-----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, WTqn/zhYO2Bn5MQ3MOyPLPmmwa6FAmzrGFZpBEulZGU6Lq2SOthj8ocpq5kyt3zb 4olCAjsrBvr3YmdNjFXdMg== 0000720851-97-000003.txt : 19970404 0000720851-97-000003.hdr.sgml : 19970404 ACCESSION NUMBER: 0000720851-97-000003 CONFORMED SUBMISSION TYPE: 10-KT PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970403 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: NESTOR INC CENTRAL INDEX KEY: 0000720851 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 133163744 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-KT SEC ACT: 1934 Act SEC FILE NUMBER: 000-12965 FILM NUMBER: 97573966 BUSINESS ADDRESS: STREET 1: ONE RICHMOND SQ CITY: PROVIDENCE STATE: RI ZIP: 02906 BUSINESS PHONE: 4013319640 MAIL ADDRESS: STREET 1: 1 RICHMOND SQUARE CITY: PROVIDENCE STATE: RI ZIP: 02906 10-KT 1 48 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [ ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended December 31, 1996 [X] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from July 1, 1996 to December 31, 1996 Commission file Number 0-12965 NESTOR, INC. (Exact name of registrant as specified in its charter) DELAWARE 13-3163744 (State of incorporation) (I.R.S. Employer Identification No.) One Richmond Square, Providence, Rhode Island 02906 (Address of principal executive offices)(Zip Code) (401) 331-9640 (Registrant's Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 Par Value (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period than 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. X Exhibit Index is on Page _________ The aggregate market value of the voting stock held by non- affiliates of the registrant, based on the average bid and asked prices of such stock on March 21, 1997 was $11,229,203. The number of shares outstanding of the Registrant's Common Stock at March 21, 1997 was 8,915,741. DOCUMENTS INCORPORATED BY REFERENCE. Information to be included in registrant's definitive proxy or information statement to be filed with the Commission not later than 120 days following the end of registrant's fiscal year is incorporated by reference in Part III of the Form 10-K. Forms 8-K dated September 19, 1996 and December 10, 1996 are incorporated by reference. ITEM 1. Business Prospective Statements The following discussion contains prospective statements regarding Nestor, Inc. ("Nestor" or "the Company"), its business, outlook and results of operations that are subject to certain risks and uncertainties and to events that could cause the Company's actual business, prospects and results of operations to differ materially from those that may be anticipated by, or inferred from, such prospective statements. Factors that may affect the Company's prospects include, without limitation:, the Company's ability to successfully develop new contracts for technology development; the impact of competition on the Company's revenues or market share; delays in the Company's introduction of new products; and failure by the Company to keep pace with emerging technologies. Readers are cautioned not to place undue reliance on these prospective statements, which speak only as of the date of this report. The Company undertakes no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made by the Company in this report and in the Company's reports filed with the Securities and Exchange Commission. General Nestor, Inc. designs, develops, markets, and supports intelligent software solutions for mission-critical decision applications in real-time environments. Nestor employs proprietary neural network predictive models to convert existing data and business experiences into meaningful recommendations and actions. The Company has leveraged its neural-network software architecture across a wide range of markets, including financial-institution credit/debit card fraud and real-time traffic-control systems. In addition, the Company believes that its technology and software architecture are well suited for intelligent decision applications addressing a variety of other markets, including health care payments, long distance and mobile phone fraud, database marketing, and intranet/internet information discovery applications. On December 10, 1996, the Company changed its fiscal year-end from June 30 to December 31 to better reflect the underlying nature and timing of the Company's product lines. The change in fiscal year-end was effective for the six months ended December 31, 1996 ("transition period"). Background The Company was incorporated under the laws of the State of Delaware on March 21, 1983, in order to exploit, develop and succeed to certain patent rights and know-how relating to the Nestor Learning SystemT ("NLS"), which the Company acquired in 1983 from its predecessor Nestor Associates, a limited partnership. NLS is an adaptive or self-organizing software system, commonly referred to as a neural network, that is capable of extracting the salient features of input patterns without being told what features to look for and of subsequently recognizing similar patterns identified by such features. Thus, NLS can be said to learn from its experience. Nestor Products Nestor offers complete application-software solutions that include adaptive decision models, implementation, education, training, consulting and engineering support services. Current Nestor software products detect credit/debit card fraud (PRISMT), provide remote traffic management of freeways and intersections (TrafficVisionT), provide responsive on-line information to internet Web site visitors (InterSite) and provide much greater efficiencies in document processing and fax distribution environments (OmniTools & N'Route, which were exclusively licensed to NCS in June 1996). Nestor's software solutions are designed for client-server implementation and flexible integration with customers' existing computing infrastructures. Installation time periods for the Company's software solutions depend upon the particular product involved, and can take as little as three days or as long as six months. The Company believes that PRISM customer payback periods for license, installation, and first year user fees are typically less than one year. The Company designs and develops specialized software products utilizing its proprietary software and information-management knowledge, and, to a lesser degree, designs hardware components that will enhance the performance of its software products. The Company's products comprise the following categories: Fraud Detection and Risk Assessment Systems - are designed to effectively detect and control fraudulent transactions for financial institutions that issue credit, debit, or other financial use cards. The Company is evaluating the expansion of these product technologies into additional applications such as health-care payments, long-distance telephone fraud, mobile-phone service theft, and database marketing. Traffic Management Systems - are a combination of internally developed software and internally and externally developed hardware components that perform as a traffic management system for open road and intersection applications. The products enable dual use of video networks to support both traffic/roadway. Internet Web Server0 Systems - are designed to synthesize information from multiple data sources within an organization and provide content to present to Web site visitors based on the current state of the visitor's information. Intersite's purpose is to provide scores of site visitors which are useful in predicting the purchasing behavior of visitors. Intelligent Character Recognition Systems - - include packages of software applications such as OmniTools, NestorReader, and N'Route which increase productivity in document processing and fax distribution environments. Fraud Detection and Risk-Assessment Systems Custom software packages developed by the Company are the Proactive Risk Management (PRISMT) and the Nestor Fraud Detection (FDST) systems, which have been licensed to six financial- services clients as of December 31, 1996. These systems can detect bank-card or credit-card fraud, and can be readily updated by clients to adapt to changing patterns of fraudulent transactions. By monitoring each cardholder's historical and current transactions, PRISM is capable of detecting unusual patterns of card use and of rapidly detecting a significant proportion of fraudulent transactions with an extremely low error rate. Customers have reported a reduction of more than 50% in their credit-card fraud loss experience within 30 days of installation. In March 1993, the Company completed the installation of its FDS product at Mellon Bank. The success of the FDS installation at Mellon has been instrumental in obtaining additional orders for FDS and PRISM. Like many other credit-card issuers, Mellon Bank had been using a rule-based system for fraud detection. Mellon has reported to the Company that FDS is finding 20 times as many instances of fraud as their rule-based system, while requiring reviews of only one-third as many accounts. In December 1994, the Company installed a merchant-fraud detection system at Europay International S.A., a Master Card affiliated association of 700 banks that settle international bank-card transactions involving currency exchange. Experience with United Kingdom and Belgium banks indicates a counterfeit detection rate of up to 50%. In February 1995, the Company announced PRISMT. PRISM enhances the fraud-detection capabilities of FDS to include workflow management and other PC-based productivity tools that are designed to enable the fraud manager and fraud-control team to efficiently identify and track frauds detected by the system. The initial PRISM system was an FDS installed at G.E. Capital Consumer Financial Services, which was upgraded to incorporate PRISM in 1995. PRISM is currently being marketed to financial institutions expanding the company's presence into the retail credit card market and international markets. The following are the primary attributes of the Fraud Detection and Proactive Risk Management Systems: Flexible neural-network decision engine. The Company's software implements a powerful, patented neural-network technology for adaptive fraud detection that is accurate, fast, field-trainable and operates in real-time. The neural-network and rule-bases are provided through software that allows the Company's products to be customized to fit the customers needs and profiles without extensive custom programming. Unlike other rule-based systems, the Company's products learn from the experience of the specific customer accounts instead of applying "industry" experience to the customer's environment. The Company's software can be rapidly trained to look for customer-specific fraud potential by requiring as few as three training passes through a customer's data. The system automatically adapts itself for problem complexity and maximizes the detection of actual fraud while minimizing false positive indications. Automatic and ongoing learning ability. The Company's software is trained to detect fraudulent patterns based upon the customer's own historical data. Subsequent to installation, the software continues to update its records for current patterns and automatically modifies its predictive model to respond to fraud pattern changes in the customer's user base and environment. Other competitive systems may require extensive updating of the software to reflect current industry or customer experience. The Company's software allows the client to operate with the most current and customer-specific database possible, with simple updates entirely under client control. Quick return on initial investment to customers. Due in part to customizing the PRISM software to react based upon a client's specific fraud experience, the product has resulted in fraud loss savings of greater than 50% at G.E. Capital Consumer Financial Services and over 50% in counterfeit detection at Europay International S.A.. Performance at this level would provide a customer experiencing average industry fraud losses a payback on their first year installation and use fees of approximately four to six months. On-line, transaction-based capability. Nestor's software can provide an immediate, situation-specific response to each customer transaction. For example, the PRISM system can immediately detect and report fraudulent activity within the first one or two transactions, rather than within one or two days of transactions. Flexible client-server and operating solutions. Nestor's solutions can be integrated into a customer's existing environment or architecture. The Company's products are based upon a distributed client-server architecture consisting of operating components that operate on a wide range of industry standard, client-server platforms, including the IBM, MVS/CICS, Tandem's proprietary, fault tolerant Non Stop Kernel (NSK), UNIX and Windows NT operating platforms. The Company believes that its product is the only one available today that is adapted to Tandem's NSK operating system, over which the Company estimates more than 65% of the world-wide volume of ATM and Debit-card transactions are processed. PRISM also provides an analysis environment consisting of: a user-friendly, MS Windows-compatible graphical user interface, an "open-systems" architecture that is easily adapted to a client's working environment, fully integrated work flow tools for enhanced productivity, customizable reporting tools, and in-depth fraud analysis and system maintenance tools. Nestor's Fraud Detection and Risk Assessment Strategy The Company's objectives are: to deliver high quality products and services using proprietary neural-network technology to the banking, retail, telecommunications and health-care management industries, and to accrete a growing revenue stream from ongoing product usage fees. The Company's strategy for achieving these objectives includes the following key elements: Expand current distribution network. The Company plans to expand its worldwide direct sales, distribution and service forces. The Company intends to continue developing domestic markets while augmenting its international growth. Nestor has executed a nonexclusive PRISM reseller agreement with CSK Corporation in Japan during 1996 (See "Licensing, Joint Venture and Development Agreements"), and is negotiating marketing agreements in Europe and South America. The Company also intends to increase direct sales efforts in North America through expansion of direct sales staff and through marketing and service agreements with established providers of products and services to its target markets. On September 19, 1996, the Company signed a non- exclusive license agreement with Applied Communications, Inc. (ACI), a subsidiary of Transaction Systems Architects, Inc., under which ACI agreed to distribute PRISM throughout the world. (See "Licensing, Joint Venture and Development Agreements".) Earn recurring revenues through on-going fees based upon product usage. The Company's products provide immediate and ongoing savings to the client through a reduction in the occurrence of undetected fraud losses. The Company has priced its product to include upfront fees for licensing and installation, thereby providing an attractive payback of the customer's initial investment as discussed above, and including an ongoing usage fee based upon the number of customer transactions or accounts being reviewed by the software. This ongoing revenue stream is expected to grow as new customers install the product. Future growth may also result from the customer's internal growth in the number of transactions or accounts being reviewed by the software. Apply PRISM products to other markets. The Company believes that many markets exist which are experiencing fraud type losses and possess data characteristics similar to the financial institution industry. The Company plans to extend the successes of the PRISM product in credit-card fraud detection to other areas with a high level of transactions and a history of similar fraud-type loss experience. Some of these market opportunities may include health-care claim payments and long-distance telephone fraud. Nestor's strategy is to broaden its product offerings to address these markets in conjunction with development funding from strategic government and industry sources. Traffic Management Systems TrafficVision is a combination of Company-developed software and modular hardware components that provide for remote monitoring to support traffic data collection and control of traffic flows. The product is flexible and can be configured to a wide range of road configurations, including open roads and intersections. Features include remote video monitoring, real-time vehicle classification, individual vehicle tracking, simultaneous communication of video and traffic data over a single communication network, and generation and logging to a database of a variety of traffic-information measurements. Historically, traffic sensing and control has been handled by wire induction loops buried beneath the road surface. The system provides basic information such as vehicle counts and speed (with multiple loop configurations), in support of the function of controlling traffic light signals when traffic is present. Such loops experienced a 100% failure rate within the first 10 years of operation. Replacement/repair is often not performed or performed long after loop failure due to the high cost of digging up the roadway. TrafficVision provides all the benefits currently offered by loop systems and substantial additional options that increase the traffic controller's effectiveness in managing traffic congestion, infractions, and accidents. The fact that TrafficVision operates completely above ground aids in effective maintenance. Additionally, the Company believes that the technology will prove to be cost effective in comparison to loop technology in applications of multiple-lane intersections. TrafficVision is designed to incorporate the Company's Ni1000 Recognition Accelerator hardware chip (See "Ni1000 Chip" below). Development of a working prototype model commenced on September 1, 1995, in conjunction with a funding agreement with California Institute of Technology Jet Propulsion Laboratory (see "Licensing, Joint Venture, and Development Agreements"). The project was completed in December 1996 and phase II field testing is expected to be ordered and completed in fiscal 1997. The following are the primary attributes of the Company's Traffic Management Systems: Accurate, real-time interpretation of traffic video images. The Company has leveraged its patented neural-network decision engine discussed above in Fraud Detection to the application of real- time processing and learning in the context of video image interpretation for traffic management and control. Prior industry attempts to provide video-based detection of traffic have not proven effective due to the difficulty of designing robust detection algorithms under a variety of illumination, visibility and traffic conditions, as well as the need to implement such algorithms on cost-effective computing platforms that provide real-time operation. The Company's neural-network technology, combined with its Ni1000 chip, discussed below, is able to interpret video images accurately and respond in a real- time environment. Rapid deployment and increased services for customers. The Company's software solutions are designed for rapid deployment and to provide additional information to customers beyond that delivered by current loop systems. TrafficVision is designed to be installed entirely above ground and to tie into existing customer hardware where appropriate. Maintenance becomes more efficient than with underground loop systems. TrafficVision systems allow the customer to obtain the same information and accuracy as is available through loop technology (e.g. vehicle count and detection for signal control), and additional benefits such as remote real-time video monitoring for traffic flow, vehicle tracking or incidence response. Leverages customer investment in video infrastructure. State traffic departments are deploying roadside video cameras to provide images of road and traffic conditions to better manage traffic flows and incident response. Nestor's Traffic Monitoring Systems are designed to support "dual use" of pan-tilt-zoom equipped cameras for surveillance and traffic detection and monitoring, thus leveraging the customer's investment in existing video equipment. Additionally, Nestor's solution supports simultaneous video and data communication over a single video communication network, thus further leveraging the customer's video infrastructure investment. Compatibility with industry standard platforms. Nestor's traffic monitoring solutions are architected around dominant industry- standard platforms: namely, the Windows 95/NT operating system, tools and communication support components and general "WinTel" hardware specifications. This facilitates integration into a customer's existing computing environment, leverages PC economics to offer a compelling price/performance advantage and lowers product engineering development costs. Additionally, the Company's Traffic Monitoring Systems are designed to support the emerging NTCIP communications standards being mandated in the traffic detector industry. Further, roadside TrafficVision detector stations will be compatible with existing and new traffic controller hardware, such as the new CALTRANS 2070 controller standard. Nestor's Traffic Management System Strategy The Company's objectives are to be the high-quality supplier of intelligent video-based traffic monitoring systems to replace loop detectors at those sites where video has advantages in either functionality or cost and to capture new traffic monitoring applications beyond the capability of loop detector systems. The Company's strategy for achieving these objectives contains the following key elements: Expand national and worldwide distribution. The Company plans to target leading transportation departments (DOTs) through direct sales to provide convincing demonstrations of TrafficVision's superior performance, to create performance standards based upon TrafficVision functionality and to generate a market pull that will lead to volume distribution agreements with traffic integrators and traffic equipment suppliers. The Company intends to establish distribution agreements with foreign traffic integrators, concentrating initially in the Far East where the Company believes large investments are being planned in transportation infrastructure. Maintain technology leadership and patent protection in developed solutions. As noted above, the Company has obtained patent protection for its proprietary neural networks and hardware systems (see "Patents") which the Company believes to be uniquely suited to applications that require field trainability or self- modification to adapt to new or changing patterns in the data. The Ni1000 chip allows for high-speed processing applications, such as video-image processing, on a personal computer platform. The Company continues to maintain and explore new patent protection rights for its proprietary software applications. The Company was issued a new patent in fiscal 1996, and has an application pending relating to its work in the traffic- management areas. Ni1000 Chip, PCI 4000 Recognition Accelerator Board and IBM ZISCT Chip Neural networks are inherently parallel systems whose operation, until recently, has only been simulated on serial computers. The relative slowness of serial simulation has prohibited the use of neural networks in many high-value applications that require high- speed learning and recognition. The Ni1000 Recognition AcceleratorT chip is an embodiment of the Company's technology that increases typical processing speeds by hundreds of times and is expected to open these previously untapped markets to neural- network solutions. Manufactured by Intel and introduced by the Company in June 1994, the Ni1000 chip was developed with funding by the Defense Advanced Projects Research Agency ("DARPA"). Commercial delivery of Ni1000 chips and Ni1000 Development Systems began in June 1994. In April 1994, the Company and Intel Corporation signed an agreement which provided the Company with exclusive marketing rights to the Ni1000 Recognition Accelerator, subject to certain minimum purchases of the Ni1000 Recognition Accelerator by the Company. (See "Licensing, Joint Venture and Development Agreements.") In connection with the development of the Ni1000 Recognition Accelerator, the Company and Intel were jointly named as winner of the 1994 Discover Awards for Technological Innovation in the category of Computer Hardware & Electronics. The Ni1000 Recognition Accelerator was selected by the editors of Electronic Design News as a finalist in their 1994 "Innovation of The Year" contest. Continued development work in neural-network hardware was centered on the development of a PC-compatible circuit-board incorporating multiple Ni1000 Recognition Accelerators, and associated development-environment software. Development of the circuit board and software were funded, in part, by a contract dated August 26, 1993, between the Company and Office of Naval Research and administered by the Advanced Projects Research Agency of the Department of Defense ("ARPA"). In connection with such development work, the Company entered into a Technology Development Subcontract with Alta Technology Corporation on December 20, 1994 (see "Licensing, Joint Venture and Development Agreements", below). PCI 4000 Recognition Accelerator Board An outgrowth of the Company's ARPA-funded development work is the PCI 4000 Recognition AcceleratorT, which was developed cooperatively with Alta Technology Corporation. The PCI 4000 is a circuit board containing up to four Ni1000 Recognition Accelerators and a Pentium controller, which is compatible with any PC or workstation that provides PCI (Peripheral Component Interconnect) support. IBM ZISCT Chip On January 31, 1996, the Company signed a technology licensing agreement with IBM to use Nestor's pattern recognition technology in an IBM developed neural-network semiconductor device called the ZISCT (see "Licensing, Joint Venture and Development Agreements"). The Company believes that the entry of IBM into the field of neural-network applications may assist the Company in the marketing of its own hardware components. Internet Web Server Systems During 1996, the Company began development of an internet product incorporating the neural-network technology called Nestor InterSite. Nestor InterSite is server-side software that enables the Web host to understand individual on-line customers and dynamically present personalized content. To date, the Internet has largely been used as a medium for the broadcast of static information. Its potential for truly interactive dialogs has not been realized. However, the Internet, or more specifically the World Wide Web, is undergoing a revolution. New technologies are being introduced which will cause Internet web sites to become dynamic and personalized. The growth of commerce on the Internet is just beginning. However, the Company believes several industries are poised to rapidly expand their sales through this channel. Most prominent among these is the financial services industry, which is expected to rapidly adopt the internet as a viable business medium. Nestor InterSite will allow vendors to learn about their web visitor community, permitting the web host to tailor its products and services accordingly. Vendors should retain more customers, sell more products to those customers and identify customers who are interested in premium products and services. The following are the primary attributes of Nestor InterSite: Neural Network Scoring Models: Nestor InterSite employs multiple models by which to score visitors, producing scores in several basic categories: Attitudinal: analyze visitors into psychographic categories according to their answers to information source preferences and produce a probability of affiliation with one attitudinal segment. Conceptual: analysis of full-text within visited Web pages, call center logs, and chat and news groups enables the extraction of semantic interests. Nestor InterSite produces the top 10 conceptual categories for each visitor. Sales Receptivity: models the correlation between source data and purchasing behavior. The purchasing behavior which is scored includes the probability of interest in an up-sell, a cross-sell, or a promotion. Data Acquisition: Nestor InterSite stores a visitor profile for all registered visitors. The system collects data from all available sources which are relevant for scoring customer interests. Supported data sources include legacy databases, call center logs, Web page forms, and Web site text. Nestor InterSite combines data from these sources into a set of SQL tables which are stored locally on the Nestor InterSite server. Control Center: Site visitors' scores are matched to available content through a powerful user interface. The Control Center enables the analysis of the visitor community according to model measures along with the assignment of content based on scores. Nestor's Internet Web Server System Strategy The Company's objective is to deliver high quality products and services coupling proprietary neural-network technology with industry-standard Unix and Microsoft platforms. The financial services industry will be the first industry the Company targets. The Company's strategy for achieving its objective includes the following key elements: Complete initial installations. The Company will concentrate on completing and installing beta versions of InterSite by mid 1997. These installations will become the references for full product- rollout in late 1997. Develop sales channels. Nestor InterSite will be sold as a complete backoffice solution to automate marketing communications through the Web. A sale will include integration with legacy systems, development of custom models, training of webmasters and business managers and annual maintenance. This type of product dictates a consultative sales strategy. The Company's initial approach will be through direct sales. These efforts will be augmented by teaming with partners who can complement the productivity improvements provided by Nestor InterSite. Internationally, Nestor will initially employ direct sales efforts, leveraging off of the Company's international success with the Prism product. Intelligent Character Recognition Products On June 11, 1996, the Company licensed the exclusive development and marketing rights in its Intelligent Character-Recognition ("ICR") products (NestorReader, OmniTools, and N'Route) to National Computer Systems, Inc. ("NCS"), and is no longer involved in developing, packaging and marketing these products (see "Licensing, Joint Venture and Development Agreements"). The Company expects to receive royalties from the sales of these products and any enhanced versions of these products by the licensee. The following are the principal ICR products developed and marketed by the Company through June 11, 1996, and marketed by NCS since then: NestorReader(TM) NestorReader is a software product that is designed to perform character recognition from images of hand-printed and machine- printed characters in intelligent character recognition systems. A principal application of NestorReader has been to replace the human process of reading data from forms and entering the data into computers by means of a keyboard. NestorReader is licensed to original equipment manufacturers, value-added resellers and systems integrators for integration into image-processing systems. NestorReader extends the range of optical character recognition to include hand print and faxed characters at a price/performance ratio that the Company believes is unequaled by competitive technologies. In optical character recognition, existing techniques have successfully solved the problem of reading conventional, clean, machine-printed characters. Management believes that hand printed characters - with their high degree of variability - and faxed characters, with their high noise level, can only be read satisfactorily by more powerful technologies like NestorReader. OmniTools(TM) OmniTools is a software product that enables corporate applications developers to access the functionality of NestorReader from within Windows applications without the need for C programming. Developers need only use such familiar tools as Visual Basic or applications macro languages including Visual Basic for Applications. ICR solutions can thus be developed from Access, Excel, Foxpro, Lotus 123, Paradox and other Windows applications. The Company began marketing OmniTools in fiscal 1994. N'Route N'Route is a Windows end-user application that automatically routes incoming faxes and scanned images directly to their intended recipients. N'Route does this by recognizing the name or other identifier written on a document and then routing the document to its destination "mailbox" on Lotus Notes, cc:Mail or Windows for Workgroups users with Microsoft Mail. Installation and maintenance by a network administrator is by dialog boxes and menus and requires no programming or character-recognition expertise. In February 1995, N'Route was awarded the Imaging Magazine "Product of The Year" award for 1994. Sales, Marketing and Methods of Distribution The Company sells and markets its software and services in North America through a direct sales organization and through third- party licensing agreements. Outside of North America, the Company negotiates marketing agreements with various industry service providers. The Company's product lines are targeted toward large commercial users (e.g., banks for the PRISM product), or federal and state government agencies (e.g., Departments of Transportation for the TrafficVision product). The products require technical assistance through the sales and installation processes. Accordingly, the Company maintains an in-house staff of engineers to support the sales, installation, and customer-service functions. The Company's FDS and PRISM products are licensed directly by the Company to financial institutions. The TrafficVision products will be marketed directly to governmental traffic management departments or their chosen integrators. The Ni1000 Recognition Accelerator and the Ni1000 Development System are marketed directly by the Company to developers of high-speed applications, and are used in internally developed products. The Company's Intelligent Character Recognition products are marketed exclusively by NCS. The Company obtains product inquiries from product mailings, attendance at trade shows, media advertising, trade-press coverage and its internet site. In financial services, the Company has in the past created custom applications including risk assessment for bank-card fraud detection, mortgage origination and insurance, consumer credit and securities trading. Nestor's FDS and PRISM products are an outgrowth of such development projects. In the United States and Canada the Company markets FDS and PRISM directly. The Company has worldwide licenses with Total Systems, Inc. (Total) to provide its PRISM product to customers for which Total provides card processing services, and ACI who packages PRISM with its BASE24 and TRANS24 products for worldwide distribution. In Japan, custom financial applications are marketed through its licensee, CSK Corporation. FDS and Prism are licensed to applications developers in Europe and Japan under a standard, non- transferable, non-exclusive software license limited to a single computer. Developers of applications may not make, use or sell multiple copies of such applications without entering into additional licensing arrangements with the Company. Management of the Company believes that the success of the PRISM and FDS products will create a valuable franchise in each institution, leading to extensions of the Company's technology to other risk- assessment applications. During the transition period, the Jet Propulsion Laboratory, GE Consumer Credit Financial Services, BankOne, Mellon Bank and Customer Services, Inc. accounted for 19%, 18%, 15%, 13% and 11%, of the Company's revenues respectively. In fiscal 1996, National Computer Systems and Europay International accounted for 30% and 13% of the Company's revenues, respectively. In fiscal 1995, Europay International accounted for 16% of the Company's revenues. The loss of any of these customers for any reason could have a material adverse effect on the Company's business, financial condition and results of operations. The Company is not required to maintain significant inventories in order to deliver its products. The Company does not generally grant payment terms to customers in excess of 90 days. At December 31, 1996, the Company had a backlog of approximately $209,000 in undelivered development and installation contracts and approximately $582,000 in prepaid royalties. As of June 30, 1996, the Company had a backlog of approximately $408,000 in undelivered development and installation contracts and $431,000 of prepaid royalties and fees. As of June 30, 1995, the Company had a backlog of approximately $101,000 in undelivered development and installation contracts and $439,000 of prepaid royalties and fees. Technology The Company's technology deals with the problem of pattern recognition. When presented with a pattern of information, it can be valuable to identify that pattern, whether it is a pattern of fraudulent credit card use, fraudulent health care claims, handwritten characters, vehicles in a traffic flow, and so on. Several methods currently exist to address the problem of processing information in order to recognize a pattern in the information. Included among these are "expert" systems of rules, and neural networks. The Company's products combine both of these methods to optimize pattern recognition capabilities. Rule-Based Technology. The Company's systems employ expert or rule-based technology to define customer strategy, policy and procedures in its products. Rule-based systems contain decision trees of conclusions based on the existence of various conditions. For example, a credit card transaction has been authorized. To determine if that transaction was fraudulent and whether or not an account should be investigated, the following set of questions may be asked: has the card been reported lost or stolen since the transaction occurred? If "yes", the transaction equals "fraud"; if no, did the purchase amount exceed the credit limit? If "yes", did the purchase occur less than one hour after the previous purchase? If "yes, and so on. It is almost impossible to cover all possibilities of combinations of circumstances even with the most comprehensive suite of rules. So, while allowing the implementation of select rules may be beneficial, a decision based solely on rules may not always be correct or practical. Neural-Network Technology. Neural-networks simulate a virtual network of interconnected units, processing data in parallel, and communicating with each other at lightning speeds. A trained neural-network expects input and then outputs a response: either "unrecognized", "recognized", or "not sure". Exceeding the capability of if-then-else conditional rules, the power of the neural-networks is in their ability to accurately recognize input, such as attempting to recognize characters from a scanned handwritten sample, which is ill-defined (i.e. written in very light pencil), affected by "noise" (i.e. smudged), or blatantly unusual (i.e. overly large or small, or containing skewed characters). Nestor, as the result of extensive research, has created a proprietary neural-network technology referred to as the Restricted Coulomb Energy ModelT (RCE) which has been granted five patents. The RCE model has many unique features. It has the fastest learning and processing speed of any neural-network system. It has been demonstrated that the RCE will learn to recognize patterns orders of magnitude faster than a typical public domain neural-network such as Back Propagation (BP). RCE has the ability to add new features or classes without the need to retrain and re-engineer the complete system. For example, using BP, experts must re-engineer and completely retrain the entire system if new features or classes are added. Re-engineering and retraining is impractical for many real-world applications. RCE is a dynamic configuration of the network so that it can scale and configure itself to accommodate the complexity of a problem and make the most efficient use of available hardware. With BP, one must precisely engineer the number of neurons through experimentation in order to use the technology, and a stable solution is not guaranteed. Nestor has also been granted a sixth patent for a multi-unit system referred to as the Nestor Learning SystemT (NLS) which is ideally suited for many real-world pattern recognition applications. The NLS has a patented hierarchical, multi-network system for better control and accuracy. This approach is analogous to the way the human neural-network is believed to function. The Company believes that the rapid model development and operational flexibility afforded by its technology provides a competitive advantage in the development of intelligent-decision software solutions. Research and Development Activities of the Company The Company believes that its future depends upon its ability to improve its current technologies and products and to develop new technologies and products. The Company intends to pursue new and enhanced technologies and products. The Company attempts to locate external resources to assist in the costs of developing new technologies or products, but may bear all or a portion of such costs internally. The Company's research is almost entirely applied research intended to develop solutions to specific pattern-recognition problems. This research has resulted in various patents relating to improvements to the Company's basic technology (see "Patents"). The Company received one new patent in fiscal 1996 and has one application pending as of December 31, 1996. These improvements are incorporated into the Company's products. The market for the Company's products may be impacted by changing technologies. The Company's success will depend upon its ability to maintain and enhance its current products and develop new products in a timely and cost-effective manner that meets changing market conditions. There can be no assurance that the Company will be able to develop and market on a timely basis, if at all, product enhancements or new products that respond to changing market conditions or that will be accepted by customers. Any failure by the Company to anticipate or to respond adequately to changing market conditions, or any significant delays in product development or introduction could have a material adverse effect on the Company's business, financial condition and results of operations. The Company expended, in the six months ended December 31, 1996, and in the fiscal years ended June 30, 1996, 1995, and 1994 respectively, $294,000, $823,000, $2,093,000 and $1,160,000 in support of the various aspects of Company-sponsored research and development. Patents The Company has continually sought and obtained patent protection for its proprietary neural networks and systems, which have as a principal feature rapid learning from a relatively small number of examples. The Company believes that this capability makes the Company's technology uniquely suited to applications that require field trainability or self-modification to adapt to new or changing patterns in the data. The Company's patents also cover multiple-neural-network systems, which enable the company to develop products that combine high accuracy with high processing speeds; and the Company's RCE neural network, which exhibits rapid learning and minimizes the internal connections needed for its functioning. This sparse connectivity has enabled the Company to develop, with Intel Corporation, a neural-network integrated circuit (the Ni1000 Recognition AcceleratorT chip) containing many more nodes than has been possible with other designs. The Company owns ten United States patents and twenty-three foreign patents issued in eleven countries. In addition, there is one application pending in the United States, and there are five applications pending in various foreign countries, as of December 31, 1996. The foreign patents and patent applications correspond to one or more of the United States patents. In the field of web server systems, the Company faces competition from a number of sources, including commodity-software providers, traditional database vendors, and vertical solution providers. The first two groups include such companies as Microsoft, Netscape and Oracle. Companies providing vertical solutions include BroadVision, Inc. and Firefly, Inc. The market for internet-oriented products is intensely competitive with new competitors emerging frequently. The Company believes that seven of its United States patents, and eleven corresponding foreign patents, are material to its business. These United States patents expire at various times from 1998 to 2008. The corresponding foreign patents expire at various times from 1995 to 2008. The following table lists the Company's material United States patents:
4,254,474 An Information Processing System Using Threshold Passive Modification March 3, 1981 1998 4,326,259 Self-organizing General Pattern Class Separator and Identifier April 20, 1982 1999 4,760,604 Parallel, Multi-unit, Adaptive, Nonlinear Pattern Class Separator and Identifier July 26, 1988 2005 4,897,811 N-Dimensional Coulomb Neural Network Which Provides for Cumulative Learning of Internal Representations January 30, 1990 2007 4,958,375 Parallel, Multi-unit, Adaptive Pattern Classification System Using Inter-unit Correlations And An Intra-class Separator Methodology September 18, 1991 2008 5,054,093 Parallel, Multi-unit, Adaptive, Nonlinear Pattern Class Separator and Identifier October 1, 1991 2008 5,479,574 Method and Apparatus for Adaptive Classification December 26, 1995 2012
Competition In the field of fraud-detection and risk-assessment systems, the Company encounters competition from a number of sources, including (a) other software companies, (b) companies' internal MIS departments, (c) network and service providers, and (d) neural-network tool suppliers. In the fraud-detection market, the Company has experienced competition from Fair, Isaac & Co., HNC Software, Inc., IBM, NeuralTech Inc., Neuralware, Inc., Visa International and others. The Company's fraud detection product also competes against other methods of preventing credit-card fraud, such as card-activation programs, credit cards that contain the cardholder's photograph, smart cards and other card authorization techniques. The introduction of these and other new technologies will result in increased competition for the Company and its products. In the field of traffic management systems, the Company's TrafficVision products (see "Recent Product Developments") face competition primarily from standard providers of existing loop system products. Other technologies exist from various sources that provide some of the basic traffic management functions provided by the loop system, such as Microwave, Ultrasonic, Infrared, and Acoustic. The Company believes that these technologies have limitations and do not provide the full range of options available through TrafficVision. Video-based systems are also available through other companies such as Econolite, Peek Traffic, Odetics, Traficon, Siemens, and Rockwell International. However, the Company believes that the platforms on which these video-based products operate do not provide the image processing capabilities possessed by TrafficVision and the Ni1000 Recognition Accelerator Chip. In the field of high-speed processing, the Company's Ni1000 Recognition Accelerator product (see "Recent Product Developments", above) faces competition primarily from Adaptive Solutions, Inc., whose CNAPS board contains proprietary parallel- processing integrated circuits. The Company believes that the CNAPS board is a general-purpose parallel processor that is not optimized for pattern classification. The Company further believes that the CNAPS board and associated software have a list price that is approximately 50% higher than similar configurations of the Company's Ni1000 products, and that the Company's hardware products typically operate at speeds 10 to 50 times faster than the CNAPS product in pattern-classification applications. Most of the Company's competitors have significantly greater financial, marketing and other resources than the Company. As a result, they may be able to respond more quickly to new or emerging technologies or to devote greater resources to the development, promotion and sale of their products than the Company. Competitive pressures faced by the Company may materially adversely affect its business, financial condition and results of operations. Employees As of December 31, 1996, the Company had 37 full-time employees, including 23 in product development, 7 in sales and marketing and 7 in finance and administration. Three of these employees have earned Ph.D. degrees. One of the Company's current directors (and a founder of Nestor Associates) received the Nobel Prize in Physics in 1972. All of these employees are located in the United States. None of the Company's employees is represented by a labor union. The Company has experienced no work stoppages and believes its employee relationships are generally good. The Company's success depends to a significant degree upon the continued employment of the Company's key personnel. Accordingly, the loss of any of the Company's key personnel could have a materially adverse effect on the Company's business, financial condition and results of operations. No employee currently has an employment contract in place with the Company. The Company believes its future success will depend upon its ability to attract and retain industry-skilled managerial, engineering, and sales personnel, for whom the competition is intense. In the past, the Company has experienced difficulty in recruiting a sufficient number of qualified sales people. In addition, competitors may attempt to recruit the Company's key employees. There can be no assurance that the Company will be successful in attracting, assimilating and retaining such qualified personnel, and the failure to attract, assimilate and retain key personnel could have a materially adverse effect on the Company's business, financial condition and results of operations. Licensing, Joint Venture and Development Agreements The Company seeks to enter into license agreements and research and development contracts in order to obtain greater market penetration and additional funding of the development of its technology in specific fields of use. Total Systems, Inc. During the six month period ended December 31, 1996, the Company designed and installed a fraud detection system for Total Systems, Inc., a major provider of card processing services for financial institutions. Total Systems will provide PRISM fraud detection services to its customers along with the other transaction processing services. The Company will receive fees based upon the number of transactions that are scored by PRISM and expects revenues to commence in the second quarter of 1997. Applied Communications, Inc. (ACI) On September 19, 1996, the Company entered into a non-exclusive license agreement with ACI which grants to ACI the right to integrate PRISM with ACI's products and distribute on a worldwide basis. ACI provides authorization and transaction processing software to more than 475 customers throughout the world. The Company will receive royalties based on PRISM license, engineering and ongoing use fees received from ACI sublicenses. National Computer Systems, Inc. (NCS) On June 11, 1996, the Company entered into an exclusive Licensing Agreement and an Asset Purchase Agreement with NCS transferring the development, production, and marketing rights of the Company's Intelligent Character Recognition (ICR) products to NCS. The Company received $1,400,000 as an initial license fee pursuant to the Licensing Agreement, and expects to receive royalties on future sales of the product by NCS. Minimum annual royalties range from $160,000 in 1997 to $350,000 in 2001 and beyond. If NCS terminates its exclusive rights under the contract, minimum royalty payments would not be required subsequent to such termination. The Asset Purchase Agreement transferred tangible and intangible assets used exclusively in the ICR business to NCS for $300,000. The initial license fee and asset sale proceeds are recognized as revenues in Fiscal 1996. IBM ZISC (TM) On January 31, 1996, the Company signed a technology licensing agreement with IBM to use Nestor's pattern recognition technology in an IBM developed neural network semiconductor device. IBM has the right to use the technology in the IBM ZISC (zero instruction set computing) digital integrated Neural Network chip and in future versions of the chip and related product enhancements. The IBM ZISC chip is expected to enable such complex mission- critical applications as image recognition for satellite, military and medical operations, financial data management and risk assessment, automotive applications, as well as highly sensitive identification systems such as sonar and fingerprinting and other crime-scene type analysis. The Company will receive royalties from the sales of the chip and related products. California Institute of Technology Jet Propulsion Laboratory (JPL) On September 1, 1995, the Company commenced a partially funded development agreement with JPL to design a Traffic Surveillance and Detection Technology capable of directly measuring desired traffic parameters simultaneously, combined with higher accuracy and at a lower cost than available with current technology. The Company is applying its expertise in rapid pattern recognition and neural network designs to the project. The prototype and initial program was completed in December 1996. The Company expects to receive a Phase II contract for field testing of the prototype in early 1997. The total value of the contract is $597,000, all of which had been recognized as revenue by December 31, 1996. DARPA/ARPA The Company entered into a development agreement dated March 13, 1990 with DARPA for the development of a neural-network chip prototype embodying the Company's proprietary technology. On April 21, 1992 the Company and DARPA agreed to increase the contract to approximately $1,630,000 and extended the expected completion date to May 1993. In May 1990, the Company signed a Technology Development Agreement with Intel Corporation, under which Intel agreed to provide the design and manufacturing capabilities to satisfy the requirements of the contract with DARPA. The total cost to the Company of the subcontract with Intel is $750,000. On April 30, 1992, the cost of the subcontract was increased to $1,050,000. During the year ended June 30, 1993 the Company included in revenue approximately $436,000 relating to its work under the DARPA contract. On August 26, 1993, the Company entered into a follow-on program with ARPA (formerly known as DARPA) to design and produce a PC compatible application design and development environment, comprising both hardware and software, which will enable users to incorporate the Ni1000 into products. The total value of this contract, which was completed in December 1995, was $776,167, of which approximately $423,000 was realized in fiscal 1994. CSK On June 13, 1996, the Company executed a nonexclusive PRISM Reseller Agreement with CSK Corporation to market, install, maintain, train and support the PRISM product in Japan. The agreement is for a term of two years. As of December 31, 1996, CSK had received orders from three Japanese financial institutions for PRISM feasibility studies. Intel Corporation On October 15, 1993, the Company and Intel Corporation had entered into a license agreement, pursuant to which Intel acquired a non-exclusive right to develop and sell products incorporating the Company's technology. On April 7, 1994, the license agreement was amended to grant to the Company exclusive marketing rights to the Ni1000 Recognition Accelerator Chip, which Intel will manufacture and sell to the Company subject to the Company's meeting certain minimum purchase requirements. If such minimum purchase requirements are not met by the Company, the Company's right to market the Ni1000 Recognition Accelerator Chip will become non-exclusive. The Company placed the first required minimum purchase order in June 1995 and has maintained minimum order requirements. Alta Technology On December 20, 1994, the Company entered into a Technology Development Subcontract ("the Subcontract") with Alta Technology Corporation ("Alta") relating to the development of a multi-chip Ni1000 circuit board. Pursuant to the Subcontract, the Company and Alta granted to each other licenses to use certain of their respective proprietary technologies that are required for manufacturing the Ni1000 circuit board, including Ni1000 boards to be delivered to ARPA under a contract between the Company and the Office of Naval Research. The Subcontract is in the amount of $154,200 payable by the Company to Alta, upon receipt by the Company of payments by ARPA, during the period ending May 31, 1995. As of June 30, 1995, the Alta subcontract had been re- negotiated to $194,200, and Alta had billed the Company in the aggregate amount of $198,000. Of the total ARPA contract of $776,167, the Company had billed $765,841 to ARPA at June 30, 1995, and the remainder in 1996. Recent Financing On August 4, 1994, Wand Partners, Inc. purchased from the Company, for an aggregate purchase price of $1,500,000, (i) 1,500 shares of Series C Convertible Preferred Stock of the Company which are presently convertible into 1,000,000 shares of Common Stock of the Company, and (ii) a warrant to purchase 1,000,000 shares of Common Stock of the Company at a price of $1.50 per share ("Wand Warrants"). The net proceeds to the Company of this transaction, after expenses, were $1,470,000. Pursuant to a Standby Financing and Purchase Agreement dated March 16, 1995, Wand loaned to the Company the sum of $1,200,000 evidenced by a promissory note (the "Note") which bears interest at the rate of 10% per annum payable in shares of Common Stock of the Company valued at $1.00 per share until September 15, 1995 when the Note matures. On June 30, 1995, the Company and Wand entered into a First Amended and Restated Standby Financing and Purchase Agreement, pursuant to which Wand made an additional loan to the Company bringing the principal amount of the Note to $1,700,000 and extended the term of the note to October 15, 1995. The Note is callable by the holder at any time up to the commencement of the rights offering in the event of a material adverse change in the condition or prospects of the Company. Wand has agreed to waive the Rights that it otherwise would have been entitled to receive in the rights offering to shareholders described below. Instead, upon the conclusion of the rights offering, Wand has agreed to cancel and surrender the Note to the Company and to apply the principal amount of the Note, and an additional $300,000 first to the purchase of up to a maximum of 220,000 Unregistered Units (in proportion to the Units purchased by other stockholders of the Company pursuant to this offering) and then to the purchase of additional shares of Series C Convertible Preferred Stock. The terms and conditions of such Series C Convertible Preferred Stock are the same as the 1,500 shares of Series C Convertible Preferred Stock previously owned by Wand. Concurrently with the purchase by Wand of such additional shares of Series C Convertible Preferred Stock, the Company reduced the exercise price of the Wand Warrants from $1.50 per share to $0.65 per share. The Company will record an expense as a result of the reduction in exercise price upon exercise of warrants. The expense will represent the difference between the market value of the Company's Common Stock being acquired and the aggregate reduced exercise price of the warrants on the date of exercise, but not more than the reduction in exercise price. The maximum such expense to be recorded will be $850,000. During the period ended December 31, 1996, the Company began recording, on a prorated basis, the maximum expense over the remaining life of the warrants. As consideration for this commitment, the Company has issued to Wand as a commitment fee 100,000 shares of the Common Stock of the Company, the market value of which was charged to operating expenses in 1995. Upon completion of the offering and the conversion of the Note as described above, the Company has agreed to issue to Wand 700,000 ten-year warrants to purchase shares of the Common Stock of the Company at $1.00 per share, and the difference between the market value of the underlying Common Stock of the Company and the aggregate exercise price of such warrants was charged to operating expenses at the time of issuance of such warrants in the amount of $131,250 during fiscal 1996. On August 16, 1995, a registration statement filed by the Company with the Securities and Exchange Commission became effective. The registration statement related to the shares received upon the exercise of warrants in April 1994 as described above, and to the shares underlying certain warrants issued to the Selling Agent of the first private placement described above. The registration statement was filed principally to effect a rights offering to shareholders of the Company, each of whom was granted the right to purchase one Unit for each five shares of Common Stock owned or into which convertible preferred stock was convertible. A Unit consisted of one share of Series D Convertible Preferred Stock, which is convertible into Common Stock at any time after January 1, 1996, and a warrant to purchase one-half share of Common Stock at a purchase price of $2.00 per share. Such warrants are exercisable immediately and for a term of three years after the effective date of the registration statement. At June 30, 1995, there were outstanding 1,500 shares of Series C Convertible Preferred Stock. In early October 1995, Wand exchanged certain Notes payable for an additional 1,970 shares of Series C Preferred Stock. On January 31, 1996, Wand exchanged all of its Series C Convertible Preferred Stock for 1,444 shares of Series E Convertible Preferred Stock and 2,026 shares of Series G Convertible Preferred Stock. In addition, on January 31, 1996, Wand purchased 599 shares of Series F Convertible Preferred Stock for a total of $599,000. On March 7, 1996, Wand purchased 777 shares of Series G Convertible Preferred Stock for a total of $777,000. See below and Item III, Financial Statements and Footnotes. Series E, F,G and H Convertible Preferred Stock Each share of Series F and G Preferred Stock is convertible at the option of the holder at any time after June 30, 1996 into shares of Common Stock at the conversion price of $1.25 per share, subject to adjustment. Each share of Series E and H Preferred Stock is convertible at the option of the holder at any time and from time to time into shares of Common Stock at the conversion price of (a) $1.50 per share subject to adjustment prior to August 1, 2004 or (b) on or after August 1, 2004 at a conversion price which is the lower of $1.00 or the conversion price in effect pursuant to (a). Except as provided herein, any holder of Series E and G Preferred Stock that is subject to the Bank Holding Company Act of 1956 ("BHCA Holder"), as amended, shall have no voting rights. Each holder of Series E and G Preferred Stock that is not a BHCA Holder shall be entitled to vote on all matters as to which stockholders of the Company are entitled to vote, and each such holder shall be entitled to cast a number of votes equal to the greatest number of whole shares of Common Stock into which such holder's shares of Series E and G Preferred Stock could be converted. The holders of the Series F and H Convertible Preferred Stock are entitled to one vote for each share of Common Stock into which the shares are convertible. In the event the Company is in default with respect to the payment of (i) two consecutive cash dividends after the "Restricted Period" as hereinafter defined or (ii) two dividends within any six consecutive dividend periods the holders of the Series F and G Preferred Stock shall have the right to elect two directors and the holders of the Series E and H Preferred Stock shall have the right to elect four directors for so long as the default continues. In the event the Company is in default with respect to the payment of (i) four consecutive cash dividends after the Restricted Period as hereinafter defined or (ii) four dividend payments within any eight consecutive quarterly dividend periods, the holders of the Series F and G shall have the right to elect four directors and the holders of the Series E and H Preferred Stock shall have the right to elect eight directors for so long as the default continues. In the event the Company violates the provision of, or is in default under the terms of any loan agreement or in the event a judgment is entered against the Company or any subsidiary in the amount of $50,000 or more, the holders of the Series F and G Convertible Preferred Stock shall have the right to elect four directors and the holders of the Series E and H Preferred Stock shall have the right to elect eight directors for so long as the default continues. The holders of the Series F and G Preferred Stock, except during the Restricted Period, are entitled to receive out of funds of the Company legally available for such purpose as and when declared by the Board of Directors of the Company quarterly dividends in cash at a rate of nine percent (9%) compounded daily per annum of the stated par value per share ($1,000 on original issuance) of Series F and G Preferred Stocks. Dividends shall accrue, be accumulated and added to the stated value whether or not declared. So long as any shares of Series F and G Preferred Stock are outstanding, the Company shall not declare or pay any dividends on any outstanding Common or Preferred Stock, other than the Series D, F and G Preferred Stock. The Restricted Period as it relates to the payment of dividends on the Series F and G Preferred Stock means a period beginning on the date of issuance of the Series F and G Preferred Stock and ending on September 30, 1997. While no dividends are payable during the Restricted Period, they will accrue and accumulate during the Restricted Period. The holders of the Series E and H Preferred Stock, except during the Restricted Period, are entitled to receive out of funds of the Company legally available for such purpose as and when declared by the Board of Directors of the Company quarterly dividends in cash at a rate of seven percent (7%) compounded daily per annum of the stated par value per share ($1,000 on original issuance) of Series E and H Preferred Stocks. Dividends shall accrue, be accumulated and added to the stated value whether or not declared. So long as any shares of Series E and H Preferred Stock are outstanding, the Company shall not declare or pay any dividends on any outstanding Common or Preferred Stock, other than the Series D, F and G Preferred Stock. The Restricted Period as it relates to the payment of dividends on the Series E and H Preferred Stock means a period beginning on the date of issuance of the Series E and H Preferred Stock and ending on the earlier of (a) the first day of the calendar quarter in which the Company first pays cash dividends on its Common Stock or (b) June 30, 1998. While no dividends are payable during the Restricted Period, they will accrue and accumulate during the Restricted Period. The Company is obligated to redeem all outstanding shares of Series E, F, G and H Preferred Stock outstanding at the stated value plus accrued dividends on August 1, 2004. The holders of the Series E, F, G and H Preferred Stock have the right to require that the Company redeem, to the extent the Company may lawfully do so, all or a portion of the then outstanding shares of Series E, F, G and H Convertible Preferred Stock at the stated value plus accrued interest and unpaid dividends in the event of a merger, reorganization, transfer of the majority of the voting securities of the Company, or sale of more than 25% of the assets of the Company. ITEM 2. Properties. The Company leases offices and research and development facilities, consisting of approximately 10,000 square feet, located at One Richmond Square, Providence, Rhode Island 02906, for which the annual base rental is $141,742. The Company believes these facilities will be adequate to serve its needs in the foreseeable future. ITEM 3. Legal Proceedings. There are no material pending legal proceedings as of the date of this filing. ITEM 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the second quarter of the period ended December 31, 1996. ITEM 5. Market for Registrant's Common Stock and Related Securityholder Matters The Company's common stock was first offered to the public in December, 1983. The principal market in which the Company's common stock is traded is the over-the-counter market. The quotations below reflect inter-dealers prices, and do not include retail markups, markdown or commissions and may not necessarily represent actual transactions. The shares of common stock are traded in the over-the-counter market and bear the symbol "NEST". Low Bid High Ask Period Ended December 31, 1996 1st Quarter 1 11/16 3 1/4 2nd Quarter 2 1/8 3 Year Ended June 30, 1996 1st Quarter 1 1/4 1 11/16 2nd Quarter 9/16 1 3/8 3rd Quarter 23/32 2 3/16 4th Quarter 1 3/8 3 3/16 Year Ended June 30, 1995 1st Quarter 1 2-3/8 2nd Quarter 5/8 1-1/4 3rd Quarter 1/2 3-3/8 4th Quarter 1-1/4 2-1/2 As at March 21, 1997, the number of holders of record of the issued and outstanding common stock of the Company was 415. The Company has not declared any cash dividends with respect to its common stock since its formation. ITEM 6. Selected Financial Data
Operating revenue $ 1,195,904 $ 5,461,580 $ 3,195,563 $ 2,230,474 $ 1,849,104 $ 2,219,425 Other income (expense) $ 26,280 $ 39,950 $ (221,024) $ (282,418) $ (27,459) $ 3,137 Net income (loss) $ (935,337) $ 12,690 $ (3,457,422) $ (1,758,584) $ (1,613,565) $(1,814,856) Earnings per share Weighted number of outstanding shares 8,689,031 7,847,510 7,411,502 6,840,407 6,801,929 6,788,006 (Loss) per share $ (.13) $ (.03) $ (.48) $ (.26) $ (.22) $ (.27) SELECTED BALANCE SHEET DATA: Total assets $ 2,817,944 $ 3,351,871 $ 1,812,495 $ 1,096,314 $ 935,337 $ 1,793,782 Working capital $ 1,243,577$ 1,983,661 $ (1,882,875) $ 220,243 $ 131,827 $ 535,126 Long-term Redeemable Preferred Stock $ 5,398,908 $ 5,207,538 $ 1,600,328 $ --- $ --- $ --- Capital leases $ 9,455 $ 9,455 $ --- $ 3,363 $ 5,413 $ --- Deferred income $ 430,899 $ 430,899 $ 438,896 $ 954,491 $ 954,491 $ 954,491 Prior period Selected Financial Data has been reclassified to conform to 1996 classifications. ITEM 7: Management's Discussion and Analysis Liquidity and Capital Resources Cash Position and Working Capital The Company had cash and short term investments of approximately $774,000 at December 31, 1996; $2,013,000 at June 30, 1996; $452,000 at June 30, 1995; and $416,000 at June 30, 1994. At December 31, 1996, the Company had working capital of $1,244,000, as compared with $1,983,000 at June 30, 1996, and a working- capital deficiency of $1,882,000 at June 30, 1995. The decrease in working capital from June 1996 to December 1996 reflects primarily the loss for the period reduced by the proceeds from the sale of common stock. The Company had a negative net worth of $4,332,000 at December 31, 1996, as compared with negative net worth of $3,433,000 at June 30, 1996, and negative net worth of $3,663,000 at June 30, 1995. Management believes that the Company's revenues will generate sufficient liquidity, when combined with its liquid assets as at December 31, 1996, to meet the Company's anticipated cash requirements through the end of the year ending December 31, 1997. If the Company does not realize revenues sufficient to maintain its operation at the current level, management of the Company would curtail certain of the Company's operations until additional funds become available through investment or revenues. Deferred Income Operations of the Company have been partly funded by prepayments under engineering contracts and licenses of the Company's technology. Such prepayments are recognized as revenue under the percentage-of-completion method as engineering is completed or delivery obligations are fulfilled. The Company bases its estimate of the percentage of completion on the amount of labor applied to a given project, compared with the estimated total amount of labor required. The remainder of such prepaid revenue is reflected on the Company's balance sheet as deferred income, and is treated as a liability. Total deferred income was $769,000 at December 31, 1996, as compared with $517,000 at June 30, 1996 and $516,000 at June 30, 1995. Future Commitments The Company purchased additional computers and related equipment during the six months ended December 31, 1996, and the fiscal years ended June 30, 1996 and 1995, and valued its investments in computers and related equipment (net of depreciation) at $255,590 at December 31, 1996. The Company has no material commitments for capital expenditures although management expects that the Company may make future commitments for the purchase of additional computing and related equipment, for development of hardware, for consulting and for promotional and marketing expenses. The company has no material commitments other than a commitment to purchase from Intel Corporation a supply of Ni1000 Recognition Accelerator chips. The Company placed a purchase order in the amount of $195,000 with Intel Corporation in June 1996, and expects to take delivery of this order during the second quarter of 1997. Inflation Management believes that the rate of inflation in recent years has not had a material effect on the Company's operations. Results of Operations Analysis of Six Months Ended December 31, 1996 Compared to Six Months Ended December 31, 1995 On June 11, 1996, the Company entered into an exclusive Licensing Agreement with National Computer Systems, Inc. (NCS) transferring the development, production, and marketing rights of the Company's Intelligent Character Recognition (ICR) products to NCS. Largely as a result of the transfer of ICR operations to NCS, for the transition period the Company realized a 26% decrease in revenues compared to the corresponding period of the prior fiscal year. Expenses in the transition period decreased 8% and the operating loss increased 62% when compared with the corresponding period of the prior year. The Company began in the quarter ended September 30, 1996, a project to customize its PRISM Fraud Detection System for a customer. Because the terms of the agreement have not been finalized, the Company is accounting for the development costs in accordance with SOP 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts," which provides that costs be deferred until delivery is made under the terms of an enforceable agreement. The Company executed its agreement on March 28, 1997 and made required deliveries. For the six months ended December 31, 1996, the Company deferred $364,000 of costs associated with this project. Revenues The following table compares revenues for the transition period with revenues for the comparable period of the preceding year, including and excluding revenues from ICR operations transferred to NCS: Total Revenues Total Total Six-Month Revenues Revenues Period Six-Month Six-Month Ended Period Period Dec. 31, 1995 Ended Ended Excluding Dec. 31, 1996 Dec. 31, 1995 Change ICR Change $1,196,000 $2,149,000 -44% $1,195,000 0% The Company's revenues arise from licensing of the Company's products and technology, from the sale of tangible products, and from contract engineering services and are discussed separately below. During the six months ended December 31, 1996, revenues decreased $953,000 to $1,196,000 from $2,149,000 in the corresponding period of the prior fiscal year. Revenues in the year-earlier period included $954,000 of revenues associated with the ICR products that were licensed to NCS in June 1996. Software Licensing Product-licensing revenues totaled $526,000 in the transition period, as compared with $902,000 in the year-earlier period. The decrease in software licensing revenues reflects, primarily, the net of two effects: a decrease in ICR licensing revenues and an increase in licensing revenues relating to the Company's Prism Fraud Detection product. During the transition period royalties paid by NCS relating to its sales of ICR products amounted to $68,000, a decrease of $704,000 in ICR revenues the Company recognized in the six months ended December 31, 1995. Revenues from the Company's Prism product totaled $396,000 in the transition period, as compared with $150,000 in the corresponding period of the prior fiscal year. The growth of such revenues reflects additional Prism licenses and increased license fees from existing licensees. Engineering Services During the six months ended December 31, 1996, revenues from engineering contracts totaled $606,000 as compared to $1,076,000 in the year-earlier period, including $182,000 of engineering revenues relating to the ICR products. Excluding engineering revenues relating to ICR products, revenues in the transition period decreased $470,000 compared with the corresponding period of the prior fiscal year. Revenues relating to customer-funded modifications of Nestor's Fraud Detection System totaled $380,000 in the transition period, as compared with $743,000 in the six months ended December 31, 1995. The Company's contracts with the Defense Advanced Research Projects Agency (DARPA) require engineering services rendered by the Company to develop a generic commercial application of the Company's technology to high-speed pattern recognition through the creation of an integrated circuit, associated circuit boards, and supporting development software. The Company has two contracts with DARPA. The first contract, which was signed in April 1990, is in the amount of $1,630,000; as of December 31, 1996, approximately $1,623,000 had been earned. The second contract, signed August 26, 1993, is in the amount of $776,000; as of September 30, 1996, approximately $773,000 had been earned. On September 1, 1995, the Company signed an agreement with the Jet Propulsion Laboratory (JPL) to develop a prototype sensor system designed for vehicular-traffic surveillance and detection. The contract, valued at approximately $597,000, was completed in December 1996. The terms of the DARPA and JPL contracts call for delivery of prototype products, but do not specify any subsequent purchasing or licensing provisions. During the six months ended December 31, 1996, the Company recognized revenues totaling $226,000 under its government contracts. In the year-earlier period such revenues totaled $97,000. Sales of Tangible Products The tangible products currently sold by the Company are based upon the Company's Ni1000 Recognition Accelerator Chip and the PCI4000 Recognition Accelerator Board, which are marketed along with development software that enables customers to develop high- speed recognition applications. Revenues from the Company's Ni1000 Development System totaled $64,000 in the transition period, as compared with $191,000 in the corresponding period of the prior fiscal year. The decrease in revenues is accounted for by a decrease in unit volume as the Company focuses on its TrafficVision product, which incorporates the Ni1000 Recognition Accelerator Chip (see Investment in Product Development and Marketing, below). Operating Expenses Total operating expenses - consisting of engineering, research and development, sales and marketing, and general and administrative expenses - amounted to $2,115,000 in the six months ended December 31, 1996, as compared with $2,691,000 in the year-earlier period. Included in expenses for the six months ended December 31, 1995 are approximately $1,068,000 of expenses attributable to the ICR products, which were licensed to NCS in June 1996. Most of the expenses associated with the ICR products are no longer incurred by the Company as NCS hired most of the staff assigned to development, sales, and support of the ICR products. Offsetting the decrease in expenses attributable to the absence of the ICR products is the Company's increased spending on its Prism Fraud Detection System, on its TrafficVision product, and on its newest product, Nestor InterSite, which is designed for use in internet and intranet environments. During the transition period the Company increased its spending on its Prism Fraud Detection System by approximately $23,000 as compared with the year-earlier period. Spending on TrafficVision increased $358,000 from last year to this year, and the Company spent $167,000 on InterSite. Engineering Services Costs related to engineering services totaled $922,000 in the transition period, as compared to $805,000 in the corresponding period of the prior fiscal year. As a percentage of revenues, these costs increased from 75% last year to 152% this year reflecting additional costs incurred on projects that had been expected to conclude in the quarter ended September 30, 1996. Research and Development Research and development expenses totaled $294,000 in the six months ended December 31, 1996, as compared with $472,000 in the corresponding period of the prior fiscal year. The decrease in such costs was due, primarily, to the net of two effects: research and development costs relating to the ICR products totaled $350,000 in the year-earlier period, while there were no such costs in the transition period; and the Company began development in July 1996 of its Nestor InterSite product and such development costs totaled $137,000. Selling and Marketing The largest decrease in expenses was in selling and marketing. In the transition period selling and marketing expenses decreased $440,000 to $457,000 from $897,000 in the corresponding period of the prior fiscal year. The decrease in selling costs reflects the net of the absence of selling and marketing costs associated with the ICR products in the transition period and an increase in selling costs associated with the Prism and TrafficVision products. ICR selling costs in the six months ended December 1995 totaled $637,000. General and Administrative General and administrative expenses totaled $432,000 in the transition period, as compared with $493,000 in the year-earlier period. The decrease in costs from last year to this year reflects the net of numerous account decreases and increases, with no single expense changing materially. Expenditures on Product Development and Marketing Revenues relating to the Company's Prism and Fraud Detection System exceeded expenses by $71,000 in the six months ended December 31, 1996, The Company has installed its products at Mellon Bank, GE Consumer Credit Financial Services, BankOne, Europay International (an association of 700 banks in Europe). In September 1996, the Company signed a license agreement with Applied Communications, Inc. (ACI) enabling ACI to integrate and market Nestor's products with certain products of ACI. ACI provides authorization and transaction-processing software to nearly 500 financial institutions worldwide. The largest investment made by the Company was in its Intelligent Sensors Division, which is responsible for the development and marketing of the TrafficVision products, an outgrowth of work under the JPL contract. The Company expects commercial products will be available in the second quarter of 1997. For the six months ended December 31, 1996, expenses of this group exceeded revenues by $437,000. The Company began development in July 1996 of a product for use in internet applications. Nestor InterSite enables customers to understand individual on-line customers as they visit Web sites and to dynamically present personalized content to those visitors. The Company expects beta products will be available in the second quarter of 1997. Net Income Per Share During the transition period, the Company experienced a loss of $935,000, as compared with a loss of $723,000 in the corresponding period of the prior fiscal year. For the six months ended December 31, 1996, loss per share available for common stock was $0.13 per share, as compared with a loss per share of $0.11 in the corresponding period of the prior fiscal year. For the six months ended December 31, 1996, there were outstanding a weighted average of 8,689,031 shares, as compared with 7,719,371 in the year-earlier period. Analysis of Years Ended June 30, 1996, 1995 and 1994 For its fiscal year ended June 30, 1996, the Company realized a 71% increase in revenues over the prior fiscal year while expenses decreased 15% from the prior year, resulting in a profit of $12,690 after taxes. Included in Total Revenues for the fiscal year ended June 30, 1996 is an initial license fee of $1,400,000 that the Company received pursuant to its License Agreement with NCS. In addition to the initial license fee, the Company will receive royalties on future sales of the products by NCS. Minimum annual royalties range from $160,000 in 1997 to $350,000 in 2001 and beyond. The Company also signed in June 1996 an Asset Purchase Agreement which transferred tangible and intangible assets used exclusively in the ICR business to NCS for $300,000. The net gain on the sale of these assets was approximately $213,000 and is recognized as "Other income" in the quarter ended June 30, 1996. Revenues The Company realized revenues from operations of $5,461,000 during the fiscal year ended June 30, 1996, including the $1,400,000 license fee from NCS, as compared with $3,195,000 realized during fiscal 1995, and $2,230,000 realized during fiscal 1994. Total revenues for the fiscal year ended June 30, 1994 included $300,000 of revenue received pursuant to an agreement with Intel Corporation relating to the acquisition by the Company of exclusive marketing rights to the Ni1000 Recognition Accelerator. As part of this agreement, the Company agreed to a price increase for the Ni1000 Recognition Accelerator and agreed to make minimum purchases over a two-year period in order to retain its exclusive marketing rights. Intel delivered to the Company certain marketing materials; assigned to the Company its interest in future accounts receivable under the beta program for the Ni1000 Recognition Accelerator; and, as additional consideration for the Company's entering into the agreement, paid to the Company the sum of $300,000. As there were no specific performance requirements or identifiable costs associated with this payment and the Company had no liability to return any part of such payment, the Company recorded this payment as revenue, which revenue is non-recurring. Software Licensing The Company's software licensing revenues in fiscal 1996 derived primarily from licenses of its ICR products. Licensing fee revenues totaled $2,825,000 in the fiscal year ending June 30, 1996, including the $1,400,000 license fee from NCS, as compared with $1,714,000 in the prior fiscal year and $1,349,000 in the fiscal year ended June 30, 1994. The increase in revenues from 1994 to 1995 was driven by an increase in unit volume. The increase in revenues from 1995 to 1996 is attributable to the initial license fee paid by NCS; excluding that transaction, license fee revenues decreased from 1995 to 1996 as a result of lower unit volume. For 1997, the Company will not receive ICR licensing fees but expects to receive royalties from NCS on future sales of the ICR products by NCS under the Licensing Agreement signed in June 1996. The minimum annual royalty for 1997 is $160,000. (See Expenses, below, for a discussion of the effect on the Company's expenses of this licensing arrangement.) Engineering Services Revenues from engineering contracts totaled $2,378,000 in fiscal 1996, as compared with $1,195,000 in the prior year and $641,000 in fiscal 1994. The components of these revenues are separately analyzed below. During the fiscal year ended June 30, 1996, the Company realized revenues from engineering contracts with industrial and commercial customers of approximately $324,000, as compared with $81,000 during the preceding year and $24,000 during fiscal 1994. The increase in these revenues from 1995 to 1996 reflects a shift in the allocation of engineering efforts from internally funded product-development efforts to customer-funded projects, in part intended to offset reduced ICR licensing revenues. During fiscal 1996, customizing the Company's fraud-detection system produced engineering revenues of approximately $1,593,000, as compared with $771,000 in fiscal 1995 and $236,000 in fiscal 1994. The Company's contracts with the Advanced Research Projects Agency (ARPA), formerly called the Defense Advanced Research Projects Agency, require engineering services rendered by the Company to develop a generic commercial application of the Company's technology to high-speed pattern recognition through the creation of an integrated circuit, associated circuit boards, and supporting development software. The Company has two contracts with ARPA. The first contract, which was signed in April 1990, is in the amount of $1,630,000; as of June 30, 1996, approximately $1,623,000 had been earned. The second contract, signed August 26, 1993, is in the amount of $776,000; as of June 30, 1996, approximately $773,000 had been earned. On September 1, 1995, the Company signed a contract with the Jet Propulsion Laboratory (JPL) to develop a prototype sensor system designed for vehicular-traffic surveillance and detection. The contract, valued at approximately $597,000, is expected to run for 13 months from September 1995. The terms of the ARPA and JPL contracts call for delivery of prototype products, but do not specify any subsequent purchasing or licensing provisions. During the fiscal year ended June 30, 1996, revenues from the Company's government contracts totaled $378,000, as compared with such revenues of $342,000 in the prior year and $423,000 of such revenues in the fiscal year ended June 30, 1994. Tangible Product Sales The tangible products currently sold by the Company are based upon the Company's Ni1000 Recognition Accelerator Chip, which is marketed along with development software that enables customers to develop high-speed recognition applications. Revenues from the Company's Ni1000 Development System totaled $257,000 in the fiscal year ended June 30, 1996, as compared with $286,000 in the preceding year and $239,000 in fiscal 1994. In April 1994, the Company and Intel Corporation signed an agreement which provided the Company with exclusive marketing rights to the Ni1000 Recognition Accelerator, subject to the Company's being obligated to make minimum purchases of the Ni1000 Recognition Accelerator in the amount of $97,500 to be ordered by June 30, 1995, and $195,000 to be ordered by June 30, 1996. The Company has placed orders for the required minimum purchases. Expenses Total operating expenses - consisting of operations, selling and marketing, and general and administrative expenses - amounted to $5,488,000 for the fiscal year ended June 30, 1996, as compared with $6,431,000 in the prior year, and $3,706,000 in 1994. Expenses in fiscal 1995 and 1994 reflect the reclassification of $210,500 and $287,969, respectively, to "Other income (expense)". These amounts represent non-cash charges relating to the issuance of stock or exercise of warrants at below-market prices. Included in fiscal 1996 expenses are approximately $1,997,000 of expenses attributable to the ICR products, which were licensed to NCS in June 1996. Most of the expenses associated with the ICR products will no longer be incurred by the Company as NCS hired most of the staff assigned to development, sales, and support of the ICR products. Management expects expenses to decrease initially in fiscal 1997 reflecting the License of the ICR products to NCS. However, as the Company invests in existing and new product opportunities, management expects expenses to increase. The decrease in expenses from 1995 to 1996 reflects both staff attrition and management's efforts to reduce expenses. The majority of the decrease in total expenses derived from decreases in promotion, salaries and consulting, recruiting and subcontracting. Labor costs continue to be the Company's single greatest expense category. During fiscal 1996, the Company paid $3,103,000 for wages and consulting fees, as compared with $3,302,000 in the prior year and $1,955,000 in fiscal 1994. The decrease from 1995 to 1996 reflects a decrease in staffing: full-time employees totaled 33 at June 30, 1996, as compared with 53 at June 30 1995, and 31 at June 30, 1994. In mid-June 1996, NCS hired 14 full- time employees who had been employed by the Company prior to signing the License agreement with NCS. Immediately prior to the transfer of these employees, the Company had 47 employees. Operating Expenses Operating expenses, which are primarily labor costs related to product development, engineering and sales totaled $5,488,000 for the fiscal year ended June 30, 1996, as compared with $6,431,000 in the prior year and $3,706,000 in fiscal 1994. Operating costs and expenses related to the production of revenues from software licensing totaled $686,000 in fiscal 1996, as compared with $1,979,000 in the preceding year and $1,159,000 in fiscal 1994. The decrease in such costs from 1995 to 1996 reflects management's decision to shift engineering resources from internally funded product-development efforts to customer- funded engineering projects. Costs related to engineering services totaled $1,833,000 in the fiscal year ended June 1995, as compared to $665,000 in the prior year and $628,000 in fiscal 1994. The increase of these costs reflects the increase in engineering services revenues. The Company's expenditures for research and development were $2,639,000 in fiscal 1996; $2,759,000 in fiscal 1995; and $1,788,000 in fiscal 1994. Selling and marketing expenses represented the largest decrease in expenses from 1995 to 1996. Such expenses totaled $1,764,000 in the fiscal year ending June 30, 1996, as compared with $2,547,000 in the preceding year and $951,000 in fiscal 1994. The decrease in expenses from 1995 to 1996 reflected management's decision in the fourth quarter of 1995 to terminate an aggressive marketing plan for the Company's ICR products, which had begun in the second quarter of fiscal 1995. That plan had entailed increases in sales staff, promotional expenditures, and the staffing of a customer-support group dedicated to ICR product support. Sales and marketing compensation, consisting of salaries, fringe benefits, and commissions, totaled $999,000 in fiscal 1996, as compared with $1,030,000 in the prior year and $431,000 in the fiscal year ending June 1994. Related consulting decreased to $69,000 in fiscal 1996 from $195,000 in 1995 and $31,000 in 1994. Promotional expenses, comprising advertising, promotion, and conventions and meetings, decreased $513,000 to $232,000 in fiscal 1996 from $745,000 in the prior year. Such costs totaled $226,000 in the fiscal year ended June 30, 1994. General and administrative expenses totaled $828,000 in fiscal 1996, as compared with $843,000 in the preceding year and $782,000 in fiscal 1994. As noted above, general and administrative expenses in fiscal 1995 and 1994 reflect the reclassification of $210,500 and $287,969, respectively, to "Other income (expense)". These amounts represent non-cash charges relating to the issuance of stock or exercise of warrants at below-market prices. Other Income (Expense) In fiscal 1996, the Company recorded "Other income" of approximately $40,000, net of "Other expense". Included in this amount is a gain on the sale of intangibles of $213,000 relating to the Asset Purchase Agreement with NCS signed in June 1996. The Company recorded interest expense, net of interest income, totaling $39,000. Additionally, the Company recorded a non-cash expense of $131,000 relating to the reduction of exercise price of outstanding warrants in connection with the Rights Offering completed in the second fiscal quarter. In the fiscal year ended June 30, 1995, the Company recorded "Other expense" of $221,000. Non-cash charges relating to the issuance of stock at below-market prices totaled $210,000, and the Company recorded net interest expense of $11,000. In fiscal 1994, "Other expense" totaled $282,000, reflecting primarily non-cash charges relating to the exercise of warrants at below-market prices, of $288,000. Investment in Product Development and Marketing. The largest investment made by the Company was in its Intelligent Character Recognition group. During the fiscal year ended June 1996, product-development and marketing expenses exceeded revenues (excluding the initial license fee paid by NCS) by approximately $436,000. As noted above, on June 11, 1996, National Computer Systems, Inc. signed a License Agreement which transferred to them the right to develop and market these products. NCS is required to pay minimum annual royalties to maintain its exclusive license. The Company has since terminated most of the costs associated with these products. Expenses of the Company's generic products (the Ni1000 Recognition Accelerator and the Company's proprietary software- development tools) exceeded revenues by approximately $212,000 in fiscal 1996. In September 1995, the Company began work on a contract with the Jet Propulsion Laboratory to develop a prototype sensor system designed for vehicular-traffic surveillance and detection. Revenues relating to the Company's PRISM and Fraud Detection System exceeded expenses by approximately $256,000 in fiscal 1996. The Company has license agreements with Mellon Bank, GE Consumer Credit Financial Services, Bank One, Europay International (an association of 700 banks in Europe), and with a European financial-services company for the use of these products. Net Income Per Share For the fiscal year ended June 1996, the Company experienced a gain of $12,690, as compared with a loss of $3,457,422 in the prior year and a loss of $1,758,584 in fiscal 1994. For the fiscal year ended June 1996, loss per share available for common stock was $0.03 per share, as compared with a loss per share of $0.48 in fiscal 1995 and a loss per share of $0.26 in fiscal 1994. For the fiscal year ended June 30, 1996, there were outstanding a weighted average of 7,847,510 shares, as compared with 7,411,502 in the prior year and 6,840,407 in the fiscal year ended June 30, 1994. <\PAGE> SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused the report to be signed on its behalf by the undersigned, thereunto duly authorized. NESTOR, INC. (Registrant) /s/David Fox, President and CEO Date: March 31, 1997 Pursuant to the 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. Signatures Signatures Title Date /s/Leon N Cooper Co-Chairman of the Board March 31, 1997 and Director /s/Charles Elbaum Co-Chairman of the Board March 31, 1997 and Director /s/David L. Fox President, Chief Executive March 31, 1997 Officer and Director /s/Herbert S. Meeker Secretary and Director March 31, 1997 /s/Sam Albert Director March 31, 1997 /s/Jeffrey Harvey Director March 31, 1997 /s/Thomas F. Hill Director March 31, 1997 /s/Bruce Schnitzer Director March 31, 1997 CONSOLIDATED FINANCIAL STATEMENTS FORM 10-K JUNE 30, 1996 NESTOR, INC. Part II Item 8 CONTENTS Independent Auditor's Report Statement No. Consolidated Balance Sheets 1 Consolidated Statements of Operations - For the Six Months Ended December 31, 1996 and For the Years Ended June 30, 1996, 1995 and 1994 2 Consolidated Statements of Cash Flows - For the Six Months Ended December 31, 1996 and For the Years Ended June 30, 1996, 1995 and 1994 3 Consolidated Statements of Stockholders' Equity - For the Six Months Ended December 31, 1996 and For the Years Ended June 30, 1996, 1995 and 1994 4 Notes to Consolidated Financial Statements Part II Item 8 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders of Nestor, Inc. We have audited the accompanying consolidated balance sheet of Nestor, Inc. as of December 31, 1996, and the related consolidated statements of operations, cash flows and stockholders' equity for the period July 1, 1996 to December 31, 1996. Our audit also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nestor, Inc. at December 31, 1996, and the consolidated results of its operations and its cash flows for the period July 1, 1996 to December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Ernst & Young LLP Providence, Rhode Island March 14, 1997 Consolidated Balance Sheets
ASSETS December 31, June 30, June 30, 1996 1996 1995 Current assets: Cash and cash equivalents $ 774,457 $2,013,317 $ 452,588 Accounts receivable, net of allowance for doubtful accounts 1,009,149 594,310 661,734 Unbilled contract revenue 126,945 282,936 208,352 Deferred development costs 364,405 --- --- Other current assets 276,615 230,738 131,163 Total current assets 2,551,571 3,121,301 1,453,837 Property and equipment at cost - net of accumulated depreciation 255,590 219,787 347,325 Other assets 10,783 10,783 11,333 Total Assets $ 2,817,944 $3,351,871 $ 1,812,495 LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities: Notes payable $ --- $ ---- $ 1,700,000 Accounts payable and accrued expenses 670,742 724,727 1,294,123 Other current liabilities 298,848 326,809 265,278 Deferred income 338,404 86,104 77,311 Total current liabilities 1,307,994 1,137,640 3,336,712 Noncurrent liabilities: Long term obligations under capital leases 12,212 9,455 --- Other noncurrent liabilities --- --- 100,000 Total liabilities 1,320,206 1,147,095 3,436,712 Long term portion of deferred income 430,899 430,899 438,896 Series C, E, F, G and H redeemable convertible preferred stock 4,846 shares at December 31, 1996 and June 30, 1996 and 1,500 shares at June 30, 1995 (liquidation value $1,000 per share plus accrued dividends) 5,398,908 5,207,538 1,600,328 Commitments and contingencies --- --- --- Stockholders' deficit: Preferred stock, $1.00 par value, authorized 10,000,000 shares; issued and outstanding: Series A - 452,064 shares at December 31, 1996, June 30, 1996 and 1995 452,064 452,064 452,064 Series B - 1,635,000 shares at December 31, 1996, 2,075,000 shares at June 30, 1996 and 2,540,000 shares at June 30, 1995 1,635,000 2,075,000 2,540,000 Series D - 179,671 shares at December 31, 1996, 184,671 shares at June 30, 1996 and none at June 30, 1995 279,230 277,007 --- Common stock, $.01 par value, authorized 30,000,000 shares; issued and outstanding: 8,916,141 shares at December 31, 1996, 8,280,941 shares at June 30, 1996 and 7,606,710 shares at June 30, 1995 89,161 82,809 76,067 Warrants and options 417,500 375,000 375,000 Additional paid-in capital 11,927,644 11,501,790 11,103,449 Retained (deficit) (19,132,668) (18,197,331) (18,210,021) Total stockholders' deficit (4,332,069) (3,433,661) (3,663,441) Total Liabilities and Stockholders' Deficit $ 2,817,944 $3,351,871 $ 1,812,495 The Notes to the Financial Statements are an integral part of this statement.
Consolidated Statements of Operations
Six Months Ended December 31, For the Years Ended June 30, 1996 1996 1995 1994 Revenue: Software licensing $ 526,353 $ 2,825,600 $ 1,713,897 $ 1,349,470 Engineering services 605,776 2,378,135 1,195,201 641,579 Tangible product sales 63,775 257,845 286,465 239,425 Total revenue 1,195,904 5,461,580 3,195,563 2,230,474 Operating Expenses: Engineering services 922,325 1,833,531 665,421 628,448 Tangible product sales 8,978 32,189 13,838 89,775 Research and development 294,136 823,000 2,093,616 1,159,920 Selling and marketing 457,281 1,764,585 2,661,453 951,426 General and admin. 432,301 1,035,535 997,633 877,071 Total operating expenses 2,115,021 5,488,840 6,431,961 3,706,640 (Loss) from operations (919,117) (27,260) (3,236,398) (1,476,166) Other income (expense) - net (16,220) 39,950 (221,024) (282,418) Net Income (Loss) $ (935,337) $ 12,690 $(3,457,422) $(1,758,584) Dividends accrued on preferred stock 201,094 261,210 100,328 --- Net Loss Available for Common Stock $(1,136,431) $ (248,520) $(3,557,750) $(1,758,584) Loss per share (Note 3) $ (0.13) $ (0.03) $ (0.48)$ (0.26) Weighted Average Number of shares Outstanding 8,689,031 7,847,510 7,411,502 6,840,407 The Notes to the Financial Statements are an integral part of this statement.
Consolidated Statements of Cash Flows
Six Months Ended For the Years Ended December 31, June 30, 1996 1996 1995 1994 Cash flows from operating activities: Net income (loss) $ (935,337) $ 12,690 $(3,457,422) $(1,758,584) Adjustments to reconcile net income (loss) to net cash used by operating activities: Depreciation and amortization 45,328 104,559 113,562 200,460 Loss on disposal of fixed assets --- 4,346 --- 106 Expenses charged to operations relating to options, warrants and capital transactions 42,500 178,375 210,500 287,969 Changes in assets and liabilities: (Increase) decrease in accounts receivable (414,839) 67,424 (340,651) (69,791) (Increase) decrease in unbilled contract revenue 155,991 (74,584) (87,674) (60,274) Increase in deferred development costs (364,405) --- --- --- (Increase) in other current assets (45,877) (99,575) (110,721) (8,193) (Increase) decrease in other assets --- 550 (5,000) --- (Decrease) increase in accounts payable, accrued expenses and other liabilities (83,593) (568,309) 786,010 144,294 (Decrease) increase in deferred income 252,300 796 (15,630) 44,746 Net cash (used) by operating activities (1,347,932) (373,728) (2,907,026) (1,219,267) Cash flows from investing activities: Purchase of property and equipment (71,390) (57,531) (249,319) (66,292) Proceeds from the disposal of fixed assets --- 85,000 --- 1,900 Net cash provided (used) by investing activities (71,390) 27,469 (249,319) (64,392) Cash flows from financing activities: Repayment of obligations under capital leases (5,338) (7,924) (10,796) (5,998) Proceeds from notes payable --- 300,000 1,700,000 --- Rights offering expense --- (136,421) (39,769) --- Proceeds from issuance of common stock 185,800 99,510 73,288 625,125 Proceeds from issuance of preferred stock - net --- 1,651,823 1,470,000 811,608 Net cash provided by financing activities 180,462 1,906,988 3,192,723 1,430,735 Net change in cash and cash equivalents (1,238,860) 1,560,729 36,378 147,076 Cash and cash equivalents - beginning of year 2,013,317 452,588 416,210 269,134 Cash and cash equivalents - End of Year $ 774,457 $ 2,013,317 $ 452,588 $ 416,210 Supplemental cash flows information: Interest paid $ 3,227 $ 4,372 $ 3,728 $ 1,685 Income taxes paid $ --- $ --- $ --- $ --- The Notes to the Financial Statements are an integral part of this statement.
Nestor, Inc. Consolidated Statement of Stockholders' Equity
Common Stock Preferred Stock Additional Retained Stock Shares Amount Shares Amount Paid-in Capital (Deficit) Warrants Total Balance at June 30, 1993 6,802,710 $ 68,027 2,407,064 $2,407,064 $10,033,105 $(12,994,015) $ --- $ (485,819) Issuance of Capital Stock 332,625 3,326 815,000 815,000 906,367 --- --- 1,724,693 Conversion of Preferred Stock to Common Stock 95,000 950 (95,000) (95,000) 94,050 --- --- --- (Loss) for the year ended June 30, 1994 --- --- --- --- --- (1,758,584) --- (1,758,584) Balance at June 30, 1994 7,230,335 $ 72,303 3,127,064 $3,127,064 $11,033,522 $(14,752,599) --- $ (519,710) Issuance of Capital Stock 141,375 1,414 --- --- 282,374 --- --- 283,788 Issuance of Preferred Stock --- --- 100,000 100,000 100,000 --- --- 200,000 Cost of rights offering --- --- --- --- (39,769) --- --- (39,769) Conversion of Preferred Stock to Common Stock 235,000 2,350 (235,000) (235,000) 232,650 --- --- --- Dividends accrued on Redeemable Convertible Preferred Stock Series C --- --- --- --- (100,328) --- --- (100,328) Reclassification of Series C Redeemable Convertible Preferred Stock from capital --- --- --- --- (405,000) --- 375,000 (30,000) (Loss) for the year ended June 30, 1995 --- --- --- --- --- (3,457,422) --- (3,457,422) Balance at June 30, 1995 7,606,710 $ 76,067 2,992,064 $2,992,064 $11,103,449 $(18,210,021) $375,000 $(3,663,441) Issuance of Common Stock 177,998 1,780 --- --- 175,928 --- --- 177,708 Issuance of Preferred Stock --- --- 210,549 315,824 (10,000) --- --- 305,824 Conversion of Preferred Stock to Common Stock 490,878 4,909 (490,878) (503,817) 498,908 --- --- --- Dividends on Preferred Stock Series D paid in Common Stock 5,355 53 --- --- 13,495 --- --- 13,548 Dividends accrued on Preferred Stock --- --- --- --- (274,819) --- --- (274,819) Expenses incurred in reduction of exercise price of outstanding warrants --- --- --- --- 131,250 --- --- 131,250 Costs incurred in connection with August 1995 securities registration --- --- --- --- (136,421) --- --- (136,421) Income for the year ended June 30, 1996 --- --- --- --- --- 12,690 --- 12,690 Balance at June 30, 1996 8,280,941 $ 82,809 2,711,735 $2,804,071 $11,501,790 $(18,197,331) $375,000 $ (3,433,661) Issuance of Common Stock 190,200 1,902 --- --- 183,898 --- --- 185,800 Conversion of Preferred Stock to Common Stock 445,000 4,450 (445,000) (447,500) 443,050 --- --- --- Dividends accrued on Preferred Stock Series D --- --- --- 9,723 (9,723) --- --- --- Accural of value of warrants (Note 7) --- --- --- --- --- --- 42,500 42,500 Dividends accrued on Redeemable Convertible Preferred Stock --- --- --- --- (191,371) --- --- (191,371) (Loss) for the six months ended December 31, 1996 --- --- --- --- --- (935,337) --- (935,337) Balance at December 31, 1996 8,916,141 $ 89,161 2,266,735 $2,366,294 $11,927,644 $(19,132,668) $417,500 $(4,332,069) The Notes to the Financial Statements are an integral part of this statement.
Note 1 - Summary of significant accounting policies: A. Organization Nestor, Inc. (the "Company") was organized on March 21, 1983 in Delaware to exploit, develop and succeed to certain patent rights and know-how which the Company acquired from its predecessor, Nestor Associates, a limited partnership. The Company's principal office is located in Providence, RI. The accompanying financial statements include the accounts of Nestor, Inc. and Nestor Financial Services Group, a joint venture (organized in December, 1986, and dissolved effective December 31, 1995 - See Note 9). All intercompany transactions and balances have been eliminated. B. Product and patent development costs The costs of development of the Company's software which consist primarily of labor and outside consulting and which are an inherent cost of the Company's business and costs of research and development are expensed until technological feasibility has been established for the product. Thereafter, all software production costs would be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. At December 31, 1996, the Company had no capitalized software development costs because the products developed were simultaneously available for general release to customers when technological feasibility was established. Capitalized costs are amortized on a straight-line basis over the estimated economic life (three to five years) of the product. Patent-development costs are similarly treated. Their amortization would be on a straight-line basis over the shorter of the estimated economic life, or statutory life, of the patent. C. Depreciation and amortization Depreciable assets are recorded at cost. Depreciation is provided on the straight-line method over the estimated useful lives of the respective assets. Maintenance and repairs are expensed as incurred. Major renewals and betterments are capitalized. D. Revenue recognition The Company recognizes revenue based upon the following methods: a) Revenue from software licensing/sales is recognized upon shipment provided that no significant vendor and post-contract support obligations remain outstanding and collection of the resulting receivable is deemed probable. Where there are insignificant post-contract support obligations and/or warranties remaining at the time of shipment, the Company recognizes revenue and accrues the estimated cost of fulfilling such obligations or warranties. Product returns or exchanges are charged to operations as incurred. Where the Company anticipates significant returns of products sold, the Company establishes an allowance for anticipated returns or exchanges at the time of sale. When a product is sold subject to customer approval, revenue is recognized upon approval by the customer. b) Engineering contract revenue from long- term contracts is recognized on the percentage-of- completion method, based upon the pattern of actual performance under the agreement with the customer. Management records expected losses on contracts in the period in which such losses become foreseeable. c) Training revenue is recognized upon the completion of training sessions with the customer. E. Cash equivalents For the purpose of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of 90 days or less to be cash equivalents. F. Accounting for issuance and exercise of warrants and options to purchase Common Stock The Company records no expense upon the issuance of warrants and options issued at fair market value. For employee warrants and options issued at an exercise price below fair market value, the Company records an expense equal to the difference between the market value of the underlying shares of Common Stock and the exercise price of such options or warrants. For other options and warrants issued after December 31, 1995, the Company records options and warrants at fair market value. G. Concentrations of credit risk The Company's financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. The Company places its cash and temporary cash investments with high credit quality institutions. At times such investments may be in excess of the FDIC insurance limit. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its trade accounts receivable credit risk exposure is limited. The Company does not require collateral from its customers. Management believes the allowance carried for doubtful accounts receivable is adequate to cover potential losses associated with uncollectible accounts receivable. H. Inventory Inventory, consisting primarily of finished goods, is valued at the lower of cost or market on the first-in, first-out basis. Inventories are included as "Other current assets" on the Consolidated Balance Sheets. I. Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. J. Change in Fiscal Year The Company changed its fiscal year from June 30 to December 31 effective December 31, 1996. The results for the six month period ended December 31, 1996 have been presented in the main body of the financial statements. K. Change in Presentation In order to conform with the December 31, 1996 presentation, expenses charged to operating expenses for the fiscal years ended June 30, 1996, 1995 and 1994 have been reclassified in these financial statements from "Software Licensing" and "Tangible Product Sales" and are presented as "Research and Development" on the Consolidated Statements of Operations. Note 2 - Results for the six months ended December 31, 1995: The following financial information for the six months ended December 31, 1995 is unaudited and is being presented for comparative purposes: Six Months Ended Six Months Ended December 31, 1995 December 31, 1996 (Unaudited) Total revenues $ 1,195,904 $ 2,149,088 Net Loss (935,337) (723,227) Net loss available for common stock (1,136,431) (813,028) Net (loss) per share $ (0.13) $ (0.11) Note 3 - Income (loss) per share: Income (loss) per share amounts are based on income (loss) available for common stock divided by the weighted average number of common shares outstanding. For the six months ended December 31, 1996, and for the years ended June 30, 1996, 1995 and 1994, the dilutive effect of exercise or conversion of options, warrants and preferred stock were not included in the calculation as this would result in anti-dilution. During the quarter ended December 31, 1996, the Company modified its method for computing earnings per share to give effect to dividends accrued on preferred stock. The effect of this change on earnings per share is as follows: Period As Originally As Ended Reported Adjusted Quarter ended Sept. 30, 1996 (0.03) (0.04) Fiscal year ended June 30, 1996 --- (0.03) Fiscal year ended June 30, 1995 (0.47) (0.48) The following earnings per share calculations are based on the Company's reported net income (loss) for the periods presented. The reported net income (loss) has been adjusted to reflect dividends accrued on convertible preferred stock. Note 4 - Income taxes: The Company accounts for income taxes from the deferred liability method as required by FASB Statement No. 109, "Accounting for Income Taxes." Under Statement No. 109, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets and liabilities, and are measured using the enacted rates and laws that will be in effect when the differences are expected to reverse. There was no current federal or state and no deferred federal or state provision (benefit) for income taxes for the six months ended December 31, 1996, and for the fiscal years ended June 30, 1996, 1995, and 1994. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1996, June 30, 1996 and June 30, 1995 are as follows:
December 31, June 30, June 30, 1996 1996 1995 Deferred tax liabilities: Accounts receivable $ --- $ 237,000 $ 264,000 Unbilled contract revenue --- 113,000 83,000 Other - net --- 33,000 20,000 Total deferred tax liabilities --- 383,000 367,000 Deferred tax assets: Accounts receivable 58,000 --- --- Accrued expenses 104,000 277,000 507,000 Deferred income 173,000 206,000 206,000 Other - net 2,000 14,000 13,000 Net operating loss 6,354,000 6,224,000 5,998,000 Total deferred tax assets 6,691,000 6,721,000 6,724,000 Valuation allowance (6,691,000) (6,338,000) (6,357,000) Net deferred tax assets --- 383,000 367,000 Net Deferred Tax Balance $ --- $ --- ---
The Company provides a valuation allowance to reflect the uncertainties associated with the realization of its deferred tax assets including limitations provided by Section 382 of the Internal Revenue Code. A reconciliation of the provision for income taxes to the amount computed using the Federal statutory tax rates consists of the following:
Six Months Ended Years Ended June 30, December 31, 1996 1996 1995 1994 Income (Loss) Before Taxes $ (892,000) $ 13,000 $(3,457,000) $(1,759,000) Tax at statutory rate of 34% $ (303,000) $ 4,000 $(1,176,000) $ (598,000) State income tax (net of federal benefit) (53,000) 1,000 (207,000) (106,000) Effect of permanent differences 3,000 7,000 7,000 1,000 Valuation allowance 353,000 (12,000) 1,376,000 703,000 Income Tax Expense $ --- $ --- $ --- $ ---
The Company has available at December 31, 1996, $17,328,000 and $7,863,000 of net operating loss carryforwards for federal and state purposes, respectively. These loss carryforwards may be applied against future taxable income and begin to expire in 1998. Note 5 - Accounts receivable, net of allowance for doubtful accounts:
June 30, December 31, 1996 1996 1995 Trade accounts receivable $ 1,154,384 $ 760,019 $ 719,710 Allowance for doubtful accounts (145,235) (165,709) $(57,976) Accounts receivable, net of allowance for doubtful accounts $ 1,009,149 $ 594,310 $ 661,734
Note 6 - Commitments and contingencies: The Company leases a facility in Rhode Island under an operating lease dated July 1, 1985, as amended. This lease provides for minimum annual rentals of $134,993 until February 1997 and $141,742 until February 1998. The Company is also obligated to pay its proportionate share of increases in real estate taxes and common area maintenance over a base period. Commencing March 1, 1996, the base rent is to be increased by the percentage increase in the C.P.I. index over the prior year, but not less than 5%. Rent expense of $47,989, $171,928, $153,385, and $118,731 was charged to operations for the six months ended December 31, 1996 and for the years ended June 30, 1996, 1995 and 1994 respectively. On August 1, 1994, the Company signed a Financial Advisory Agreement with Wand Partners, Inc. The terms of the Agreement specify that Wand Partners, Inc. will provide consulting services for a fee of $40,000 per year, plus out-of-pocket expenses. The Agreement is in effect so long as Wand Partners, Inc. owns at least 500,000 shares of Nestor's Common Stock, or other equities which are convertible into that number of shares of Common Stock (See Note 16 - Related party transactions). The Company placed a purchase order in the amount of $195,000 with Intel Corporation in June 1996 for a supply of Ni1000 Recognition Accelerator chips and expects to take delivery of the chips during the second quarter of 1997. The aggregate minimum payments due over the remaining term of the above agreements is as follows: December 31, 1997 $ 404,418 December 31, 1998 68,424 December 31, 1999 40,000 December 31, 2000 40,000 December 31, 2001 40,000 $ 592,842 Note 7 - Options and warrants: On April 1, 1984, the Company adopted an Incentive Stock Option Plan providing for the granting of options to purchase shares of the Company's common stock at a price equal to the market price of the stock at the date of grant. The Company's Stock Option Plan has authorized the grant of options to employees for up to 2,450,000 shares of the Company's common stock. Options are exercisable for five years from the date of grant. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock- Based Compensation ("SFAS 123") which is first applicable to the Company's fiscal year ended June 30, 1996. The Company will continue to account for its stock option plans in accordance with the provisions of APB 25, Accounting for Stock Issued to Employees. Accordingly, no compensation cost has been recognized for the Company's Stock Option Plan. The following table presents the activity of the Company's Stock Option Plan for the six months ended December 31, 1996, and for the fiscal years ended June 30, 1996, 1995, and 1994:
Six Months Ended December 31, Years Ended June 30, 1996 1996 1995 1994 Weighted Weighted Weighted Weighted Av. Ex. Av. Ex. Av. Ex. Av. Ex. Shares Price Shares Price Shares Price Shares Price Outstanding beginning of year 1,356,000 1.03 1,399,000 1.80 1,141,000 1.90 795,500 1.85 Granted 612,000 2.38 1,406,000 1.04 348,000 1.60 412,500 1.91 Exercised 186,500 0.98 100,500 1.09 13,875 1.52 37,000 1.19 Canceled --- --- 1,348,500 1.83 76,125 2.43 30,000 1.64 Outstanding end of year 1,781,500 1.50 1,356,000 1.03 1,399,000 1.80 1,141,000 1.90 Options exercisable at year end 1,101,875 1.22 1,023,500 1.00 950,375 1.88 730,375 2.00 Weighted average fair value of options granted during the year $ 0.71 $ 0.71
The following table presents weighted average price and life information about significant option groups outstanding at December 31, 1996.
Options Outstanding Options Exercisable Weighted Average Weighted Weighted Number Remaining Average Number Averaged Range of Outstanding Contractual Exercise Exercisable Exercisable Exercise Prices at 12/31/96 Life (Years) Price at 12/31/96 Price $.87 - $1.00 1,081,500 3.68 $0.99 911,875 $0.99 $1.50 - $1.94 84,500 4.35 1.58 21,125 1.58 $2.00 - $2.32 503,500 4.49 2.31 140,875 2.31 $2.41 - $2.94 112,000 4.66 2.69 28,000 2.69 1,781,500 4.00 $1.50 1,101,875 $1.22
The following are the pro forma net loss and net loss per share for the six months ended December 31, 1996, and for the fiscal year ended June 30, 1996, as if the compensation cost for the option plan had been determined based on the fair value at the grant date for grants in those periods, consistent with the provisions of SFAS 123:
Six Months Ended Fiscal Year Ended December 31, 1996 June 30, 1996 As Pro As Pro Reported Forma Reported Forma Net income (loss) $(935,337) $(1,241,072) $ 12,690 $(635,037) Net (loss) per share $ (0.13) (0.17) (0.03) (0.11)
The effects on the six months ended December 31, 1996, and the fiscal year ended June 30, 1996, pro forma loss per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reporting the results of operations for future years because additional options will vest subsequent to December 31, 1996 and the Company expects to grant additional options in future years. Because SFAS No. 123 is first applicable to the Company's fiscal year ended June 30, 1996, the full effects on pro forma earnings will not be felt until 1998. The fair value of each option grant was estimated using the Black-Scholes model with risk-free interest rates on the date of grant which ranged from 5.4% to 6.8%. The Company has never declared nor paid dividends on its common stock and does not expect to in the foreseeable future. The volatility factor of the expected market price of the Company's common stock used in estimating the fair value of the grants was .858 and the expected life of the options was estimated as five years. The Company, at the discretion of the Board of Directors, has granted warrants from time to time, generally in conjunction with the sale of equities.
Dec. 31, June 30 1996 1996 1995 1994 Officers 10,000 10,000 88,000 198,000 Others 2,826,239 3,126,964 2,329,375 1,284,375 Eligible, End of Year for Exercise Currently (at prices ranging from $.65 to $4.62 per share) 2,836,239 3,136,964 2,417,375 1,482,375 Warrants issued --- 1,309,589 1,410,000 407,500 Low exercise price $ --- $ 0.65 $ 1.50 $ 3.00 High exercise price $ --- $ 2.00 $ 2.00 $ 3.00
Of the warrants outstanding at December 31, 1996, 210,150 were issued in conjunction with the issuance of the Series D Convertible Preferred Stock. These warrants entitle the registered owner to purchase one-half of one share of Common Stock at the per-share exercise price of $2.00. All other outstanding warrants entitle the owner to purchase one share of Common Stock for each warrant, at prices ranging from $0.65 to $2.00 per share. The warrants outstanding as of December 31, 1996, are currently exercisable and expire at various dates through October 5, 2005. For the six months ended December 31, 1996, and for the fiscal years ended June 30, 1996, 1995 and 1994, when warrants were issued at market value, no expense was recorded by the Company. When warrants were issued below market value, a charge against earnings was recorded. During the year ended June 30, 1996, the exercise price of 1,000,000 warrants issued in the prior year was reduced from $1.50 to $.65. The maximum expense to be recorded by the Company upon exercise of these warrants will be $850,000. During the period ended December 31, 1996, the Company began recording, on a prorated basis, the maximum expense over the remaining life of the warrants. Note 8 - Major customers: In the six months ended December 31, 1996, five customers accounted for 19%, 18%, 15%, 13% and 11% of the Company's revenues. In the fiscal year ended June 30, 1996, one customer accounted for 30% of the Company's total revenues. Another customer accounted for 13% of the Company's revenues during the year ended June 1996 and 16% of the Company's revenues during the year ended June 1995. A third customer accounted for 11% of the Company's revenues during the year ended June 1995 and 19% of the Company's revenues during the year ended June 1994. A fourth customer accounted for 17% of the Company's revenues during the fiscal year ended June 30, 1994. Note 9 - Property and equipment at cost - net:
Useful Life In Years or December 31, June 30, Lease Term 1996 1996 1995 Leasehold improvements $ 22,945 $ 22,945 $ 22,945 Lease Term Office furniture and equipment 199,254 199,254 201,942 5 - 7 Computer equipment 1,184,981 1,103,851 1,200,514 3 - 5 1,407,180 $1,326,050 $1,425,401 Less: Accumulated depreciation and amortization 1,151,590 1,106,263 1,078,076 $ 255,590 $ 219,787 $ 347,325
Depreciation and amortization expense on the above assets of $45,327, $104,559, $100,229, and $93,777 was recorded for the six months ended December 31, 1996, and for the years ended June 30, 1996, 1995 and 1994, respectively. Note 10 - Revenue from sources outside the United States: Revenues from licenses, engineering and sales of tangible products sold outside the United States were as follows:
Six Months Ended December 31, Years Ended June 30, 1996 1996 1995 1994 France $ 30,000 $ 65,085 $ 98,785 $ 35,450 Belgium 42,000 727,375 507,900 169,000 Australia --- 66,590 18,400 63,195 Germany --- 173,877 81,649 23,000 Japan 14,094 36,424 2,100 21,368 Canada --- 41,710 27,985 17,145 Singapore 10,535 65,530 65,315 --- All other countries 14,225 213,208 271,101 156,935 $110,854 $1,389,799 $1,073,235 $ 486,093
Note 11 - Accounts payable and accrued expenses: Accounts payable and accrued expenses consists of the following:
December 31, June 30, 1996 1996 1995 Trade accounts payable $231,395 $269,320 $ 795,692 Accrued salaries 185,842 276,004 327,812 Other accrued expenses 253,505 179,403 170,619 $670,742 $724,727 $1,294,123
Note 12 - Preferred stock: Series A Preferred Stock is convertible at any time into one fully paid and non-assessable share of Common Stock. Series A Preferred has the same dividend rights as shares of Common Stock but carries no voting rights. Each share of Series A Preferred has the right to receive in liquidation $2.00 before any distribution is made on Common Stock or on any other class of stock ranking junior to Series A. The liquidation value of Series A Preferred was $904,128 at December 31, 1996, June 30, 1996 and June 30, 1995. Series B Convertible Preferred Stock is convertible into Common Stock of the Company at any time on a share- for-share basis. Series B Convertible Preferred Stock has the same rights with respect to voting and dividends as the Common Stock, except that each share of Series B Convertible Preferred Stock has the right to receive in liquidation $1.00 before any distribution is made to holders of the Common Stock. The liquidation value of Series B Preferred was $1,635,000, $2,075,000 and $2,540,000 at December 31, 1996, June 30, 1996 and June 30, 1995, respectively. Series D Convertible Preferred Stock is convertible after January 1, 1996 at the option of the holder at any time, and from time to time, into one fully paid and non-assessable share of Common Stock of the Company. The Series D Preferred shall have the right to receive annual dividends at the rate of seven percent (7%) of the stated value per share ($1.50), which dividend shall be paid in cash or in shares of Common Stock at the option of the Company. On June 30, 1996, the Company paid a stock dividend on the Series D Preferred totaling $13,548. The Company shall have the right, after June 1, 1996, to redeem in cash the Series D Preferred, in whole or in part from time to time, at the stated value per share plus accrued dividends. The liquidation value of Series D Preferred was $279,230 plus accrued dividends at December 31, 1996; $277,007 plus accrued dividends at June 30, 1996; and none at June 30, 1995. The Series D Convertible Preferred Stock ranks on a parity with Series B Convertible Preferred Stock with respect to dissolution, liquidation, or winding up of the Company and is entitled to receive, out of assets of the Company available for distribution upon liquidation, dissolution or winding up of the Company, $1.50 per share plus an amount equal to all dividends on shares accrued but unpaid, and is junior to the Series A Convertible Preferred Stock and all series of Redeemable Convertible Preferred Stock. The holders of the Series D Preferred are entitled to one vote for each share of Common Stock into which the Series D Preferred is convertible, and therefore shall have the same voting rights on a share-for-share basis, as the holders of the Common Stock. The holders of the Common Stock and of the Series D Preferred shall vote together as one class on all matters submitted to a vote of shareholders of the Company. Note 13 - Redeemable Convertible Preferred Stock: The Company is required to redeem all of the following series of convertible preferred stock on or before August 1, 2004. Accordingly, this preferred stock subject to mandatory redemption has been presented separately outside of permanent stockholders' equity in the accompanying financial statements.
December 31, June 30, June 30, 1996 1996 1995 Series C, par value $1.00 per share, 0 shares outstanding at December 31, 1996 and June 30, 1996, and 1,500 shares issued and outstanding at June 30, 1995. $0, $0 and $100,328 of accumulated dividends at December 31, 1996, June 30, 1996 and 1995, respectively. $ --- $ --- $1,600,328 Series E, par value $1.00 per share, 1,444 shares outstanding at December 31, 1996 and June 30, 1996, and 0 shares issued and outstanding at June 30, 1995. $189,226, $133,213 and $0 of accumulated dividends at December 31, 1996, June 30, 1996 and 1995, respectively. 1,633,226 1,577,213 --- Series F, par value $1.00 per share, 599 shares outstanding at December 31, 1996 and June 30, 1996, and 0 shares issued and outstanding at June 30, 1995. $51,313, $22,802 and $0 of accumulated dividends at December 31, 1996, June 30, 1996 and 1995, respectively. 650,313 621,802 --- Series G, par value $1.00 per share, 777 shares outstanding at December 31, 1996 and June 30, 1996, and 0 shares issued and outstanding at June 30, 1995. $46,875, $18,619 and $0 of accumulated dividends at December 31, 1996, June 30, 1996 and 1995, respectively. 823,875 795,619 --- Series H, par value $1.00 per share, 2,026 shares outstanding at December 31, 1996 and June 30, 1996, and 0 shares issued and outstanding at June 30, 1995. $265,494, $186,904 and $0 of accumulated dividends at December 31, 1996, June 30, 1996 and 1995, respectively. 2,291,494 2,212,904 --- TOTAL $5,398,908 $5,207,538 $1,600,328
At June 30, 1995, there were issued and outstanding 1,500 shares of Series C Convertible Preferred Stock. In early October 1995, Wand Partners, Inc. exchanged certain Notes payable for an additional 1,970 shares of Series C Preferred Stock. On January 31, 1996, Wand Partners, Inc. exchanged all of its Series C Convertible Preferred Stock for 1,444 shares of Series E Convertible Preferred Stock and 2,026 shares of Series H Convertible Preferred Stock. On January 31, Wand Partners, Inc. purchased 599 shares of Series F Convertible Preferred Stock for a total of $599,000, and on March 7, 1996, Wand purchased 777 shares of Series G Convertible Preferred Stock for a total of $777,000. Each of these series of stock is described below. Series F and G Convertible Preferred Stock Except as noted below the Series F and G Preferred Stock have the same terms and conditions. Each share of Series F and G Preferred Stock is convertible at the option of the holder at any time and from time to time into shares of Common Stock at a conversion price of (a) $1.25 per share, subject to adjustment, after June 30, 1996. With respect to dividend rights, redemption rights and rights on liquidation, winding up or dissolution, the Series F Preferred Stock ranks pari passus with the Series G Preferred Stock and ranks prior to the Series A, B, D, E, and H Preferred Stocks and the Common Stock of the Company. Except as provided herein, any holder of Series G Preferred Stock that is subject to the Bank Holding Company Act of 1956 ("BHCA Holder"), as amended, shall have no voting rights. Each holder of Series G Preferred Stock that is not a BHCA Holder shall be entitled to vote on all matters as to which stockholders of the Company are entitled to vote, and each such holder shall be entitled to cast a number of votes equal to the greatest number of whole shares of Common Stock into which such holder's shares of Series G Preferred Stock could be converted. The holders of the Series F Convertible Preferred Stock are entitled to one vote for each share of Common Stock into which the shares are convertible. In the event the Company is in default with respect to the payment of (i) two consecutive cash dividends after the "Restricted Period" as hereinafter defined or (ii) two dividends within any six consecutive dividend periods the holders of the Series F and G Preferred Stock shall have the right to elect two directors for so long as the default continues. In the event the Company is in default with respect to the payment of (i) four consecutive cash dividends after the Restricted Period as hereinafter defined or (ii) four dividend payments within any eight consecutive quarterly dividend periods, the holders shall have the right to elect four directors for so long as the default continues. In the event the Company violates the provisions of, or is in default under the terms of any loan agreement or in the event a judgment is entered against the Company or any subsidiary in the amount of $50,000 or more, the holders of the Series F and G Convertible Preferred Stock shall have the right to elect four directors. The holders of the Series F and G Preferred Stock, except during the Restricted Period, are entitled to receive out of funds of the Company legally available for such purpose as and when declared by the Board of Directors of the Company quarterly dividends in cash at a rate of nine percent (9%) compounded daily per annum of the stated value per share ($1,000.00 on original issuance) of Series F and G Preferred Stocks. Dividends shall accrue, be accumulated and added to the stated value whether or not declared. So long as any of the shares of Series F and G Preferred Stock are outstanding, the Company shall not declare or pay any dividends on any outstanding Common or Preferred Stock, other than the Series D, F and G Preferred Stock. The Restricted Period as it relates to the payment of dividends on the Series F and G Preferred Stock means the period beginning on the date of issuance of the Series F or G Preferred Stock and ending on September 30, 1997. While no dividends are payable during the Restricted Period, they will accrue and accumulate during the Restricted Period. The Company is obligated to redeem all the outstanding shares of Series F and G Preferred Stock outstanding at the stated value plus accrued dividends on August 1, 2004. The holders of the F and G Preferred Stock have the right to require that the Company redeem, to the extent the Company may lawfully do so, all or a portion of the then outstanding shares of Series F and G Convertible Preferred Stock at the stated value plus accrued and unpaid dividends in the event of a merger, reorganization, transfer of the majority of the voting securities of the Company, or sale of more than 25% of the assets of the Company. Series E and Series H Convertible Preferred Stock Except as noted below, the Series E and Series H Preferred Stock have the same terms and conditions. Each share of Series E and H Preferred Stock is convertible at the option of the holder at any time and from time to time into shares of Common Stock at a conversion price of (a) $1.50 per share subject to adjustment prior to August 1, 2004 or (b) on or after August 1, 2004 at a conversion price which is the lower of $1.00 or the conversion price in effect pursuant to (a). With respect to dividend rights, redemption rights and rights on liquidation, winding up or dissolution, the Series E and H Preferred Stocks rank (i) junior to the Series F Preferred Stock and the Series G Preferred Stock; (ii) pari passus with the Series A Preferred Stock; and (iii) rank prior to the Series B Preferred Stock and the Series D Preferred Stock and the Common Stock of the Company. Except as provided herein, any holder of Series E Preferred Stock that is subject to the Bank Holding Company Act of 1956 ("BHCA Holder"), as amended, shall have no voting rights. Each holder of Series E Preferred Stock that is not a BHCA Holder shall be entitled to vote on all matters as to which stockholders of the Company are entitled to vote, and each such holder shall be entitled to cast a number of votes equal to the greatest number of whole shares of Common Stock into which such holder's shares of Series E Preferred Stock could be converted. The holders of the Series H Convertible Preferred Stock are entitled to one vote for each share of Common Stock into which the shares are convertible. Except as hereinafter provided, the holders of the Series E Preferred Stock and the Series H Preferred Stock shall have the right, voting separately as a class, to elect two directors to the Board of Directors of the Company. However, in the event the Company is in default with respect to the payment of (i) two consecutive cash dividends after the "Restricted Period" as hereinafter defined or (ii) two dividends within any six consecutive quarterly dividend periods, the holders shall have the right to elect four directors for so long as the default continues. In the event the Company is in default with respect to the payment of (i) four consecutive cash dividends after the 'Restricted Period" as hereinafter defined or (ii) four dividend payments within any eight consecutive quarterly dividend periods, the holders shall have the right to elect six directors for so long as the default continues. In the event the Company violates the provisions of, or is in default under the terms of any loan agreement or in the event a judgment is entered against the Company or any subsidiary in the amount of $50,000 or more, the holders of the Series E and H Convertible Preferred Stock shall have the right to elect eight directors. The holders of the Series E Preferred Stock and the Series H Preferred Stock, except during the Restricted Period, are entitled to receive out of funds of the Company legally available for such purpose as and when declared by the Board of Directors of the Company quarterly dividends in cash at a rate of seven percent (7%) compounded daily per annum of the stated value per share ($1,000.00 on original issuance) of Series E and H Preferred Stocks. Dividends shall accrue, be accumulated and added to the stated value whether or not declared. So long as any of the shares of Series E and H Preferred Stock are outstanding, the Company shall not declare or pay any dividends on any outstanding Common or Preferred Stock, other than the Series D, F and G Preferred Stock. The Restricted Period as it relates to the payment of dividends on the Series E and H Preferred Stock means the period beginning on the date of issuance of the Series E and H Preferred Stock and ending on the earlier of (a) the first day of the calendar quarter in which the Company first pays cash dividends on its Common Stock or (b) June 30, 1998. While no dividends are payable during the Restricted Period, they will accrue and accumulate during the Restricted Period. The Company is obligated to redeem all the outstanding shares of Series E and H Preferred Stock outstanding at the stated value plus accrued dividends on August 1, 2004. The holders of the E and H Preferred Stock have the right to require that the Company redeem, to the extent the Company may lawfully do so, all or a portion of the then outstanding shares of Series E and H Convertible Preferred Stock at the stated value plus accrued and unpaid dividends in the event of a merger, reorganization, transfer of the majority of the voting securities of the Company, or sale of more than 25% of the assets of the Company. Note 14 - Related party transactions: Herbert S. Meeker, a director of the Company, is a partner in the law firm of Baer, Marks & Upham, which the Company uses for legal services. For the six months ended December 31, 1996, and for the years ended June 30, 1996, 1995, and 1994, the Company recorded an expense for Baer, Marks & Upham of $7,200, $14,440, $14,440 and $14,000, respectively. In addition, in the year ended June 30, 1995, the Company recorded a charge against additional paid-in capital of $26,736 for the work done by Baer, Marks & Upham on the Company's Rights Offering. Included in Other current liabilities at December 31, 1996, June 30, 1996 and 1995 are $8,045, $8,885 and $10,181, respectively, due Baer, Marks & Upham. Bruce W. Schnitzer, who became a director of the Company in August 1994, is Chairman of Wand Partners, Inc., a private investment firm that the Company uses for management consulting. For the six months ended December 31, 1996, and for the years ended June 30, 1996 and 1995, the Company recorded an expense for Wand Partners, Inc. of $25,060, $46,076 and 43,530, respectively. Included in Other current liabilities at December 31, 1996, June 30, 1996 and 1995 are $0, $0 and $32,592, respectively, due Wand Partners, Inc. Thomas F. Hill, who became a director of the Company in August 1994, is President of Hill & Partners, a consulting firm that the Company uses for marketing consulting. For the year ended June 30, 1995, the Company recorded an expense for Hill & Partners of $106,679. Included in Other current liabilities at June 30, 1995 is $37,661 due Hill & Partners. Thomas D. Halket, who became an officer of the Company in January 1993, is an outside counsel for the Company. For six months ended December 31, 1996, and for the years ended June 30, 1996, 1995 and 1994, the Company recorded an expense for Thomas Halket of $65,425, $144,176, $103,326, and $80,196, respectively. Included in Other current liabilities at December 31, 1996, June 30, 1996 and 1995 are $6,864, $34,799 and $6,900, respectively. Note 15 - Notes payable: On August 16, 1995, a registration statement of the Company relating primarily to rights granted to the Company's shareholders became effective. Each right enabled the holder to purchase a Unit consisting of one share of Series D Convertible Preferred Stock, convertible into one share of Common Stock after January 1, 1996, and one warrant to purchase one-half share of Common Stock for three years after the effective date of the registration statement at a price of $2.00 per share. Gross proceeds of the rights offering, which closed on September 29, 1995, totaled $285,823. In early October the Company received the proceeds of the offering and issued the stock. Costs of the offering, which were charged to additional paid-in capital, totaled approximately $136,000. Pursuant to a Standby Financing and Purchase Agreement dated March 16, 1995, as amended on June 30, 1995, Wand Partners, Inc. loaned to the Company the sum of $1,700,000 evidenced by promissory notes, which bore interest at the rate of 10% per annum, payable in shares of Common Stock of the Company. On September 12, 1995, Wand Partners, Inc. made an additional loan to the Company in the amount of $300,000, bringing the principal amount of all of the Company's promissory notes to $2,000,000. In early October, Wand Partners, Inc. exchanged these notes for 20,000 unregistered Units and 1,970 shares of Series C Preferred Stock. The terms and conditions of such Series C Convertible Preferred Stock are the same as the 1,500 shares of Series C Convertible Preferred Stock previously purchased by Wand Partners, Inc.. Upon completion of the offering and the conversion of the notes described above, the Company issued to Wand Partners, Inc. 700,000 ten-year warrants to purchase shares of the Common Stock of the Company at $1.00 per share. The Company recorded a charge of $131,250 representing the difference between the market value of the underlying Common Stock of the Company and the aggregate exercise price of such warrants. Note 16 - Long-term portion of deferred income: In December 1994, a customer agreed to convert $200,000 of its prepayment into equity and the Company agreed to refund to the customer its prepayments of royalties and engineering fees under its license agreement with the Company. The amounts to be refunded are equal to the greater of (a) seven percent (7%) of the Company's revenues from licensing of its credit-card risk assessment products in Europe or (b) certain minimum payments during the period ending December 31, 1996. The refunding of the customer's prepayments based upon the Company's European risk-assessment revenues is expected to continue through December 1999, but in no event shall exceed in the aggregate prepayments made by the customer, reduced by refunds made to the customer and by the amount of prepayments applied to the purchase of Series A Preferred Stock of the Company. At December 31, 1996 and June 30, 1996, such long-term portion of deferred income remaining on the books of the Company amounted to $430,899 after giving effect to the application of $200,000 of deferred income to the purchase by the customer of 100,000 shares of Series A Preferred Stock, $30,000 refunded by the Company to the customer, and the reclassification of $275,000 to Other current liabilities. At June 30, 1995, $100,000 of the amount owed by the Company was recorded as Other noncurrent liabilities and the balance was shown as Other current liabilities. There is no interest on these amounts due the customer. Note 17 - Significant transactions: On June 11, 1996, the Company entered into an exclusive Licensing Agreement and an Asset Purchase Agreement with National Computer Systems, Inc. (NCS) transferring the development, production, and marketing rights of the Company's Intelligent Character Recognition (ICR) products to NCS. The Company received $1,400,000 as an initial license fee pursuant to the Licensing Agreement, and has the right to receive royalties on future sales of the products by NCS. Minimum annual royalties range from $160,000 in 1997 to $350,000 in 2001 and beyond. If NCS terminates its exclusive rights under the contract, minimum royalty payments would not be required subsequent to such termination. The initial license fee was included in software licensing revenue in the year-ended June 30, 1996. The Asset Purchase Agreement transferred tangible and intangible assets used exclusively in the ICR business to NCS for $300,000. The net gain on the sale of these assets was recognized as Other income in the year-ended June 30, 1996. Note 18 - Other income (expense) - net: Other income (expense) as reflected in the consolidated statements of operations consists of the following:
Six Months Ended December 31, Years Ended June 30, 1996 1996 1995 1994 Interest expense $(3,227) $(51,574) $ (34,801) $ (1,685) Expense relating to financing operations(42,500) (131,250) (210,500) (287,969) Net gain on sale of tangible and intangible assets (See Note 17) --- 213,185 --- --- Other - net 29,507 9,589 24,277 7,236 Other Income (Expense) - Net $(16,220) $ 39,950 $(221,024) $(282,418)
Note 19 - Deferred development costs: The Company began in the quarter ended September 30, 1996, a project to customize its PRISM Fraud Detection System for a customer. Because the terms of the agreement have not been finalized, the Company is accounting for the development costs in accordance with SOP 81-1, "Accounting for Performance of Construction- Type and Certain Production-Type Contracts," which provides that costs be deferred until delivery is made under the terms of an enforceable agreement. During the quarter ended December 31, 1996, the Company recorded an adjustment to reverse revenues totaling $211,000 and capitalize related costs of $118,000 originally recorded in the quarter ended September 30, 1996. This change had the effect of increasing net loss per share by $.01. The Company expects to conclude an agreement and make required deliveries in early 1997. For the six months ended December 31, 1996, the Company deferred $364,000 of costs associated with this project. NESTOR, INC. Part IV Item 14 CONSOLIDATED FINANCIAL STATEMENT SCHEDULE VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Balance Addition at Charged Balance Beginning Charged to at of to Other Deductions End Description Period Expense Accounts Reserve of Period Allowances deducted from accounts receivable: Year ended June 30, 1994 $ 1,550 $ 21,680 $ --- $ --- $ 23,230 Year ended June 30, 1995 $ 23,230 $ 45,276 $ --- $(10,530) $ 57,976 Year ended June 30, 1996 $ 57,976 $120,656 $ --- $(12,923) $ 165,709 Six months ended December 31, 1996 $ 165,709 $ 38,888 $ --- $59,362 $ 145,235
ITEM 8. Financial Statement and Supplementary Data See annexed financial statements. ITEM 9. Changes in or Disagreement with Accounting and Financial disclosure Information regarding changes in accountants was previously filed under cover of Form 8-K which is incorporated herein by reference. ITEM 10. Directors and Executive Officers of the Registrant. Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Commission not later than 120 days following the end of the Company's fiscal year. ITEM 11. Executive Compensation. Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Commission not later than 120 days following the end of the Company's fiscal year. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Commission not later than 120 days following the end of the Company's fiscal year. ITEM 13. Certain Relationships and Related Transactions. Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Commission not later than 120 days following the end of the Company's fiscal year. ITEM 14. Exhibits, Financial Statement, Schedules and Reports on Form 8-K. (a)The following documents are filed as part of this report: (1) The financial statements of the Company and accompanying notes, as set forth in the contents to the financial statements annexed hereto, are included in Part II, Item 8. Schedule IV: Valuation and Qualifying Accounts and Reserves All other schedules are omitted because such information is not applicable. (2) Exhibits numbered in accordance with Item 601 of Regulation S-K. (See Exhibit Index) Exhibits filed herewith: (None) (b) Reports on Form 8-K: On October 4, 1996, the Company filed with the Commission a Current Report on Form 8-K dated September 19, 1996. On December 17, 1996, the Company filed with the Commission a Current Report on Form 8-K dated December 10, 1996. INDEX OF EXHIBITS Exhibit Number Description of Exhibit 3.1 Certificate of Incorporation of the Company, filed as an Exhibit to the Company's Registration Statement on Form S18, Commission File No. 286182-B, is hereby incorporated herein by reference. 3.2 Amendment to the Certificate of Incorporation of the Company, dated December 5, 1985, filed as an Exhibit to the Company's Form 8 amending the Company's Form 10-K for the fiscal year ended June 30 1987 (the "1987 Form 8"), is hereby incorporated herein by reference. 3.3 Amendment to the Certificate of Incorporation of the Company, dated December 4, 1986, filed as an Exhibit to the 1987 Form 8, is hereby incorporated herein by reference. 3.4 Bylaws of the Company, as amended, filed as Exhibit to the 1987 Form 8, is hereby incorporated herein by reference. 4 Nestor, Inc. Incentive Stock Option Plan, as amended, filed as an Exhibit to the Company's Registration Statement on Form S-8, filed May 5, 1987, is hereby incorporated herein by reference. 10.1 Non-Exclusive Field- of-Use License Agreement dated June 21, 1988 between the Company and Morgan Stanley & Co. Incorporated, filed as an Exhibit to the Company's Form 10-K for the fiscal year ended June 30, 1988, is hereby incorporated herein by reference. 10.2 Cooperative Marketing Agreement dated May 26, 1988 between the Company and Arthur D. Little, Inc., filed as an Exhibit to the Company's Form 10-K for the fiscal year ended June 30, 1988, is hereby incorporated herein by reference. 10.3 Lease Rider dated February 6, 1985 between Richmond Square Technology Park Associates and the Company, filed as an Exhibit to the Company's Report on Form 10-K for the fiscal year ended June 30, 1986, is hereby incorporated herein by reference. 10.4 Employment Agreement dated August 4, 1986 between the Company and Michael G. Buffa, filed as Item 5 of the Company's Report on Form 8-K dated September 11, 1986, is hereby incorporated herein by reference. 10.5 Joint Venture Agreement between the Company and Oliver, Wyman & Co., dated December 4, 1986, filed as an Exhibit to the 1987 Form 10-K, is hereby incorporated herein by reference. 10.6 Employment Agreement dated as of July 1, 1989 between the Company and David Fox filed as an Exhibit to the 1989 Form 10-K is hereby incorporated by reference. 10.7 Employment Agreement dated as of September 15, 1988 between the Company and Douglas L. Reilly filed as an Exhibit to the 1989 Form 10-K is hereby incorporated by reference. 10.8 Memorandum dated January 1, 1989 regarding stock bonus plan for Douglas L. Reilly filed as an Exhibit to the 1989 Form 10-K is hereby incorporated by reference. 10.9 Amendment to Joint Venture Agreement dated May 8, 1990 between the Company and Oliver, Wyman & Co. filed as an Exhibit to the 1992 Annual Report on Form 10-K is hereby incorporated by reference. 10.10 License Agreement dated October 26, 1990 by and between the Company and Sligos, S. A. filed as an Exhibit to the Company's 1992 Annual Report on Form 10- K is hereby incorporated by reference. 10.11 Supplemental License Agreement dated September 9, 1991 by and between the Company and Sligos, S. A., filed as an Exhibit to the Company's 1992 Annual Report on Form 10-K, is hereby incorporated by reference. 10.12 NestorWriter(TM) License and Development Agreement dated September 11, 1991 between the Company and Poqet Computer Corporation. 10.13 License Agreement for Product Development and Marketing dated October 30, 1990 between the Company and Lyonnaise des Eaux-Dumez. 10.14 Software Development Agreement dated October 30, 1990 between the Company and Lyonnaise des Eaux-Dumez. 10.15 License Agreement dated November 27, 1990 between the Company and Atari Corporation. 10.16 License Agreement for Product Development and Marketing dated March 18, 1991 between the Company and Dassault Electronique. 10.17 Agreement of Purchase and Sale dated August 16, 1991 between the Company and Diversified Research Partners filed as Item 5 of the Company's report on Form 8-K dated August 21, 1991 is hereby incorporated herein by reference. 10.18 License Agreement dated October 15, 1993, between the Company and Intel Corporation filed as an Exhibit to the Company's 1994 Annual Report on Form 10- K is hereby incorporated by reference. 10.19 Exclusive Marketing Agreement dated April 7, 1994, between the Company and Intel Corporation filed as an Exhibit to the Company's Current Report on Form 8-K dated April 7, 1994, is hereby incorporated by reference. 10.20 Securities Purchase Agreement dated August 1, 1994, between the Company and Wand/Nestor Investments L.P. ("Wand") filed as Item 5 of the Company's report on Form 8-K dated August 8, 1994, is hereby incorporated herein by reference. 10.21 Standby Financing and Purchase Agreement dated as of March 16, 1995 between the Company and Wand, filed as an Exhibit to the Company's Current Report on Form 8-K dated March 16, 1995, is hereby incorporated by reference. 10.22 First Amended and Restated Standby Financing and Purchase Agreement dated June 30, 1995 between the Company and Wand, filed as an Exhibit to the Company's Current Report on Form 8-K dated July 7, 1995, is hereby incorporated by reference. 10.23 Amendment Agreement dated December 20, 1994 between the Company and Sligos, S.A., filed as an Exhibit to the Company's Registration Statement on Form S-2, Commission File No. 33-93548, is hereby incorporated herein by reference. 10.24 Technology Development Subcontract dated December 20, 1994, between the Company and Alta Technology Corporation, filed as an Exhibit to the Company's Registration Statement on Form S-2, Commission File No. 33-93548, is hereby incorporated herein by reference. 10.25 Agreements between the Company and Europay International S.A. ("Europay") consisting of: (i) Fraud Study Agreement dated August 3, 1993, together with appendices and exhibits thereto; (ii) Confidentiality Agreement dated August 3, 1993; (iii) Nestor Fraud Detection System User License dated September 21, 1994; (iv) Source Code Addendum to Nestor Fraud Detection System User License, dated September 22, 1994; and (v) Memorandum of Understanding dated May 5, 1995, filed as an Exhibit to the Company's Registration Statement on Form S-2, Commission File No. 33-93548, is hereby incorporated herein by reference. 10.26Lease of executive offices of the Company, together with the most recent rider thereto, filed as an Exhibit to the Company's Registration Statement on Form S-2, Commission File No. 33-93548, is hereby incorporated herein by reference. 10.27 Non-Exclusive License Agreement between the Company and International Business Machines Corporation, filed as an Exhibit to the Company's Current Report on Form 8-K dated January 30, 1996, is hereby incorporated by reference. 10.28 Securities Purchase and Exchange Agreement between the Company and Wand/Nestor Investments L.P., filed as an Exhibit to the Company's Current Report on Form 8-K dated January 30, 1996, is hereby incorporated by reference. 10.29 Securities Purchase Agreement between the Company and Wand/Nestor Investments L.P., filed as an Exhibit to the Company's Current Report on Form 8-K dated March 7, 1996, is hereby incorporated by reference. 10.30 Asset Purchase Agreement and License Agreement between the Company and National Computer Systems, Inc., filed as an Exhibit to the Company's Current Report on Form 8-K dated June 11, 1996, is hereby incorporated by reference. 10.31 Prism Non-Exclusive License Agreement between the Company and Applied Communications, Inc., filed as an Exhibit to the Company's Current Report on Form 8- K dated September 19, 1996, is hereby incorporated by reference. Portions of the Exhibit omitted, pursuant to a grant of confidential treatment. 22 Subsidiaries of the Company, filed as an Exhibit to the 1987 Form 10-K, is hereby incorporated herein by reference. EX-27 2
5 6-MOS DEC-31-1996 DEC-31-1996 774,457 0 1,009,149 0 0 2,551,571 1,407,180 1,151,590 2,817,944 1,307,994 0 5,398,908 2,366,294 89,161 0 2,817,944 63,775 1,195,904 8,978 922,325 0 0 0 0 0 0 0 0 0 (935,337) 0 0
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