-----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, B62rgbrBj6J482L9FgFTbUtWmHsoICSoKRu0735Pibo/EHnrNpD+9DM3CvbNGORT xkzFcjZQBn8q/qpEb+EuoA== 0000720851-01-500005.txt : 20010409 0000720851-01-500005.hdr.sgml : 20010409 ACCESSION NUMBER: 0000720851-01-500005 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20001231 FILED AS OF DATE: 20010402 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: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-12965 FILM NUMBER: 1589288 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-K 1 form10k.txt FORM10K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended December 31, 2000 ----------------------------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to -------------- -------------- Commission file Number 0-12965 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: 40 The aggregate market value of the 8,044,936 shares of voting stock held by non-affiliates of the registrant, based on the average bid and asked prices of such stock on February 28, 2001 was $5,908,201. The number of shares outstanding of the Registrant's Common Stock at February 28, 2001 was 17,688,449. 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. ITEM 1. Business General The Company designs, develops, markets, installs and supports technologies and intelligent software solutions for decision and data-mining applications in real-time environments. The Company products employ proprietary neural network predictive technologies to convert existing data and business experiences into meaningful recommendations and actions. The Company designs and develops high-value software products that can bring additional value to customers by utilizing its proprietary technology and information-management knowledge. The Company has leveraged its neural-network software architecture across a wide range of markets, including e-Commerce Profitability, Risk Management, Customer Relationship Management and, through license to third parties, Traffic Management and Intelligent Character Recognition Systems. e-Commerce Profitability Solutions - Products in this market represent the Company's newest solutions, and comprise the PRISM(R) eFraud(TM)and eCLIPSE(TM) e-business decision-support solutions. Targeted at on-line retailers, financial services companies, commerce service providers and application service providers, PRISM eFraud detects fraudulent on-line transactions in real-time, and enables organizations to take immediate and informed loss prevention actions. The eCLIPSE CRM product discussed below, also targeted at this core set of e-businesses, enables companies to dynamically personalize websites and off-line communications using each organization's unique customer information. Risk Management - Products in this market represent the Company's largest product line and its most established applications. These products are designed to effectively detect and control fraudulent transactions for financial institutions and retailers that issue or process credit, debit, or other financial use cards and retailers that accept card payments over the phone or Internet and are exposed to charge-back losses from fraud or liability for other schemes, such as money-laundering. These applications include PRISM Credit, PRISM Debit, PRISM Money-Laundering and PRISM Merchant products. Products in the Risk Management group represent approximately 94% of the Company's 2000 revenue. Customer Relationship Management - are designed to synthesize information from multiple data sources within an organization and provide personalized content to individual customers, including web site visitors, based on the current state of the customer's information. In 2000, the Company unveiled its eCLIPSE product, which is a combination of two product initiatives in intelligent personalization (CampaignOne and InterSite) into a product capable of providing intelligent and consistent marketing campaigns across all channels within an organization. eCLIPSE, provides a comprehensive solution for effective enterprise-wide customer marketing. eCLIPSE accumulates customer data from all customer contact points within an organization, allows the development of comprehensive, personalized marketing campaigns on segments or all of a population, including champion-challenger and budget considerations, and deploys the developed campaigns to the appropriate channel, including the Internet. eCLIPSE allows for consistent personalization across all communication channels. Campaigns can be further enhanced by the use of the Company's proprietary models in areas such as customer profitability, retention, and cross selling. Products in this group represent approximately 3% of the Company's 2000 revenue. Traffic Management - These products, developed and marketed by Nestor Traffic Systems, Inc. ("NTS"), 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 data and surveillance. Through an exclusive licensing agreement with NTS, a 34.6% owned affiliate of the Company (formerly a wholly-owned subsidiary), the Company applies its image-understanding technologies and other patent-pending technologies to the field of intelligent traffic-management systems. NTS products include CrossingGuard, Rail CrossingGuard, and TrafficVision. Using standard video equipment, NTS software is capable of understanding traffic patterns in real-time allowing for red-light enforcement and safety features at intersections and rail crossings, and also data collection, analysis, and real-time exception alarms for open roads. As NTS is now accounted for under the equity method of accounting, it did not contribute to revenues in 2000 or 1999. In fiscal 1998, this group represented approximately 10% of consolidated revenues. In January 2001, an agreement in principle was reached to combine the Company and NTS by merging NTS into a wholly-owned subsidiary of the Company, with Nestor, Inc., in effect, becoming the surviving entity. For a detailed description of the proposed merger, see Note 16 of the Company's financial statements. Intelligent Character Recognition Systems - Currently marketed through National Computer Systems, Inc., this product line includes packages of software applications such as OmniTools, NestorReader, and N'Route which increase productivity in document processing and fax distribution environments. Royalties from this group represent less than 1% of the Company's fiscal 2000 revenues. 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 System(TM) ("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. On January 1, 1997, the Company formed two wholly-owned subsidiaries: Nestor Traffic Systems, Inc. and Nestor Interactive, Inc. ("Interactive"). NTS develops and markets the TrafficVision, CrossingGuard, and the Rail CrossingGuard product lines. The Company now owns a 34.6% interest in NTS and uses equity accounting to account for the investment. As discussed above, see Note 16 of the Company's financial statements for details of a proposed merger of NTS into the Company. Interactive developed InterSite, an Internet personalization solution, but this subsidiary has been inactive since November 1998. The Company offers complete application-software solutions that include adaptive decision models, implementation, education, training, consulting, processing and engineering support services. Current Company software products detect bankcard (credit/debit) and private-label (retail) card, merchant and other forms of fraud (PRISM), provide intelligent, enterprise-wide marketing campaign management and real-time targeted information to Internet Web site visitors (eCLIPSE), provide traffic management and safety (through its affiliate NTS) of freeways (TrafficVision), rail crossings (Rail CrossingGuard), and intersections (CrossingGuard), and provide much greater efficiencies in document processing and fax distribution environments (NestorReader, OmniTools and N'Route which products were licensed to National Computer Systems in June 1996). The Company'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 twelve months. The Company believes that PRISM customer payback periods for license, installation, and first year user fees are typically less than one year. Fraud Detection and Risk-Assessment Systems The Company's fraud detection and risk assessment solutions include the Proactive Risk Management (PRISM) system which has been licensed to more than 40 financial-services and retail clients as of December 31, 2000. These systems can detect bankcard 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. In 1993, the Company completed the installation of the Nestor Fraud Detection System (FDS), the predecessor of the PRISM products, at Mellon Bank. The success of the FDS installation at Mellon has been instrumental in obtaining additional orders for 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 found 20 times as many instances of fraud as their rule-based system, while requiring reviews of only one-third as many accounts. In February 1995, the Company announced PRISM. PRISM enhanced 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 upgrade to FDS installed at G.E. Capital Consumer Financial Services; the upgrade incorporated PRISM in 1995. During 1999, the Company expanded its PRISM product line with the introduction of PRISM Debit (Debit), PRISM Bankruptcy (Bankruptcy), and PRISM Credit (Credit). Debit is an intelligent risk management system that detects, monitors, responds to and prevents off-line debit card fraud. Bankruptcy is a bankruptcy decision-support system that provides transaction-level analysis of each account and enables card issuers to better manage risk while increasing portfolio profitability. Credit is a multi-faceted fraud detection system that dramatically reduces losses associated with credit and retail card application fraud. In 1999, the Company released version 5.0 of PRISM. This enhanced version features an open software framework that allows users to customize PRISM's graphical user interface to meet their specific processing and customer service requirements. Additionally, PRISM 5.0 facilitates the user's ability to interface the PRISM software with their card processing authorization system, charge-back recovery systems and other external applications to enhance the organization's overall risk management operations. Also in 1999, PRISM was expanded to include e-commerce risk management (PRISM eFraud) and money laundering detection (PRISM Money Laundering Detection). These solutions detect fraudulent on-line transactions and money laundering activities, respectively. The following are the primary attributes of the PRISM Risk Management Systems: Comprehensive Graphical User Interface and Case Management System. PRISM 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. 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 clients' needs and profiles without extensive custom programming. Unlike competitive 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. The Company'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. The Company'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 components that operate on a wide range of industry standard, client-server platforms, including the IBM, MVS/CICS, Compaq's proprietary, fault tolerant Non Stop Kernel (NSK), UNIX and Windows NT operating platforms. Nestor's Fraud Detection and Risk Assessment Strategy The Company's objectives are: to deliver high quality products and services including proprietary neural-network technology to the banking, retail, Internet, 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 sales, distribution and service forces through the appointment of partners with expertise in various product channels (i.e. telecommunications and internet transaction processing). The Company intends to continue developing domestic markets while augmenting its international growth. On February 1, 2001, the Company entered into a new non-exclusive license agreement with Applied Communications, Inc. ("ACI"), a subsidiary of Transaction Systems Architects, Inc. Pursuant to the license agreement, ACI has been granted the right to integrate and distribute all of the Company's PRISM and fraud detection products throughout ACI's worldwide sales and support network. ACI made an initial payment of $1.1 million to the Company upon execution of the agreement, and is required to make guaranteed minimum royalty payments during the first year in an amount of approximately $500,000. The license requires the payment of a 15% royalty starting on February 1, 2002, but no further guaranteed minimum royalty payments will be required. This agreement replaces the license agreement signed with ACI on April 18, 1997. See "Certain Relationships and Related Transactions." The Company executed a non-exclusive PRISM reseller agreement with CSK Corporation in Japan in 1996. The Company also intends to increase sales efforts through marketing and service agreements with established providers of products and services to its target markets. 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 up front 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 posses data characteristics similar to the financial institution industry. The Company plans to extend the successes of the PRISM product in 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. Customer Relationship Management Systems During 2000, the Company introduced eCLIPSE, a comprehensive customer relationship and marketing campaign management solution designed to maximize the effectiveness and efficiency of on-line and off-line marketing campaigns for all aspects of financial opportunity from: customer acquisition, retention, cultivation and overall customer profitability. eCLIPSE can utilize customers' internal models along with the Company's customized neural-network models. eCLIPSE combines and improves on previous products developed by the Company: CampaignOne and InterSite. Nestor eCLIPSE 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. Intelligent Character Recognition Products On June 11, 1996, the Company licensed the 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 receives royalties from the sales of these products and any enhanced versions of these products by the licensee. 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 and its affiliates product lines are targeted toward large commercial users (e.g., banks for the PRISM and eCLIPSE products), or federal, state and local government agencies (e.g., Departments of Transportation for the CrossingGuard and TrafficVision products). 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 PRISM and eCLIPSE products are licensed directly by the Company and through select distributors, primarily to financial institutions. The Traffic Management products are being marketed directly by NTS and through distributors to governmental traffic management departments or their chosen integrators. The Company's Intelligent Character Recognition products are marketed 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. The Company's FDS and PRISM products are an outgrowth of such development projects. In the United States and Canada, the Company markets PRISM and eCLIPSE through ACI and directly. ACI is the Company's largest reseller, with offices and employees around the world. ACI has reseller rights to all of the Company's PRISM products on a stand-alone basis or packaged with their proprietary products. The Company has a worldwide license with Total System Services, Inc. ("Total") to provide its PRISM product to customers for which Total provides card-processing services (provided in North and Central America). In Japan, custom financial applications are marketed through its licensee, CSK Corporation. Management of the Company believes that the success of the PRISM and eCLIPSE products will create a valuable franchise in each institution, leading to extensions of the Company's technology to other risk-assessment and marketing applications. During 2000, ACI accounted for 65% of the Company's revenues. During 1999, ACI and CSK accounted for 61%, and 14% of the Company's revenues, respectively. During 1998, ACI, GE Consumer Credit Financial Services and Mellon Bank accounted for 28%, 20% and 14% of the Company's revenues, respectively. During 1999, GE Consumer Credit Financial Services and Mellon Bank accounts were acquired by other banks and the annual use fees being realized from PRISM ceased. 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. As of December 31, 2000 and 1999 the Company had a backlog of approximately $1,046,000 and $1,208,000, respectively, in undelivered license, development and installation contracts. At December 31, 1998, the Company had a backlog of approximately $578,000 in undelivered development and installation contracts, in addition to $914,000 in NTS backlog as of December 31, 1998. NTS backlog is not included in the Company's 2000 or 1999 figures. Neural-network Technology The Company's technology deals with the problem of pattern recognition within complex data. 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, customer buying behavior, handwritten characters, vehicles in a traffic flow, or others. 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, statistical analysis, and neural networks. The Company's products may combine all of these methods to optimize pattern recognition capabilities. Neural-networks simulate a virtual network of interconnected units, processing data in parallel, and communicating with each other at high speeds. A trained neural-network receives 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 patterns in multi-dimensional non- linear input, such as attempting to recognize characters from a scanned handwritten sample, which is ill-defined, affected by "noise", or blatantly unusual (i.e. overly large or small, or containing skewed characters). The Company, as the result of extensive research, has created a proprietary neural-network technology referred to as the Restricted Coulomb Energy Model(TM) (RCE) which has been granted five patents. The RCE model has many unique features. It has rapid learning from sparse data and fast processing speeds. 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 in order to use the technology, and a stable solution is not guaranteed. The Company has also been granted a sixth patent for a multi-unit system referred to as the Nestor Learning System(TM) ("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 continues to develop and improve its 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 funding the costs of developing new technologies or products, but may bear all 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 and patents pending relating to improvements to The Company's basic technology (see "Patents"). The Company has six applications pending as of December 31, 2000, primarily in the area of traffic management. These improvements are incorporated into the Company's products where applicable. 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 years ended December 31, 2000, 1999, and 1998, respectively, $1,247,000, $921,000, and $2,113,000, in support of the various aspects of Company-sponsored research and development. Expenses in 1998 include $860,000 from NTS operations which are not consolidated in 2000 and 1999. 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's RCE neural network exhibits rapid learning and minimizes the internal connections needed for its functioning. The Company believes that these capabilities make 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. The Company owns seven United States patents and seven foreign patents issued in four countries and Europe. In addition, the Company has five applications pending in the United States, is a joint owner of one United States application and has three foreign applications pending, as of December 31, 2000. The foreign patents and patent applications correspond to one or more of the United States patents. The Company believes that seven of its United States patents, and four of the corresponding foreign patents, are material to its and its affiliates business. These United States patents expire at various times from 2005 to 2019. The corresponding foreign patents expire at various times through 2007. The following table lists the Company's material United States patents:
Patent No. Title Date of Issue Expiration - ---------- ----- ------------- ---------- 4,760,604 Parallel, Multi-unit, Adaptive, Nonlinear Pattern Class July 26, 1988 2005 Separator and Identifier 4,897,811 N-Dimensional Coulomb Neural Network Which Provides for January 30, 1990 2007 Cumulative Learning of Internal Representations 4,958,375 Parallel, Multi-unit, Adaptive Pattern Classification September 18, 1990 2007 System Using Inter-unit Correlations And An Intra-class Separator Methodology 5,054,083 Parallel, Multi-unit, Adaptive, Nonlinear Pattern Class October 1, 1991 2008 Separator and Identifier 5,479,574 Method and Apparatus for Adaptive Classification December 26, 1995 2012 5,701,398 Adaptive Classifier Having Multiple Sub Networks December 23, 1997 2014 6,188,329 Integrated Traffic Light Violation Citation Generation February 13, 2001 2019 and Court Date Scheduling System
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, MasterCard Corporation, 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 customer relationship management 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, IBM and Oracle. Companies providing vertical solutions include Acxiom, Experian, Harte- Hanks, BroadVision, Cyber Dialogue, Engage Technologies, Net Perceptions, Vignette, and HNC Software and others. The market for Internet- oriented personalization products is intensely competitive with new competitors emerging frequently. 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, 2000, the Company had forty-four full-time employees, including twenty-three in software engineering and product development, eight in sales and marketing and thirteen in management, finance and support. 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 are 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 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, software development and sales personnel, for whom the competition is intense. In the past, the Company has experienced difficulty in recruiting a sufficient number of qualified engineering and 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. Applied Communications, Inc. (ACI) On February 1, 2001, the Company entered into a new non-exclusive license agreement with Applied Communications, Inc., a subsidiary of Transaction Systems Architects, Inc. Pursuant to the license agreement, ACI has been granted the right to integrate and distribute all of the Company's PRISM and fraud detection products throughout ACI's worldwide sales and support network. ACI will pay $1.1 million to the Company in four equal installments over the four months following February 1, 2001, and is required to make guaranteed minimum royalty payments during the first year in an amount of approximately $500,000. The license requires the payment of a 15% royalty starting on February 1, 2002, but no further guaranteed minimum royalty payments will be required. This agreement replaces the license agreement signed with ACI on April 18, 1997. Additionally, ACI hired twelve of the Company's engineering, modeling, and customer support employees and assumes responsibility for product enhancements, installation, modeling, and support for ACI licensees. On April 18, 1997, the Company expanded its non-exclusive original 1996 license agreement with ACI. The expanded license grants to ACI the right throughout the world to integrate and distribute all of the PRISM products. ACI provides authorization, transaction processing, and other software to more than 2,300 customers in 79 countries throughout the world. The Company receives royalties based on PRISM and other product licensing, engineering and ongoing use fees received by ACI from ACI sublicenses. In April 1998, ACI's parent company, Transaction Systems Architects, Inc. (TSAI) entered into a Stock Purchase Agreement with the Company. TSAI purchased 2.5 million shares of common stock for $5,000,000 and obtained a warrant to purchase an additional 2,500,000 common shares for $7,500,000. The warrant expires on March 1, 2002. Additionally, TSAI provided a $1,000,000 Line of Credit at the prime interest rate plus 1%, which matured on March 1, 2001. As of December 31, 2000, the Company had advances against the line totaling $425,000. This balance is being repaid evenly over twelve months commencing March 1, 2001. Total System Services, Inc. During 1996, the Company designed and installed a fraud detection system for Total System Services, Inc. (Total), a major provider of card processing services for financial institutions. Total provides PRISM fraud detection services to its customers along with the other transaction processing services. The Company receives fees based upon the number of transactions that are scored for Total's customers by PRISM. CSK Corporation 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 was for an initial term of two years and is being renewed annually. 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. In June 1998, NCS did not meet its minimum royalty for the license year and forfeited exclusive rights. NCS continues to market the ICR products on a non-exclusive basis. ITEM 2. Properties. ----------- The Company leases offices and research and development facilities, consisting of approximately 13,000 square feet, located at One Richmond Square, Providence, Rhode Island 02906, for which the annual base rental is $195,000. The Company believes these facilities will be adequate to serve its needs in the foreseeable future. A portion of this facility is subleased to NTS, on a month-to-month basis, for approximately $12,000 per month, including telephone, utilities and other facilities related expenses. ITEM 3. Legal Proceedings. ------------------ On October 6, 1998, HNC Software Corp. ("HNC"), a significant competitor of the Company's in the field of financial services, obtained a patent entitled "Fraud Detection Using Predictive Modeling" and began advising prospective customers of the Company of the patent. Upon review of the patent and consideration of prior actions taken by HNC, the Company initiated a lawsuit against HNC in the United States District Court in Providence, RI on November 25, 1998 alleging violation of Sections 1 and 2 of the Sherman Act (antitrust), violation of the Rhode Island Antitrust Act, patent invalidity, and infringement of the Company's patents (infringement claims withdrawn January 10, 2000). The suit seeked various damages, including lost profits and treble damages. On June 15, 1999, HNC answered the lawsuit denying the allegations, bringing a counterclaim alleging infringement of the above described patent by the Company, and seeking a declaration of invalidity and unenforceability of one of the Company's patents. On the same day, HNC brought suit in San Diego, CA against Applied Communications, Inc. (ACI) and its parent TSAI alleging various causes of action including patent infringement of the above described patent by the Company's PRISM product which ACI markets. In April 2000, HNC, ACI and its parent agreed to dismiss the California lawsuit. ACI has requested that the Company provide indemnification for approximately $850,000 of its legal counsel costs pursuant to the PRISM License Agreement then in effect between ACI and the Company. The Company is disputing the indemnification claim and does not believe it is obligated to reimburse these costs. On January 17, 2001, HNC and the Company agreed to settle the case. The Company agreed to drop their claims in return for HNC agreeing not to enforce, or threaten to enforce, the their patent against the Company or its customers. ITEM 4. Submission of Matters to a Vote of Security Holders. ---------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2000. ITEM 5. Market for Registrant's Common Stock and Related Security Holder Matters. ------------------------------------------------ The Company's common stock was first offered to the public in December 1983 and is traded on the Nasdaq OTC Bulletin Board under the symbol "NEST." Low Bid High Ask ------- -------- Year Ended December 31, 2000 - ---------------------------- 1st Quarter 11/16 5-3/4 2nd Quarter 1-1/2 4-1/4 3rd Quarter 1-14/16 2-5/16 4th Quarter 17/64 2 Year Ended December 31, 1999 - ---------------------------- 1st Quarter 7/16 1-3/32 2nd Quarter 3/4 1-1/16 3rd Quarter 25/32 1 4th Quarter 23/32 1-63/64 As at February 28, 2001, the number of holders of record of the issued and outstanding common stock of the Company was 394, which includes brokers who hold shares for approximately 1493 beneficial holders. The Company has not paid any cash dividends with respect to its Common Stock since formation. ITEM 6. Selected Financial Data. ------------------------ The following data includes the accounts of Nestor, Inc. and Interactive in 1999 and 2000 and Nestor, Inc., NTS and Interactive in prior years.
Six Months Ended Year Ended Years Ended December 31, December 31, June 30, ------------------------------------------------------------- ------------ ----------- 2000 1999 1998 1997 1996 1996 ---- ---- ---- ---- ---- ---- Operating revenue $ 3,652,422 $ 5,114,779 $ 2,241,376 $5,681,076 $1,195,904 $ 5,461,580 Operating income (loss) $(1,548,777) $ 742,451 $(5,236,975) $ (295,985) $ (919,117) $ (27,260) Other income (expense) $ (106,675) $ (97,386) $ (26,178) $ 31,321 $ (16,220) $ 39,950 Net income (loss) $(2,994,574) $ (836,824) $(5,263,153) $ (294,664) $ (935,337) $ 12,690 Earnings per share Weighted number of outstanding shares - basic and diluted 17,901,602 17,844,327 15,249,932 9,243,508 8,689,031 7,847,510 Loss per share $ (0.17) $ (0.05) $ (0.36) $ (0.08) $ (0.13) $ (0.03) SELECTED BALANCE SHEET DATA: Total assets $ 4,922,703 $ 6,773,905 $ 3,250,089 $2,613,031 $2,817,944 $ 3,351,871 Working capital $ (199,775) $ 1,211,257 $ 535,806 $ 146,081 $ 879,172 $ 1,983,661 Long-term Redeemable Preferred Stock $ -- $ -- $ -- $5,792,787 $5,398,908 $ 5,207,538 Capital leases $ -- $ -- $ -- $ 10,220 $ 9,455 $ 9,455 Deferred income $ 2,036,896 $ 1,965,532 $ 440,400 $ -- $ 430,899 $ 430,899
ITEM 7. Management's Discussion and Analysis ------------------------------------ Prospective Statements The following discussion contains prospective statements regarding the Company, its business outlook and results of operations, all of which 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 (see further discussion in Exhibit 99.1) and in the Company's reports filed with the Securities and Exchange Commission. Liquidity and Capital Resources Cash Position and Working Capital The Company had cash and short-term investments of approximately $150,000 at December 31, 2000 as compared with $1,049,000 at December 31, 1999. At December 31, 2000, the Company had a working capital deficit of $200,000, as compared with working capital of $1,211,000 at December 31, 1999. The decrease in working capital in 2000 reflects primarily the working capital used in operations in the current year. The Company had a net worth of $168,000 at December 31, 2000, as compared with a net worth of $2,304,000 at December 31, 1999. The decrease in net worth resulted from net operating losses realized by the Company of $1,549,000 in 2000 and the net effect of the Company's portion of equity raised by its subsidiary, NTS, totaling $666,000 in 2000 offset by the Company's equity portion if NTS's net loss in 2000 of $1,339,000. Additional capital may be required to enable the Company to carry out needed marketing campaigns for its products, for continued development and upgrading of its products and for customer support. On February 1, 2001, the Company entered into a source code license agreement with Applied Communications Worldwide, Inc., a subsidiary of Transaction Systems, Architects, Inc. ("TSAI"). The license included an initial and guaranteed minimum fees in 2001 of $1,577,000, and an ongoing license fee equal to 15% of future revenues. In addition, ACI hired twelve employees of the Company thereby assuming future product enhancement, installation, modeling, and support services. Additionally, the Company has reached an agreement to merger with NTS by reacquiring the 65% common stock ownership it currently does not own in exchange for shares to Nestor, Inc., and for additional shares, convert a $4,000,000 NTS note along with an additional $4,000,000 cash contribution from a new investor group. On March 24, 1999, the Company entered into a $1,000,000 Line of Credit agreement with Transaction Systems Architect, Inc. ("TSAI"). The loan is secured by the royalty stream and other fees produced by the Company's License Agreements with Financial Services Division customers. The loan matured on February 29, 2001, and principal payments are due in twelve equal installments beginning March 1, 2001. Interest on the loan is equal to the effective prime interest rate plus 1%. The outstanding principal balance on the loan was $420,000 at December 31, 2000 and February 28, 2001 when it matured. The loan has not been replaced by the Company. Management believes that the Company's revenues, new license agreement and expense reduction realized on February 1, 2001, and the proposed merger with NTS will generate sufficient liquidity, when combined with its liquid assets as of December 31, 2000, to meet the Company's anticipated cash requirements from current operations through the year ending December 31, 2001. If the Company does not realize the merger or revenues sufficient to maintain its operations at the current level, management of the Company would modify certain initiatives until additional funds become available through investment or revenues. Litigation On October 6, 1998, HNC Software Corp. ("HNC"), a significant competitor of the Company's in the field of Financial Services, obtained a patent entitled "Fraud Detection Using Predictive Modeling" and began advising prospective customers of the Company of the patent. Upon review of the patent and consideration of prior actions taken by HNC, the Company initiated a lawsuit against HNC in the United States District Court in Providence, RI on November 25, 1998 alleging a number of claims including; violation of Sections 1 and 2 of the Sherman Act (antitrust), and violation of the Rhode Island Antitrust Act, and patent invalidity. The suit seeks various damages, including lost profits and treble damages. On June 15, 1999, HNC answered the lawsuit denying the allegations, bringing a counterclaim alleging infringement of the above described patent by the Company, and seeking a declaration of invalidity and unenforceability of one of the Company's patents. On the same day, HNC brought suit in San Diego, CA against Applied Communications, Inc. (ACI) and its parent TSAI alleging various causes of action including patent infringement of the above described patent by the Company's PRISM product which ACI markets. In April 2000, HNC, ACI and its parent agreed to dismiss the San Diego suit. ACI has requested that the Company provide indemnification for approximately $900,000 of its legal counsel costs pursuant to the PRISM licensing agreement between ACI and the Company. The Company has denied and is disputing the indemnification claim. The Company and HNC reached a mutually agreeable settlement on January 16, 2001, the terms of which are confidential. All claims have been dismissed. Costs associated with the suit were being expensed as incurred, and totaled approximately $600,000 and $356,000 in 2000 and 1999. Future Commitments During 2000, the Company entered into a three year operating lease for computers and related equipment valued at $97,000. The Company has no other material commitments for capital expenditures although management expects that the Company may make future commitments for the purchase of additional computers and related computing equipment, for furniture and fixtures, for development of hardware, for consulting and for promotional and marketing expenses. The Company maintains a lease for office space totaling approximately 13,000 square feet. The lease provides for monthly rent, including utilities, except electricity, in the amount of approximately $17,000 per month and expires in March 2003. The Company believes the facilities are adequate for its 2000 needs. 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 the Years Ended December 31, 2000 and 1999 In the year ended December 31, 2000, the Company realized a 40% decrease in revenues compared to the prior calendar year. Expenses increased 19% in 2000 resulting in an operating loss of $1,549,000 when compared to an operating profit of $742,000 in the prior year. Revenues from our distribution partners, ACI and CSK, were down in 2000 as were revenues from direct sales efforts. Revenues The Company's revenues arise from licensing of the Company's products and technology and from contract engineering services and are discussed separately below. During the year ended December 31, 2000, revenues decreased $1,463,000 to $3,652,000 from $5,115,000 in the prior calendar year. Customers held off committing to new software integration projects in 2000 in part resulting from the effects of the millennium change and perceived software issues. Software Licensing Product-licensing revenues totaled $2,537,000 in 2000, as compared with $3,872,000 in 1999. The decrease in these revenues reflects a decrease in initial license fees realized from new PRISM products of $900,000 as thirteen new license were realized in 1999 as compared to eight in 2000, and a decrease in monthly use fees of $360,000 resulting from licenses sold or terminated that were not fully offset by the new licenses coming on-line in 2000. Engineering Services Engineering revenues totaled $1,115,000 in 2000, as compared with $1,243,000 in 1999. These revenues relate to new license installations and customer-funded modifications of the Company's PRISM products. The decrease is related to the drop in new PRISM licenses, and the associated installation work, noted in "Software Licensing" above, offset in part by modeling and customization work in 2000 from 1999 licenses. Operating Expenses Total operating expenses - consisting of engineering, research and development, selling and marketing, and general and administrative expenses - amounted to $5,201,000 in the year ended December 31, 2000, an increase of $829,000 over total operating costs of $4,372,000 in the prior year. Engineering Services Costs related to engineering services totaled $967,000 in 2000, as compared with $1,023,000 in 1999. The decrease in these costs reflects related decrease in engineering revenues realized in 2000. Research and Development Research and development expenses totaled $1,247,000 in the year ended December 31, 2000 as compared with $921,000 in the prior year. The increase in such costs reflects the net of increased investment in product development in all of the Company's product lines in the current year, including PRISM V6.0 shipped in the fourth quarter of 2000, development of eCLIPSE, and development of PRISM eFraud during 2000. Selling and Marketing Selling and marketing costs increased $276,000 to $1,494,000 in the year ended December 31, 2000, from $1,218,000 in the prior year. The increase in selling costs in the year reflects, primarily, an increase in staffing for the development and support of partner and direct customer relationships for the licensing of the PRISM products. General and Administrative General and administrative expenses totaled $1,493,000 in 2000, as compared with $1,210,000 in the previous year. General and administrative costs for the year ended December 2000 reflect increased legal expenses related to the lawsuit initiated against a competitor in November 1998, settled in January 2001. Other Expense For 2000, net other expense was $107,000, as compared with net other expense of $97,000 in the year-earlier period. In 2000, other expense was comprised primarily of $106,000 of amortization expense related to the assigned value of warrants outstanding and being amortized over their remaining life. Loss from Investment in Affiliate During 2000, the Company's affiliate NTS sold additional common stock interests reducing the Company's equity interest in the affiliate to 34.6%. The Company's interests in NTS are accounted for under the equity method of accounting in 2000 and 1999. As a result of the Company's equity interest in NTS, the Company reported a loss from investment in affiliate of $1,339,000 in 2000, representing 34.6% of NTS's actual net loss in 2000 of $3,513,000, and the Company reported $1,482,000 in 1999, representing 49% of NTS's actual net loss in 1999 of $2,453,000 reflecting varying ownership percentages during 1999. NTS continues to be a development stage company, incurring costs of raising capital, research and development, establishing supplies and production processes, and sales and marketing. During 1998, NTS was included in the consolidated financial results of the Company and reported a net loss of $1,934,000. Investment in Product Development and Marketing With the exception of $80,000 related to a custom PRISM installation at December 31, 1998, the Company has not capitalized any expenses relating to the development or marketing of its products. Net Income During 2000, the Company experienced a loss of $2,995,000, as compared with a loss of $1,289,000 in the prior year. For the year ended December 31, 2000, loss per share available for common stock was $0.17 per share, as compared with a loss per share of $0.05 in the corresponding period of the prior fiscal year. For the year ended December 31, 2000, there was outstanding a weighted average of 17,901,602 shares, as compared to 17,844,327 shares in the year-earlier period. Analysis of the Years Ended December 31, 1999 and 1998 During 1999, NTS (a wholly-owned subsidiary of the Company on December 31, 1998) sold an aggregate 58% common stock equity interest to third parties through two transactions. This resulted in the Company reporting the subsidiary in accordance with the equity method of accounting beginning in 1999. The operating results of the subsidiary for the year ended December 31, 1998 are still reported on the consolidation basis of accounting. For the purpose of comparison, the following table compares the results of operations for fiscal years 1999 and 1998 as if the subsidiary was accounted for under the equity method of accounting in both periods with the 1998 results being reclassified accordingly. December 31, ------------------------------------ 1999 1998 (As Reported) (Reclassified) ------------- -------------- Software licensing revenues $ 3,872,016 $ 1,349,962 Engineering services revenues 1,242,763 656,890 ------------- ------------- Total revenues 5,114,779 2,006,852 ------------- ------------- Engineering services expense 1,023,046 1,799,629 Research and development expense 920,918 1,252,726 Selling and marketing expense 1,218,476 1,295,539 General and administrative expense 1,209,888 962,001 ------------- ------------- Total operating expenses 4,372,328 5,309,895 ------------- ------------- Income (loss) from operations 742,451 (3,303,043) Other expenses (97,386) (26,178) -------------- -------------- Income (loss) before taxes and loss from investment in affiliate 645,065 (3,329,221) Loss from investment in affiliate (1,481,889) (1,933,932) -------------- ------------- Net Loss $ (836,824) $ (5,263,153) ============== ============== The MD&A discussion that follows for the years ended December 31, 1999 and 1998 addresses the variances noted in the above table. The differences in the December 31, 1998 financial statement accounts as reported in the enclosed financial statements and those above are solely due to reclassification of the results of NTS to a single line entry "Loss from investment in affiliate". In the year ended December 31, 1999, the Company realized a 154.9% increase in revenues compared to the prior calendar year. Expenses increased 17.7% in 1999 resulting in an operating profit of $742,000 in 1999 as compared to an operating loss of $3,303,000 in the prior year. Revenues The Company's revenues arise from licensing of the Company's products and technology and from contract engineering services and are discussed separately below. During the year ended December 31, 1999, revenues increased to $5,115,000 from $2,007,000 in the prior calendar year (excluding $235,000 in NTS 1998 revenues). Software Licensing Product-licensing revenues totaled $3,872,000 in 1999, as compared with $1,350,000 in 1998. The increase in these revenues reflects an increase in license fees realized from PRISM products. PRISM licensing revenues amounted to $3,837,000 in 1999, an increase of $2,519,000 from year-earlier revenues of $1,318,000. The increase results from the increase in new licenses delivered in 1999 versus 1998, fourteen versus three, respectively, and the increase in use fee based revenues of $885,000 (101% versus 1998) in 1999. Included in the 1999 use fee revenues is $423,000 related to the sale of a PRISM license to Applied Communications, Inc. in the fourth quarter of 1999. Engineering Services Engineering revenues totaled $1,243,000 in 1999, as compared with $657,000 in 1998. The increase relates to additional engineering fees related to new license installations, associated customer-specific model development, and custom enhancement work contracted and delivered during 1999. During 1998, the Company realized $44,000 of revenues related to engineering work on its InterSite product. No such revenues were realized in 1999. Operating Expenses Total operating expenses - consisting of engineering, research and development, selling and marketing, and general and administrative expenses - amounted to $4,372,000 in the year ended December 31, 1999, a decrease of $938,000 over total operating costs of $5,310,000 in the prior year (excluding $2,168,000 in NTS 1998 operating expenses). Included in operating expenses in 1998 are write-downs of deferred development costs and other intangibles of approximately $400,000 in the financial services division and $295,000 in the InterSite product line. Engineering Services Costs related to engineering services totaled $1,023,000 in 1999, as compared with $1,799,000 in 1998. The decrease in these costs reflects the write-offs in 1998 totaling approximately $695,000 discussed above. Research and Development Research and development expenses totaled $921,000 in the year ended December 31, 1999 as compared with $1,253,000 in the prior year. The decrease in such costs reflects the termination of further InterSite development in November 1998. Research and development expenses related to the development of InterSite in 1998 were approximately $630,000 and the reduction was partially offset by additional salary expense relative to new hiring in financial services and other financial services staff salary increases. Selling and Marketing Selling and marketing costs decreased $78,000 to $1,218,000 in the year ended December 31, 1999, from $1,296,000 in the prior year. Selling costs associated with InterSite, in which the Company ceased further investment effective November 1998, totaled $192,000 in 1998, which was not incurred in 1999. In addition, other marketing related expenses were reduced by approximately $70,000 resulting from more focused advertising and trade show activities. These decreases were partially offset by increases from additional commissions relative to the increased revenues ($105,000) and foreign sales taxes ($61,000). General and Administrative General and administrative expenses totaled $1,210,000 in 1999, as compared with $962,000 in the previous year. General and administrative costs for the year ended December 1999 reflect primarily the increased legal expenses related to the lawsuit initiated against a competitor in November 1998. Other Expense For 1999, net other expense was $97,000 as compared with net other expense of $26,000 in the year-earlier period. In 1998, other expense was comprised primarily of $106,000 of amortization expense related to the assigned value of warrants outstanding offset by $73,000 of interest income. During 1999, net interest income recorded amounted to $9,000. Loss from Investment in Affiliate During 1999, the Company's subsidiary NTS sold common stock interests totaling 58% of its equity. As a result, the Company's interests in NTS are accounted for under the equity method of accounting in 1999. As a result of the Company's equity interest in NTS, the Company reported a loss from investment in affiliate of $1,482,000 in 1999, representing 49% of NTS's actual net loss in 1999 of $2,455,000 reflecting varying ownership percentages during 1999. During 1998, NTS was included in the consolidated financial results of the Company and reported a net loss of $1,934,000. Investment in Product Development and Marketing With the exception of $80,000 related to a custom PRISM installation at December 31, 1998, the Company has not capitalized any expenses relating to the development or marketing of its products. The following information details the amounts by which the Company's expenses in connection with each of its major product lines exceeded revenues for such product lines. The Company's PRISM product line was profitable during 1999. The Company began development in July 1996 of products for use in Internet and intranet environments. Costs associated with this effort totaled $1,383,000 in 1998. The Company ceased further direct investment in development of this product line in November 1998. The net investment in this subsidiary during 1998 was $1,383,000. The net investment in the NTS product line was $1,933,000 in 1998. The net investment in the PRISM product line was $1,954,000 in 1998. Net Income During 1999, the Company experienced a net loss of $837,000, as compared with a net loss of $5,263,000 in the prior year. For the year ended December 31, 1999, loss per share available for common stock was $0.05 per share, as compared with a loss per share of $0.36 in the corresponding period of the prior fiscal year. For the year ended December 31, 1999, there was outstanding a weighted average of 17,844,327 shares, as compared with 15,249,932 in the year-earlier period. ITEM 7(a) Quantitative and Qualitative Disclosure about Market Risk. ---------------------------------------------------------- Management assesses their exposure to these risks as immaterial. 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, 2001 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 Title Date - ---------- ----- ---- /s/Leon N Cooper Co-Chairman of the Board and Director March 31, 2001 - -------------------- /s/Charles Elbaum Co-Chairman of the Board and Director March 31, 2001 - -------------------- /s/David L. Fox President, Chief Executive Officer March 31, 2001 - -------------------- and Director /s/Herbert S. Meeker Secretary and Director March 31, 2001 - -------------------- /s/Sam Albert Director March 31, 2001 - -------------------- /s/Thomas H. Boje Director March 31, 2001 - -------------------- /s/Jeffrey Harvey Director March 31, 2001 - -------------------- /s/Thomas F. Hill Director March 31, 2001 - -------------------- /s/Bruce Schnitzer Director March 31, 2001 - -------------------- CONSOLIDATED FINANCIAL STATEMENTS --------------------------------- FORM 10-K --------- December 31, 2000 ----------------- NESTOR, INC. Part II ------------ Item 8 CONTENTS Page No. Independent Auditor's Report 20 Consolidated Balance Sheets - 21 December 31, 2000 and 1999 Consolidated Statements of Operations - 22 For the Years Ended December 31, 2000, 1999 and 1998 Consolidated Statements of Stockholders' Equity - 23 For the Years Ended December 31, 2000, 1999 and 1998 Consolidated Statements of Cash Flows - 24 For the Years Ended December 31, 2000, 1999 and 1998 Notes to Consolidated Financial Statements 25 Part II Item 8 Report of Independent Auditors The Board of Directors and Stockholders of Nestor, Inc. We have audited the accompanying consolidated balance sheets of Nestor, Inc. as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2000. Our audits 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 audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 audits provide a reasonable basis for our opinion. In our opinion, the 2000 and 1999 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nestor, Inc. at December 31, 2000 and 1999, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Providence, Rhode Island February 26, 2001 NESTOR, INC. Consolidated Balance Sheets --------------------------- DECEMBER 31, ASSETS 2000 1999 --------------------------- CURRENT ASSETS: Cash and cash equivalents ...................... $ 150,035 $ 1,048,802 Accounts receivable, net of allowance for doubtful accounts ........................ 693,555 984,318 Unbilled contract revenue ...................... 1,260,884 1,200,484 Due from affiliate ............................. 322,952 320,459 Other current assets ........................... 91,042 161,809 ------------ ------------ Total current assets ......................... 2,518,468 3,715,872 Long term unbilled contract revenue .............. 2,036,896 1,965,532 Investment in affiliate .......................... 81,100 710,690 Property and equipment at cost, net of accumulated depreciation ................ 177,377 269,917 Deferred development costs ....................... 32,000 56,000 Patent development costs ......................... 76,862 55,894 ------------ ------------ TOTAL ASSETS ..................................... $ 4,922,703 $ 6,773,905 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Line of credit ................................. $ 419,769 $ -- Accounts payable ............................... 253,696 271,397 Accrued employee compensation .................. 265,779 314,202 Accrued liabilities ............................ 472,983 547,799 Deferred income ................................ 1,306,016 1,371,217 ------------ ------------ Total current liabilities .................... 2,718,243 2,504,615 NONCURRENT LIABILITIES: Long term deferred income ...................... 2,036,896 1,965,532 ------------ ------------ Total liabilities ............................ 4,755,139 4,470,147 ------------ ------------ Commitments and contingencies .................. -- -- STOCKHOLDERS' EQUITY: Preferred stock, $1.00 par value, authorized 10,000,000 shares; issued and outstanding: Series B - 235,000 shares at December 31, 2000 and 345,000 shares at December 31, 1999 ............................ 235,000 345,000 Common stock, $.01 par value, authorized 30,000,000 shares; issued and outstanding: 17,688,449 shares at December 31, 2000 and 17,499,327 shares at December 31, 1999 ....... 176,884 174,993 Warrants and options ........................... 843,434 736,951 Additional paid-in capital ..................... 27,434,129 26,574,123 Retained deficit ............................... (28,521,883) (25,527,309) ------------ ------------ Total stockholders' equity ................... 167,564 2,303,758 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ....... $ 4,922,703 $ 6,773,905 ============ =========== Significant related party transactions are described in Note 13. The Notes to the Financial Statements are an integral part of this statement. NESTOR, INC. Consolidated Statements of Operations -------------------------------------
YEARS ENDED DECEMBER 31, 2000 1999 1998 --------------------------------------------- Revenue (Note 13): Software licensing ...................... $ 2,537,511 $ 3,872,016 $ 1,352,071 Engineering services .................... 1,114,911 1,242,763 746,007 Tangible product sales .................. -- -- 143,298 ------------- ------------ ------------ Total revenue ........................ 3,652,422 5,114,779 2,241,376 ------------- ------------ ------------ Operating expenses: Engineering services .................... 966,681 1,023,046 2,066,558 Tangible product costs .................. -- -- 54,010 Research and development ................ 1,247,205 920,918 2,112,746 Selling and marketing ................... 1,493,968 1,218,476 1,831,697 General and administrative .............. 1,493,345 1,209,888 1,413,340 ------------- ------------ ------------ Total operating expenses ............. 5,201,199 4,372,328 7,478,351 ------------- ------------ ------------ Income (loss) from operations .............. (1,548,777) 742,451 (5,236,975) Other expense - net ....................... (106,675) (97,386) (26,178) ------------- ------------ ------------ Income (loss) before income taxes and investment loss ...................... (1,655,452) 645,065 (5,263,153) Income taxes ............................... -- -- -- Loss from investment in affiliate .......... (1,339,122) (1,481,889) -- ------------- ------------ ------------ Net loss ................................... $ (2,994,574) $ (836,824) $ (5,263,153) ============= ============ ============ Loss Per Share: Net loss ................................... $ (2,994,574) $ (836,824) $ (5,263,153) Dividends accrued on preferred stock ....... -- -- 151,396 ------------ ------------ ------------ Net loss available for common stock ........ $ (2,994,574) $ (836,824) $ (5,414,549) ============= ============ ============ Loss per share, basic and diluted .......... $ (0.17) $ (0.05) $ (0.36) ============= ============ ============ Shares used in computing loss per share: Basic and diluted ....................... 17,901,602 17,844,327 15,249,932 ============= ============ ============ 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 Warrants -------------------- ---------------------- Paid-in Retained and Shares Amount Shares Amount Capital (Deficit) Options Total ------ ------ ------ ------ ---------- --------- -------- ----- Balance at December 31, 1997 9,403,987 $ 94,040 1,615,871 $1,710,347 $12,579,920 $(19,427,332) $523,984 $(4,519,041) Issuance of Common Stock 2,557,104 25,571 -- -- 5,060,282 -- -- 5,085,853 Conversion of Preferred Stock to Common Stock 1,223,255 12,232 (1,223,255) (1,294,882) 1,282,650 -- -- -- Premium on Conversion of Preferred Stock Series B to Common Stock 19,200 192 -- -- (192) -- -- -- Dividends on Preferred Stock Series D paid in Common Stock and cash 8,889 89 -- (17,941) 17,827 -- -- (25) Dividend accrued on Preferred Stock Series D -- -- -- 8,900 (8,900) -- -- -- Repurchase of Preferred Stock Series D -- -- (27,616) (41,424) -- -- -- (41,424) Conversion of Redeemable Convertible Preferred Stock to Common Stock 4,266,892 42,669 -- -- 5,823,568 -- -- 5,866,237 Dividends accrued on Redeemable Convertible Preferred Stock -- -- -- -- (142,496) -- -- (142,496) Costs incurred in connection with Redeemable Preferred conversion and TSAI Common Stock purchase -- -- -- -- (108,103) -- -- (108,103) Accretion of value of warrants -- -- -- -- -- -- 106,483 106,483 Loss for the year ended December 31, 1998 -- -- -- -- -- (5,263,153) -- (5,263,153) ---------- -------- ---------- ----------- ----------- ------------ -------- ------------ Balance at December 31, 1998 17,479,327 $174,793 365,000 $ 365,000 $24,504,556 $(24,690,485) $630,467 $ 984,331 Conversion of Preferred Stock to Common Stock 20,000 200 (20,000) (20,000) 19,800 -- -- -- Issuance of equity by subsidiary -- -- -- -- 2,049,767 -- -- 2,049,767 Accretion value of warrants -- -- -- -- -- -- 106,484 106,484 Loss for the year ended December 31, 1999 -- -- -- -- -- (836,824) -- (836,824) ---------- -------- ---------- ----------- ------------ ------------ -------- ----------- Balance at December 31, 1999 17,499,327 $174,993 345,000 $ 345,000 $26,574,123 $(25,527,309) $736,951 $ 2,303,758 Issuance of Common Stock 79,122 791 -- -- 84,846 -- -- 85,637 Conversion of Preferred Stock to Common Stock 110,000 1,100 (110,000) (110,000) 108,900 -- -- -- Issuance of equity by subsidiary -- -- -- -- 666,260 -- -- 666,260 Accretion value of warrants -- -- -- -- -- -- 106,483 106,483 Loss for the year ended December 31, 2000 -- -- -- -- -- (2,994,574) -- (2,994,574) ---------- -------- ---------- ----------- ------------ ------------ -------- ----------- Balance at December 31, 2000 17,688,449 $176,884 235,000 $ 235,000 $27,434,129 $(28,521,883) $843,434 $ 167,564 ========== ======== ========== ========== =========== ============ ======== =========== The Notes to the Financial Statements are an integral part of this statement.
NESTOR, INC. Consolidated Statements of Cash Flows -------------------------------------
YEARS ENDED DECEMBER 31, 2000 1999 1998 -------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ........................................... $ (2,994,574) $ (836,824) $ (5,263,153) Adjustments to reconcile net loss to net cash used by operating activities: Write-down for impairment loss .................. -- -- 790,641 Depreciation and amortization ................... 116,540 120,257 114,810 Loss from investment in affiliate ............... 1,339,122 1,481,889 -- Expenses charged to operations relating to options, warrants and capital transactions ..... 106,483 106,484 106,483 Changes in assets and liabilities: (Increase) decrease in accounts receivable .... 290,763 (471,570) 44,464 (Increase) in unbilled contract revenue ........ (131,764) (2,397,648) (477,906) (Increase) decrease in other assets ............ 70,767 (168,053) (98,649) (Decrease) increase in accounts payable and accrued expenses ......................... (124,624) 279,101 199,750 (Decrease) increase in deferred income ......... 6,163 2,244,213 684,304 ------------- ----------- ------------ Net cash provided (used) by operating activities (1,321,124) 357,849 (3,899,256) ------------- ----------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Advances to affiliate - net ........................ (45,764) (320,459) -- Purchase of property and equipment ................. -- (61,337) (132,209) Patent development costs ........................... (20,968) (55,894) -- ------------ ----------- ------------ Net cash used by investing activities (66,732) (437,690) (132,209) ------------ ----------- ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of obligations under capital leases ...... (16,317) (46,540) (47,246) Proceeds from notes payable/line of credit ......... 419,769 -- 250,000 Repayment of notes payable ......................... -- -- (250,000) Redemption of Preferred Series D Stock ............. -- -- (41,424) Proceeds from issuance of common stock - net ....... 85,637 -- 4,977,749 Payments of dividends on preferred stock ........... -- -- (69,070) ------------ ----------- ------------ Net cash provided (used) by financing activities 489,089 (46,540) 4,820,009 ------------- ----------- ------------ Net change in cash and cash equivalents ............. (898,767) (126,381) 788,544 Cash and cash equivalents - beginning of year ....... 1,048,802 1,175,183 386,639 ------------ ----------- ------------ Cash and cash equivalents - end of year ............. $ 150,035 $ 1,048,802 $ 1,175,183 ============ =========== ============ SUPPLEMENTAL CASH FLOWS INFORMATION: Interest paid ...................................... $ 10,603 $ 13,054 $ 20,350 ============ =========== ============ Income taxes paid .................................. $ -- $ -- $ 37,500 ============ =========== ============ Significant non-cash transactions are described in Notes 3, 5, 7, 8 and 12 The Notes to the Financial Statements are an integral part of this statement.
NOTES TO THE FINANCIAL STATEMENTS 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. in 1999 and 2000 and Nestor, Inc., Nestor Traffic Systems, Inc. ("NTS") and Nestor Interactive, Inc. ("Interactive") in 1998. NTS and Interactive were organized effective January 1, 1997 as two wholly owned subsidiaries. Effective November 7, 1998, the Company ceased further investment in the Interactive subsidiary. Any future marketing or development of Interactive's product has been transferred to Nestor, Inc. All intercompany transactions and balances have been eliminated. On March 25 and November 30, 1999, NTS sold in the aggregate a 58.1% common-stock interest to a private group of investors (Note 12). In accordance with Company policy, no gain was recognized on these transactions, and the Company recorded an increase in the equity value of its investment in affiliate. As a result of these transactions, the Company changed from consolidation to equity accounting for its remaining interest in NTS for the year ended December 31, 1999. In June 2000, NTS sold additional shares of its common stock to private investors, bringing the Company's ownership of NTS to 34.62%. As discussed in Note 16, in January 2001, an agreement in principle was reached to combine the Company and NTS by merging NTS into a wholly-owned subsidiary of the Company with Nestor, Inc., in effect, becoming the surviving entity. B. CASH EQUIVALENTS For the purpose of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of 90 days or less to be cash equivalents. C. UNBILLED CONTRACT REVENUES Unbilled contract revenues represent primarily minimum guaranteed monthly license fees (See F and G below) where a customer pays a portion of the license fees over the software license term (usually five years) based on a contractually predetermined minimum volume of transactions. D. DEPRECIATION AND AMORITIZATION Depreciable assets are recorded at cost. Depreciation and amortization are provided on the straight-line method over the estimated useful lives of the respective assets or lease terms. Maintenance and repairs are expensed as incurred. Major renewals and betterments are capitalized. E. PRODUCT AND PATENT DEVELOPMENT COSTS The costs of development of the Company's software - which consist primarily of labor and outside consulting and 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 are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. 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 expensed or capitalized, as appropriate. Amortization of capitalized costs is on a straight-line basis over the shorter of the estimated economic life, or statutory life, of the patent. F. DEFERRED INCOME Corresponding with unbilled contract revenues, deferred income represents primarily minimum guaranteed monthly license fees (see C above and G below) where a customer pays a portion of the license fees over the software license term (usually five years) based on a contractually predetermined minimum volume of transactions. Additionally, in certain instances, the Company bills and/or collects payment from customers prior to the delivery of the software product or performance of contracted maintenance or services, resulting in deferred income. G. REVENUE RECOGNITION The Company derives revenue from software licenses (Initial License Fees), user fees (Monthly License fees), other postcontract customer support (PCS) and engineering services. Postcontract customer support includes maintenance agreements. Engineering services range from installation, training, and basic consulting to modeling, software modification and customization to meet specific customer needs. In software arrangements that include multiple elements, the Company allocates the total arrangement fee among each deliverable based on the relative fair value of each of the deliverables determined based on vendor-specific objective evidence. As of January 1, 1998, the Company adopted AICPA Statement of Position 97-2 - Software Revenue Recognition ("SOP 97-2"), which is effective for transactions entered into in 1998. The most significant impact of SOP 97-2 on the Company's revenue recognition accounting policies is that for contracts with multiple elements, revenue, in some instances, may be recognized later than under past practices. Revenue is recognized as follows: Software Licenses - The Company recognizes the revenue allocable to software licenses upon delivery of the software product to the end user, unless the fee is not fixed or determinable or collectibility is not probable. The Company considers all arrangements with payment terms extending beyond twelve months and other arrangements with payment terms longer than normal not to be fixed or determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer. In most situations, the Company considers its acceptance terms as perfunctory. Arrangements that include acceptance terms that are not considered perfunctory are not recognized until acceptance has occurred. If collectibility is not considered probable, revenue is recognized when the fee is collected. Revenue on arrangements with customers who are not the ultimate users (distributors, other resellers, etc.) is not recognized until the software is delivered to an end user. 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. If customer acceptance is uncertain, revenue is recognized upon approval by the customer. Postcontract Customer Support - Revenue allocable to PCS is recognized on a straight-line basis over the period the PCS is provided. Software Services - Arrangements that include software services are evaluated to determine whether those services are essential to the functionality of other elements of the arrangement. When software services are considered essential, revenue under the arrangement is recognized using contract accounting (see below). When the software services are not considered essential, the revenue allocable to the software services is recognized as the services are performed. Contract Accounting - For arrangements that include customization or modification of the software, or where software services are otherwise considered essential, revenue is recognized using contract accounting. Revenue from these software arrangements is recognized on a percentage-of-completion method based upon costs incurred to date in relation to estimated total costs. Training revenue is recognized upon the completion of training sessions with the customer. H. REVENUE CONCENTRATION The Company realizes a significant volume of business from Applied Communications, Inc. (ACI). In 2000, 1999 and 1998, revenues from ACI constituted 63%, 61% and 28%, respectively, of total revenues. I. 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 result, 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. J. 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. K. EARNINGS (LOSS) PER SHARE The Company reports its earnings (loss) per share ("EPS") in accordance with the provisions of the Financial Accounting Standards Board Statement No. 128, Earnings Per Share ("FAS 128"). Basic EPS is calculated by dividing the income available to common stockholders by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted EPS is computed giving effect to common stock equivalents and other dilutive securities, unless the computation results in anti-dilution. NOTE 2 - ACCOUNTS RECEIVABLE, NET OF ALLOWANCE FOR DOUBTFUL ACCOUNTS: December 31, -------------------------- 2000 1999 ---- ---- Trade accounts receivable $ 697,700 $ 988,463 Allowance for doubtful accounts (4,145) (4,145) --------- --------- Accounts receivable, net of allowance for doubtful accounts $ 693,555 $ 984,318 ========= ========= NOTE 3 - 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. By the end of 1997, the Company had deferred $575,000 of costs in connection with engineering and installation of the project. Management believed that these costs would be fully recovered over the five year term of the contract. In view of the level of revenue generated by this contract, at December 31, 1998, the Company evaluated the carrying value of the deferred contract costs, utilizing estimated future contract revenues and ongoing customer support costs, appropriately discounted. In accordance with FAS 121 - "Impairment of Long Lived Assets," the Company wrote-down deferred development costs to $80,000 with an offsetting charge to engineering services. The residual deferred costs are being amortized on a straight-line basis over the remaining term of the contract. NOTE 4 - PROPERTY AND EQUIPMENT AT COST - NET: Useful Life in Years or December 31, Lease Term ------------------------ ----------- 2000 1999 ---- ---- Office furniture and equipment $ 234,706 $ 234,706 5 - 7 Leased computer equipment under capital leases 113,893 113,893 5 Computer equipment 1,268,855 1,268,855 3 - 5 ---------- ---------- 1,617,454 1,617,454 Less: Accumulated depreciation and amortization 1,440,077 1,347,537 ---------- ---------- $ 177,377 $ 269,917 ========== ========== Depreciation and amortization expense on the above assets of $92,540, $96,257 and $114,810, was recorded for the years ended December 31, 2000, 1999, and 1998, respectively. Accumulated depreciation and amortization includes $63,741, $40,963 and $18,184 of amortization related to leased equipment under capital leases at December 31, 2000, 1999 and 1998, respectively. NOTE 5 - INTANGIBLE ASSET: On March 31, 1997, the Company purchased from Cyberiad Software, Inc. ("Cyberiad"), a Rhode Island corporation, substantially all of Cyberiad's assets for use in the Company's Interactive subsidiary product. In this transaction, the Company issued 200,000 shares of its common stock to Cyberiad and agreed to assume approximately $10,500 of Cyberiad's liabilities. Accordingly, the Company recorded as an intangible asset the excess of its acquisition cost over the fair value of the net liabilities assumed ($394,517) and began to amortize this asset over 36 months. Amortization expense recorded in the year ended December 31, 1997 was $98,629. Since the Company ceased further investment in the Interactive subsidiary (see Note 1) and future realization of the asset was uncertain, the remaining value of this asset was written off in November 1998. NOTE 6 - LINE OF CREDIT: On March 24, 1999, the Company entered into a $1,000,000 Line of Credit agreement with Transaction Systems Architect, Inc. ("TSAI"). The loan is secured by the royalty stream and other fees produced by the Company's License Agreements with Financial Services Division customers. As of December 31, 2000, $419,769 had been advanced against the loan. The Company did not require additional advances through February 28, 2001 when the loan matured. Principal payments are due in twelve equal monthly installments ($34,981) beginning March 1, 2001. Interest is based on the prime interest rate plus 1% and is due quarterly in arrears. Included in accrued expenses at December 31, 2000 is $4,296 of interest due to TSAI. NOTE 7 - COMMON AND PREFERRED STOCK: On April 29, 1998, Nestor sold to Transaction Systems Architects, Inc. ("TSAI") $5 million of newly issued common stock at a price of $2 per share and a warrant to purchase an additional 2.5 million shares at $3 per share expiring March 1, 2002 (Note 8). Proceeds from the sale consisted of $4.5 million in cash and surrender of a $500,000 note owed to TSAI. Concurrent with this transaction, Wand Partners converted its $5.8 million of redeemable convertible preferred stock into common stock. The redeemable convertible preferred stock originally accrued and accumulated dividends at rates of seven to nine percent, compounded quarterly on the stated value per share and such dividends not paid in cash increased the stated value. The Company paid cash dividends totaling $69,046 in 1998 on the redeemable convertible preferred stock. 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 $1.00 in liquidation before any distribution is made to holders of the Common Stock. The liquidation value of Series B Preferred was $235,000 and $345,000 at December 31, 2000 and 1999, respectively. In May 1998, the Company offered Series B stockholders a 2% conversion premium payable in common stock for a share-for-share conversion of all shares held. The conversion offer, which expired on June 26, 1998, resulted in a premium of 19,200 common shares as 960,000 Series B shares were converted. The rights and benefits of remaining Series B stockholders are unchanged, including ongoing standard conversion rights. Series D Convertible Preferred Stock was convertible after January 1, 1996 at the option of the holder into one fully paid and non-assessable share of Common Stock of the Company on a share-for-share basis. The Company issued a redemption call in May 1998 for all of the outstanding Series D shares at a redemption price of $1.50 plus unpaid dividends payable as of June 30, 1998. Stockholders had the option of converting into common shares under the Preferred Shares Agreement and, as a result, 143,155 common shares were issued. After paying dividends of $17,941 on June 30, 1998, the Company reclassified the unconverted Series D balance to accrued expenses where approximately $36,000 remains unpaid at December 31, 2000 and 1999. NOTE 8 - 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 generally vest over three years and are exercisable for five years from the date of grant. On May 6, 1997, the Company adopted the 1997 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 1997 Stock Option Plan has authorized the grant of options to employees for up to 1,000,000 shares of the Company's common stock. Options vest over three years and are exercisable for up to ten years from the date of grant, although most options currently outstanding expire five years from the date of grant. The Company has adopted the disclosure-only provisions of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation ("FAS 123"). 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 in the financial statements for qualifying grants issued pursuant to the Company's Stock Option Plan. On October 23, 1998, the Company's Board of Directors approved a repricing of the Company's Stock Option Plan. The price of the new options was $.6875, the closing price on October 23, 1998. Options were exchanged at equal value using the Black-Scholes model and acceptance of the repricing offer was optional on the part of the employee. Employees surrendered 543,500 options for repricing and the Company granted 254,085 repriced options in accordance with this offer. The effect of this repricing is reflected in the tables below. The following table presents the activity of the Company's Stock Option Plan for the years ended December 31, 2000, 1999 and 1998:
Years Ended December 31, ------------------------------------------------------------------------------ 2000 1999 1998 ---- ---- ---- Weighted Weighted Weighted Av. Ex. Av. Ex. Av. Ex. Shares Price Shares Price Shares Price ------ ----- ------ ----- ------ ----- Outstanding beginning of year 1,628,316 $1.20 1,579,124 $1.22 2,214,000 $1.58 Granted 270,500 .94 62,500 .72 454,124 .99 Exercised 79,122 1.08 -- -- 31,250 1.09 Canceled 714,873 .99 13,308 1.08 1,057,750 1.88 --------- --------- --------- Outstanding end of year 1,104,821 $1.28 1,628,316 $1.20 1,579,124 $1.22 ========= ========= ========= Options exercisable at year end 805,928 $1.42 1,322,786 $1.24 1,102,846 $1.22 ========= ========= ========= Weighted average fair value of options granted during the year $ 0.75 $ 0.42 $ 0.71 ========= ========= =========
The following table presents weighted average price and life information about significant option groups outstanding at December 31, 2000.
Options Outstanding Options Exercisable ------------------------------------------- --------------------------- Weighted Average Weighted Weighted Number Remaining Average Number Averaged Range of Outstanding Contractual Exercise Exercisable Exercisable Exercise Prices at 12/31/00 Life (Years) Price at 12/31/00 Price --------------- ----------- ------------ ----- ----------- ----- $ .31 15,000 3.00 $0.31 7,500 $0.31 $ .69 - $ .94 582,571 3.26 0.74 324,428 0.73 $1.38 - $1.94 283,750 2.01 1.54 274,000 1.55 $2.09 - $2.32 138,000 4.05 2.26 136,625 2.26 $2.50 - $2.91 85,500 5.08 2.69 63,375 2.75 --------- ---- ---- --------- ----- 1,104,821 3.18 $1.28 805,928 $1.42 ========= ==== ===== ========= =====
The following are the pro forma net loss and net loss per share for the years ended December 31, 2000, 1999 and 1998, as if the compensation cost for the option had been determined based on the fair value at the grant date for grants in those periods and reflected in the financial statements: Years Ended December 31, --------------------------------------------- 2000 1999 1998 ---- ---- ---- Net loss: As Reported $(2,994,574) $ (836,824) $(5,263,153) Pro Forma $(2,573,487) $(1,022,488) $(4,710,218) Net loss per share: As Reported $ (0.17) $ (0.05) $ (0.36) Pro Forma $ (0.14) $ (0.06) $ (0.32) The effects on the years ended December 31, 2000, 1999 and 1998 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, 2000 and the Company expects to grant additional options in future years. 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 4.3% 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 1.009 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. The following table presents warrants outstanding: December 31, ------------------------------------ 2000 1999 1998 ---- ---- ---- Eligible, end of year for exercise currently 4,999,040 5,000,580 5,000,580 ========= ========= ========= Warrants issued -- -- 2,500,000 Low exercise price $ -- $ -- $ 3.00 High exercise price $ -- $ -- $ 3.00 The warrants outstanding as of December 31, 2000 are currently exercisable and expire at various dates through October 5, 2005. The outstanding warrants entitle the owner to purchase one share of common stock for each warrant, at prices ranging from $0.65 to $3.00 per share; however, upon completion of the transactions contemplated by the merger agreement and the secured note agreement (Note 16), the current exercise price will be reduced in accordance with the terms and conditions of the warrant. 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 cumulative 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. Accordingly, the Company recognized expenses totaling $106,000 annually in 2000, 1999 and 1998. NOTE 9 - SEGMENT INFORMATION: A. Description of reportable segments In prior years, the Company had three reportable segments. During 1998, the Internet segment ceased operations, and in 1999, 58.1% of the Traffic Systems segment was sold, leaving Financial Solutions as the sole reportable segment at December 31, 1999. Segment information for 1999 and 2000 has been omitted since all operations relate to a single segment. The Financial Solutions division produces and sells credit and debit card fraud detection products and database marketing products to financial institutions and processors of financial data. The Traffic Systems segment provided remote traffic management products, mainly to municipalities and universities. The Company's Internet segment was engaged in the development of an internet commerce solution. B. Measurement of segment profit or loss and segment assets The Company evaluates performance based on profit or loss from operations before income taxes. The accounting policies of the reportable segments are the same as those described in Note 1. C. Segment profit or loss and segment assets All revenues are from external customers. There are no intercompany sales. The "All Other" category represents general corporate activity.
Financial Traffic All Solutions Systems Internet Other Totals --------- ------- -------- ----- ------ Year Ended Dec. 31, 1998: Revenues $ 1,931,000 $ 235,000 $ 44,000 $ 31,000 $ 2,241,000 Depreciation and amortization expense 548,000 25,000 309,000 23,000 905,000 Segment profit (loss) (1,954,000) (1,933,000) (1,383,000) 7,000 (5,263,000) Segment assets 788,000 318,000 46,000 1,440,000 2,592,000 Expenditures for long-lived assets 29,000 37,000 8,000 58,000 132,000
D. Geographic Information Revenues are attributed to countries based on the location of customers. All long-lived assets are located in the United States. Years Ended December 31, ---------------------------------------- 2000 1999 1998 ---- ---- ---- United States $2,841,558 $4,196,612 $1,918,951 Belgium 276,799 151,200 212,097 Germany -- -- 17,460 Japan 117,532 685,850 55,333 Canada 416,533 81,117 27,000 Singapore -- -- 10,535 ---------- ---------- ---------- $3,652,422 $5,114,779 $2,241,376 ========== ========== ========== E. Revenues from Major Customers All revenues presented are derived from the Company's Financial Solutions segment with the exception of Customer E, which relates to the Traffic Systems segment. Customer A is a subsidiary of TSAI (see Notes 6, 7, 13, 15 and 16). Years Ended December 31, -------------------------------------- 2000 1999 1998 ---- ---- ---- Customer A $2,299,208 $3,106,631 $620,732 Customer B 285,834 -- -- Customer C -- 685,850 -- Customer D -- -- 445,115 Customer E -- -- 302,979 Customer F 276,799 -- -- Customer G 256,876 -- -- NOTE 10 - OTHER EXPENSE - NET: Other income (expense) as reflected in the consolidated statements of operations consists of the following: Years Ended December 31, --------------------------------------- 2000 1999 1998 ---- ---- ---- Interest income (expense) $ (192) $ 9,098 $ (20,350) Expense relating to financing operations (106,483) (106,484) (106,483) Other - net -- -- 100,655 ---------- --------- --------- Other expense - net $(106,675) $ (97,386) $ (26,178) ========= ========= ========= NOTE 11 - INCOME TAXES: The Company accounts for income taxes using the deferred liability method as required by Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes ("FAS 109"). Under FAS 109, deferred tax assets and liabilities are determined based on differences between the 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. Due to operating losses throughout the reporting periods, no provision for income taxes was made in 2000, 1999 or 1998. Significant components of the Company's deferred tax liabilities and assets as of December 31, 2000 and 1999 are as follows: December 31, ----------------------------- 2000 1999 ---- ---- Deferred tax liabilities: ------------------------- Property and equipment $ 3,000 $ -- Deferred development costs 13,000 22,000 ----------- ----------- Total deferred tax liabilities 16,000 22,000 Deferred tax assets: -------------------- Accounts receivable 2,000 2,000 Accrued expenses 347,000 308,000 Deferred income 35,000 32,000 Tax credits 17,000 17,000 Net operating loss 6,839,000 5,988,000 ----------- ----------- Total deferred tax assets 7,240,000 6,347,000 Valuation allowance (7,224,000) (6,325,000) ----------- ----------- Net deferred tax assets 16,000 22,000 ----------- ----------- Net deferred tax balance $ -- $ -- =========== =========== In accordance with FAS 109, a valuation allowance must be established until it is more likely than not that future benefits arising from net deferred tax assets will be realized. Realization is not assured in future tax projections. A reconciliation of the provision for income taxes to the amount computed using the Federal statutory tax rates consists of the following: Years Ended December 31, ------------------------------------------- 2000 1999 1998 ---- ---- ---- Income (loss) before taxes and investment loss $(1,655,000) $ 645,000 $(5,263,000) =========== ========= =========== Tax at statutory rate of 34% $ (563,000) $ 219,000 $(1,789,000) State income tax (net of federal benefit) (110,000) 47,000 (313,000) Effect of permanent differences (54,000) 36,000 101,000 Valuation allowance 727,000 (302,000) 2,001,000 ------------ ---------- ----------- Income tax expense $ -- $ -- $ -- ============ ========== =========== The Company has available at December 31, 2000, $18,399,000 and $9,829,000 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 2001. NOTE 12 - NESTOR TRAFFIC SYSTEMS, INC. AFFILIATE: On March 25, 1999, Nestor Traffic Systems, Inc., a subsidiary of the Company, sold a 37.5% common stock interest (540,000 shares at $4.35 per share) to a private group of investors for $2,350,000 in cash and issued an option to purchase an additional 17.5% of its common stock for $1,750,000. The option was scheduled to expire on January 31, 2000. On November 30, 1999, the Company, NTS and the investor group agreed to accelerate the exercise of the option and an additional 20.6% interest (710,000 shares at $2.47 per share) was sold for $1,755,000. On June 23, 2000, NTS sold additional shares of its common stock to private investors for $2,025,000 (450,000 shares at $4.50 per share). The investor group includes three officers and a director of the Company and the subsidiary, who in the aggregate, have contributed $970,085 of cash invested on the same basis as third-party investors. As discussed in Note 16, in January 2001, an agreement in principle was reached to combine the Company and NTS by merging NTS into a wholly-owned subsidiary of the Company with Nestor, Inc., in effect, becoming the surviving entity. As a result of the 1999 transactions, the Company's interest in NTS decreased to 41.9%, prompting the change from consolidation to equity accounting for the year ended December 31, 1999. The Company owns 34.62% of NTS at December 31, 2000. The investment in affiliate balances of $81,100 and $710,690 at December 31, 2000 and 1999, respectively, reflect the Company's interest in NTS's equity. Presented below is summarized NTS financial information at December 31, 2000 and 1999 and for the years then ended: December 31, ------------------------------ 2000 1999 ---- ---- Current assets $ 466,000 $2,124,000 Noncurrent assets 694,000 298,000 Current liabilities 925,000 724,000 Stockholders' equity 234,000 1,698,000 Total revenues 873,000 167,000 Operating expenses 4,425,000 2,656,000 Net loss 3,513,000 2,453,000 During the period January 1, 1999 through March 31, 1999, the Company advanced NTS financing to cover operating expenses amounting to approximately $550,000. Of this advance, $275,000 was reimbursed in March 1999, and the balance was paid in January 2001. Periodically, other advances are made by the Company to NTS primarily as a result of shared accounts. These amounts are due as invoiced and are also included in the due from affiliate balance. The amount due from NTS at December 31, 2000 and 1999 was $322,952 and $320,459, respectively. On January 1, 1999, the Company entered into an exclusive license with NTS to apply certain proprietary technologies in the fields of using video and other sensors to analyze, monitor and respond to movement of persons or objects in vehicular, rail, air or other modes of transportation or supporting the foregoing. The license expires upon the expiration of the underlying patents protecting the technologies used in NTS's products. The license provides for royalties to the Company starting in 2000 equal to 5% of the gross margin realized from sales or licensing of products subject to the license, and increasing to 10% of the gross margin in calendar years 2001 and beyond. The license requires minimum annual royalties of $125,000 beginning in 2001, increasing to $1,000,000 in 2005 and beyond, in order to maintain exclusive rights. This license will be extinguished upon effectiveness of the merger discussed in Note 16. The Company recorded royalties of $9,548 for 2000 and such amount is included in due from affiliate at December 31, 2000. No royalties were due or payable in 1999. NTS uses facility and administrative services of the Company, including office space and executive, accounting and other support personnel. NTS reimburses the Company monthly for these services at a rate of $39,913 for up to 15 NTS employees, and $47,267 for above 15 employees. Such reimbursement will decrease as NTS moves into its own office space and develops an independent executive and support staff. Facility and administrative fees charged to NTS were $567,000 in 2000 and $479,000 in 1999. Included in the due from affiliate balance at December 31, 2000 is $47,267 for December 2000 fees. NOTE 13 - 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 years ended December 31, 2000, 1999 and 1998, the Company recorded an expense for Baer, Marks & Upham of $4,874, $15,600 and $15,600, respectively. 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 years ended December 31, 2000, 1999 and 1998, the Company recorded an expense for Wand Partners, Inc. of $43,048, $41,497 and $47,770, respectively. During 1998, the Company paid Wand Partners dividends totaling $69,046 on the redeemable preferred stock held by Wand. Included in accrued liabilities at December 31, 2000, 1999 and 1998 are $141,243, $99,167 and $63,738, respectively, due Wand Partners, Inc. Thomas D. Halket, who became an officer of the Company in January 1993, was a partner in the law firm of Hughes Hubbard & Reed LLP, which the Company used as outside counsel. For the years ended December 31, 2000, 1999 and 1998, the Company recorded an expense for Hughes Hubbard & Reed LLP of $35,852, $76,106 and $80,039, respectively. During 1998, TSAI, the parent company of Applied Communications, Inc. (ACI), became a significant shareholder of the Company (Note 7). Thomas H. Boje, Vice President, Corporate Development of TSAI, became a director of the Company in April 2000. For the years ended December 31, 2000, 1999 and 1998, the Company recorded revenues of $2,299,208, $3,106,631 and $620,730, respectively from ACI. At December 31, 2000 and 1999, accounts receivable included $639,013 and $489,494 due from ACI and unbilled were $3,184,924 and $3,141,574. Also at December 31, 2000 and 1999, deferred income included $3,192,849 and $2,904,634 from ACI. Further related party transactions with TSAI and ACI are discussed in Notes 6, 7, 8, 15 and 16. See Note 12 for transactions with affiliate. NOTE 14 - COMMITMENTS AND CONTINGENCIES: The Company maintains a facility in Rhode Island under an operating lease dated April 1, 1998, as amended. This lease provides for annual rentals of $195,000 through March 2001, $201,500 through March 2002, and $208,000 through March 2003. Rent expense of $195,000, $195,000 and $193,953 was charged to operations for the years ended December 31, 2000, 1999 and 1998, respectively. During 2000, The Company began leasing computer equipment under an operating lease agreement. The lease provides for monthly rent payments in arrears over a three-year term. At the end of the lease term, the Company may purchase the equipment at fair market value, extend the lease term or return the equipment. The value of leased equipment was $97,035 at December 31, 2000 and rent expense was $33,233 for the year. 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 13 - Related party transactions). The aggregate minimum payments due over the remaining term of the above agreements are as follows: December 31, 2001 $ 280,000 December 31, 2002 287,000 December 31, 2003 106,000 December 31, 2004 40,000 December 31, 2005 40,000 Thereafter 40,000 --------- $ 793,000 ========= NOTE 15- LITIGATION: On October 6, 1998, HNC Software Corp. ("HNC"), a significant competitor of the Company's in the field of Financial Services, obtained a patent titled "Fraud Detection Using Predictive Modeling" and began advising prospective customers of the Company of the patent. Upon review of the patent and consideration of prior actions taken by HNC, the Company initiated a lawsuit against HNC in the United States District Court in Providence, RI on November 25, 1998 alleging violation of Sections 1 and 2 of the Sherman Act (antitrust), violation of the Rhode Island Antitrust Act, patent invalidity, and infringement of Nestor's patents (infringement claims withdrawn January 10, 2000). On June 15, 1999, HNC answered the lawsuit denying the allegations, bringing a counterclaim alleging infringement of the above described patent by the Company, and seeking a declaration of invalidity and unenforceability of one of the Company's patents. On the same day, HNC brought suit in San Diego, CA against ACI and its parent alleging various causes of action including patent infringement of the above described patent by the Company's PRISM product which ACI markets. In April 2000, HNC, ACI and its parent agreed to dismiss the lawsuit. ACI has requested that the Company provide indemnification for approximately $900,000 of its legal counsel costs pursuant the PRISM license agreement between ACI and the Company. The Company is disputing the indemnification claim and therefore, no accrual has been established. The Company and HNC reached a mutually agreeable settlement on January 16, 2001, the terms of which are confidential. All claims have been dismissed. Costs associated with the suit have been expensed as incurred. NOTE 16- SUBSEQUENT EVENTS: A. MERGER AND SECURED NOTE AGREEMENT In January 2001, an agreement in principle was reached to combine the Company and Nestor Traffic Systems, Inc., by merging NTS into a wholly-owned subsidiary of the Company, with Nestor, Inc. in effect becoming the surviving entity. The combination is subject to certain conditions including a fairness opinion of the transaction by a qualified investment company and approval by the shareholders of both companies. On January 9, 2001, the Company and NTS entered into a secured note agreement with NTS Investors, LLC (an independent investment group ("Group")). The Group loaned NTS $4,000,000 as of February 1, 2001 with principal and interest at 8% due on December 31, 2001. The note contains various covenants including restrictions on the use of proceeds and payments to Nestor, Inc. It is secured by NTS assets. Upon consummation of the combination contemplated above, the Group will convert the note to equity and increase its total investment to $8,000,000 in exchange for approximately 16,756,000 shares (33.34%) of Nestor, Inc. common stock, the current NTS shareholders will receive approximately 15,580,000 shares (31%) of Nestor, Inc. common stock and current Nestor, Inc. shareholders would then own approximately 17,922,000 shares (35.66%). If the combination is not consummated on or before December 31, 2001, the Group may elect on or before January 31, 2002 to convert the note into NTS common stock for up to a 25% fully diluted equity interest and reacquire up to an additional 25% fully diluted equity interest in NTS for an additional $4,000,000. In the event that the combination is completed, the Group will receive the right to acquire additional common stock at the same price at which warrants of Nestor, Inc. are exercised so as to maintain their ownership interest percentage. In addition, the Group will receive the option to acquire up to 1,000,000 shares of the Company's common stock at $.75 per share for three years as dilution protection against both the Company's and NTS's converted employee stock options outstanding. B. NEW ACI LICENSE AGREEMENT On February 1, 2001, the Company entered into a license agreement with ACI pursuant to which ACI was granted a worldwide, perpetual, non-revocable, non-transferable and non-exclusive license in the field of use of fraud detection (including money laundering detection) in electronic payments. ACI may brand, customize, and extend the software products covered by the license agreement as well as use the software programs as a development platform to develop new functional and new end-user products or applications subject to the terms and conditions of the license. In return, ACI is fully responsible and liable for the provision of services to its licensees. Nestor, Inc. had previously provided support, maintenance and enhancements for these products. ACI has agreed to pay initial and guaranteed minimum license fees during the first year in the aggregate of $1,576,650 and, in addition, an ongoing license fee of 15% for source code license rights to the software products. The license granted to ACI is for products that presently constitute a substantial portion of the Company's gross revenues. During 2000, the Company recorded license fees of $1,401,305 under the previous 40% royalty rate and $897,903 of engineeirng revenues at normal full-fee rates (Note 13). Future ACI revenues are expected to decrease significantly due to the decrease in the royalty rate from 40% to 15% and the elimination of ACI engineering revenues. Future expenses relating to these revenues will also decrease because ACI has hired twelve employees from Nestor, Inc., effective February 1, 2001 and is reimbursing the Company $13,000 per month for up to six months for the continued use of Nestor, Inc. facilities and equipment prior to their office relocation. This agreement replaces the April 28, 1998 license agreement with ACI. NESTOR, INC. Part IV ------------ Item 14 CONSOLIDATED FINANCIAL STATEMENT SCHEDULE Schedule II ----------------------------------------- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Balance at Charged to Deductions Balance at Beginning of Charged to Other from End of Period Expense Accounts Reserve Period ------ ------- -------- ------- ------ Allowances deducted from accounts receivable: Year Ended December 31, 1998 $ 154,554 $ 40,081 $ -- $(163,450) $ 30,300 Year Ended December 31, 1999 $ 30,300 $ 5,000 $ -- $ (31,155) $ 4,145 Year Ended December 31, 2000 $ 4,145 $ 62,850 $ -- $ (62,850) $ 4,145
ITEM 8. Financial Statement and Supplementary Data. ------------------------------------------ See annexed financial statements. ITEM 9. Changes in or Disagreement with Accounting and Financial disclosure. ------------------------------------------------------------------- Not Applicable. 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 II: 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 and filed herewith. 21.2 Nestor Traffic Systems, Inc. audited financial statements for the year ended December 31, 2000. 99.1 Safe Harbor for Forward-Looking Statements Under the Private Securities Litigation Reform Act of 1995. (b) Reports on Form 8-K: On May 7, 1998, the Corporation filed with the Securities and Exchange Commission a current report on Form 8-K dated April 28, 1998 which is hereby incorporated by reference. On December 3, 1998, the Corporation filed with the Securities and Exchange Commission a current report on Form 8-K dated November 25, 1998 which is hereby incorporated by reference. On April 23, 1999, the Corporation filed with the Securities and Exchange Commission a current report on Form 8-K dated March 25, 1999 which is hereby incorporated by reference. On January 18, 2001, the Corporation filed with the Securities and Exchange Commission a current report on Form 8-K dated January 11, 2001 which is hereby incorporated by reference. On February 9, 2001, the Corporation filed with the Securities and Exchange Commission a current report on Form 8-K dated February 1, 2001 which is hereby incorporated by reference. INDEX OF EXHIBITS - ----------------- Exhibit No. 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. 4.1 Nestor, Inc. 1997 Incentive Stock Option Plan, as amended, filed as an Exhibit to the Company's Registration Statement on Form S-8, filed May 16, 1997, is hereby incorporated by reference. 4.2 Securities Purchase Agreement dated April 28, 1998 with Transaction Systems Architects, Inc. to purchase 2,500,000 common shares of the Company and a warrant for an additional 2,500,000 common shares. 4.3 Nestor Traffic Systems, Inc., Form of Subscription Agreement dated March 25, 1999, to sell a 37.5% equity position in its common stock and issue a warrant for an additional 17.5% common stock interest. 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. 10.26 Lease 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. 10.32 License Agreement dated as of March 28, 1997, between Nestor, Inc. and Total System Services, Inc. filed as an Exhibit to the Company's Current report on Form 8-K dated April 8, 1997, is hereby incorporated by reference. Portions of the Exhibit omitted, pursuant to a grant of confidential treatment. 10.33 Asset Acquisition Purchase Agreement dated March 31, 1997 among Nestor Interactive, Inc., Cyberiad Software, Inc., Christopher L. Scofield and Jeffrey Pflum filed as an Exhibit to the Company's Current Report on Form 8-K dated April 10, 1997, is hereby incorporated by reference. 10.34 Nestor, Inc. 1997 Incentive Stock Option Plan, as amended, filed as an Exhibit to the Company's Current Report on Form 8-K dated May 6, 1997 is hereby incorporated by reference. 10.35 Amendment to the PRISM Non-Exclusive License Agreement dated as of April 18, 1997, between Nestor, Inc. and Applied Communications, Inc. filed as an Exhibit to the Company's Current Report on Form 8-K dated April 30, 1997 is hereby incorporated by reference. Portions of the Exhibit omitted pursuant to a grant of confidential treatment. 10.36 Exclusive License Agreement between Nestor, Inc. and Nestor Traffic Systems, Inc. dated January 1, 1999 filed as an Exhibit to the Company's Current Report on Form 8-K dated March 25, 1999. 10.37 Secured Note Agreement by and among Nestor, Inc., Nestor Traffic Systems, Inc. and NTS Investors LLC dated January 9, 2001 and filed as an Exhibit to the Company's Current Report on Form 8-K on January 18, 2001 is hereby incorporated by reference. 10.38 License Agreement between Nestor, Inc. and ACI Worldwide, Inc. dated February 1, 2001, filed as an Exhibit to the Company's Current Report on Form 8-K on February 9, 2001 is hereby incorporated by reference. 21 Nestor IS, Inc., a wholly-owned subsidiary of Nestor, Inc. incorporated January 1, 1997, doing business as Nestor Intelligent Sensors. 21.1 Nestor Interactive, Inc. a wholly-owned subsidiary of Nestor, Inc. incorporated January 1, 1997. 21.2 Nestor Traffic Systems, Inc. financial statements for year ended December 31, 2000. 99.1 Safe Harbor for Forward-Looking Statements under the Private Securities Litigation Reform Act of 1995. 103 Copy of Complaint filed on November 25, 1998 against HNC Software, Inc. alleging anticompetitive, exclusionary and predatory conduct in the Registrant's market. EX-21 2 exhibit_nts.txt EXH_NTS Exhibit 21.2 FINANCIAL STATEMENTS NESTOR TRAFFIC SYSTEMS, INC. (A Development Stage Company) December 31, 2000 NESTOR TRAFFIC SYSTEMS, INC. (A Development Stage Company) CONTENTS Page No. -------- Independent Auditor's Report 3 Balance Sheets - December 31, 2000 and 1999 4 Statements of Operations - For the Years Ended December 31, 2000 and 1999 5 Statements of Stockholders' Equity - For the Years Ended December 31, 2000 and 1999 6 Statements of Cash Flows - For the Years Ended December 31, 2000 and 1999 7 Notes to Financial Statements 8 Report of Independent Auditors The Board of Directors and Stockholders of Nestor Traffic Systems, Inc. We have audited the accompanying balance sheets of Nestor Traffic Systems, Inc. (a development stage company) as of December 31, 2000 and 1999, and the related statements of operations, stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 audits provide a reasonable basis for our opinion. In our opinion, the 2000 and 1999 financial statements referred to above present fairly, in all material respects, the financial position of Nestor Traffic Systems, Inc. at December 31, 2000 and 1999, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States. The accompanying financial statements have been prepared assuming that Nestor Traffic Systems, Inc. will continue as a going concern. As discussed in Note 1, the Company is a development stage company that since inception has expended cash in excess of cash generated from operations. Additionally, the Company has a working capital deficit and has not achieved sufficient revenues to support future operations without additional financing. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are discussed in Note 11. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. ERNST & YOUNG LLP Providence, Rhode Island February 26, 2001 NESTOR TRAFFIC SYSTEMS, INC. (A Development Stage Company) Balance Sheets ASSETS December 31, ---------------------------- 2000 1999 ---- ---- CURRENT ASSETS: Cash and cash equivalents $ 54,690 $ 1,599,112 Accounts receivable 57,592 30,756 Unbilled contract revenue 109,673 20,000 Inventory 158,691 442,493 Other current assets 85,273 31,561 ----------- ----------- Total current assets 465,919 2,123,922 Investment in leased equipment - net of accumulated depreciation 487,031 138,961 Property and equipment at cost - net of accumulated depreciation 161,321 156,997 Other assets 45,320 1,680 ----------- ----------- TOTAL ASSETS $ 1,159,591 $ 2,421,560 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses $ 593,383 $ 394,324 Due to affiliate 322,952 320,459 Deferred income 8,998 8,998 ----------- ----------- Total current liabilities 925,333 723,781 Commitments and contingencies -- -- STOCKHOLDERS' EQUITY: Common stock, $.01 par value, authorized 4,000,000 shares; issued and outstanding 2,600,000 shares at December 31, 2000 and 2,150,000 shares at December 31, 1999 26,000 21,500 Additional paid-in capital 9,599,371 7,554,446 Deficit accumulated during the development stage (9,391,113) (5,878,167) ----------- ----------- Total stockholders' equity 234,258 1,697,779 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,159,591 $ 2,421,560 =========== =========== The Notes to the Financial Statements are an integral part of this statement. NESTOR TRAFFIC SYSTEMS, INC. (A Development Stage Company) Statements of Operations
(Unaudited) Cumulative January 1, 1997 to Years Ended December 31, December 31, 2000 --------------------------------- ------------------ 2000 1999 ----- ---- Revenue: Lease and service fees $ 79,295 $ 18,474 $ 107,030 Product sales and engineering services 793,856 148,959 1,496,576 ------------ ------------ ------------ Total revenue 873,151 167,433 1,603,606 ------------ ------------ ------------ Operating Expenses: Engineering services 1,691,489 675,315 2,899,341 Product costs 681,742 36,644 862,589 Research and development 714,812 905,880 3,066,922 Selling and marketing 695,943 717,004 2,463,036 General and administrative 640,926 321,456 1,777,949 ------------ ------------ ------------ Total operating expenses 4,424,912 2,656,299 11,069,837 ------------ ------------ ------------ Loss from operations (3,551,761) (2,488,866) (9,466,231) Other income - net 38,815 36,333 75,118 ------------ ------------ ------------ Loss before income taxes (3,512,946) (2,452,533) (9,391,113) Income taxes -- -- -- ------------ ------------ ------------ Net Loss $ (3,512,946) $ (2,452,533) $ (9,391,113) ============ ============ ============ The Notes to the Financial Statements are an integral part of this statement.
Nestor Traffic Systems, Inc. (A Development Stage Company) Statements of Stockholders' Equity
Deficit Accumulated Common Stock During (the) ---------------------- Additional Development Shares Amount Paid-in Capital Stage Total ------ ------ --------------- ----- ----- Issuance of Common Stock 1,000 $ 1 $ 1,009 $ -- $ 1,010 Capital contributed by Nestor, Inc. -- -- 1,565,780 -- 1,565,780 Loss for the year ended December 31, 1997 -- -- -- (1,491,701) (1,491,701) ---------- ------- ---------- ----------- ----------- Balance at December 31, 1997 (unaudited) 1,000 $ 1 $1,566,789 $(1,491,701) $ 75,089 Capital contributed by Nestor, Inc. -- -- 1,904,156 -- 1,904,156 Loss for the year ended December 31, 1998 -- -- -- (1,933,933) (1,933,933) ---------- ------- ---------- ----------- ----------- Balance at December 31, 1998 (unaudited) 1,000 $ 1 $3,470,945 $(3,425,634) $ 45,312 Issuance of Common Stock 2,149,000 21,499 4,083,501 -- 4,105,000 Loss for the year ended December 31, 1999 -- -- -- (2,452,533) (2,452,533) ---------- ------- ---------- ----------- ----------- Balance at December 31, 1999 2,150,000 $21,500 $7,554,446 $(5,878,167) $ 1,697,779 Issuance of Common Stock 450,000 4,500 2,020,325 -- 2,024,825 Issuance of Warrants -- -- 24,600 -- 24,600 Loss for the year ended December 31, 2000 -- -- -- (3,512,946) (3,512,946) ---------- ------- ---------- ----------- ----------- Balance at December 31, 2000 2,600,000 $26,000 $9,599,371 $(9,391,113) $ 234,258 ========== ======= ========== =========== =========== The Notes to the Financial Statements are an integral part of this statement.
NESTOR TRAFFIC SYSTEMS, INC. (A Development Stage Company) Statements of Cash Flows
(Unaudited) Cumulative January 1, 1997 to Years Ended December 31, December 31, 2000 --------------------------------- ------------------ 2000 1999 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(3,512,946) $(2,452,533) $(9,391,113) Adjustments to reconcile net loss to net cash used by operating activities: Depreciation 102,509 51,033 197,372 Changes in assets and liabilities: Accounts receivable (26,836) (30,756) (57,592) Unbilled contract revenue (89,673) (11,659) (107,722) Inventory 283,803 (210,880) (39,232) Other assets (72,752) (19,186) (101,868) Accounts payable and accrued expenses 199,059 121,939 469,614 Deferred income -- 8,998 8,998 ----------- ----------- ----------- Net cash used by operating activities (3,116,836) (2,543,044) (9,021,543) ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (66,333) (140,967) (257,944) Investment in leased equipment (388,571) (142,336) (530,907) ----------- ----------- ----------- Net cash used by investing activities (454,904) (283,303) (788,851) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Due to affiliate 2,493 320,459 322,952 Capital investsments by affiliate - net -- -- 3,412,307 Proceeds from issuance of common stock - net 2,024,825 4,105,000 6,129,825 ----------- ----------- ----------- Net cash provided by financing activities 2,027,318 4,425,459 9,865,084 ----------- ----------- ----------- Net change in cash and cash equivalents (1,544,422) 1,599,112 54,690 Cash and cash equivalents - beginning of period 1,599,112 -- -- ----------- ----------- ----------- Cash and cash equivalents - end of period $ 54,690 $ 1,599,112 $ 54,690 =========== =========== =========== SUPPLEMENTAL CASH FLOWS INFORMATION: Interest paid $ 51 $ -- $ 51 =========== =========== =========== Income taxes paid $ -- $ -- $ -- =========== =========== =========== Non-cash transaction: Net assets transferred from affiliate $ -- $ -- $ 58,639 =========== =========== =========== The Notes to the Financial Statements are an integral part of this statement.
NOTES TO THE FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. ORGANIZATION Nestor Traffic Systems, Inc. (the "Company") was organized on January 1, 1997 in Delaware as a wholly-owned subsidiary of Nestor, Inc. to exploit and develop certain patent rights and know-how, which the Company licenses from Nestor, Inc. During 1999, the Company issued common stock to a group of private investors in two separate transactions aggregating $4,105,000, representing a 58.1% equity ownership in the Company. In June 2000, the Company sold additional shares of its common stock to private investors for $2,025,000, bringing their equity ownership to 65.38%. Nestor, Inc. owns the remaining 34.62% equity of the Company and accounts for the investment using equity accounting. As discussed in Note 11, in January 2001, an agreement in principle was reached to combine the Company into a Nestor, Inc. subsidiary, with Nestor, Inc. owning 100% of the Company post-merger. The Company's principal office is located in Providence, RI, and it maintains a branch office in Irvine, CA. The Company is a development stage company and has had limited revenues. Activities through December 31, 2000 consist primarily of raising capital, research and development, establishing supplies and production processes, and sales and marketing. The financial statements have been prepared on a going-concern basis. From its inception through December 31, 2000, the Company has expended cash in excess of cash generated from operations. Additionally, the Company has a working capital deficit and has not achieved sufficient revenues to support future operations without additional financing. Management is in the process of identifying new customers and raising additional capital to support its operations and provide sufficient liquidity to enable it to continue as a going concern (Note 11). These conditions raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. B. CASH EQUIVALENTS The Company considers all highly liquid debt instruments purchased with an original maturity of 90 days or less to be cash equivalents. C. DEPRECIATION Depreciable assets are recorded at cost. Depreciation is provided on the straight-line method over the estimated useful lives or lease term of the respective assets. Maintenance and repairs are expensed as incurred. Major renewals and betterments are capitalized. D. REVENUE RECOGNITION Revenue is derived mainly from the sale or lease of products which incorporate the Company's software and the delivery of services based upon such products. Lease and service fees include software license and processing service fees tied to citations issued to red-light violators. The Company provides equipment, in some instances under operating lease agreements, and engineering services ranging from installation, training, and basic consulting to software modification and customization to meet specific customer needs. Postcontract customer support includes maintenance agreements. In software arrangements that include multiple elements, the Company allocates the total arrangement fee among each deliverable based on the relative fair value of each of the deliverables determined based on vendor-specific objective evidence. Revenue has been recognized as follows: Product Sales - The Company recognizes the revenue allocable to product sales upon delivery of the product to the end user, unless the fee is not fixed or determinable or collectibility is not probable. The Company considers all arrangements with payment terms extending beyond twelve months and other arrangements with payment terms longer than normal not to be fixed or determinable. In most situations, the Company considers its acceptance terms as perfunctory. Arrangements that include acceptance terms that are not considered perfunctory are not recognized until acceptance has occurred. If collectibility is not considered probable, revenue is recognized when the fee is collected. Revenue on arrangements with customers who are not the ultimate users (distributors, other resellers, etc.) is not recognized until the software is delivered to an end user. Product returns or exchanges are charged to operations as incurred. Lease and Service Fees - The Company recognizes lease and service fee revenue from operating lease arrangements with customers over the terms of the lease agreements. The majority of the Company's CrossingGuard revenues are expected to be generated from fees received from red-light violation citations issued by the system and associated services. Revenues are recognized upon the issuance of related tickets. Contract Accounting - For arrangemetns that include customization or modification of the software, or where software services are otherwise considered essential, revenue is recognized using contract accounting. Revenue from these software arrangements is recognized on a percentage-of completion method with progress-to-completion measured based upon estimated total costs. Certain contracts include penalty provisions relating to timely performance and delivery. Penalties are charged to operations as incurred. Postcontract Customer Support - Revenue is recognized on a straight-line basis over the period provided. Training revenue is recognized upon the completion of training sessions with the customer. E. 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 result, 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. F. INVENTORY Inventory is valued at the lower of cost or market on the first-in, first-out basis and consists of the following at December 31, 2000 and 1999: December 31, ----------------------------------------- 2000 1999 ---- ---- Work-in-progress $ 138,445 $ 325,171 Finished goods 20,246 117,322 --------------- ---------------- Total inventory $ 158,691 $ 442,493 =============== ================ G. 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. H. CHANGE IN PRESENTATION Certain December 31, 1999 amounts have been reclassified to conform to the December 31, 2000 presentation. NOTE 2 - INVESTMENT IN LEASED EQUIPMENT: In 1999, the Company entered into an operating lease with a customer providing for quarterly fixed payments of system lease and software license fees of $13,497 over a term of 36 months, and providing for a lump-sum buyout of $20,834 at the end of the term. Future minimum lease revenues are $53,988 in 2001 and $49,489 in 2002, totaling $103,477 over the remaining term of the lease. In addition, the agreement calls for software license and processing fees tied to citations issued to red light violators, which totaled $25,307 in 2000. At December 31, 2000, the Company has five contracts in process with anticipated acceptance under operating lease agreements having 36-month terms. Equipment and installation costs related to operating lease contracts are capitalized and, after acceptance, are depreciated over the minimum lease term of the related lease agreement, currently three years. Revenues realized from these agreements, generally in the form of per-citation fees, is expected to be adequate to cover the capitalized and future costs related to these agreements. December 31, ------------------------- 2000 1999 ---- ---- Equipment under operating leases: Work-in process $ 388,571 $ -- Installed and accepted 142,336 142,366 ---------- ---------- 530,907 142,336 Less: Accumulated depreciation (43,876) (3,375) ---------- ---------- Net investment in leased equipment $ 487,031 $ 138,961 ========== ========== NOTE 3 - PROPERTY AND EQUIPMENT AT COST-NET: December 31, --------------------- Useful Life 2000 1999 or Lease Term ---- ---- ------------- Computer equipment $ 231,284 $ 184,449 5 years Demonstration equipment 101,315 93,244 3 years Leasehold improvements 11,426 -- 5 years --------- --------- 344,025 277,693 Less: Accumulated depreciation (182,704) (120,696) --------- --------- $ 161,321 $ 156,997 ========= ========= NOTE 4 - DUE TO AFFILIATE: During the period January 1, 1999 through March 31, 1999, Nestor, Inc. advanced the Company financing to cover operating expenses amounting to approximately $550,000. Of this advance, $275,000 was reimbursed to Nestor, Inc. in March 1999, and the balance was paid in January 2001. Included in due to affiliate at December 31, 2000 is $9,548 representing royalties for 2000 and the December 2000 facility and administrative fee of $47,267 (Note 9). Periodically, other advances are made on behalf of the Company by Nestor, Inc., primarily as a result of shared accounts. These amounts are due and paid as invoiced and are also included in the due to affiliate balance. NOTE 5 - COMMON STOCK: On March 25, 1999, the Company sold a 37.5% common stock interest to a private group of investors for $2,350,000 in cash and issued an option to purchase an additional 17.5% of its common stock for $1,750,000. The option was scheduled to expire on January 31, 2000. On November 30, 1999, the Company and the investor group agreed to accelerate the exercise of the option and the investor group purchased an additional 20.6% ownership in the Company for $1,755,000. On June 23, 2000, the Company sold additional shares of its common stock to private investors for $2,025,000, bringing their equity ownership to 65.38%. The investor group includes three officers and a director of the Company who, in the aggregate, have contributed $970,085 of cash invested on the same basis as third-party investors. As discussed in Note 11, in January 2001, an agreement in principle was reached to combine the Company with a Nestor, Inc. subsidiary, with Nestor, Inc. acquiring a 100% equity interest in the Company in exchange for Nestor common stock. If the merger does not occur, new investors have the option of investing $8,000,000 in the Company for a 50% common equity position. NOTE 6 - OPTIONS: On May 5, 1999, the Company adopted the 1999 Stock Option Plan providing for the granting of options to purchase shares of the Company's common stock at a price equal to the fair market value of the common stock at the date of grant as determined by the Board of Directors. The 1999 Stock Option Plan has authorized the grant of options to employees for up to 400,000 shares of the Company's common stock. Options are exercisable for up to ten years from the date of grant. As discussed in Note 11, an agreement in principle was reached to combine the Company and Nestor, Inc., with Nestor, Inc. being the surviving entity. Options outstanding at the combination date are expected to be exchanged for comparable Nestor, Inc. options at the exchange ratio in effect on the combination date. The Company has adopted the disclosure-only provisions of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation ("FAS 123"). The Company will continue to account for its stock option plan in accordance with the provisions of APB 25, Accounting for Stock Issued to Employees. Accordingly, no compensation cost has been recognized in the financial statements for qualifying grants issued pursuant to the Company's Stock Option Plan. The following table presents the activity of the Company's Stock Option Plan for the years ended December 31, 2000 and 1999:
2000 1999 ------------------------- ----------------------- Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price ------ ----- ------ ----- Outstanding beginning of year 87,000 $5.00 -- $ -- Granted 109,000 5.00 90,000 5.00 Exercised -- -- -- -- Canceled 1,000 5.00 3,000 5.00 -------- -------- Outstanding end of year 195,000 $5.00 87,000 $5.00 ======== ======== Options exercisable at year end 56,200 $5.00 17,400 $5.00 ======== ======== Weighted average fair value of options granted during the year $ 1.87 $ 1.42 ======== ========
All options granted and outstanding have a ten-year life and vest 20% upon issuance and each anniversary thereafter, until fully vested. Below is the pro forma net loss for the years ended December 31, 2000 and 1999, as if the compensation cost for the option had been determined based on the fair value at the grant date: December 31, ------------------------------------- 2000 1999 ---- ---- Net Loss: As Reported $ (3,512,946) $ (2,452,533) Pro Forma $ (3,566,961) $ (2,468,730) The fair value of each option grant was estimated using the Minimum Value method with risk-free interest rates on the date of grant, which ranged from 5.3% to 6.8%. The Company has never declared nor paid dividends on its common stock and does not expect to in the foreseeable future. NOTE 7 - OTHER INCOME - NET: Other income as reflected in the statements of operations consists primarily of interest income realized on short-term investments. NOTE 8 - INCOME TAXES: The Company accounts for income taxes using the deferred liability method as required by Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes. Under FAS 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. Significant components of the Company's deferred tax liabilities and assets as of December 31, 2000 and 1999 are as follows: December 31 -------------------------------- 2000 1999 ---- ---- Deferred tax assets: ------------------- Accrued expenses $ 48,000 $ 25,000 Net operating loss 3,694,000 2,317,000 ------------ ------------ Total deferred tax assets 3,742,000 2,342,000 Valuation allowance (3,742,000) (2,342,000) ------------ ------------ Net deferred tax assets -- -- ------------ ------------ Net deferred tax balance $ -- $ -- ============ ============ In accordance with FAS 109, a valuation allowance must be established until it is more likely than not that future benefits arising from net deferred tax assets will be realized. Realization is not assured in future tax projections. A reconciliation of the provision for income taxes to the amount computed using the Federal statutory tax rates consists of the following: 2000 1999 ---- ---- Loss before taxes $ (3,513,000) $ (2,453,000) ============= ============= Tax at statutory rate of 34% $ (1,195,000) $ (834,000) State income tax (net of federal benefit) (208,000) (145,000) Effect of permanent differences 3,000 3,000 Valuation allowance 1,400,000 976,000 ------------- ------------- Income tax expense $ -- $ -- ============= ============= The Company has available at December 31, 2000, $9,248,000 of net operating loss carryforwards for federal and state purposes. These loss carryforwards may be applied against future taxable income and begin to expire in 2012 for federal purposes and 2002 for state purposes. The Company has had numerous equity transactions during its history. These transactions may affect the Company's ability to utilize these net operating loss carryforwards due to certain provisions contained in IRC Section 382. NOTE 9 - RELATED PARTY TRANSACTIONS: On January 1, 1999, the Company entered into an exclusive license with Nestor, Inc. to apply certain proprietary technologies in the fields of using video and other sensors to analyze, monitor and respond to movement of persons or objects in vehicular, rail, air or other modes of transportation or supporting the foregoing. The license expires upon the expiration of the underlying patents protecting the technologies used in the Company's products. The license provides for royalties to Nestor, Inc. starting in 2000 equal to 5% of the gross margin (revenues less third-party direct cost of sales) realized from sales or licensing of products subject to the license, and increasing to 10% of the gross margin in calendar years 2001 and beyond. The license requires minimum annual royalties of $125,000 beginning in 2001, increasing to $1,000,000 in 2005 and beyond, in order to maintain exclusive rights. The Company recorded royalties of $9,548 for 2000 and such amount is included in due to affiliate at December 31, 2000. No royalties were due or payable in 1999. The Company uses facility and administrative services of Nestor, Inc., including use of office space and executive, accounting and other support personnel. The Company reimburses Nestor, Inc. monthly for these services at a rate of $39,913 for up to 15 Company employees, and $47,267 for above 15 employees. These fees will be replaced with direct expenses as the Company moves into its own office space (Note 10) and develops an independent executive and support staff. Facility and administrative fees charged to the Company were $567,000 in 2000 and $479,000 in 1999. Included in due to affiliate at December 31, 2000 is $47,267 for December 2000 fees. NOTE 10 - COMMITMENTS AND CONTINGENCIES: The Company maintains a sales and support office in California under an operating lease dated July 1, 1999. This lease provides for monthly rentals of $650, and can be terminated upon 60 days advance notice. Total expense under the lease was $7,800 in 2000 and $3,900 in 1999. The Company entered into an operating lease dated June 21, 2000 for office and warehouse facilities in Rhode Island. This lease provides for monthly rentals of $10,360 for August 2000 through July 2003 and then increases to $10,800 monthly through July 2005. Rent expense for this lease was $51,800 in 2000. On October 14, 1999, the Company entered into an engagement letter with FAC Equities, a division of First Albany Corporation, to provide financial advisory and investment banking services to the Company relating to the potential sale of additional equity securities by the Company. The Company issued a warrant to FAC to purchase up to 10,000 shares of the company's common stock at $.01 per share (expires October 14, 2004) and recorded deferred financing costs of $24,600 associated with these warrants in 2000. While this agreement expired in July 2000 without closing an equity transaction, FAC is still entitled to a fee equal to 5% of the gross proceeds in cash plus a warrant equal to 3% of the common shares, or equivalents, sold in any transaction consumated prior to July 13, 2002 with an investor identified by FAC. NOTE 11 - SUBSEQUENT EVENTS: In January 2001, an agreement in principle was reached to combine the Company and Nestor, Inc., by merging the Company into a wholly-owned subsidiary of Nestor, Inc., with Nestor, Inc., in effect, being the surviving entity. The combination is subject to certain conditions including a fairness opinion of the transaction by a qualified investment company and approval by the shareholders of both companies. On January 9, 2001, the Company and Nestor, Inc. entered into a secured note agreement with NTS Investors, LLC (an independent investment group ("Group")). The Group loaned the Company $4,000,000 as of February 1, 2001 with principal and interest at 8% due on December 31, 2001. The note contains various covenants including restrictions on the use of proceeds and payments to Nestor, Inc. It is secured by the Company's assets. Upon consummation of the combination contemplated above, the Group will convert the note to equity and increase its total investment to $8,000,000 in exchange for approximately 16,756,000 shares (33.34%) of Nestor, Inc. common stock, the Company's current shareholders will receive approximately 15,580,000 shares (31%) of Nestor, Inc. common stock and current Nestor, Inc. shareholders would then own approximately 17,922,000 shares (35.66%). If the combination is not consummated on or before December 31, 2001, the Group may elect on or before January 31, 2002 to convert the note into the Company's common stock for up to a 25% fully diluted equity interest and reacquire of up to an additional 25% fully diluted equity interest for an additional $4,000,000. In the event that the combination is completed, the Group will receive the right to acquire additional common stock of Nestor, Inc. at the same price at which warrants of Nestor, Inc. are exercised so as to maintain their ownership interest percentage. In addition, the Group will receive the option to acquire up to 1,000,000 shares of Nestor common stock at $.75 per share for three years as dilution protection against both Nestor Inc.'s and the Company's converted employee stock options outstanding. EX-99 3 ex99.txt SAFEHARB Exhibit 99.1 NESTOR, INC. SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CERTAIN CAUTIONARY STATEMENTS AND RISK FACTORS Nestor, Inc. and its subsidiaries (collectively, the Company) or their representatives from time to time may make or may have made certain forward-looking statements, whether orally or in writing, including without limitation, any such statements made or to be made in the Management's Discussion and Analysis contained in its various SEC filings or orally in conferences or teleconferences. The Company wishes to ensure that such statements are accompanied by meaningful cautionary statements, so as to ensure to the fullest extent possible the protections of the safe harbor established in the Private Securities Litigation Reform Act of 1995. ACCORDINGLY, THE FORWARD-LOOKING STATEMENTS ARE QUALIFIED IN THEIR ENTIRETY BY REFERENCE TO AND ARE ACCOMPANIED BY THE FOLLOWING MEANINGFUL CAUTIONARY STATEMENTS IDENTIFYING CERTAIN IMPORTANT FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD-LOOKING STATEMENTS. This list of factors is likely not exhaustive. The Company operates in a rapidly changing and evolving business involving electronic commerce and payments, and new risk factors will likely emerge. Management cannot predict all of the important risk factors, nor can it assess the impact, if any, of such risk factors on the Company's business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those in any forward-looking statements. ACCORDINGLY, THERE CAN BE NO ASSURANCE THAT FORWARD-LOOKING STATEMENTS WILL BE ACCURATE INDICATORS OF FUTURE ACTUAL RESULTS AND IT IS LIKELY THAT ACTUAL RESULTS WILL DIFFER FROM RESULTS PROJECTED IN FORWARD-LOOKING STATEMENTS. SUCH DIFFERENCES MAY BE MATERIAL. Nestor is dependent on its PRISM products Nestor has derived a substantial majority of its total revenues from licensing its PRISM family of software products and providing services and maintenance related to those products. The PRISM products and related services and maintenance are expected to provide the majority of Nestor's revenues in the foreseeable future. Nestor's results will depend upon continued market acceptance of its PRISM products and related services as well as Nestor's ability to continue to adapt and modify them to meet the changing needs of its customers. Any reduction in demand for, or increase in competition with respect to, PRISM products would have a material adverse effect on Nestor's financial condition and results of operations. Nestor is subject to risks of conducting international operations Nestor has derived a material portion of its total revenues from sales to customers outside the United States. International operations generally are subject to certain risks, including: - difficulties in staffing and management, - reliance on independent distributors, - fluctuations in foreign currency exchange rates, - compliance with foreign regulatory requirements, - variability of foreign economic conditions, and - changing restrictions imposed by U.S. export laws. There can be no assurance that Nestor will be able to manage the risks related to selling its products and services in international markets. Nestor is dependent on the banking industry Nestor's business is concentrated in the banking industry, making Nestor susceptible to a downturn in that industry. For example, a decrease in bank spending for software and related services could result in a smaller overall market for electronic payment software. Furthermore, banks are continuing to consolidate, decreasing the overall potential number of buyers for Nestor's products and services. These factors as well as others negatively affecting the banking industry could have a material adverse effect on Nestor's financial condition and results of operations. Nestor must manage its growth effectively Nestor is experiencing a period of growth which is placing demands on its managerial and operations resources. Nestor's inability to manage its growth effectively or to maintain its current level of growth could have a material adverse effect on its financial condition and results of operations. Nestor may not be able to attract and retain key personnel Nestor's success depends on certain of its executive officers, the loss of one or more of whom could have a material adverse effect on Nestor's financial condition and results of operations. None of Nestor's U.S.-based executive officers is a party to an employment agreement. Nestor believes that its future success also depends on its ability to attract and retain highly-skilled technical, managerial and marketing personnel, including, in particular, additional personnel in the areas of research and development and technical support. Competition for personnel is intense. There can be no assurance that Nestor will be successful in attracting and retaining the personnel it requires. The market for software and related services is highly competitive Many applications software vendors offer products that are directly competitive with PRISM and other products of Nestor. Nestor also experiences competition from software developed internally by potential customers and experiences competition for its consulting services from professional services organizations. In addition, processing companies provide services similar to those made possible by Nestor's products. Many of Nestor's current and potential competitors have significantly greater financial, marketing, technical and other competitive resources than Nestor. Current and potential competitors, including providers of transaction-based software, processing, or professional services, may establish cooperative relationships with one another or with third parties to compete more effectively against Nestor. It is also possible that new competitors may emerge and acquire market share. In either case, Nestor's financial condition and results of operations could be adversely affected. Nestor's future success depends on its ability to timely develop and market product enhancements and new products. The market for software in general is characterized by rapid change in computer hardware and software technology and is highly competitive with respect to the need for timely product innovation and new product introductions. Nestor believes that its future success depends upon its ability to enhance its current applications and develop new products that address the increasingly complex needs of customers. In particular, Nestor believes that it must continue to respond quickly to users' needs for additional functionality and multi-platform support. The introduction and marketing of new or enhanced products requires Nestor to manage the transition from current products in order to minimize disruption in customer purchasing patterns. There can be no assurance that Nestor will continue to be successful in the timely development and marketing of product enhancements or new products that respond to technological advances, that its new products will adequately address the changing needs of the domestic and international markets or that it will successfully manage the transition from current products. Nestor is continually developing new products, product versions and individual features within a complex software system. Development projects can be lengthy and are subject to changing requirements, programming difficulties and unforeseen factors which can result in delays in the introduction of new products and features. Delays could have a material adverse effect on Nestor's financial condition and results of operations. In addition, new products, versions or features, when first released by Nestor, may contain undetected errors that, despite testing by Nestor, are discovered only after a product has been installed and used by customers. To date, undetected errors have not caused significant delays in product introduction and installation or required substantial design modifications. However, there can be no assurance that Nestor will avoid problems of this type in the future. Nestor is dependent on proprietary technology Nestor relies on a combination of patents, trade secret and copyright laws, nondisclosure and other contractual and technical measures to protect its proprietary rights in its products. There can be no assurance that these provisions will be adequate to protect its proprietary rights. In addition, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Although Nestor believes that its intellectual property rights do not infringe upon the proprietary rights of third parties, there can be no assurance that third parties will not assert infringement claims against Nestor. Fluctuations in quarterly operating results may result in volatility in Nestor's stock price Nestor's quarterly revenues and operating results may fluctuate depending on the timing of executed contracts, license upgrades and the delivery of contracted business during the quarter. In addition, quarterly operating results may fluctuate due to the extent of commissions associated with third party product sales, timing of Nestor's hiring of additional staff, new product development and other expenses. No assurance can be given that operating results will not vary due to these factors. Our sales cycles vary significantly which makes it difficult to plan our expenses and forecast our results Nestor's sales cycles typically range from six to twelve months, but may take longer. It is therefore difficult to predict the quarter in which a particular sale will occur and to plan our expenses accordingly. The period between our initial contact with potential clients and their licensing of our products and services varies due to several factors, including: - the complex nature of our products and services, - our clients' budget cycles, - our clients' internal evaluation and approval requirements, and - our clients' delays of licensing due to announcements or planned introductions of new products or services by our competitors. Any delay or failure to complete sales in a particular quarter could reduce our revenue in that quarter, as well as subsequent quarters over which revenue or the license would likely be recognized. If our sales cycles unexpectedly lengthen in general or for one or more large engagements, it would delay our receipt of the related revenue. If we were to experience a delay of several weeks or longer on a large engagement, it could harm our ability to meet our forecasts for a given quarter. Customers may cancel contracts Nestor derives a substantial portion of its total revenues from maintenance fees and monthly software license fees pursuant to contracts which the customer has the right to cancel. A substantial number of cancellations of these maintenance or monthly license fee contracts would have a material adverse effect on Nestor's financial condition and results of operations. Nestor's stock price may be volatile The stock market has from time to time experienced extreme price and volume fluctuations, particularly in the high technology sector, which have often been unrelated to the operating performance of particular companies. Any announcement with respect to any variance in revenue or earnings from levels generally expected by securities analysts for a given period could have an immediate and significant effect on the trading price of the Class A Common Stock. In addition, factors such as announcements of technological innovations or new products by Nestor, its competitors or other third parties, as well as changing market conditions in the computer software or hardware industries, may have a significant impact on the market price of the Class A Common Stock. We cannot predict our future capital needs, and we may not be able to secure additional financing in the future We believe that our existing cash, working capital, backlog, and line of credit will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, we may need to raise additional funds in the future to fund our operations, to expand or enhance our products and services or to respond to competitive pressures or perceived opportunities. Nestor cannot be assured that additional financing will be available on acceptable terms, or at all. If adequate funds are not available or not available on acceptable terms, Nestor's business and financial results may suffer. Nestor's growth strategy involves numerous risks and challenges Nestor has expanded and may seek to continue to expand its operations through the acquisition of additional businesses that complement its core skills and have the potential to increase its overall value. Nestor's future growth may depend, in part, upon the continued success of its acquisition strategy. Nestor may not be able to successfully identify and acquire, on favorable terms, compatible businesses. Acquisitions involve many risks, which could have a material adverse effect on Nestor's business, financial condition and results of operations, including: - Acquired businesses may not achieve anticipated revenues, earnings or cash flow; - Integration of acquired businesses and technologies may not be successful and Nestor may not realize anticipated economic, operational and other benefits in a timely manner, particularly if Nestor acquires a business in a market in which Nestor has limited or no current expertise or with a corporate culture different from Nestor's; - Potential dilutive effect on Nestor's stockholders from continued issuance of Common Stock as consideration for acquisitions; - Adverse effect on net income of amortization expense related to goodwill and other intangible assets and other acquisition-related charges, costs and expenses on net income; - Competing with other companies, many of which have greater financial and other resources to acquire attractive companies makes it more difficult to acquire suitable companies on acceptable terms; and - Disruption of Nestor's existing business, distraction of management and other resources and difficulty in maintaining Nestor's current business standards, controls and procedures. Directors, officers and principal shareholders exercise significant control over the Company. Nestor's directors, officers, and principal shareholders who own greater than 5% of the outstanding common stock, and entities affiliated with them, beneficially own approximately 49% of our common stock. These shareholders, acting together, will be able to exert substantial influence over all matter requiring approval by Nestor's shareholders. These matters include the election and removal of directors and any merger, consolidation or sale of all or substantially all or Nestor's assets. This concentration of ownership may have the effect of delaying, deferring or preventing a change in control, or impeding a merger, consolidation, takeover or business combination even if the transaction might be beneficial to Nestor's shareholders. -----END PRIVACY-ENHANCED MESSAGE-----