10QSB 1 videolocity-10qsb073106.txt VIDEOLOCITY 10QSB 073106 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB (Mark One) [X] Quarterly Report Under Section 13 or 15(d) of The Securities Exchange Act of 1934 For the Quarterly Period ended July 31, 2006 [ ] Transition Report Under Section 13 or 15(d) of the Exchange Act Commission File Number 33-2310-D VIDEOLOCITY INTERNATIONAL, INC. ----------------------------------------------------------------- (Exact name of small business issuer as specified in its charter) Nevada 87-0429154 ------------------------------- ----------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 5532 Lillehammer Lane, Suite 300, Park City, Utah 84091 -------------------------------------------------------- (Address of principal executive officers) Issuer's telephone number: (435) 615-8338 Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2) of the Exchange Act. Yes [ ] No [X] APPLICABLE ONLY TO CORPORATE ISSUERS State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date: Class Outstanding as of September 15, 2006 -------------------------- ------------------------------------ Common Stock, 28,057,277 Par Value $0.001 par value Transitional Small Business Disclosure Format (check one): Yes [ ] No [X]
VIDEOLOCITY INTERNATIONAL, INC. TABLE OF CONTENTS Page ---- PART I Item 1. Financial Statements........................................................... 2 Item 2. Management's Discussion and Analysis or Plan of Operation...................... 18 Item 3. Controls and Procedures........................................................ 22 PART II Item 1. Legal Proceedings.............................................................. 22 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.................... 23 Item 3. Defaults Upon Senior Securities................................................ 23 Item 4. Submissions of Matters to a Vote of Security Holders........................... 24 Item 5. Other Information.............................................................. 24 Item 6. Exhibits and Reports on Form 8-K............................................... 24 Signatures..................................................................... 25
Videolocity International Inc. and Subsidiaries (A Development Stage Company) UNAUDITED CONSOLIDATED CONDENSED BALANCE SHEET July 31, 2006 ASSETS CURRENT ASSETS Cash $ 23,489 Other assets 11,584 ----------- Total current assets 35,073 Property and equipment, at cost, net 548,151 Other assets 24,909 ----------- $ 608,133 =========== LIABILITIES AND STOCKHOLDERS' DEFICIT CURRENT LIABILITIES Accounts payable $ 257,824 Deferred revenue 357,147 Accrued liabilities 3,872,108 Accrued interest payable 611,586 Notes payable 840,000 Current portion of long term obligations - capital lease 273,171 ----------- Total current liabilities 6,211,836 Long term obligations less current portion - capital lease 177,924 Notes payable - related parties 125,000 Notes payable 1,544,800 Compensation debenture 320,000 MINORITY INTERESTS 4,866 COMMITMENTS AND CONTINGENCIES -- STOCKHOLDERS' DEFICIT Common stock, $0.001 par value; 100,000,000 shares authorized, 26,624,477 issued and outstanding 26,626 Preferred stock, $0.001 par value; 5,000,000 shares authorized none outstanding -- Additional paid-in capital 6,917,287 Deficit accumulated during the development stage (14,720,206) ----------- Total stockholders' deficit (7,776,293) ----------- $ 608,133 =========== The accompanying notes are an integral part of these statements. -2-
Videolocity International Inc. and Subsidiaries (A Development Stage Company) UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS From May 26, Three months ended Nine months ended 2000 July 31, July 31, through ---------------------------- ---------------------------- July 31, 2006 2005 2006 2005 2006 ------------ ------------ ------------ ------------ ------------ Revenue $ -- $ 39,101 $ -- $ 100,144 $ 124,645 Cost of Goods Sold -- 16,917 -- 57,237 94,948 ------------ ------------ ------------ ------------ ------------ Gross Profit -- 22,184 -- 42,907 29,697 Operating expenses Salaries, payroll taxes, and employee benefits 79,447 172,724 329,105 755,610 6,961,090 Professional fees and consultants 6,852 28,845 49,524 63,610 1,387,560 Technology development consulting -- 25,580 22,080 109,365 872,350 Directors compensation through stock plan 9,990 200,000 9,990 200,000 304,990 Rent and Utilities 3,000 18,706 23,588 51,195 437,742 Provision for bad debts -- -- 1,091 -- 601,091 Travel, conventions, meals and entertainment -- 8,143 2,763 27,150 240,696 Depreciation and amortization 7,004 35,689 49,441 107,753 228,245 Gain on transfer of license agreements -- -- -- -- (114,509) Write off of goodwill -- -- -- -- 958,628 Other 2,136 18,279 18,841 54,025 630,824 ------------ ------------ ------------ ------------ ------------ 108,429 507,966 506,423 1,368,708 12,508,707 ------------ ------------ ------------ ------------ ------------ Operating loss (108,429) (485,782) (506,423) (1,325,801) (12,479,010) Interest income -- -- -- -- 5,578 Legal Settlement -- -- -- -- (200,433) Gain on sale of stock, net -- -- -- -- 338,049 Interest and beneficial conversion expense (44,457) (90,108) (220,427) (214,567) (2,290,878) Expense for stock options on services, debt -- -- -- (19,526) (88,646) Minority interests -- -- -- -- (4,866) ------------ ------------ ------------ ------------ ------------ Loss before income taxes (152,886) (575,890) (726,850) (1,559,894) (14,720,206) Income taxes -- -- -- -- -- ------------ ------------ ------------ ------------ ------------ NET LOSS $ (152,886) $ (575,890) $ (726,850) $ (1,559,894) $(14,720,206) ============ ============ ============ ============ ============ Loss per common share Basic and Diluted $ (0.01) $ (0.03) $ (0.03) $ (0.09) Weighted-average common and dilutive common equivalent shares outstanding Basic and Diluted 24,993,384 20,022,380 24,430,461 18,347,188
The accompanying notes are an integral part of these statements. -3-
Videolocity International Inc. and Subsidiaries (A Development Stage Company) CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT July 31, 2006 Deficit Accumulated Additional during the Preferred stock Common stock paid-in Development Shares Amount Shares Amount capital Stage ----------- ----------- ----------- ----------- ----------- ----------- Balance at May 26, 2000 (inception) -- $ -- -- $ -- $ -- $ -- Issuance of common stock -- -- 640,610 641 85,685 -- Net loss for the period -- -- -- -- -- (129,778) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2000 -- -- 640,610 641 85,685 (129,778) Issuance of preferred stock 950,000 950 -- -- 949,050 -- Issuance of common stock for acquisition of Videolocity, Inc. -- -- 3,028,076 3,028 386,092 -- Provision for redemption value of preferred stock -- -- -- -- (3,957,380) -- Issuance of common stock for: Services -- -- 20,000 20 19,980 -- Cash -- -- 610,000 610 499,390 -- Stock incentive plans -- -- 5,000 5 4,995 -- Bonus interest and extensions of debt -- -- 15,000 15 74,985 -- Net loss for the year -- -- -- -- -- (2,379,623) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2001 950,000 950 4,318,686 4,319 (1,937,203) (2,509,401) Redemption and cancellation of preferred stock (950,000) (950) 180,000 180 3,957,380 -- Cancellation of common stock -- -- (50,000) (50) 50 -- Interest expense recognized on beneficial conversion feature on -- -- -- -- 303,900 -- notes payable Issuance of common stock for: Bonus interest and extensions on debt -- -- 148,500 149 132,493 -- Conversion of debt -- -- 355,000 355 354,645 -- Services -- -- 419,871 419 444,453 -- Stock incentive plans -- -- 504,539 505 453,637 -- Net loss for the year -- -- -- -- -- (3,086,210) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2002 -- -- 5,876,596 5,877 3,709,355 (5,595,611) Interest expense recognized on beneficial conversion feature on -- -- -- -- 120,000 -- notes payable Issuance of common stock for: Bonus interest and extensions on debt -- -- 335,000 335 82,914 -- Services -- -- 16,000 16 944 -- Stock incentive plans -- -- 119,400 119 169,847 -- Net loss for the year -- -- -- -- -- (1,989,490) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2003 -- $ -- 6,346,996 $ 6,347 $ 4,083,060 $(7,585,101)
continued -4-
Videolocity International Inc. and Subsidiaries (A Development Stage Company) CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT July 31, 2006 Continued Balance at October 31, 2003 -- $ -- 6,346,996 $ 6,347 $ 4,083,060 $(7,585,101) Fees related to eFees related to Equity Distribution Agreement -- -- -- -- (390,000) -- Issuance of stock options for: Guarantee -- -- -- -- 69,120 -- Services -- -- -- -- 46,316 -- Loan -- -- -- -- 140,432 -- Issuance of common stock for: Bonus interest and extensions on debt -- -- 736,500 736 215,464 -- Services -- -- 500,000 500 87,500 -- Cash -- -- 500,000 500 224,500 -- Cash under Equity Line -- -- 140,746 141 37,859 -- Conversion of debt -- -- 6,429,056 6,429 1,580,851 -- Stock incentive plans -- -- 770,000 770 144,081 -- Legal settlement -- -- 80,000 80 22,320 -- Net loss for the year -- -- -- -- -- (2,157,619) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2004 -- $ -- 15,503,298 $ 15,503 $ 6,261,503 $(9,742,720) Issuance of stock options for: Loan -- -- -- -- 19,526 -- Issuance of common stock for: Bonus interest and extensions on debt -- -- 36,667 37 2,796 -- Cash under Equity Line -- -- 6,330,100 6,331 323,669 -- Conversion of debt -- -- 1,489,334 1,489 210,609 -- Stock incentive plans -- -- 48,800 49 36,551 -- Legal settlement -- -- 30,000 30 1,170 -- Net loss for the year -- -- -- -- -- (4,250,636) ----------- ----------- ----------- ----------- ----------- ----------- Balance at October 31, 2005 -- $ -- 23,438,199 $ 23,439 $ 6,855,824 $(13,993,356) Issuance of common stock for: Stock incentive plans -- -- 18,500 19 12,931 -- Net loss for the quarter -- -- -- -- -- ( 304,571) ----------- ----------- ----------- ----------- ----------- ----------- Balance at January 31, 2006 -- $ -- 23,456,699 $ 23,458 $ 6,868,755 $(14,297,927) Issuance of common stock for: Conversion of debt -- -- 1,000,000 1,000 19,000 -- Net loss for the quarter -- -- -- -- -- ( 269,393) ----------- ----------- ----------- ----------- ----------- ----------- Balance at April 30, 2006 -- $ -- 24,456,699 $ 24,458 $ 6,887,755 $(14,567,320) Issuance of common stock for: Conversion of debt -- -- 1,777,778 1,778 18,222 -- Bonus interest and extensions on debt -- -- 390,000 390 11,310 -- Net loss for the quarter -- -- -- -- -- ( 152,886) ----------- ----------- ----------- ----------- ----------- ----------- Balance at July 31, 2006 -- $ -- 26,624,477 $ 26,626 $ 6,917,287 $(14,720,206) ============ =========== ========== =========== =========== ============
The accompanying notes are an integral part of this statement. -5-
Videolocity International Inc. and Subsidiaries (A Development Stage Company) UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS From For the nine months ended May 26, 2000 July 31, (inception) ---------------------------- Through 2006 2005 July 31, 2006 ------------ ------------ ------------ Increase (decrease) in cash Cash flows from operating activities Net loss $ (726,850) $ (1,559,894) $(14,720,206) Adjustments to reconcile net loss to net cash used in operating activities Minority interests -- -- 4,866 Provision for bad debts 1,091 -- 601,091 Write off of goodwill -- -- 958,628 Gain on sale of investment stock -- -- (338,049) Gain on transfer of license -- -- (114,509) Depreciation and amortization 49,441 107,754 338,463 Interest expense recognized on beneficial conversion -- -- 423,900 Issuance of common stock under stock plans 12,950 36,600 823,508 Issuance of common stock for services -- -- 553,832 Issuance of common stock for interest -- 2,433 509,925 Options issued on guarantee, services, and loans -- -- 275,394 Issuance of common stock for legal settlement -- 19,526 22,400 Changes in assets and liabilities Accounts receivable -- (6,638) (1,091) Other assets 22,954 24,146 (36,493) Accounts payable and accrued liabilities 221,983 522,133 3,760,867 Deferred revenue 357,147 -- 357,147 Accrued interest 123,016 152,616 830,964 ------------ ------------ ------------ Total adjustments 788,582 858,570 8,970,843 ------------ ------------ ------------ Net cash provided by (used in) operating activities 61,732 (701,324) (5,749,363) ------------ ------------ ------------ Net cash flows from investing activities - Investment stock and licenses, net -- -- 555,791 Increase in notes receivable -- -- (600,000) Purchase of property and equipment (514) -- (165,491) ------------ ------------ ------------ Net cash flows used in investing activities (514) -- (209,700) ------------ ------------ ------------ Cash flows from financing activities Increase in notes payable -- 595,000 4,809,800 Proceeds from lease -- -- 357,000 Cash received on equity distribution agreement -- -- 38,000 Payments on lease -- (40,104) (181,554) Payments on notes payable (40,000) (25,000) (65,000) Proceeds from issuance of common stock -- -- 1,024,306 ------------ ------------ ------------ Net cash (used in) provided by financing activities (40,000) 529,896 5,982,552 ------------ ------------ ------------ Net increase (decrease) in cash 21,218 (171,428) 23,489 Cash at beginning of period 2,271 185,696 -- ------------ ------------ ------------ Cash at end of period $ 23,489 $ 14,268 $ 23,489 ============ ============ ============ Supplemental disclosures of cash flow information ------------------------------------------------- Cash paid during the period for Interest $ -- $ -- $ -- Income taxes -- -- --
Noncash investing and financing activities ------------------------------------------ During the nine months ended July 31, 2006 the Company transferred $189,383 from long term obligations- capital lease to accrued liabilities to reflect lease payments made on behalf of the Company by a third party guarantor. The Company also issued 390,000 shares of common stock totaling $11,700 from accruals as the expense had been recorded and accrued in a prior quarter. The accompanying notes are an integral part of these statements. -6- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - ACCOUNTING POLICIES The information for Videolocity International Inc. (the Company) as of July 31, 2006 and for the three and nine months ended July 31, 2006 and 2005 is unaudited, but includes all adjustments (consisting only of normal recurring adjustments) which in the opinion of management, are necessary to state fairly the financial information set forth therein in accordance with accounting principles generally accepted in the United States of America. NOTE B - UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and the instructions to Form 10-QSB and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such regulations. This report on Form 10-QSB for the three and nine months ended July 31, 2006 should be read in conjunction with the Company's annual report on Form 10-KSB for the fiscal year ended October 31, 2005. The results of operations for the three and nine months ended July 31, 2006 may not be indicative of the results that may be expected for the year ending October 31, 2006. NOTE C - ORGANIZATION AND BUSINESS ACTIVITY The Company is a Nevada corporation organized on November 5, 1985 under the name Pine View Technologies. On November 27, 2000 the Company's name was changed to Videolocity International, Inc. On December 4, 2000, the Company acquired Videolocity Inc. in a transaction recorded as a recapitalization with the Company being the legal survivor and Videolocity Inc. being the accounting survivor and the operating entity. Videolocity Inc., the accounting survivor, was founded on May 26, 2000. The Company and its subsidiaries were established to develop and market systems and other products for the delivery of on demand video, high speed internet access, and other digital content to end users such as hotels, hospitals, residences, and condominiums. At July 31, 2006, the Company was considered a development stage company as its activities had principally been related to market analysis, capital raising, development and other business planning activities and as such the Company has recorded minimal revenue from its planned principal operations. There are currently no preferred shares outstanding. Preferred shares may be issued from time to time in one or more distinctly designated series. The Board of Directors has the authority to designate the powers, preferences, qualifications, powers, limitations, and the rate and timing of dividends prior to the issuance of any series of preferred stock. NOTE D - PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts and operations of the Company and its wholly owned subsidiaries, Videolocity Inc., Videolocity Technologies Inc., Hospitality Concierge Inc., Videolocity Direct Inc., Fifth Digit Technologies LLC and the Company's 94 percent owned subsidiary Healthcare Concierge Inc. All material intercompany accounts and transactions have been eliminated in consolidation. NOTE E - NET EARNINGS (LOSS) PER SHARE Basic Earnings (Loss) Per Share (EPS) are calculated by dividing net earnings (loss) available to common shareholders by the weighted-average number of common shares outstanding during each period. Diluted EPS are similarly calculated, except that the weighted-average number of common shares outstanding includes common shares that may be issued subject to existing rights with dilutive potential. All common shares with dilutive potential described in Notes J, K, L, and O are not included in the computation of diluted loss per share for periods of net loss because to do so would be anti-dilutive. -7- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE F - OTHER ASSETS At July 31, 2006, other assets consisted of the following: Short term Long term Non trade receivables $ 1,584 $ -- Prepaid expenses 10,000 -- Deposits -- 24,909 ---------- ---------- $ 11,584 $ 24,909 ========== ========== NOTE G - PROPERTY AND EQUIPMENT At July 31, 2006, property and equipment and estimated useful lives consist of the following: Amount Years --------- --------- Equipment $ 165,492 3-5 Equipment under capital lease 657,613 3-5 --------- 823,105 Less accumulated depreciation and amortization 274,954 --------- $ 548,151 ========= NOTE H - JOINT VENTURE AND DEFERRED REVENUES On December 1, 2005, the Company entered into an operating agreement with E. Oliver Capital Group LLC toward the formation of a joint venture between Videolocity International, Inc. and E. Oliver Capital Group LLC. Under the agreement E. Oliver Capital Group LLC is required to advance to Videolocity the funds required to maintain corporate functions of Videolocity including SEC reporting, legal, audit, public relations, investor relations, and general business based on the budgets provided by Videolocity. Through July 31, 2006 E. Oliver Capital Group has forwarded to Videolocity approximately $357,000 under the agreement that has been recorded as deferred revenue in the financial statements. Under the agreement, the amounts forwarded to Videolocity are to be recouped through distributions from the joint venture and prior to Videolocity receiving cash distributions from the joint venture. Videolocity is entitled to distributions from the joint venture including technical transfer fees and licensing fees as follows: Videolocity International, Inc. shall receive (i)100% of all technical transfer fees (the mark up over cost and installation of equipment deployed) and the first 5% of the net licensing fees derived by the LLC in licensing the Intellectual Property Technology from the current version 1.0 of the Intellectual Property Technology and (ii) twenty-five percent (25%) of the technical transfer fees and the first 5% of the net licensing fees derived by the LLC in licensing version 2 of the intellectual property technology currently in development. NOTE I - ACCRUED LIABILITIES At July 31, 2006, accrued liabilities consisted of the following: Payroll, payroll taxes, and related amounts $ 3,142,962 Director and consultant compensation 212,990 Capital lease paid on Company's behalf (Note K) 474,261 Other 41,895 ----------- $ 3,872,108 =========== -8- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE J - NOTES PAYABLE At July 31, 2006 the Company has notes payable totaling $2,509,800 due to various individuals and companies including $125,000 to current related parties including Board of Directors and Management. Of the total, $370,000 is written at 12% simple interest, $1,294,800 is written at 8 percent simple interest and $845,000 has no stated interest rate. Interest has been imputed from the date of issuance on all non-interest bearing notes payable. Of the total notes payable $662,800 is convertible into common stock of the Company at the option of the debt holder in the following amounts: $167,800 is convertible at $1.00 per share, $60,000 is convertible at $0.72 per share, $10,000 is convertible at $0.30 per share, $80,000 is convertible at $0.25 per share, $65,000 is convertible at $0.22 per share, $125,000 is convertible at $0.20 per share, $60,000 is convertible at $0.15 per share, $15,000 is convertible at $0.12 per share and $80,000 is convertible at $0.04 per share. The notes payable have maturities as follows: $50,000 matured during August 2003, $25,000 matured during November 2003, $250,000 matures during December 2006, $1,034,800 matures during December 2007, $120,000 matures during January 2008, $535,000 is callable on demand when the Company has secured between $1 million and $5 million in new debt or equity funding, $320,000 is due on a schedule of $10,000 per week until paid in full using advances under the Company's Standby Equity Line (Note O) and $175,000 (original $215,000) is due on a set schedule of $5,000 per month until paid in full (noted below). Approximately $75,000 is past due as of July 31, 2006. In prior periods, the Company has issued options to purchase Company stock under certain of the notes payable originated in the following amounts: 400,000 shares at $0.77 per share, 120,000 shares at $0.72 per share, 20,000 shares at $0.50 per share, 200,000 shares at $0.14 per share, 60,000 at $0.12 per share and 400,000 at $0.04 per share. All options granted in conjunction with new notes payable were granted at or above the fair market value on the date the notes payable were originated. Where necessary, the value of the options granted is based on the fair value at the date of grant calculated using the Black-Scholes option-pricing model. Expense was recognized at the time the options become exercisable. On April 30, 2002 the Company filed a UCC-1 financing statement, with the state of Nevada, on six Provisional Patent applications held in the name of Videolocity Technologies, Inc. in favor of certain promissory note holders totaling $1,500,000 including $100,000 to current related parties. During the year ended October 31, 2004, the Company converted a total of $535,000 of notes payable under the UCC-1 into common stock of the Company including $135,000 to related parties. During the year ended October 31, 2005, the Company converted $100,000 and paid back $20,000, and during the nine months ended July 31, 2006, the Company has paid back $40,000 of notes payable under the UCC-1. As of July 31, 2006 there remains a total of $805,000 of notes payable under the UCC-1. While obtaining extensions on $630,000 of the UCC-1 notes, the Company received a release from "any and all security interest in debtors intellectual properties and assets to include proceeds and products of collateral". The Company signed an agreement for the remaining $175,000 (originally $215,000) as noted below. On February 6th, 2003 the Company received a formal notice of default regarding a $215,000 note payable under the UCC-1. During the year ended October 31, 2005, the Company received a demand notice on the $215,000 note payable. On November 30, 2005, with an addendum signed on December 5, 2005, the Company and the $215,000 note holder reached an agreement to settle the note payable, in total, with twenty four monthly payments of $5,000 per month beginning January 5, 2006 and ending on December 5, 2007 for the aggregate amount of $120,000. The note holder has agreed to stay any actions to enforce or collect during the repayment term. At any time the Company fails to meet its required payment, the note holder will have the right to proceed with all legal remedies to collect upon and satisfy the note payable. The Company has the right to prepay all or a portion of the total at its discretion. The settlement agreement also provided that the Company release the note holder, ISOZ, LC, and its employees, agents, representatives and affiliates and assigns, from any and all actions, judgments, claims or causes of action and from any claim or allegation previously made by the Company against the note holder. The Company has made all required payments to date including three payments totaling $15,000 during the quarter ended July 31, 2006. -9- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE K - LONG TERM OBLIGATIONS - CAPITAL LEASE The Company has a capital lease agreement that included approximately $658,000 in equipment and approximately $357,000 in operating capital. The lease terms require approximately $26,000 in monthly payments over a 48 month term. The lease was guaranteed by an unrelated privately held Company. The privately held Company was granted 1,000,000 options to purchase common stock at $0.20 per share that expired February 4, 2006. Additionally, there was a clause that if the Company's outstanding shares surpassed 20,000,000 prior to February 4, 2006, the privately held Company would be granted additional options at the then current market price to purchase shares equal to 2.5 percent of the then outstanding shares of the Company. This clause also expired on February 4, 2006. Expense recognized for the period ended October 31, 2004 related to these options totaled $69,120. The equipment was recorded as equipment under capital leases. The Company has been unable to make the required payments on the lease and the guarantor has made approximately $474,000 in lease payments on behalf of the Company. The amounts paid on behalf of the Company have reduced the outstanding balance on the lease and have been recorded as accrued liabilities of the Company (Note I). The following is a schedule by year of future minimum payments under long term obligations, together with the present value of the net payments as of July 31, 2006: Cash proceeds from Equipment Lease Total ---------- ---------- ---------- Through July 31, 2007 $ 197,098 $ 106,033 $ 303,131 Through July 31, 2008 122,092 61,854 183,946 Thereafter -- -- -- ---------- ---------- ---------- Total minimum payments 319,190 167,887 487,077 Less amount representing interest 24,383 11,599 35,982 ---------- ---------- ---------- Present value of net minimum payments 294,807 156,288 451,095 Less current portion 176,978 96,193 273,171 ---------- ---------- ---------- Long-term portion $ 117,829 $ 60,095 $ 177,924 ========== ========== ========== NOTE L - STOCK INCENTIVE PLANS As of July 31, 2006, the Company has two share-based compensation plans and, in addition, has approved and issued stock outside the plans as described below. On October 1, 2000 the Company established a stock incentive plan to attract and retain qualified key employees. The Company reserved 1,000,000 common shares that can be issued under the plan. Awards made under the plan are issued in units with each unit being convertible into one share of common stock at the option of the holder. The plan units vest, generally, over three years as specified in each individual grant. The individual units are issued with a strike price of $0.00. Accordingly, compensation expense is incurred by the Company over the vesting periods and is calculated using the stock price on the grant date times the number of shares vesting. Through July 31, 2006, the Company has granted 998,384 plan units of which 998,384 units have vested and have been exercised under the plan. On March 26, 2002 the Company filed an additional stock option and stock award plan. The purpose of the plan is to enable the Company to attract and retain qualified persons to serve as officers, directors, key employees and consultants of the Company, and to align the financial interests of these persons with those of its shareholders by providing those officers, directors, key employees and consultants with a proprietary interest in the Company's performance and progress through the award of stock options, appreciation rights or stock awards from time to time. The plan shall remain in effect for a period of five years or until amended or terminated by action of the Board. The termination of the Plan shall not affect any outstanding awards made under the Plan. The maximum number of shares of Common Stock, which may be issued pursuant to the Plan is 500,000. Through July 31, 2006, the Company has granted and issued a total of 467,855 shares under the Plan. -10- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Restated Articles of Incorporation, approved by a majority of the stockholders on November 15, 2000, authorizes the Board of Directors to issue, from time to time, without any vote or other action by the stockholders, of any or all shares of the Corporation of any class at any time authorized, and any securities convertible into or exchangeable for such shares, in each case to such persons and for such consideration and on such terms as the Board of Directors from time to time in its discretion lawfully may determine, provided that the consideration for the issuance of shares of stock of the corporation having par value shall not be less than such par value. Pursuant to the Articles of Incorporation, during December 2003, as an incentive, and to retain current key individuals, the Board of Directors approved a total of 9,200,000 options to purchase stock outside of the plans to employees and directors that vested at various times through FY 2004. During the quarter ended April 30, 2005, as an incentive, and to retain current key individuals, the Board of Directors approved a total of 2,000,000 options to purchase stock outside of the plans to employees that vest at various times through FY 2006. Prior to February 1, 2006, we accounted for our stock option and incentive plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. Accordingly, compensation costs for stock options were measured as the excess, if any, of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. The Company adopted Statement of Financial Accounting Standards No. 123(R) as of February 1, 2006 which requires the measurement and recognition of compensation expense for all stock-based awards based on estimated fair values. This Standard applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. Under the Standard, the cumulative effect of initially applying the Statement, if any, is recognized as of the required effective date and requires that all public entities that used the fair-value-based method of either recognition or disclosure under Statement 123 apply this Statement using a modified version of prospective application. This transition method requires that compensation cost be recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123. During March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107") providing supplemental guidance for the implementation of Statement 123(R). We have applied the provisions of SAB 107 in our adoption of Statement 123(R). We adopted Statement 123(R) using the modified prospective transition method. In accordance with that method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of Statement 123(R). Share-based compensation expense recognized during 2006 under Statement 123(R) would include: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of February 1, 2006 of which the Company had none, and (b) compensation cost for all share-based payments granted subsequent to February 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). The following amounts were recognized in our consolidated statement of operations for share-based compensation for the periods ended July 31:
Three Months Ended Nine Months Ended July 31, July 31, ----------------------- ----------------------- 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Compensation Cost: Stock options $ -- $ 2,350 $ 12,950 $ 36,600 Restricted stock 16,625 -- 16,625 -- ---------- ---------- ---------- ---------- Total share based compensation expense $ 16,625 $ 2,350 $ 29,575 $ 36,600 ========== ========== ========== ========== Compensation expense per share: $ 0.00 $ 0.00 $ 0.00 $ 0.00
We did not receive cash from stock option exercises for the nine months ended July 31, 2006 and 2005. Statement 123(R) requires that the cash retained as a result of the tax deductibility of employee share-based awards be presented as a component of cash flows from financing activities in the consolidated statement of cash flows. Due to our net operating loss position, we did not recognize a tax benefit from options exercised under the share-based payment arrangements. Cash flow from operating activities for the nine months ended July 31, 2006 included non-cash compensation expense related to stock options of $12,950 and non-cash compensation expense in the amount of $16,625 related to non-vested shares (restricted stock). -11- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Pro Forma Information under Statement 123 The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of Statement 123 to options granted under our stock option plan for the three and nine months ended July 31, 2005. For purposes of this pro forma disclosure, the value of the options was estimated using the Black-Scholes option-pricing formula at date of grant and amortized to expense over the options' vesting periods.
Three Months Nine Months Ended Ended July 31, 2005 July 31, 2005 -------------- --------------- Net loss, as reported $ (575,890) $ (1,559,894) Add: stock based employee compensation expense included in reported net loss 2,350 36,600 Less: stock based employee compensation expense determined under fair value method, net of related tax effects (45,991) (45,991) -------------- --------------- Net loss, pro forma $ (619,531) $ (1,569,285) ============== =============== Loss per share (basic and diluted) As reported $ (0.03) $ (0.09) Pro forma (0.03) (0.09)
Stock Option Valuation and Expense Information under Statement 123(R) During the three months and nine months ended July 31, 2006 and 2005 we did not grant stock options. As such, we did not value stock options during those periods. All options granted previous to the Company's adoption of Statement 123(R) were 100 percent vested prior to the adoption of the Statement. In the future, if the Board of Directors grants additional stock options we plan to use the Black-Scholes-Merton option pricing model to determine the fair value of the options issued, which is an acceptable model in accordance with Statement 123(R). The Black-Scholes-Merton model requires the use of exercise data and the use of a number of behavior assumptions including the volatility of the stock price, the weighted average risk-free interest rate, dividend rate, and the weighted average expected life of the options. Statement 123(R) requires forfeitures to be estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates. Prior to adoption of Statement 123(R), we accounted for forfeitures as they occurred for the purposes of our pro forma information under Statement 123, as disclosed in the Notes to Consolidated Financial Statements for the related periods. The weighted average fair value of options granted and the assumptions used in the Black-Scholes-Merton model during the quarter ended July 31 are set forth in the table below.
July 31, July 31, 2006 2005 ---------- -------------- Weighted average fair value of options granted $ 0.00 $0.00 Dividend yield 0.0% 0.0% Weighted average risk-free interest 0.0% 0.0% Weighted average expected volatility 0.0% 0.0% Weighted average expected life - employee - - Weighted average expected life - non-employee director - -
-12- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes stock option activity for the period May 26, 2000 (inception) through July 31, 2006: Shares subject Weighted-average to options exercise price ------------- ----------- Outstanding at May 26, 2000 (inception) -- $ - Granted -- $ - Exercised -- $ - Forfeited -- $ - ------------- ----------- Outstanding at October 31, 2000 -- $ - Granted 490,833 $ 1.13 Exercised (5,000) $ 1.00 Forfeited -- $ - ------------- ----------- Outstanding at October 31, 2001 485,833 $ 1.14 Granted 185,400 $ 1.08 Exercised (36,684) $ 1.35 Forfeited (416,249) $ 1.01 ------------- ----------- Outstanding at October 31, 2002 218,300 $ 1.30 Granted -- $ - Exercised (119,400) $ 1.45 Forfeited (4,200) $ 1.40 ------------- ----------- Outstanding at October 31, 2003 94,700 $ 1.04 Granted 9,955,000 $ 0.13 Exercised (770,000) $ 0.19 Forfeited (2,400) $ 1.50 ------------- ----------- Outstanding at October 31, 2004 9,277,300 $ 0.14 Granted 2,020,000 0.09 Exercised (48,800) 0.75 Forfeited -- - ------------- ----------- Outstanding at October 31, 2005 11,248,500 $ 0.12 Granted -- - Exercised (18,500) 0.70 Forfeited -- - ------------- ----------- Outstanding at January 31, 2006 11,230,000 $ 0.12 Granted -- - Exercised -- - Forfeited -- - ------------- ----------- Outstanding at April 30, 2006 11,230,000 $ 0.12 Granted -- - Exercised -- - Forfeited (30,000) (0.30) ------------- ----------- Outstanding at July 31, 2006 11,200,000 $ 0.08 Exercisable at July 31, 2006 11,200,000 $ 0.12 -13- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Weighted Average Weighted Average Range of Exercise Number Remaining Contractual Exercise Price Prices Outstanding / Exercisable Life (Years) Outstanding / Exercisable ----------------- ------------------------- --------------------- ------------------------- $0.00 to 0.10 2,000,000 / 2,000,000 8.59 $0.09 / $0.09 $0.11 to 0.20 9,200,000 / 9,200,000 7.35 $0.13 / $0.13 ------------- ------------ ---- ------- -------- 11,200,000 /11,200,000 7.57 $0.12 / $0.12
The Company's aggregate intrinsic value of stock options represents the difference between the closing stock price on July 31, 2006 and the exercise price, multiplied by the number of in-the-money options that would have been received by the option holders had all option holders exercised their options on July 31, 2006. Accordingly, the intrinsic value of options at July 31, 2006 is $0.00 because the Company does not have any in the money options as of that date. In the three months ended July 31, 2006, 30,000 of vested options to purchase shares with a weighted average exercise price of $0.30 expired. The remaining outstanding share options expire in 2013 though 2015. Non-Vested Shares (Restricted Stock) Certain officers, directors and key employees have been awarded non-vested shares (restricted stock). Vesting applicable to non-vested shares (restricted stock) lapse based either on performance or service standards as determined by the Board of Directors. During the three months ended April 30, 2005 as an incentive and to retain key individuals, the Board of Directors approved 2,000,000 shares to be issued in restricted stock to officers of the Company to be issued when administratively possible. As of July 31, 2006 the 2,000,000 shares of restricted stock have not been issued, however the Company has recorded an accrued liability for the expense incurred during the vesting period. Additionally, during June 2006 the Board of Directors approved a total of 6,650,000 shares of restricted stock that vests quarterly through the second quarter of 2007 (March 2007) to retain certain key individuals. The fair value of the non-vested shares is equal to the fair market value on the date of grant and is amortized ratably over the vesting period. The fair value of the restricted stock is currently being amortized ratably over the specific vesting period. A summary of the status of non-vested shares (restricted stock) and changes as of July 31, 2006 is set forth below: Weighted Average Non-vested Grant-date Shares Fair Value --------- ------------ Non-vested shares outstanding, beginning of period -- $ -- Granted 6,650,000 0.01 Vested 1,662,500 0.01 Forfeited/canceled -- -- --------- ------------ Non-vested shares outstanding, end of period 4,987,500 $ 0.01 ========= ============ -14- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Unrecognized Compensation Expense As of July 31, 2006 unrecorded compensation costs related to awards issued under the Company's various share-based compensation arrangements are as follows:
Weighted average recognition July 31, period 2006 (months) ------------ ------------ Unrecognized compensation cost: Stock options, net of expected forfeitures $ -- - Non-vested shares (restricted stock) -- time based vesting 49,875 0.67 ------------ Total unrecognized compensation cost $ 49,875
NOTE M - INCOME TAXES The Company has sustained net operating losses in all periods presented. There were no deferred tax assets or income tax benefits recorded in the financial statements for net deductible temporary differences or net operating loss carryforwards because the likelihood of realization of the related tax benefits cannot be established. Accordingly, a valuation allowance has been recorded to reduce the net deferred tax asset to zero. The increase in the valuation allowance was approximately $57,000 for the three months and approximately $274,000 for the nine months ended July 31, 2006. As of July 31, 2006, the Company had net operating loss carryforwards for tax reporting purposes of approximately $10,500,000 expiring through 2026. NOTE N - COMMITMENTS AND CONTINGENCIES The Company is engaged in various lawsuits and claims, either as plaintiff or defendant, in the normal course of business. In the opinion of management, based upon advice of counsel, the ultimate outcome of these lawsuits will not have a material impact on the Company's financial position or results of operations. Promissory Loan Agreement On June 2, 2003, the Company signed a ten percent simple interest promissory note with an unrelated privately held company where the privately held company was to provide $5,000,000 in operating funds to the Company. The terms of the note provided that the Company pay a two percent fee totaling $100,000 for arranging the loan. Terms of repayment included interest on a quarterly basis and the balance of the note at the end of thirty-six months. Additionally, the privately held company would receive one seat on the Board of Directors until such time as the promissory note was paid in full. After weeks of delays and promises regarding funding, the privately held company signed an addendum to the original note promising funding of the note by September 19, 2003. When the funding was not met according to the addendum, the privately held company signed a second addendum promising funding of the note by November 10, 2003. After months of delays, and the privately held company not fulfilling the terms of the original agreement and/or the signed addendums the Company filed a multi count civil complaint against the privately held company. The privately held company filed a motion with the Court to dismiss the complaints filed by the Company. This motion to dismiss was denied by the Court on March 12, 2004. Management, based on the advice of legal counsel, believes that at a minimum the $100,000 is recoverable in its action against the privately held company. However, based on the anticipated costs to recover the $100,000, the Company wrote off the fee during the year ended October 31, 2005. Note Receivable The Company has a $600,000 non-interest bearing note receivable that was due on or before February 28, 2002. The Company holds 1,000,000 shares of Merit Studios, Inc. common stock as collateral valued at $6,000 at April 30, 2006. As of the year ended October 31, 2005, the Company recorded an allowance for bad debt totaling $600,000 against the note receivable. The Company started a legal action against Merit Studios, Inc. toward collection of the note receivable. On May 29, 2003, the Company was awarded a summary judgment against Merit Studios, Inc. totaling approximately $673,000 plus reasonable costs and attorneys fees to collect. The Company's attorney, working with the courts, is attempting to identify assets of Merit Studios in order to enforce the judgment. -15- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE O - STANDBY EQUITY DISTRIBUTION AGREEMENT AND COMPENSATION DEBENTURE During May 2004, the Company entered into a Standby Equity Distribution Agreement with Cornell Capital Partners, LP, a New Jersey-based domestic investment fund. Pursuant to the terms of the funding agreement with Cornell Capital, Videolocity had the right, but not the obligation, to require Cornell Capital to purchase shares of the company's common stock in amounts up to $350,000 per drawdown and up to $1 million per month to a maximum of $20 million over the 24 months following the effective date. The equity drawdowns are entirely at Videolocity's discretion and the agreement does not require minimum drawdowns. The effective date of the agreement is the date that the Securities and Exchange Commission first declared a registration statement effective registering the resale of the securities. The drawdowns were subject to an effective registration statement with the United States Securities and Exchange Commission covering the resale of the shares. The Company filed an SB-2 on July 9, 2004 to register 19,314,099 shares of common stock and the SB-2 was declared effective by the Securities and Exchange Commission on July 22, 2004. As of July 31, 2006, the Company has issued 140,746 shares to Cornell and received $38,000 under the agreement. As consideration for Cornell to enter into the agreement, the Company issued a $390,000, 5% convertible debenture. The principal and interest are due during May 2007. At the Company's option, the principal and interest due can be repaid or converted to common stock at a rate of 250% of the current closing bid price of the common stock as listed on a principal market as quoted by Bloomberg L.P. or 100% of the lowest closing bid price of the Company's common stock for the three trading days immediately preceding the conversion date. At the holder's option, they may convert to the Company's stock until paid in full. The Company may redeem all or a portion of the outstanding principal at a redemption price of 120% multiplied by the portion of the principal sum being redeemed plus any accrued and unpaid interest. Through July 31, 2006, Cornell has converted $70,000 of the debenture balance into 3,521,680 shares of the Company's common stock. The balance of the compensation debenture as of July 31, 2006 totals $320,000. The Company placed 10,000,000 of the registered shares into escrow to facilitate drawdowns and the repayment of a $400,000 loan due to Cornell Capital Partners LP (Note J) and through July 31, 2006 has issued 6,330,100 shares under the Standby Equity Distribution Agreement using the proceeds to repay $330,000 of the loan. The balance of the loan at July 31, 2006 totals $70,000. The Company placed another 5,000,000 of the registered shares into escrow to facilitate repayment of a second loan totaling $250,000. The repayment of this loan begins subsequent to the completion of payments under the first loan. The Company has not issued any shares in repayment of the second loan. Those shares not issued under drawdowns or as repayment on the loan will be returned to the Company. As of July 31, 2006, the Company has 8,669,900 shares that remain in escrow. The shares held in escrow are not included in the Company's outstanding shares (15,000,000 held in escrow less 6,330,100 shares issued). NOTE P - SIGNIFICANT TRANSACTIONS WITH RELATED PARTIES As of July 31, 2006 the Company has 8% notes payable to current directors, and officers totaling $125,000. The Company has accounts payable totaling approximately $47,000 due to a former director at July 31, 2006. As of July 31, 2006 executive officers and directors of the Company own approximately 5% of the outstanding stock. NOTE Q - GOING CONCERN The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. However, the Company has incurred losses since its inception and has not yet been successful in establishing profitable operations. These factors raise substantial doubt about the ability of the Company to continue as a going concern. The Company's product is ready for immediate deployment, although the Company needs to obtain capital, either long-term debt or equity to continue the implementation of its overall business plan. In this regard, management is proposing to raise necessary additional funds not provided by its planned operations through loans and/or through additional sales of its common stock. Our plan of operation will depend on our ability to raise substantial additional capital, of which there can be no assurance. The financial statements do not include any adjustments that might result from the outcome of these uncertainties. NOTE R - SUBSEQUENT EVENTS During August 20006 we received a formal demand letter from Cornell Capital regarding repayment of the two notes payable originally totaling $650,000 with a remaining balance of $320,000. The demand letter and subsequent correspondence demanded repayment of the notes on or before September 8, 2006. We have been in conversations with Cornell regarding setting up a new payment schedule to resolve this demand. -16- Videolocity International Inc. and Subsidiaries (A Development Stage Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS On September 8, 2006 we mailed a formal default notification to E Oliver Capital Group LLC because of its failure to contribute funds and make cash payments to Videolocity as required under the Operating Agreement. We have demanded the immediate withdrawl by E Oliver Capital Group LLC from EOCG Media LLC as well as the immediate reassignment of all rights to the Intellectual Property Technology, which includes the DESTM and related services, trade secrets, patents, copyrights; and any other intellectual property rights including High Speed Internet Access together with digital streaming video technology, existing license agreements and agreements for Video-on-Demand programming for DESTM previously assigned by Videolocity pursuant to the Operating Agreement and/or Joint Venture Agreements between the companies. -17- Item 2. Management's Discussion and Analysis or Plan of Operation The following information should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this Form 10-QSB. Forward-Looking Information This report on Form 10-QSB includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may relate to such matters as anticipated financial performance, future revenues or earnings, business prospects, projected ventures, new products and services, anticipated market performance and similar matters. When used in this report, the words "may," "will," expect, ," "should, " anticipate," "continue," "estimate," "project," "intend," and similar expressions are intended to identify forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 regarding events, conditions, and financial trends that may affect our future plans of operations, business strategy, operating results, and financial position. We caution readers that a variety of factors could cause our actual results to differ materially from the anticipated results or other matters expressed in forward-looking statements. These risks and uncertainties, many of which are beyond our control, include (i) the sufficiency of existing capital resources and our ability to raise additional capital to fund cash requirements for future operations; (ii) uncertainties involved in the rate of growth of our business and acceptance of our products and services; (iii) volatility of the stock market, particularly within the technology sector; and (iv) general economic conditions. Although we believe the expectations reflected in these forward-looking statements are reasonable, such expectations may prove to be incorrect. Plan of Operation General Videolocity's primary focus is to design, develop, manufacture, install, operate and maintain its proprietary Digital Entertainment System (DES(TM)). The DES is an Internet Protocol Television (IPTV) system that allows consumers to select, on an on-demand basis, movies from an extensive menu of titles. It also provides cable and digital satellite programming and interactive entertainment services such as high speed Internet access, television Internet access, digital music, youth programming, gaming, targeted advertising and informational applications. Videolocity plans to derive its revenues from licensing the DES for deployment into the hospitality, healthcare, residential and wireless markets. Videolocity plans to expand its revenue base and global market reach through its technology-licensing program and through strategic partnerships. Videolocity is well positioned to provide the DES products through a direct sales and operations model and will license the DES to other service providers for delivery to hospitality, healthcare and more importantly, the residential market that includes service via wireless/wired broadband, fiber to the home, broadband over power lines and digital satellite networks. Management believes that the flexibility and scalability of Videolocity's offerings provide a gateway into these and other emerging markets. Videolocity is a company that has completed the development of new technology and is presently applying the new technology into market-accepted products. The Company believes that its proprietary technology enhances the quality of information transfer with superior presentation and with significantly higher data storage compression. The Company's seasoned management team has selected the hospitality entertainment sector as the first application of its development. This decision has launched the Company into what is perceived to be a well-defined market that demands an upgrade of present technology at aggressively competitive costs, while providing value added services that generate new residual revenue streams. Through the DES, hospitality, timeshare and healthcare property owners will be able to offer guests superior quality, quantity and capability for in-room entertainment and information transfer services. Further applications, including, but not limited to security, medical information transfer, education and advertising, are being researched and developed to enhance future revenue streams beyond the markets already served. A unique value associated with Videolocity and the DES product is the year-over-year recurring revenue stream which we anticipate will be earned on existing installations while new channels of distribution are marketed throughout the United States, Europe, Caribbean, and Asia Pacific. Thus, the Company now relies on the financial resources of its partners to satisfy the growing consumer demand. Our plan of operation will depend on our ability to raise substantial additional capital, of which there can be no assurance. -18- Videolocity has created a barrier to entry for competition through the development of its proprietary technologies and trade secrets. The core technologies are standards-based and relative to the advancement of critical areas including but not limited to Videolocity's: 1. Digital Entertainment Solution 2. Video Encoding & Compression Process 3. Graphical User Interface 4. Embedded Software Image 5. Proprietary PCI Video Card 6. Linux Solution During May 2004 we entered into a Standby Equity Distribution Agreement with Cornell Capital Partners, LP, a New Jersey-based domestic investment fund. Under the equity distribution agreement, Videolocity had the right, but not the obligation, to require Cornell Capital to purchase shares of Videolocity common stock up to a maximum amount of $20 million over a 24-month period. There is no minimum draw down although we could draw-down up to four times per month at a maximum $350,000 per draw and a maximum of $1 million per month. The draw-downs were subject to an effective registration statement with the United States Securities and Exchange Commission covering the resale of the shares. The registration statement was declared effective by the Securities and Exchange Commission on July 22, 2004. The 24-month term commenced on the effective date of the registration statement. The purchase price of the shares were 98% of the lowest closing bid price of our common stock during the five consecutive trading days immediately following receipt of notice of our intent to make a draw. From the effective date through July 31, 2006, the Company has issued 140,746 shares to Cornell and received $38,000 under the agreement. Videolocity has two outstanding loans and a convertible debenture with Cornell Capital Partners and under the terms of repayment, Cornell or its assignees have the option to convert a portion of the loan and the debenture into registered stock and may sell that stock into the market. Although, Videolocity has only drawn a total of $38,000 from the Standby Equity Distribution Agreement, as a result of the stock received on conversion of the outstanding loans and convertible debenture, Videolocity has been subject to an abundance of selling pressure in the market. Joint Venture On December 1, 2005, we entered into an operating agreement with E. Oliver Capital Group LLC toward the formation of a joint venture between Videolocity International, Inc. and E. Oliver Capital Group LLC. EOCG Media LLC was formed as a Delaware limited liability company and is the parent company of EOCG Media Ltd., a British Virgin Islands corporation. Under the agreement Videolocity assigned to EOCG Media LLC the U.S. patent rights to the DES and assigned EOCG Media Ltd. the patent rights to DES in the rest of the World. The finalization of the agreement was contingent on shareholder approval and Videolocity obtaining extensions of outstanding notes payable. Toward that goal, Videolocity forwarded a proposal to certain shareholders and pursued extensions with the holders of all notes payable. We did not solicit proxies and submitted the proposal to shareholders holding at least a majority of the outstanding shares of the Company. Through May 30, 2006, we received written consent from shareholders representing a majority of the outstanding stock of the Company approving the agreement. Additionally, we reached extensions on notes payable totaling approximately $1,406,000 and have worked out a payment schedule on an additional $215,000 of notes payable. Under the agreement E. Oliver Capital Group was required to advance to Videolocity the funds necessary to maintain corporate functions of Videolocity including SEC reporting, legal, audit, public relations, investor relations, and general business based on the budgets provided by Videolocity. Under the agreement, the amounts forwarded to Videolocity were to be recouped through revenue distributions from the joint venture and prior to Videolocity receiving cash distributions from the joint venture. Videolocity would be entitled to distributions from the joint venture including technical transfer fees and licensing fees as follows: Videolocity shall receive (i) 100% of all technical transfer fees (the mark up over cost and installation of equipment deployed) and the first 5% of the net licensing fees derived by the LLC in licensing the Intellectual Property Technology from the current version 1.0 of the Intellectual Property Technology and (ii) twenty-five percent (25%) of the technical transfer fees and the first 5% of the net licensing fees derived by the LLC in licensing version 2.0 of the intellectual property technology currently in development. Additionally, under the agreement Capital Group LLC was required to "contribute from time to time such funds as necessary to operate and deploy the E. Oliver intellectual property technology including necessary salaries and other operating expenses and capital expenditures of the LLC". -19- On September 8, 2006 we mailed a formal default notification to E Oliver Capital Group LLC because of E. Oliver Capital Group LLC's continued failure to"contribute from time to time such funds as necessary to operate and deploy the intellectual property technology, including necessary salaries and other operating expenses and capital expenditures of the LLC" and its failure to make its obligatory cash payments to Videolocity as required under the Operating Agreement. Videolocity's letter gave notice of the default and under the terms of the Agreement demanded the immediate withdrawl by E Oliver Capital Group LLC from EOCG Media LLC as well as the immediate reassignment of all rights to the Intellectual Property Technology, which includes the DESTM and related services, trade secrets, patents, copyrights; and any other intellectual property rights including High Speed Internet Access together with digital streaming video technology, existing license agreements and agreements for Video-on-Demand programming for DESTM previously assigned by Videolocity pursuant to the Operating Agreement and/or Joint Venture Agreements. We have given E. Oliver Capital Group ten days to complete the reassignment and to withdraw from EOCG Media LLC. The Agreement does not give any cure time and if these items are not completed within ten days we will pursue all other appropriate legal actions to resolve this matter to the benefit of Videolocity. New Opportunities We are currently evaluating several financing sources to continue to bring the Videolocity DES product to market. We have identified and had discussions with another funding entity that is interested in forming a joint venture similar in structure to the agreement that Videolocity previously entered with E. Oliver Capital Group. Discussions initially have been focused on funding amounts and structure, as well as, residual revenues and technology transfer fees that will be due to Videolocity under such an agreement. As we already have had considerable contact with several potential strategic partners in the Caribbean marketplace, we have aligned with the Caribbean Hotel Association ("CHA"), that represents 35 national hotel associations and over 1,000 member hotels. In 2005, the CHA represented over 125,476 of the approximate 252,000 hotel rooms throughout the Caribbean and serviced a total of 5.27 million unique visitors. Many of the Caribbean hotels are comprised of less than 100 rooms that make them an ideal candidate for the DES, a low-cost alternative to the incumbent systems. The DES may be deployed at a fraction of the cost of competitive systems and provides a software based, up-gradable alternative for future growth and additional revenue applications. Videolocity has minimized its staffing requirements and general business expenses until we have finalized agreements with funding sources. Videolocity is operating more efficiently, with fewer full time employees, although several key employees remain. Videolocity will continue to explore additional technological development and market opportunities. Liquidity and Capital Resources During the three months ended July 31, 2006, our total current assets increased approximately $19,000 and total assets increased approximately $12,000 from approximately $596,000 to approximately $608,000. The increase in current assets during the quarter is primarily due to the increase of cash of approximately $19,000. The cash inflow was from cash received as deferred revenue through our joint venture agreement. We have minimized all corporate activities and operations until we have finalized agreements with new funding sources. During the nine months ended July 31, 2006, our total current assets decreased approximately $3,000 primarily from an increase in cash of approximately $21,000 received from our joint venture, which was offset by a decrease in other assets of approximately $23,000, primarily consisting of prepaid expenses. We have received approximately $357,000 from our joint venture during the nine months ended July 31, 2006, which was used to maintain our operations until the joint venture started deploying the DES technology product into the market. During the nine months ended July 31, 2006, total assets decreased approximately $52,000, primarily due to maintaining operations including a decrease in other assets of approximately $23,000, which primarily consisted of prepaid expenses, a decrease in property and equipment approximately $49,000 from depreciation expenses, offset by an increase in cash of approximately $22,000. During the three months ended July 31, 2006, total current liabilities increased from approximately $5,974,000 to approximately $6,212,000, an approximate $238,000 increase. There are several factors that contributed to this net increase in current liabilities during the period. The most significant was an increase in accrued liabilities totaling approximately $120,000, primarily from officers not being paid all of their salary and officers not taking salary during the period, combined with an accrual to account for an additional liability for payments made on our behalf on our lease by our third party guarantor. Deferred revenue also increased by approximately $83,000 and accrued interest payable increased approximately $33,000 during the period. Deferred revenues were advances received from a joint venture on future revenues from the joint venture's use of our technology. -20- During the nine months ended July 31, 2006, total current liabilities decreased from approximately $7,024,000 to approximately $6,212,000, an approximate $812,000 decrease. There are several factors that contributed to this net decrease in current liabilities during the period including a transfer of approximately $1,585,000 in notes payable to long term notes payable from certain note holders signing extension agreements on their notes payable. This was offset by approximately $422,000 increase in accrued liabilities primarily from officers not being paid all of their salary and/or officers not taking salary during the period, combined with an accrual to record an additional liability for payments made on our behalf on our lease by our third party guarantor totaling. Deferred revenue also increased approximately 274,000 and accrued interest payable increased approximately $123,000 during the period. Deferred revenues are advances received from a joint venture on future revenues from the joint venture's use of our technology. Results of Operations To date, we have been primarily a development stage company and have realized revenues from one installation of our technologies. We formed a joint venture that was actively marketing the Videolocity DES. During the three months ended July 31, 2006 we did not realize revenues from our previously installed system as the system has not been reactivated since the hotel underwent a major renovation. The system was shut down in the final phase of the renovation. We have worked with hotel management to determine a resolution to reinstall the DES or remove it and relocate it into another property and have also consulted with legal counsel to determine a path to resolution. No formal action has taken place to date. For the three months ended July 31, 2006, operational expenses decreased approximately $400,000 overall, or approximately seventy-nine percent, as compared to the three months ended July 31, 2005. This is attributed primarily to a strong effort to minimize all expenses possible until we have secured additional funding and can continue with our business plan and normal operations. The overall decrease for the three months is primarily made up of a decrease in salaries and other payroll expenses of approximately $94,000, or fifty four percent. Payroll expenses were decreased substantially as compared to the prior period as a direct result of fewer employees until the additional funding is formalized. We had decreases in most operational expenses during the three months ended July 31, 2006 as compared to the similar period in the prior year including, technology development consulting of approximately $26,000, depreciation of approximately $29,000, professional fees and consultants of approximately $22,000, travel and conventions of approximately $8,000, due to not having the operating capital to conduct certain of those activities. The largest decrease totaling approximately $190,000 was in Director compensation through the stock plan. We also had decreases in rent and utilities of approximately $16,000 due to moving into shared office space. During the three months ended July 31, 2006, non-operating expenses decreased approximately $46,000 as compared to the three months ended July 31, 2005 primarily resulting from the decrease of interest expense. For the nine months ended July 31, 2006, operational expenses decreased approximately $862,000, or approximately 63 percent, as compared to the nine months ended July 31, 2005. This is attributed primarily to a decrease in salaries and other payroll expenses of approximately $427,000 as well as decreases in most operational expenses during the period. Payroll expenses were decreased substantially as compared to the prior period as a direct result of the reduction of employees. We had decreases in most operational expenses as a result of not having the operating capital to conduct certain activities including technology development expenses of approximately $87,000, travel and conventions of approximately $24,000. Other decreases in operational expenses included rent and utilities of approximately $28,000 due to now sharing office space, depreciation expense of approximately $58,000, other expenses of approximately $35,000 and professional fees and consultants of approximately $14,000. During the nine months ended July 31, 2006, non-operating expenses decreased approximately $14,000 as compared to the nine months ended July 31, 2005 primarily resulting from recording of an expense for stock options of approximately $19,000 in the three months ended July 31, 2005. Our plan of operation will depend on our ability to raise substantial additional capital, of which there can be no assurance. Net Operating Loss As of July 31, 2006, we have, together with our subsidiaries, accumulated a net operating loss carryforward of approximately $10,500,000, with an operating loss tax benefit of approximately $3,913,000. No tax benefit has been recorded in the financial statements because the tax benefit has been fully offset by a valuation reserve as the realization of the future tax benefit cannot be established. The net operating loss will expire through 2026. Inflation In the opinion of management, inflation has not and will not have a material effect on our operations in the immediate future. -21- Item 3. Controls and Procedures We maintain disclosure controls and procedures that are designed to be effective in providing reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management to allow timely decisions regarding required disclosure. In designing and evaluating disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute assurance of achieving the desired objectives. Also, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. The design of any system of controls is based, in part, upon certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of management, including our chief executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based upon that evaluation, management concluded that our disclosure controls and procedures are effective to cause the information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods prescribed by SEC, and that such information is accumulated and communicated to management, including our chief executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. There was no change in our internal controls over financial reporting identified in connection with the requisite evaluation that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART II Item 1. Legal Proceedings On August 26, 2002 our subsidiary, Healthcare Concierge Inc. filed an action in the Third District Court of Salt Lake County, Utah against Merit Studios, Inc. The action sought $600,000 that is owed by Merit Studios to Healthcare Concierge pursuant to a promissory note executed in consideration for the reconveyance to Merit Studios of two license agreements. During June 2003 we received notification of a summary judgment from the Third District Court of Salt Lake County. The Court ordered that judgment be entered in our favor totaling approximately $673,000 which includes the original note receivable plus accrued interest to date and some other small amounts. It was further ordered that the judgment shall be augmented in the amount of reasonable costs and attorney's fees in collecting the judgment. The Company's attorney, working with the courts, is attempting to identify assets of Merit Studios in order to enforce the judgment. On June 2, 2003, we signed a ten percent simple interest promissory note with an unrelated privately held company where the privately held company was to provide $5,000,000 in operating funds to the Company. The terms of the note provided that the Company pay a two percent fee totaling $100,000 for arranging the loan. Terms of repayment included interest on a quarterly basis and the balance of the note at the end of thirty-six months. Additionally, the privately held company would receive one seat on the Board of Directors until such time as the promissory note was paid in full. After weeks of delays and promises regarding funding, the privately held company signed an addendum to the original note promising funding of the note by September 19, 2003. When the funding was not met according to the addendum, the privately held company signed a second addendum promising funding of the note by November 10, 2003. After months of delays, and the privately held company not fulfilling the terms of the original agreement and/or the signed addendums we filed a multi count civil complaint against the privately held company. The privately held company filed a motion with the Court to dismiss the complaints filed by the Company. This motion to dismiss was denied by the Court on March 12, 2004. Management, based on the advice of legal counsel, believes that, at a minimum, the $100,000 is recoverable in its action against the privately held company. However, based on the anticipated costs to recover the $100,000, the Company has written off the fee during the year ended October 31, 2005. -22- On October 19, 2005, the Company's attorney received notification that a default judgment was filed with the third district court on June 21, 2005 totaling approximately $318,000 including principal, accrued interest, and legal fees, together with interest from that date until paid in full regarding a note payable in the amount of $215,000. Prior to October 19, 2005 the Company was unaware of the judgment and did not have knowledge that a complaint had been filed because the Company had not been served. Accordingly, being unaware of the complaint the Company did not respond. On November 30, 2005, with an addendum signed on December 5, 2005, the Company and the note holder reached an agreement to settle the note payable, in total, with twenty four monthly payments of $5,000 per month beginning January 5, 2006 and ending on December 5, 2007 for the aggregate amount of $120,000. The note holder has agreed to stay any actions to enforce or collect upon the judgment during the repayment term. At any time the Company fails to meet its required payment, the note holder will have the right to proceed with all legal remedies to collect upon and satisfy the judgment and note payable. The Company has the right to prepay all or a portion of the total at its discretion. The settlement agreement also provided that the Company release the note holder, ISOZ, LC, and its employees, agents, representatives and affiliates and assigns, from any and all actions, judgments, claims or causes of action and from any claim or allegation previously made by the Company against the note holder. We are engaged in various other lawsuits and claims, either as plaintiff or defendant, in the normal course of business. In the opinion of management, based upon advice of counsel, the ultimate outcome of these lawsuits will not have a material impact on our financial position or results of operations. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds Recent Sales of Unregistered Securities During the three months ended July 31, 2006, we issued an aggregate of 2,167,778 shares of common stock, 666,667 of which were registered shares under the Company's Form SB-2 registration statement toward an agreement for the conversion of a compensation debenture. We also issued 1,111,111 shares of restricted common stock pursuant to a conversion of a compensation debenture and as per the exemption as provided by Section 3(a)(9) of the Securities Act of 1933. Additionally, we issued 390,000 shares of unregistered common stock as compensation for extensions of notes payable. Subsequent to July 31, 2006 and to date, we have issued 1,432,800 shares as compensation for extensions of notes payable. These shares and the 390,000 shares issued during the third quarter were issued in private, isolated transactions pursuant to an exemption from registration provided by Section 4(2) of the Securities Act of 1933. We accrued an expense during the timeframe that the extensions were signed and have now issued the stock. Item 3. Defaults Upon Senior Securities During August we received a formal demand letter from Cornell Capital regarding repayment of the two notes payable originally totaling $650,000 with a remaining balance of $320,000. The demand letter and subsequent correspondence demanded repayment of the notes on or before September 8, 2006. We have been in conversations with Cornell regarding setting up a new payment schedule to resolve this demand. On February 6, 2003 we received a formal notice of default from ISOZ, LC regarding our $215,000 in notes payable to ISOZ, LC. On March 29, 2005 the Company received a demand letter regarding the $215,000 in notes payable to ISOZ, LC. On October 19, 2005, the Company's attorney received notification that a default judgment was filed with the third district court on June 21, 2005 totaling approximately $318,000 including principal, accrued interest, and legal fees, together with interest from that date until paid in full regarding the note payable. Prior to October 19, 2005 the Company was unaware of the judgment and did not have knowledge that a complaint had been filed because the Company had not been served. Accordingly, being unaware of the complaint the Company did not respond. On November 30, 2005, with an addendum signed on December 5, 2005, the Company and the note holder reached an agreement to settle the note payable, in total, with twenty four monthly payments of $5,000 per month beginning January 5, 2006 and ending on December 5, 2007 for the aggregate amount of $120,000. The note holder has agreed to stay any actions to enforce or collect upon the judgment during the repayment term. At any time the Company fails to meet its required payment, the note holder will have the right to proceed with all legal remedies to collect upon and satisfy the judgment and note payable. The Company has the right to prepay all or a portion of the total at its discretion. The settlement agreement also provided that the Company release the note holder, ISOZ, LC, and its employees, agents, representatives and affiliates and assigns, from any and all actions, judgments, claims or causes of action and from any claim or allegation previously made by the Company against the note holder. To date, the Company has made all required payments under the agreement totaling $45,000. Also, during the quarter ended July 31, 2005, the Company received a default notice on our lease payable. Currently, the guarantor of the lease has taken over the payments on the lease and has made payments totaling approximately $474,000 which have been recorded in accrued liabilities. -23- Our notes payable have maturities or have been extended as follows: $50,000 matured during August 2003, $25,000 matured during November 2003, $250,000 matures during December 2006, $1,034,800 matures during December 2007, $120,000 matures during January 2008, $535,000 is callable on demand when the Company has secured between $1 million and $5 million in new debt or equity funding,, $320,000 is due on a schedule of $10,000 per week until paid in full using advances under the Company's Standby Equity Line and $175,000 (originally $215,000) is due on a set schedule of $5,000 per month until paid in full. Approximately $75,000 is currently past due. We are actively pursuing extensions and/or conversions on the notes payable. Item 4. Submissions of Matters to a Vote of Security Holders This item is not applicable. Item 5. Other Information This item is not applicable. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. The following documents are included attached as exhibits to this report. Exhibit 31.1 Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Exhibit 32.2 Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K This Item is not applicable. -24- SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. VIDEOLOCITY INTERNATIONAL, INC. BY: /S/ ROBERT E. HOLT ------------------------------------ ROBERT E. HOLT President and Director Date: September 19, 2006 BY: /S/ CORTNEY TAYLOR ------------------------------------ CORTNEY TAYLOR Chief Financial Officer (Principal accounting Officer) Date: September 19, 2006 -25-