and 1994, the Company's net sales totaled approximately $106.9 million, $86.6 million and $46.8 million, respectively. The increases in sales in 1996 compared with 1995 and 1995 compared with 1994, were attributable principally to increases sales at NTC. The following table summarizes the Company's year-to-year sales performance by subsidiary and segment:
$ in millions ----------------------------------- Subsidiary Segment 1996 1995 1994 - ---------- ------- ----------------------------------- NTC Telephone (telecommunications services) $83.7 $ 70.0 $ 34.2 NTC Telephone (marketing programs) 17.1 13.1 11.4 RCI Optical 4.7 2.0 -- AutoNETWORK Network 1.4 1.5 1.2 ----------------------------------- Total Company Net Sales $106.9 $ 86.6 $ 46.8 ----------------------------------- -----------------------------------
NTC's net sales increase was driven largely by continued expansion of the customer base for its telecommunication services. As a result of this continuing expansion, NTC's telecommunication service revenues represented 83.0%, 84.2% and 75.0% of NTC's total revenues for 1996, 1995 and 1994, respectively, with the remaining 17.0%, 15.8% and 25.0% generated by sales of NTC's marketing programs for 1996, 1995 and 1994, respectively. Revenues from the optical segment may decline in 1997 because the Company's percentage ownership in RCI is lower than in 1995 and 1996, and machine orders at RCI have declined while RCI implements design modifications and improvements. See "Item 1. Business--Rapid Cast, Inc.--Technical Overview of the Rapid Cast LenSystem." COST OF SALES - Total Company cost of sales for 1996, 1995 and 1994, were approximately $68.6 million, $57.9 million and $31.2 million, respectively. The increases in cost of sales were attributed principally to the increase in carrier costs associated with increased telephone service sales by NTC and a volume related rise in RCI cost of sales. Gross margin when stated as a percentage of net sales was 35.9%, 33.1% and 33.3% for 1996, 1995 and 1994, respectively. The increase in gross margin in 1996 was attributable principally to reductions in NTC's telecommunication service cost of sales resulting from: 1) lower long-distance transport costs from NTC's carriers and, 2) continuing improvements in the mix of sales in the higher profit product lines. The following table summarizes the Company's year-to-year changes in three major cost components:
$ in millions ----------------------------------- 1996 1995 1994 ----------------------------------- Carrier costs for NTC's long distance telephone service $44.7 $ 40.4 $ 21.3 Commissions paid to NTC independent sales reps 18.0 14.2 7.7 All other costs of sales 5.9 3.3 2.2 ----------------------------------- Total Company Cost of Sales $68.6 $ 57.9 $ 31.2 ----------------------------------- -----------------------------------
32 NTC's total commission expenses for 1996, 1995 and 1994, were $18.0 million, $14.2 million and $7.7 million, respectively. The increases were attributed principally to the residual monthly sales commissions and various bonuses and overrides paid to sales representatives on increased marketing and telephone service revenues. The third cost component shown in the table above is "all other costs of sales" which represents: (1) NTC's costs of producing sales materials for its independent sales representatives, (2) RCI's costs of producing optical systems and ancillary goods, and (3) AutoNETWORK costs of providing communications network products and services. GENERAL AND ADMINISTRATIVE - Total general and administrative costs for 1996, 1995 and 1994, were approximately $36.9 million, $19.8 million and $9.4 million, respectively. General and administrative expenses represented 34.57%, 22.9% and 20.2% of net sales in 1996, 1995 and 1994, respectively. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. NTC's general and administrative costs increased to 24.5% of sales in 1996 from 20.3% of sales in 1995. This increase was due principally to: (1) increases in fees paid to local exchange carriers (LEC's) to process NTC's billing and collection of its LEC-billed long distance telephone service, and (2) increases in compensation and fringe benefits expended as NTC continues to build infrastructure to support anticipated future sales growth. RCI's general and administrative costs continue to reflect the startup nature of its operations. DEPRECIATION AND AMORTIZATION - The Company's depreciation and amortization expense totaled $2.0 million, $1.0 million and $0.4 million for 1996, 1995 and 1994, respectively. These increases were caused by the continuing investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its rapid expansion in sales. BAD DEBT EXPENSE - The Company's bad debt expense totaled $6.1 million, $4.1 million and $1.8 million for 1996, 1995 and 1994, respectively. Bad debt expense represented 5.7%, 4.8% and 3.8% of net sales in 1996, 1995 and 1994, respectively. The increase in bad debt was caused primarily by increased provisioning of NTC's LEC billed receivables which currently carry a higher than estimated bad debt provision and direct billed collection agency write-offs. OTHER (INCOME) AND EXPENSE - The Company's other (income) and expense totaled $3.4 million, $1.0 million and $(0.3) million for 1996, 1995 and 1994, respectively. The increase in 1996 was attributable in large part to settlement costs of $2.0 million associated with claims by officers against the Company. The increase in 1995 was attributed principally to: (1) a $0.4 million settlement with convertible noteholders relating to the acquisition of RCI, (2) a $0.2 million settlement with a former Company officer, and (3) a $0.3 million write-off of marketable securities by NTC. CHARGE FOR ASSET IMPAIRMENT - The charge for asset impairment totaled $39.1 million for 1996 for the devaluation of the Company's investment in RCI. There was no impairment in 1995 and 1994. MINORITY INTEREST - Effective July 1, 1995, when it became apparent that control of Incomnet was "other than temporary," RCI's operating results were presented on a consolidated basis, with 49% of its losses charged to minority interest. NET INCOME (LOSS) - The Company's net income (loss) totaled $(37.7) million, $1.4 million and $4.1 million for 1996, 1995 and 1994, respectively. Net income (loss) represented (35.2)%, 1.6% and 8.7% of net sales for 1996, 1995 and 1994, respectively. The decreases were attributed principally to: (1) higher losses at RCI in 1996 due to the devaluation of patent rights and significantly increased operating costs incurred to build infrastructure for future potential sales growth, and (2) higher losses at the Company's headquarters which were caused by the establishment of reserves for devaluation of the Company's investment in RCI and for settlement costs. EMPLOYMENT - Employment of the Company totaled 288 at December 31, 1996, not including independent sales representatives, who are classified as independent sales representatives and not employees of the Company. 33 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and supplementary financial information which are required to be filed under this item are presented under "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 10-K" in this document, and are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS OF THE REGISTRANT The information required under this Item is contained in the definitive Proxy Statement for the Company's 1997 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A by May 31, 1997, and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required under this Item is contained in the definitive Proxy Statement for the Company's 1997 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A by May 31, 1997, and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required under this Item is contained in the definitive Proxy Statement for the Company's 1997 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A by May 31, 1997, and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required under this Item is contained in the definitive Proxy Statement for the Company's 1997 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A by May 31, 1997, and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K INDEX TO FINANCIAL STATEMENTS: Page ---- Report of Independent Auditors..............................................37 Consolidated balance sheet at December 31, 1996 and 1995....................38 Consolidated statement of operations for the years ended December 31, 1996, 1995 and 1994.........................................................39 Consolidated statement of cash flows for the years ended December 31, 1996, 1995 and 1994.........................................................40 Consolidated statement of shareholders' equity for the years ended December 31, 1996, 1995 and 1994............................................41 34 Notes to consolidated financial statements..................................42 Schedule II - Valuation and qualifying accounts at December 31, 1996 and 1995....................................................................55 All other schedules are omitted as the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto. INDEX TO EXHIBITS: Exhibits designated by the symbol ** are management contracts or compensatory plans or arrangements that are required to be filed with this report pursuant to this Item 14. The Company undertakes to furnish to any shareholder so requesting a copy of any of the following exhibits upon payment to the Company of the reasonable costs incurred by the Company in furnishing any such exhibit. EXHIBIT NO. DESCRIPTION - ----------- ----------- 3.1 Certificate of Determination for Series A 2% Convertible Preferred Stock. (Incorporated by reference from Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996). 4.1 Form of Warrant to Purchase 75,000 Shares of Incomnet, Inc. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 4.2 Form of Warrant to Purchase 510,000 Shares of RCI Common Stock with Registration Rights Agreement, dated April 19, 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 4.3 Form of Warrant to Purchase RCI Common Stock, dated February 8, 1995. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 4.4 Form of Warrant to Purchase 360,000 Shares of Incomnet, Inc. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 4.5 Form of Warrant to Purchase 12,500 Shares of Incomnet, Inc. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.1 Employment Agreement with James Quandt, dated January 6, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.2 Amended and Restated Management Incentive Agreement Between NTC and Incomnet, Inc., dated January 28, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.3 Settlement Agreements With Prior Noteholders. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 35 10.4 Form of 8% Convertible Note Issued by RCI in January 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 10.5 Form of Short-Term 10% Note Issued by RCI in April 1996. (Incorporated by reference from the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996). 10.6 Amended Carrier Switched Services Agreement with Wiltel, Inc. dated June 17, 1996. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. Certain information has been deleted from this agreement pursuant to a request for confidential treatment pursuant to Rule 406). 10.7 Settlement Agreement Between Joel W. Greenberg and Incomnet, Inc. (Incorporated by reference from the Company's Report on Form 8-K, dated June 7, 1996, relating to the settlement agreement with Joel W. Greenberg and his resignation as a director of the Company). 10.8 Form of Registration Rights Agreement Between Incomnet, Inc. and Purchasers of Series A Convertible Preferred Stock. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended). 10.9 Form of Purchase Agreement for the Series A 2% Convertible Preferred Stock. (Incorporated by reference from Incomnet's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 10, 1996 and declared effective on October 31, 1996, or incorporated by reference from the Company's filings with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended). 10.10 Management Incentive Agreement with NTC, dated October 14, 1996. (Incorporated by reference from Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996). 10.11 Settlement Agreements With Edward Jacobs and Jerry Ballah, dated November 14, 1996. (Incorporated by reference from Incomnet, Inc.'s Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 22, 1996). 10.12 Shareholders Agreement for Rapid Cast, Inc., dated January 16, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.13 Registration Rights Agreement for Rapid Cast, Inc., dated January 16, 1997. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.14 Settlement Agreement and Mutual Release Between Incomnet, Inc. and the RCI Parties, dated January 9, 1996. (Incorporated by reference from Incomnet, Inc.'s Pre-Effective Amendment Number One to the Registration Statement on Form S-3 filed with the Securities and Exchange Commission on March 24, 1997). 10.15 Lease Agreement By NTC for space in Honolulu, Hawaii. * 10.16 Credit Agreement dated March 27, 1997 between National Telephone & Communication, Inc. and First Bank & Trust, Irvine Regional office. * 21 Subsidiaries of the Registrant * 36 23 Consent of independent auditors * 27 Financial data schedule (Article 5 of regulations S-X) * *Previously filed on Form 10-K filed with the Securities and Exchange Commission on April 15, 1997. REPORTS ON FORM 8-K, FILED IN 1996 20.1 Report on Form 8-K - Agreement with National Telephone & Communications, Inc. (NTC) for incentive stock option program and for a public offering of NTC's stock dated February 6, 1996 and filed on February 9, 1996. 20.2 Report on Form 8-K - Settlement Agreement with Joel W. Greenberg. 20.3 Report on Form 8-K - Gerald Katell's Resignation from the Board of Directors dated August 8, 1996 and filed on August 15, 1996. 20.4 Report on Form 8-K - Appointment of Dr. Howard Silverman as director dated January 20, 1997 and filed on January 28, 1997. 37 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: July 8, 1997 INCOMNET, INC. (Registrant) By: /s/ MELVYN REZNICK ------------------ MELVYN REZNICK President and Chief Executive Officer Pursuant to requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
Signature Capacity Date --------- -------- ---- /s/ MELVYN REZNICK President, Chief Executive Officer, - ------------------ and Chairman of the Board of Directors July 8, 1997 MELVYN REZNICK /s/ ALBERT MILSTEIN Director July 8, 1997 - ------------------- ALBERT MILSTEIN /s/ Dr. HOWARD SILVERMAN Director July 8, 1997 - ------------------------ Dr. HOWARD SILVERMAN /s/ NANCY ZIVITZ Director July 8, 1997 - ---------------- NANCY ZIVITZ
38 REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Incomnet, Inc. We have audited the consolidated balance sheet of Incomnet, Inc. and subsidiaries as of December 31, 1996 and 1995 and the related consolidated statements of operations, shareholders' equity and cash flow for each of the three years in the period ended December 31, 1996, and the schedule listed in Item 14. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Incomnet, Inc. at December 31, 1996 and 1995 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. As discussed in Note 11 to the financial statements, the Company is a party to a class action matter, claiming losses arising from alleged securities violations based upon the denial and non-disclosure of a pending investigation by the Securities and Exchange Commission and on alleged undisclosed securities transactions by its former President. Legal counsel to the Company has advised that the ultimate outcome of this matter and a range of potential loss cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in the accompanying financial statements. /s/ Stonefield Josephson ACCOUNTANCY CORPORATION Santa Monica, California March 27, 1997 39 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (DOLLARS IN THOUSANDS)
December 31, ------------ ASSETS 1996 1995 ---- ---- Current assets: Cash & cash equivalents $ 2,214 $ 1,645 Accounts receivable, including $267 and $542 due from related party at December 31, 1996 and 1995 and less allowance for doubtful accounts of $1,993 at December 31, 1996 and $1,063 at December 31, 1995 13,137 12,177 Notes receivable - current portion 323 103 Notes receivable from officers & shareholders, net of reserves of $209 438 863 Inventories 2,760 1,647 Other current assets 1,332 1,197 ---------- ---------- Total current assets 20,204 17,632 Property, plant and equipment, at cost, net 14,357 9,146 Patent rights, net 1,241 41,689 Goodwill, net 4,542 4,839 Investments, notes receivable and other assets 243 800 ---------- ---------- Total assets $40,587 $74,106 ---------- ---------- ---------- ---------- LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 14,746 $ 8,784 Accrued expenses 8,217 3,687 Current portion of notes payable 3,918 2,531 Deferred income 4,040 1,190 ---------- ---------- Total current liabilities 30,921 16,192 Deferred tax liability, net -- 8,449 Other long-term liabilities 1,040 11 Commitments (Note 12) -- -- Minority Interest -- 6,906 Shareholders' equity: Common stock, no par value; 20,000,000 shares authorized; 13,369,681 shares issued and outstanding at December 31, 1996 and 13,262,648 shares at December 31, 1995 61,320 60,884 Preferred stock, no par value; 100,000 shares authorized; 2,440 shares issued and outstanding at December 31, 1996 2,355 -- Treasury stock (5,492) (5,492) Accumulated deficit (49,557) (12,844) ---------- ---------- Total shareholders' equity 8,626 42,548 ---------- ---------- Total liabilities, minority interest & shareholders' equity $ 40,587 $ 74,106 40 ---------- ---------- ---------- ----------
See accompanying "Notes to Consolidated Financial Statements." 41 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS
Years Ended December 31, ------------------------ (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1996 1995 1994 ---- ---- ---- NET SALES $106,905 $86,565 $46,815 ---------- ---------- ---------- OPERATING COSTS & EXPENSES: Cost of sales 68,562 57,948 31,221 General & administrative 36,886 19,793 9,438 Depreciation & amortization 2,013 1,007 444 Bad debt expense 6,051 4,125 1,789 Total acquisition costs & expenses 2,334 1,625 265 Charge for asset impairment 39,147 -- -- Other (income) expense 3,429 1,002 (342) ---------- ---------- ---------- Total operating costs and expenses 158,422 85,500 42,815 ---------- ---------- ---------- Operating income (loss) (51,517) 1,065 4,000 INCOME TAXES (BENEFIT) (7,812) 111 1 ---------- ---------- ---------- Income (loss) before minority interest and extraordinary items (43,705) 954 3,999 RCI acquisition - equity in profit (loss) of unconsolidated subsidiary, net of tax -- (97) -- Cumulative effect of accounting change on years prior to 1996, net of tax of $10 (Note 16) (877) -- -- MINORITY INTEREST 6,906 509 -- EXTRAORDINARY ITEM: Gain (loss) on settlement with creditors -- -- 72 ---------- ---------- ---------- Net income (loss) $ (37,676) $ 1,366 $ 4,071 ---------- ---------- ---------- ---------- ---------- ---------- INCOME (LOSS) PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Net income (loss) before extraordinary items $ (2.75) $ 0.11 $ 0.42 Cumulative effect of accounting change (0.07) -- -- ---------- ---------- ---------- Net income (loss) per share $ (2.82) $ 0.11 $ 0.42 ---------- ---------- ---------- ---------- ---------- ---------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES FOR 1996 AND COMMON SHARE AND COMMON SHARE EQUIVALENTS OUTSTANDING FOR 1995 13,370 12,706 9,593 ---------- ---------- ---------- ---------- ---------- ----------
See accompanying "Notes to Consolidated Financial Statements." 42 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)
Years Ended December 31, ------------------------ 1996 1995 1994 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: After tax profit (loss) $(37,676) $ 1,366 $ 4,071 Depreciation & amortization - operations 2,013 1,413 444 Depreciation & amortization - acquisitions 2,334 651 121 Write-off of patent rights 39,147 -- -- Deferred income taxes (8,449) -- -- Minority interest (6,906) (8,227) -- Other non-cash (income) loss 877 358 (54) Changes in operating assets and liabilities: Accounts receivable (960) (2,784) (6,718) Notes receivable - current portion (220) (103) -- Notes receivable - due from officers and shareholders 425 (863) -- Inventories (1,113) (401) 42 Other current assets 171 (1,000) (82) Accounts payable 5,962 2,571 3,316 Accrued expenses 4,540 1,834 150 Deferred income 2,848 (896) 1,649 ---------- ---------- ---------- Net cash provided (used) by operating activities 2,993 (6,081) 2,939 ---------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (7,224) (7,389) (1,694) Additions to patents (717) (21,002) -- (Increase) decrease in investments 281 16 (263) ---------- ---------- ---------- Net cash used in investing activities (7,660) (28,375) (1,957) ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Increase (decrease) in short-term debt 2,904 1,306 (265) Additions to long-term debt 1,274 -- -- Reduction of long-term debt (1,763) -- -- Sale of preferred stock, net 2,355 -- -- Issuance of common stock, net 436 29,508 8,069 Treasury stock -- (4,827) 465 Other, net 30 419 39 ---------- ---------- ---------- Net cash provided by financing activities 5,236 26,406 8,308 ---------- ---------- ---------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 569 (8,050) 9,290 Cash and cash equivalents at beginning of year 1,645 9,695 405 ---------- ---------- ---------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 2,214 $ 1,645 $ 9,695 ---------- ---------- ---------- ---------- ---------- ---------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 181 $ 153 $ 1 Income taxes 635 574 1
See accompanying "Notes to Consolidated Financial Statements." 43 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (AMOUNTS IN THOUSANDS, EXCEPT SHARES DATA)
Common Stock Common Stock Preferred Treasury Accumulated Shares Amount Stock Stock Deficit Total - ------------------------------------------------------------------------------------------------------------------------ BALANCE AT DECEMBER 31, 1993 9,061,382 $22,176 -- -- $(18,247) $3,929 Common stock issued upon exercise of warrants 1,308,833 8,545 -- -- -- 8,545 Common stock issued under private placement 100,000 500 -- -- -- 500 Common stock issued in exchange for NTC shares 82,639 155 -- -- -- 155 Repurchase of treasury shares (70,000) -- -- (665) -- (665) Net income -- -- -- -- 4,071 4,071 - ------------------------------------------------------------------------------------------------------------------------ BALANCE AT DECEMBER 31, 1994 10,482,854 $31,376 -- $ (665) $(14,176) $16,535 Common stock issued upon exercise of warrants 489,582 4,343 -- -- -- 4,343 Common stock issued under private placement 157,500 1,890 -- -- -- 1,890 Common stock issued upon conversion of note 2,300,000 22,664 -- -- -- 22,664 Common stock issued in exchange for NTC shares 253,712 507 -- -- -- 507 Repurchase of treasury shares (451,000) -- (5,085) -- (5,085) Treasury shares sold 30,000 -- 362 -- 362 Change in valuation of marketable securities -- -- -- -- (34) (34) Other -- 104 -- (104) -- -- Net income -- -- -- -- 1,366 1,366 - ------------------------------------------------------------------------------------------------------------------------ BALANCE AT DECEMBER 31, 1995 13,262,648 $60,884 -- $(5,492) $(12,844) $42,548 Common stock issued upon settlement of litigation 107,033 436 -- -- -- 436 Issuance of preferred stock, net (2,440 shares issued) -- -- 2,355 -- -- 2,355 Cumulative effect -- -- -- -- 877 877 Change in valuation of marketable securities 86 86 Net loss -- -- -- -- (37,676) (37,676) - ------------------------------------------------------------------------------------------------------------------------ BALANCE AT DECEMBER 31, 1996 13,369,681 $61,320 $2,355 $(5,492) $(49,557) $8,626
See accompanying "Notes to Consolidated Financial Statements." 44 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiary National Telephone & Communications-Registered Trademark-, Inc. (NTC), and its 51%-owned subsidiary Rapid Cast, Inc. (RCI). As a company with a controlling interest in RCI, the Company is accounting for RCI using the consolidation method of accounting. The Company shifted from the equity method of accounting for RCI under FASB Statement No. 94 in the first and second quarters of 1995 to the consolidation method when control became other than temporary. In the first quarter of 1997, outside equity investments in RCI (see Note 17) reduced Incomnet's ownership interest to less than 50%, thereby requiring the equity method of accounting for RCI in 1997. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior year amounts to conform to current year presentation. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial statements include the allowance for doubtful accounts, deferred marketing reserve, income tax valuation allowance, investment reserves, litigation settlement costs and future undiscounted cash flows used in the analysis of the impairment of long-lived assets. In connection therewith, management provides its best estimate of amounts arising from settlement of litigation and related legal fees, when such amounts become practicably determinable, although the measurement of the actual amount and expenditure of cash and other consideration may take place in future reporting periods. REVENUE RECOGNITION - The Company recognizes revenue during the month in which services or products are delivered, as follows: (1) NTC's long distance telecommunications service revenues are generated when customers make long distance telephone calls from their business or residential telephones or by using any of NTC's telephone calling cards. Proceeds from prepaid telephone calling cards are recorded as deferred income when the cash is received, and recognized as income as the telephone service is utilized. Deferred income is carried on the balance sheet as an accrued liability. Total 1996 long distance telephone service sales totaled $83.7 million. (2) NTC's marketing-related revenues are derived from programs and material sold to the Company's base of independent sales representatives, including forms and supplies, fees for representative and certified trainer renewals, and the Company's Certified Trainer, Independent Representative and Long Distance University programs. The Company requires that all such services and materials be paid at the time of purchase. Revenues from marketing-related materials, net of amounts deferred for future services to be provided to the representatives, are booked as cash sales when the revenues are received. A portion of the revenues from marketing-related programs and materials are deferred and recognized over a twelve month period, to accrue its obligation to provide customer support to its independent sales representatives. For the fiscal year ended December 31, 1996, marketing sales totaled $17.1 million. (3) RCI's optical-related revenues are derived from the sale of the Company's optical lens manufacturing system and related supplies. Revenues from optical-related systems and supplies are recognized as sales at the time the products are shipped to the customer. Based on historical experience of immaterial returns, RCI does not establish a reserve for returns at the time of sale. All items returned to RCI are placed back into inventory at the lower of cost or fair market value. For the fiscal year ended December 31, 1996, optical product sales totaled $4.7 million. (4) The Company's network service revenues are recognized as sales as the service is delivered. Total 1996 network service sales totaled $1.4 million. CONCENTRATION OF CREDIT RISK - The Company sells its telephone and network services to individuals and small businesses throughout the United States and does not require collateral. It sells its optical products both domestically and internationally. Reserves for uncollectible amounts are provided, which management believes are sufficient. INCOME TAXES - The Company recognizes the amount of current and deferred taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and as measured by the provisions of enacted laws. Deferred income taxes result from temporary differences in the basis of assets and liabilities reported for financial statement and income tax purposes. 45 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 COMPUTER HARDWARE, FURNITURE AND OFFICE EQUIPMENT - Computer hardware, furniture and office equipment are stated at cost. Depreciation is provided by the straight-line method over estimated useful lives ranging from five to ten years. COMPUTER SOFTWARE - The Company capitalizes the costs associated with purchasing, developing and enhancing its computer software. All software costs are amortized using the straight-line method over estimated useful lives ranging from three to ten years. LEASEHOLD IMPROVEMENTS - All leasehold improvements are stated at cost and are amortized using the straight-line method over the expected lease term. NET INCOME (LOSS) PER SHARE - Net income (loss) per common share is based on the weighted average number of common shares for 1996 and common shares and common share equivalents for 1995. Common share equivalents have been excluded in 1994 because their effect was immaterial. The Financial Accounting Standards Board has issued a new statement recently which requires companies to report "basic" earnings per share, which will exclude options, warrants and other convertible securities. The accounting and disclosure requirements of this statement are effective for financial statements for fiscal years beginning after December 15, 1997, with earlier adoption encouraged. Management does not believe that the adoption of this pronouncement will have a material impact on the financial statements. CASH AND CASH EQUIVALENTS - Cash and cash equivalents consist of cash-on-hand and short-term certificates of deposit. FAIR VALUES OF FINANCIAL INSTRUMENTS - Unless otherwise indicated, the fair values of all reported assets and liabilities which represent financial instruments (none of which are held for trading purposes) approximate the carrying values of such amounts. INVENTORIES - Inventory primarily consists of completed optical machines at the RCI subsidiary and is valued at the lower of cost (weighted average method) or market. INVESTMENTS - Marketable securities are considered available-for-sale and are stated at fair market value. The excess of fair market value over cost would be included as a separate component of Shareholders' Equity. During the fourth quarter of 1996, the Company deemed these investments permanently impaired and recorded a loss of $0.3 million to their estimated realizable value. INTANGIBLE ASSETS - Goodwill, representing the excess of purchase price over the fair value of the net assets of NTC, is amortized on a straight-line method basis over its estimated useful life of twenty years. Accumulated amortization at December 31, 1996 and 1995 was $1.2 million and $0.9 million, respectively. Patent rights are stated at cost since the date of acquisition of RCI, and are amortized on a straight-line basis over seventeen years (see below). Accumulated amortization at December 31, 1996 and 1995 was $9.9 million and $0.04 million, respectively. LONG-LIVED ASSETS - The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" (SFAS No. 121), in March 1995. In accordance with SFAS No. 121, the Company reviewed its long-lived assets and certain identifiable intangibles for impairment. Patent rights obtained in the February 1995 acquisition of a controlling interest in RCI were evaluated by management and deemed to have been impaired. There was a significant decrease in market value of RCI as evidenced by an outside equity investment in January of 1997, the change in the market acceptance of products which were based on those patent rights, and actual and forecasted operating losses and cash flow losses which were significantly greater than originally anticipated. Accordingly, management estimated the fair value of the patent rights acquired in the RCI acquisition, based upon, among other valuation techniques, the present value of estimated expected cash flows. The carrying value of the patent rights exceeded management's estimates of the discounted present value of net cash flows to be derived therefrom, and a writedown of approximately $39.1 million and elimination of a related deferred tax liability of $8.5 million. 46 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 STOCK OPTION PLANS - The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations in accounting for the employee stock options, rather than adopt the alternative fair value accounting provided under The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation." 2. FUNDING OF MARKETING COMMISSIONS AND DEFERRED INCOME: The Company's subsidiary, NTC, maintains a separate bank account for the payment of marketing commissions. Funding of this account is adjusted regularly to provide for management's estimates of required reserve balances. NTC estimates the total commissions owed to active independent representatives ("IR Earned Compensation") each week for all monies collected that week due to the efforts of those active independent representatives. All IR Earned Compensation is then paid to the independent representatives, when due, directly out of the separate bank account. 3. RELATED PARTY TRANSACTIONS: Notes receivable from officers and shareholders arise from aggregate loans of $0.6 million made to three individuals in connection with the exercise of their options to purchase the Company's common stock. The notes are non-interest bearing and due on demand, and are partially secured by the stock acquired upon the exercise of the options. For one of the officer loans, the Company agreed to look only to the shares held by the officer as a source of loan repayment. Accordingly, a reserve of $208,800 was provided in the fourth quarter of 1995, representing the difference between the market value of the shares held by the officer and the amount of the loan. Included in accounts receivable is approximately $0.3 million and $0.5 million at December 31, 1996 and 1995, respectively, due from companies controlled by an individual who is an Incomnet shareholder and a founding shareholder of RCI. On August 15, 1996, RCI and one of its shareholders/officers entered into an agreement whereby (1) certain contributed property received from the shareholder/officer valued at $250,000 reduced the amount of indebtedness to RCI relating to the purchase of equipment and supplies by the shareholder/officer and certain other entities controlled by the shareholder/officer from RCI approximating $445,000, with a remaining balance due RCI of approximately $195,000, (2) the remaining balance due to RCI described in (1) will be used to reduce the amount of indebtedness to the shareholder/officer by the Company of approximately $513,000 (including accrued interest through the date of the agreement), with a remaining balance due to the shareholder/officer of approximately $318,000 as of the date of the agreement, and (3) in connection with RCI terminating a "Purchase Commitment Agreement" with the shareholder/officer and certain other entities controlled by the shareholder/officer, the shareholder/officer surrendered 142,222 shares of common stock (representing approximately 4% of the shareholder/officer's holdings in RCI) with an estimated fair value of $448,000. 4. ACQUISITION OF RAPID CAST, INC.: On February 8, 1995, the Company acquired a 51% ownership in Rapid Cast, Inc. for $28,164,000 in a transaction accounted for using the purchase method of accounting. The acquisition resulted in the recognition of intangible patent assets of approximately $42.0 million, $8.0 million of which was written off in the third quarter ending September 30, 1996, and the remaining balance of $31.1 million of which was written off in the fourth quarter ending December 31, 1996. The remaining balance is being amortized over 17 years. The following summary, prepared on a pro forma basis, combines the consolidated results of operations as if RCI had been acquired as of the beginning of the periods presented, after including the impact of certain adjustments, such as minority interest, equity in loss of unconsolidated subsidiary and patent amortization. (Dollars in thousands, except per share amounts). 1995 1994 ---- ---- Sales $87,860 $46,815 47 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 Net income $ 1,080 $ 4,071 Net income per share $ .08 $ 0.42 The pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the entire periods presented. In addition, they are not intended to be a projection of future results and do not reflect any synergy that might be achieved from combined operations. 5. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, at cost, including capitalized lease assets, consist of the following: (IN THOUSANDS) December 31, ------------------------ 1996 1995 ---- ---- Computer hardware and software $ 7,100 $ 5,113 Furniture and office equipment 3,456 1,878 Leasehold improvements 7,595 4,134 ------ ----- 18,151 11,125 Less accumulated depreciation 3,794 1,979 ------ ----- $14,357 $9,146 ------ ----- ------ ----- 6. PATENT RIGHTS FROM ACQUISITION OF RCI During the third and fourth quarters of 1996, the Company evaluated the carrying value of its patent rights in comparison with management's estimates of discounted net present values of cash flows from those patents, and provided impairment losses of approximately $8.0 million and $31.1 million, respectively. 7. INVESTMENTS, NOTES RECEIVABLE AND OTHER ASSETS Investments, notes receivable and other assets consist of the following: (IN THOUSANDS) December 31, ------------------------- 1996 1995 ---- ---- Marketable securities available-for-sale $ 35 $321 Notes receivable -- 155 Other assets 208 324 --- --- $243 $800 --- --- --- --- Marketable securities available-for-sale consist of shares of common stocks of publicly traded companies. During the fourth quarter of 1996, the Company deemed these investments permanently impaired and recorded a loss of $0.3 million to their estimated realizable value. Notes receivable are carried at lower of amortized cost or net realizable value. Other assets consist primarily of deposits. 8. NOTES PAYABLE: Notes payable consists of the following:
(IN THOUSANDS) December 31, -------------- 1996 1995 ---- ---- Current Portion of Notes Payable: Notes payable to founding shareholders of RCI, interest at 7%, due in July 1996, $1,091 of which was exchanged for RCI shares in January 1997, balance repaid $1,205 $1,518 Notes payable to certain shareholders, officers and director
48 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 of RCI, interest at 10%, $543 repaid in January 1997 from the proceeds of private placement (see Note 17) balances exchanged for equity shares of RCI 1,587 -- Revolving line of credit of RCI, interest at bank reference rate (approximately 10% at December 31, 1996 and 1995) repaid in January 1997 from the proceeds of private placement 500 490 Convertible notes payable to certain shareholders and officers of RCI, interest at 8%, exchanged for equity shares of RCI in January of 1997 322 -- Capitalized lease obligations, payable in varying installments to 2000 288 -- Note payable in connection with financing of RCI acquisition, interest at 8%, repaid in January 1996 -- 500 Miscellaneous 16 23 -------- ------- Total current portion of notes payable $3,918 $2,531 -------- ------- Long Term Portion of Notes Payable: Capitalized lease obligations, payable in varying installments to 2000 $1,002 $ -- Miscellaneous 38 11 -------- ------- Total long term portion of notes payable $1,040 $ 11 -------- ------- Total notes payable $4,958 $2,542 -------- ------- -------- -------
Interest paid for 1996 and 1995 was approximately $0.2 million in each year and none in 1994. Interest resulted primarily from interest paid on Notes used to acquire RCI and from interest paid by RCI on its bank revolving line of credit. 9. INCOME TAXES: On February 15, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes". Effective January 1, 1993, the Company adopted SFAS No, 109, the effect of which was immaterial to the Company's financial statements in 1994 and resulted in a deferred tax liability in 1995. Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of the deferred income tax assets and liabilities are as follows: (IN THOUSANDS) December 31, ------------------------ 1996 1995 -------- --------- Deferred tax assets Allowance for doubtful accounts $ 3,205 $ 1,360 Nondeductible reserves 67 -- Net operating loss carryforwards 11,526 7,503 Other -- 113 49 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 -------- -------- Subtotal 14,798 8,976 -------- -------- Deferred tax liabilities Property and equipment, principally due to differences in depreciation 1,847 676 Patent rights -- 8,449 -------- -------- Subtotal 1,847 9,125 -------- -------- Total 12,951 (149) Less valuation allowance (12,951) (8,300) -------- -------- Net deferred tax liability $ -- $ 8,449 -------- -------- -------- -------- The deferred taxes at December 31, 1995 are presented in the accompanying balance sheet as deferred tax assets-current (included in prepaid expenses and other) of $0.4 million and deferred tax liability-noncurrent of $8.4 million. The following is a reconciliation of the federal statutory tax rate and the effective tax rate: 1996 1995 ---- ---- Federal statutory tax rate (34.0)% 34.0% Goodwill 0.6 9.9 Loss producing no current tax benefit 17.0 -- State taxes, net of federal benefits -- 38.2 Benefit from net operating loss carryforward -- (71.5) Other, net 1.2 -- -------- -------- Effective tax rate (15.2)% 10.6% -------- -------- -------- -------- Income tax benefits are recognized only when their realization is assured. Accordingly, potential future income tax benefits resulting from net operating losses incurred to date are not reflected in the consolidated financial statements. At December 31, 1996, Incomnet had available net operating loss carryforwards for federal income tax purposes of approximately $22,600,000, expiring in various years between 2000 and 2011, and Rapid Cast had a carryforward of approximately $6,028,000 expiring through 2012. The company files combined income tax returns for Incomnet and NTC and separate returns for RCI. Accordingly, the respective federal net operating loss carryforwards of each corporation are available to offset taxable income only of each separate corporation. 10. SHAREHOLDERS' EQUITY: STOCK OPTIONS - In July 1996, the Company's shareholders adopted a stock option plan that replaced a previous plan adopted by shareholders in 1994. The plan is for executives at the Company's parent company level. The plan allows for the issuance of up to 1,500,000 shares at an exercise price equal to the price of the last sale of the Company's common stock on the date of issuance. The Company's subsidiaries have adopted their own separate stock option plans to be implemented when those companies become publicly traded. To date, the Company has issued 685,000 stock options that are now vested and can be exercised at prices from $4.25 to $4.87 up to May 31, 2002. The Company has also issued 300,000 stock options at prices from $4.37 to $4.85 that will vest when the Company's RCI subsidiary reaches certain financial goals. These options have not yet vested. In November 1994, the Company approved the 1994 Plan for directors, employees, and key outside consultants of the Company that provided for the issuance of up to 1,500,000 shares of common stock. The plan requires that the option price must be at least 100% of the fair market value of the shares on the date the option is granted. In November 1994, options to purchase 1,200,000 shares of the Company's common stock were granted at exercise 50 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 prices of $10 per share. These options will be vested based upon a performance requirement in which National Telephone & Communications, Inc. must earn at least $15.0 million in pre-tax profits during any continuous four audited quarterly periods until December 31, 1997. The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had compensation cost for the Company's stock option plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS 123, the Company's net loss and loss per share would have been increased to the pro forma amounts indicated below: (IN THOUSANDS) 1996 ---- Net loss - reported $(37,676) ------ Net loss - pro forma $(37,940) ------ Loss per share - reported $ (2.82) ---- Loss per share - pro forma $ (2.83) ---- The fair value of each option grant in 1996 and 1995 was estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: divided yield of 0.0%; expected annual volatility of 66.1%; risk-free interest rate of 6.0% and expected lives of 3 years for options. The weighted average per share fair value of options granted in 1996 was approximately $2.50. The pro forma amounts shown for the impact of SFAS 123 are not necessarily indicative of future results because of the phase in rules and differences in number of grants, stock price and assumptions for future years. WARRANTS - Since 1994, the Company has issued warrants to purchase the Company's common stock to key employees, directors or other individuals or organizations as follows: 51 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996
Dollar Canceled or Issued Number Price Exercised Amount Expired Expiration ------ ------ ----- --------- ------ ----------- ---------- 1-17-94 500,000 $ 7.00 500,000 $3,500,000 5/27/94 500,000 10.00 500,000 5,000,000 5/27/94 100,000 8.50 100,000 850,000 5/27/94 100,000 8.50 100,000 850,000 5/27/94 50,000 8.50 5/27/97 5/27/94 50,000 8.50 5/27/97 8/14/94 10,000 8.50 10,000 85,000 11/15/94 100,000 11.25 25,000 281,250 11/15/94 10,000 11.25 10,000 112,500 1/10/95 500,000 10.25 500,000 1/10/95 500,000 11.25 500,000 6/30/95 900,000 14.00 900,000 8/29/95 250,000 11.00 250,000 8/29/95 35,000 4.875 (1) 8/29/97 8/29/95 35,000 4.875 (1) 8/29/97 8/29/95 25,000 4.875 (1) 25,000 12/20/95 2,000 5.125 (1) 2,000 12/20/95 3,000 5.125 (1) 3,000 12/20/95 1,000 5.125 (1) 1,000 12/20/95 1,000 5.125 (1) 1,000 5/9/96 100,000 6.00 (2) 5/9/01 5/9/96 50,000 7.00 (2) 5/9/01 5/9/96 75,000 5.37 (2) 12/31/98 12/9/96 360,000 3.75 (2) 12/9/99 12/17/96 12,500 2.94 (2) 12/17/01 --------- --------- ----------- --------- 4,269,500 1,245,000 $10,678,750 2,182,000
(1) The exercise price on these warrants was adjusted pursuant to a redemption of old stock options and a reissuance of an equivalent number of new stock options with the same expiration date. (2) These warrants were issued pursuant to legal settlements in 1996. Since 1994, the Company has issued warrants to purchase a total of 4,269,500 shares of the Company's common stock. At March 21, 1997, warrants to purchase 1,245,000 of those shares have been exercised bringing the Company $10,678,750; warrants to purchase 2,182,000 shares have been canceled or have expired; and warrants remain outstanding to purchase 767,500 shares of the Company's common stock at prices ranging from $2.94 to $8.50. WARRANT - OPTION TABLE - The number and weighted average exercise prices of options and warrants from each of the three years ended December 31, 1996, 1995 and 1994, respectively, are as follows:
1994 1995 1996 ---- ---- ---- AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE NUMBER PRICE NUMBER PRICE NUMBER PRICE ------ -------- ------ -------- ------ -------- Outstanding at beginning of the year.......489,582 $5.00 2,609,582 $ 8.94 3,872,000 $10.72 Outstanding at end of the year...........2,609,582 8.94 3,872,000 10.72 5,029,500 9.30 Exercisable at end of the year...........2,609,582 8.94 3,872,000 10.72 4,729,500 10.26 Granted during the year....2,620,000 9.30 2,252,000 11.81 1,402,500 4.64 Exercised during the year....500,000 7.00 989,582 8.49 0 - Forfeited/expired during the year...................0 - 0 - 245,000 5.00 The range of exercise price of outstanding options and warrants at December 31, 1996 is $4.13 to $14.00, and the average contractual life is approximately three years.
COMMON STOCK - On August 5, 1994, the Company announced that its Board of Directors authorized the repurchase of up to 1,000,000 shares of its common stock from time to time on the open market or in private transactions. The Company's Chief Executive Officer was given the discretion to decide when and if the Company would repurchase shares and to effect such transactions. As of March 27, 1997, the Company has repurchased a net of 486,000 shares of common stock with a value of $5,491,845 under the terms of the repurchase authorization as follows: Years ended Shares December 31, Repurchased Cost (IN THOUSANDS) -------------- --------------- --------------------- 1994 70,000 $ 665 1995 416,000 4,827 --------------- --------------------- 486,000 $5,492 --------------- --------------------- --------------- --------------------- 2% CONVERTIBLE PREFERRED STOCK - In the fourth quarter of 1996, the Company issued 2,440 shares of Series A Convertible Preferred Stock, for net proceeds of $2,354,640. Dividends on the preferred stock accrue at the rate of 2% per annum, payable in cash or in shares of Common Stock at the conversion date. Each share is convertible into common stock at a conversion price equal to the lesser of the market value on the date of funding or 80% of the market value immediately prior to the date of conversion. PRIVATE PLACEMENT - On June 30, 1995, the Company initiated a private placement of 900,000 shares of the Company's restricted common stock at $12 per share for a total of $10,800,000 and warrants to purchase 900,000 additional shares of the Company's common stock at $14 per share. The warrants were exercisable for a period of 52 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 six months until December 31, 1995. The Company received $1,890,000 in cash from subscribers to the private placement, which was the effective purchase of 157,500 shares and warrants to purchase an additional 157,500 shares for $14 per share. The Company also received subscription notes for $8,910,000 payable upon the registration of the shares and shares underlying the warrants with the Securities and Exchange Commission. These notes were for the purchase of 742,500 shares of the Company's common stock and warrants to purchase an additional 742,500 shares for a purchase price of $14 per share. As the Company did not register the shares, the notes for $8,910,000 were canceled on December 31, 1995 by mutual consent with the investors. As a result, the investors were no longer obligated to pay the notes to the Company and the Company was no longer obligated to issue additional shares or warrants to the investors. Since the warrants to purchase 157,500 additional shares were not exercised, these warrants expired on December 31, 1995. As a result, the Company issued a total of 157,500 shares in consideration for the $1,890,000 in cash paid by the investors. The Company's balance sheet reflects the issuance of 157,500 shares of the Company's common stock in exchange for $1,890,000 in capital. SHORT SWING PROFITS - In January 1996, the Company was served with a derivative shareholders lawsuit entitled RICHARD MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ, 96 Civil 0225 in the United States District Court for the Southern District of New York, alleging violations of Section 16(b) of the Securities Exchange Act of 1934, as amended, and demanding that the Company assert claims against Mr. Schwartz for the payment of short-swing profits plus interest. Mr. Schwartz has retained separate counsel for this action. In early July 1996, Mr. Schwartz deposited 800,000 shares of his Incomnet, Inc. Common Stock into a court-approved escrow account with the Company's New York counsel as security for his obligation to pay short swing profits. In early February 1997, plaintiff's counsel prepared a motion for summary judgment in the case seeking $5,050,000 in short swing profits from Mr. Schwartz plus pre-judgment interest. On February 21, 1997, the plaintiffs and Sam Schwartz, entered into a stipulated settlement pursuant to which Mr. Schwartz agreed to pay $4,250,000 to the Company as full payment of his short swing profit obligation to the Company. The plaintiff's lawyer indicated that he would request a fee of $850,000 plus reimbursement of $65,000 of expenses, to be paid by the Company from the proceeds of the recovery. Under the stipulated settlement, the disgorgement of short-swing profits would be payable $600,000 in cash and the balance by tender to the Company of shares of the Company's Common Stock owned by Mr. Schwartz, based on 90% of the average between the bid and the asked price of the Company's Common Stock on the NASDAQ market during the 30 calendar days immediately preceding the date that the court enters an order approving the settlement. Pursuant to the agreement, Mr. Schwartz has deposited $600,000 in cash and has agreed to deposit additional shares of the Company's common stock into a separate escrow account from the one which already contains 800,000 shares of the Company's stock owned by him or his affiliates. The Company intends to oppose the amount of plaintiff's attorney's fees sought. The Company does not otherwise intend to oppose the proposed settlement. On April 11, 1997, a revised stipulation was filed containing the same economic terms. Notice of the settlement is to be given to the shareholders by April 21, 1997. Any opposition to the settlement is due by May 16, 1997, and a hearing to approve the settlement is to be held on May 30, 1997. There is no assurance that the Company will recover the short-swing profits from Mr. Schwartz. 11. COMMITMENTS, CONTINGENCIES AND OTHER: LITIGATION - The Company is a defendant in a class action matter alleging securities violation with respect to alleged false denial and non-disclosure of a Securities and Exchange Commission investigation and alleged non-disclosure of purchases and sales of the Company's stock by an affiliate of the former Chairman of the Board. Counsel for the company is unable to estimate the ultimate outcome of this matter and is unable to predict a range of potential loss. Accordingly, no amounts have been provided for the class action lawsuit in the accompanying financial statements. The Company is under investigation by the Securities and Exchange Commission under a non-public "formal order of private investigation." Management has furnished all information requested by the Commission and does not believe that the matter will have a material adverse impact on its financial position or results of operations. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The total Company allowance for doubtful accounts totaled $2.0 million or 13.2% of gross accounts receivable at December 31, 1996 and $1.1 million or 8.0% of gross accounts receivable at December 31, 1995. The following table summarizes the Company's year-to-year reserve balances by subsidiary and segment: $ IN THOUSANDS December 31, --------------------- Subsidiary Segment 1996 1995 - ------------ ---------- --------------------- 53 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 NTC Telephone $1,908 $1,063 RCI Optical 85 -- AutoNETWORK Network -- -- --------------------- Total Company $1,993 $1,063 --------------------- --------------------- % of Gross Accounts Receivables 13.2% 8.0% --------------------- --------------------- Reserves for NTC's telecommunications service accounts receivable relate primarily to its direct billed and LEC billed long distance telephone services. Delinquent direct billed receivables are collected by a combination of NTC's internal collection department and by external collection agencies. Delinquent LEC billed receivables are collected by the LEC's. The estimated percentage of accounts which will become uncollectible is reviewed periodically by management and is adjusted in accordance with historical experience. Reserves for NTC's marketing program accounts receivable are provided at 100% of the expected bad debt. These receivables result from payments for marketing programs which have been denied due to returned checks and rejected credit card payments. BUILDING LEASES - Rent expense for the years ended December 31, 1996, 1995 and 1994 was $0.8 million, $0.8 million, and $0.3 million, respectively. The Company leases its office and operating facilities, equipment and automobiles under noncancellable operating leases. The aggregate future minimum annual rental payments required under these leases are as follows (IN THOUSANDS): For years ending December 31, ------------- 1997 $2,146 1998 2,176 1999 1,643 2000 1,455 2001 1,361 Thereafter 2,602 In addition, effective February 1996, NTC entered into a revised multiple-year $1.0 billion contract with Wiltel, Inc., which has a fixed term expiring January 2002. As in the prior carrier contract with Wiltel, Inc., NTC commits to purchase the designated volume of telephone time in accordance with a schedule over the term of the contract. NTC currently relies in part, on the purchases of another unaffiliated long distance telephone service provider to meet its volume purchase requirements under the new contract. 12. NETWORK MARKETING COSTS: NTC's net cost to operate its network marketing program consist of the following: (IN $ MILLIONS) 1996 1995 -------------------- Sales $17.4 $13.1 Cost of sales 13.7 11.2 Operating expenses for support services 4.3 3.8 -------------------- Total marketing-related costs 18.0 15.0 -------------------- Net marketing cost $ 0.6 $ 1.9 -------------------- -------------------- 54 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 % of total NTC (long distance & marketing) sales 0.6% 2.3% Marketing sales are generated by the sale of materials, training and support services to assist NTC independent sales representatives in selling new retail customers and enrolling other representatives in the NTC program. Beginning in January 1996, NTC began to accrue its obligation to provide customer support to its representatives (see Note 16). These reserved marketing revenues are reflected as deferred income on the Company's balance sheet and are amortized over the succeeding twelve months. The marketing-related costs include commissions paid to independent sales representatives for acquiring new retail telephone customers, as well as the cost of sales materials, salaries and wages of marketing department personnel, services required to support the independent sales representatives, and other directly identifiable support costs, but do not include residual commissions paid on continuing long distance telephone usage or the typical indirect cost allocations, such as floor-space and supporting departments. Marketing-related costs for 1996 and 1995, of $18.0 million and $15.0 million, respectively, are compared against marketing-related revenues for 1996 and 1995 of $17.4 million and $13.1 million, respectively. The results are a net loss in marketing-related activities for 1996 and 1995 of $0.6 million and $1.9 million, or 0.6% and 2.3%, respectively, of total NTC sales. 13. COMPENSATION OF INDEPENDENT SALES REPRESENTATIVES: The Company's subsidiary, NTC, compensates its independent sales representatives by an earned commission structure based upon signing up new telephone customers and based upon the telephone usage generated by those customers. Expenses associated with commissions, bonuses and overrides paid out to NTC's independent sales representatives for 1996 and 1995 were $18.0 million and $14.2 million, respectively. 14. SEGMENT INFORMATION: In 1994, the Company conducted its business operations in two industry segments, including Network Services and Telephone Services. In 1995 and 1996, because of the acquisition of RCI, the Company conducted business in three segments, including Network Services, Telephone Services and Optical Systems. No one customer accounted for as much as 10% of the revenues of any segment in 1996, 1995 or 1994. 55 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996
(IN THOUSANDS) Telephone Optical Network General YEAR ENDED DECEMBER 31, 1996 Services Systems Services Corporate Consolidated - ---------------------------- --------- -------- -------- --------- ------------ Sales $100,811 $ 4,660 $1,426 $ 8 $106,905 -------- -------- ------ -------- -------- Operating income (loss) 3,735 (26,495) 475 (29,232) (51,517) Income taxes 374 (8,449) 263 -- (7,812) -------- -------- ------ -------- -------- Income (loss) before minority interest and extraordinary items $ 3,361 $(18,046) $ 212 $(29,232) $(43,705) -------- -------- ------ -------- -------- -------- -------- ------ -------- -------- Identifiable assets $ 32,987 $ 5,951 $1,562 $ 87 $ 40,587 Depreciation and amortization 1,630 118 265 $ 2,334 4,347 Capital expenditures 6,412 669 143 -- 7,224 Telephone Optical Network General YEAR ENDED DECEMBER 31, 1995 Services Systems Services Corporate Consolidated - ---------------------------- --------- -------- -------- --------- ------------ Sales $ 83,127 $ 1,993 $1,370 $ 75 $ 86,565 -------- -------- ------ -------- -------- Operating income (loss) 5,060 (1,040) 369 (3,324) 1.065 Income taxes 365 -- (102) $ (152) 111 -------- -------- ------ -------- -------- Income (loss) before minority interest and extraordinary items $ 4,695 $ (1,040) $ 471 $ (3,172) $ 954 -------- -------- ------ -------- -------- -------- -------- ------ -------- -------- Identifiable assets $ 21,758 $ 25,345 $1,569 $ 25,434 $ 74,106 Depreciation and amortization 705 429 279 $ 1,100 2,513 Capital expenditures 6,681 199 509 -- 7,389 Telephone Optical Network General YEAR ENDED DECEMBER 31, 1994 Services Systems Services Corporate Consolidated - ---------------------------- --------- -------- -------- --------- ------------ Sales $ 45,609 $ -- $1,206 $ -- $ 46,815 -------- -------- ------ -------- -------- Operating income (loss) 3,742 -- 154 104 4,000 Income taxes -- -- 1 -- 1 -------- -------- ------ -------- -------- Income (loss) before extraordinary items $ 3,742 $ -- $ 153 $ 104 $ 3,999 -------- -------- ------ -------- -------- -------- -------- ------ -------- -------- Identifiable assets $ 12,830 $ -- $4,271 $ 9,057 $ 26,158 Depreciation and amortization 221 -- 489 -- 710 Capital expenditures 1,547 -- 147 -- 1,694
56 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 15. FOURTH QUARTER ADJUSTMENTS: During the fourth quarter of 1995, the Company recorded adjustments having the effect of reducing net income by approximately $3.1 million or $ 0.24 per share. These adjustments resulted primarily from reserve provisioning related to settlements with shareholders and with the Company's former Chairman, revisions of management's estimates regarding the collectibility of accounts receivable, write-off of marketable securities and inventory, and reserve provisioning for estimated legal fees. 16. CHANGE IN ACCOUNTING: Effective January 1, 1996, the Company changed its accounting procedures to defer a portion of marketing revenues, which had previously been recognized upon receipt. The Company believes that the change is preferable because it provides a better matching of revenues with services provided to the marketing representatives. The cumulative effect of this change and certain other changes for the periods prior to January 1, 1996 of approximately $0.9 million is shown as a cumulative effect adjustment. The effect of the changes on 1996 is to increase income before cumulative effect adjustment by $0.03 per share. 17. SUBSEQUENT EVENTS: On January 15, 1997, RCI completed a Convertible Preferred Stock and Warrants Purchase Agreement with two institutional investors whereby they issued (i) 7,275,000 shares of newly created Series A Convertible Preferred Stock, par value $.001 per share, (ii) 725,000 shares of newly created Series B Non-Voting Convertible Preferred Stock, par value $.001 per share, and (iii) 1,400,000 warrants (expiring five years from the date of issuance) with each warrant entitling the holder thereof to purchase one share of common stock at an exercise price of $1.74 per share, for aggregate gross proceeds of $12,000,000. The proceeds were used to (i) repay $500,000 of principal, plus accrued and unpaid interest, under RCI's existing note payable to bank, (ii) repay $2,765,339 of existing bridge financing owing to Incomnet, including accrued and unpaid interest thereon, (iii) repay $940,091 of additional existing bridge financing owing to certain shareholders including accrued and unpaid interest thereon, (iv) to repurchase 1,200,000 shares of common stock from one of RCI's shareholders/officers for a purchase price of $1,536,000, (v) to make a $325,000 partial settlement payment to complete the settlement of the RCI patent infringement case, which has been dismissed, (vi) to pay fees and expenses incurred by the institutional investors estimated to be approximately $500,000, and (vii) the balance is for general working capital purposes including the immediate repayment of overdue accounts payable of approximately $1,800,000. The two institutional investors retain an option to invest an additional $5,000,000 by July 15, 1997 and an additional $5,000,000 by July 15, 1998 with substantially the same terms as previously described. This transaction reduced the Company's outstanding interest to less than 50% of the voting control of RCI. Accordingly, commencing in the first quarter of 1997, RCI will be accounted for using the equity method of accounting. In addition, on March 26, 1997, NTC entered into a credit agreement with a bank for a $5.0 million accounts receivable line of credit to support NTC's operations and establishment of additional branch marketing offices. This new agreement provides for interest at prime plus 1.0% and is secured generally by NTC's accounts receivable. As of March 31, 1997, there are no borrowings against this line of credit. Under the terms of the agreement, NTC is required to comply with various covenants, including covenants requiring NTC to maintain specified ratios and levels of tangible net worth and net income, and limiting the ability of NTC to pledge assets or incur liens on assets. 57 Schedule II INCOMNET, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1996 AND 1995
(IN THOUSANDS) Balance at Amounts Balance beginning charged to costs at end Classification of period and expenses Write-offs (1) of period - -------------------- ---------- ---------------- -------------- --------- Year ended December 31, 1996 Deducted from asset accounts: Accounts receivable reserve $1,063 $9,517 $ (8,587) $1,993 Patent reserves 2,019 7,916 (9,891) 44 Goodwill reserves 942 296 -- 1,238 Notes receivable reserve 209 1,472 (1,472) 209 Inventory reserves 100 70 170 Reserve for marketable securities 34 225 (34) 225 ------ ------- -------- ------ Total $4,367 $19,496 $(19,984) $3,879 ------ ------- -------- ------ ------ ------- -------- ------ Year ended December 31, 1995 Deducted from asset accounts: Accounts receivable reserve $ 991 $ 7,590 $ (7,518) $1,063 Patent reserves 0 2,019 -- 2,019 Goodwill reserves 664 278 -- 942 Notes receivable reserve 0 209 -- 209 Inventory reserves 0 100 -- 100 Reserve for marketable securities 2,000 -- (1,966) 34 ------ ------- -------- ------ Total $3,655 $10,196 $ (9,484) $4,367 ------ ------- -------- ------ ------ ------- -------- ------ Year ended December 31, 1994 Deducted from asset accounts: Accounts receivable reserve $ 356 $ 4,576 $ (3,941) $ 991 Goodwill reserves 0 664 -- 664 Reserve for marketable securities 2,845 -- (845) 2,000 ------ ------- -------- ------ Total $3,201 $ 5,240 $ (4,786) $3,655 ------ ------- -------- ------ ------ ------- -------- ------
(1) Amounts are net of recoveries. 58 EX-13.12 7 EXHIBIT 13.12 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A AMENDMENT No. 1 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1997 COMMISSION FILE NO. 0-12386 INCOMNET, INC. A California IRS Employer No. Corporation 95-2871296 21031 Ventura Blvd., Suite 1100 Woodland Hills, California 91364 Telephone no. (818) 887-3400 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:.................None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:..............................................Common Stock, No Par Value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days................................. YES X NO Number of shares of registrant's common stock outstanding as of March 31, 1997........................................................13,550,000 ITEM 1. FINANCIAL STATEMENTS INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET ($ IN 000s)
March 31, December 31, 1997 1996 ---- ---- ASSETS Current assets: Cash & cash equivalents $ 2,164 $ 2,214 Accounts receivable, including $460 and $267 due from related party at March 31, 1997 and December 31, 1996, respectively and less allowance for doubtful accounts of $1,065 at March 31, 1997 and $1,078 at December 31, 1996 14,192 13,137 Notes receivable - current portion 471 323 Notes receivable from officers & shareholders, net of reserves of $209 795 438 Inventories 326 2,760 Other current assets 1,086 1,332 ------- -------- Total current assets 19,034 20,204 Property, plant and equipment, at cost, net 14,139 14,537 Patent rights, net 1,241 Goodwill, net 4,468 4,542 Investment in marketable securities 191 Deposits and other 357 376 Investments, notes receivable and other assets 223 243 ------- -------- Total assets $38,222 $ 40,587 ------- -------- ------- -------- 2 LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $12,438 $ 14,746 Accrued expenses 7,601 8,217 Current portion of notes payable 220 3,918 Deferred income 3,313 4,040 ------- -------- Total current liabilities 23,572 30,921 Notes payable 925 1,041 Liabilities in excess of assets of RCI 3,952 Commitments (Note 12) Shareholders' equity: Common stock, no par value; 20,000,000 shares authorized; and 13,553,229 shares at March 31, 1997 and 13,369,681 shares issued and outstanding at December 31, 1996 61,785 61,320 Preferred stock, no par value; 100,000 shares authorized; 2,075 shares issued and outstanding at March 31, 1997 and 2,440 shares issued and outstanding at December 31, 1997 1,990 2,355 Treasury stock (5,492) (5,492) Additional paid in capital 36 Accumulated deficit (48,547) (49,557) ------- -------- Total shareholders' equity 9,772 8,626 ------- -------- Total liabilities, minority interest & shareholders' equity $ 38,221 $ 40,587 ------- -------- ------- --------
See accompanying "Notes to Consolidated Financial Statements." 3 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) THREE MONTHS ENDED MARCH 31, ($ in 000s) 1997 1996 ----------- ----------- SALES $ 31,169 $ 24,399 ----------- ----------- OPERATING COSTS & EXPENSES: Cost of sales 21,531 15,906 General & administrative 6,159 6,290 Depreciation & amortization 665 429 Bad debt expense 1,697 1,091 Other (income)/expense (83) 69 NTC Acquisition - goodwill amortization 74 74 RCI Acquisition - patent rights amortization 503 RCI Acquisition - interest and legal 6 ----------- ----------- Total costs & expenses 30,043 24,363 ----------- ----------- Income before income taxes, extraordinary items & minority interest 1,126 31 INCOME TAXES 107 94 ----------- ----------- Income before extraordinary items & minority interest 1,019 (63) MINORITY INTEREST 480 EXTRAORDINARY ITEMS 9 -- ----------- ----------- Net income $ 1,010 $ 417 ----------- ----------- ----------- ----------- INCOME PER COMMON SHARE AND COMMON SHARE EQUIVALENTS $ .07 $ .03 ----------- ----------- ----------- ----------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARE EQUIVALENTS OUTSTANDING 13,550,000 13,278,242 ----------- ----------- ----------- ----------- See accompanying "Notes to Consolidated Financial Statements." 4 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) THREE MONTHS ENDED MARCH 31, ($ in 000s)
1997 1996 ------- ------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,010 $ 417 Minority interest -- (480) Depreciation & amortization - operations 665 429 Depreciation & amortization - acquisitions 74 577 Other -- 74 ------- ------ Net cash inflow/(outflow) from operating activities 1,749 1,017 ------- ------ CASH FLOWS FROM (INCREASE)/DECREASE IN OPERATING ASSETS: Accounts receivable (1,055) 416 Notes receivable - current portion (147) (113) Notes receivable - due from officers and shareholders (357) (65) Inventories 2,434 443 Prepaid expenses & other 245 (188) Notes receivable - long term 155 Deferred tax (41) Deposits & other (148) (52) ------- ------ Net cash inflow/(outflow) from changes in operating assets 931 596 ------- ------ CASH FLOWS FROM INCREASE/(DECREASE) IN OPERATING LIABILITIES: Accounts payable (2,308) 299 Accrued expenses (616) (384) Deferred income (727) 71 ------- ------ Net cash inflow/(outflow) from changes in operating liabilities (3,651) (14) ------- ------ Net cash inflow/(outflow) from operations (971) 1,577 ------- ------ CASH FLOWS FROM (INCREASE)/DECREASE IN INVESTING ACTIVITIES: Acquisition of plant & equipment (447) (2,162) Organization cost (184) Patents/intangible assets 1,241 (36) Investment in Lab Tech 35 Investment in RCI Liability in excess of asset 3,952 ------- ------ Net cash inflow/(outflow) from investing activities 4,597 2,198 ------- ------
See accompanying "Notes to Consolidated Financial Statements." 5 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) THREE MONTHS ENDED MARCH 31, (CONT'D)
1997 1996 ------- ------- CASH FLOWS FROM INCREASE/(DECREASE) IN FINANCING ACTIVITIES: Bank overdraft -- Minority interest (1) Notes payable - current (3,698) 158 Sale of common stock, net 465 147 Preferred Stock (365) Treasury stock -- Notes payable - long term (114) 495 Paid in capital 36 -- Prior period adjustment to retainer earnings -- Change in valuation allowance -- ------- ------- Net cash inflow/(outflow) from financing activities (3,676) 799 ------- ------- Net cash inflow/(outflow) from investing & financing 921 (1,399) ------- ------- Net increase/(decrease) in cash & cash equivalents $ (50) $ 200 ------- ------- ------- -------
See accompanying "Notes to Consolidated Financial Statements." 6 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 1. MANAGEMENT'S REPRESENTATION: The consolidated financial statements included herein have been prepared by the management of Incomnet, Inc. (the Company) without audit. Certain information and note disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted. In the opinion of the management of the Company, all adjustments considered necessary for fair presentation of the consolidated financial statements have been included and were of a normal recurring nature, and the accompanying consolidated financial statements present fairly the financial position as of March 31, 1997, and the results of operations for the three months ended March 31, 1997 and 1996, and cash flows for the three months March 31, 1997 and 1996. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes for the three years ended December 31, 1996, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 15, 1997. The interim results are not necessarily indicative of the results for a full year. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, National Telephone & Communications-Registered Trademark-, Inc. (NTC). The statements do not include consolidated results of Rapid Cast, Inc., the Company's 35%-owned subsidiary, which is accounted for using the equity method of accounting under FASB Statement No. 94. The Company accounted for RCI using the consolidated method of accounting from the third quarter of 1995 until December 31, 1996 because the Company owned 51% of RCI. In January 1997, the Company's ownership changed from 51% of RCI to 35% and, as a result, the method of accounting has changed to the equity method under FASB Statement No. 94. On the date of change in the method of accounting, RCI's liabilities significantly exceeded its assets, and the Company recorded its ratable share of such excess in the balance sheet caption "Liabilities in excess of assets of RCI". Accordingly, all assets and liabilities of RCI, including patent rights of $1,241,000 (after previously recorded reserves of approximately $39 million) were, during the first quarter of 1997, combined under this caption. REVENUE RECOGNITION - The Company recognizes revenue during the month in which services or products are delivered, as follows: (1) NTC's long distance telecommunications service revenues are generated when customers make long distance telephone calls from their business or residential telephones or by using any of NTC's telephone calling cards. Proceeds from prepaid telephone calling cards are recorded as deferred revenues when the cash is received, and recognized as revenue as the telephone service is utilized. The reserve for deferred revenues is carried on the balance sheet as an accrued liability. Long distance telephone service sales in the three months ending March 31, 1997 totaled $25.1 million versus long distance telephone service sales of $20.3 million in the three months ending March 31, 1996, an increase of 24%. (2) NTC's marketing-related revenues are derived from programs and material sold to the Company's base of independent sales representatives, including forms and supplies, fees for representative and certified trainer renewals, and the Company's Certified Trainer, Independent 7 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 Representative and Long Distance University programs. The Company requires that all such services and materials be paid at the time of purchase. Revenues from marketing-related materials, net of amounts deferred for future services provided to the representatives, are booked as cash sales when the revenues are received. A portion of the revenues from marketing related programs and materials is deferred and recognized over a twelve month period to accrue the Company's obligation to provide customer support to its independent representatives. For the three months ending March 31, 1997, marketing sales totaled $5.7 million versus marketing sales of $2.7 million for the three months ended March 31, 1996, an increase of 113%. (3) The Company's network service revenues are recognized as sales as the service is delivered. Network service sales in the three months ending March 31, 1997 totaled $0.4 million versus $0.3 million in the three months ending March 31, 1996. CONCENTRATION OF CREDIT RISK - The Company sells its telephone and network services to individuals and small businesses throughout the United States and does not require collateral. Rapid Cast sells its optical products both domestically and internationally. Reserves for uncollectible amounts are provided, which management believes are sufficient. COMPUTER HARDWARE, FURNITURE AND OFFICE EQUIPMENT - Computer hardware, furniture and office equipment are stated at cost. Depreciation is provided by the straight-line method over the assets' estimated useful lives of 5 to 10 years. COMPUTER SOFTWARE - The Company capitalizes the costs associated with purchasing, developing and enhancing its computer software. All software costs are amortized using the straight-line method over the assets' estimated useful lives of 3 to 10 years. LEASEHOLD IMPROVEMENTS - All leasehold improvements are stated at cost and are amortized using the straight-line method over the expected lease term. NET INCOME PER SHARE - Net income per common share is based on the weighted average number of common shares for 1997, and common shares and common share equivalents for 1996. ACQUISITION AMORTIZATION - The excess of purchase price over net assets of NTC has been recorded as an intangible asset and is being amortized by the straight-line method over twenty years. DEFERRED TAX LIABILITY - Deferred income taxes result from temporary differences in the basis of assets and liabilities reported for financial statement and income tax purposes. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. Funding of Marketing Commissions and Deferred Income: 8 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 The Company's subsidiary, NTC, maintains separate bank accounts for the payment of marketing commissions. Funding of these accounts is adjusted regularly to provide for management's estimates of required reserve balances. NTC estimates the total commissions owed to active independent representatives ("IR Earned Compensation") each week for all monies collected that week due to the efforts of those active independent representatives. All IR Earned Compensation is then paid to the independent representatives, when due, directly out of the separate bank account. IMPAIRMENT OF LONG LIVED ASSETS: In accordance with the provisions of SFAS No. 121, the Company regularly reviews long-lived assets and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount to the assets may not be recoverable. CURRENT ACCOUNTING PRONOUNCEMENTS: The Financial Accounting Standards Board has issued SFAS No. 123, "Accounting for Stock-Based Compensation," which encourages companies to account for stock compensation awards based on their fair value at the date the awards are granted. This statement does not require the application of fair value method and allows the continuance of current accounting method, which requires accounting for stock compensation awards based on their intrinsic value as of the grant date. However, SFAS No. 123 requires pro forma disclosure of net income and, if presented, earnings per share, as if the fair value based method of accounting defined in this statement has been applied. The accounting and disclosure requirements of this statement are effective for financial statements for fiscal years beginning after December 15, 1995, although earlier adoption is encouraged. The Company has elected not to adopt the fair value provisions of this statement. 4. NETWORK MARKETING COSTS: During the three months ending March 31, 1997, NTC's net costs to operate its network marketing program was $0.5 million versus $0.7 million for the three months ended March 31, 1996, as summarized below (in $ millions): 3 Months Ending 3 Months Ending March 31, 1997 March 31, 1996 --------------- -------------- Sales $ 5.7 $ 2.7 ------- ----- Cost of sales 4.9 2.5 Operating expenses for support services 1.3 0.9 ------- ----- Total marketing-related costs 6.2 3.4 ------- ----- Net marketing cost $ 0.5 $ 0.7 ------- ----- ------- ----- % of total NTC (long distance & marketing) sales 1.8% 3.2% 9 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 Marketing sales of $5.7 million for the three months ended March 31, 1997 and $2.7 million for the three months ended March 31, 1996 were generated by the sale of materials, training and support services to assist NTC independent sales representatives in selling new retail customers and enrolling other representatives in the NTC program. Effective January 1, 1996, the Company changed its accounting procedures to defer a portion of marketing revenues, which had previously been recognized upon receipt. The Company believes that the change is preferable because it provides a better matching of revenues with services provided to the marketing representatives. The cumulative effect of this change and certain other changes for the periods prior to January 1, 1996 equal to approximately $.09 million is shown as a cumulative effect adjustment. When the three month marketing-related costs of $6.2 million is compared against marketing-related revenues of $5.7 million the result is $0.5 million in net marketing-related activities during the three months ended March 31, 1997 versus a net cost of $0.7 million in marketing related activities during the three months ended March 31, 1996. 5. COMPENSATION OF INDEPENDENT SALES REPRESENTATIVES: The Company's subsidiary, NTC, compensates its independent sales representatives by an earned commission structure based upon signing up new telephone customers and based upon the telephone usage generated by those customers. In the three months ending March 31, 1997, expenses associated with commissions, bonuses and overrides paid out to NTC's independent representatives were $5.4 million versus $3.3 million for the three months ended March 31, 1996. 6. COMMITMENTS AND CONTINGENCIES: Litigation - The Company is a defendant in a class action matter and related lawsuits alleging securities law violations with respect to alleged false denial and non-disclosure of a Securities and Exchange Commission investigation and alleged non-disclosure of purchases and sales of the Company's stock by the former Chairman of the Board and one of his affiliates. Counsel for the Company is unable to estimate the ultimate outcome of these matters and is unable to predict a range of potential loss. Accordingly, no amounts have been provided for the class action or related lawsuits in the accompanying financial statements. The Company is under investigation by the Securities and Exchange Commission under a non-public "formal order of private investigation." Management has furnished all information requested by the Commission and does not believe that the matter will have a material adverse impact on its financial position or results of operations. 7. SUBSEQUENT EVENT: In April 1997, NTC entered into an agreement to extend the lease on its headquarters building at 2801 Main Street, Irvine, California. According to the terms of this agreement, NTC would be obligated to pay formula based monthly lease payments estimated to be approximately $57,000 per month during 1997 and increasing to approximately $72,000 per month for the remainder of the initial five year lease term. In addition, in February 1997, NTC entered into a ten year lease 10 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) MARCH 31, 1997 for office space in Honolulu, Hawaii, with the lease expiring in 2007. The monthly payments on the lease in Honolulu commence at $36,698 per month in 1997 and 1998, and increase on a bi-annual basis through the term of the lease to $43,536 per month in 2006 and 2007. 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW: The following is management's discussion and analysis of certain significant factors which have affected the results of operations and financial condition of the Company during the period included in the accompanying financial statements. This discussion should be read in conjunction with the financial statements and associated notes. The discussion herein is qualified by reference to the Cautionary Statements. See "Part II. Cautionary Statements". LIQUIDITY AND CAPITAL RESOURCES: GENERAL - Overall, the Company achieved slightly negative cash flows of $50,000 during the first three months of 1997 resulting from negative cash flows from operations ($971,000) which were almost entirely offset by positive cash flows from investing $4.6 million less negative cash flow from financing activities ($3.7 million) as discussed below: CASH FLOW FROM OPERATIONS - The Company generated $971,000 in negative cash flow from operations during the first nine months of 1996, compared to $1.6 million in positive cash flow from operations during the prior year's comparable period. This year-to-year decrease in cash flow from operations resulted primarily from: (1) a $1.1 million increase in profits adjusted for non-cash expenses, offset by (2) a $1.1 million increase in accounts receivable, and (3) a $2.3 million decrease in accounts payable. Much of the changes in operating assets arise from the change in accounting for the Rapid Cast subsidiary, which was presented on the consolidated basis at December 31, 1996, but because Incomnet's ownership diminished to approximately 33% during the first quarter, was presented on the equity method of accounting at March 31, 1997. CASH FLOW FROM INVESTING - The Company generated positive cash flows from investing activities of $4.6 million in the first three months of 1997 and negative cash flows of ($2.2 million) in the first three months of 1996. CASH FLOW FROM FINANCING - Positive cash flows from investing activities of $4.6 million were offset by negative cash flow from financing activities of ($3.7 million) during the first three months of 1997, due principally from the change in method of accounting for the Rapid Cast subsidiary. The Company had material commitments for capital expenditures of $1.5 million in tenant improvements for its Honolulu, Hawaii office space at December 31, 1996, and expects to continue making improvements to the NTC headquarters building and purchasing additional equipment commensurate with the expansion of its business. During 1996, the Company had capital expenditures of $7.2 million for plant and equipment. 12 LITIGATION - The Company is subject to pending litigation and an investigation by the Securities and Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and results of operations. Management does not believe that the investigation by the Securities and Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Part II. Item 1. Legal Proceedings." RESULTS OF OPERATIONS: SALES - First quarter, 1997 sales of $31.2 million increased 28% over the first quarter, 1996 sales of $24.4 million. The majority of this increase was attributable to NTC's sales increase to $30.8 million from $23.0 million in the three months ending March 31, 1997 as compared to the same period in 1996, respectively. The following table summarizes the Company's sales performance by subsidiary and segment during the comparable first quarters in 1997 and 1996: $ in millions ----------------- Subsidiary Segment 1997 1996 - --------------- --------------------------------------- ---- ---- NTC Telephone (telecommunications services) $25.1 $20.3 NTC Telephone (marketing programs) 5.7 2.7 RCI Optical -- 1.1 AutoNETWORK Network 0.4 0.3 ----- ----- Total Company Sales $31.2 $24.4 ----- ----- ----- ----- COST OF SALES - Total Company cost of sales increased to $21.5 million or 69% of sales during the quarter ending March 31, 1997 versus $15.9 million or 65% of sales during the comparable prior year quarter. The quarter-to-quarter increase in cost of sales resulted largely from increasing carrier costs associated with increased telephone service sales by NTC. The following table summarizes the Company's changes in three major cost components for the first quarter: $ in millions ------------------- 1997 1996 ------ ------- Commissions paid to NTC independent sales reps $ 5.4 $ 3.5 Carrier costs for NTC's long distance telephone 15.9 12.2 AutoNETWORK .2 .2 ------ ------- Total Cost of Sales (excluding $0.7 million of costs relating to RCI in 1996) $ 21.5 $ 15.9 ------ ------- ------ ------- 13 NTC's total commission expense increased to $5.4 million in the first quarter of 1997 compared to $3.5 million in the same quarter of 1996. NTC's carrier costs to deliver long distance telephone service to its telephone customers increased to $15.9 million in the first quarter of 1997 compared to $12.2 million in the first quarter of 1996. This increase in carrier costs reflects the year-to-year growth in telephone sales, although these costs have grown at a slower pace than sales, thus reflecting improvements in overall telephone gross profits. The third cost component shown in the table above is the AutoNETWORK division's costs of providing communications network products and services. GENERAL & ADMINISTRATIVE - Total general and administrative costs decreased to $6.2 million or 20% of sales in the quarter ending March 31, 1997 compared to $6.3 million or 26% of sales in the same prior year quarter. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. The reduction in the current quarter primarily reflects the elimination of Rapid Cast. NTC's general and administrative costs decreased to 18% of sales in the first quarter of 1997 from 21% of sales in the first quarter of 1996. This reduction is caused largely by increases in sales volume without a corresponding increase in the overhead structure. During 1996 NTC made significant expenditures in building its infrastructure to support future sales growth. DEPRECIATION & AMORTIZATION - Total Company depreciation and amortization expense was $665,000 in the first quarter of 1997 verses $429,000 in the first quarter of 1996. This increase was caused by continuing investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its anticipated expansion in sales. BAD DEBT EXPENSE - Total Company bad debt expense increased to $1.7 million in the first quarter of 1997 compared to $1.1 million in the same prior year quarter. The quarter-to-quarter increase in bad debt was caused primarily by increases in sales volumes. ACQUISITION COSTS & EXPENSES - Acquisition costs decreased to $74,000 during the first quarter of 1997 compared to $583,000 during the first quarter of 1996. This decrease was primarily caused by writing off in the third and fourth quarters of 1996 the total patent rights acquired when the Company acquired 51% of RCI in 1995 in the third and fourth quarters of 1996. Acquisition costs & expenses in the first quarter of 1997 were related to the acquisition of NTC in 1992. MINORITY INTEREST - Beginning on July 1, 1995, the Company converted from the equity method to the consolidated method of accounting for its 51% ownership in RCI. As a result, $480,345, or 49% (the "minority interest") of RCI's losses during the three months ending March 31, 1996, has been eliminated from the Company's "Consolidated Statements of Operations" for 1996 and, therefor, no RCI revenues or expenses are recognized after that date. On January 1, 1997, the Company converted back to the equity method of accounting. NET INCOME - Total Company net income increased to $1 million or 3.2% of sales in the first quarter of 1997 as compared to net income of $417,000 or 1.7% of sales in the first quarter ended March 31, 14 1996. The quarter-to-quarter increase in net income resulted from no longer recording losses incurred at the Rapid Cast subsidiary. 15 PART II - OTHER INFORMATION CAUTIONARY STATEMENTS: This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends that such forward-looking statements be subject to the safe harbors created by such statutes. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties. Accordingly, to the extent that this Quarterly Report contains forward-looking statements regarding the financial condition, operating results, business prospects or any other aspect of the Company and its subsidiaries, please be advised that the Company and its subsidiaries' actual financial condition, operating results and business performance may differ materially from that projected or estimated by the Company in forward-looking statements. The differences may be caused by a variety of factors, including but not limited to adverse economic conditions, intense competition, including intensification of price competition and entry of new competitors and products, adverse federal, state and local government regulation, inadequate capital, unexpected costs and operating deficits, increases in general and administrative costs, lower sales and revenues than forecast, loss of customers, customer returns of products sold to them by the Company or its subsidiaries, disadvantageous currency exchange rates, termination of contracts, loss of supplies, technological obsolescence of the Company's or its subsidiaries' products, technical problems with the Company's or its subsidiaries' products, price increases for supplies and components, inability to raise prices, failure to obtain new customers, litigation and administrative proceedings involving the Company, including the pending class action and related lawsuits and SEC investigation, the possible acquisition of new businesses that result in operating losses or that do not perform as anticipated, resulting in unanticipated losses, the possible fluctuation and volatility of the Company's operating results, financial condition and stock price, losses incurred in litigating and settling cases, dilution in the Company's ownership of its subsidiaries and businesses, adverse publicity and news coverage, inability to carry out marketing and sales plans, challenges to the Company's patents, loss or retirement of key executives, changes in interest rates, inflationary factors, and other specific risks that may be alluded to in this Quarterly Report or in other reports issued by the Company. In addition, the business and operations of the Company are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements. In light of the significant uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. ITEM 1. LEGAL PROCEEDINGS SECURITIES AND EXCHANGE COMMISSION INVESTIGATION: The investigation of the Company by the SEC, which was commenced in August 1994, has not experienced any material changes from its status as described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996. 16 The Company continues to believe that it has provided substantial documentation to the Commission that demonstrates the propriety of its business operations and that the ultimate result of the investigation will not have a material adverse effect on the Company's financial condition or results of operations. CLASS ACTION AND RELATED LAWSUITS: The status of the pending class action lawsuit described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996, SANDRA GAYLES, ET AL. VS. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 KMW (BQRx), has materially changed since the filing of the Form 10-K for the fiscal year ending December 31, 1996 in the following manner: On May 6, 1997, the court in the pending class action lawsuit SANDRA GAYLES ET AL. VS. SAM D. SCHWARTZ AND INCOMNET, INC. ruled that approximately 20 former shareholders of the Company have the right to "opt out" of the class action lawsuit and file their own separate lawsuit against the Company and Sam D. Schwartz, the Company's former President. The Company expects these potential plaintiffs to file a separate lawsuit against it and its former President in the near future. The potential plaintiffs purchased the Company's stock in the open market through Everest Securities, a brokerage firm which has since terminated its business. The potential claims are expected to be based on alleged violations of applicable securities laws, because of alleged statements made by the Company's former President to the securities broker at Everest Securities in 1995. The amount of damages to be sought by the potential plaintiffs is not yet known. The Company intends to vigorously defend the claims if they are asserted against it. In a hearing on May 5, 1997, the plaintiffs in a lawsuit entitled SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York and transferred in March 1997 to the same court in California which is hearing the pending class action lawsuit, were allowed to continue as a separate pleading from the class action lawsuit. As such, the Company anticipates that it will be involved in a separate lawsuit with the SILVA RUN WORLDWIDE LIMITED plaintiffs as described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996. INCOMNET, INC. VS. SAM D. SCHWARTZ: On April 25, 1997, the Company filed a lawsuit against Sam D. Schwartz, its prior President and Chairman of the Board, alleging fraud, breach of fiduciary duty, negligence, declaratory relief, breach of contract and imposition of constructive trust. The lawsuit was filed in the Superior Court of California in the County of Los Angeles. In the lawsuit, the Company alleges that Mr. Schwartz failed to disclose to the Company or its board of directors that he would obtain a direct financial benefit in connection with certain transactions considered or entered into by the Company during the period from 1993 to 1995. The Company further alleges that Mr. Schwartz 17 fraudulently induced the Company to enter into a Severance Agreement between him and the Company in November 30, 1995 (see "Item 1. Business - Employees, Officers and Directors - Officers" in the Company's Form 10-K for the fiscal year ending December 31, 1995), and that he breached his fiduciary duty to the Company by self-dealing, acting in bad faith and concealing material facts. The Company seeks payment from Mr. Schwartz of the actual damages incurred by it as a result of Mr. Schwartz's conduct, as well as interest, punitive damages, attorney's fees and costs and reimbursements of all payments previously made to Mr. Schwartz pursuant to the Severance Agreement. Furthermore, the Company seeks a declaratory order that Mr. Schwartz committed acts or omissions involving known misconduct, the absence of good faith, an improper personal benefit, a reckless disregard of his duties to the Company and its shareholders, an unexcused pattern of inattention, and a violation of Sections 310 and 316 of the California Corporations Code. The Company cannot predict at this time the outcome of the case or the effect it may have on the operating results, financial condition or business performance of the Company or its subsidiaries. In addition to the above changes to the status of the class action lawsuit, the case currently remains in the discovery phase and the parties continue to engage in settlement discussions. SECTION 16(b) LAWSUIT: In January 1996, the Company was served with a derivative shareholders lawsuit entitled RICHARD MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ, 96 Civil 0225 in the United States District Court for the Southern District of New York, alleging violations of Section 16(b) of the Securities Exchange Act of 1934, as amended, and demanding that the Company assert claims against Mr. Schwartz for the payment of short-swing profits plus interest. The status of that case has not materially changed since the filing of the Form 10-K for the fiscal year ending December 31, 1996, except as follows: Notice of the settlement was given to the shareholders on or about April 21, 1997. Any opposition to the settlement is due by May 16, 1997, and a hearing to approve the settlement is to be held on May 30, 1997. There is no assurance that the Company will recover the short-swing profits from Mr. Schwartz. LEGAL ACTION AGAINST PRIOR REPRESENTATIVES: The status of the pending lawsuit by NTC against certain of its prior representatives described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996, has not materially changed since the filing of the Form 10-K. POTENTIAL LAWSUITS: There is no assurance that claims similar to those asserted in the pending class action and related lawsuits, or other claims, will not be asserted against the Company by new parties in the future. In this regard, potential plaintiffs have from time to time orally asserted claims against the Company and its prior directors. Several members of the class in the pending class action lawsuit against the Company have opted out. Sam Schwartz may file claims against the Company for indemnification and payments under his Severance Agreement with the Company. See "Item 1. Business - Employees, Officers and Directors - Officers" in the Company's Form 10-K for the fiscal year ending December 31, 1995. If such claims are filed as legal complaints, the Company will seek to have them consolidated with 18 other pending lawsuits, if appropriate, or will defend them separately. From time to time, the Company is also involved in litigation arising from the ordinary course of business, the ultimate resolution of which management believes will not have a material adverse effect on the financial condition or results of operations of the Company. ITEM 2. CHANGES IN SECURITIES Item 2 is not applicable for the three months ended March 31, 1997. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Item 3 is not applicable for the three months ended March 31, 1997. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Item 4 is not applicable for the three months ended March 31, 1997. ITEM 5. OTHER INFORMATION LOAN TO ROBERT AND NANCY ZIVITZ: On November 5, 1996, the Company loaned $265,000 to Robert and Nancy Zivitz for a period of 90 days, at an interest rate of 10% per annum. Nancy Zivitz is a member of the Company's Board of Directors. The loan was approved by a vote of the Company's Board of Directors on October 11, 1996 and is secured by 201,800 shares of the Company's stock held in the name of Robert Zivitz. On February 5, 1997, the maturity date of the loan was extended by the Company until December 31, 1997. ACQUISITION OF CALIFORNIA INTERACTIVE COMPUTING. INC. (CIC): GENERAL: On May 2, 1997, Incomnet, Inc. ("Company") acquired 88,370.5 shares representing 100% of the outstanding common stock of California Interactive Computing, Inc. ("CIC"), a private corporation headquartered in Valencia, California. The Company agreed to pay a total of $1,758,302 in cash, payable over a five year period of time. See Item 5. Other Information - Acquisition of California Interactive Computing, Inc. - Schedule of Payments." In addition, the Company has agreed to assume the outstanding balance of $418,527.91 for loans to CIC made by two of CIC's shareholders. The Company has also signed an employment agreement for a period of two years with Jerry C. Buckley, CIC's former president and CEO, pursuant to which it will pay Mr. Buckley $10,000 per month in consideration for Mr. Buckley's services as the Director of Strategic Planning for CIC. The Company has also agreed to provide 10,000 and 20,000 stock options, respectively, in CIC to two former shareholders when a plan is established for CIC's officers, directors, employees and key consultants. CIC is engaged in the development and marketing of software that is used to process insurance-related claims, including workers compensation, disability, general medical and property & 19 casualty. Its software is leased to companies who provide their own insurance and claims administration, to insurance companies, and to third-party administrators who process claims for either self-insured companies or insurance companies. CIC was incorporated in 1977 in California and has provided software for claims processing for 20 years. SCHEDULE OF PAYMENTS: At the close of the transaction on May 2, 1997, the Company paid a total of $249,818 to the former shareholders of CIC, $84,818 of which was paid to acquire CIC's stock and $165,000 of which was utilized to pay down loans to two former CIC shareholders. The Company has signed promissory notes in the aggregate principal amount of $1,927,016.91 to four former shareholders of CIC to repay the balance of the loans owed by CIC ($253,527.91 as of May 2, 1997) and to pay the balance of the price to purchase their CIC stock by the Company ($1,674,489 as of May 2, 1997). These notes bear interest at the rate of 8% per annum. The stock of CIC purchased by the Company is held in an escrow account until the promisory notes issued by the Company to CIC former shareholders are repaid in full. The outstanding balances owed on these notes can be repaid at any time, which would lower the total amount of scheduled payments, including interest. During the first year after the acquisition, the Company has agreed to pay $27,859 to one shareholder in 12 equal monthly payments of principal and interest. During the 13th - 24th month after the acquisition, the Company has contracted to pay a total of $591,175 of principal and interest, of which $369,136 is scheduled to be paid for the purchase of CIC stock from four former shareholders and of which $222,039 is scheduled to pay down the outstanding loans owed by CIC to two former shareholders. During the 25th - 36th month after the acquisition, the Company has contracted to pay a total of $559,662 of principal and interest, of which $514,662 is scheduled to be paid for the purchase of CIC stock from four former CIC shareholders and of which $45,000 is scheduled to pay off the remaining balance of the loans owed by CIC to two former CIC shareholders. During the 37th - 48th month after the acquisition, the Company is contracted to pay a total of $574,572 of principal and interest for the purchase of CIC stock from four former shareholders. During the 49th - 60th month after the acquisition, the Company is contracted to pay a total of $514,662 of principal and interest for the purchase of CIC stock from four former shareholders. DIRECTORS OF CIC: The former directors of CIC tendered their resignation, effective at the acquisition. The Company has named Melvyn Reznick, its President and CEO, Stephen A. Caswell, its Vice President and Corporate Secretary, and Jerry C. Buckley, CIC's former President and CEO, to serve on CIC's Board of Directors. Mr. Reznick will serve as Chairman, President, CEO and CFO of CIC. Mr. Caswell will serve as Executive Vice President and Secretary of CIC. Mr. Buckley will serve as a director. See the Company's Report on Form 8-K, dated May 13, 1997. PRODUCTS & SERVICES: CIC develops and markets a trademarked line of software products designed to handle insurance-related claims processing. Insurance-related products include GenCOMP-TM-, GenMED-TM-, GenDIS-TM-, GenPAC-TM-, GenRISK-TM-, GenIRIS-TM- and Top Rate-TM-. In addition, CIC also offers several computer and service-related products, including GenARS-TM-, which is an optical disk-based information storage and retrieval system, and GenSERVE-TM-, which is a maintenance and service program for customers. 20 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K INDEX TO EXHIBITS: EXHIBIT NO. DESCRIPTION - ----------- ----------- 10-1 Amended Lease Agreement for National Telephone & Communication's Corporate headquarters at 2801 Main St., Irvine, California* * Previously filed on Form 10-Q filed with the Securities and Exchange Commission on May 15, 1997. REPORTS ON FORM 8-K, FILED IN 1997 - ---------------------------------- 20.1 Report on Form 8-K - Election of Dr. Howard Silverman As Director & Amendment to Employment Contract of Melvyn Reznick, filed on February 7, 1997. 20.2 Report on Form 8-K - Reincorporation of National Telephone & Communications, Inc. filed on April 10, 1997. 20.3 Report on Form 8-K - Acquisition of California Interactive Computing, Inc., filed on May 13, 1997. 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. INCOMNET, INC. Date: July 8, 1997 /s/ Melvyn Reznick -------------------------- Melvyn Reznick President, CEO & CFO 21 EX-13.13 8 EXHIBIT 13.13 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1997 COMMISSION FILE NO. 0-12386 INCOMNET, INC. A California IRS Employer No. Corporation 95-2871296 21031 Ventura Blvd., Suite 1100 Woodland Hills, California 91364 Telephone no. (818) 887-3400 Securities registered pursuant to Section 12(b) of the Act:................None Securities registered pursuant to Section 12(g) of the Act:........Common Stock, No Par Value 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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO__ Number of shares of registrant's common stock outstanding as of June 30, 1997.......................................................13,554,239 -1- ITEM 1. FINANCIAL STATEMENTS INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (UNAUDITED) (DOLLARS IN 000S) JUNE 30, DECEMBER 31, 1997 1996 -------- -------------- ASSETS CURRENT ASSETS: Cash & cash equivalents $ 1,601 $ 2,214 Accounts receivable, including $277,680 and $267,000 due from related party at June 30, 1997 and December 31, 1996, respectively and less allowance for doubtful accounts of $1,140,000 at June 30, 1997 and $1,993,000 at December 31, 1996 19,074 13,137 Notes receivable - current portion 454 323 Notes receivable from officers & shareholders, net of reserves of $209,000 1,218 438 Inventories 395 2,760 Other current assets 1,133 1,332 ------- ------ Total current assets 23,875 20,204 Property, plant and equipment, at cost, net 13,957 14,357 Patent rights, net 1,241 Goodwill, net 6,709 4,542 Building construction/remodeling 2,418 -- Deposits, investments and other assets 879 243 ------- ------ Total assets $47,838 $40,587 ------- ------ ------- ------ -2- INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (UNAUDITED) (CONT'D) (DOLLARS IN 000S) JUNE 30, DECEMBER 31, 1997 1996 -------- -------------- LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $14,455 $14,746 Accrued expenses 7,996 8,217 Current portion of notes payable 5,198 3,918 Deferred income 3,485 4,040 ------- ------ Total current liabilities 31,134 30,921 Liabilities in excess of assets of RCI 3,600 -- Notes payable -- 1,041 Notes payable - CIC 1,919 -- Commitments (Note 12) SHAREHOLDERS' EQUITY: Common stock, no par value; 20,000,000 shares authorized; and 13,554,239 shares at June 30, 1997 and 13,369,681 shares issued and outstanding at December 31, 1996 61,847 61,320 Preferred stock, no par value; 100,000 shares authorized; 2,075 shares issued and outstanding at June 30, 1997 and 2,440 shares issued and outstanding at December 31, 1997 1,990 2,355 Treasury stock (5,492) (5,492) Accumulated deficit (47,160) (49,557) ------- ------ Total shareholders' equity 11,185 8,626 ------- ------ Total liabilities, & shareholders' equity $ 47,838 $ 40,587 ------- ------ ------- ------ See accompanying "Notes to Consolidated Financial Statements." -3- INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) THREE MONTHS ENDED JUNE 30, (DOLLARS IN 000s) 1997 1996 ---- ---- SALES $ 34,855 $ 25,305 ---------- ---------- OPERATING COSTS & EXPENSES: Cost of sales 24,610 15,461 General & administrative 7,851 7,537 Depreciation & amortization 732 465 Bad debt expense 152 1,444 Other (income)/expense 67 721 ---------- ---------- Total operating costs and expenses 33,411 25,628 ---------- ---------- Income/(loss) before income taxes & minority interest 1,443 (323) INCOME TAXES 101 93 ---------- ---------- Income/(loss) before minority interest 1,342 (416) MINORITY INTEREST -- 646 ----------- ---------- Net income 1,342 $ 230 =========== ========== INCOME PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Income before extraordinary items $ 0.10 $ 0.02 Extraordinary items -- -- ----------- ---------- Net income $ 0.10 $ 0.02 =========== ========== WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARE EQUIVALENTS OUTSTANDING 13,600,000 13,294,324 =========== ========== See accompanying "Notes to Consolidated Financial Statements." 4 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) SIX MONTHS ENDED JUNE 30, (DOLLARS IN 000s) 1997 1996 ---- ---- SALES $ 66,023 $ 49,705 ---------- ---------- OPERATING COSTS & EXPENSES: Cost of sales 46,141 31,367 General & administrative 14,010 13,829 Depreciation & amortization 1,397 894 Bad debt expense 1,848 2,537 Other (income)/expense 59 1,370 ---------- ---------- Total operating costs and expenses 63,455 48,797 ---------- ---------- Income/(loss) before income taxes, extraordinary items & minority interest 2,569 (292) INCOME TAXES 208 187 ---------- ---------- Income/(loss) before extraordinary items & minority interest 2,361 (477) MINORITY INTEREST -- 1,127 EXTRAORDINARY ITEMS 9 -- ---------- ---------- Net income 2,370 $ 648 ========== ========== INCOME PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Income before extraordinary items $ 0.18 $ 0.05 Extraordinary items -- -- ---------- ---------- Net income $ 0.18 $ 0.05 ========== ========== WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARE EQUIVALENTS OUTSTANDING 13,500,000 13,286,283 ========== ========== See accompanying "Notes to Consolidated Financial Statements." 5 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) SIX MONTHS ENDED JUNE 30, (Dollars in 000s) 1997 1996 ------ ------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $2,370 $(477) Depreciation & amortization 1,397 894 Minority interest -- 1,127 Other - net -- 52 ------- ------ Net cash inflow/(outflow) from operating activities 3,767 1,596 ------- ------ CASH FLOWS FROM (INCREASE)/DECREASE IN OPERATING ASSETS: Accounts receivable (5,937) (1,156) Notes receivable - current portion (131) (81) Notes receivable - due from officers and shareholders (780) (65) Inventories 2,365 (521) Prepaid expenses & other 199 (467) Notes receivable - long term -- 155 Deposits & other (636) (6) ------ ------ Net cash inflow/(outflow) from changes in operating assets (4,920) (2,143) ------ ------ CASH FLOWS FROM INCREASE/(DECREASE) IN OPERATING LIABILITIES: Accounts payable (291) 1,541 Accrued expenses (221) (652) Deferred income (555) 715 ------ ------ Net cash inflow/(outflow) from changes in operating liabilities (1,067) 1,605 ------ ------ Net cash inflow/(outflow) from operations (2,220) 1,058 ------ ------ CASH FLOWS FROM (INCREASE)/DECREASE IN INVESTING ACTIVITIES: Acquisition of plant & equipment (3,415) (3,390) Patents/intangible assets 1,241 (106) Investment in Lab Tech -- 17 Liability in excess of assets 3,600 -- Goodwill (2,167) 148 ------ ------ Net cash inflow/(outflow) from investing activities (741) (3,331) ------ ------ See accompanying "Notes to Consolidated Financial Statements." -6- INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (CONT'D) SIX MONTHS ENDED JUNE 30, (Dollars in 000s) 1997 1996 ------ ------ CASH FLOWS FROM INCREASE/(DECREASE) IN FINANCING ACTIVITIES: Notes payable - current 1,280 2,803 Sale of common stock, net 527 148 Loans from a major shareholder -- 320 Notes payable - long term 818 (808) Other - net 88 46 Preferred stock (365) -- ------ ------ Net cash inflow/(outflow) from financing activities 2,348 2,509 ------ ------ Net increase/(decrease) in cash & cash equivalents $ (613) $ 236 ------ ------ ------ ------ See accompanying "Notes to Consolidated Financial Statements." -7- INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 1997 1. MANAGEMENT'S REPRESENTATION: The consolidated financial statements included herein have been prepared by the management of Incomnet, Inc. (the "Company") without audit. Certain information and note disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted. In the opinion of the management of the Company, all adjustments considered necessary for fair presentation of the consolidated financial statements have been included and were of a normal recurring nature, and the accompanying consolidated financial statements present fairly the financial position as of June 30, 1997, and the results of operations for the three months and six ended June 30, 1997 and 1996, and cash flows for the six months June 30, 1997 and 1996. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes for the three years ended December 31, 1996, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 15, 1997. The interim results are not necessarily indicative of the results for a full year. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, National Telephone & Communications-Registered Trademark-, Inc. (NTC) and California Interactive Computing, Inc. (CIC) (see Item 5. Acquisition of California Interactive Computing, Inc.). The statements do not include consolidated results of Rapid Cast, Inc., the Company's 35%-owned subsidiary, which is accounted for using the equity method of accounting under FASB Statement No. 94. The Company accounted for RCI using the consolidated method of accounting from the third quarter of 1995 until December 31, 1996 because the Company owned 51% of RCI. In January 1997, the Company's ownership changed from 51% of RCI to 35% and, as a result, the method of accounting has changed to the equity method under FASB Statement No. 94. On the date of change in the method of accounting, RCI's liabilities significantly exceeded its assets, and the Company recorded its ratable share of such excess in the balance sheet caption "Liabilities in excess of assets of RCI". Accordingly, all assets and liabilities of RCI, including patent rights of $1,241,000 (after previously recorded reserves of approximately $39 million) were, during the first quarter of 1997, combined under this caption. REVENUE RECOGNITION - The Company recognizes revenue during the month in which services or products are delivered, as follows: (1) NTC's long distance telecommunications service revenues are generated when customers make long distance telephone calls from their business or residential telephones or by using any of NTC's telephone calling cards. Proceeds from prepaid telephone calling cards are recorded as deferred revenues when the cash is received, and recognized as revenue as the telephone service is utilized. The reserve for deferred revenues is carried on the balance sheet as an accrued liability. Long distance telephone service sales in the three and six months ending June 30, 1997 totaled $29.7 million and $54.8 million, respectively versus long distance telephone service sales of $20.2 million and $40.5 million, respectively in the three and six months ending June 30, 1996. (2) NTC's marketing-related revenues are derived from programs and material sold to the Company's base of independent sales representatives, including forms and supplies, fees for representative and certified trainer renewals, and the Company's Certified Trainer, Independent Representative and Long Distance University programs. The Company requires that all such services and materials be paid at the time of purchase. Revenues from marketing-related materials, net of amounts deferred for future services provided to the representatives, are booked as cash sales when the revenues are received. A portion of the revenues from marketing related programs and materials is deferred and recognized over a twelve month period to accrue the Company's obligation to provide customer support to its independent representatives. For the three months and six months ending June 30, 1997, marketing sales totaled $4.3 million and $10 million, respectively versus marketing sales of $3.5 million and $6.1 million, respectively for the three months and six months ended June 30, 1996. (3) The Company's network service revenues from its AutoNETWORK service are recognized as sales as the service is delivered. Network service sales in the three months and six months ending June 30, 1997 totaled $371,564 and $741,092, respectively versus $363,844 and $701,034, respectively in the three months ending June 30, 1996. -8- INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 1997 (4) Revenues from the Company's CIC subsidiary are derived from the sale of computer software and from related services, such as software maintenance fees, custom programming and customer training. Revenues are recognized when software is shipped to customers and when services are performed and invoiced. Because the Company acquired CIC on May 2, 1997, revenues and earnings only reflect CIC's operations from May 2, 1997. For the first two months of operation commencing on May 2, 1997, CIC had revenues of $447,043. CONCENTRATION OF CREDIT RISK - The Company sells its telephone and network services to individuals and small businesses throughout the United States and does not require collateral. Rapid Cast sells its optical products both domestically and internationally. Reserves for uncollectible amounts are provided, which management believes are sufficient. COMPUTER HARDWARE, FURNITURE AND OFFICE EQUIPMENT - Computer hardware, furniture and office equipment are stated at cost. Depreciation is provided by the straight-line method over the assets' estimated useful lives of 5 to 10 years. COMPUTER SOFTWARE - The Company capitalizes the costs associated with purchasing, developing and enhancing its computer software. All software costs are amortized using the straight-line method over the assets' estimated useful lives of 3 to 10 years. LEASEHOLD IMPROVEMENTS - All leasehold improvements are stated at cost and are amortized using the straight-line method over the expected lease term. NET INCOME PER SHARE - Net income per common share is based on the weighted average number of common shares for 1997, and common shares and common share equivalents for 1996. ACQUISITION AMORTIZATION - The excess of purchase price over net assets of NTC has been recorded as an intangible asset and is being amortized by the straight-line method over twenty years. DEFERRED TAX LIABILITY - Deferred income taxes result from temporary differences in the basis of assets and liabilities reported for financial statement and income tax purposes. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. FUNDING OF MARKETING COMMISSIONS AND DEFERRED INCOME: The Company's subsidiary, NTC, maintains separate bank accounts for the payment of marketing commissions. Funding of these accounts is adjusted regularly to provide for management's estimates of required reserve balances. NTC estimates the total commissions owed to active independent representatives ("IR Earned Compensation") each week for all monies collected that week due to the efforts of those active independent representatives. All IR Earned Compensation is then paid to the independent representatives, when due, directly out of the separate bank account. IMPAIRMENT OF LONG LIVED ASSETS: In accordance with the provisions of SFAS No. 121, the Company regularly reviews long-lived assets and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount to the assets may not be recoverable. CURRENT ACCOUNTING PRONOUNCEMENTS: The Financial Accounting Standards Board has issued SFAS No. 123, "Accounting for Stock-Based Compensation," which encourages companies to account for stock compensation awards based on their fair value at the date the awards are granted. This statement does not require the application of fair value method and allows the continuance of current accounting method, which requires accounting for stock compensation awards based on their intrinsic value as of the grant date. However, SFAS No. 123 requires pro forma disclosure of net income and, if presented, earnings -9- INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 1997 per share, as if the fair value based method of accounting defined in this statement has been applied. The accounting and disclosure requirements of this statement are effective for financial statements for fiscal years beginning after December 15, 1995, although earlier adoption is encouraged. The Company has elected not to adopt the fair value provisions of this statement. 4. NOTES PAYABLE: Notes payable consist of the following as of June 30, 1997: Notes payable to founding stockholders of CIC, interest at 8%, due beginning in May 1998 $1,918,533 Note payable to bank for line of credit to NTC, interest at prime plus 1%, due as current liability $4,010,686 Capitalized lease obligations $1,187,371 ------------- $7,116,590 ------------- ------------- 5. NETWORK MARKETING COSTS: During the three and six months ending June 30, 1997, NTC's net costs to operate its network marketing program were $0.4 million and $0.6 million, respectively, as summarized below (in $ millions):
3 Months Ending 6 Months Ending June 30, 1997 June 30, 1997 --------------- --------------- Sales $ 4.3 $ 10.0 Cost of sales 3.3 8.2 Operating expenses for support services 1.4 2.4 ------- -------- Total marketing-related costs 4.7 10.6 ------- -------- Net marketing cost $ 0.4 $ 0.6 % of total NTC (long distance & marketing) sales 1.2% 0.9% ------- -------- ------- --------
Marketing sales of $4.3 million and $10.0 million, during the three and six month periods ending June 30, 1997, respectively, were generated by the sale of materials, training and support services to assist NTC independent sales representatives in selling new retail customers and enrolling other representatives in the NTC program. Beginning in January, 1996, NTC commenced reserving a portion of all marketing revenues in order to provide a fund from which to draw estimated future refunds of marketing proceeds. These reserved marketing revenues are reflected as deferred income on the Company's balance sheet and are amortized over the succeeding twelve months. The marketing-related costs include commissions paid to independent sales representatives for acquiring new retail telephone customers, as well as the cost of sales materials, salaries and wages of marketing department personnel, services required to support the independent sales representatives, and other directly identifiable support costs, but do not include residual commissions paid on continuing long distance telephone usage or the typical indirect cost allocations, such as floor-space and supporting departments. When the three and six month marketing-related costs of $4.7 million and $10.6 million, respectively, are compared against marketing-related revenues of $4.3 million and $10.0 million for the same periods, the result is a net loss in marketing-related activities of $0.4 million and $0.6 million or 1.2% and 0.9% of total NTC sales, respectively. -10- INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 1997 6. COMPENSATION OF INDEPENDENT SALES REPRESENTATIVES: The Company's subsidiary, NTC, compensates its independent sales representatives by an earned commission structure based upon signing up new telephone customers and based upon the telephone usage generated by those customers. In the three and six months ending June 30, 1997, expenses associated with commissions, bonuses and overrides paid out to NTC's independent representatives were $4.8 million and $10.9 million, respectively versus $3.8 million and $7.3 million, respectively in the three and six months ended June 30, 1996. 7. COMMITMENTS AND CONTINGENCIES: LITIGATION: The Company is a defendant in a class action matter and related lawsuits alleging securities law violations with respect to alleged false denial and non-disclosure of a Securities and Exchange Commission investigation and alleged non-disclosure of purchases and sales of the Company's stock by the former Chairman of the Board and one of his affiliates. Counsel for the Company is unable to estimate the ultimate outcome of these matters and is unable to predict a range of potential loss. Accordingly, no amounts have been provided for the class action or related lawsuits in the accompanying financial statements. The Company is under investigation by the Securities and Exchange Commission under a non-public "formal order of private investigation." Management has furnished all information requested by the Commission and does not believe that the matter will have a material adverse impact on its financial position or results of operations. EXTENSION OF LEASE: In April 1997, NTC entered into an agreement to extend the lease on its headquarters building at 2801 Main Street, Irvine, California. According to the terms of this agreement, NTC would be obligated to pay formula based monthly lease payments estimated to be approximately $57,000 per month during 1997 and increasing to approximately $72,000 per month for the remainder of the initial five year lease term. In addition, in February 1997, NTC entered into a ten year lease for office space in Honolulu, Hawaii, with the lease expiring in 2007. The monthly payments on the lease in Honolulu commence at $36,698 per month in 1997 and 1998, and increase on a bi-annual basis through the term of the lease to $43,536 per month in 2006 and 2007. 8. ACQUISITION OF CALIFORNIA INTERACTIVE COMPUTING. INC. (CIC): GENERAL: On May 2, 1997, Incomnet, Inc. ("Company") acquired 88,370.5 shares representing 100% of the outstanding common stock of California Interactive Computing, Inc. ("CIC"), a private corporation headquartered in Valencia, California. The Company agreed to pay a total of $1,758,302 in cash, payable over a five year period of time. See Item 5. Other Information - Acquisition of California Interactive Computing, Inc. - Schedule of Payments." In addition, the Company has agreed to assume the outstanding balance of $418,527.91 for loans to CIC made by two of CIC's shareholders. The transaction has been accounted for using the purchase method of accounting. The Company has also signed an employment agreement for a period of two years with Jerry C. Buckley, CIC's former president and CEO, pursuant to which it will pay Mr. Buckley $10,000 per month in consideration for Mr. Buckley's services as the Director of Strategic Planning for CIC. The Company has also agreed to provide 10,000 and 20,000 stock options, respectively, in CIC to two former shareholders when a plan is established for CIC's officers, directors, employees and key consultants. CIC is engaged in the development and marketing of software that is used to process insurance-related claims, including workers compensation, disability, general medical and property & casualty. Its software is leased to -11- companies who provide their own insurance and claims administration, to insurance companies, and to third-party administrators who process claims for either self-insured companies or insurance companies. CIC was incorporated in 1977 in California and has provided software for claims processing for 20 years. SCHEDULE OF PAYMENTS: At the close of the transaction on May 2, 1997, the Company paid a total of $249,818 to the former shareholders of CIC, $84,818 of which was paid to acquire CIC's stock and $165,000 of which was utilized to pay down loans to two former CIC shareholders. The Company has signed promissory notes in the aggregate principal amount of $1,927,016.91 to four former shareholders of CIC to repay the balance of the loans owed by CIC ($253,527.91 as of May 2, 1997) and to pay the balance of the price to purchase their CIC stock by the Company ($1,674,489 as of May 2, 1997). These notes bear interest at the rate of 8% per annum. The stock of CIC purchased by the Company is held in an escrow account until the promisory notes issued by the Company to CIC former shareholders are repaid in full. The outstanding balances owed on these notes can be repaid at any time, which would lower the total amount of scheduled payments, including interest. During the first year after the acquisition, the Company has agreed to pay $27,859 to one shareholder in 12 equal monthly payments of principal and interest. During the 13th - 24th month after the acquisition, the Company has contracted to pay a total of $591,175 of principal and interest, of which $369,136 is scheduled to be paid for the purchase of CIC stock from four former shareholders and of which $222,039 is scheduled to pay down the outstanding loans owed by CIC to two former shareholders. During the 25th - 36th month after the acquisition, the Company has contracted to pay a total of $559,662 of principal and interest, of which $514,662 is scheduled to be paid for the purchase of CIC stock from four former CIC shareholders and of which $45,000 is scheduled to pay off the remaining balance of the loans owed by CIC to two former CIC shareholders. During the 37th - 48th month after the acquisition, the Company is contracted to pay a total of $574,572 of principal and interest for the purchase of CIC stock from four former shareholders. During the 49th - 60th month after the acquisition, the Company is contracted to pay a total of $514,662 of principal and interest for the purchase of CIC stock from four former shareholders. DIRECTORS OF CIC: The former directors of CIC tendered their resignation, effective at the acquisition. The Company has named Melvyn Reznick, its President and CEO, Stephen A. Caswell, its Vice President and Corporate Secretary, and Jerry C. Buckley, CIC's former President and CEO, to serve on CIC's Board of Directors. Mr. Reznick will serve as Chairman, President, CEO and CFO of CIC. Mr. Caswell will serve as Executive Vice President and Secretary of CIC. Mr. Buckley will serve as a director. See the Company's Report on Form 8-K, dated May 13, 1997. PRODUCTS & SERVICES: CIC develops and markets a trademarked line of software products designed to handle insurance-related claims processing. Insurance-related products include GenCOMP-TM-, GenMED-TM-, GenDIS-TM-, GenPAC-TM-, GenRISK-TM-, GenIRIS-TM- and Top Rate-TM-. In addition, CIC also offers several computer and service-related products, including GenARS-TM-, which is an optical disk-based information storage and retrieval system, and GenSERVE-TM-, which is a maintenance and service program for customers. -12- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW: The following is management's discussion and analysis of certain significant factors which have affected the results of operations and financial condition of the Company during the period included in the accompanying financial statements. This discussion should be read in conjunction with the financial statements and associated notes. The discussion herein is qualified by reference to the Cautionary Statements. See "Part II. Cautionary Statements". LIQUIDITY AND CAPITAL RESOURCES: GENERAL - Overall, the Company achieved negative cash flows of $613,000 during the first six months of 1997 versus positive cash flow of $236,000 during the first six months of 1996. The negative cash flows resulted from negative cash flows from operations of $2.2 million and negative cash flows from investing activities of $0.7 million, which were offset by positive cash flows from financing activities of $2.3 million as discussed below: CASH FLOW FROM OPERATIONS - The Company generated $2.2 million in negative cash flow from operations during the six months ended June 30, 1997, compared to $1.1 million in positive cash flow from operations during the prior year's comparable period. This decrease in cash flow from operations resulted primarily from: (1) a $3.8 million inflow of cash from net income and depreciation & amortization, offset by (2) a $5.9 million increase in accounts receivable and a $2.4 million decrease in inventories. During this period, operating liabilities decreased by $1.1 million. CASH FLOW FROM INVESTING - The Company generated negative cash flows from investing activities of $0.7 million in the six months ended June 30, 1997 versus negative cash flows $3.3 million in the first six months of 1996. In the first six months of 1997, the Company increased its acquisition of plant & equipment by $3.4 million. Goodwill also increased by $2.2 million associated with the Company's acquisition of CIC. The increase in plant & equipment was primarily due to capital expenditures of $1.5 million in tenant improvements for NTC`s Honolulu, Hawaii office space. The Company expects NTC to continue making improvements to its headquarters building and to purchase additional equipment commensurate with the expansion of its business. The Company also anticipates investing in software development at CIC. As an offset to the Company's negative cash flows from investing activities, the Company experienced positive cash flows from investing activities due to a $1.2 million decrease in patents/intangible assets and a $3.6 million decrease in liability in excess of assets associated with the write-off of the Company's investment in RCI. CASH FLOW FROM FINANCING - The Company had net cash inflow of $2.4 million in the six months ended June 30, 1997 versus net cash inflow of $2.5 million in the six months ended June 30, 1997. Significant items include an increase of $1.3 million in notes payable - current and $0.8 million in notes payable - long term, as well as an increase of $0.5 million due to the sale of common stock. LITIGATION - The Company is subject to pending litigation and an investigation by the Securities and Exchange Commission. Management is not yet able to predict the impact of the pending litigation on its financial condition and results of operations. Management does not believe that the investigation by the Securities and Exchange Commission will result in a material impact on the Company's financial condition or results of operations. See "Part II. Item 1. Legal Proceedings." RESULTS OF OPERATIONS: SALES - Second quarter, 1997 sales of $34.9 million increased 38% over the second quarter, 1996 sales of $25.3 million. The majority of this increase was attributable to NTC's sales increase to $34 million from $23.6 million in the three months ending June 30, 1997 versus 1996, respectively. A secondary cause of the -13- increase in sales was the inclusion of $447,043 in sales from two months of operations of the Company's newly-acquired subsidiary, CIC (see Item 5. Other Information.- Acquisition of California Interactive Computing, Inc.). The following table summarizes the Company's sales performance by subsidiary and segment during the comparable second quarters in 1997 and 1996: $ in millions ----------------- Subsidiary Segment 1997 1996 - ---------- --------------------------------------- ------- ------- NTC Telephone (telecommunications services) $ 29.7 $ 20.2 NTC Telephone (marketing programs) 4.3 3.4 RCI Optical -- 1.3 CIC Computer Software 0.5 -- AutoNETWORK Network 0.4 0.4 ------- ------- Total Company Sales $ 34.9 $ 25.3 ------- ------- ------- ------- COST OF SALES - Total Company cost of sales increased to $24.6 million or 70% of sales during the quarter ending June 30, 1997 verses $15.5 million or 61% of sales during the comparable prior year quarter. The increase in cost of sales resulted largely from an increase in carrier costs associated with increased telephone service sales by NTC. The increase in costs as a percent of sales was largely generated by a drop in NTC's telecommunication service gross profits due to a special limited-time offer of attractive international rates. The following table summarizes the changes in three major cost components from the second quarter ended June 30, 1997 and 1996, respectively: $ in millions ----------------- 1997 1996 ------- ------- Commissions paid to NTC independent sales reps $ 4.8 $ 3.8 Carrier costs for NTC's long distance telephone service 18.6 10.2 All other costs of sales 1.2 1.5 ------- ------- Total Company Cost of Sales $ 24.6 $ 15.5 ------- ------- ------- ------- NTC's total commission expense increased to $4.8 million in the second quarter of 1997 compared to $3.8 million in the same quarter of 1996. NTC's carrier costs to deliver long distance telephone service to its telephone customers increased to $18.6 million in the second quarter of 1997 compared to $10.2 million in the second quarter of 1996. This increase in carrier costs reflects the increased growth in telephone sales, although these costs have grown at a faster pace than sales, thus reflecting a decline in gross profits from telephone service. The third cost component shown in the table above is "all other costs of sales" which represents: (1) NTC's costs of producing sales materials for its independent sales representatives, (2) CIC's costs of producing its computer software and providing related services, and (3) AutoNETWORK costs of providing communications network products and services. GENERAL & ADMINISTRATIVE - Total general and administrative costs increased to $7.9 million or 23% of sales in the quarter ending June 30, 1997 compared to $7.5 million or 30% of sales in the same prior year quarter. General and administrative expenses for the six months ended June 30, 1997 increased to $14 million or 21% of sales versus $13.8 million or 28% of sales in the second quarter of 1996. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are -14- required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. This decrease in general and administrative expenses as a percentage of sales in the three month and six month periods was caused by improved efficiencies at NTC and by no longer consolidating the financial statements of RCI. In the second quarter of 1996, RCI's general and administrative expenses represented 11% of total general and administrative expenses. DEPRECIATION & AMORTIZATION - Total Company depreciation and amortization expense increased to approximately $732,000 in the three months ended June 30, 1997 verses $464,896 in three months ended June 30, 1996. Depreciation and amortization expense increased to $1.4 million in the six months ended June 30, 1997 versus approximately $894,000 in the same period of 1996. This increase was primarily caused by greater investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its rapid expansion in sales. BAD DEBT EXPENSE - Total Company bad debt expense decreased to approximately $152,000 in the second quarter of 1997 compared to $1.4 million in the same prior year quarter. Bad debt expense for the six months ended June 30, 1997 decreased to $1.8 million from $2.5 million in the six months ended June 30, 1996. The decrease was due primarily to decreases in NTC's LEC-billed bad debt. OTHER INCOME & EXPENSE - The Company's other income and expense declined to net other expense of approximately $67,000 in the second quarter of 1997 verses net other income of approximately $721,000 during the comparable prior year quarter. The Company's other income and expense declined to net other expense of approximately $59,000 in the six months ended June 30, 1997 verses net other income of approximately $1.3 million during the six months ended June 30, 1996. This net decline was primarily caused by no longer booking acquisition costs associated with the acquisition of the Company's 35%-owned subsidiary, RCI. In the six month period ended June 30, 1996, the Company booked acquisition expense of $1.1 million associated with its acquisition of RCI. MINORITY INTEREST - Beginning on July 1, 1995, the Company converted from the equity method to the consolidated method of accounting for its 51% ownership in RCI. As a result, $646,265 or 49% of RCI's losses from April 1 through June 30, 1996 (the "minority interest") was eliminated from the Company's "Consolidated Statements of Operations" for 1996. On January 1, 1997, the Company converted back to the equity method of accounting. NET INCOME - Total Company net income increased to $1.3 million or 3.8% of sales in the second quarter of 1997 as compared to net income of $230,429 or 0.9% of sales in the same quarter of 1996. Net income increased to $2.4 million in the six months ended June 30, 1997 from $648,003 in the six months ended June 30, 1996. The increase in net income resulted from: (1) no longer booking losses associated with the acquisition and operations of RCI, (2) reserving for anticipated legal fees associated with lawsuits against the Company and (3) slightly increased earnings at NTC. In the six months ended June 30, 1997, earnings at NTC were $2.8 million versus $2.7 million for the six months ended June 30, 1996. -15- PART II - OTHER INFORMATION CAUTIONARY STATEMENTS: This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends that such forward-looking statements be subject to the safe harbors created by such statutes. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties. Accordingly, to the extent that this Quarterly Report contains forward-looking statements regarding the financial condition, operating results, business prospects or any other aspect of the Company and its subsidiaries, please be advised that the Company and its subsidiaries' actual financial condition, operating results and business performance may differ materially from that projected or estimated by the Company in forward-looking statements. The differences may be caused by a variety of factors, including but not limited to adverse economic conditions, intense competition, including intensification of price competition and entry of new competitors and products, adverse federal, state and local government regulation, inadequate capital, unexpected costs and operating deficits, increases in general and administrative costs, lower sales and revenues than forecast, loss of customers, customer returns of products sold to them by the Company or its subsidiaries, disadvantageous currency exchange rates, termination of contracts, loss of supplies, technological obsolescence of the Company's or its subsidiaries' products, technical problems with the Company's or its subsidiaries' products, price increases for supplies and components, inability to raise prices, failure to obtain new customers, litigation and administrative proceedings involving the Company, including the pending class action and related lawsuits and SEC investigation, the possible acquisition of new businesses that result in operating losses or that do not perform as anticipated, resulting in unanticipated losses, the possible fluctuation and volatility of the Company's operating results, financial condition and stock price, losses incurred in litigating and settling cases, dilution in the Company's ownership of its subsidiaries and businesses, adverse publicity and news coverage, inability to carry out marketing and sales plans, challenges to the Company's patents, loss or retirement of key executives, changes in interest rates, inflationary factors, and other specific risks that may be alluded to in this Quarterly Report or in other reports issued by the Company. In addition, the business and operations of the Company are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements. In light of the significant uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. ITEM 1. LEGAL PROCEEDINGS SECURITIES AND EXCHANGE COMMISSION INVESTIGATION: The investigation of the Company by the SEC, which was commenced in August 1994, has not experienced any material changes from its status as described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996. The Company continues to believe that it has provided substantial documentation to the Commission that demonstrates the propriety of its business operations and that the ultimate result of the investigation will not have a material adverse effect on the Company's financial condition or results of operations. CLASS ACTION AND RELATED LAWSUITS: The status of the pending class action lawsuit described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996, known as and updated in "Item 1. Legal Proceedings" in the Company's Form 10-Q for its fiscal quarter ending March 31, 1997, SANDRA GAYLES, ET AL. VS. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 KMW (BQRx), has materially changed since the filing of the Form 10-K for the fiscal year ending December 31, 1996 and Form 10-Q for the fiscal quarter ending March 31, 1997, in the following manner: -16- On May 6, 1997, the court in the pending class action lawsuit SANDRA GAYLES ET AL. VS. SAM D. SCHWARTZ AND INCOMNET, INC. ruled that approximately 20 former shareholders of the Company have the right to "opt out" of the class action lawsuit and file their own separate lawsuit against the Company and Sam D. Schwartz, the Company's former President. The Company expects these potential plaintiffs to file a separate lawsuit against it and its former President in the near future. The potential plaintiffs purchased the Company's stock in the open market through Everest Securities, a brokerage firm which has since terminated its business. The potential claims are expected to be based on alleged violations of applicable securities laws relating to alleged statements made by the Company's former President to the securities broker at Everest Securities in 1995. The amount of damages to be sought by the potential plaintiffs is not yet known. The Company intends to vigorously defend the claims if they are asserted against it. The Company is presently engaged in settlement discussions with the plaintiff's counsel in the class action lawsuit. There are no assurances that any settlement will be reached. In a hearing on May 5, 1997, the plaintiffs in a lawsuit entitled SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York and transferred in March 1997 to the same court in California which is hearing the pending class action lawsuit, were allowed to continue as a separate pleading from the class action lawsuit. As such, the Company anticipates that it will be involved in a separate lawsuit with the SILVA RUN WORLDWIDE LIMITED plaintiffs as described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996. INCOMNET, INC. VS. SAM D. SCHWARTZ: On April 25, 1997, the Company filed a lawsuit against Sam D. Schwartz, its prior President and Chairman of the Board, alleging fraud, breach of fiduciary duty, negligence, declaratory relief, breach of contract and imposition of constructive trust. The lawsuit was filed in the Superior Court of California in the County of Los Angeles. In the lawsuit, the Company alleges that Mr. Schwartz failed to disclose to the Company or its board of directors that he would obtain a direct financial benefit in connection with certain transactions considered or entered into by the Company during the period from 1993 to 1995. The Company further alleges that Mr. Schwartz fraudulently induced the Company to enter into a Severance Agreement between him and the Company in November 30, 1995 (see "Item 1. Business - Employees, Officers and Directors - Officers" in the Company's Form 10-K for the fiscal year ending December 31, 1995), and that he breached his fiduciary duty to the Company by self-dealing, acting in bad faith and concealing material facts. The Company seeks payment from Mr. Schwartz of the actual damages incurred by it as a result of Mr. Schwartz's conduct, as well as interest, punitive damages, attorney's fees and costs and reimbursements of all payments previously made to Mr. Schwartz pursuant to the Severance Agreement. Furthermore, the Company seeks a declaratory order that Mr. Schwartz committed acts or omissions involving known misconduct, the absence of good faith, an improper personal benefit, a reckless disregard of his duties to the Company and its shareholders, an unexcused pattern of inattention, and a violation of Sections 310 and 316 of the California Corporations Code. On June 24, 1997, Mr. Schwartz answered the Company's lawsuit against him denying the allegations and counterclaiming for (i) enforcement of any payments due under his Severance Agreement with the Company, (ii) indemnification against third party claims, and (iii) payment of the same settlement to him as was paid to the prior noteholders who purchased convertible notes from the Company on February 8, 1995 (Mr. Schwartz also purchased convertible notes from the Company on February 8, 1995), even though the Company's settlement with those prior noteholders was based on the misconduct of Mr. Schwartz. See "THE COMPANY - Settlement with Prior Noteholders." The Company intends to vigorously assert its claims against Mr. Schwartz, including possible contribution claims with respect to the Company's proposed settlement payments to the plaintiffs in the class action lawsuit, and to vigorously defend against Mr. Schwartz's counterclaims. The lawsuit against Mr. Schwartz has entered the discovery phase and there is no assurance regarding its outcome. There is no assurance that the case will not have a material adverse impact on the financial condition, operating results and business performance of the Company or its subsidiaries. See "Item 1. Legal Proceedings - INCOMNET, INC. VS. SAM D. SCHWARTZ" in the Company's Form 10-Q for -17- the quarter ended March 31, 1997, and "Item 3. Legal Proceedings - Settlement with Prior Noteholders" in the Company's 1996 Form 10-K. SECTION 16(B) LAWSUIT: In January 1996, the Company was served with a derivative shareholders lawsuit entitled RICHARD MORALES VS. INCOMNET, INC. AND SAM D. SCHWARTZ, 96 Civil 0225 in the United States District Court for the Southern District of New York, alleging violations of Section 16(b) of the Securities Exchange Act of 1934, as amended, and demanding that the Company assert claims against Mr. Schwartz for the payment of short-swing profits plus interest. On July 10, 1997, the United States District Court for the Southern District of New York gave final approval to the settlement of that lawsuit in which Mr. Sam D. Schwartz agreed to pay to the Company cash and stock valued at $4,250,000. In final settlement of the lawsuit, Mr. Schwartz has delivered to the Company 1,047,966 shares of the Company's common stock and $600,000 in cash. Under the agreement, the Company paid $626,450 in attorney's fees and expenses to the shareholder's counsel. LEGAL ACTION AGAINST PRIOR REPRESENTATIVES: The status of the pending lawsuit by NTC against certain of its prior representatives described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996 and updated in the filing of the Form 10-Q for the fiscal quarter ending March 31, 1997, has not materially changed since the filing of the Form 10-K. POTENTIAL LAWSUITS: There is no assurance that claims similar to those asserted in the pending class action and related lawsuits, or other claims, will not be asserted against the Company by new parties in the future. In this regard, potential plaintiffs have from time to time orally asserted claims against the Company and its prior directors. Several members of the class in the pending class action lawsuit against the Company have opted out. If such claims are filed as legal complaints, the Company will seek to have them consolidated with other pending lawsuits, if appropriate, or will defend them separately. From time to time, the Company is also involved in litigation arising from the ordinary course of business, the ultimate resolution of which management believes will not have a material adverse effect on the financial condition or results of operations of the Company. ITEM 2. CHANGES IN SECURITIES Item 2 is not applicable for the three months ended June 30, 1997. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Item 3 is not applicable for the three months ended June 30, 1997. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Item 4 is not applicable for the three months ended June 30, 1997. ITEM 5. OTHER INFORMATION ADDITION OF NEW BOARD MEMBERS: On August 7, 1997, the Company entered into an agreement with Stanley C. Weinstein, David Wilstein and Richard M. Horowitz in which all three individuals would join the Company's Board of Directors. On May 5, 1997, Mr. Wilstein and Mr. Horowitz were members of a group that filed a Schedule 13D with the Securities and Exchange Commission ("SEC"), stating that they may be deemed to be a group pursuant to SEC Rule 13d-5(b)(1) promulgated under Sections 13(d) and 13(g) of the Securities and Exchange Act of 1934, as amended. -18- Pursuant to the Agreement, the Company agreed to (1) hold harmless and indemnify all of the members of the Company's Board of Directors to the maximum extent permitted by the General Corporation Law of California, (2) increase directors and officers insurance to $5 million and (3) resolve uncertainties that are merely of a technical nature that may exist in the Company's Articles of Incorporation at the next meeting of the Company's shareholders. As part of the Agreement, Mr. Wilstein and Mr. Horowitz agreed that they would not assert that any other director of the Company should be deemed to be a member of the group that filed the Schedule 13D on May 5, 1997. As part of the Agreement, all parties agreed (1) that it would be the policy of the Board that the Board will not support any derivative lawsuit unless such a suit pleads with particularity facts that give rise to a strong inference that a director or directors acted in violation of his, her or their duty of loyalty or duty of care to the Company, unless a different standard is required, (2) to recommend that the shareholders of the Company approve clarifying amendments to the Company's Articles of Incorporation, deleting reference to the number of directors, (3) to amend the Company's Bylaws so that the Board shall be comprised of seven members, and (4) to take actions to cause the annual meeting to be held on September 22, 1997 and to act together to nominate all seven Board members as the slate for the upcoming meeting of shareholders, provided that all members wish to serve on the Board or resign from the Board and subsequently nominate a different slate of directors. ISSUANCE OF 6% CONVERTIBLE PREFERRED STOCK: In July 1997, the Company issued 1,800 shares of Series B 6% Convertible Preferred Stock to raise $1.8 million, less fees equal to approximately 7% of the capital raised. In connection with the issuance of the Series B Preferred Stock, the Company also issued warrants to purchase 50,000 shares of the Company's common stock at an exercise price of $5.36 per share for a period of two years and an option to acquire an additional 125 Series B Preferred Stock at 88% of the average bid price of the Company's common stock in the five days preceding the date of issuance of the additional Series B Preferred Stock. The basic terms and conditions of the Series B 6% Convertible Preferred Stock are as follows: VOTING. The Series B 6% Convertible Preferred Stock does not have voting rights. DIVIDEND. The Series B 6% Convertible Preferred Stock has a cumulative noncompounded annual dividend of 6% payable in cash or stock at the Company's option upon conversion of the Preferred Stock into Common Stock, and prior to the payment of any dividends on the Common Stock. No dividends may be declared or paid on the Convertible Series B Preferred Stock until all cumulative unpaid dividends have been declared and paid on the outstanding Convertible Series A Preferred Stock. LIQUIDATION PREFERENCE. The Series B 6% Convertible Preferred Stock has a liquidation preference of $1,000 per share plus all cumulative unpaid dividends, whether or not declared by the Company's Board of Directors. Upon any liquidation or change of control of the Company (i.e. transfer of more than 50% of its voting stock), the Preferred Stockholders are entitled to the second priority in payment from the Company's assets, before any payments are made on the Company's Common Stock, until the liquidation preference is paid in full. The Series B 6% Convertible Preferred Stock is junior in preference to Series A 2% Convertible Preferred Stock issued in October 1996 (see the Company's Annual Report of Form 10-K filed on April 15, 1997). No liquidation preference may be paid to the holders of the Convertible Series B Preferred Stock until the full liquidation preference has been paid to the holders of the outstanding Convertible Series A Preferred Stock. CONVERSION. The Preferred Stockholders may convert each share of Series B 6% Convertible Preferred Stock into the number of shares of the Company's Common Stock calculated as follows, at any time upon the earlier of (i) 120 days after the issuance of the Preferred Stock, or (ii) when the shares of Common Stock underlying the Preferred Stock are registered with the Securities and Exchange Commission. The conversion price (the "Conversion Price") for each share of Series B 6% Convertible Preferred Stock is equal to the lesser of (a) 80% of the average bid price for the Company's Common Stock on the public trading market for the five -19- trading days immediately preceding the conversion date, as specified by the Preferred Stockholder, or (b) the bid price of the Company's Common Stock on the funding date (i.e. the issuance date of the Preferred Stock). To calculate the number of shares of Common Stock issuable upon the conversion of the Preferred Stock, the Conversion Price is multiplied by a ratio, the numerator of which is the sum of 1,000 and the accrued but unpaid dividends, and the denominator of which is the Conversion Price. If for any reason a registration statement covering the shares of Common Stock issuable upon the conversion of the Preferred Stock is not in effect with the Securities and Exchange Commission at the time of a valid conversion by a Preferred Stockholder, then the Conversion Price is reduced by 3% per month for each of the first three months that the effectiveness of the registration is late, and thereafter the Company is obligated to pay a cash penalty equal to 3% of the investment per month. The Company has the right to cause a conversion of the Preferred Stock into Common Stock on the same terms at any time after one year after the Preferred Stock is issued. REDEMPTION. The Company has the right to redeem the Preferred Stock for its issuance price plus cumulative unpaid dividends if the Company's stock trades at a price which averages $2.00 per share or less for any period of five consecutive trading days after the Preferred Stock is issued. REGISTRATION RIGHTS. Pursuant to a Registration Rights Agreement entered into by the Company with each purchaser of the Series B 6% Convertible Preferred Stock, the Company is obligated to file a registration statement with the Securities and Exchange Commission covering the shares of Common Stock underlying the Preferred Stock within 30 days after the Preferred Stock is issued, and to have the registration statement declared effective within 120 days after it is filed. ANTIDILUTION PROVISION. The Certificate of Determination for the Series B 6% Convertible Preferred Stock contains comprehensive provisions for adjustments to the Conversion Price and the conversion ratio of the Preferred Stock in the event of stock dividends, asset distributions, reorganizations, recapitalizations, mergers, stock splits or similar transactions by the Company, in order to protect the Preferred Stock from dilution as a result of such transactions. RESTRICTIVE COVENANTS. During the first 90 days after the Series B 6% Convertible Preferred Stock is issued, the Company is not permitted to issue any other securities, except in limited circumstances, including pursuant to the exercise of outstanding options or warrants or pursuant to existing settlement agreements, without first notifying the Preferred Stockholders and giving them a right of first refusal to purchase the securities themselves. While the Series B 6% Convertible Preferred Stock is outstanding or until it is converted into Common Stock, the Company is not permitted to engage in certain transactions, such as the redemption or purchase of its own Common Stock (except in connection with the collection of Section 16(b) short-swing profits), without the prior consent of the Preferred Stockholders. Furthermore, the Company cannot take any action which would modify the rights of the Preferred Stockholders under the Certificate of Determination without the prior consent of the Preferred Stockholder being affected by the modification. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K INDEX TO EXHIBITS: EXHIBIT NO. DESCRIPTION - ----------- ----------------- 10-1 Loan Agreement between National Telephone & Communications, Inc. and First Bank -20- & Trust, Irvine, CA. 10-2 Agreement As To Board Membership Between Incomnet, Inc. and Stanley Weinstein, David Wilstein and Richard Horowitz, dated August 7, 1997. REPORTS ON FORM 8-K, FILED IN 1997 - - ---------------------------------------------------- 20.1 Report on Form 8-K - Election of Dr. Howard Silverman As Director & Amendment to Employment Contract of Melvyn Reznick, filed on February 7, 1997. 20.2 Report on Form 8-K - Reincorporation of National Telephone & Communications, Inc. filed on April 10, 1997. 20.3 Report on Form 8-K - Acquisition of California Interactive Computing, Inc., filed on May 13, 1997. 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. INCOMNET, INC. Date: August 14, 1997 /s/ MELVYN REZNICK -------------------------- Melvyn Reznick President, CEO & CFO -21- EX-13.14 9 EXHIBIT 13.14 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1997 COMMISSION FILE NO. 0-12386 INCOMNET, INC. A California IRS Employer No. Corporation 95-2871296 21031 Ventura Blvd., Suite 1100 Woodland Hills, California 91364 Telephone no. (818) 887-3400 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:.....................None SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:.....................Common Stock, No Par Value 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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO --- --- Number of shares of registrant's common stock outstanding as of September 30, 1997...................................14,006,793 1 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS) September 30, December 31, 1997 1996 ---- ---- ASSETS Current assets: Cash & cash equivalents 1,169 $ 2,214 Accounts receivable, including $287,000 and $267,000 due from related party at September 30, 1997 and December 31, 1996, respectively and less allowance for doubtful accounts of $2.1 million at September 30, 1997 and $1.9 million at December 31, 1996 18,914 13,137 Notes receivable - current portion 445 323 Notes receivable from officers & shareholders, net of reserves of $209,000 1,009 438 Inventories 499 2,760 Other current assets 1,327 1,332 -------- -------- Total current assets 23,363 20,204 Property, plant and equipment, at cost, net 16,670 14,357 Goodwill, net 6,894 5,783 Investments, notes receivable and other assets 1,725 243 -------- -------- Total assets 48,652 $ 40,587 -------- -------- -------- --------
See accompanying "Notes to Consolidated Financial Statements." 2 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONT'D)
(DOLLARS IN THOUSANDS) September 30, December 31, 1997 1996 ---- ---- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable 14,597 $ 14,746 Accrued expenses 6,502 8,217 Current portion of notes payable 5,994 3,918 Deferred income 3,190 4,040 -------- -------- Total current liabilities 30,283 30,921 Long-term liabilities Notes payable 1,190 1,040 Notes payable, GenSource 2,165 -- Liabilities in excess of assets of RCI 3,600 -- Shareholders' equity: Common stock, no par value; 20,000,000 shares authorized; 14,006,793 shares issued and outstanding at September 30, 1997 and 13,369,681 shares at December 31, 1996 69,972 61,320 Preferred stock, no par value; 100,000 shares authorized; 3,909 issued and outstanding September 30, 1997 and 2,355 shares issued and outstanding at December 31, 1996 3,698 2,355 Treasury stock (5,492) (5,492) Accumulated deficit (56,765) (49,557) -------- -------- Total shareholders' equity 11,413 8,626 -------- -------- Total liabilities & shareholders' equity $ 48,652 $ 40,587 -------- -------- -------- --------
See accompanying "Notes to Consolidated Financial Statements." 3 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) THREE MONTHS ENDED SEPTEMBER 30, (DOLLARS IN THOUSANDS) 1997 1996 ---- ---- SALES $ 33,318 $ 27,591 -------- -------- OPERATING COSTS & EXPENSES: Cost of sales 23,384 17,777 General & administrative 6,730 8,254 Depreciation & amortization 821 502 Bad debt expense 1,600 1,292 Other (income)/expense 11,238 10,676 -------- -------- Total operating costs and expenses 43,773 38,501 -------- -------- Income/(loss) before income taxes and minority interest (10,455) (10,910) INCOME TAX BENEFITS/(EXPENSE) 887 (866) -------- -------- Income/(loss) before minority interest (9,569) (10,044) MINORITY INTEREST -- 781 Net income/(loss) $ (9,569) $ (9,263) -------- -------- -------- -------- INCOME/(LOSS) PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Net income/(loss) $ (0.70) $ (0.70) -------- -------- -------- -------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARE EQUIVALENTS OUTSTANDING 13,687,977 13,244,674 ---------- ---------- ---------- ---------- See accompanying "Notes to Consolidated Financial Statements." 4 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, (DOLLARS IN THOUSANDS) 1997 1996 ---- ---- SALES $ 99,341 $ 77,296 --------- -------- OPERATING COSTS & EXPENSES: Cost of sales 69,525 49,144 General & administrative 20,740 22,083 Depreciation & amortization 2,218 1,396 Bad debt expense 3,448 3,829 Other (income)/expense 11,297 12,046 --------- -------- Total operating costs and expenses 107,228 88,498 --------- -------- Income/(loss) before income taxes and minority interest (7,886) (11,202) INCOME TAX BENEFITS/(EXPENSE) 679 (679) --------- -------- Income/(loss) before minority interest (7,207) (10,523) MINORITY INTEREST -- 1,908 --------- -------- Net income/(loss) $ (7,207) $ (8,615) --------- -------- --------- -------- INCOME/(LOSS) PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Net income/(loss) $ (0.53) $ (0.65) --------- -------- --------- -------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARE EQUIVALENTS OUTSTANDING 13,687,977 13,268,050 ---------- ---------- ---------- ---------- See accompanying "Notes to Consolidated Financial Statements." 5 INCOMNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, 1997 1996 --------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (7,207) $ (10,523) Depreciation and amortization 2,524 3,222 --------- -------- (4,683) (7,301) -------- -------- CASH FLOWS FROM (INCREASE)/DECREASE IN OPERATING ASSETS: Accounts receivable (5,777) (372) Notes receivable - current (122) (67) Notes receivable - due from officers (571) 711 Inventories 2,261 (1,101) Prepaid expenses and other& (5) (1,374) Notes receivable - long term - 155 Deposits and other (1,481) (20) -------- -------- (5,695) (2,068) -------- -------- CASH FLOWS FROM INCREASE/(DECREASE) IN OPERATING LIABILITIES Accounts payable (149) 2,225 Accrued expenses (1,715) 869 Deferred income (850) 528 -------- -------- (2,714) 3,622 -------- -------- Net cash flow from operations (13,092) (5,747) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of plant and equipment (3,725) (5,159) Patents/intangible assets - (162) Investment in Lab Tech - 66 Goodwill from acquisition of GenSource (2,223) Liability in excess of assets 3,600 Goodwill from acquisition of NTC - 222 Goodwill from acquisition of RCI - 8,000 -------- -------- Net cash flow from investing activities (2,348) 2,967 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Notes payable - current - 3,146 Sale of common stock, net 8,651 436 Preferred stock 1,343 Notes payable - long term 4,391 (876) Other - net 10 46 -------- -------- Net cash flow from financing activities 14,395 2,752 -------- -------- Net increase/(decrease) in cash and equivalents $ (1,045) $ (28) -------- -------- -------- -------- See accompanying "Notes to Consolidated Financial Statements." 6 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 1997 1. MANAGEMENT'S REPRESENTATION: The consolidated financial statements included herein have been prepared by the management of Incomnet, Inc. (the Company) without audit. Certain information and note disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted. In the opinion of the management of the Company, all adjustments considered necessary for fair presentation of the consolidated financial statements have been included and were of a normal recurring nature, and the accompanying consolidated financial statements present fairly the financial position as of September 30, 1997, and the results of operations for the three and nine months ended September 30, 1997 and 1996, and cash flows for the nine months ended September 30, 1997 and 1996. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes for the three years ended December 31, 1996, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 1997. The interim results are not necessarily indicative of the results for a full year. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, National Telephone & Communications-TM-, Inc. (NTC) and GenSource-TM- Corporation (GenSource - see "Item 5. Change of Name From California Interactive Computing, Inc. to GenSource Corporation"). The statements do not include consolidated results of Rapid Cast, Inc., the Company's 22%-owned subsidiary, which is accounted for using the equity method of accounting. The Company accounted for RCI using the consolidated method of accounting from the third quarter of 1995 until December 31, 1996 because the Company owned 51% of RCI. In January 1997, the Company's ownership changed from 51% of RCI to 35%, as a result, the method of accounting has changed to the equity method. In June 1997, the Company's ownership position changed to 22%. On the date of change in the method of accounting, RCI's liabilities significantly exceeded its assets, and the Company recorded its ratable share of such excess in the balance sheet caption "Liabilities in excess of assets of RCI". Accordingly, all assets and liabilities of RCI, including patent rights of $1,241,000 (after previously recorded reserves of approximately $39 million) were, during the first quarter of 1997, combined under this caption. REVENUE RECOGNITION - The Company recognizes revenue during the month in which services or products are delivered, as follows: (1) NTC's long distance telecommunications service revenues are generated when customers make long distance telephone calls from their business or residential telephones or by using any of NTC's telephone calling cards. Proceeds from prepaid telephone calling cards are recorded as deferred revenues when the cash is received, and recognized as revenue as the telephone service is utilized. The reserve for deferred revenues is carried on the balance sheet as an accrued liability. Long distance telephone service sales in the three months and nine months ending September 30, 1997 totaled $28.7 million and $83.5 million, respectively versus long distance telephone service sales of $21.1 million and $61.6 million, respectively in the three months and nine months ending September 30, 1996. (2) NTC's marketing-related revenues are derived from programs and material sold to the Company's base of independent sales representatives, including forms and supplies, fees for representative and certified trainer renewals, and the Company's Certified Trainer, Independent Representative and Home Study programs. The Company requires that all such services and materials be paid at the time of purchase. Revenues from marketing-related materials, net of amounts deferred for future services provided to the representatives, are booked as cash sales when the revenues are received. A portion of the revenues from marketing-related programs and materials is deferred and recognized over a twelve month period to accrue the Company's obligation to provide customer support to its independent representatives. For the three months and nine months ending September 30, 1997, marketing sales totaled $3.6 million and $13.6 million, respectively versus marketing sales of $4.8 million and $10.9 million, respectively for the three months and nine months ended September 30, 1996. 7 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 1997 (3) The Company's network service revenues from its AutoNETWORK service are recognized as sales as the service is delivered. Network service sales in the three months and nine months ending September 30, 1997 totaled $369,885 and $1.1 million, respectively versus $360,587 and $1.1 million, respectively in the three months and nine months ending September 30, 1997. (4) Revenues from the Company's GenSource subsidiary (see "Item 5. Change of Name From California Interactive Computing, Inc. to GenSource Corporation") are derived from the sale of computer software and from related services, such as software maintenance fees, custom programming and customer training. Revenues are recognized when software is shipped to customers and when services are performed and invoiced. Because the Company acquired GenSource on May 2, 1997, revenues and earnings only reflect GenSource's operations from May 2, 1997. Revenues in the three months and five months ending September 30, 1997 totaled $662,678 and $1.1 million, respectively. CONCENTRATION OF CREDIT RISK - The Company sells its telephone, network services and insurance-related software and related services to individuals and small businesses throughout the United States and does not require collateral. Reserves for uncollectible amounts are provided, which management believes are sufficient. COMPUTER HARDWARE, FURNITURE AND OFFICE EQUIPMENT - Computer hardware, furniture and office equipment are stated at cost. Depreciation is provided by the straight-line method over the assets' estimated useful lives of 3 to 10 years. COMPUTER SOFTWARE - The Company capitalizes the costs associated with purchasing, developing and enhancing its computer software. All software costs are amortized using the straight-line method over the assets' estimated useful lives of 3 to 10 years. LEASEHOLD IMPROVEMENTS - All leasehold improvements are stated at cost and are amortized using the straight-line method over the expected lease term. NET INCOME PER SHARE - Net income per common share is based on the weighted average number of common shares and common share equivalents for 1997 and 1996. ACQUISITION AMORTIZATION - The excess of purchase price over net assets of NTC and GenSource have been recorded as an intangible asset and is being amortized by the straight-line method over twenty years. DEFERRED TAX LIABILITY - Deferred income taxes result from temporary differences in the basis of assets and liabilities reported for financial statement and income tax purposes. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. FUNDING OF MARKETING COMMISSIONS AND DEFERRED INCOME: The Company's subsidiary, NTC, maintains separate bank accounts for the payment of marketing commissions. Funding of these accounts is adjusted regularly to provide for management's estimates of required reserve balances. NTC estimates the total commissions owed to active independent representatives ("IR Earned Compensation") each 8 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 1997 week for all monies collected that week due to the efforts of those active independent representatives. All IR Earned Compensation is then paid to the independent representatives, when due, directly out of the separate bank account. IMPAIRMENT OF LONG-LIVED ASSETS - In accordance with the provisions of SFAS No. 121, the Company regularly reviews long-lived assets and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount to the assets may not be recoverable. 4. NOTES PAYABLE: Notes payable consist of the following as of September 30, 1997: Notes payable to founding stockholders of GenSource, interest at 8%, due beginning in May 1998 $ 2,165,095 Note payable to bank for line of credit to NTC, interest at prime plus 1.25%, due as current liability $ 5,550,000 Capitalized lease obligations $ 1,633,995 ----------- $ 9,349,090 ----------- ----------- 5. NETWORK MARKETING COSTS: During the three and nine months ending September 30, 1997, NTC's net costs to operate its network marketing program were $3.0 million and $11.2 million, respectively, as summarized below (in $ millions):
3 Months Ending 9 Months Ending September 30,1997 September 30,1997 ----------------- ----------------- Sales $ 3.6 $ 13.6 ----- ------ Cost of sales 3.0 11.2 Operating expenses for support services 1.3 4.1 ----- ------ Total marketing-related costs 4.3 15.3 ----- ------ Net marketing cost $ 0.7 $ 1.7 % of total NTC (long distance & marketing) sales 2.2% 1.8%
9 INCOMNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEPTEMBER 30, 1997 Marketing sales of $3.6 million and $13.6 million, during the three and nine month periods ending September 30, 1997, respectively were generated by the sale of materials, training and support services to assist NTC independent sales representatives in selling new retail customers and enrolling other representatives in the NTC program. Beginning in January 1996, NTC began to accrue its obligation to provide customer support to its representatives. These reserved marketing revenues are reflected as deferred income on the Company's balance sheet and are amortized over the succeeding twelve months. The marketing-related costs include commissions paid to independent sales representatives for acquiring new retail telephone customers, as well as the cost of sales materials, salaries and wages of marketing department personnel, services required to support the independent sales representatives, and other directly identifiable support costs, but do not include residual commissions paid on continuing long distance telephone usage or the typical indirect cost allocations, such as floor-space and supporting departments. When marketing-related costs of $4.3 million and $15.3 million for the three months and nine months ended September 30, 1997, respectively are compared against marketing-related revenues of $3.6 million and $13.6 million for the same period, the results are a net cost in marketing-related activities during the three months and nine months ended September 30, 1997 of $0.7 million and $1.7 million, respectively, or 2.2% and 1.8%, respectively of total NTC sales. 6. COMPENSATION OF INDEPENDENT SALES REPRESENTATIVES: The Company's subsidiary, NTC, compensates its independent sales representatives by an earned commission structure based upon signing up new telephone customers and based upon the telephone usage generated by those customers. In the three and nine months ending September 30, 1997, expenses associated with commissions, bonuses and overrides paid out to NTC's independent representatives were $4.4 million and $15.3 million, respectively versus commissions, bonuses and overrides paid out to NTC's independent representatives of $5.0 million and $12.3 million, respectively for the three months and nine months ended September 30, 1996. 7. COMMITMENTS AND CONTINGENCIES: Litigation - The Company is a defendant in a class action matter and related lawsuits alleging securities law violations with respect to alleged false denial and non-disclosure of a Securities and Exchange Commission investigation and alleged non-disclosure of purchases and sales of the Company's stock by an affiliate of the former Chairman of the Board. On October 7, 1997, the Company announced that it had reached a settlement of the class action lawsuit for $8,650,000. Accordingly, the Company has taken a reserve of $8,650,000 in the third quarter ended September 30, 1997 for expenses associated with the anticipated settlement [see "Part II. Item 1. Legal Proceedings - Class Action and Related Lawsuits"]. Counsel for the company is unable to estimate the ultimate outcome of the related lawsuits and is unable to predict a range of potential loss. Accordingly, no amounts have been provided for the related lawsuits in the accompanying financial statements. In addition, the Company has recorded an additional 1.5 million shares of its common stock in connection with the settlement of this matter. On October 28, 1997, the Company announced that that its NTC subsidiary reached a settlement of a civil consumer protection lawsuit with the State of California. Accordingly, the Company has taken a reserve of $1.6 million in the third quarter ended September 30, 1997 for expenses associated with the anticipated settlement [see "Part II. Item 1. Legal Proceedings - Civil Consumer Protection Lawsuit With The State of California"]. The amounts provided for these matters are included in the caption "Other (income)/expense" in the accompanying Consolidated Statements of Operations. The Company is under investigation by the Securities and Exchange Commission under a non-public "formal order of private investigation." Management has furnished all information requested by the Commission and does not believe that the matter will have a material adverse impact on its financial position or results of operations. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES: Overall, the Company had negative cash flows of $1.1 million during the first nine months of 1997 resulting from negative cash flows from operations of $13.1 million and negative cash flows from investing activities of $2.4 million, which were offset by positive cash flows from investing activities of $14.4 million. The Company expects that its operating and investing activities will continue to experience negative cash flows due to (1) anticipated cash costs associated with the class action lawsuit, related lawsuits and other legal and regulatory issues (see "Item 1. Legal Proceedings") and (2) anticipated funding requirements of approximately $1.2 million through fiscal year 1998 associated with the operation and acquisition of GenSource (see the Company's Report on Form 10-Q for the second quarter ended June 30, 1997). To meet these anticipated funding needs, the Company has issued options to acquire up to 250 shares of Series B 6% Convertible Preferred Stock at an 88% conversion ratio, the right to acquire 200 shares of Series B 6% Convertible Preferred Stock at an 80% conversion ratio, and warrants to acquire 105,000 shares of the Company's common stock (see "Item 5. Conveyance of Series A 2% Convertible Preferred Stock and Issuance of Series B 6% Convertible Preferred Stock"). There is no assurance that these options will be exercised and therefore management is not certain that its liquidity and capital resources will be sufficient to fund these activities for the foreseeable future. The Company's cash flows are discussed below, as follows: CASH FLOW FROM OPERATIONS - The Company experienced $13.1 million in negative cash flow from operations during the first nine months of 1997 compared to $5.8 million in negative cash flow from operations during the prior year's comparable period. This year-to-year decrease in cash flow from operations resulted primarily from: (1) a net loss from operating activities of $7.2 million, which includes reserves of $8.65 million and $1.6 million for anticipated legal settlements, (2) an increase in operating assets, primarily accounts receivable of $5.7 million and (3) a decrease in operating liabilities of $2.7 million. CASH FLOW FROM INVESTING - The Company experienced negative cash flows from investing activities of $ 2.3 million in the first nine months of 1997 as compared with a positive cash flow of $2.9 million in the first nine months of 1996. The negative cash flow in the first nine months of 1997 resulted primarily from $3.7 million used to acquire plant and equipment, primarily by NTC, and by $2.2 million for the acquisition of GenSource, reduced by a $3.6 million liability in excess of assets arising from changing to the equity method of accounting for RCI. CASH FLOW FROM FINANCING - Positive cash flows from financing activities totaled $14.4 million during the first nine months of 1997 compared with $2.7 million during the first nine months of 1996. The positive cash flow during the first nine months of 1997 resulted primarily from (1) issuance of $8.65 million of common stock primarily to settle the class action lawsuit against the Company (see "Item 1. Legal Proceedings"), (2) net sales of $1.3 million worth of convertible preferred stock (see "Item 5. Conveyance of Series A 2% Convertible Preferred Stock and Issuance of Series B 6% Convertible Preferred Stock"), (3) increased borrowings under NTC's line of credit and (4) assumption of $2.2 million in obligations associated with the acquisition of GenSource. RESULTS OF OPERATIONS: SALES - Sales of $33.3 million in the third quarter ended September 30, 1997 increased 21% over sales of $27.6 million in the third quarter ended September 30, 1996. The majority of this increase was attributable to NTC's sales increase to $32.3 million in the three months ended September 30, 1997 from $25.8 million in the three months ended September 30, 1996, respectively. The following table summarizes the Company's sales performance by subsidiary and segment during the comparable third quarters in 1997 and 1996: $ in millions ------------------ Subsidiary Segment 1997 1996 - -------------- --------------------------------------- ------ ------ NTC Telephone (telecommunications services) $ 28.7 $ 21.1 NTC Telephone (marketing programs) 3.6 4.7 RCI Optical -- 1.4 GenSource Software 0.6 -- AutoNETWORK Network 0.4 0.4 ------ ------ Total Company Sales $ 33.3 $ 27.6 ------ ------ ------ ------ COST OF SALES - Total Company cost of sales increased to $23.4 million or 70% of sales during the quarter ending September 30, 1996 verses $17.7 million or 64% of sales during the comparable prior year quarter. The quarter-to-quarter increase in cost of sales resulted largely from the increase in carrier costs associated with increased telephone service sales by NTC. The increase in the percentage of overall sales to 70% in the third quarter of 1997 from 64% in the third quarter of 1996 was due primarily to a percentage increase in NTC's carrier costs in the third quarter of 1997 versus the third quarter of 1996. The following table summarizes the Company's changes in three major cost components in the third quarter ended September 30, 1997 and 1996, respectively: $ in millions ---------------------- September September 30, 1997 30, 1996 --------- --------- Commissions paid to NTC independent sales reps $ 4.4 $ 5.0 Carrier costs for NTC's long distance telephone service 17.8 11.0 All other costs of sales 1.2 1.8 ------ ------ Total Company Cost of Sales $ 23.4 $ 17.8 ------ ------ ------ ------ 11 NTC's total commission expense decreased to $4.4 million in the third quarter of 1997 compared to $5.0 million in the same quarter of 1996. NTC's carrier costs to deliver long distance telephone service to its telephone customers increased to $17.8 million in the third quarter of 1997 compared to $11.0 million in the third quarter of 1996. This increase in carrier costs reflects a decline in the gross margin of carrier-related sales. In the third quarter of 1996, gross margin was 48%, or $11.0 million in carrier costs on $21.1 million in carrier sales, while in the third quarter of 1997, gross margin declined to 38%, or $17.8 million in carrier costs on $28.7 million in carrier sales. The third cost component shown in the table above is "all other costs of sales" which represents: (1) NTC's costs of producing sales materials for its independent sales representatives, (2) GenSource's cost of producing software products and related services, and (3) AutoNETWORK's costs of providing communications network products and services. GENERAL & ADMINISTRATIVE - Total general and administrative costs decreased to $6.7 million or 20% of sales in the quarter ending September 30, 1996 compared to $8.3 million or 30% of sales in the same prior year quarter. General and administrative costs generally include the costs of employee salaries, fringe benefits, supplies, and related support costs which are required in order to provide such operating functions as customer service, billing, marketing, product development, information systems, collections of accounts receivable, and accounting. The decrease in general and administrative expense is associated with improved efficiencies at NTC and by no longer consolidating the financial statements of RCI. DEPRECIATION & AMORTIZATION - Total Company depreciation and amortization expense was $821,409 in the third quarter of 1997 verses $501,787 in the third quarter of 1996. This increase was caused primarily by continuing investment by NTC in computer hardware and software, furniture and equipment, and leasehold improvements required to support its anticipated expansion in sales. BAD DEBT EXPENSE - Total Company bad debt expense increased to $1.6 million in the third quarter of 1997 from $1.3 million in the third quarter of 1996. The increase in bad debt was associated with an increase in total sales at NTC in the third quarter of 1997 versus the third quarter of 1996. OTHER INCOME & EXPENSE - The Company's other income and expense was an expense of $11.2 million in the third quarter of 1997 compared to other expense of $10.7 million in the third quarter of 1996. The $11.2 million in other expenses consists primarily of: (1) an $8.7 million reserve for the settlement of the class action lawsuit against the company, (2) a $1.6 million reserve for the settlement of a civil consumer protection lawsuit by the State of California against the Company's NTC subsidiary and approximately $600,000 in additional legal expenses associated with related lawsuits and administrative matters. NET INCOME - The Company incurred a net income loss of $9.6 million in the third quarter of 1997 compared to a loss of $9.3 million in the third quarter of 1997. The net loss was due primarily to the reserves taken for legal settlements, including $8.65 million to settle the class action lawsuit against the Company and $1.6 million for NTC to settle a civil consumer protection lawsuit with the State of California (See "Item 1. Legal Proceedings"). Without the reserves for legal settlements and associated expenses, the Company had net operating income of approximately $806,397 in the third quarter ended September 30, 1997. 12 PART II - OTHER INFORMATION CAUTIONARY STATEMENTS: This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends that such forward-looking statements be subject to the safe harbors created by such statutes. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties. Accordingly, to the extent that this Quarterly Report contains forward-looking statements regarding the financial condition, operating results, business prospects or any other aspect of the Company and its subsidiaries, please be advised that the Company and its subsidiaries' actual financial condition, operating results and business performance may differ materially from that projected or estimated by the Company in forward-looking statements. The differences may be caused by a variety of factors, including but not limited to adverse economic conditions, intense competition, including intensification of price competition and entry of new competitors and products, adverse federal, state and local government regulation, inadequate capital, unexpected costs and operating deficits, increases in general and administrative costs, lower sales and revenues than forecast, loss of customers, customer returns of products sold to them by the Company or its subsidiaries, disadvantageous currency exchange rates, termination of contracts, loss of supplies, technological obsolescence of the Company's or its subsidiaries' products, technical problems with the Company's or its subsidiaries' products, price increases for supplies and components, inability to raise prices, failure to obtain new customers, litigation and administrative proceedings involving the Company, including the pending class action and related lawsuits and SEC investigation, the possible acquisition of new businesses that result in operating losses or that do not perform as anticipated, resulting in unanticipated losses, the possible fluctuation and volatility of the Company's operating results, financial condition and stock price, losses incurred in litigating and settling cases, dilution in the Company's ownership of its subsidiaries and businesses, adverse publicity and news coverage, inability to carry out marketing and sales plans, challenges to the Company's patents, loss or retirement of key executives, changes in interest rates, inflationary factors, and other specific risks that may be alluded to in this Quarterly Report or in other reports issued by the Company. In addition, the business and operations of the Company are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements. In light of the significant uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. ITEM 1. LEGAL PROCEEDINGS CIVIL CONSUMER PROTECTION LAWSUIT WITH THE STATE OF CALIFORNIA: On October 28, 1997, the Company announced that its NTC subsidiary reached a settlement of a civil consumer protection lawsuit with the State of California. In the settlement, which NTC reached without admitting any wrongdoing, NTC agreed to a court order requiring them to implement policies to prevent the practice of slamming (switching customers' long distance telephone service without their permission or knowledge) by its independent sales representatives and employees, and agreed to pay $1,250,600 in costs and penalties. NTC also agreed to institute safeguards to prevent slamming violations from occurring in the future. Among those safeguards, NTC agreed to wait 24 hours after the consumer agrees to switch their telephone company to NTC before calling the customer to confirm that the consumer really wants to switch to NTC. The lawsuit was brought through the California Attorney General's Office and the Orange County District Attorney Office. The California Public Utility Commission was the investigative agency. As part of a related administrative action, restitution to consumers is being sought by the Consumer Services Division of the California Public Utility Commission. NTC is in settlement discussions with the California Public Utility Commission, but there is no assurance that a settlement will be reached. SECURITIES AND EXCHANGE COMMISSION INVESTIGATION: The investigation of the Company by the SEC, which was commenced in August 1994, has not experienced any material changes from its status as described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996. The Company continues to believe that it has provided substantial documentation to 13 the Commission that demonstrates the propriety of its business operations and that the ultimate result of the investigation will not have a material adverse effect on the Company's financial condition or results of operations. CLASS ACTION AND RELATED LAWSUITS: The status of the pending class action lawsuit described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996, known as and updated in "Item 1. Legal Proceedings" in the Company's Form 10-Q for its fiscal quarters ending March 31, 1997 and June 30, 1997, SANDRA GAYLES, ET AL. VS. SAM D. SCHWARTZ AND INCOMNET, INC., Case No. CV95-0399 KMW (BQRx), has materially changed since the filing of the Form 10-K for the fiscal year ending December 31, 1996 and Form 10-Q for the fiscal quarter ending June 30, 1997, in the following manner: On October 7, 1997, the Company reached a settlement of the lawsuit. The settlement, which is subject to court approval, consists of a payment of $500,000 in cash plus securities with a value of $8.15 million for a total settlement value of $8.65 million. The securities consist of 1,500,000 shares of the Company's common stock, plus a number of warrants to be determined if the value of the common stock does not equal at least $8.15 million after the settlement is approved by the court. On July 22, 1997, the Company was named in a lawsuit, JAMES A BELTZ, ET AL. VS. SAMUEL D. SCHWARTZ and RITA SCHWARTZ, husband and wife; STEPHEN A. CASWELL; JOEL W. GREENBERG; INCOMNET, INC., a California corporation; DAVID BODNER and MURRAY HUBERFELD, in the United States District Court, District of Minnesota. The lawsuit was filed by 17 individuals who were allowed to opt out of the class action lawsuit to pursue a lawsuit on their own. The lawsuit alleges that Mr. Schwartz and the other defendants created a fraudulent scheme to drive up the price of the Company's stock in violation of federal securities law. The lawsuit alleges losses by the plaintiffs of approximately $1.5 million and seeks unspecified damages. The status of the pending lawsuit described in the Company's Form 10-Q for its second quarter ending June 30, 1997, known as SILVA RUN WORLDWIDE LIMITED VS. INCOMNET, INC., SAM D. SCHWARTZ, BEAR STEARNS & CO., INC., LESLIE SOLMONSON, RONALD F. SEALE, MARINER RESERVE FUND, COMPANIA DI INVESTIMENTO ANTILLANO, COUTTS & CO. AG, SALVATORE M. FRANZELLA, PETER G. EMBIRICOS, AND JOS SCHUETZ, filed in the United States District Court for the Southern District of New York and transferred in March 1997 to the same court in California which is hearing the pending class action lawsuit has not materially changed since the filing of the Form 10-Q for the second quarter ending June30, 1997. INCOMNET, INC. VS. SAM D. SCHWARTZ: The status of the lawsuit by the Company against Sam D. Schwartz, its prior President and Chairman of the Board, alleging fraud, breach of fiduciary duty, negligence, declaratory relief, breach of contract and imposition of constructive trust, which was commenced in April 25, 1997, has not experienced any material changes from its status as described in "Item 1. Legal Proceedings - INCOMNET VS. SAM D. SCHWARTZ" in the Company's Form 10-Q for its fiscal quarter ending June 30, 1997. LEGAL ACTION AGAINST PRIOR REPRESENTATIVES: The status of the pending lawsuit by NTC against certain of its prior representatives described in "Item 3. Legal Proceedings" in the Company's Form 10-K for its fiscal year ending December 31, 1996 and updated in the filing of the Form 10-Qs for the fiscal quarters ending March 31, 1997 and June 30, 1997, respectively, has not materially changed since the filing of the Form 10-K. POTENTIAL LAWSUITS: There is no assurance that claims similar to those asserted in the pending class action and related lawsuits, or other claims, will not be asserted against the Company by new parties in the future. In this regard, potential plaintiffs have from time to time orally asserted claims against the Company and its prior directors. Several members of the class in the class action lawsuit against the Company have opted out and filed their own lawsuits against the Company as described above. From time to time, the Company is also involved in litigation arising from the ordinary course of 14 business, the ultimate resolution of which management believes will not have a material adverse effect on the financial condition or results of operations of the Company. ITEM 2. CHANGES IN SECURITIES Item 2 is not applicable for the three months ended September 30, 1997. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Item 3 is not applicable for the three months ended September 30, 1997. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Item 4 is not applicable for the three months ended September 30, 1997. ITEM 5. OTHER INFORMATION EMPLOYMENT AGREEMENT BETWEEN INCOMNET AND EDWARD R. JACOBS: On October 30, 1997, the Company's NTC subsidiary entered into a new employment agreement with Edward R. Jacobs, who had been the Chairman and Chief Executive Officer of NTC under a previous employment agreement from December 28, 1994 to July 25, 1997. Under terms of the new agreement, which was approved by NTC's Board of Directors, Mr. Jacobs will serve as the Chairman of the Board of NTC until July 25, 1999. Detailed information on the employment agreement is in the Company's Proxy Statement dated November 17, 1997. CONVEYANCE OF SERIES A 2% CONVERTIBLE PREFERRED STOCK AND ISSUANCE OF SERIES B 6% CONVERTIBLE PREFERRED STOCK: CONVEYANCE OF SERIES A 2% CONVERTIBLE PREFERRED STOCK. From September 20, 1996 to October 25, 1996, the Company sold 2,440 shares of Series A 2% Convertible Preferred Stock (the "Series A Stock") to 12 accredited private investors [See the Company's Annual Report on Form 10-K for fiscal year ended December 31, 1996]. The sale included an agreement that the Company would register the stock with an S-3 Registration Statement and included liquidated damages of 3% per month should the Registration Statement not be declared effective beginning 75 days after the funding was completed. The Company submitted the Registration Statement in November 1996, but has not yet had it declared effective, which has resulted in liquidated damages commencing in January 1997. These damages have been paid by the Company to holders of the Series A Stock as either cash or additional shares. On November 7, 1997, 1,700 shares of the Series A Stock was purchased from four institutional investors, who were original purchasers of the Series A Stock, for $1.7 million by 12 individual accredited investors. These individuals have all agreed to waive all registration rights and liquidated damage rights associated with the Series A Stock and have agreed that they will convert their Series A Stock into shares subject to Rule 144 of the Securities and Exchange Act of 1933, as amended, instead of shares that will be registered by the Company. The Company has paid total liquidated damages of $540,000 in cash to the four original purchasers of the Series A Stock conveyed to the new buyers. On November 3, 1997, three other individuals converted $225,000 of the Series A Stock (i.e. the original investment amount) to the Company's common stock, subject to Rule 144. These three individuals received liquidated damages of $67,500 paid in additional shares of common stock at a price of $3.00 per share. As of November 7, 1997, only 150 shares of original Series A Stock remains on the Company's books held by two individuals. These individuals are owed liquidated damages of approximately $45,000. SERIES B 6% CONVERTIBLE PREFERRED STOCK. In July 1997, the Company's Board of Directors approved the issuance of 2,990 shares of Series B 6% Convertible Preferred Stock (the "Series B Stock"), with each share worth $1,000 that could be converted into the Company's common stock. At that time, the Company raised $1.8 million by selling 1,834 shares of the authorized Series B Stock (see the Company's Report on Form 10-Q for the second quarter ending June 30, 1997 for a detailed description). On November 4, 1997, the Company issued 600 additional shares of Series B Stock, raising an additional $600,000, less a cash fee of $60,000 to the 15 investment banker, who arranged the sale ( the same investment banker arranged the sale of the 1,834 shares of Stock sold in July 1997). In connection with this new issuance of the Series B Stock, the Company also issued warrants to the investment banker to purchase 55,000 shares of the Company's common stock at an exercise price of $3.00 per share for a period of two years, an option to the investment banker to acquire an additional 125 Series B Stock at 88% of the average bid price of the Company's common stock quoted on the five trading days immediately preceding the date of issuance of the additional Series B Stock, and the right for one year of the investment banker to provide the Company with an additional $200,000 in Series B Stock. The cash fee, warrants and options paid and issued, respectively to the investment banker were contingent upon the investment banker placing $1.7 million of Series A Stock being sold by four original institutional purchasers who owned the Series Stock, to 12 new individuals who would waive all associated registration rights. On November 7, 1997, this contingency was met (see "Conveyance of Series A 2% Convertible Preferred Stock"). The basic terms and conditions of the Series B Stock are as follows: VOTING. The Series B Stock does not have voting rights. DIVIDEND. The Series B Stock has a cumulative non-compounded annual dividend of 6% payable in cash or stock at the Company's option upon conversion of the Series B Stock into the Company's common stock, and prior to the payment of any dividends on the Company's common stock. No dividends may be declared or paid on the Series B Stock until all cumulative unpaid dividends have been declared and paid on the outstanding Series A Stock. LIQUIDATION PREFERENCE. The Series B Stock has a liquidation preference of $1,000 per share plus all cumulative unpaid dividends, whether or not declared by the Company's Board of Directors. Upon any liquidation or change of control of the Company (i.e. transfer of more than 50% of its voting stock), the Preferred Stockholders are entitled to the second priority in payment from the Company's assets, before any payments are made on the Company's common stock, until the liquidation preference is paid in full. The Series B Stock is junior in preference to Series A Stock issued in October 1996 (see the Company's Annual Report of Form 10-K filed on April 15, 1997). No liquidation preference may be paid to the holders of the Series B Stock until the full liquidation preference has been paid to the holders of the outstanding Series A Stock. CONVERSION. The Preferred Stockholders may convert each share of Series B Stock into the number of shares of the Company's common stock calculated as follows, at any time upon the earlier of (i) 120 days after the issuance of the Preferred Stock, or (ii) when the shares of common stock underlying the Preferred Stock are registered with the Securities and Exchange Commission. The conversion price (the "Conversion Price") for each share of Series B Stock is equal to the lesser of (a) 80% of the average bid price for the Company's common stock on the public trading market for the five trading days immediately preceding the conversion date, as specified by the Preferred Stockholder, or (b) the bid price of the Company's common stock on the funding date (i.e. the issuance date of the Preferred Stock). To calculate the number of shares of common stock issuable upon the conversion of the Preferred Stock, the Conversion Price is multiplied by a ratio, the numerator of which is the sum of 1,000 and the accrued but unpaid dividends, and the denominator of which is the Conversion Price. If for any reason a registration statement covering the shares of common stock issuable upon the conversion of the Preferred Stock is not in effect with the Securities and Exchange Commission at the time of a valid conversion by a Preferred Stockholder, then the Conversion Price is reduced by 3% per month for each of the first three months that the effectiveness of the registration is late, and thereafter the Company is obligated to pay a cash penalty equal to 3% of the investment per month. The Company has the right to cause a conversion of the Preferred Stock into common stock on the same terms at any time after one year after the Preferred Stock is issued. REDEMPTION. The Company has the right to redeem the Preferred Stock for its issuance price plus cumulative unpaid dividends if the Company's stock trades at a price which averages $2.00 per share or less for any period of five consecutive trading days after the Preferred Stock is issued. REGISTRATION RIGHTS. Pursuant to a Registration Rights Agreement entered into by the Company with each purchaser of the Series B Stock, the Company is obligated to file a registration statement 16 with the Securities and Exchange Commission covering the shares of common stock underlying the Preferred Stock within 30 days after the Preferred Stock is issued, and to have the registration statement declared effective within 120 days after it is filed. ANTIDILUTION PROVISION. The Certificate of Determination for the Series B Stock contains comprehensive provisions for adjustments to the Conversion Price and the conversion ratio of the Preferred Stock in the event of stock dividends, asset distributions, reorganizations, recapitalizations, mergers, stock splits or similar transactions by the Company, in order to protect the Preferred Stock from dilution as a result of such transactions. RESTRICTIVE COVENANTS. During the first 90 days after the Series B Stock is issued, the Company is not permitted to issue any other securities, except in limited circumstances, including pursuant to the exercise of outstanding options or warrants or pursuant to existing settlement agreements, without first notifying the Preferred Stockholders and giving them a right of first refusal to purchase the securities themselves. While the Series B Stock is outstanding or until it is converted into common stock, the Company is not permitted to engage in certain transactions, such as the redemption or purchase of its own common stock (except in connection with the collection of Section 16(b) short-swing profits), without the prior consent of the Preferred Stockholders. Furthermore, the Company cannot take any action which would modify the rights of the Preferred Stockholders under the Certificate of Determination without the prior consent of the Preferred Stockholder being affected by the modification. AMENDMENT OF EMPLOYMENT AGREEMENT OF MELVYN REZNICK AND EMPLOYMENT AGREEMENT WITH STEPHEN A. CASWELL: On June 8, 1997, the Company's Board of Directors approved an extension of the employment agreement with Melvyn Reznick, the President and Chairman of the Board of the Company, and a new employment agreement with Stephen A. Caswell, the Company's Vice President and Corporate Secretary. The existing employment agreement with Mr. Reznick was extended until the earlier of (i) June 30, 2002, or (ii) six months after the date that 100% of the Company's holdings of NTC stock are sold, conveyed or otherwise distributed but no sooner than December 31, 1999 ("Early Termination Date"). In the event of an improper termination of the agreement by the Company for any reason, Mr. Reznick is entitled (i) to be paid a lump sum amount equal to his annual salary during the remaining term of his agreement plus his annual salary for three additional years, plus accrued bonus, if any, (ii) to receive all of his benefits during such period, and (iii) to exercise all of his vested stock options at any time during the remaining term of the options. In the event of an early termination because of the disposition of 100% of the Company's NTC stock, then the Company has agreed to pay Mr. Reznick a lump sum amount equal to the sum of the annual compensation and accrued but unpaid bonus (if any, with respect to the bonus) which would be payable to him for one additional year after the Early Termination Date, but not beyond June 30, 2002, as well as receive his benefits during that period and exercise his vested stock options during the remaining term of the options. Mr. Caswell's employment agreement has a term which expires on the earlier of (i) December 31, 1999, or (ii) six months after the date that 100% of the Company's holdings of NTC stock are sold, conveyed or otherwise distributed. In the event of an improper termination of Mr. Caswell's employment agreement by the Company for any reason, Mr. Caswell is entitled (i) to be paid a lump sum amount equal to his annual salary during the remaining term of his agreement plus his annual salary for 15 additional months, (ii) to receive all of his benefits during that period, and (iii) to exercise all of his vested stock options at any time during the remaining term of the options. In the event of an early termination because of the disposition of 100% of the Company's NTC stock, then the Company has agreed to pay Mr. Caswell a lump sum amount equal to the sum of the annual compensation and accrued bonus (if any, with respect to the bonus) which would be payable to him for one additional year after the Early Termination Date, but not beyond December 31, 1999, as well as receive his benefits during the remaining term of the options. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K INDEX TO EXHIBITS: 17 EXHIBIT NO. DESCRIPTION - ----------- ----------- 10.1 Amendment to Employment Agreement Between Incomnet and Melvyn Reznick, dated June 8, 1997. 10.2 Employment Agreement Between Incomnet and Stephen A. Caswell, dated June 8, 1997. 10.3 Employment Agreement Between NTC and Edward R. Jacobs, dated July 25, 1997. REPORTS ON FORM 8-K, FILED IN 1997 - ---------------------------------- 20.1 Report on Form 8-K - Election of Dr. Howard Silverman As Director & Amendment to Employment Contract of Melvyn Reznick, filed on February 7, 1997. 20.2 Report on Form 8-K - Reincorporation of National Telephone & Communications, Inc. filed on April 10, 1997. 20.3 Report on Form 8-K - Acquisition of California Interactive Computing, Inc., filed on May 13, 1997. 20.4 Report on Form 8-K - Election of Richard M. Horowitz, Stanley C. Weinstein and David Wilstein as Directors, filed on August 20, 1997. 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. INCOMNET, INC. Date: November 13, 1997 /s/ MELVYN REZNICK -------------------------- Melvyn Reznick President, CEO & CFO 18 EX-23.1 10 EXHIBIT 23.1 EXHIBIT 23.1 CONSENT OF STONEFIELD JOSEPHSON INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The undersigned independent certified public accounting firm hereby consents to the inclusion of its report on the financial statements of Incomnet, Inc. for the years ending December 31, 1996, 1995 and 1994, and to the reference to it as experts in accounting and auditing relating to said financial statements, in the Registration Statement for Incomnet, Inc., dated December 3, 1997. /s/ Stonefield Josephson Accountancy Corporation - ------------------------------------------------------ STONEFIELD JOSEPHSON ACCOUNTANCY CORPORATION Santa Monica, California December 3, 1997 -----END PRIVACY-ENHANCED MESSAGE-----