-----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, QnlBGJfw6lp6OUd4dnsBOurM2FtexvTWtOcEfJ8Um1q3Aa9Asa7BabfFQwqTwFAh UPiXqRGW1Rc1oi/PQ4BNhQ== 0000892569-99-001928.txt : 19990716 0000892569-99-001928.hdr.sgml : 19990716 ACCESSION NUMBER: 0000892569-99-001928 CONFORMED SUBMISSION TYPE: SB-2/A PUBLIC DOCUMENT COUNT: 5 FILED AS OF DATE: 19990715 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PATRIOT SCIENTIFIC CORP CENTRAL INDEX KEY: 0000836564 STANDARD INDUSTRIAL CLASSIFICATION: COMMUNICATIONS EQUIPMENT, NEC [3669] IRS NUMBER: 841070278 STATE OF INCORPORATION: DE FISCAL YEAR END: 0531 FILING VALUES: FORM TYPE: SB-2/A SEC ACT: SEC FILE NUMBER: 333-76275 FILM NUMBER: 99664657 BUSINESS ADDRESS: STREET 1: 10989 VIA FRONTERA CITY: SAN DIEGO STATE: CA ZIP: 92127 BUSINESS PHONE: 6196794428 MAIL ADDRESS: STREET 1: 12875 BROOKPRINTER PLACE STREET 2: SUITE 300 CITY: POWAY STATE: CA ZIP: 92064 FORMER COMPANY: FORMER CONFORMED NAME: PATRIOT FINANCIAL CORP DATE OF NAME CHANGE: 19920521 SB-2/A 1 AMENDMENT NO. 2 TO FORM SB-2 1 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 14, 1999 REGISTRATION NO. 333-76275 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------- PRE-EFFECTIVE AMENDMENT NO. 2 FORM SB-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ----------- PATRIOT SCIENTIFIC CORPORATION (Name of small business issuer in its charter) DELAWARE 3674 84-1070278 (State or Jurisdiction of (Primary Standard (I.R.S. Employer Incorporation or Organization) Industrial Classification Identification Number) Code Number)
10989 VIA FRONTERA SAN DIEGO, CALIFORNIA 92127 (858) 674-5000 (Address and telephone number of principal executive offices and principal place of business) ROBERT PUTNAM, SECRETARY PATRIOT SCIENTIFIC CORPORATION 10989 VIA FRONTERA SAN DIEGO, CALIFORNIA 92127 (858) 674-5000 (Name, address and telephone number of agent for service) ----------- COPIES TO: OTTO E. SORENSEN, ESQ. STEVEN J. DAVIS, ESQ. LUCE, FORWARD, HAMILTON & SCRIPPS LLP 600 WEST BROADWAY, SUITE 2600 SAN DIEGO, CALIFORNIA 92101 (619) 236-1414 (619) 232-8311 (FAX) ----------- APPROXIMATE DATE OF PROPOSED SALE TO THE PUBLIC: AS SOON AS PRACTICABLE AFTER THE EFFECTIVE DATE OF THIS REGISTRATION STATEMENT. ----------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [X] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [ ] ----------- 2 The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.
CALCULATION OF REGISTRATION FEE ====================================================================================================== Proposed Maximum Proposed Title of Each Class of Offering Maximum Amount of Securities Amount to be Price Per Aggregate Registration to be Registered Registered Security(1) Offering Price Fee - ------------------------------------------------------------------------------------------------------ Common Stock, $.00001 par value 12,091,749 $0.60 $7,255,049 $2,016.90 - ------------------------------------------------------------------------------------------------------ Common Stock, $.00001 par value(2) 3,507,021 $0.60 $2,104,213 $ 584.97 - ------------------------------------------------------------------------------------------------------ TOTAL 15,598,770 $0.60 $9,359,262 $2,601.87 ======================================================================================================
(1) Estimated solely for purposes of calculating the registration fee in accordance with Rule 457(c) under the Securities Act of 1933, as amended (the "Act"), based on the average of the closing bid and asked prices for the Registrant's Common Stock (the "Common Stock") as reported on the OTC Electronic Bulletin Board on July 8, 1999. (2) Issuable upon the exercise of Common Stock Purchase Warrants issued or issuable to Selling Shareholders. 3 The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, Dated July 14, 1999 ---------------------- P R O S P E C T U S ----------------------- PATRIOT SCIENTIFIC CORPORATION 10989 Via Frontera San Diego, California 92127 (858) 674-5000 THE RESALE OF 15,598,770 SHARES OF COMMON STOCK The selling price will be determined by market factors at the time of their resale. THE OFFERING This prospectus relates to the resale by the selling shareholders of up to 15,598,770 shares of common stock. The selling shareholders may sell the stock from time to time in the over-the-counter market at the prevailing market price or in negotiated transactions. Of the shares offered: - 1,656,966 shares are presently outstanding, - up to 10,434,783 shares are issuable to Swartz Private Equity, LLC based on an investment agreement dated February 24, 1999, as amended and restated as of July 12, 1999, - up to 1,565,217 shares are issuable upon the exercise of warrants issuable to Swartz under the investment agreement, and - 1,941,804 shares are issuable upon the exercise of warrants issuable to other selling shareholders. We will receive no proceeds from the sale of the shares by the selling shareholders. However, we have received proceeds from the sale of shares currently outstanding and may receive proceeds from the sale of shares to Swartz and, if exercised, will receive proceeds from the sale of shares issuable upon the exercise of warrants by Swartz and certain other selling shareholders. Trading Symbol PTSC (Over-the-counter Electronic Bulletin Board) THIS INVESTMENT INVOLVES A HIGH DEGREE OF RISK. PLEASE REFER TO RISK FACTORS BEGINNING ON PAGE 7 The Securities and Exchange Commission (SEC) and state securities regulators have not approved these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense and should be reported immediately to the SEC by calling 1-800-SEC-0330. 1 4 PATRIOT SCIENTIFIC CORPORATION PROSPECTUS Please read this prospectus carefully. It describes our company, finances and products. Federal and state securities laws require that we include in this prospectus all the important information that you will need to make an investment decision. You should rely only on the information contained in this prospectus to make your investment decision. We have not authorized anyone to provide you with information that is different from what is contained in this prospectus. The following table of contents has been designed to help you find important information contained in this prospectus. We have included subheadings to aid you in searching for particular information you might want to return to. We encourage you to read the entire prospectus. TABLE OF CONTENTS
Page PROSPECTUS SUMMARY 5 About Our Company 5 About Our Products and Market 5 About Our Investment Agreement 6 Additional Shares We are Registering 6 Key Facts 6 RISK FACTORS 7 Our Major Product Line has had Limited Revenues 7 We Have Incurred Significant Losses and May Continue To Do So 7 We Will Require Additional Financing 8 Our Products May Not Be Completed On Time 8 The Market in Which We Operate is Highly Competitive 9 Protection of our Intellectual Property is Limited; There is a Risk of Claims for Infringement 9 We are a Defendant in a Pending Lawsuit 10 Our Products are Dependent on the Internet, ISDN, Java and Government Funding 10 Violation of Section 5 11 Forward-Looking Statements 12 PLAN OF DISTRIBUTION 12 SELLING SHAREHOLDERS 13 Investment Agreement 13 Overview 13 Put Rights 13 Warrants 14 Violation of Section 5 14
2 5
Page Limitations and Conditions Precedent to Our Put Rights 14 Short Sales 15 Cancellation of Puts 15 Shareholder Approval 15 Termination of Investment Agreement 15 Restrictive Covenants 15 Right of First Refusal 16 Swartz's Right of Indemnification 16 Additional Shares Being Registered 16 Common Stock 16 Warrants 17 Selling Shareholders 18 THE COMPANY 19 General 19 Background 19 Business 20 Available Information 20 Organization and Corporate Development 21 Internet Growth and the Emergence of the Java Programming Language 22 ShBoom Microprocessor Technology 23 General Background 23 Industry Background 24 Technology Description 25 The PSC1000 Microprocessor as a Java Processor 26 Stage of Development 27 Business Strategy 28 Competition 29 High Speed Data Communications Products 30 General Background 30 ISDN and Digital Communications Description 30 Major Communications Division Products 30 Production and Marketing Strategy 32 Competition 32 Radar and Antenna Technology 32 General Background 32 Gas Antenna Technology Description 33 Ground Penetrating Radar Technology Description 33 Stage of Development 34 Business Strategy 34 Competition 34 Research and Development 34 Licenses, Patents, Trade Secrets and Other Proprietary Rights 35 Marketing and Distribution 38 Dependence Upon Single Customers 38 Facilities 39 Employees 39 Government Regulation 39 USE OF PROCEEDS 40
3 6
Page LITIGATION 41 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 41 Results of Operations for the Years Ended May 31, 1998 and 1997 42 Results of Operations for the Nine Months Ended February 28, 1999 and 1998 43 Liquidity and Capital Resources 44 Potential Violation of Section 5 of the Securities Act 46 New Accounting Pronouncements 46 Tax Loss Carry-forwards 47 Year 2000 Compliance 47 MANAGEMENT 48 Identification of Directors and Executive Officers 48 Biographical Information 49 General Conflicts of Interest 51 Indemnification of Officers, Directors and Others 52 Exclusion of Director Liability 52 Executive Compensation 52 Option Grants 54 Aggregated Option Exercises and Fiscal Year-End Values 54 Compensation of Directors 55 Employee Contracts 55 PRINCIPAL SHAREHOLDERS 57 CERTAIN TRANSACTIONS 58 TRADING MARKET AND RELATED MATTERS 60 DESCRIPTION OF SECURITIES 61 LEGAL MATTERS 62 EXPERTS 62 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS F-1
4 7 PROSPECTUS SUMMARY ABOUT OUR COMPANY Our company is engaged in the development, marketing, and sale of patented microprocessor technology and high-performance digital communication products. These products have applications in the Internet and computer, networking and telecommunications markets. We also own and are developing radar and antenna technology. Our strategy is to exploit our technologies and products through product sales, licensing, strategic alliances and government contracting. ABOUT OUR PRODUCTS AND MARKET The market for digital communication products and microprocessors is experiencing significant growth due in part to the Internet. The Internet provides organizations and individuals with new means to conduct business. The growth of the Internet is creating a demand for hardware, software and peripherals. The large number of users connecting to the Internet is creating a demand for traditional analog modems and higher speed digital modems. Java is a programming language for the Internet. With Java, data and programs do not have to be stored on the user's computer; they can reside anywhere on the Internet to be called upon as needed. Java can run on a variety of computer operating systems, thus avoiding the problem of incompatibility across networks, and Java offers a high degree of data security. Because of Java's useful features, we believe that it may also become a popular programming language for embedded control applications. A microprocessor is the computer chip that provides intelligence for electronic devices. Our microprocessor technology, trade named ShBoom, uses a proprietary architecture in a high-performance microprocessor integrated on a single silicon chip. Our first ShBoom-architecture microprocessors, the PSC1000 family, are targeted as Java programming language processors, for internally developed digital communication products and for use as the computer on embedded controllers. Embedded controllers are used in sophisticated products, such as laser printers, motion and industrial controllers, cable and satellite modems and television set-top boxes. We are also licensing the ShBoom core technology for use by others in multi-function microprocessors. Our CyberShark digital modem provides consumers with a high-performance interface between a computer and telephone lines. Our communications division also offers original equipment manufacturers, systems integrators and value added resellers products for high speed access to the Internet, remote access drivers, video conferencing equipment and digital telephony products. We are also engaged in developing radar and antenna technologies. Our ground penetrating radar prototype has demonstrated the ability to penetrate multiple solid objects (walls and barriers) and in certain ground strata has been able to resolve objects of six-inch size at approximately ten feet in depth. 5 8 ABOUT OUR INVESTMENT AGREEMENT We have entered into an investment agreement with Swartz Private Equity, LLC to raise up to $5 million through a series of sales of our common stock. The dollar amount of each sale is limited by our common stock's trading volume and a minimum period of time since the last sale. Each sale will be to Swartz. In turn, Swartz will either sell our stock in the open market, place our stock through negotiated transactions with other investors, or hold our stock in their own portfolio. This prospectus covers the resale of our stock by Swartz either in the open market or to other investors. ADDITIONAL SHARES WE ARE REGISTERING Recently, we sold common stock to private investors and issued short-term notes (with warrants attached) payable to private investors. The resale of the common stock by these private investors, either already bought or obtainable on the exercise of the warrants, is included in this registration. KEY FACTS Shares being offered for resale to the public 15,598,770 Total shares outstanding prior to the offering 40,861,120 as of July 8, 1999 Total shares outstanding after the offering 54,802,924 Total shares outstanding after the offering and exercise of all options/warrants 59,109,283 Price per share to the public Market price at time of resale Total proceeds raised by offering None, however, up to $5 million may be received from Swartz under the investment agreement and additional amounts may be received from the exercise of warrants Investment agreement Our amended and restated investment agreement with Swartz is included as an exhibit to this registration statement Dividend Policy No dividends expected
6 9 RISK FACTORS The common shares being offered for resale by the selling shareholders are highly speculative in nature, involve a high degree of risk and should be purchased only by persons who can afford to lose the entire sum invested in the common shares. Before purchasing any of the common shares, you should carefully consider the following factors relating to our business and prospects. PATRIOT'S MAJOR PRODUCT LINE, THE MICROPROCESSOR, HAS HAD LIMITED REVENUES AND IS STILL IN THE PRE-PRODUCTION STAGE OF DEVELOPMENT We are in the pre-production stage of development on our major product line, the microprocessor, which has had limited revenues. Our other product lines have not generated enough revenue to support our company. Therefore, we have limited financial results upon which you may base an assessment of our potential. There is no assurance that we will become profitable. We have experienced in the past and may experience in the future many of the problems, delays and expenses encountered by any early stage business, many of which are beyond our control. These include: - substantial delays and expenses related to testing and development of our new products, - production and marketing problems encountered in connection with our new and existing products and technologies, - competition from larger and more established companies, and - lack of market acceptance of our new products and technologies. PATRIOT WAS A HISTORY OF LOSSES, EXPECTS FUTURE LOSSES AND MAY NOT ACHIEVE OR SUSTAIN ANNUAL PROFITABILITY We expect to incur operating losses in the future. There is no assurance that sales of our products will ever generate sufficient revenues to fund our continuing operations, that we will generate positive cash flow or that we will attain or sustain profitability. To date, we have incurred significant losses. As of February 28, 1999, our accumulated deficit was $22,900,135 and our working capital deficit was $1,013,056. For the fiscal year ended May 31, 1998, we incurred a net loss of $7,514,785 and for the previous fiscal year a net loss of $2,188,792. For the nine months ended February 28, 1999, we incurred a net loss of $3,315,512. These losses have resulted primarily from: - significant costs associated with the development of our products, - marketing of those products, - the interest charges and expenses related to previous equity and debt financings, and - compensation costs related to the earnout of escrowed common shares. As a result of our history of recurring net losses and negative cash flow from operations, our independent certified public accountants have expressed substantial doubt as to our ability to continue as a viable business. 7 10 PATRIOT MAY NOT BE ABLE TO OBTAIN ADDITIONAL CAPITAL TO FUND ITS OPERATIONS WHEN NEEDED The lack of additional funding could force us to substantially curtail or cease our operations, which would have a material adverse effect on our business. Based on our potential rate of cash operating expenditures and our current plans, we anticipate our cash requirements for the next twelve months may need to come primarily from the proceeds of the investment agreement. However, our ability to raise funds under the investment agreement is subject to certain conditions. These conditions include the effectiveness of a registration statement covering the resale of the shares sold under the investment agreement and a limitation on our ability to issue shares based on the volume of trading in the common stock. We anticipate that our future cash requirements may be supplemented by improved product sales, the sale of additional equity securities, debt financing and/or the sale or licensing of certain of our technologies. However, there can be no assurance that any future funds required in excess of the proceeds of the investment agreement will be generated from operations or from the aforementioned or other potential sources. Further, there can be no assurance that any such required funds, if available, will be available on attractive terms or that they will not significantly dilute our existing shares. PATRIOT MAY EXPERIENCE DIFFICULTIES IN THE INTRODUCTION OF NEW PRODUCTS THAT COULD RESULT IN PATRIOT HAVING TO INCUR SIGNIFICANT UNEXPECTED EXPENSES OR DELAY THE LAUNCH OF NEW PRODUCTS Our technologies and products are in various stages of development. These development stage products may not be completed in time to allow production or marketability due to the inherent risks of new product and technology development, limitations on financing, competition, obsolescence, loss of key personnel and other factors. Although we may be able to license some of our technology at its current stage of development, there can be no assurance thereof. Unanticipated technical obstacles can arise at any time and result in lengthy and costly delays or in a determination that further development is not feasible. Discovery of microprocessor design errors, frequent in the industry prior to and after production, could result in lengthy and costly redesign, fabrication (production) and testing in an industry where new technology rapidly eclipses prior innovations. The development of our technologies has taken longer than anticipated and could be additionally delayed. Therefore, there can be no assurance of timely completion and introduction of improved products on a cost-effective basis, or that such products, if introduced, will achieve market acceptance such that, in combination with existing products, they will sustain us or allow us to achieve profitable operations. INTENSE COMPETITION IN THE MARKET FOR MICROPROCESSORS COULD PREVENT PATRIOT FROM INCREASING OR SUSTAINING REVENUE AND PREVENT PATRIOT FROM ACHIEVING OR SUSTAINING ANNUAL PROFITABILITY Our products could be rendered noncompetitive or obsolete. Technological competition from larger and more established microprocessor, digital communication and radar and antenna companies is significant and expected to increase. Most of the companies with which we compete and expect to compete have far greater capital resources and more significant research and development staffs, marketing and distribution programs and facilities, and many of them have substantially greater experience in the production and marketing of products. Our ability to compete effectively may be adversely affected by the ability of these competitors to 8 11 devote greater resources to the sale and marketing of their products than we can. In addition, one or more of our competitors may succeed or may already have succeeded in developing technologies and products that are more effective than any of those we currently offer or are developing. PATRIOT'S LIMITED ABILITY TO PROTECT ITS INTELLECTUAL PROPERTY MAY ADVERSELY AFFECT ITS ABILITY TO COMPETE A successful challenge to our ownership of our technology could have a material adverse effect on our business prospects. There can be no assurance that any application of our technologies will not infringe upon the proprietary rights of others or that licenses required by us from others will be available on commercially reasonable terms, if at all. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We currently have nine U.S. patents issued and five U.S. patents pending. We have one patent pending in Europe and Japan and have filed an application for another patent in Europe, Japan and elsewhere. Any issued patent may be challenged and invalidated. Patents may not issue from any of our pending applications. Any claims allowed from existing or pending patents may not be of sufficient scope or strength to provide significant protection for our products. Patents may not be issued in all countries where our products can be sold so as to provide meaningful protection or any commercial advantage to us. Our competitors may also be able to design around our patents. Vigorous protection and pursuit of intellectual property rights or positions characterize the fiercely competitive semiconductor industry, which has resulted in significant and often protracted and expensive litigation. There can be no assurance, therefore, that our competitors will not assert that our technologies or products infringe on their patents or proprietary rights. Problems with patents or other rights could increase the cost of our products or delay or preclude new product development and commercialization by us. If infringement claims against us are deemed valid, we may not be able to obtain appropriate licenses on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions or to defend against infringement claims. We did not develop the basic ShBoom technology. We acquired the rights in this technology through a series of agreements from two co-inventors. There can be no assurance that we will not be subject to claims from such prior parties related to the technology or that any such parties will not attempt to exploit the technology independently of our rights to do so. One of the co-inventors of this technology has filed a lawsuit against another prior owner and us. He is seeking, among other things, a return of the technology. This lawsuit is further discussed in this prospectus under "Litigation". The asset purchase agreement and plan of reorganization between Patriot, nanoTronics Corporation and Helmut Falk was the agreement under which we acquired the basic ShBoom technology. The agreement also contained a number of warranties and indemnities related to the ownership of the technology and other matters. We believe nanoTronics 9 12 Corporation has been liquidated and, due to Mr. Falk's death in July 1995, our ability to obtain satisfaction for any future claims as a result of a breach of the agreement may be limited. PATRIOT CAN NOT PREDICT THE OUTCOME OF A LAWSUIT IN WHICH IT IS A DEFENDANT In October 1998, we were sued in the District Court for Travis County, Texas by a co-inventor of the original ShBoom technology. We removed the suit to the United States District Court for the Western District of Texas, Austin Division, where it was dismissed because the court did not have jurisdiction over us. The suit has been refiled in the Superior Court of San Diego County, California. The suit also names as defendants nanoTronics and Gloria Felcyn on behalf of the Falk Family Trust. We purchased the technology from nanoTronics in 1994. The suit seeks a judgment for damages based on royalties allegedly due the co-inventor, a rescission of the technology transfer agreement between nanoTronics and the co-inventor, and a restoration of the technology to the co-inventor. A trial has been scheduled for December, 1999. We and the other defendants intend to vigorously contest the plaintiff's allegations. We do not believe the co-inventor is entitled to a return of the original ShBoom technology or that we are obligated to pay any royalties on aspects of the ShBoom technology specified in prior agreements between nanoTronics and the co-inventor. We believe that, should there be royalties due the co-inventor, the obligation is that of nanoTronics. However, if the co-inventor receives a judgment affirming his claim to the technology, we would probably be effectively precluded from selling any microprocessor incorporating that technology. Additionally, we could become subject to unindemnified claims relating to any failure by nanoTronics to pay any royalties that may be due to the co-inventor. Also, we could be liable for up to $1,250,000 to nanoTronics under certain indemnification provisions. Should we be required to make any royalty payments or indemnification payments, such payments could adversely impact our operating margins and sales volume. PATRIOT IS DEPENDENT ON THE INTERNET, ISDN, JAVA AND GOVERNMENT FUNDING FOR ACCEPTANCE OF ITS PRODUCTS Our digital communication products and microprocessor products will depend in large part upon a robust and growing industry and infrastructure for providing Internet access and carrying Internet traffic and the emergence of Java as a widespread programming language for the Internet or in embedded applications. There can be no assurance that the infrastructure or complementary products necessary to make the Internet a viable commercial marketplace will be developed, or, if they are developed, that the Internet will become a viable commercial marketplace. Even if the Internet continues its robust growth, there can be no assurance of a market for our ISDN products given their dependence upon telephone company policies and rates and the intense competition from other access technologies such as cable modems and satellites. There also can be no assurance that Java will become a widespread programming language for the Internet or in embedded applications or that a market will develop for devices to run Java efficiently. If the Internet does not become a viable commercial marketplace, or if ISDN products become technologically obsolete, or if Java applications for microprocessors do not develop, then our business, operating results and financial condition will be materially and adversely affected. 10 13 We received our initial contract for characterization of our antenna technology in April 1997. We are devoting only limited development and marketing efforts to our radar and antenna technologies and are seeking additional government or other funding to further develop these technologies. Government defense and other funding sources are facing serious cutbacks, and accordingly our opportunity to develop new technologies with this type of funding has been reduced. Successful funding requires significant efforts and long lead times. We have limited experience in obtaining government funding, and we rely on consultants and agents to assist us in our efforts in that regard. There can be no assurance that we will be successful in our efforts to obtain additional government assistance for any of our projects or technologies. PATRIOT MAY BE IN VIOLATION OF SECTION 5 OF THE SECURITIES ACT AND CONSEQUENTLY CERTAIN INVESTORS MAY HAVE RESCISSION RIGHTS AS TO SHARES ACQUIRED AND PATRIOT AND CERTAIN PRINCIPALS OF PATRIOT MAY BE SUBJECT TO CIVIL AND CRIMINAL PENALTIES In April 1999, we sold shares of common stock to two individuals in the accumulated amount of $75,000 and in June 1999 we issued shares to an institutional investor upon conversion of a short term note in the amount of $116,183. These sales occurred after the commencement of a public offering by us and, therefore, by making these sales we may have violated Section 5 of the Securities Act. In July 1999, we amended and restated the investment agreement with Swartz to eliminate the discretion of Swartz as to the timing of its purchase of our common stock. The amended and restated investment agreement requires Swartz, after we put shares of common stock to it, to purchase our common stock on the twentieth day following the put. The previous agreement enabled Swartz, in its sole discretion, to purchase our common stock at any time during a twenty day period following our put to it. By entering into the amended and restated investment agreement, we completed our sale of common stock to Swartz. Since this private sale to Swartz occurred after we commenced our public offering, we may have sold securities to Swartz in violation of Section 5 of the Securities Act. Consequently, the two individual investors, the institutional investor and Swartz may have the right to rescind these purchases of common stock. In addition, Patriot and certain officers and directors of Patriot may be subject to civil and criminal penalties for potential violation of either or both Section 5 of the Securities Act and applicable state law as a result of these sales. FORWARD-LOOKING STATEMENTS This prospectus includes "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934, and the Private Securities Litigation Reform Act of 1995, and we desire to take advantage of the "safe harbor" provisions in those laws. Therefore, we are including this statement for the express purpose of availing ourselves of the protections of these safe harbor provisions with respect to all of the forward-looking statements we make. The forward-looking statements in this prospectus reflect our current views with respect to possible future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including specifically the absence of significant revenues, financial resources, a history of losses, a possibility that technology cannot be completed or that its completion might be delayed, significant competition, the uncertainty of patent and proprietary rights, uncertainty as to royalty payments and indemnification risks, trading risks of low-priced stocks and those other risks and uncertainties discussed herein that could cause our actual results to differ materially from our historical results or those we anticipate. In this prospectus, the words "anticipates," "believes," "expects," "intends," "future" and similar expressions identify certain forward-looking statements. You are cautioned to consider the specific risk factors described in "Risk Factors" and elsewhere in this prospectus and not to place undue reliance on the forward-looking statements contained in this prospectus, which speak only as of the date of this prospectus. We undertake no obligation to publicly revise these forward-looking statements to reflect the effect of events or circumstances that may arise after the date of this prospectus. All written and oral forward-looking statements made subsequent to the date of this prospectus and attributable to us or persons acting on our behalf are expressly qualified in their entirety by this section. 11 14 PLAN OF DISTRIBUTION Each selling shareholder is free to offer and sell his or her common shares at such times, in such manner and at such prices as he or she may determine. The types of transactions in which the common shares are sold may include transactions in the over-the-counter market (including block transactions), negotiated transactions, the settlement of short sales of common shares, or a combination of such methods of sale. The sales will be at market prices prevailing at the time of sale or at negotiated prices. Such transactions may or may not involve brokers or dealers. The selling shareholders have advised us that they have not entered into any agreements, understandings or arrangements with any underwriters or broker-dealers regarding the sale of their securities. The selling shareholders do not have an underwriter or coordinating broker acting in connection with the proposed sale of the common shares. The selling shareholders may effect such transactions by selling common stock directly to purchasers or to or through broker-dealers, which may act as agents or principals. Such broker-dealers may receive compensation in the form of discounts, concessions, or commissions from the selling shareholders. They may also receive compensation from the purchasers of common shares for whom such broker-dealers may act as agents or to whom they sell as principal, or both (which compensation as to a particular broker-dealer might be in excess of customary commissions). Swartz Private Equity, LLC is, and each remaining selling shareholder and any broker-dealer that acts in connection with the sale of common shares may be deemed to be "underwriters" within the meaning of Section 2(11) of the Securities Act. Any commissions received by such broker-dealers and any profit on the resale of the common shares sold by them while acting as principals might be deemed to be underwriting discounts or commissions. The selling shareholders may agree to indemnify any agent, dealer or broker-dealer that participates in transactions involving sales of the common shares against certain liabilities. Because Swartz is and the remaining selling shareholders may be deemed to be "underwriters" within the meaning of Section 2(11) of the Securities Act, the selling shareholders will be subject to prospectus delivery requirements. We have informed the selling shareholders that the anti-manipulation rules of the SEC, including Regulation M promulgated under the Securities and Exchange Act, may apply to their sales in the market and has provided the selling shareholders with a copy of such rules and regulations. Selling shareholders also may resell all or a portion of the common shares in open market transactions in reliance upon Rule 144 under the Securities and Exchange Act, provided they meet the criteria and conform to the requirements of such Rule. 12 15 SELLING SHAREHOLDERS AMENDED AND RESTATED INVESTMENT AGREEMENT OVERVIEW. On February 24, 1999, we entered into an investment agreement with Swartz Private Equity, LLC. which was amended and restated as of July 12, 1999. The amended and restated investment agreement entitles us to issue and sell our common stock for up to an aggregate of $5 million from time to time during a three-year period through July 12, 2002. This is also referred to as a put right. PUT RIGHTS. In order to invoke a put right, we must have an effective registration statement on file with the SEC registering the resale of the common shares which may be issued as a consequence of the invocation of that put right. Additionally, we must give at least ten but not more than twenty business days advance notice to Swartz of the date on which we intend to exercise a particular put right and we must indicate the number of shares of common stock we intend to sell to Swartz. At our option, we may also designate a maximum dollar amount of common stock (not to exceed $2 million) which we will sell to Swartz during the put and/or a minimum purchase price per common share at which Swartz may purchase shares during the put. The number of common shares sold to Swartz may not exceed 20% of the aggregate daily reported trading volume during a period which begins on the business day immediately following the day we invoked the put right and ends on and includes the day which is twenty business days after the date we invoked the put right. For each common share, Swartz will pay us the lesser of: - the market price for such put, minus $.05 or - a percentage of the market price for the put, with that percentage determined by the market price in effect on the date we inform Swartz of the put. If the market price is less than $1.00 per share, the percentage will be 80%; if the market price is $1.00 or greater but less than $2.00 per share, the percentage will be 85%, and if the market price is $2.00 or greater, the percentage will be 90%. Market price is defined as the lowest closing bid price for the common stock during the pricing period which is the twenty business days following the date notice of the put was provided to Swartz. However, the market price may not be less than the designated minimum per share price, if any, that we indicated in our notice. WARRANTS. Within five business days after the end of each pricing period, we are required to issue and deliver to Swartz a warrant to purchase a number of shares of common stock equal to 15% of the common shares issued to Swartz in the applicable put. Each warrant will be exercisable at a price which will initially equal 110% of the market price on the last day of the applicable pricing period. The warrants will have semi-annual reset provisions. Each warrant will be immediately exercisable and have a term beginning on the date of issuance and ending five years thereafter. POTENTIAL VIOLATION OF SECTION 5 OF THE SECURITIES ACT. In July 1999, we amended and restated the investment agreement with Swartz to eliminate the discretion of Swartz as to the timing of its purchase of our common stock. The amended and restated investment agreement requires Swartz, after we put shares of common stock to it, to purchase our common stock on the twentieth day following the put. The previous agreement enabled Swartz, in its sole discretion, to purchase our common stock at any time during a twenty day period following our put to it. By entering into the amended and restated investment agreement, we completed our sale of common stock to Swartz. Since this private sale to Swartz occurred after we commenced our public offering, we may have sold securities to Swartz in violation of Section 5 of the Securities Act. Consequently, Swartz may have the right to rescind this purchase of common stock. In addition, Patriot and certain officers and directors of Patriot may be subject to civil and criminal penalties for potential violation of either or both Section 5 of the Securities Act and applicable state law as a result of these sales. 13 16 LIMITATIONS AND CONDITIONS PRECEDENT TO OUR PUT RIGHTS. Swartz is not required to acquire and pay for any common shares with respect to any particular put for which: - we have announced or implemented a stock split or combination of our common stock; - we have paid a common stock dividend; - we have made a distribution of our common stock or of all or any portion of our assets between the put notice date and the date the particular put closes; or - we have consummated a major transaction (including a transaction, which constitutes a change of control) between the advance put notice date and the date the particular put closes. SHORT SALES. Swartz and its affiliates are prohibited from engaging in short sales of our common stock unless they have received a put notice and the amount of shares involved in a short sale does not exceed the number of shares specified in the put notice. CANCELLATION OF PUTS. We must cancel a particular put between the date of the advance put notice and the last day of the pricing period if: - we discover an undisclosed material fact relevant to Swartz's investment decision; - the registration statement registering resales of the common shares becomes ineffective; or - shares are delisted from the then primary exchange. However, we will be required to issue common shares equal to the lesser of: - 20% of the daily reported trading volume during the pricing period up to the applicable put cancellation date, - the number of shares of common stock put to Swartz which when multiplied by the applicable put share price equals the designated maximum dollar amount for the put, or - 9.9% of the total amount of our common stock that would be outstanding upon completion of the put. SHAREHOLDER APPROVAL. We may issue more than 20% of our outstanding shares. If we become listed on the Nasdaq Small Cap Market or Nasdaq National Market, then we must get shareholder approval to issue more than 20% of our outstanding shares. Since we are currently a bulletin board company, we do not need shareholder approval. TERMINATION OF INVESTMENT AGREEMENT. We may also terminate our right to initiate further puts or terminate the investment agreement by providing Swartz with notice of such intention to terminate; however, any such termination will not affect any other rights or obligations we have concerning the investment agreement or any related agreement. RESTRICTIVE COVENANTS. During the term of the investment agreement and for a period of one-year thereafter, we are prohibited from certain transactions. These include the issuance of any debt or equity securities in a private transaction which are convertible or exercisable into shares of common stock at a price based on the trading price of the common stock at any time after the initial issuance of such securities or with a fixed conversion or exercise 14 17 price subject to adjustment. We are also prohibited from entering into any private equity line type agreements similar to the investment agreement without obtaining Swartz's prior written approval. RIGHT OF FIRST REFUSAL. Swartz has a right of first refusal to purchase any variable priced securities offered by us in any private transaction which closes on or prior to six months after the termination of the investment agreement. SWARTZ'S RIGHT OF INDEMNIFICATION. We are obligated to indemnify Swartz (including their stockholders, officers, directors, employees and agents) from all liability and losses resulting from any misrepresentations or breaches we made in connection with the investment agreement, our registration rights agreement, other related agreements, or the registration statement. ADDITIONAL SHARES BEING REGISTERED COMMON STOCK. The following table shows recent sales of common stock to private investors.
Name Date of Sale Number of Shares ---- ------------ ---------------- Robert Crawford December 4, 1998 100,000 December 16, 1998 100,000 April 26, 1999 200,000 April 28, 1999 100,000 James C. and Josephine M. Zolin December 29, 1998 130,435 January 29, 1999 50,000 Wayne Opperman January 29, 1999 50,000 Clifford E. Koerner February 1, 1999 100,000 Richard D. Daniels February 1, 1999 50,000 Luce, Forward, Hamilton and Scripps LLP February 11, 1999 279,326 William G. Crawford April 28, 1999 100,000 Castle Creek Technology Partners, LLC June 14, 1999 397,205 --------- Total additional shares being registered 1,656,966 ---------
The shares issued to Luce, Forward, Hamilton and Scripps LLP, our general counsel, were in lieu of a cash payment for the services they provided to us through December 31, 1998. The shares issued to Castle Creek Technology Partners, LLC were a result of their decision to 15 18 convert a short-term note payable plus accrued interest into common shares rather than receiving cash. In April 1999, we sold shares of common stock to two individuals in the accumulated amount of $75,000 and in June 1999 we issued shares to an institutional investor upon conversion of a short term note in the amount of $116,183. These sales occurred after the commencement of a public offering by us and, therefore, by making these sales we may have violated Section 5 of the Securities Act. Consequently, the two individual investors and the institutional investor may have the right to rescind these purchases of common stock. In addition, Patriot and certain officers and directors of Patriot may be subject to civil and criminal penalties for potential violation of either or both Section 5 of the Securities Act and applicable state law as a result of these sales. WARRANTS. The following table shows the private investors and the number of shares issuable upon the exercise of warrants we granted to them in conjunction with short-term loans.
Name Date of Grant Number of Shares Issuable ---- ------------- ------------------------- Castle Creek Technology Partners, LLC November 19, 1998 50,000 March 20, 1999 25,000 April 20, 1999 40,000 May 20, 1999 60,000 James C. and Josephine M. Zolin February 25, 1999 85,714 March 8, 1999 57,143 April 29, 1999 200,000 June 14, 1999 67,568 Wayne Opperman February 25, 1999 42,857 March 8, 1999 28,571 April 29, 1999 100,000 Richard D. Daniels March 8, 1999 28,571 April 30, 1999 200,000 June 14, 1999 67,568 Robert Lewis, Jr. April 1, 1999 30,303 William J. Kalandros April 1, 1999 30,303 Victor Gabourel April 29, 1999 100,000 Wayne J. Coulon April 29, 1999 100,000 Craig Schilling April 29, 1999 100,000 Arthur D. Kinane April 29, 1999 100,000 Clifford E. Koerner April 30, 1999 100,000 Charles G.Moore May 21, 1999 200,000 Fortney Revocable Living Trust June 3, 1999 128,206 ---------- Total shares issuable on exercise of warrants 1,941,804 ---------
16 19 SELLING SHAREHOLDERS The following table sets forth certain information with respect to the selling shareholders as of July 8, 1999. Except as set forth below, none of the selling shareholders currently is an affiliate of ours, and none of them has had a material relationship with us during the past three years. None of the selling shareholders are or were affiliated with registered broker-dealers. An asterisk indicates if their common stock ownership is less than one percent.
Amount and Percentage of Beneficial Maximum Number Common Stock Ownership of of Shares of After the Sale Common Stock as Common Stock ----------------- Name of July 8, 1999 Offered for Sale Number % ---- ---------------- ---------------- ------ - Swartz Private Equity, LLC 12,000,000 12,000,000 -- * Robert Crawford 675,000 500,000 175,000 * Richard D. Daniels 517,139 346,139 171,000 * William J. Kalandros 30,303 30,303 -- * Robert Lewis, Jr 30,303 30,303 -- * Clifford E. Koerner 460,000 200,000 260,000 * Luce, Forward, Hamilton & Scripps LLP (general legal counsel to Patriot) 279,326 279,326 -- * Wayne Opperman 314,428 221,428 93,000 * Castle Creek Technology Partners, LLC 572,205 572,205 -- * James C. and Josephine M. Zolin 710,425 590,860 119,565 * William G. Crawford 100,000 100,000 -- * Victor Gabourel 100,000 100,000 -- * Wayne J. Coulon 100,000 100,000 -- * Craig Schilling 100,000 100,000 -- * Arthur D. Kinane 100,000 100,000 -- * Charles G. Moore 200,000 200,000 -- * Fortney Revocable Living Trust 128,206 128,206 -- *
17 20 THE COMPANY GENERAL Patriot Scientific Corporation was organized under Delaware law on March 24, 1992, as the successor by merger to Patriot Financial Corporation, a Colorado corporation incorporated on June 10, 1987. Our address is 10989 Via Frontera, San Diego, California 92127, and our telephone number is (858) 674-5000. Our home page can be located on the world wide web at http://www.ptsc.com. We are engaged in the development and marketing of patented microprocessor technology and high speed data communication products. We also own and are developing innovative radar and antenna technology. Our strategy is to exploit our technologies through product sales, licensing, strategic alliances or government contracting. In 1997, we emerged from the development stage primarily as a result of the acquisition of Metacomp Inc. There can be no assurance that we can achieve profitable operations, and we may need additional financial resources during the next twelve months. BACKGROUND In February 1989, we completed our initial public offering under a registration statement on Form S-18 under the Securities Act of 1933. This offering raised gross proceeds of $50,000 and net proceeds of approximately $28,640 upon the sale of 2,500,000 units at $.02 per unit. Each unit sold in the public offering consisted of one common share and one Class A common stock purchase warrant exercisable to acquire one share of common stock and one Class B common stock purchase warrant. All Class A and Class B warrants have since been exercised or have lapsed. On August 10, 1989, we acquired our ground penetrating radar technology from the inventor, Mr. Elwood G. Norris, our Chairman. The details of that acquisition and certain related agreements are described in more detail in "Certain Transactions" below. A description of the ground penetrating radar technology, certain information about the industry generally, and our operational plans are discussed below under the caption "Business". On May 12, 1992, we redomiciled ourselves from Colorado to Delaware by merging into a wholly owned Delaware subsidiary, Patriot Scientific Corporation, organized for that purpose. The reincorporation resulted in a reverse stock split. Three shares of the Colorado corporation, par value $.00001, were converted into one share of the Delaware corporation, par value $.00001. The reincorporation also effected a change in our charter and bylaws and a name change to Patriot Scientific Corporation. In May 1993, we registered under the Securities Act of 1933 a total of 7,631,606 18 21 shares issuable upon the exercise of outstanding Class A and Class B common stock purchase warrants. We received net proceeds of $3,343,915 upon the exercise of those warrants and the issuance of 7,538,102 common shares. None of such warrants remain outstanding. Effective May 31, 1994, we entered into an asset purchase agreement and plan of reorganization with nanoTronics Corporation located in Eagle Point, Oregon and Helmut Falk. We issued a total of 10,000,000 restricted common shares to nanoTronics to acquire certain microprocessor technology of nanoTronics. The technology acquired, the ShBoom technology, is being used to develop a sophisticated yet low cost microprocessor. 5,000,000 of the shares were issued on a non-contingent basis, and the remaining 5,000,000 shares are subject to the terms of an earnout escrow arrangement. 2,000,000 of these restricted shares had been released from escrow as of July 8, 1999. Effective December 26, 1996, we acquired 96.9% of the outstanding shares of Metacomp, Inc., a California corporation, from 56 shareholders in exchange for the issuance of 1,272,068 shares of our common stock. Based on the closing price of our common stock of $1.375 on the date of the acquisition, the price of the acquisition was $1,749,094. This business combination was accounted for as a pooling-of-interests. BUSINESS AVAILABLE INFORMATION. We file reports, proxy statements and other information with the SEC, and these reports may be inspected and copied at the public reference facilities maintained by the SEC at 450 Fifth Street, N.W., Judiciary Plaza, Washington, D.C. 20549. You may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. The same information may be obtained at the following Regional Offices of the SEC: 75 Park Place, New York, New York 10007, and the Northwest Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60621. Copies of such material may be obtained from the Public Reference Section of the SEC's Washington, D.C. office at prescribed rates. We mail a copy of our audited Annual Report on Form 10-KSB along with a proxy statement to our shareholders prior to our annual meeting. We have filed a registration statement on Form SB-2, of which this prospectus is a part, with the SEC. This registration statement or any part thereof may also be inspected and copied at the public reference facilities of the SEC. Our filings may also be accessed through the SEC's web site (http://www.sec. gov) or by visiting our web site at (http://www.ptsc.com) and linking to the SEC's site. 19 22 ORGANIZATION AND CORPORATE DEVELOPMENT. Our business involves three technologies: - PSC1000 microprocessor technology, - high-speed data communications technology, and - radar and antenna technology. The stages of development of the three major technologies is as follows: - PSC1000 Microprocessor. This technology is generating minor amounts of revenue from the sale of evaluation boards and microprocessors. Also, during the current fiscal year we have recognized non-recurring engineering revenue and initial license fees related to the microprocessor application. We are continuing our efforts to debug our 0.35 micron microprocessor, which is currently at the foundry stage. We are also engaged in continuing efforts to port an operating system and the personalJava application to the microprocessor. Although we anticipate the microprocessor to be our main product line, it currently accounts for only 33% of our revenue. - High-speed data communications. Revenue from this technology is being generated primarily from mature communication products that are nearing the end of their life cycles. New communication products have yet to penetrate the market place. We are continuing our efforts to introduce our newer products to the market. This product line currently accounts for 65% of our revenue. - Radar and antenna. We have generated revenue from two U.S. Navy contracts under which we are to provide proof of concept and characterization of our gas plasma antenna. We have suspended our development of this product line until we obtain additional third party funding. This product line currently accounts for 2% of our revenue. We anticipate that the PSC1000 family of microprocessors will benefit our radar and antenna and high-speed data communications technologies, in that the PSC1000 microprocessor may provide a low-cost, high performance alternative to existing microprocessors. Due to our small size and staffing overlaps among the technologies, certain personnel work on more than one of the technologies from time to time. During at least the last three years, we have focused the majority of our efforts on the PSC1000 and high-speed data communications technologies. The PSC1000 technology and our initial microprocessors, the PSC1000 family, are targeted for the embedded controller and Java language processor marketplaces. In reviewing markets for the PSC1000 technology, we identified within the communications markets a possible opportunity for a product we offer based on ISDN (which 20 23 stands for integrated services digital network, a high-speed method of transmitting data over the Internet). Our product is a computer compatible plug-in card allowing high-speed, cost-effective digital ISDN access to the Internet and other networks. This product, the CyberShark high-speed data modem, is being marketed to Internet providers, distributors, value-added resellers and original equipment manufacturers and has been integrated with Metacomp's high speed data communication products. In 1994, during the course of our ground penetrating radar development, we identified certain antenna technology employing ionized gas as the conducting element. In May 1997, we received a $19,000 contract from the U.S. Navy for a proof of concept for an ionized gas antenna. In October 1997, we received a phase I $62,000 contract from the Office of Naval Research under the Small Business Innovation Research Program. The purpose of this funding was to evaluate and characterize the gas antenna technology. Both of these contracts have been completed and revenue has been recognized. Currently, there is no follow-on funding from either of these two Navy sources. We believe this technology could have applications in private industry as well as in military communications and radar. However, we have no present plans to devote significant resources to this technology other than from outside funding, if available. INTERNET GROWTH AND THE EMERGENCE OF THE JAVA PROGRAMMING LANGUAGE. The Internet is a rapidly growing global web of computer networks. Developed over 25 years ago, this "network of networks" allows computers connected to the Internet to "talk" to one another. The Internet provides organizations and individuals with new means to conduct business. Commercial uses of the Internet include business-to-business and business-to-consumer transactions, product marketing, advertising, entertainment, electronic publishing, electronic services and customer support. We believe that organizations will also increasingly use the Internet and private Intranet networks to improve communications, distribute information, lower operating costs and change operations. Use of the Internet has grown rapidly since its commercialization in the early 1990's, impacting computer hardware, software and peripheral industries. The rapid growth in popularity of the Internet is in part due to continuing penetration of computers and modems into U.S. households, growth of the informational, entertainment and commercial applications and resources of the Internet and the growing awareness of such resources among individuals, and the increasing availability of user-friendly navigational and utility tools which enable easier access to the Internet's resources. The growth of the Internet and corporate Intranets is creating a demand for hardware, software and peripherals. The large and growing number of users connecting to the Internet is creating a demand for traditional analog and ISDN digital modems, such as our CyberShark, and other high-speed data communication devices. New software, such as Java, is emerging to serve the requirements of Internet users. Java is a programming language that was originally developed for personal digital assistant devices and television set top boxes. It was formally announced as an object-oriented language for the Internet in May 1995 by Sun Microsystems Inc. A large number of major computer, software, browser and on-line service provider companies have licensed the Java 21 24 language. Accordingly, although no assurance can be given, Java appears to be emerging as a fundamental platform for Internet related applications. A growing number of Java applications, or applets, are now available on the Internet. These applications not only enhance web pages but also perform many functions of traditional computer software programs. Our PSC1000 technology lends itself to potential markets in which the use of Java is prevalent. With Java, data and programs do not have to be stored on the user's computer, but can reside anywhere on the Internet to be called upon as needed. Among its various attributes, two key features of Java are (1) its ability to run on a variety of computer operating systems thus avoiding the problem of incompatibility across networks, and (2) security, because Java enables the construction of virus-resistant, tamper-resistant systems by using resource-access control and public-key encryption. Because of Java's useful features, it may also become a popular programming language for embedded applications. Since Java is designed to run on multiple types of devices and operating systems, it allows developers to write a program once for many types of operating systems, instead of having to write new versions for each type. Java does this by interpreting a program's commands into something a particular type of computer can understand. This interpretive design runs programs slower than if they were tailored for each type of computer and is resulting in a need for specialized microprocessors and compilers to increase Java's speed. The growth of Java is causing a number of companies to consider it as a basis for a new style of computing tailored to the Internet and not encumbered by the limitations of, or requiring, traditional computer operating systems (such as Microsoft DOS). The concept is to design inexpensive access devices to communicate via the Internet. Major companies such as Oracle and Sun Microsystems Inc have made public announcements of such devices. ShBoom MICROPROCESSOR TECHNOLOGY. General Background. In 1991, nanoTronics Corporation was formed and acquired the ShBoom technology, a base technology for an advanced microprocessor integrated on a single computer chip. nanoTronics subsequently engaged in substantial technical development and fabricated a first-generation microprocessor in early 1994. Since the acquisition of the ShBoom technology from nanoTronics, effective May 31, 1994, we have been engaged in correcting errors in the microprocessor design, adding additional technical features to further modernize the design, and improving and testing the new design. We initially fabricated a prototype 0.8-micron microprocessor in late May 1996. The next generation of the PSC1000 family was a 0.5 micron microprocessor that was delivered in September 1997. The 0.5 micron microprocessor is being employed in demonstrations for prospective customers and is currently being shipped in limited numbers to customers as an embedded microprocessor. A 0.35 micron production microprocessor is currently being debugged and features reduced size and improved performance. We are currently contemplating, but have not expended funds, on future enhancements and generations or modifications of microprocessors employing the ShBoom 22 25 technology. Industry Background. The semiconductor logic market has three major sectors: - standard logic products, - application specific standard products, and - application specific integrated circuits. Standard logic products, such as the Intel's X86 and Pentium and Motorola's 680X0 microprocessor families, are neither application nor customer specific. They are intended to be utilized by a large group of systems designers for a broad range of applications. Because they are designed to be used in a broad array of applications, they may not be cost effective for specific applications. Application specific integrated circuits are designed to meet the specific application of one customer. While cost effective for that application, application specific integrated circuits require large sales volumes of that application to recover their development costs. Application specific standard processors are developed for one or more applications but are not generally proprietary to one customer. Examples of these applications include modems, cellular telephones, wireless communications, multimedia applications, facsimile machines and local area networks. We have designed our microprocessor to be combined with application-specific software to serve as an embedded control product for the application specific standard processor market sector. Application specific standard processors are typically used in embedded control systems by manufacturers to provide an integrated solution for application specific control requirements. Such systems usually contain a microprocessor or microcontroller, logic circuitry, memory and input/output circuitry. Electronic system manufacturers combine one or more of these elements to fit a specific application. The microprocessor provides the intelligence to control the system. The logic circuitry provides functions specific to the end application. The input/output circuitry may also be application specific or an industry standard component. The memory element, if not on the microprocessor, is usually a standard product used to store program instructions and data. In the past, these functions have been executed through multiple integrated circuits assembled on a printed circuit board. The requirements for reduced cost and improved system performance have created market opportunities for semiconductor suppliers to integrate some or all of these elements into a single application specific standard processor or chip set, such as the PSC1000 family of microprocessors which are based on the ShBoom-architecture. The PSC1000 family provides close integration of the microprocessor and input/output function with the logic circuitry, thereby providing an advanced application specific standard processor. Embedded control systems enable manufacturers to differentiate their products, replace less efficient electromechanical control devices, add product functionality and reduce product costs. In addition, embedded control systems facilitate the emergence of completely new classes of products. Embedded control systems have been incorporated into thousands of products and subassemblies worldwide, including automotive systems, remote controls, appliances, portable computers and devices, cordless and cellular telephones, motor controls and many other systems. 23 26 Microprocessors are generally available in 4-bit through 64-bit architectures, which refers to the amount of data they can process. 4-bit microprocessors are relatively inexpensive, typically less than $1.00 each. Although they lack certain performance and features, they account for more than 40% of worldwide microcontroller volume. Also in general use today are 8-bit architectures, generally costing $1.00 to $10.00 each and accounting for an additional 40% of worldwide microcontroller volume. To date 16-bit, 32-bit and 64-bit architectures, with typical costs of over $10.00 each, have offered very high performance, but are generally considered to be expensive for high-volume embedded control applications. The use of 16-bit , 32-bit and 64-bit architectures offers fewer internal limitations, making programming easier and providing higher performance. Although generally more expensive per unit and requiring more support logic and memory, these devices offer many advantages for more sophisticated embedded control systems. Electronic system designers, driven by competitive market forces, seek semiconductor products with more intelligence, functionality and control that can be used to reduce system costs and improve performance. For these needs, the ShBoom architecture was designed to be a sophisticated 32-bit reduced instruction set computer microprocessor with advanced features, including the most commonly needed support logic, but at a low cost; thereby providing improved performance to existing embedded control applications and creating the opportunity for the development of new, cost-effective applications. Technology Description. Conventional high-performance microprocessors are register-based with large register sets. These registers are directly addressable storage locations requiring a complex architecture that consumes costly silicon. This conventional architecture provides processing power for computer applications but complicates and slows the execution of individual instructions and increases silicon size, thereby increasing the microprocessor cost. Our technology is fundamentally different from most other microprocessors because it is stack-oriented, in that the data is stored in groups. Our microprocessor employs certain features of both register and stack designs. The resultant merged stack-register architecture improves program execution for a wide range of embedded applications. Our design combines two processors in one highly integrated package, a microprocessing unit for performing conventional processing tasks, and an input-output processor for performing input-output functions. This replaces many dedicated peripheral functions supplied with other processors. The microprocessor's design simplifies the manipulation of data. ShBoom's architecture employs instructions that are shrunk from 32-bits to 8-bits. This simplified instruction scheme improves execution speed for computer instructions. Our architecture incorporates many on-chip system functions, thus eliminating the requirement of support microprocessors and reducing system cost to users. The 0.8 micron microprocessor has been designed to operate at a speed of 50Mhz; the 0.5 micron microprocessor at a speed of 100Mhz; and the 0.35 micron microprocessor at 150 MHz. They are all compatible with a wide range of memory technology from low cost dynamic random-access memory to high-speed static random access memory. The microprocessors can be packaged in various surface-mount and die-form packaging. There can be no assurance that the 24 27 designed speed will be achieved with production models of the 0.5 and 0.35 micron microprocessors or future versions or that all of the desired functions will perform as anticipated. The ShBoom technology is not designed or targeted to compete with high-end processors for use in personal computers. It is targeted for embedded control applications. We believe that the features described above differentiate the PSC1000 family from other 8-bit to 64-bit microprocessors targeted for embedded control applications. Considering the reduced requirement for support microprocessors, the PSC1000 family is intended to be available at a high volume price that should be price competitive with high-end 8-bit microprocessor and general 16-bit microprocessor systems but with higher performance (speed and functional capability). The PSC1000 family has been designed to allow high-speed and high-yield fabrication using generally available wafer fabrication technology and facilities. The PSC1000 Microprocessor as a Java Processor. We believe the PSC1000 microprocessor architecture is capable of being an efficient and cost-effective Java programming language processor, because Java is designed to run on a stack-oriented architecture and the stack-oriented ShBoom architecture executes the virtual stack machine internal to Java efficiently. Many Java operation codes or instructions require only a single 8-bit PSC1000 family instruction to be executed, providing a performance advantage over other more expensive processors that require six or more 32-bit instructions to do the same task. This feature allows the execution of Java programs with increased speed and reduced code size thereby enabling lower system memory costs. In addition, the incorporation of many on-chip system functions is expected to allow the PSC1000 family to perform most of the other functions required of an Internet computer device or Java accelerator, thereby eliminating components. Since Internet computers are designed to be inexpensive appliances for Internet access, cost, speed and performance are expected to be key requirements for designers. We believe the ShBoom technology can compete favorably on the basis of such requirements, although there can be no assurance we can successfully exploit Java related applications or that competitors will not create superior Java processors. We have ported the Java operating environment to the PSC1000 family, which currently uses the C programming language for software support. We are a licensee of Sun Microsystems Inc. This enables us to develop and distribute products based on Sun's JavaOS Technologies. We recently exercised an option to license from Sun Microsystems Inc., personal Java, a platform on which to run Java applications. We also licensed from Wind River an operating system, VXWorks, and entered into a relationship with Forth Inc. whereby Forth will provide software support and operating system development tools for the Forth Programming language. We expect that successful implementation of this software should result in a microprocessor which is competitive in the Java virtual machine and embedded applications markets. We believe that, if the implementation is successfully completed, the PSC1000 family will be competitive with Java microprocessors announced by competitors. However, there can be no assurance of successful implementation of this package of software or of a market for a PSC1000 family Java microprocessor. Stage of Development. In early 1994, nanoTronics initiated production of a first 25 28 generation of wafers at a contract fabrication facility using 6-inch wafers employing 0.8 micron double-metal CMOS technology. After the May 31, 1994 acquisition, we improved the original design, added new features and performed simulations and tests of the improved designs. In October 1995, a run of six wafers of second-generation 0.8 micron microprocessors was fabricated by a contract fabrication facility. Subsequently, we tested these microprocessors, while completing a C computer language compiler and preparing application development tools. The compiler and application development tools are necessary to enable system designers to program the PSC1000 family for specific applications. We made corrections to the design suggested by the testing of prototype units and produced an additional run of second-generation microprocessors from remaining wafers in May 1996. In July 1996, we employed these microprocessors in demonstration boards for use by developers and prospective customers and licensees. In December 1997, we completed development of and started shipping a 0.5-micron microprocessor based on the PSC1000 technology and found that 0.5-micron double-metal CMOS technology improved operating speed, reduced power requirements, reduced physical size and reduced fabrication cost. In May 1998, we began a production run of a 0.35-micron microprocessor that we anticipate will further increase operating speed and cost-performance over the previous generations of the PSC1000 family of microprocessors. At each stage of development, microprocessors require extensive testing to ascertain performance limitations and the extent and nature of errors (bugs), if any. When significant limitations or errors are discovered, additional rounds of design modifications and fabrication are required prior to having functional and demonstrable microprocessors for prospective customers and licensees. Although our 0.5 micron microprocessor has been sent to prospective customers in anticipation of production orders, there can be no assurance that we, during our continued testing of these products, will not identify errors requiring additional rounds of design and fabrication prior to commercial production. Additional delays could have an adverse effect on the marketability of our technology and financial condition. We have developed marketing materials, product manuals and application development tools for use by licensees and customers. The manuals and tools are necessary to enable system designers to quickly and easily program the PSC1000 family for specific applications. We believe that the PSC1000 family is ready for licensing or sale and that any additional changes encountered in current testing will be minor and can be made during initial production runs of PSC1000 family microprocessors for customers, when and if orders are obtained. We also believe the ShBoom core technology is ready for licensing for use by others to develop custom multiple function microprocessors. An initial licensing agreement was entered into in December 1998. This agreement establishes a library arrangement with Venture System LSI Assist Center, (or VSAC), a Japanese quasi-governmental unit. VSAC allows our core license to be made available to qualified Japanese entities for their evaluation and review. To be qualified, the Japanese entity must have total capital of less than 100 million yen, have less than 26 29 300 employees, and be a Japanese legal entity. Every qualified company that attains a volume of 1,000 units must enter into a sub-license agreement with us. In April 1998, we entered into a contract with Olea Exhibits and Displays, Inc. to incorporate the PSC1000 microprocessor as a main component on a digital video disk controller card. The controller card will be used in a kiosk application (an interactive, automated travel brochure) for the Mexican travel industry. The value of the initial contract is $3,355,000. The contract is subject to Olea receiving funds from the Mexican Department of Tourism. Product shipments, which were to have started in late 1998, have been delayed pending the receipt of those funds and the completion of the DVD by those who will be advertising on the kiosks. It is now anticipated that we will receive funding from Olea and start shipping our product during the first calendar quarter of our fiscal year 2000 (June 1, 1999 to August 31, 1999) and we will complete shipping the contract during the balance of fiscal year 2000. Business Strategy. The increasing demand for embedded control has made the market for microprocessors one of the largest segments of the semiconductor logic market. Forbes magazine in July 1998 estimated that the embedded systems market would be worth $27 billion by the year 2000. This type of demand will drive the need for embedded processors. Our strategy does not entail competing directly with suppliers who have multiple microprocessor types addressing all parts of the embedded systems market, but on identifying certain market niches that the PSC1000 would best address due to its low cost, low power and ability to run Java efficiently. Because of the above factors, we intend to focus the majority of our efforts on the Java microprocessor business, a new but relatively unpenetrated market without an established base of microprocessor products and for which we believe the PSC1000 has desirable technical and market advantages. We believe that the ShBoom architecture is suited for controller applications requiring high-performance and low system cost, such as kiosks, laser printers, dot-matrix printers, video terminals, robotics, motion controllers, industrial controllers, digital communication devices, video games, cable and satellite modems and TV set-top boxes. We expect that early licensing of the technology and product applications will focus on embedded control. We have appointed eight international distributors for foreign markets. We also have a full-time Vice President of Sales and Marketing to lead marketing of the PSC1000 family. We believe the appropriate approach for us initially lies in a balanced effort of cultivating licensees and developing specific product enhancement partnerships, producing original equipment manufactured products, developing innovative in-house products, and providing technical support to third parties on a contract basis. The overall balance of these approaches will be monitored and modified as we attempt to ascertain and capitalize on the highly dynamic and competitive embedded microprocessor market. There can be no assurance that we can successfully exploit our PSC1000 microprocessor technology. 27 30 Subject to the availability of financial and personnel resources, while we are commercializing the PSC1000 family and the ShBoom core technology, our strategy is to also design and develop future versions of the microprocessor with more demanding sub-micron technology and with more features. However, our resources are limited, and there can be no assurance that we will be able to continue microprocessor enhancement. Initial fabrications of the 0.8 micron and 0.5 micron processors were performed by contract fabrication facilities. The 0.35-micron microprocessor is being fabricated by a contract fabrication facility that has agreed to provide production quantities for our customers. There can be no assurance fabrication facilities will be available to produce the PSC1000 family in the future. However, since there are a large number of fabrication facilities with the capability to produce the PSC1000 family of microprocessors, we believe microprocessors can be produced on a contract basis. Industry shortages of fabrication facilities that may exist and are predicted to exist in the future are generally limited to the more demanding architectures. If a shortage of fabrication facilities develops, it could have a material adverse effect on our financial condition. Competition. The semiconductor industry is intensely competitive and has been characterized by price erosion, rapid technological change and foreign competition in many markets. The industry consists of major domestic and international semiconductor companies, most of which have greater financial, technical, marketing, distribution, development and other resources than ours. The market for microprocessors and for embedded control applications is at least as competitive. While our strategy is to target high-volume licensees and microprocessor customers requiring more sophisticated but low-cost devices, we can still expect significant competition. We may also elect to develop embedded control system products utilizing the ShBoom architecture for ourselves or by contract for other manufacturers. We expect that the PSC1000 family, if successfully commercialized in the embedded controller market, will compete with a variety of 16/64-bit microprocessors including ARM, MIPS and the PowerPC. As a Java processor, we expect our PSC1000 family will compete with a broad range of microprocessors including licensees of Sun Microsystems, Inc.'s PicoJava. The producers of these microprocessors have significantly greater resources than ours. A new entrant, such as ours, is at a competitive disadvantage compared to these and other established producers. A number of factors contribute to this, including: - the lack of product performance experience, - lack of experience by customers in using application development systems, ~ no record of technical service and support, and - limited marketing and sales capabilities. 28 31 HIGH SPEED DATA COMMUNICATIONS PRODUCTS. General Background. Starting in fiscal 1995, we initiated the development of a computer compatible plug-in card allowing high-speed, cost-effective digital ISDN access to the Internet and other networks. In December 1996, we acquired 96.9% of Metacomp to create a communications division including engineering, assembly, marketing and distribution. The acquisition of Metacomp expanded the product line and added high-speed data communications revenue and a customer base. Metacomp, founded in 1978, was a high technology company that designed, assembled, and sold a wide range of high performance data and telecommunications solutions for wide area networking and high-speed data communications requirements. The business combination with Metacomp was treated as a pooling-of-interests, and the Metacomp product line was combined with our ISDN product to form the communications division. ISDN and Digital Communications Description. The Integrated Services Digital Network (ISDN) is a set of digital transmission protocols that virtually all of the world's communications carriers have adopted as a standard. ISDN brings the digital network to the individual user by turning the twisted-pair copper telephone line into a high-speed, high-capacity ISDN line with the capacity for two transmissions (one voice, fax or computer conversation and one data conversation) to happen at the same time. Further, up to eight separate devices (telephones, computers, fax machines, etc.) can be connected to the same ISDN line and each given separate telephone numbers. In many home and business applications, the use of an ISDN line provides dramatically increased speed and, by allowing multiple uses of one line, improved economics over multiple lines. ISDN service is easily connected by local telephone companies. In addition to ISDN products, our communications division also provides high speed communication products that can be customized to meet the customer's specific needs. This is done via software tailored for each customer. These products are often used by businesses for wide area network applications or other high speed industrial communication systems. Major Communications Division Products. We have a line of ISDN interface products for high speed, cost effective digital communications through telephone networks. These products include: CyberShark Family CyberShark - This low-cost basic rate ISDN adapter card has been designed to allow small businesses and telecommuters to access corporate networks and the Internet via ISDN. The card includes an analog phone jack that allows the user to connect his existing analog phone or fax machines for simultaneous voice conversation. 29 32 CyberShark/HSET - This basic rate adapter card is designed to be used with a headset/handset used by distributed call centers and remote agents. It offers access to and supports domestic as well as European telecommunication protocols. The CyberShark/HSET can be used on Windows/95, Windows/NT, and Linux operating systems. CyberShark/PRI - This primary rate ISDN adapter card provides intelligent support of up to 23 simultaneous digital connections allowing easy integration into third-party voice, analog modem, or video conferencing. The CyberShark/PRI is also available to support T1, an advanced North American communication system, and E1, the European equivalent to the T1. The CyberShark/PRI can be used on the Windows/NT operating system. FlagShip Family FlagShip/PRI-2 - This ISDN product is a dual-span primary rate adapter card that supports up to 46 simultaneous digital connections. NetShark - This ISDN product is a high-density two-card set that combines a primary rate ISDN interface card with a modem card containing up to 60 modems. NetShark provides dial-in access to remote users using either 64 Kbps ISDN or 56 Kbps V.90 connections and operating under control of Windows NT's built in Remote Access Server or Routing and Remote Access Server software. Other VME Product Line - We also offer a line of intelligent high-speed communications engines in a virtual memory European form factor. Some of our customers for these products include the military as well as large satellite based data communications companies. Atcomm2/4 Product Line - We also market an intelligent two or four channel product that is used for high-speed data communications. Engineering and Development - The communications division also obtains revenue from providing contract engineering and software development for customers. From time to time we are able to retain a proprietary interest in developed products and in such circumstances retain a license/royalty interest. Our product strategy is to continue to provide data communication solutions through improving current products and introducing new products. We have three research and development personnel assigned to high speed data communication product development and enhancement. These activities include customer specific development for original equipment 30 33 manufacturers, value added resellers and others as well as new proprietary product development and enhancement. Production and Marketing Strategy. Our strategy is to have our high-speed data communication products manufactured on a sub-contract basis with, in some instances, final assembly at our facility. We test and distribute the products. An in-house marketing staff manages the marketing of our high-speed data communications products. Our telecommunication products and ISDN products (other than CyberShark) are targeted for original equipment manufacturers, systems integrators, value added resellers, and sophisticated end users. Competition. There are a number of ISDN board-level products competitive to CyberShark offered by competitors including NetAccess, ISDN-tek, Inc., Zyxel, Digi International and U.S. Robotics. These companies have substantially greater resources than ours. Although not all of these companies offer personal computer plug-in card terminal adapters directly competitive with our product, additional direct competitors may introduce competitive products. We believe our products are competitive on both features and price with the products currently in the marketplace or those known by us to have been announced. ISDN modems also compete with traditional analog modems and with other interface technologies such as cable modems. Accordingly this field is subject to rapid technological change and fierce competition. We do not believe we can avail ourselves of patent protection on most of our high-speed data communication products in development. However, we rely on trade secret laws and copyrights to protect our high-speed data communications products. RADAR AND ANTENNA TECHNOLOGY. General Background. During the period from 1980-1983, Mr. Norris, our Chairman, developed a technique employing microwave radiation to penetrate the earth's surface. This radar technology relates to ground penetrating radar. This technology is one of many of a family of geophysical tools and sensing technologies that include seismic, electromagnetics, gravity, borehole sampling and other techniques. Ground penetrating radar is a technique for producing profiles of subsurface strata and features by emitting radar waves and recording the reflected signals. We commenced active development of our ground penetrating radar technology in April 1992. By May 1993, we were able to demonstrate the sensing, processing and crude visualization of images from our technology, and by May 1994 we had completed our prototype device. Since May 1994, we have focused our efforts and limited financial resources on the PSC1000 technology and communication products, effectively suspending development and most marketing efforts related to ground penetrating radar. Gas Antenna Technology Description. In September 1994, we filed a patent 31 34 application on certain gas antenna technology invented during our ground penetrating radar development. Immediately upon receiving notice of allowance in June, 1995, the invention was classified secret by the U.S. Department of Commerce at the request of a defense agency. This technology is not currently used in and is separate and apart from the ground penetrating radar technology, although it may be employed in the ground penetrating radar technology in the future. In January 1996, we filed an application seeking declassification of the technology, and in June 1996, we were advised that de-classification had been approved. The U.S. patent was issued in January 1997. The de-classification allows us to exploit the technology for both governmental and commercial purposes. Our gas antenna technology employs ionized gas as the conducting element of an antenna. This is a fundamental change from traditional antenna design that generally employs solid wires as the conducting element. We believe ionized gas is an efficient conducting element with a number of advantages. Since the gas is ionized only for the precise time of transmission or reception, ringing and associated effects of solid wire antenna design are reduced. The design allows for extremely short pulses, important to many forms of digital communication and radar. The design further provides the opportunity to construct an antenna that can be dynamically reconfigured for frequency, direction, bandwidth, gain and beamwidth. We believe antennas can be designed that are low in weight, small in size and lower in power consumption than traditional solid wire antennas. We obtained two U.S. Navy contracts to evaluate a prototype of the gas plasma antenna technology. There can be no assurance that we will obtain additional development funds or that we can successfully exploit this technology. Ground Penetrating Radar Technology Description. We have developed sensors (wave generators and antenna) and techniques for the processing, conversion, compression, storage, and visualization (collectively, computer processing) of ground penetrating radar data. We have developed proprietary techniques for wave generation and proprietary antenna for the sending and receiving of data. We use proprietary methods to capture and process returned signals. We have assembled a mobile prototype version of our ground penetrating radar technology. This prototype encompasses a blending of laboratory equipment (with internal software and hardware custom configured and modified to function as desired) and specialized components including antenna, power generators and amplifiers. The prototype has demonstrated the ability to penetrate multiple solid objects (walls and barriers) and identify return signals from additional objects such as walls, persons and manmade barriers. In certain ground strata, we have been able to resolve objects of six-inch size at approximately ten feet in depth. Our device does not require contact with the ground, providing enhanced mobility, extended area coverage and the ability to look sideways (for example through walls and in mine shafts). We have one U.S. patent on antenna technology for our ground penetrating radar. 32 35 Other aspects of the ground penetrating radar system are maintained as trade secrets, although additional patent applications may be filed in the future. Stage of Development. Our prototype system is used for limited prospective customer and user evaluations of the technology. We have demonstrated using the technology to detect plastic mines, side viewing through walls and solid structures for detection of bodies or other objects, and viewing plastic pipes and other underground objects. We believe that most prospective users will require more specifically tailored equipment and multiple devices. Commercialization of the ground penetrating radar technology will require additional development to improve visualization software and to replace the current system with specifically designed components to minimize cost and weight and improve portability. There can be no assurance that a commercially viable device will or can be produced, and we have no existing users or customers who use the ground penetrating radar technology. There can be no assurance any prospective users will select our device over competitive devices, if any. Business Strategy. We have limited resources to pursue further development to commercialize a ground penetrating radar system for the above markets and to exploit the gas plasma antenna technology. Our strategy is to use our ground penetrating radar and gas plasma antenna prototypes to demonstrate to prospective users our capabilities and to seek partnering arrangements to develop custom commercial devices for specific applications. Our marketing activities to date have been very limited and are focused primarily towards governmental agencies and major prime contractors to the U.S. government. The strategy is to seek sponsorship to assist in further development and commercialization of the present technology. There can be no assurance that we can obtain any outside assistance or successfully complete development and commercially exploit our ground penetrating radar or gas plasma antenna technology. Competition. The segment of the electronics industry that involves the manufacture and sale of ground penetrating radar equipment is not large or cohesive enough to be referred to as an "industry." Further, it is a specialized subset of geophysical tools that include seismic equipment and other geophysical and scientific instruments. The antenna industry consists of a large number of companies with substantial resources, a large installed base, established government and commercial relationships, and large research and development staffs. It is possible that any such technology owned or developed by others may be further advanced than our technology. We have not yet developed a commercially marketable prototype of our ground penetrating radar or gas plasma antenna technology. Most of our potential competitors are actively engaged in operations and have had time to develop product recognition and market share and have greater financial and other resources than ours. 33 36 RESEARCH AND DEVELOPMENT. Our current development efforts are focused on the introduction of the PSC1000-family microprocessor and high-speed data communication products. The development of our technologies has taken longer than anticipated and could be subject to additional delays. Therefore, there can be no assurance of timely or successful marketing of the PSC1000-family or of continued market acceptance of existing and proposed high speed data communication products. We incurred research and development expenditures of $1,607,828 for our fiscal year ended May 31, 1998 and $1,367,937 for the fiscal year ended May 31, 1997. The majority of our expenditures in fiscal 1998 and 1997 have been devoted to our PSC1000 and high-speed data communications technologies. To date, we have expensed internal software development costs as incurred. We believe that technical advances are essential to our success and expect that we will continue to expend substantial funds on research and development of our technologies. However, there can be no assurance that such research and development efforts will result in the design and development of competitive technologies in a timely manner. LICENSES, PATENTS, TRADE SECRETS AND OTHER PROPRIETARY RIGHTS. We rely on a combination of patents, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect our proprietary technologies. Our policy is to seek the issuance of patents that we consider important to our business to protect inventions and technology that support our microprocessor and radar and antenna technologies. We have six U.S. patents issued and five U.S. patents pending, most dating back to 1989, on the ShBoom microprocessor technology. We have one ShBoom technology patent pending in five European countries and Japan and may file additional applications under international treaties depending on an evaluation of the costs and anticipated benefits that may be obtained by expanding possible patent coverage. In addition to such factors as innovation, technological expertise and experienced personnel, we believe that a strong patent position is becoming increasingly important to compete effectively in the semiconductor industry. It may become necessary or desirable in the future for us to obtain patent and technology licenses from other companies relating to certain technology that may be employed in future products or processes. To date, we have not received notices of claimed infringement of patents based on our existing processes or products; but, due to the nature of the industry, we may receive such claims in the future. Likewise, we believe that we may have claims against other semiconductor companies should certain of our pending patents be favorably granted. However, there can be no assurance thereof nor any assurance that we could successfully exploit any potential patent claims against larger competitors. We acquired the basic ShBoom technology from nanoTronics Corporation in return for 10,000,000 shares of our common stock in 1994. We do not believe we are obligated to pay any royalties on aspects of the ShBoom technology specified in prior agreements between nanoTronics Corporation and a previous inventor. We believe that, should there be royalties due to the previous inventor, the obligation is that of nanoTronics. We have been informed by 34 37 nanoTronics that the inventor has rejected a tender of a part of the consideration paid by us to nanoTronics. The inventor has proposed that he is entitled to royalties and the return of the basic ShBoom technology. The inventor has filed a lawsuit to enforce these claims. The lawsuit is further discussed in the "Litigation" section of this prospectus. If it is ultimately determined that the inventor is entitled to royalties, we could be subject to indemnification claims by nanoTronics of up to $1,250,000 based on our agreement with nanoTronics. Based on the asset purchase agreement and plan of reorganization between Patriot, nanoTronics and Mr. Falk, we were the recipients of a number of warranties and indemnities. We believe nanoTronics has been or is in the process of liquidation and due to Mr. Falk's death in July 1995, we may be limited in our ability to obtain satisfaction should we have any future claims against nanoTronics or the Falk Family Estate. We have entered into the following licenses related to the microprocessor technology: - Sun Microsystems Inc. In June 1997, we entered into an agreement with Sun Microsystems, Inc. which enabled us to develop and distribute products based on Sun's JavaOS technology. In June 1998, we exercised an option under that agreement to license from Sun, personalJava, a smaller platform on which to run Java applications, that did not include an operating system. We determined that personalJava was better suited to the markets available to the PSC1000. We are currently working on porting personalJava to the PSC1000. - Wind River. In July 1997, we entered into an agreement with Wind River that provided us with a license for an operating system, VXWorks, to be used in conjunction with personalJava. We are currently working on porting VXWorks to the PSC1000. - Forth Inc. In July 1997, we entered into a license agreement with Forth Inc. whereby Forth will provide software support and operating system development tools for the Forth programming language. Several customers are evaluating the PSC1000 as a microprocessor using the Forth programming language. - VSAC. In December 1998, we entered into a licensing agreement with Venture System LSI Assist Center under which our core license is made available for evaluation and review by qualified Japanese companies. Certain companies attaining 1,000 unit volumes will be required to enter into sub-license agreements with us. We have two U.S. patents on our gas plasma antenna technology including one U.S. patent on antenna technology directly related to our ground penetrating radar technology. No foreign application has been made. Although plans in this regard are not definite, our intention is 35 38 to apply for patents only as to selected aspects of our ground penetrating radar and gas plasma antenna technology in order to reduce the risk of infringement or duplication by competitors. Considering the rapid advancements in the field of electronics generally, we believe that our interests will best be served by treating as trade secrets non-patented components or instrumentation groups used in some of our technologies. There are a large number of patents owned by others in the radar and antenna fields generally and in the field of ground penetrating radar specifically. Accordingly, although we are not aware of any possible infringement and have not received any notices of claimed infringement, we may receive such claims in the future. In 1995, we entered into a fully paid license agreement with Telenetworks that enables us to use their ISDN software technology. In addition to the protection afforded us through this ISDN technology license, we have created our own software and hardware designs and use copyright, trade secret laws, software security measures and nondisclosure agreements to protect our proprietary products, technology and software. We have one U.S. patent on our high-speed data communication technology. Despite our precautions, it may be possible for unauthorized third parties to copy aspects of, or otherwise obtain and use, our high-speed data communication technology and software without authorization. In addition, we cannot be certain that others will not develop substantially equivalent or superior proprietary technology thereby substantially reducing the value of our proprietary rights. In 1993, we licensed the technology related to a family of communication interface microprocessors to Sipex Corporation. The agreement provided that Sipex could exclusively use the technology through December 1998 if it paid a $50,000 per year minimum. Subsequent to December 1998 the license continues on a non-exclusive basis based on the mutual consent of both parties. Currently, Sipex is continuing to use the technology and paying a royalty fee. In addition, we entered into a license agreement with Multi-Tech relating to the ATComm/PRI technology. Multi-Tech paid us an up-front license fee of $50,000 plus an additional royalty fee of $50 per unit for each unit sold up to a maximum royalty fee of $25,000 after which time the agreement becomes a paid up license. Multi-Tech also pays us a support fee of $5,000 per year for five years through 2001. Currently Multi-Tech is continuing to use the technology and paying a royalty fee. There can be no assurance that any patents will issue from pending or future applications or that any patents that are issued will provide meaningful protection or other commercial advantages to us. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful. We generally require all of our employees and consultants, including our management, to sign a non-disclosure and invention assignment agreement upon employment with us. 36 39 MARKETING AND DISTRIBUTION. Our products are marketed through a combination of a direct sales force and distributors. Approximate sales by principal geographic area (as a percentage of sales) for fiscal years ended May 31 were as follows:
1998 1997 ---- ---- Domestic sales 96% 77% Foreign sales North America 1% 13% Europe 3% 6% Other -- 4% Total sales 100% 100%
All of our operating assets are located within the United States. While sales to certain geographic areas generally vary from year to year, we do not expect that changes in the geographic composition of sales will have a material adverse effect on operations. DEPENDENCE UPON SINGLE CUSTOMERS. Ten percent (10%) or more of our consolidated net sales for the fiscal years indicated were derived from shipments to the following customers:
1998 1997 ---- ---- Intermec $578,000 $473,000 G.E. Capital $478,000 $472,000 Spacenet Carrier $ -- $212,000 Technology Advanced $207,000 $ -- Communications
All of the above sales were for communication products and were shipped against multiple purchase orders from each customer. FACILITIES. We have one 10,000 square foot office located at 10989 Via Frontera, San Diego, California. The facility is leased and is currently held under an option that will expire in July 1999. We are currently in discussions with the existing lessor to extend the current lease and 37 40 are looking at other alternative properties of similar size in the San Diego area. There are a variety of facilities of similar size and cost available should we decide to relocate our offices. In addition, several of our employees who are supporting the PSC1000 microprocessor are telecommuting from their homes in northern California. EMPLOYEES. We currently have twenty full-time and two part-time personnel. Eleven full-time persons are employed in research and development, three full-time persons are engaged in manufacturing and assembly, three full-time persons are engaged in marketing and three full-time and two part-time persons are engaged in general and administrative activities. These persons include Mr. Norris and Mr. Putnam, who only devote a part of their available time to our affairs. We also engage additional consultants and part-time persons as needed from time to time. Our future success depends in significant part upon the continued service of our key technical and senior management personnel. The competition for highly qualified personnel is intense, and there can be no assurance that we will be able to retain our key managerial and technical employees or that we will be able to attract and retain additional highly qualified technical and managerial personnel in the future. None of our employees is represented by a labor union, and we consider our relations with our employees to be good. None of our employees is covered by key man life insurance policies. GOVERNMENT REGULATION. To our knowledge, our products are not subject to governmental regulation by any federal, state or local agencies that would affect the manufacture, sale or use of our products, other than occupational health and safety laws and labor laws which are generally applicable to most companies. We cannot, of course, predict what sort of regulations of this type may be imposed in the future but do not anticipate any unusual difficulties in complying with governmental regulations which may be adopted in the future. Our proposed ground penetrating radar device and antenna technology uses microwave radio waves. The Federal Communications Commission (FCC) regulates the use of such radio waves in a product. Since we have limited manufacturing capabilities, we most likely would license the technology to other companies for production. The other companies would be required to obtain the proper FCC approvals for their products. We do not believe that the operation of the ground penetrating radar prototype on contract analysis projects requires FCC approval. We have not incurred costs associated with environmental laws and do not anticipate such laws will have any significant effect on our future business. USE OF PROCEEDS We expect to sell to Swartz Private Equity, LLC $5,000,000 of common stock under the investment agreement. Additional amounts may be received if the warrants to purchase common stock are exercised. In addition, we have already received $343,000 from the sale of common stock to private investors. This amount plus funds raised from the issuance of short-term 38 41 loans, $698,000, were used to meet our operating expenses for the months of November 1998 through June 1999. Net proceeds are determined after deducting all expenses of the offering (estimated to be $64,600). We intend, in the following order of priority, to use the net proceeds from this offering as follows:
Repayment of short-term loans $ 698,000 Marketing, sales, and commercialization 1,000,000 Expenses for marketing and sales in conjunction with the market introduction of the microprocessor as a commercial product. Such expenses include market research studies, marketing collateral materials, trade show participation, public relations, advertising expenses and sales and marketing personnel. Completion of the microprocessor development 1,000,000 Expenses for completion of the development include porting an operating system and personalJava to the microprocessor and obtaining tools to make use of the processor more user- friendly. Working capital and general corporate purposes 2,237,400 ---------- Total $4,935,400 ==========
The amount and timing of working capital expenditures may vary significantly depending upon numerous factors such as: - The progress of our final development of the microprocessor, - Revenues generated from existing and anticipated products and licenses, - The development of marketing and sales resources, - Administrative and legal expenses, and ~ Other requirements not now known or estimable. We believe that our available cash and existing sources of funding, together with the proceeds of this offering and interest earned thereon, will be adequate to maintain our current and planned operations for at least the next 18 months. 39 42 LITIGATION In October 1998, Patriot was sued in the District Court for Travis County, Texas by the Fish Family Trust, an assignee of a co-inventor of the original ShBoom technology. The suit also named as defendants nanoTronics and Gloria Felcyn as trustee of the Falk Family Trust. The suit sought a judgment for damages, a rescission of the technology transfer agreement by which nanoTronics obtained the technology and a restoration of the technology to the Fish Family Trust. We had the suit removed to the United States District Court for the Western District of Texas, Austin Division. We requested the Federal District Court dismiss the suit based on a lack of minimum contacts with Texas or, in the alternative, to transfer the case to the Southern District of California. In January 1999, the Federal District Court dismissed the suit for lack of subject matter and personal jurisdiction. The Fish Family Trust then refiled the suit in the Superior Court of San Diego County, California seeking remedies similar to the action dismissed by the Federal District Court. We have joined with nanoTronics and Gloria Felcyn, Trustee, and retained joint legal counsel to defend this suit. We have not had any meaningful settlement discussions. A trial has been scheduled for December, 1999. We and the other defendants intend to vigorously contest the plaintiff's allegations. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Our results of operations have been and may continue to be subject to significant variations. The results for a particular period may vary due to a number of factors. These include: - the overall state of the semiconductor and communications segments of the economy, - the development status of and demand for our products, - economic conditions in our markets, - the timing of orders, - the timing of expenditures in anticipation of future sales, - the mix of products sold by us, - the introduction of new products, - product enhancements by us or our competitors, and - pricing and other competitive conditions. As described in Note 1 to the Consolidated Financial Statements, effective December 26, 1996, we acquired 96.9% of the common stock of Metacomp. The business combination was accounted for as a pooling of interests and, accordingly, our financial statements have been presented to include the results of Metacomp as though the business combination occurred as of 40 43 June 1, 1995. In addition, Metacomp changed its fiscal year-end from July 31 to May 31 to conform to our fiscal year-end. Based on the difference in fiscal year-ends, results of operations for the two months ended July 31, 1996 were included in our results of operations for the year ended May 31, 1997. In connection with their audit report on our consolidated financial statements as of and for the year ended May 31, 1998, BDO Seidman, LLP, our independent auditors, expressed substantial doubt about our ability to continue as a going concern because of recurring net losses and negative cash flow from operations. See note 16 of the consolidated financial statements for discussion. RESULTS OF OPERATIONS FOR THE YEARS ENDED MAY 31, 1998 AND 1997 Net sales. Total net sales for the fiscal year ended May 31, 1998 increased 3.0% to $1,902,874 from $1,847,421 for the fiscal year ended May 31, 1997. This increase was due primarily to the initial sales of the microprocessor and the development contracts for the radar/antenna product line. Cost of sales. Cost of sales as a percentage of net sales increased to 61.2% in fiscal 1998 compared to 54.3% in fiscal 1997. This increase in the cost of sales percentage was a result of increasing the obsolescence reserve by $203,000 for component and finished parts inventory related to older products being phased out. Additional inventory write downs and reserves may be necessary in future years since additional communication products are nearing the end of their life cycles. Future sales may not be sufficient to use existing finished parts inventory (which had built up in previous years in anticipation of larger orders) and component parts may not be usable in other products. Each period we review component part and finished goods inventory quantities and estimate the amount of useable inventory based on historical usage. If the quantities anticipated to be used are less than the quantities on hand, then we increase the obsolescence reserve and record additional cost of sales. Research and development expenses increased 17.5% from $1,367,937 in fiscal 1997 to $1,607,828 for fiscal 1998. This increase was due primarily to an increase in licensed software support and update fees. Selling, general and administrative expenses increased 67.1% from $2,448,751 in fiscal 1997 to $4,090,937 in fiscal 1998. This increase was due primarily to: - the costs of two financings, which financings were in the total amount of $3,000,000, - an increase in personnel costs related to our addition of one marketing executive and one financial officer, - the compensation costs of $1,995,000 related to the earnout from escrow of 2,000,000 shares of common stock in 1998 as compared to compensation cost of $725,000 related to the earnout of 500,000 shares of common stock in 1997 as discussed in Note 4 to the Consolidated Financial Statements, and - an increase in marketing costs related to introducing our products to the marketplace. Amortization of purchased ShBoom technology was $612,333 for fiscal 1997. The technology was totally amortized during fiscal year 1997 and, accordingly, there was no corresponding expense for fiscal year 1998. 41 44 Other income (expense) was significantly higher for fiscal 1998 as a result of a recognition of $2,592,446 of non-cash interest related to the discount on convertible term debentures and valuation of warrants as discussed in Note 5 to the Consolidated Financial Statements and the interest on these debentures. A one-time extraordinary income item of $1,779,457 was recorded in fiscal 1997. Metacomp filed for protection from its creditors in 1991 and entered a plan of reorganization with the U.S. Bankruptcy Court. The Chapter 11 plan was completed in July 1996 and resulted in this amount of debt being discharged. RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED FEBRUARY 28, 1999 AND 1998 Net sales. Total net sales for the nine months ended February 28, 1999 decreased 2.9% to $1,108,022 from $1,140,711 for the corresponding period of fiscal 1998. This decrease was due primarily to a reduction in follow on shipments for our matured communication products several of which are approaching the end of their life cycles. Development and sales of new communications products have not achieved a level to replace the maturing products. Also, we had to reschedule the product delivery on our kiosk application order of $3,355,000. Although no assurance can be given, the kiosk order is scheduled to begin shipments in the first fiscal quarter of 2000, June 1 to August 31, 1999, with the balance of shipments to be completed by the end of fiscal year 2000. Cost of sales. Cost of sales as a percentage of net sales increased to 61.7% for the nine months ended February 28, 1999 compared to 47.9% for the corresponding period of the previous fiscal year. This increase is due in part to lower profit margins on the non-recurring engineering portion of our kiosk application order compared to profit margins typically associated with our other product lines. The remainder of the kiosk order is anticipated to put upward pressure on the cost of sales as a percentage of net sales when shipments of the product portion of the kiosk order commences. Research and development expenses increased 25.7% for the nine months ended February 28, 1999 to $1,634,060 from $1,299,975 for the corresponding period for the previous fiscal year. This was due to an increase in licensed software support and update fees for the Java OS and Personal Java application, increased costs of porting a real time operating system to the PSC1000, and costs related to the development of the kiosk. Selling, general and administrative expenses decreased by 32.5% to $1,770,158 for the nine months ended February 28, 1999 compared to $2,620,908 for the corresponding period of the previous fiscal year. This decrease was due primarily to a reduction in compensation costs. Other expense was $335,993 for the nine months ended February 28, 1999 compared to $1,665,725 for the corresponding period for the previous fiscal year. This decrease was due primarily to the non-cash interest related to Convertible Term Debentures discussed in Note 5 to the Consolidated Financial Statements and the interest on those Debentures being significantly 42 45 lower in the current nine month period. LIQUIDITY AND CAPITAL RESOURCES At February 28, 1999, working capital was a negative $1,013,056 and cash and cash equivalents totaled $16,800. We have funded our operations primarily through the issuance of securities and debt financings. Cash and cash equivalents decreased $585,656 during the nine months ended February 28, 1999. The net cash used in operating activities was $1,136,873, additions to property and equipment were $273,096, and funds generated from debt and equity financings were $824,313. During the nine months ended February 28, 1999, accounts receivable decreased $136,220 as a result of a reduction in sales, increased collection efforts and the sale of receivables to a bank under a factoring agreement. Prepaid expenses increased $49,198 as a result of maintenance contracts on software being amortized over the entire year. Accounts payable increased $900,413 as a result of annual obligations for software maintenance and a slow down in payments as a result of the cash and cash equivalent reduction. Our current cash requirements to sustain our operations for the next twelve months are estimated to be $1,600,000. We expect that these requirements will be provided: Internally by: - the cash profits related to the $3,355,000 kiosk order, (a portion of which is anticipated as an advance payment during our first fiscal quarter of 2000 (June 1 to August 31, 1999), previous to any product shipments, and Externally by: - short-term debt instruments, including a receivable financing arrangement established with our bank, - previous to the effective date of the registration of the underlying stock to be resold under the investment agreement, private placement debt and/or equity financings, - subsequent to the effective date of the registration of the underlying stock to be resold under the investment agreement, draws against the equity line of credit, and - other sources of financing in the event the equity line of credit is not completed. Since February 28, 1999, we have issued short-term debt financings for $553,000 and sold equity to two private investors totaling $75,000. These amounts have enabled us to meet our current needs and will provide funding for the next 30 to 60 days. If, during the next 60 days, we do not receive the initial funding for the kiosk order or the initial draw against the investment agreement, then additional similar debt or equity financings will be necessary to continue to meet our cash requirements. In February 1999, we entered into an agreement for up to $5,000,000 under an investment agreement. The investment agreement allows us, at our sole discretion, to put common stock into the hands of Swartz Private Equity, LLC at a discount from market, ranging from 10% to 20% 43 46 depending on the market price of the common stock. The puts are subject to common stock trading volume limitations and registration of the securities. We anticipate the initial put under the investment agreement will take place during the first quarter of fiscal year 2000, June 1- August 31, 1999. The funds anticipated from the kiosk order are subject to our customer receiving funds from the Mexican Department of Tourism and on several occasions product shipments have been rescheduled pending the receipt of those funds. As discussed below, the offering that relates to this proposed $5,000,000 financing may have been in violation of Section 5 of the Securities Act of 1933. We are also holding discussions with various other possible financing sources and management believes that additional financing can be obtained in the event that the proposed $5,000,000 financing is not completed. However, no assurance can be given that we will, in fact, be able to obtain additional financing or that the terms of such financing will be favorable to us. We anticipate that we may require additional equipment, fabrication, components and supplies during the next twelve months to continue development of our technologies. Product introductions such as those currently underway for communication products and the PSC1000 may require significant inventory, product launch, marketing personnel and other expenditures that we can not currently estimate. Further, if expanded development is commenced or new generations of microprocessors are accelerated beyond our current plans, additional expenditures, that we can not currently estimate, may be required. It is possible therefore, that higher levels of expenditures may be required than we currently contemplate resulting from changes in development plans or as required to support new developments or commercialization activities or otherwise. Based on the current fiscal year's rate of cash operating expenditures and current plans, we anticipate a need for additional cash to meet our requirements for the next twelve months. There can be no assurance that any funds required during the next twelve months or thereafter can be generated from operations or that if such required funds are not internally generated that funds will be available from external sources such as debt or equity financings or other potential sources. The lack of additional capital could force us to substantially curtail or cease operations and would, therefore, have a material adverse effect on our business. Further, there can be no assurance that any such required funds, if available, will be available on attractive terms or that they will not have a significantly dilutive effect on our existing shareholders. POTENTIAL VIOLATION OF SECTION 5 OF THE SECURITIES ACT In April 1999, we sold shares of common stock to two individuals in the accumulated amount of $75,000 and in June we issued shares to an institutional investor upon conversion of a short term note in the amount of $116,183. These sales occurred after the commencement of a public offering by us and, therefore, by making these sales we may have violated Section 5 of the Securities Act. In July 1999, we amended and restated the investment agreement with Swartz to eliminate the discretion of Swartz as to the timing of its purchase of our common stock. The amended and restated investment agreement requires Swartz, after we put shares of common stock to it, to purchase our common stock on the twentieth day following the put. The previous agreement enabled Swartz, in its sole discretion, to purchase our common stock at any time during a twenty day period following our put to it. By entering into the amended and restated investment agreement, we completed our sale of common stock to Swartz. Since this private sale to Swartz occurred after we commenced our public offering, we may have sold securities to Swartz in violation of Section 5 of the Securities Act. Consequently, the two individual investors, the institutional investor and Swartz may have the right to rescind these purchases of common stock. In addition, Patriot and certain officers and directors of Patriot may be subject to civil and criminal penalties for potential violation of either or both Section 5 of the Securities Act and applicable state law as a result of these sales. Management believes that the possibility of damages related to these potential violations of the Securities Act is remote and that such potential violations will have no material impact on the Company's financial statements. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information" which supersedes SFAS No. 14 "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes standards governing the way that public companies report financial information about operating segments in annual financial statements, and requires reporting of selected information about operating segments in interim financial statements issued to the public. It also establishes standards for disclosure regarding products and services, geographic areas and major customers. SFAS No. 131 defines operating segments as components of a company about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. We have only one operating segment. SFAS No. 131 is effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. We will implement SFAS No. 131 in our May 31, 1999 financial statements. Results of operations and financial position will be unaffected by 44 47 implementation of the standard. We believe the adoption of this statement will have no material impact on our financial statements. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair market value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes in fair value or cash flows. SFAS No. 133 is effective for fiscal periods beginning after June 15, 1999. We believe the adoption of this statement will have no material impact on our financial statements. TAX LOSS CARRYFORWARDS As of May 31, 1998, we had approximately $9,052,000 of tax loss carryforwards. A valuation allowance has been recorded for the net-deferred tax asset of $4,258,000 arising primarily from tax loss carryforwards because we cannot determine that it is more likely than not that the deferred tax asset will be realized. See also Note 8 to the Consolidated Financial Statements. YEAR 2000 COMPLIANCE Many existing computer programs use only two digits to identify a year in the date field, with the result that data referring to the year 2000 and subsequent years may be misinterpreted by these programs. If present in the computer applications of a company or third parties (such as customers, financial institutions, and suppliers) and not corrected, this problem may cause computer applications to fail or to create erroneous results and could cause a disruption in operations and have an adverse effect on a company's business and results of operations. We have adopted a formal plan to evaluate our readiness for the Year 2000 and to address any deficiencies. The plan encompasses: - information technology (IT) systems, - non-IT systems, - our products, and - systems of third parties, including distributors and key suppliers. INFORMATION TECHNOLOGY. Our principal computer systems that we use for financial accounting, manufacturing, inventory control, purchasing, sales administration, engineering, and other business functions are not Year 2000 compliant. We have identified a replacement system that we expect to purchase, install, and have fully functional before June 30, 1999. The cost of this new system will be approximately $30,000. 45 48 NON-IT SYSTEMS. By the end of June 1999, we expect to have completed an evaluation of telephone systems, manufacturing equipment, facility heating and cooling systems, and other non-IT systems for Year 2000 readiness and will promptly take remedial action as necessary. OUR PRODUCTS. We have completed a series of tests, utilizing industry standards, of the electronics systems of our products, including those product lines no longer being manufactured but remaining in use at customer sites. Our review has determined that the products should continue to operate according to specifications after December 31, 1999. KEY VENDORS AND SUPPLIERS. We will initiate a survey of our key vendors and suppliers to assess their plans for bringing any non-compliant systems into Year 2000 compliance. This study is expected to be completed by the end of June 1999. Other than the replacement computer system discussed above, substantially all of the effort to evaluate our Year 2000 readiness has been made using internal personnel, and therefore incremental expenses have been less than $50,000. We have not incurred any material expenses in connection with our evaluation of non-IT systems and do not expect material expense in the future, although the evaluation of non-IT systems is not yet complete. We have not incurred any material expenses to date in connection with the evaluation of our products and the status of our vendors and suppliers with respect to Year 2000 issues. We do not anticipate material expenses in the future, although the evaluation of key vendors' and suppliers' Year 2000 readiness is not yet complete. Our Year 2000 readiness plan, as well as our consideration of contingency plans, are ongoing and will continue to evolve as new information becomes available. At the present time, we believe that it is difficult to identify the cause of the most reasonably likely worst case Year 2000 scenario. We have not yet adopted any formal contingency plans and will determine the need for such plans as part of our ongoing assessment of vendors and suppliers, products, and internal business systems. Due to the complexity and pervasiveness of the Year 200 issue, and in particular the uncertainty regarding the Year 2000 compliance programs of third parties, no assurances can be given that the Year 2000 problem will not have material adverse effects on our business or our results from operations. MANAGEMENT IDENTIFICATION OF DIRECTORS AND EXECUTIVE OFFICERS Our current directors and executive officers, their ages, positions held with us and duration as such, are as follows: 46 49
NAME AGE POSITION AND OFFICES DIRECTOR SINCE - ---- --- -------------------- -------------- Elwood G. Norris 60 Chairman and Director August 1989 James T. Lunney 44 President, CEO and April 1998 Director Lowell W. Giffhorn 52 Chief Financial Officer N/A Donald R. Bernier 56 Director January 1995 Helmut Falk, Jr. 42 Director December 1997 Phillip Morettini 42 Vice President Sales and N/A Marketing Frederick G. Thiel 38 Director February 1999 Robert Putnam 40 Secretary N/A Jayanta K. Maitra 48 Vice President N/A Engineering Richard G. Blum 68 Director February 1999
The terms of all directors will expire at the next annual meeting of our shareholders, or when their successors are elected and have qualified. Directors are elected each year, and all directors serve one-year terms. Officers serve at the pleasure of the board of directors. No family relationship exists among our management members. Mr. Norris, Mr. Bernier and Mr. Falk were elected to the board of directors in December 1997. Mr. Lunney was appointed to the board of directors in April 1998. Mr. Thiel and Mr. Blum were appointed to the board of directors in February 1999. BIOGRAPHICAL INFORMATION ELWOOD G. NORRIS. Mr. Norris has been a director of Patriot since 1989 and served as Chairman and Chief Executive Officer (CEO) until June 1994. In June 1995 he was again appointed President and CEO until June 1996, when he was appointed Chairman. Since March 1988, he has been a director of e.Digital, Inc., a public company engaged in electronic product development, distribution and sales. Until October 1995, when he became Chief Technology Officer, he was also President of e.Digital, and in January 1997 he was appointed interim CEO. Since August 1980, he has also been a director of American Technology Corporation, a publicly held consumer electronics company, and served as its President and CEO until February 1994. Mr. Norris is an inventor with over twenty U.S. patents primarily in the fields of electrical and acoustical engineering. He invented the base ground penetrating radar technology and the gas plasma antenna technology owned by us. Mr. Norris works only part-time for us. JAMES T. LUNNEY. Mr. Lunney has been the President and CEO of Patriot since March 1998 and was appointed as a Director in April 1998. From February 1997 to March 1998, he was the President of Signal Processing Systems, a San Diego manufacturer of signal processing 47 50 technologies. From November 1992 to February 1997, he was the Manager of Production Programs, Vice President and Business Area Manager for Signal Processing, which was a division of Scientific Atlanta until August 1996, when it was acquired by Global Associates Ltd. Previously, Mr. Lunney held various managerial positions with GE Aerospace, Defense Systems Division and Ordinance Systems Division. In 1977, he received a B.S. in Electrical Engineering from Worcester Polytechnic Institute. ROBERT PUTNAM. Mr. Putnam has been the Secretary and Treasurer of Patriot since 1989 and was a director from 1989 to April 1998. Since 1988 he has served as Secretary of e.Digital, Inc. Since 1984 he has been a director of American Technology Corp., where he served as Secretary/Treasurer from 1984 and as President and CEO from February 1994 until September 1997. He received a B.A. degree in Mass Communication/Advertising from Brigham Young University in 1983. Mr. Putnam works only part-time for us. JAYANTA K. MAITRA. Mr. Maitra has been Vice President of Engineering of Metacomp since 1990 and was appointed Vice President of Engineering of Patriot in January 1997. From 1985 to 1987 he was Manager of Hardware Engineering for Systech Corporation, a San Diego based hardware and software communications company. From 1974 to 1985 he held various engineering positions with several computer related technology companies. He obtained a B.S. in Electrical Engineering from the Indian Institute of Technology in 1972 and an M.S. in Electrical Sciences at State University of New York in 1973. LOWELL W. GIFFHORN. Mr. Giffhorn was the principal in his own financial management consulting firm from August 1996 until joining Patriot as Chief Financial Officer (CFO) in May 1997. From November 1996 to May 1997, Mr. Giffhorn, in addition to other consulting engagements, performed the duties of Acting CFO for Patriot. From June 1992 to August 1996 and from September 1987 to June 1990 he was the CFO of Sym-Tek Systems, Inc. and Vice President of Finance for its successor, Sym-Tek Inc. Sym-Tek Systems, Inc. was a major supplier of capital equipment to the semiconductor industry, which filed under Chapter 11 of the U.S. Bankruptcy Code in May 1994 while Mr. Giffhorn was the CFO. He was instrumental in selling the assets of Sym-Tek Systems, Inc. to Sym-Tek Inc., a wholly owned subsidiary of Aetrium Inc. He continued with Sym-Tek Inc. as Vice President Finance during the transition and concluded the liquidation of Sym-Tek Systems, Inc. He has over twenty-five years of experience in a variety of financial positions, including eleven years as Controller for Langley Corporation, a publicly traded, San Diego, defense contractor. Mr. Giffhorn obtained a M.B.A. degree from National University in 1975 and he obtained a B.S. in Accountancy from the University of Illinois in 1969. DONALD R. BERNIER. Since 1971, Mr. Bernier has been the owner and President of Compunetics Incorporated, a Troy, Michigan-based electronics firm of which he the founder. Compunetics engages in contract research and development, specializing in microelectronics primarily for the automotive industry. HELMUT FALK, JR. For the past six years, Dr. Falk has been the Director of Anesthesia for the Johnson Memorial Hospital in Franklin, Indiana. Dr. Falk received his D.O. from the College 48 51 of Osteopathic Medicine of the Pacific in 1987 and his B.S. in Biology from the University of California, Irvine in 1983. Dr. Falk is the son of the late Helmut Falk, who was the sole shareholder of nanoTronics and the Chairman and CEO of Patriot until his death in July 1995. Dr. Falk is also an heir to the Helmut Falk Estate, which is the beneficial owner of our shares held by the Helmut Falk Family Trust and nanoTronics Corporation. PHILIP MORETTINI. Mr. Morettini has been the Vice President of Sales and Marketing of Patriot since July 1997. From September 1995 to April 1997, he was the President and CEO of Sdept Computer Solutions, a San Diego software company. From December 1993 to September 1995, he was the principal in his own management consulting firm; and from March 1990 to September 1993, he held several positions, including Division Manager, for Horizons Technology, a San Diego software and services company. Previously, he held various marketing and product development positions with Spectragraphics and Hewlett-Packard. In 1981 Mr. Morettini received a M.B.A. degree from the University of Detroit and in 1979 he obtained a B.S. in Engineering from the University of Illinois. FREDERICK G. THIEL. Since April 1998, Mr. Thiel has been the President and CEO of Lantronix, Inc., an Irvine, CA based developer/manufacturer of computer network enabling devices and systems. From July 1996 to April 1998 he was the Vice President of Marketing and General Manager for CDM Technology, Inc., an Irvine, CA based developer of high-end storage controller and intelligent serial input/output microprocessor technology. From June 1994 to March 1996 he was the Director of World Wide Marketing for Standar Microsystems Corporation, an Irvine, CA based network technology developer and manufacturer. Mr. Thiel was educated in the United States and Europe and studied business administration while at the Stockholm School of Economics. RICHARD G. BLUM. Mr. Blum retired as Chairman and President of Kysor Europe, a wholly owned subsidiary of Kysor Industrial Corporation, in 1991. Previously Mr. Blum held a variety of executive level positions with ITT Europe and ADT Europe. He completed his undergraduate work at Oregon State and Linfield Colleges in 1951 and post graduate work at John Carrol and Canisius Universities in 1958. GENERAL CONFLICTS OF INTEREST Conflicts of interest now exist and will continue to exist between us and certain of our officers and directors due to the fact that certain officers and directors have other employment or business interests to which they devote attention. We have not established policies or procedures for the resolution of current or potential conflicts of interest between us and our management or management-affiliated entities. There can be no assurance that members of management will resolve all conflicts of interest in our favor. It is conceivable that the respective areas of interest of ours, American Technology Corp. and e.Digital could overlap or conflict. We believe that, although each of the three corporations is involved in the electronics industry, their respective areas of focus, products and technology are 49 52 sufficiently distinct that no conflict in business lines or executive loyalties will result. Therefore, no steps have been taken to resolve possible conflicts among us, American Technology Corp., and e.Digital; and any such conflicts, should they arise, will be addressed at the appropriate time. INDEMNIFICATION OF OFFICERS, DIRECTORS AND OTHERS As permitted by Delaware law, our certificate of incorporation provides that we will indemnify our officers, directors, employees and agents. This includes indemnification against attorneys' fees and other expenses and liabilities they incur to defend, settle or satisfy any civil or criminal action brought against them arising out of their association with or activities on behalf of us. However, they will not be indemnified if they are adjudged to have acted with gross negligence or to have engaged in willful misconduct. We may also bear the expenses of such litigation for any such persons upon their promise to repay such sums if it is ultimately determined that they are not entitled to indemnification. Such expenditures could be substantial and may not be recouped, even if we are so entitled. We have provided for indemnification for liabilities arising under the Securities Act of 1933 as they may be permitted to directors, officers or persons controlling us. The SEC has informed us that such indemnification is against public policy and may be unenforceable. EXCLUSION OF DIRECTOR LIABILITY In accordance with Delaware law, our certificate of incorporation excludes personal liability on the part of our directors to us for monetary damages based upon any violation of their fiduciary duties as directors, except as to: - liability for any breach of the duty of loyalty, - acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, - acts in violation of Section 174 of the General Corporation Law of Delaware, or - any transaction from which a director receives an improper personal benefit. This exclusion of liability does not limit any right which a director may have to be indemnified and does not affect any director's liability under federal or applicable state securities laws. EXECUTIVE COMPENSATION The following table sets forth information concerning the compensation of our chief executive officers and each of the other four most highly compensated executive officers whose salary and bonus exceeded $100,000 for the fiscal years ended May 31, 1996, 1997 and 1998. 50 53 SUMMARY COMPENSATION TABLE
Annual Cash Compensation Long-Term Compensation ---------------------------- ----------------------------------- Name and Principal Fiscal Options All Other Position Year Salary Bonus (# of Shares) Compensation(7) James T. Lunney 1998 $ 26,385 Nil 350,000 None President and CEO(1) shares Michael A. Carenzo 1998 $164,133 Nil 50,000 None President and CEO(2) 1997 $138,000 shares None 900,000 shares Elwood G. Norris 1996 $60,000 Nil 50,000 None President and CEO(3) shares Helmut Falk 1996 $9,231 Nil None None President and CEO(4) Norman J. Dawson 1998 $114,169 Nil 50,000 None Vice President and 1997 $128,483 Nil 533,953 $4,241 General Manager(5) Jayanta K. Maitra 1998 $104,500 Nil 25,000 None Vice President 1997 $118,700 Nil 535,753 $2,874 Engineering(6)
- ---------- (1) Mr. Lunney has served as President and CEO since March 23, 1998. (2) Mr. Carenzo served as President and CEO from June 1, 1996 to March 1998, when Mr. James T. Lunney was appointed President and CEO. Mr. Carenzo continued to serve on the Board until his resignation in October, 1998. (3) Mr. Norris served as CEO from 1989 to June 1994, when Mr. Falk became Chairman, President and CEO. He was reappointed President and CEO on June 5, 1995 due to Mr. Falk's illness and served in such capacity until June 1, 1996, when Mr. Carenzo was appointed President and CEO. (4) Mr. Falk served as Chairman from June 1994 until his death on July 6, 1995. He also served as President and CEO from June 1994 to June 5, 1995. (5) Mr. Dawson was appointed Vice President and General Manager on December 26, 1996 as a result of our acquisition of Metacomp. The amounts disclosed reflect his compensation before and after the acquisition. Mr. Dawson terminated his relationship with us in October 1998. (6) Mr. Maitra was appointed Vice President Engineering on December 26, 1996 as a result of our acquisition of Metacomp. The amounts disclosed reflect his compensation before and after the acquisition. (7) Represents long-term disability insurance payments made us on behalf of Mr. Dawson and Mr. Maitra during the fiscal year ended May 31, 1997. We maintain employee benefits that are generally available to all of our employees, 51 54 including medical, dental and life insurance benefits and a 401(k) retirement savings plan. We did not make matching contributions under the 401(k) plan on behalf of the above named officers during the fiscal year ended May 31, 1998. OPTION GRANTS The following table sets forth information on grants of stock options pursuant to our 1996 Stock Option Plan to the officers reflected in the Summary Compensation Table shown above. OPTION GRANTS TABLE FOR FISCAL YEAR ENDED MAY 31, 1998
Percent of Total Number of Options Granted Option Options to Employees in Exercise Name Date Granted Fiscal Year Price - ---- ---- ------- ----------------- -------- James T. Lunney February 22, 2003 350,000 23.2% $ 0.86 Michael A. Carenzo January 26, 2003 50,000 3.3% $ 0.59 Elwood G. Norris January 26, 2003 50,000 3.3% $ 0.59 Norman J. Dawson January 26, 2003 50,000 3.3% $ 0.59 Jayanta K. Maitra January 26, 2003 25,000 1.7% $ 0.59
AGGREGATED OPTION EXERCISES AND FISCAL YEAR-END VALUES Shown below is information on exercises of stock options and fiscal year-end values under our 1996 and 1992 Stock Option Plans to the officers reflected in the Summary Compensation Table shown above.
Shares Value of Unexercised Acquired Number of Unexercised In-The-Money Options on Value Options Held at May 31, 1998 At May 31, 1998 Name Exercise Realized Exercisable Unexercisable Exercisable Unexercisable Michael A. Carenzo 40,200 $53,466 525,691 -- $ 8,000 $ -- Norman J. Dawson 54,600 $61,666 50,000 375,000 $ -- $ -- Elwood G. Norris -- -- 100,000 -- $ 8,000 $ -- James T. Lunney -- -- 116,667 233,333 $ -- $ -- Jayanta Maitra -- -- 110,753 375,000 $ 24,379 $ --
The fair market value of the unexercised in-the-money options at May 31, 1998 was determined by subtracting the option exercise price from the last sale price as reported on the over the counter bulletin board on May 31, 1998, $.75. This value was multiplied by the number of shares into which the option was exercisable. Any options whose exercise price were greater than $.75 were excluded from the valuation. We have not awarded stock appreciation rights to any employee of ours. We have no 52 55 long-term incentive plans except a $50,000 demonstration bonus payable to Mr. Norris upon successful demonstration of a prototype ground penetrating radar device. Under Mr. Maitra's Employment Contract, the board of directors canceled 75,000 stock options in fiscal year 1998 and 225,000 stock options in fiscal year 1999 which had previously been granted to him. This change was made as a consequence of our not meeting certain performance goals. As a result of Mr. Carenzo's resignation in March, 1998, 337,500 previously granted stock options were canceled. We have no defined benefit or actuarial plans covering any person. COMPENSATION OF DIRECTORS No direct or indirect remuneration has been paid or is payable by us to the directors in their capacity as directors other than the granting of stock options. We expect that, during the next twelve months, we will not pay any direct or indirect remuneration to any directors of ours in their capacity as directors other than in the form of stock option grants or the reimbursement of expenses of attending directors' or committee meetings. EMPLOYMENT CONTRACTS JAMES T. LUNNEY. We entered into an employment agreement dated as of February 23, 1998 and approved by our directors on March 24, 1998, with Mr. Lunney providing for his employment as President and CEO effective March 23, 1998. The agreement is for a three year term and provides for a base salary of $130,000 per annum for the first year with an increase in the second year to at least $140,000 per annum. The base salary may be increased at the discretion of the board of directors. The agreement provides for a guaranteed bonus of 25% of the base salary at the end of the first year of its term or on certain changes in control as defined in the agreement. During subsequent years, Mr. Lunney is eligible for a bonus equal to 25% of the base salary conditioned on Mr. Lunney meeting certain objectives established by the board of directors. In addition, the agreement provides a $600 per month car allowance. We may terminate Mr. Lunney's employment with or without cause, but termination without cause (other than disability or death) would result in a lump sum severance payment ranging, depending on length of service, from six to twelve months salary plus any prorated earned bonuses. Also, upon a change of control, as defined in the agreement, Mr. Lunney may elect to terminate employment and obtain a lump sum severance payment equal to the base salary for the remaining months of the agreement. We have granted Mr. Lunney options to purchase 350,000 common shares, 116,667 vesting on March 23, 1998 and the balance vesting equally at the end of twelve and twenty-four months from the date of the agreement, subject to earlier vesting in the event of a change in our control. PHILIP MORETTINI. We entered into an employment agreement dated as of July 28, 1997 and approved by our directors on August 18, 1997, with Mr. Morettini providing for his employment as Vice President of Sales and Marketing. The agreement is for a three year term providing for a base salary of $110,000 per annum for the first year and not less than $110,000 53 56 per annum during the second and third years of the agreement. The base salary may be increased at the discretion of the board of directors. The agreement provides for a bonus up to 50% of the annual base consideration for the applicable year. We may terminate Mr. Morettini's employment with or without cause, but termination without cause (other than disability or death) would result in a lump sum severance payment equal to four months of his then current base salary. If within twelve months of a change in control, as defined in the agreement, Mr. Morettini's employment is terminated for other than cause or if Mr. Morettini refuses to accept or voluntarily resigns from a position other than a qualified position, as that term is defined in the agreement, then he will receive a lump sum severance payment equal to twelve months of his then current salary. Under the agreement, we granted Mr. Morettini options to purchase 300,000 common shares, 30,000 vesting on July 28, 1997 and the balance vesting one-third per year starting July 28, 1998, subject to certain performance standards. Options may vest earlier subject to the discretion of the board of directors. LOWELL W. GIFFHORN. We entered into an employment agreement dated as of July 23, 1998 with Mr. Giffhorn providing for his employment as our Chief Financial Officer. The agreement is for a three year term providing for a base salary of $110,000 per annum for the first year and not less than $110,000 per annum during the second and third years of the agreement. The base salary may be increased at the discretion of the board of directors. The agreement provides for a bonus up to 50% of the annual base consideration for the applicable year. We may terminate Mr. Giffhorn's employment with or without cause, but termination without cause (other than disability or death) would result in a lump sum severance payment equal to four months of his then current base salary. If within twelve months of a change in control, as defined in the agreement, Mr. Giffhorn's employment is terminated for other than cause or if Mr. Giffhorn refuses to accept or voluntarily resigns from a position other than a qualified position, as that term is defined in the agreement, he will receive a lump sum severance payment equal to twelve months of his then current salary. JAYANTA K. MAITRA. We entered into an employment agreement dated January 1, 1997 with Mr. Maitra providing for his employment as Vice President of Engineering. The agreement is for a three year term providing for a base salary of $104,400 per year with an increase in the second and third years as recommended by the President and Chief Executive Officer and approved by the board of directors. Mr. Maitra's salary was increased to $120,000 for the second year. The agreement provides for incentive bonuses in certain instances of up to 50% of the total yearly base compensation. We may terminate Mr. Maitra's employment with or without cause, but termination without cause (other than disability or death) during the first year of the agreement would result in a lump sum severance payment equal to twelve months salary. Under the agreement, we originally granted Mr. Maitra options to purchase 500,000 common shares, 50,000 vesting on December 26, 1996 and the balance vesting one-third per year starting December 31, 1997 subject to certain performance standards. As a result of not meeting the performance standards, the board of directors canceled 300,000 of such options. Options may vest earlier subject to the discretion of the board of directors. 54 57 PRINCIPAL SHAREHOLDERS The following table sets forth, as of July 8, 1999, the stock ownership of each officer and director of ours, of all officers and directors of ours as a group, and of each person known by us to be a beneficial owner of 5% or more of our common stock. Except as otherwise noted, each person listed below is the sole beneficial owner of the shares and has sole investment and voting power over such shares. No person listed below has any option, warrant or other right to acquire additional securities of ours, except as otherwise noted.
Name and Address of Amount & Nature Title of Class Beneficial Owner of Beneficial Owner Percent of Class - -------------- ---------------- ------------------- ---------------- Common Stock par value $.00001 Gloria Felcyn, CPA 9,092,535 (1) 21.6% 14395 Saratoga Ave., Suite 100 Saratoga, CA 95070 Same Helmut Falk Family 6,092,535 (3) 14.5% Trust Gloria Felcyn, Trustee 14395 Saratoga Ave., Suite 110 Saratoga, CA 95070 Same Elwood G. Norris 4,252,500 (4) 10.1% 10989 Via Frontera San Diego, CA 92127 Same nanoTronics 3,000,000 (2) 7.1% Corporation Attn: Gloria Felcyn, CPA 14395 Saratoga Ave., Suite 110 Saratoga, CA 95070 Same Jayanta K. Maitra 298,095 (4) * 10989 Via Frontera San Diego, CA 92127 Same James T. Lunney 233,334 (5) * 10989 Via Frontera San Diego, CA 92127 Same Donald R. Bernier 125,000 (4) * 10989 Via Frontera San Diego, CA 92127 Same Philip Morettini 121,000 (4) * 10989 Via Frontera San Diego, CA 92127 Same Lowell W. Giffhorn 120,000 (5) * 10989 Via Frontera San Diego, CA 92127
55 58
Name and Address of Amount & Nature Title of Class Beneficial Owner of Beneficial Owner Percent of Class - -------------- ---------------- ------------------- ---------------- Same Robert Putnam 75,000 (4) * 10989 Via Frontera San Diego, CA 92127 Same Helmut Falk, Jr. 50,000 (5) * 10989 Via Frontera San Diego, CA 92127 Same Frederick G. Thiel 50,000 (5) * 10989 Via Frontera San Diego, CA 92127 Same Richard G. Blum 50,000 (5) * 10989 Via Frontera San Diego, CA 92127 Same All directors & 5,374,929 (6) 12.8% officers as a group (10 persons)
- ---------- * Less than 1%. (1) As trustee of the Helmut Falk Family Trust and executor of the Helmut Falk estate, Ms. Felcyn effectively controls the shares described in Notes 2 and 3 below. (2) These shares have been issued but are subject to an escrow arrangement as described in "Certain Transactions." The shares were originally issued to nanoTronics in connection with the ShBoom technology acquisition. (3) These shares remain from 5,000,000 non-escrowed shares and 2,000,000 shares released from escrow, which were issued to nanoTronics in connection with the ShBoom technology acquisition. These shares were subsequently transferred to the Helmut Falk Family Trust. (4) For Mr. Norris, the amount includes 100,000 shares, for each of Mssrs. Bernier and Putnam the amount includes 50,000 shares, for Mr. Maitra the amount includes 110,753 shares, and for Mssrs. Morettini the amount includes 120,000 shares issuable upon the exercise of immediately exercisable outstanding stock options granted pursuant to the 1996 and 1992 Stock Option Plans. (5) Consists entirely of shares issuable upon the exercise of outstanding stock options. (6) Includes 4,449,842 shares issued and outstanding and 934,087 shares issuable upon exercise of stock options. CERTAIN TRANSACTIONS There were no transactions, or series of transactions, during fiscal 1997 or 1998, nor are there any currently proposed transactions, or series of transactions, to which we are a party, in which the amount exceeds $60,000, and in which to our knowledge any director, executive officer, nominee, five percent or greater shareholder, or any member of the immediate family of any of the foregoing persons, have or will have any direct or indirect material interest other than 56 59 as described below. Based on the asset purchase agreement and plan of reorganization dated June 22, 1994 between Patriot, nanoTronics Corporation and Helmut Falk, we issued a total of 10,000,000 restricted common shares to nanoTronics, 5,000,000 of which are a contingent payment subject to the terms of an earnout escrow. These shares were issued in consideration of technology acquired. nanoTronics was formed in 1991 and acquired certain base technology for a simplified 32-bit microprocessor integrated on a single chip with merged stack/register architecture. nanoTronics expended in excess of $1.9 million (unaudited) while engaged in further development of that technology and produced from the basic architecture an enhanced microprocessor (ShBoom-architecture microprocessor). In connection with the acquisition, we also acquired certain fixed assets including a SunSparc 2 workstation and various terminals, peripheral devices and software. A majority of the expenditures by nanoTronics consisted of microprocessor and related software development costs. The result of these efforts was a successful initial fabrication of the microprocessor in early 1994 demonstrating technical feasibility of the ShBoom architecture. nanoTronics also expended funds on the preparation and prosecution of patent applications. The shares were issued to nanoTronics of which Falk was the sole shareholder. Although 5,000,000 of the shares issued were subject to the terms of an earnout escrow, as more fully described below, the shares are issued for the purpose of dividends and voting. Prior to the transaction, Mr. Falk was an unaffiliated person with respect to us. At the time of issuance the 10,000,000 common shares represented approximately 36% of our total issued and outstanding shares. Although the transaction did not result in a majority change in our board of directors, or a majority change in our stock ownership, the issuance of new stock resulted in a large percentage ownership controlled by one entity with the ability to have significant influence over our future affairs. Based on the terms of the purchase agreement, 5,000,000 of the common shares were issued to nanoTronics subject to an earnout escrow arrangement as a contingent purchase price. The terms of the escrow arrangement, as defined in the purchase agreement, provides for the earnout from escrow of 500,000 common shares for each $500,000 of Patriot revenues commencing June 1, 1994 and ending May 31, 1999. The purchase agreement also provides for full earnout on other major corporate events including a sale of substantially all our assets, certain mergers, combinations or consolidations, certain tender offers and upon a liquidation or dissolution. Any shares not earned by May 31, 1999 would be canceled. The shares may be sold, assigned or transferred within the escrow arrangement but would still be subject to the escrow terms. As of May 31, 1999: - 2,000,000 shares had been released from escrow, - an additional 2,000,000 shares have been earned and charged to compensation costs but remain in escrow pending the resolution of litigation between us, nanoTronics, and 57 60 the Fish Family Trust, and - 1,000,000 shares will be returned to us since the earnout expires as of May 31, 1999 and the revenue was not sufficient to earn this portion of the escrowed shares. We have granted certain registration and information rights with respect to the shares issued to nanoTronics, such rights being assignable to Falk and the Fish Family Trust (such trust having certain rights to become a shareholder in nanoTronics). We have been advised that nanoTronics has been liquidated with the 10,000,000 shares in the process of being transferred to the Helmut Falk Family Trust which is entitled to the same registration rights. We are obligated to use our best efforts to effect a registration upon written request up to two times subject to certain limitations. We are also obligated to include the shares, subject to certain limitations, in any underwriting and in any other registration filed by us. During January 1999 through April 1999, we entered into four short-term notes with Gloria Felcyn, the trustee for the Falk Family Trust, accumulating $175,000 with maturity dates ranging from July 18, 1999 to August 17, 1999. On the issuance of each of the first three notes, we released 500,000 shares from the earnout escrow. We are holding the remaining 2,000,000 shares earned and subject to the earnout escrow pending resolution of the Fish Family Trust lawsuit. Upon the resolution of the lawsuit, the remaining shares held in escrow will either be released to the Falk Family Trust, used either partially or in their entirety as a means of settling the lawsuit, or be returned to us. The shares being held in escrow were recorded as additional compensation costs during the period in which the earnout was satisfied. We entered into an agreement to exchange technology for stock dated August 8, 1989 with Mr. Norris. Under the agreement, Mr. Norris is entitled to a royalty equal to two and one-half percent (2.5%) of the gross revenues received by us directly or indirectly from exploitation of our ground penetrating radar technology (up to a maximum royalty of $400,000). Mr. Norris was given an advance royalty payment of $17,000. Mr. Norris also is entitled to a cash bonus of $50,000 within 45 days after we successfully demonstrate a working prototype of a ground penetrating radar unit meeting specified performance criteria and a request for such bonus is made to the board of directors and approved. TRADING MARKET AND RELATED MATTERS Our common stock is traded in the over-the-counter market and is quoted on the NASD OTC Bulletin Board system maintained by the National Association of Securities Dealers, Inc. Prices reported represent prices between dealers, do not include markups, markdowns or commissions and do not necessarily represent actual transactions. The market for our shares has been sporadic and at times very limited. The following table sets forth the high and low bid quotations for the common stock for the nine months ended February 28, 1999 and the fiscal years ended May 31, 1998 and 1997. 58 61
HIGH LOW Nine Months Ended February 28, 1999 First Quarter $0.77 $0.41 Second Quarter 0.81 0.38 Third Quarter 0.60 0.30 Fiscal Year Ended May 31, 1998 First Quarter $2.31 $1.36 Second Quarter 1.78 1.00 Third Quarter 1.15 0.53 Fourth Quarter 1.36 0.72 Fiscal Year Ended May 31, 1997 First Quarter $3.50 $1.75 Second Quarter 2.44 1.75 Third Quarter 1.83 0.94 Fourth Quarter 1.62 0.94
We have approximately 254 shareholders of record as of July 8, 1999. At July 8, 1999 there were 40,861,120 shares of common stock issued and outstanding. We have never paid a cash dividend on our common stock and do not expect to pay one in the foreseeable future. DESCRIPTION OF SECURITIES Our authorized capital stock consists of 60,000,000 shares of common stock, $.00001 par value per share. At July 8, 1999, a total of 40,861,120 common shares were issued and outstanding. The holders of common stock are entitled to one vote for each share held. The affirmative vote of a majority of votes cast at a meeting which commences with a lawful quorum is sufficient for approval of most matters upon which shareholders may or must vote, including the questions presented for approval or ratification at the Annual Meeting. However, removal of a director from office or repeal of the certificate of incorporation in its entirety require the affirmative vote of a majority of the total voting power for approval, and certain other matters (such as shareholder amendment of the bylaws, and amendment, repeal or adoption of any provision inconsistent with provisions in the certificate of incorporation regarding indemnification of directors, officers and others, exclusion of director liability, and our election not to be governed by statutory provisions concerning business combinations with interested shareholders) require the affirmative vote of two-thirds of the total voting power for approval. Common shares do not carry cumulative voting rights, and holders of more than 50% of the common stock have the power to elect all directors and, as a practical matter, to control the company. Holders of common stock are not entitled to preemptive rights, and the common stock may only be redeemed at our election. A special meeting of shareholders may be called by or at the request of: 59 62 - the Chairman of the Board, - the President or any two directors, and - persons owning in the aggregate not less than 20% of the issued and outstanding common shares entitled to vote in elections for directors. After the satisfaction of requirements with respect to preferential dividends, if any, holders of common stock are entitled to receive, pro rata, dividends when and as declared by the board of directors out of funds legally available therefor. Upon our liquidation, dissolution or winding-up, after distribution in full of the preferential amount, if any, to be distributed to holders of the preferred stock, holders of common stock are entitled to share ratably in our assets legally available for distribution to our shareholders. Our board of directors is authorized to issue 5,000,000 shares of undesignated preferred stock, $.00001 par value, without any further action by the stockholders. The board of directors may also divide any and all shares of preferred stock into series and fix and determine the relative rights and preferences of the preferred stock, such as the designation of series and the number of shares constituting such series, dividend rights, redemption and sinking fund provisions, liquidation and dissolution preferences, conversion or exchange rights and voting rights, if any. Issuance of preferred stock by the board of directors will result in such shares having dividend and/or liquidation preferences senior to the rights of the holders of common stock and could dilute the voting rights of the holders of common stock. There are currently no shares of preferred stock issued and outstanding. We have not paid any cash dividends to date, and no cash dividends will be declared or paid on the common shares in the foreseeable future. Payment of dividends is solely at the discretion of our board of directors. Interwest Transfer Company, Inc., 1981 East 4800 South, Suite 100, Salt Lake City, Utah 84117, acts as our transfer agent and registrar for our common stock. Their telephone number is (801) 272-9294. LEGAL MATTERS Luce, Forward, Hamilton & Scripps LLP, 600 West Broadway Street, Suite 2600, San Diego, California 92101 will pass on the validity of the common stock offered by us. Luce, Forward, Hamilton & Scripps LLP owns 279,326 shares of our common stock, which it received in consideration of services rendered. These shares are offered as part of this prospectus. EXPERTS The financial statements included in this Prospectus and in the Registration Statement have been audited by BDO Seidman, LLP, independent certified public accountants, to the extent and for the periods set forth in their report (which contains an explanatory paragraph regarding the Company's ability to continue as a going concern) appearing elsewhere herein and in the Registration Statement, and are included herein in reliance upon such report given upon the authority of said firm as experts in auditing and accounting. 60 63 Harlan & Boettger, LLP, independent certified public accountants for the fiscal year ended July 31, 1996, have audited the financial statements of Metacomp, Inc.. Their report appears elsewhere herein and in the registration statement. We are including and relying upon such report based on the authority of said firm as experts in accounting and auditing. 61 64 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Reports of Independent Certified Public Accountants...................... F-2-F-4 Consolidated Balance Sheet as of May 31, 1998............................ F-5 Consolidated Statements of Operations for the Years Ended May 31, 1998 and 1997.............................................. F-6 Consolidated Statements of Stockholders' Equity for the Years Ended May 31, 1998 and 1997........................................ F-7 Consolidated Statements of Cash Flows for the Years ended May 31, 1998 and 1997.............................................. F-8 Summary of Accounting Policies........................................... F-9-F-13 Notes to Consolidated Financial Statements............................... F-14 -F-27 Consolidated Balance Sheets as of February 28, 1999 (unaudited) and May 31, 1998 ............................................... F-28 Consolidated Statements of Operations for the nine months and three months ended February 28, 1999 and 1998 (unaudited) ............ F-29 Consolidated Statements of Cash Flows for the nine months ended February 28, 1999 and 1998 (unaudited) ......................... F-30 Notes to Consolidated Financial Statements ............................. F-31- F-39
F-1 65 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors Patriot Scientific Corporation San Diego, California We have audited the accompanying consolidated balance sheet of Patriot Scientific Corporation as of May 31, 1998 and the related statements of operations, stockholders' equity and cash flows for each of the years in the two year period ended May 31, 1998. 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 audits. The consolidated financial statements give retroactive effect to the merger of Patriot Scientific Corporation and Metacomp, Inc., which has been accounted for as a pooling of interests as described in Note 1 to the consolidated financial statements. As discussed in Note 1 to the consolidated financial statements, we did not audit the financial statements of Metacomp, Inc., the Company's majority owned subsidiary for its fiscal year ended July 31, 1996, of which total revenues of $239,501 are included in the consolidated financial statements for the year ended May 31, 1997. In addition, we did not audit the extraordinary item of $1,741,700 as discussed in Notes 1 and 11 to the consolidated financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts incurred for Metacomp, Inc. for the year ended May 31, 1997 is based solely on the report of such other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements 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 and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above, present fairly, in all material respects, the financial position of Patriot Scientific Corporation as of May 31, 1998, and the results of their operations and their cash flows for each of the years in the two year period ended May 31, 1998 in conformity with generally accepted accounting principles. As discussed in Note 15, the accompanying consolidated financial statements have been restated to reflect the effect of a change in the accounting treatment for escrowed shares of common stock. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 16 to the consolidated financial statements, the Company has suffered from recurring net losses and negative cash flow from operations that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 16. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ BDO Seidman, LLP Denver, Colorado July 17, 1998, except for notes 4 and 15 which are as of June 15, 1999 and note 16 which is as of July 14, 1999 F-2 66 (Harlan & Boettger Certified Public Accountants Letterhead) REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of METACOMP, INC.: We have audited the balance sheet of METACOMP, Inc. a California Corporation, as of July 31, 1996, and the related statements of operations, changes in shareholders' equity, and cash flows for the year 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 audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of July 31, 1996, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. /s/ Harlan & Boettger San Diego, California December 17, 1996 F-3 67 PATRIOT SCIENTIFIC CORPORATION Consolidated Balance Sheet (As restated)
May 31, 1998 - --------------------------------------------------------------------------------------------- ASSETS Current assets: Cash and cash equivalents $ 602,456 Accounts receivable, net of allowance of $5,000 for uncollectible accounts 593,542 Inventories (Note 2) 230,417 Prepaid expenses 109,365 - --------------------------------------------------------------------------------------------- Total current assets 1,535,780 Property and equipment, net (Note 3) 453,211 Other assets: Patents and trademarks, net 196,942 Other 3,721 - --------------------------------------------------------------------------------------------- Total other assets 200,663 - --------------------------------------------------------------------------------------------- $ 2,189,654 ============================================================================================= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 391,184 Accrued liabilities 131,088 Current portion-capital lease obligations (Note 10) 2,179 - --------------------------------------------------------------------------------------------- Total current liabilities 524,451 - --------------------------------------------------------------------------------------------- Long-term liabilities: Capital lease obligations (Note 10) 1,355 5% Convertible term debentures (Note 5) 507,000 - --------------------------------------------------------------------------------------------- Total liabilities 1,032,806 - --------------------------------------------------------------------------------------------- Commitments and contingencies (Note 10) Stockholders' equity (Notes 6, 9 and 11): Preferred stock, $.00001 par value; 5,000,000 shares authorized: none outstanding -- Common Stock, $.00001 par value; 60,000,000 shares authorized: issued and outstanding 37,880,776 379 Additional paid-in capital 20,741,092 Accumulated deficit (19,584,623) - --------------------------------------------------------------------------------------------- Total stockholders' equity 1,156,848 - --------------------------------------------------------------------------------------------- $ 2,189,654 =============================================================================================
See accompanying summary of accounting policies and notes to consolidated financial statements. F-4 68 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (As restated)
(SEE NOTE 1) Years Ended May 31, 1998 1997 - ---------------------------------------------------------------------------------------- Net sales (Note 12) $ 1,902,874 $ 1,847,421 Cost of sales: Product costs 960,688 893,445 Inventory obsolescence 203,000 110,000 - ---------------------------------------------------------------------------------------- Cost of sales 1,163,688 1,003,445 - ---------------------------------------------------------------------------------------- Gross profit 739,186 843,976 Operating expenses: Research and development 1,607,828 1,367,937 Selling, general and administrative 4,090,937 2,448,751 Amortization -- 612,333 - ---------------------------------------------------------------------------------------- 5,698,765 4,429,021 - ---------------------------------------------------------------------------------------- Operating loss (4,959,579) (3,585,045) - ---------------------------------------------------------------------------------------- Other income (expenses): Interest income 61,610 39,302 Interest expense (24,370) (30,491) Non-cash interest expense related to convertible notes (Note 5) (2,592,446) (392,015) - ---------------------------------------------------------------------------------------- (2,555,206) (383,204) - ---------------------------------------------------------------------------------------- Net loss before extraordinary item (7,514,785) (3,968,249) Extraordinary income (Note 11) -- 1,779,457 - ---------------------------------------------------------------------------------------- Net loss $ (7,514,785) $ (2,188,792) ======================================================================================== Basic and diluted income (loss) per common share (Note 7): Before extraordinary item $ (0.24) $ (0.15) Extraordinary income -- 0.07 - ---------------------------------------------------------------------------------------- Basic and diluted (loss) per common share $ (0.24) $ (0.08) ======================================================================================== Weighted average number of common shares outstanding during the period (Note 7) 31,016,956 27,250,755 ========================================================================================
See accompanying summary of accounting policies and notes to consolidated financial statements. F-5 69 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (See Note 1) (As restated)
- ----------------------------------------------------------------------------------------------------------------------------------- Years Ended May 31, 1998 and 1997 Common Stock Additional Total ------------------------------- Paid-in Accumulated Stockholders' Shares Amount Capital Deficit Equity - ----------------------------------------------------------------------------------------------------------------------------------- Balance, June 1, 1996 30,985,257 $ 310 $ 10,151,024 $ (8,139,346) $ 2,011,988 Exercise of warrants at $1.58 per share 154,883 2 239,499 -- 239,501 Common stock issued for services at $1.28 per share 22,600 -- 28,927 -- 28,927 Exercise of stock options at $.18 to $.625 per share 380,486 4 165,857 -- 165,861 Non-cash interest expense related to convertible notes recorded to additional paid-in capital (Note 6) -- -- 375,000 -- 375,000 Non-cash compensation expense (Note 6) -- -- 291,180 -- 291,180 Common stock earned under an escrow agreement for purchased technology at $1.44 per share (Note 4) -- -- 725,000 725,000 Conversion of 6% Convertible Subordinated Notes plus interest at $.85 to $1.27 per share (Note 6) 1,525,103 15 1,517,000 -- 1,517,015 Adjustment for Metacomp Inc. pooling of interests from year- end change (Note 1) -- -- - (1,741,700) (1,741,700) Net loss -- -- - (2,188,792) (2,188,792) - ----------------------------------------------------------------------------------------------------------------------------------- Balance, May 31, 1997 33,068,329 331 13,493,487 (12,069,838) 1,423,980 ================================================================================================================================== Common stock earned under an escrow agreement for purchased technology at $.75-$1.41 per share (Note 4) -- -- 1,995,000 1,995,000 Exercise of stock options at $.18 to $.875 per share 478,854 5 247,802 247,807 Non-cash interest expense related to convertible notes recorded to additional paid-in capital (Note 5) -- -- 2,018,111 2,018,111 Unamortized debt issuance costs related to convertible notes -- -- (114,100) (114,100) Conversion of 5% Convertible term debentures plus interest at $.50 to $1.09 per share (Note 5) 4,333,593 43 2,523,292 2,523,335 Value of warrants issued (Note 6) -- -- 577,500 577,500 Net loss -- -- - (7,514,785) (7,514,785) - ----------------------------------------------------------------------------------------------------------------------------------- Balance, May 31, 1998 37,880,776 $ 379 $ 20,741,092 $ (19,584,623) $ 1,156,848 ==================================================================================================================================
See accompanying summary of accounting policies and notes to consolidated financial statements. F-6 70 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (As restated)
- ---------------------------------------------------------------------------------------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS Years Ended May 31, 1998 1997 - ---------------------------------------------------------------------------------------------- OPERATING ACTIVITIES: Net loss $(7,514,785) $(2,188,792) Adjustments to reconcile net loss to cash used in operating activities: Adjustment for Metacomp Inc. pooling of interests from year-end change (Note 1) -- (1,741,700) Amortization and depreciation 341,072 836,692 Provision for doubtful accounts 41,761 5,000 Provision for inventory obsolescence 203,000 110,000 Common stock and warrants issued for services 33,500 28,927 Non -cash interest expense related to convertible notes 2,096,446 392,015 Non-cash interest expense related to warrants 496,000 -- Amortization of debt issuance costs 140,000 45,000 Non -cash compensation expense 1,995,000 1,016,180 Changes in: Accounts receivable (375,183) (65,719) Inventories 96,116 (28,377) Prepaid and other assets 7,940 (23,163) Accounts payable and accrued expenses 16,053 (74,231) - --------------------------------------------------------------------------------------------- Net cash used in operating activities (2,423,080) (1,688,168) - --------------------------------------------------------------------------------------------- INVESTING ACTIVITIES - Purchase of property, equipment and patents (417,225) (238,447) FINANCING ACTIVITIES: Principal payments on notes payable and long-term debt (2,721) (320,016) Proceeds from issuance of common stock and exercise of common stock warrants and options 247,807 405,362 Proceeds from issuance of convertible notes 3,000,000 1,500,000 Payments for debenture costs (280,000) (45,000) - --------------------------------------------------------------------------------------------- Net cash provided by financing activities 2,965,086 1,540,346 - --------------------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 124,781 (386,269) CASH AND CASH EQUIVALENTS, beginning of year 477,675 863,944 - --------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, end of year $ 602,456 $ 477,675 ============================================================================================== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Convertible notes and accrued interest exchanged for common stock $ 2,409,236 $ 1,500,000 Cash payments for interest 383 30,491 - ---------------------------------------------------------------------------------------------
See accompanying summary of accounting policies and notes to consolidated financial statements. F-7 71 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES ORGANIZATION AND BUSINESS Patriot Scientific Corporation (the "Company") is engaged in the development, marketing, and sale of patented microprocessor technology and high-performance high-speed data communication products. The Company also owns and is developing innovative radar and antenna technology. BASIS OF PRESENTATION AND CONSOLIDATION The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include the accounts of the Company, its majority owned subsidiaries, Metacomp, Inc. ("Metacomp") and Plasma Scientific Corporation. All material intercompany transactions and balances have been eliminated in consolidation. As described in Note 1, effective December 26, 1996, the Company acquired 96.9% of the common stock of Metacomp. The business combination was accounted for as a pooling of interests and, accordingly, the Company's financial statements have been presented to include the results of Metacomp as though the business combination occurred as of June 1, 1995. The minority interest is not shown separately in the Consolidated Financial Statements as it is not material. FINANCIAL INSTRUMENTS AND 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 accounts receivable. The Company's cash equivalents are placed in high quality money market accounts with major financial institutions and high grade short-term commercial paper. The investment policy limits the Company's exposure to concentrations of credit risk. Money market accounts are federally insured; however, commercial paper is not insured. The Company has not experienced any losses in such accounts. Concentrations of credit risk with respect to accounts receivable are limited due to the wide variety of customers and markets which comprise the Company's customer base, as well as their dispersion across many different geographic areas. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. Generally, the Company does not require collateral or other security to support customer receivables. As of May 31, 1998, the Company had approximately 35% and 27% in accounts receivable from two customers. The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, capital leases and convertible debt approximated fair value because of the immediate or short-term maturity of these instruments. F-8 72 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) INVENTORIES Inventories consist of raw materials, work in process and finished goods and are valued at the weighted average cost method, which approximates cost on a first-in, first-out basis, not in excess of market value. PROPERTY, EQUIPMENT AND DEPRECIATION Property and equipment are stated at cost. Depreciation is computed over the estimated useful life of three to five years using the straight line method. The Company follows the provisions of the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed Of." Long-lived assets and certain identifiable intangibles to be held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company continuously evaluates the recoverability of its long-lived assets based on estimated future cash flows from and the estimated fair value of such long-lived assets, and provides for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the long-lived asset. PURCHASED TECHNOLOGY In accordance with the provisions of FASB Interpretation No. 4, "Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method", purchased semiconductor microprocessor technology that is determined to have alternative future uses is capitalized at cost. Effective June 1, 1994, the Company began amortizing such technology using the straight-line method over its estimated useful life of three years (See Note 4). As of May 31, 1998, the purchased technology was fully amortized. Purchased technology is assessed periodically for impairment. The amount of impairment, if any, is charged to operations. The Company recovers its investments in purchased technology based upon net cash flows from future sales and license agreements. PATENTS AND TRADEMARKS Patents and trademarks are carried at cost less accumulated amortization and are amortized over their estimated useful lives of four years. The carrying value of patents and trademarks is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from individual intangible assets is less than its carrying value determined based on the provisions of SFAS No. 121 as discussed above. REVENUE RECOGNITION Revenue is recognized upon the shipment of product to the customer. Licensing and royalty income is recognized when earned. F-9 73 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) RESEARCH AND DEVELOPMENT COSTS Research and development costs are expensed as incurred. INCOME TAXES The Company accounts for income taxes under SFAS No. 109. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. NET LOSS PER SHARE At May 31, 1998, the Company implemented SFAS No. 128, "Earnings Per Share." SFAS No. 128 provides for the calculation of "Basic" and "Diluted" earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted earnings per share. All prior earnings per share data has been restated to reflect the requirements of SFAS No.128. The adoption of SFAS No. 128 had no effect on the Company's previously reported earnings per share. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. During the quarter ended May 31, 1998, based upon information then available, the Company revised its estimates regarding the recovery of certain inventories. As a result, the Company increased existing reserves for obsolescence by approximately $203,000. STOCK OPTIONS The Company applies Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for all stock option plans. Under APB Opinion 25, compensation cost has been recognized for stock options granted to employees when the option price is less than the market price of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," requires the Company to provide pro forma information regarding net income as if compensation cost for the Company's stock option plans had been determined in accordance with the fair value based method prescribed in SFAS No. 123. To provide the required pro forma information, the Company estimates the fair value of each stock option at the grant date by using the Black-Scholes option-pricing model. F-10 74 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) STATEMENT OF CASH FLOWS For purposes of the statement of cash flows, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. RECENT ACCOUNTING PRONOUNCEMENTS The FASB has issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 130 establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owner and distributions to owners. Among other disclosures, SFAS No. 130 requires that all items that are required to be recognized under current accounting standards as components of comprehensive income be reported in a financial statement that displays with the same prominence as other financial statements. SFAS No. 131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes standards on the way that public companies report financial information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial statements issued to the public. It also establishes standards for disclosure regarding products and services, geographic areas and major customers. SFAS No. 131 defines operating segments as components of a company about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. SFAS 130 and 131 are effective for financial statements for periods beginning after December 15, 1997 and require comparative information for earlier years to be restated. Because of the recent issuance of the standards, management has been unable to fully evaluate the impact, if any, the standards may have on future financial statement disclosures. Results of operations and financial position, however, will be unaffected by implementation of these standards. In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits" which standardizes the disclosure requirements for pensions and other postretirement benefits and requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis. SFAS No. 132 is effective for years beginning after December 15, 1997 and requires comparative information for earlier years to be restated, unless such information is not readily available. Management believes the adoption of this statement will have no material impact on the Company's financial statements. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair market value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging F-11 75 PATRIOT SCIENTIFIC CORPORATION SUMMARY OF ACCOUNTING POLICIES (CONTINUED) relationship must be highly effective in achieving offsetting changes in fair value or cash flows. SFAS No. 133 is effective for fiscal periods beginning after June 15, 1999. Management believes the adoption of this statement will have no material impact on the Company's financial statements. RECLASSIFICATIONS Certain items included in the 1997 financial statements have been reclassified to conform to the current year presentation. F-12 76 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ACQUISITION OF METACOMP, INC. COMMON STOCK On December 26, 1996, the Company acquired 96.9% of the common stock of Metacomp in exchange for 1,272,068 shares of the Company's common stock. Metacomp designs, manufactures, and sells high-performance high-speed data communication products. The business combination was accounted for as a pooling of interests. Accordingly, the Company's financial statements were restated to include the results of Metacomp for all periods presented. Metacomp's fiscal year-end was changed from July 31 to May 31 to conform to the Company's fiscal year-end. Based on the difference in fiscal year-ends, results of operations for the two months ended July 31, 1996 were included in the consolidated statements of operations for both years ended May 31, 1997 and 1996. For the two months ended July 31, 1996, Metacomp recorded total revenues of $239,501, a net loss before extraordinary item of $37,759, extraordinary income of $1,779,457 and net income after extraordinary item of $1,741,700. The accompanying consolidated statements of stockholders' equity and cash flows for the year ended May 31, 1997, have also been adjusted to eliminate the net income after extraordinary item. The extraordinary income was the primary source of income for these two months. Separate net sales, net income and related per share amounts of the merged entities through the date of the business combination are presented in the following table. In addition, the table includes unaudited pro forma net income and net income per share amounts as of the date of the business combination which reflect the elimination of the nonrecurring merger costs and expenses.
1997 - -------------------------------------------------------------- Net sales Patriot $ 19,362 Metacomp 874,377 - -------------------------------------------------------------- Total $ 893,739 - -------------------------------------------------------------- Net income (loss) Patriot $(1,202,485) Metacomp before extraordinary income 40,706 Metacomp extraordinary income 1,779,457 - -------------------------------------------------------------- Pro forma net income 617,678 Merger costs and expenses (30,000) Interest income (6,000) Interest expense 15,625 - -------------------------------------------------------------- Net income, as reported $ 597,303 - -------------------------------------------------------------- Basic income per common share As reported $ 0.02 Pro forma $ 0.02
Merger costs and expenses consisted of legal and accounting fees. F-13 77 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. INVENTORIES Inventories at May 31, 1998 consisted of the following:
---------------------------------------------------- Component parts $ 418,502 Work in process 60,136 Finished goods 116,779 ------------ 595,417 Reserve for obsolescence (365,000) ------------ $ 230,417 ----------------------------------------------------
3. PROPERTY AND Property and equipment consisted of the following at May 31, EQUIPMENT 1998:
---------------------------------------------------------- Computer equipment and software $1,101,418 Furniture and fixtures 286,732 Laboratory equipment 197,534 ---------------------------------------------------------- 1,585,684 Less accumulated depreciation and amortization 1,132,473 ---------------------------------------------------------- Net property and equipment $ 453,211 ----------------------------------------------------------
Depreciation expense was approximately $281,130 and $184,055 for the years ended May 31, 1998 and 1997. At May 31, 1998, property and equipment includes certain equipment under capital lease agreements with an original cost of $36,427 and accumulated depreciation of $28,084. 4. PURCHASED TECHNOLOGY SEMICONDUCTOR MICROPROCESSOR TECHNOLOGY Effective May 31, 1994, the Company acquired certain proprietary semiconductor microprocessor technology (the "ShBoom Technology") and related computer software from a corporation in exchange for 10,000,000 restricted shares of the Company's common stock (5,000,000 of which were originally placed in escrow subject to an earnout arrangement as discussed below). F-14 78 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The cost of this technology of $1,875,000 was based upon the estimated current fair market value of the 5,000,000 non-contingent shares of the Company's common stock issued under this agreement and was amortized over its estimated useful life of three years. The remaining 5,000,000 shares issued for this technology were subject to an earnout escrow arrangement. As such, when the escrowed shares are earned, they are charged to compensation costs. The terms of the escrow arrangement provide for an earnout formula of 500,000 shares for each $500,000 of revenues earned by the Company during the period from June 1, 1994 through May 31, 1999. Additionally, this agreement also provides for the full earnout of these shares if during the earnout period there is (i) any sale of the assets of the Company, (ii) a business combination with another entity where the Company is not the surviving entity, (iii) at least 75% of the Company's stock is tendered to another organization, or (iv) a liquidation or dissolution of the Company. Any of the contingent shares not earned by May 31, 1999 would be returned to the Company and canceled. During the years ended May 31, 1997 and 1998, 500,000 shares and 2,000,000 shares, respectively, were earned as a result of the arrangement and $725,000 and $1,995,000, respectively, were charged to compensation costs. The 500,000 shares that were earned during the year ended May 31, 1997 were released during the current year. At May 31, 1998, 4,500,000 shares remain in escrow of which 2,000,000 shares have been earned and charged to compensation cost but remain in escrow pending the outcome of a lawsuit between the Company, nanoTronics and the Fish Family Trust as discussed in Note 14 to the Consolidated Financial Statements. Upon the resolution of the lawsuit, the remaining shares held in escrow will either be released to the Falk Family Trust, used either partially or in their entirety as a means of settling the lawsuit, or be returned to the Company. At May 31, 1998, the 2,500,000 shares that have not met the earnout arrangement have been excluded from the calculation of basic or diluted earnings per share. RADAR TECHNOLOGY Effective August 8, 1989, the Company acquired certain proprietary ground penetrating radar ("GPR") technology from a current director of the Company, primarily in exchange for 5,000,000 shares of the Company's common stock. Such shares were subject to an escrow agreement and were releaseable to the director under various specified conditions including the Company's subsequent merger or business combination with any third party. As a result of the Company's acquisition of the ShBoom, these 5,000,000 shares were released to the director and the escrow agreement was terminated. Effective May 31, 1994, additional costs totaling $1,875,000 of this previously purchased GPR technology was recorded as compensation costs due to the release of the 5,000,000 shares. Such cost was based upon the estimated current fair market value of the Company's common stock. Additionally, under the terms of the agreement to acquire the GPR technology, the director is to be paid a royalty equal to 2.5% of all gross revenues received from the GPR technology, up to a F-15 79 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) maximum of $400,000. The director also is to receive a $50,000 bonus upon the successful demonstration of a working prototype of the technology meeting specified performance criteria. As of May 31, 1998, no amounts were due under this agreement; however, an advance of $17,000 against the royalty was paid at the inception of the agreement. 5. 5% CONVERTIBLE TERM DEBENTURES In June 1997, the Company issued to a limited number of investors for cash an aggregate of $2,000,000 of unsecured 5% Convertible Term Debentures due June 2, 1999 ("Debentures") and Stock Purchase Warrants ("Warrants") with a right to purchase an aggregate 611,733 shares of common stock, par value $.00001 per share, at an exercise price of $1.69125. In November 1997, the Company issued to the same investors for cash an aggregate of $1,000,000 of Debentures due June 2, 1999 and Warrants with a right to purchase an aggregate 305,867 shares of common stock, par value $.00001 per share, at an exercise price of $1.50. The principal and interest amount of each Debenture may, at the election of the holder, be converted in whole or in part and from time to time into fully paid and nonassessable shares of common stock, $.00001 par value, of the Company, at a price which is the lower of (i) $1.1646 per share or (ii) depending on the number of days the Debentures have been held after June 2, 1997, from 75% to 91% of the average of the closing bid prices for the common stock for the ten consecutive trading days ending on the trading day immediately preceding such conversion date. If the Debentures have not been converted into common shares of the Company by June 2, 1999, under certain conditions, the Debentures will automatically be converted into shares of the common stock of the Company. As of May 31, 1998, $2,445,000 of the Debentures and $78,335 of the accrued interest thereon had been converted into 4,333,593 common shares of the Company. Convertible debt instruments which are convertible at a discount to market are accounted for by treating such discount as additional interest expense. The Company computed the amount of the discount based on the difference between the conversion price and fair value of the underlying common stock on the dates the Debentures were issued. The Company recorded $2,018,111 of additional paid-in capital for the discount related to the embedded interest in the Debentures during fiscal 1998. The same amount, $2,018,111, was expensed for fiscal 1998 and is included under the caption "Non-cash interest expense related to convertible notes" in the accompanying Consolidated Statements of Operations. The warrants to purchase 917,600 shares of common stock were valued at $544,000. Such amount was originally recorded as a reduction of the carrying amount of the Debentures with an offset to Paid-In Capital. The discount is amortized as additional interest expense over the term of the Debentures. In the fourth quarter of fiscal 1998, $496,000 had been recorded as interest expense. The balance of $48,000 is reflected as a reduction of the Debenture balance of $555,000. F-16 80 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. STOCKHOLDERS' EQUITY PRIVATE OFFERINGS AND WARRANTS During fiscal 1997, a total of 154,883 shares of the Company's common stock were issued upon the exercise of outstanding warrants which had been issued in fiscal 1996. The net proceeds from the exercise were $239,501. During fiscal 1997, the Company issued for cash an aggregate of $1,500,000 of unsecured 6% Convertible Subordinated Promissory Notes due September 30, 1998 ("Notes"). The principal and interest amount of each Note could at the election of the noteholder be converted one or more times into fully paid and nonassessable shares of common stock, $.00001 par value, ("Shares") of the Company, at a price which was the lower of (i) $2.00 per share or (ii) 80% of the average of the five days market price prior to conversion but not less than $0.80 per share. As of May 31, 1997, all Notes plus accrued interest had been converted into 1,525,103 shares of common stock of the Company. Convertible debt instruments which are convertible at a discount to market should be accounted for by treating such discount as additional interest expense. The Company computed the amount of the discount based on the difference between the conversion price and fair value of the underlying common stock on the date the Notes were issued. In 1997, the Company recorded $375,000 of additional paid-in capital for the discount related to the embedded interest in the Notes. This same amount was expensed during fiscal 1997 under the caption "Non-cash interest expense related to convertible notes" in the accompanying Consolidated Statements of Operations. During fiscal 1998, the Company issued warrants to purchase 1,147,600 common shares of stock with exercise prices ranging from $1.25 to $7.50 per share. All warrants were outstanding at May 31, 1998. Included in this amount are warrants to purchase 917,600 common shares related to the Debentures discussed in Note 5 to the consolidated financial statements. The Company valued warrants issued in fiscal 1998 at $577,500. 1992 INCENTIVE STOCK OPTION PLAN ("ISO") The Company has an ISO Plan, expiring May 20, 2002, reserving for issuance 750,000 shares of the Company's common stock. The ISO Plan provides for grants to either full or part time employees, at the discretion of the board of directors, options to purchase common stock of the Company at a price not less than the fair market value of the shares on the date of grant. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the F-17 81 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) fair market value of the share on the date of grant. Any options granted under the ISO Plan must be exercised within ten years of the date they were granted (five years in the case of a significant stockholder). 1992 NON-STATUTORY STOCK OPTION PLAN("NSO") The Company has an NSO Plan, expiring May 20, 2002, reserving for issuance 750,000 shares of the Company's common stock. The NSO Plan provides for grants to either full or part time employees, at the discretion of the board of directors, options to purchase common stock of the Company at a price not less than the fair market value of the shares on the date of grant. Any options granted under the NSO Plan must be exercised within ten years of the date they were granted. 1995 EMPLOYEE STOCK COMPENSATION PLAN ("ESC") Effective October 1995, the Company adopted the ESC Plan, expiring September 30, 1998, reserving for issuance 250,000 shares of the Company's common stock. The ESC Plan provides for compensation awards of the Company's common stock to employees (as defined), at the discretion of the board of directors. During fiscal 1997, the Company issued 22,600 shares of common stock under the Plan recording compensation costs of $28,927 for awards valued at an estimated fair market value of $1.28 per share. During fiscal 1998, no shares were issued under this plan. As of May 31, 1998, 32,400 shares remain available for granting under this plan. 1996 STOCK OPTION PLAN Effective March 1996, the Company adopted the 1996 Stock Option Plan, which was amended by the Stockholders in December 1997, expiring March 24, 2006, reserving for issuance 4,000,000 shares of the Company's common stock. The 1996 Stock Option Plan provides for grants to either full or part time employees, at the discretion of the board of directors, options to purchase common stock of the Company at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 1996 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). During the fiscal year ended May 31, 1997, the Company issued options to purchase 1,713,000 shares of stock under the non-qualified provisions of the plan at an exercise price of 85% of the fair market value on the date of grant and recorded corresponding non-cash compensation in the amount of $291,180. During the fiscal year ended May 31, 1998, the Company issued options to purchase 1,511,000 shares of stock at market value. F-18 82 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SFAS No. 123, "Accounting for Stock-Based Compensation," requires the Company to provide pro forma information regarding net loss and net loss per share as if compensation costs for the Company's stock option plans and other stock awards had been determined in accordance with the fair value based method prescribed in SFAS No. 123. The Company estimates the fair value of each stock award at the grant date by using the Black-Scholes option-pricing model with the following weighted-average assumptions used respectively: dividend yield of zero percent for all years; expected volatility of 50 percent; risk-free interest rates of 5.6 to 6.1 percent; and expected lives of 3 to 5 years. Under the accounting provisions for SFAS No. 123, the Company's net loss per share would have been increased by the pro forma amounts indicated below:
1998 1997 - ----------------------------------------------------------------------------------- As reported Net loss before extraordinary item $ (7,514,785) $ (3,968,249) Extraordinary item -- 1,779,457 ------------- ------------- Net loss $ (7,514,785) $ (2,188,792) ============= ============= Pro forma Net loss before extraordinary item $ (8,451,147) $ (4,460,409) Extraordinary item -- 1,779,457 ------------- ------------- Net loss $ (8,451,147) $ (2,680,952) ============= ============= As reported per share Basic loss before extraordinary item $ (0.24) $ (0.15) Extraordinary item -- 0.07 ------------- ------------- Basic loss $ (0.24) $ (0.08) ============= ============= Pro forma per share Basic loss before extraordinary item $ (0.27) $ (0.16) Extraordinary item -- 0.06 Basic loss $ (0.27) $ (0.10) ============= =============
During the initial phase-in period of SFAS 123, the effect on pro forma results are not likely to be representative of the effects on pro forma results in future years since options vest over several years and additional awards could be made each year. F-19 83 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A summary of the status of the Company's stock option plans and warrants as of May 31, 1998 and 1997 and changes during the years ending on those dates is presented below:
1998 1997 ------------------------ -------------------------- Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price - ------------------------------------------------------------------------------------------------------ Outstanding, beginning of year 4,123,331 $ 1.24 3,077,775 $ 1.08 Granted 2,658,600 1.39 1,940,000 1.36 Cancelled (1,059,407) 1.11 (362,375) 2.01 Exercised (478,854) 0.52 (532,069) 0.76 - ------------------------------------------------------------------------------------------------------ Outstanding, end of year 5,243,670 $ 1.26 4,123,331 $ 1.24 - ------------------------------------------------------------------------------------------------------ Exercisable, end of year 3,430,836 $ 1.32 1,526,332 $ 0.85 - ------------------------------------------------------------------------------------------------------ Weighted average fair value of options and warrants granted during the year $ 0.61 $ 0.68 - ------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options and warrants outstanding at May 31, 1998:
Outstanding Exercisable ------------------------------------- ------------------------ Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price - ----------------------------------------------------------------------------------- $ 0.18 - 0.37 519,379 2.48 $ 0.32 511,379 $ 0.32 0.50 - 0.59 545,000 4.18 0.57 425,000 0.57 0.80 - 1.17 2,024,691 4.11 1.16 765,691 0.81 1.25 - 1.76 1,594,600 3.68 1.52 1,237,100 1.56 2.28 - 2.50 460,000 1.50 2.31 391,666 2.31 5.00 - 7.50 100,000 0.93 6.25 100,000 6.25 - ----------------------------------------------------------------------------------- $ 0.18 - 7.50 5,243,670 4.23 $ 1.26 3,430,836 $ 1.32 - -----------------------------------------------------------------------------------
F-20 84 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. EARNINGS (LOSS) PER SHARE In February 1997, SFAS No. 128, "Earnings per Share," was issued, which required the Company to change the method used to calculate earnings per share. Under SFAS No. 128, basic earnings (loss) per share is calculated as income (loss) available to common stockholders divided by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is calculated as net income (loss) divided by the diluted weighted average number of common shares. The diluted weighted average number of common shares is calculated using the treasury stock method for common stock issuable pursuant to outstanding stock options, common stock warrants, and debt convertible into common stock. Common stock options of 880,989 and 1,438,980 and debt convertible into 1,748,134 and 160,118 common shares of stock were not included in diluted earnings (loss) per share in 1998 or 1997, respectively, as the effect was antidilutive due to the Company recording losses in each of those years. In addition, 2,500,000 shares of common stock in escrow that had not met the earnout arrangement as of May 31, 1998 were not considered outstanding for diluted earnings (loss) per share. See Note 4 to the Consolidated Financial Statements. Options and warrants to purchase 2,989,604 shares of common stock at exercise prices from $0.80 to $7.50 per share were outstanding at May 31, 1998 but were not included in the computation of diluted earnings (loss) per share because the exercise prices were greater than the average market price of the common shares. Options and warrants to purchase 822,750 shares of common stock at exercise prices from $1.37 to $2.30 per share were outstanding at May 31, 1997 but were not included in the computation of diluted earnings (loss) per share because the exercise prices were greater than the average market price of the common shares. 8. INCOME TAXES As of May 31, 1998, the net deferred tax asset recorded and its approximate tax effect consisted of the following:
---------------------------------------------------------------- Net operating loss carryforwards $ 3,078,000 Purchased technology 565,000 Depreciation and amortization 279,000 Warrants valuation 180,000 Other, net 156,000 ---------------------------------------------------------------- 4,258,000 Valuation allowance 4,258,000 ---------------------------------------------------------------- Net deferred tax asset $ -- ================================================================
F-21 85 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of May 31, 1998, a valuation allowance equal to the net deferred tax asset recognized has been recorded, as Management has not determined that it is more likely than not that the deferred tax asset will be realized. No current tax provision was recorded for fiscal 1998 and 1997 due to reported losses. At May 31, 1998, the Company has net operating loss carryforwards of approximately $9,052,000 that expire through 2013 and are subject to certain limitations under the Internal Revenue Code of 1986, as amended. 9. PROFIT-SHARING PLAN Effective July 1, 1993, the Company adopted a savings and profit-sharing plan that allows participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. At the Company's discretion, the Company may match contributions at 20% of the employee's contribution up to 6% of the employee's salary. The Company contributions are vested 20% per year beginning with the first year of service. The Company's contributions to the plan were $642 in fiscal 1997. The Company made no matching contribution in fiscal 1998. 10. COMMITMENT AND CAPITAL The Company, through its subsidiary, LEASE OBLIGATIONS Metacomp, entered into an eight year operating lease for its office and manufacturing facilities located in San Diego, California. The Company also leases a copier, computers, and test equipment at interest rates between (4-18%). Future minimum lease payments required under the operating and capital leases are as follows:
---------------------------------------------------------------- Operating Capital Leases 1999 $ 96,940 $ 2,387 2000 16,190 1,393 ---------------------------------------------------------------- Total minimum lease payments 113,130 3,780 Less amount representing interest - 246 --------------------------------------------------------------- Present value of net minimum lease payments 113,130 3,534 Less current portion - 1,355 ---------------------------------------------------------------- Total $ 113,130 $ 2,179 ================================================================
Rent expense for fiscal 1998 and 1997 was $85,120 and $80,371,respectively. F-22 86 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. EXTRAORDINARY INCOME The extraordinary income is a gain from the discharge of debt as a result of the completion of Metacomp's plan of reorganization under Chapter 11 of the U.S. Bankruptcy Code as of July 1996. In 1990, Metacomp filed a Chapter 11 bankruptcy petition. In 1991, the Bankruptcy Court confirmed Metacomp's plan of reorganization which provided for 60 monthly payments to creditors with minimum payments averaging $23,400 per month or larger depending on operating results. As of July 1996, the unsecured creditors were paid approximately 13% of their approved claims and the balance was discharged. One secured creditor was scheduled to be paid in full as part of the plan of reorganization. As of July 31, 1996, this secured creditor had a remaining balance of $312,306. The Company paid to this secured creditor a remaining balance of $252,306 plus accrued interest in conjunction with the business combination with Metacomp. 12. SALES INFORMATION EXPORT SALES During the fiscal year ended May 31, 1998, the Company's foreign sales were less than 10% of total sales. During the fiscal year ended May 31, 1997, the Company's sales by geographic area consisted of the following: Domestic sales $1,428,000 Foreign sales: Canada 244,000 Other 175,000 ---------- Total foreign sales 419,000 ---------- Total net product sales $1,847,000 ==========
The Company has no foreign assets. F-23 87 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SALES TO MAJOR CUSTOMERS The Company had sales in excess of 10% to the following customers:
1998 1997 ---- ---- Customer Sales Percent Sales Percent -------- ----- ------- ----- ------- A $578,000 30.3% $473,000 25.6% B $478,000 25.1% $472,000 25.5% C -- -- $212,000 11.5% D $207,000 10.9% -- --
13. FOURTH QUARTER ADJUSTMENTS The Company recorded in the fourth quarter certain adjustments relative to non-cash interest expense related to convertible debt and associated debenture costs and a write-down of inventory due to obsolescence amounting to an aggregate of $2,100,000 which are discussed in Notes 5 and 6 to the Consolidated Financial Statements. Of the aggregate amount, $1,000,000 and $1,100,000 related to the third and fourth quarters, respectively. The Company plans to file an amended Form 10-QSB for the quarter ended February 28, 1998. 14. SUBSEQUENT EVENT In June 1998, the Company, the seller of the ShBoom technology and the co-inventor entered into a nonbinding agreement in principle to settle the dispute in consideration of mutual releases and the Company assigning patents on the ShBoom technology back to the co-inventor in exchange for the co-inventor granting a fully-paid, worldwide, subliceneable license to use the ShBoom technology patents exclusive in the Company's existing and future fields of use. In addition, nanoTronics agreed to release any obligation of the Company to deliver a number of shares of the Company's stock pursuant to the original acquisition agreement as discussed in Note 4 to the Consolidated Financial Statements. Any stock not delivered will be retired. Settlement documentation has been exchanged between the parties, although disputes remain concerning terms contained within the documents. The Company is unable at this time to determine whether such disputes will be resolved. The Company's Consolidated Financial Statements do not include any adjustments that might result from the outcome of this uncertainty. 15. RESTATEMENT OF 1998 FINANCIAL STATEMENTS During the years ended May 31,1998 and 1997, shares of common stock were earned under the terms of the escrow arrangement as discussed in Note 4 to the Consolidated Financial F-24 88 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Statements. Previously, compensation expense was recognized upon the release of shares from escrow rather than when such shares were earned. The market value of the shares at the release date was previously recorded as compensation expense in the year ended May 31, 1998. The market value of the shares at the date that such shares were earned should have been recorded as compensation expense in the fiscal years ended May 31, 1998 and 1997. Accordingly, the Company restated its 1998 and 1997 Consolidated Financial Statements. As a result of this restatement, the 1998 and 1997 net loss before extraordinary item and net loss were each increased by $1,620,000 and $725,000, respectively, and basic and diluted loss per share were each decreased by $0.04 and $0.03 per share, respectively. 16. CONTINUED EXISTENCE AND MANAGEMENT'S PLAN The Company's consolidated financial statements are presented on the going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company incurred a net loss of $7,514,785 and $2,188,792 and negative cash flow from operations of $2,423,080 and $1,688,168 in the years ended May 31 1998 and 1997, respectively. The ability of the Company to continue as a going concern is contingent upon it obtaining sufficient financing to sustain its operations. The Company currently is attempting to complete financing for up to $5 million through an investment agreement with Swartz Private Equity, LLC ("Swartz"). As discussed below, the offering that relates to this proposed financing may be in violation of Section 5 of the Securities Act of 1933. The Company is also holding discussions with various possible financing sources and believes that additional financing can be obtained in the event that the proposed $5 million financing is not completed. However, no assurance can be given that the Company will, in fact, be able to obtain additional financing or that the terms of such financing, will be favorable to the Company. As such, there is substantial doubt about the Company's ability to continue as a going concern, unless additional financing can be obtained. The consolidated 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 possible inability of the Company to continue as a going concern. In February 1999, the Company entered into an investment agreement with Swartz. The investment agreement entitles the Company, at the Company's option, to issue and sell its common stock for up to an aggregate of $5 million from time to time during a three-year period through February 24, 2002, subject to certain conditions including (1) an effective registration statement must be on file with the SEC registering the resale of the common shares, and (2) a limitation on the number of common shares which can be sold to Swartz within a 30 day time period based on the trading volume of the stock, among others. Swartz may purchase the common stock from the Company at a discount ranging from 10% to 20% depending on the price of the common stock. In addition to the common stock purchased, Swartz will receive warrants to purchase an additional 15% of the common stock equal to 110% of the market price on the last day of the purchasing period, subject to further semi-annual adjustment if the price of the common stock goes down. In April 1999, the Company sold common stock to two individuals in an accumulated amount of $75,000 and in June 1999 the Company issued stock to an institutional investor upon conversion of a short term note in the amount of $116,183. These sales occurred after the commencement of a public offering by the Company and therefore, by making these sales the Company may have violated Section 5 of the Securities Act of 1933. In July 1999, the Company amended and restated the investment agreement with Swartz to eliminate the discretion of Swartz as to the timing of its purchase of the Company's common stock. The amended and restated investment agreement requires Swartz, after the Company puts shares of common stock to it, to purchase the Company's common stock on the twentieth day following the put. The previous agreement enabled Swartz, in its sole discretion, to purchase the Company's common stock at any time during a twenty day period following the Company's put to it. By entering into the amended and restated investment agreement, the Company completed the sale of common stock to Swartz. Since the date of this private sale to Swartz is after the date the Company commenced its public offering, the Company may have sold securities to Swartz in violation of Section 5 of the Securities Act of 1933. Consequently, the two individual investors, the institutional investor and Swartz may have the right to rescind these purchases of common stock. In addition, Patriot and certain officers and directors of Patriot may be subject to civil and criminal penalties for potential violations of Section 5 of the Securities Act of 1933 and applicable state law as a result of these sales. Management believes that the possibility of damages related to these potential violations of Section 5 of the Securities Act of 1933 is remote and that such potential violations will have no material impact on the Company's financial statements. F-25 89 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED BALANCE SHEETS (As restated) ASSETS
February 28, May 31, 1999 1998 (Unaudited) Current Assets Cash and cash equivalents $ 16,800 $ 602,456 Accounts receivable 250,322 593,542 Inventories (Note 3) 187,384 230,417 Prepaid expenses and other 204,539 109,365 ------------ ------------ Total current assets 659,045 1,535,780 Property and equipment - net 531,579 453,211 Patents, trademarks, net 150,966 196,942 Other 3,721 3,721 ============ ============ Total Assets $ 1,345,311 $ 2,189,654 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current Liabilities Short-term notes payable $ 247,500 $ -- Accounts payable 1,238,156 391,184 Accrued liabilities 184,529 131,088 Current portion - capital lease obligations 1,916 2,179 ------------ ------------ Total current liabilities 1,672,101 524,451 Long-term Liabilities Capital lease obligations -- 1,355 5% Convertible Term Debentures (Note 5) -- 507,000 ------------ ------------ Total Liabilities 1,672,101 1,032,806 Stockholders' Equity (Deficit) Preferred stock $.00001 par value; authorized 5,000,000 shares; none outstanding -- -- Common stock $.00001 par value; authorized 60,000,000 shares; 41,063,915 and 37,880,776 shares issued and outstanding (Note 4) 411 379 Additional paid-in capital (Note 4) 22,572,934 20,741,092 Accumulated deficit (22,900,135) (19,584,623) ------------ ------------ (326,790) 1,156,848 ============ ============ Total Liabilities and Stockholders' Equity (Deficit) $ 1,345,311 $ 2,189,654 ============ ============
See notes to consolidated financial statements. F-26 90 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (As restated and unaudited)
Three Months Ended Nine Months Ended February 28, February 28, 1999 1998 1999 1998 Net sales $ 271,525 $ 253,691 $ 1,108,022 $ 1,140,711 Cost of sales 113,425 109,430 683,323 546,130 ------------ ------------ ------------ ------------ Gross profit 158,100 144,261 424,699 594,581 Operating expenses: Research and development 478,571 475,214 1,634,060 1,299,975 Selling, general and administrative 407,483 389,043 1,770,158 2,620,908 ------------ ------------ ------------ ------------ 886,054 864,257 3,404,218 3,920,883 ------------ ------------ ------------ ------------ Operating loss (727,954) (719,996) (2,979,519) (3,326,302) ------------ ------------ ------------ ------------ Other income (expenses): Interest income 45 16,197 3,764 51,313 Interest expense (12,970) (32,563) (19,455) (92,360) Non-cash interest expense (Notes 4 and 5) (20,500) (1,000,000) (320,302) (1,624,678) ------------ ------------ ------------ ------------ (33,425) (1,016,366) (335,993) (1,665,725) ------------ ------------ ------------ ------------ Net loss $ (761,379) $ (1,736,362) $ (3,315,512) $ (4,992,027) ============ ============ ============ ============ Basic and diluted loss per common share: $ (0.02) $ (0.06) $ (0.09) $ (0.17) ============ ============ ============ ============ Weighted average number of common shares outstanding during the period (Note 1) 39,134,034 31,432,995 37,485,732 29,974,221 ============ ============ ============ ============
See notes to consolidated financial statements. F-27 91 PATRIOT SCIENTIFIC CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (As restated and unaudited)
Nine Months Ended February 28, 1999 1998 INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS OPERATING ACTIVITIES: Net loss $(3,315,512) $(4,992,027) Adjustments to reconcile net loss to cash used in operating activities: Amortization and depreciation 194,728 225,031 Amortization of debt issuance costs 48,000 -- Common stock and warrants issued for services 94,971 10,500 Non-cash compensation expense 445,000 1,245,000 Non-cash interest expense related to convertible debentures, common stock and warrants (Notes 4 and 5) 365,472 1,624,678 Changes in: Accounts receivable 136,220 (133,687) Inventories 43,033 1,206 Prepaid and other assets (49,198) (212,406) Accounts payable and accrued expenses 900,413 8,295 ----------- ----------- Net cash used in operating activities (1,136,873) (2,223,410) ----------- ----------- INVESTING ACTIVITIES: Purchase of property and equipment (273,096) (285,701) FINANCING ACTIVITIES: Proceeds from the issuance of notes payable 247,500 -- Proceeds from sale of accounts receivable 207,000 -- Principal payments on notes payable and long-term debt (1,618) (2,203) Proceeds from issuance of common stock and exercise of common stock warrants and options 371,431 230,283 Proceeds from issuance of convertible notes -- 3,000,000 ----------- ----------- Net cash provided by financing activities 824,313 3,228,080 ----------- ----------- Net increase (decrease) in cash (585,656) 718,969 Cash and cash equivalents at beginning of period 602,456 477,675 ----------- ----------- Cash and cash equivalents at end of period $ 16,800 $ 1,196,644 =========== =========== Supplemental Disclosure of Cash Flow Information: Convertible debentures and accrued interest exchanged for common stock $ 575,642 $ 1,498,566 =========== =========== Cash payments for interest $ 19,455 $ 43,794 =========== ===========
See notes to consolidated financial statements. F-28 92 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The consolidated financial statements of Patriot Scientific Corporation ("the Company") presented herein have been prepared pursuant to the rules of the Securities and Exchange Commission for quarterly reports on Form 10-QSB and do not include all of the information and footnotes required by generally accepted accounting principles. These statements should be read in conjunction with the Company's audited financial statements and notes thereto for the year ended May 31, 1998. In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair statement of the results for interim periods. Operating results for the nine month periods are not necessarily indicative of the results that may be expected for the year. LOSS PER SHARE During the year ended May 31, 1998, the Company implemented Standard of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share." Under SFAS No. 128, basic loss per share is calculated as loss available to common stockholders divided by the weighted average number of common shares outstanding. Diluted loss per share is calculated as net loss divided by the diluted weighted average number of common shares. The diluted weighted average number of common shares is calculated using the treasury stock method for common stock issuable pursuant to outstanding stock options, common stock warrants, and debt convertible into common stock. Common stock options and warrants of 115,078 and 367,789 for the three months and 157,315 and 999,674 for the nine months and debt convertible into none and 2,707,522 common shares of stock for the three months and 330,726 and 2,351,774 common shares of stock for the nine months were not included in diluted loss per share for the periods ended February 28, 1999 or 1998, respectively, as the effect was antidilutive due to the Company recording losses in each of those periods. In addition, 1,500,000 shares of common stock in escrow as of February 28, 1999 were not considered outstanding for diluted loss per share because these shares are subject to an earnout agreement which has not yet been met. Options and warrants to purchase 3,474,291 shares of common stock at exercise prices from $0.45 to $2.30 per share were outstanding at February 28, 1999 but were not included in the computation of diluted loss per share because the exercise prices were greater than the average market price of the common shares. Options and warrants to purchase 4,426,791 shares of common stock at exercise prices from $0.80 to $7.50 per share were outstanding at February 28, 1998 but were not included in the computation of diluted loss per share because the exercise prices were greater than the average market price of the common shares. F-29 93 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) SALE OF ACCOUNTS RECEIVABLE The Company has adopted SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125"). SFAS 125 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. A factoring line established by the Company with a bank enables the Company to sell selected accounts receivable invoices to the bank with recourse. These transactions qualify for a sale of assets since (1) the Company has transferred all of its right, title and interest in the selected accounts receivable invoices to the bank, (2) the bank may pledge, sell or transfer the selected accounts receivable invoices, and (3) the Company has no effective control over the selected accounts receivable invoices since it may not redeem the invoices sold previous to the invoices being greater than 90 days past due. Under SFAS 125, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. The Company sold approximately $259,000 of its accounts receivable to a bank under a factoring agreement for approximately $207,000. Pursuant to the provisions of SFAS 125, the Company reflected the transaction as a sale of assets and established an accounts receivable from the bank for the retained amount less the costs of the transaction and less any anticipated future loss in the value of the retained asset. The retained amount is equal to 20% of the total accounts receivable invoice sold to the bank less 1% of the total invoice as an administrative fee and 1.75% per month of the total outstanding accounts receivable invoices as a finance fee. The fair value of the retained asset is based on the payment history of the accounts receivable customer. MANAGEMENT'S PLAN At February 28, 1999, working capital was a negative $1,013,056 and cash and cash equivalents totaled $16,800. The Company has funded its operations primarily through the issuance of securities and debt financings. The Company's current cash requirements to sustain its operations for the next twelve months are estimated to be $1,600,000. The Company's management expects that these requirements will be provided: Internally by: - the cash profits related to the $3,355,000 kiosk order, a portion of which is anticipated as an advance payment during its first fiscal quarter of 2000 (June 1 to August 31, 1999), previous to any product shipments, and Externally by: - short-term debt instruments, including a receivable financing arrangement established with the Company's bank, - private placement debt and/or equity financings, and - the investment agreement. F-30 94 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) Since February 28, 1999, the Company has issued short-term debt financings for $553,000 and sold equity to two private investors totaling $75,000. In February 1999, the Company entered into an agreement for up to $5,000,000 under an investment agreement as discussed in Note 6. The $5,000,000 investment agreement allows the Company, at its sole discretion, to put common stock into the hands of Swartz Private Equity, LLC at a discount from market, ranging from 10% to 20% depending on the market price of the common stock. The puts are subject to common stock trading volume limitations and registration of the securities. The Company anticipates the initial put under the investment agreement will take place during the first quarter of fiscal year 2000, June 1 to August 31, 1999. As discussed in Note 7, the offering that relates to this proposed $5,000,000 financing may be in violation of Section 5 of the Securities Act. The Company is also holding discussions with various other possible financing sources and management believes that additional financing can be obtained in the event that the proposed $5,000,000 financing is not completed. However, no assurance can be given that the Company, will, in fact, be able to obtain additional financing or that the terms of such financing will be favorable to it. There can be no assurance that any funds required during the next twelve months or thereafter can be generated from operations or that if such required funds are not internally generated that funds will be available from external sources such as debt or equity financings or other potential sources. The funds anticipated from the kiosk order are subject to the Company's customer receiving funds from the Mexican Department of Tourism and on several occasions product shipments have been rescheduled pending the receipt of those funds. The lack of additional capital could force the Company to substantially curtail or cease operations and would, therefore, have a material adverse effect on the Company's business. Further, there can be no assurance that any such required funds, if available, will be available on attractive terms or that they will not have a significantly dilutive effect on existing shareholders of the Company. 2. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" which supersedes SFAS No. 14 "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes standards on the way that public companies report financial information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial statements issued to the public. It also establishes standards for disclosure regarding products and services, geographic areas and major customers. SFAS No. 131 defines operating segments as components of a company about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. The Company will implement SFAS No. 131 in its May 31, 1999 financial statements. Results of operations and financial position will be unaffected by implementation of the standard. Management believes the adoption of this statement will have no material impact on the Company's financial statements. F-31 95 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair market value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes in fair value or cash flows. SFAS No. 133 is effective for fiscal periods beginning after June 15, 1999. Management believes the adoption of this statement will have no material impact on the Company's financial statements. 3. INVENTORIES Inventories are stated at cost (determined primarily by the weighted average cost method which approximates cost on a first-in, first-out basis) not in excess of market value. Inventories at February 28, 1999 and May 31, 1998, consist of the following:
February 28, 1999 May 31, 1998 Component parts $ 389,938 $ 418,502 Work in process 73,988 60,136 Finished goods 88,458 116,779 --------- --------- 552,384 595,417 Reserve for obsolescence (365,000) (365,000) --------- --------- $ 187,384 $ 230,417 ========= =========
4. STOCKHOLDERS' EQUITY The following table summarizes equity transactions during the nine months ended February 28, 1999:
Common Shares Amounts ------ ------- Balance June 1, 1998 37,880,776 $20,741,471 Issuance of stock and exercise of stock options 892,387 266,402 Stock issued for conversion of debentures and related accrued interest 1,735,752 575,642 Stock released from escrow for purchased technology -- 445,000 Exercise of warrants 555,000 200,000 Non-cash interest expense related to convertible notes and warrants recorded to additional paid-in capital -- 344,830 ----------- ----------- Balance February 28, 1999 41,063,915 $22,573,345 =========== ===========
F-32 96 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) A total of 5,000,000 shares of the Company's outstanding common stock were placed in escrow as a contingent cost of the Company's acquisition of its ShBoom technology in 1994. As such, when the escrowed shares are earned, they are charged to compensation costs. The terms of the escrow arrangement provide for an earnout formula of 500,000 shares for each $500,000 of revenues earned by the Company during the period from June 1, 1994 through May 31, 1999. Additionally, this agreement also provides for the full earnout of these shares if during the earnout period there is (i) any sale of the assets of the Company, (ii) a business combination with another entity where the Company is not the surviving entity, (iii) at least 75% of the Company's stock is tendered to another organization, and (iv) a liquidation or dissolution of the Company. Any of the contingent shares not earned by May 31, 1999 would be returned to the Company and canceled. During the nine months ended February 28, 1999 and 1998, 1,000,000 shares and 1,000,000 shares, respectively, were earned as a result of the arrangement and $445,000 and $1,245,000, respectively, were charged to compensation costs. The 1,000,000 shares that were earned during the nine months ended February 28, 1999 were released during the current period. At February 28, 1999, 3,500,000 shares remain in escrow of which 2,000,000 shares have been earned and charged to compensation costs but remain in escrow pending the outcome of a lawsuit between the Company, nanoTronics and the Fish Family Trust as discussed in Note 7 to the Consolidated Financial Statements. Upon the resolution of the lawsuit, the remaining shares held in escrow will either be released to the Falk Family Trust, used either partially or in their entirety as a means of settling the lawsuit, or be returned to the Company. At February 28, 1999, the 1,500,000 shares that have not met the earnout arrangement have been excluded from the calculation of basic or diluted earnings per share. During the current fiscal quarter, in exchange for services, 279,326 shares of common stock were issued to the Company's attorneys. The fair value (as determined by the quoted market price) of the common stock in excess of the liability, $30,500, has been accounted for as additional general and administrative expense. At February 28, 1999, the Company had 165,000 options outstanding pursuant to its 1992 ISO Stock Option Plan exercisable at prices ranging from $0.50 to $2.30 per share expiring beginning 2000 through 2001. The Company had 511,753 options outstanding pursuant to its 1992 NSO Stock Option Plan exercisable at prices ranging from $0.18 to $2.30 per share expiring beginning 1999 through 2002. The Company also had 3,296,691 options outstanding pursuant to its 1996 Stock Option Plan exercisable at $0.39 to $2.30 per share expiring beginning in 1999 through 2003. Some of the options outstanding under these plans are not presently exercisable and are subject to meeting vesting criteria. As of October 1, 1995, the Board of Directors adopted the 1995 Employee Stock Compensation Plan providing for the issuance of up to 250,000 common shares to Employees, as defined. F-33 97 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) Executive officers and directors were not eligible under the Plan. Through September 30, 1998, the Company had issued 217,600 common shares pursuant to the plan. The plan expired on September 30, 1998 with no additional common shares being issued. At February 28, 1999, the Company had warrants outstanding to purchase 641,171 common shares at exercise prices ranging from $0.35 to $1.69 per share expiring beginning in 2000 through 2003. During the three months and nine months ended February 28, 1999, the Company issued warrants to a group of investors who had loaned the Company in the aggregate $147,500 under short-term notes payable. The Company has included $20,500 and $29,000 for the three months and the nine months ended February 28, 1999, respectively, related to the value of these warrants in "non-cash interest expense". 5. 5% CONVERTIBLE TERM DEBENTURES In June 1997, the Company issued to a limited number of investors for cash an aggregate of $2,000,000 of unsecured 5% Convertible Term Debentures due June 2, 1999 ("Debentures") and Stock Purchase Warrants ("Warrants") with a right to purchase an aggregate 611,733 shares of common stock, par value $.00001 per share, at an exercise price of $1.69125. In September 1998, the exercise price for related warrants to purchase 370,000 shares of common stock was reduced from $1.69125 to $0.36. In November 1997, the Company issued to the same investors for cash an aggregate of $1,000,000 of Debentures due June 2, 1999 and Warrants with a right to purchase an aggregate 305,867 shares of common stock, par value $.00001 per share, at an exercise price of $1.50. In September 1998, the exercise price for related warrants to purchase 185,000 shares of common stock was reduced from $1.50 to $0.36. The additional warrants value, due to the reduction in the exercise price, of $142,500 was reflected as additional interest expense in the second fiscal quarter of 1999. The principal and interest amount of each Debenture could, at the election of the holder, be converted in whole or in part and from time to time into fully paid and nonassessable shares of common stock, $.00001 par value, of the Company, at a price which was the lower of (i) $1.1646 per share or (ii) depending on the number of days the Debentures had been held after the funding date, from 75% to 91% of the average of the closing bid prices for the common stock for the ten consecutive trading days ending on the trading day immediately preceding such conversion date. As of February 28, 1999, the Debentures had been fully converted into 6,069,345 common shares of the Company. In addition, as of February 28, 1999, the investors had exercised warrants to purchase 555,000 common shares of the Company. Convertible debt instruments which are convertible at a discount to market were accounted for by treating such discount as additional interest expense. The Company computed the amount of the F-34 98 PATRIOT SCIENTIFIC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Unaudited) discount based on the difference between the conversion price and fair value of the underlying common stock on the dates the Debentures were issued. The Company recorded $2,160,941 of additional paid-in capital for the discount related to the embedded interest in the Debentures. Of this amount, $142,830 has been expensed during the nine months ended February 28, 1999 under the caption "Non-cash interest expense." 6. INVESTMENT AGREEMENT In February 1999, the Company entered into an investment agreement with Swartz Private Equity, LLC which was amended and restated in July 1999. The amended and restated investment agreement entitles the Company, at the Company's option, to issue and sell its common stock for up to an aggregate of $5 million from time to time during a three-year period through July 12, 2002, subject to certain conditions including (1) an effective registration statement must be on file with the SEC registering the resale of the common shares, and (2) a limitation on the number of common shares which can be sold to Swartz within a 30 day time period based on the trading volume of the stock, among others. Swartz may purchase the common stock from the Company at a discount ranging from 10% to 20% depending on the price of the common stock. In addition to the common stock purchased, Swartz will receive warrants to purchase an additional 15% of the common stock equal to 110% of the market price on the last day of the purchasing period, subject to further semi-annual adjustment if the price of the common stock goes down. 7. CONTINGENCIES In October 1998, the Company was sued in the District Court for Travis County, Texas by the Fish Family Trust, a co-inventor of the original ShBoom technology. The suit also named as defendants nanoTronics and Gloria Felcyn on behalf of the Falk Trust. The suit sought a judgment for damages, a rescission of the Technology Transfer Agreement and a restoration of the technology to the co-inventor. The Company had the suit removed to the United States District Court for the Western District of Texas, Austin Division, and requested the Federal District Court to dismiss the suit based on lack of minimum contacts with Texas or, in the alternative, to transfer the case to the Southern District of California. In January 1999, the Federal District Court dismissed the suit for lack of subject matter and personal jurisdiction. The Fish Family Trust then refiled the suit in the Superior Court of San Diego County, California seeking remedies similar to the Federal District Court dismissed action. In March 1999, the Company joined with nanoTronics and Gloria Felcyn and filed its response and cross-complaint against the Fish Family Trust. The Company and the other defendants intend to vigorously contest the plaintiff's allegations. It is reasonably possible that the outcome of these matters may result in a material liability for the Company. Management does not believe, at this stage of the case, that it is possible to estimate the outcome of the litigation or a range of reasonably possible losses that might result from the suit. In April 1999, the Company sold shares of common stock to two individuals in the accumulated amount of $75,000 and in June 1999 the Company issued shares to an institutional investor upon conversion of a short term note in the amount of $116,183. These sales occurred after the commencement of a public offering by the Company and, therefore, by making these sales the Company may have violated Section 5 of the Securities Act. In July 1999, the Company amended and restated the investment agreement with Swartz to eliminate the discretion of Swartz as to the timing of its purchase of the Company's common stock. The amended and restated investment agreement requires Swartz, after the Company puts shares of common stock to it, to purchase the Company's common stock on the twentieth day following the put. The previous agreement enabled Swartz, in its sole discretion, to purchase the Company's common stock at any time during a twenty day period following the Company's put to it. By entering into the amended and restated investment agreement, the Company completed its sale of common stock to Swartz. Since this private sale to Swartz occurred after the Company commenced its public offering, the Company may have sold securities to Swartz in violation of Section 5 of the Securities Act. Consequently, the two individual investors, the institutional investor and Swartz may have the right to rescind these purchases of common stock. In addition, the Company and certain officers and directors of the Company may be subject to civil and criminal penalties for potential violation of either or both Section 5 of the Securities Act and applicable state law as a result of these sales. Management believes that the possibility of damages related to these potential violations of Section 5 of the Securities Act is remote and that such potential violations will have no material impact on the Company's financial statements. F-35 99 Until the completion of the resale of the common stock included in this prospectus, all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers' obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. Table of Contents Prospectus Summary ................................................... 5 Risk Factors ......................................................... 7 Plan of Distribution ................................................. 12 Selling Shareholders ................................................. 13 The Company .......................................................... 19 Use of Proceeds ...................................................... 40 Litigation ........................................................... 41 Management's Discussion and Analysis of Financial Condition and Results of Operations ......................................... 41 Management ........................................................... 48 Principal Shareholders ............................................... 57 Certain Transactions ................................................. 58 Trading Market and Related Matters ................................... 60 Description of Securities ............................................ 61 Legal Matters ........................................................ 62 Experts .............................................................. 62 Index to Financial Statements ........................................ F-1
The Resale of 15,598,770 Shares of Common Stock Offered by Selling Shareholders PATRIOT SCIENTIFIC CORPORATION PROSPECTUS July 14, 1999 100 PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 24. INDEMNIFICATION OF OFFICERS AND DIRECTORS. Pursuant to the Company's Certificate of Incorporation, and as permitted by Section 145 of the General Corporation Law of Delaware, the Company may indemnify its directors and officers under certain circumstances against reasonable expenses (including court costs and attorney's fees), judgments, penalties, fines, and amounts paid in settlement actually and reasonably incurred in connection with any action, suit or proceeding, whether civil, criminal, administrative or investigative, to which any of them is a party by reason of his being a director, officer, employee, or agent of the Company if it is determined that he acted in accordance with the applicable standard of conduct set forth in such statutory provisions. Thus, the indemnification provisions will protect officers and directors from liability only if the officer or director meets the applicable standard of conduct and the Company has the financial ability to honor the indemnity. ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. Expenses payable in connection with the registration and distribution of the securities being registered hereunder, all of which will be borne by the Registrant, are as follows: Registration Fee - Securities and Exchange Commission ........ $ 2,600 Printing and Engraving ....................................... 1,000* Legal Fees and Expenses ...................................... 40,000* Accounting Fees .............................................. 20,000* Blue Sky Fees and Expenses ................................... 1,000* ------- Total .................................................. $64,600* =======
- --------- * Estimated ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES. The following sets forth certain information with respect to all common stock, $.00001 par value, of the Registrant sold by it within the three-year period preceding the date of this Registration Statement: (a) The Registrant offered and sold the following described securities, either for cash or in consideration of services rendered as indicated below, without registration under the Securities Act of 1933, as amended; and exemption for such sales from registration under the Act is claimed in reliance upon the exemption provided by Section 4(2) thereof on the basis that such offers and sales were transactions not involving any public offering. Appropriate precautions against transfer have been taken, including the placing of a restrictive legend on all certificates evidencing such securities. All such sales were effected without the aid of underwriters, and no sales commissions were paid.
Number of Common Aggregate Purchase Purchase Price Per Name Date of Sale Shares Price Share ---- ------------ ------ ----- ----- Sea, Ltd. May 29, 1996 500,000(1) $ 250,000 $.50 Cash Robert Crawford December 4, 1998 100,000 25,000 .25 Cash December 16, 1998 100,000 23,000 .23 Cash April 26, 1999 200,000 35,000 .175 Cash April 28, 1999 100,000 20,000 .20 Cash
i 101
Number of Common Aggregate Purchase Purchase Price Per Name Date of Sale Shares Price Share ---- ------------ ------ ----- ----- James C. and Josephine M. Zolin December 29, 1998 130,435 30,000 .23 Cash January 29, 1999 50,000 17,500 .35 Cash Wayne Opperman January 29, 1999 50,000 17,500 .35 Cash Clifford E. Koerner February 1, 1999 100,000 35,000 .35 Cash Richard D. Daniels February 1, 1999 50,000 17,500 .35 Cash Luce, Forward, Hamilton and Scripps, LLP February 11, 1999 279,326 94,971 .34 Services William G. Crawford April 28, 1999 100,000 20,000 .20 Cash Castle Creek Technology Partners, LLC June 14, 1999 397,205 116,183 .292 Note Conversion
(1) This reflects exercise of warrants granted as a portion of a unit sold at $.50 per unit, each consisting of one share of common stock and one warrant to purchase an additional share of common stock at a price of $.50 per share. (b) On February 29, 1996, the Registrant offered and sold for cash an aggregate of 253,166 shares of common stock at a price of $1.58 per share to a limited number of investors (all but one of whom already were shareholders of the Registrant), as well as warrants to purchase an additional 253,166 common shares at a price of $1.58 per share. During May 1996, such warrants were exercised resulting in the issuance of 126,583 common shares, and in August 1996 the remaining warrants were exercised. Also in August of 1996, 25,000 warrants granted with a manufacturing agreement were exercised at a price of $1.58 per share. (c) In November 1996, the Company issued 431,297 shares of common stock at $1.04 per share, in December 1996, the Company issued 933,622 shares at $0.85 to $1.08 per share; and in February 1997, the Company issued 160,184 shares at $1.27 per share. All of such issuances resulted from the conversion of 6% convertible subordinated notes and accrued interest thereon aggregating $1,517,015. These securities were offered and sold without registration under the Securities Act of 1933, as amended, and exemption for such sales from registration under the Act is claimed in reliance upon the exemption provided by Rule 903 of Regulation S thereunder on the basis that such offers and sales were made in offshore transactions to persons who were not "U.S. Persons" as defined in Rule 902 of Regulation S. Appropriate precautions were taken against transfer into the United States or to any "U.S. Person" during the applicable restricted period, including the placing of a restrictive legend on all certificates issued. All such sales were effected without the aid of underwriters, and no sales commissions were paid. (d) On January 8, 1997, the Company issued 1,272,068 common shares to 56 persons in connection with the acquisition of Metacomp, Inc. pursuant to an Exchange Offer and Letter of Transmittal dated December 4, 1996. The effective date of the acquisition was December 26, 1996. The closing price of the common shares on December 26, 1996 was $1.375 per share, resulting in aggregate consideration of $1,749,094. These common shares were issued without registration under the Securities Act of 1933, as amended, pursuant to the exemption provided by Regulation D on the ground that such transactions did not involve any public offering. Appropriate precautions against transfer have been taken, including the placing of a restrictive legend on all certificates evidencing such securities. Such shares were issued without the aid of underwriters, and no sales commissions were paid. ii 102 (e) During the period of November 1997 through September 1998, the Company issued 6,069,345 common shares to two investors pursuant to 5% convertible debentures aggregating $3,000,000 and the accrued interest thereon. The per share price for the conversions ranged from $.395 to $1.202. In addition to the principal, $98,977 of interest was converted into common shares. In September and October 1998, one of the investors exercised a warrant to purchase 555,000 shares of the Company's common stock at an exercise price of $.36036 per share. The securities were registered for resale on Forms S-3 which became effective in September and November 1997. ITEM 27. EXHIBITS. The Exhibits to this Registration Statement are listed in the Exhibit Index commencing at page EX-1 hereof. ITEM 28. UNDERTAKINGS. The undersigned Registrant hereby undertakes the following: (1) To file, during any period in which offers or sales are being made, a post-effective amendment to this Registration Statement: (i) to include any prospectus required by Section 10(a)(3) of the Securities Act of 1933; (ii) to reflect in the prospectus any facts or events arising after the effective date of this Registration Statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information in this Registration Statement; and (iii) to include any material information with respect to the plan of distribution not previously disclosed in this registration, or any material change to such information in the Registration Statement. (2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (3) To remove from registration by means of a post-effective amendment to this Registration Statement any of the securities being registered which remain unsold at the termination of this offering. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling the Registrant pursuant to the General Corporation Law of Delaware, the Certificate of Incorporation, or otherwise, the Registrant has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in such Act, and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or person controlling the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or person controlling the Registrant in connection with any securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in such Act and will be governed by the final adjudication of such issue. iii 103 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all the requirements for filing on Form SB-2 and has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Diego, State of California, on the date below. DATED: July 14, 1999 PATRIOT SCIENTIFIC CORPORATION By: /s/ LOWELL W. GIFFHORN ------------------------------------- Lowell W. Giffhorn Chief Financial Officer Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed by the following persons in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /S/ JAMES T. LUNNEY President, Director, July 14, 1999 - ----------------------------- Chief Executive Officer James T. Lunney /S/ LOWELL W. GIFFHORN Chief Financial Officer, July 14, 1999 - ----------------------------- Principal Financial Lowell W. Giffhorn Officer and Principal Accounting Officer /S/ ELWOOD G. NORRIS Chairman and Director July 14, 1999 - ---------------------------- Elwood G. Norris /S/ HELMUT FALK, JR. Director July 14, 1999 - ---------------------------- Helmut Falk, Jr. /S/ DONALD BERNIER Director July 14, 1999 - ---------------------------- Donald Bernier /S/ RICHARD G. BLUM Director July 14, 1999 - ---------------------------- Richard G. Blum Director - ---------------------------- Frederick G. Thiel
iv 104 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM SB-2 Registration Statement Under The Securities Act of 1933 EXHIBITS PATRIOT SCIENTIFIC CORPORATION (Exact name of registrant as specified in its charter) EX-1 105 EXHIBIT INDEX PATRIOT SCIENTIFIC CORPORATION The following exhibits are included as part of this registration statement, except those exhibits marked (1), which have previously been filed with the Securities and Exchange Commission and are incorporated by reference to another registration statement, report or document. References to the "Company" in this Exhibit Index mean PATRIOT SCIENTIFIC CORPORATION, a Delaware corporation.
Exhibit No. Document No. - ---------- -------- -- 2.0 PLAN OF ACQUISITION, REORGANIZATION, ARRANGEMENT, LIQUIDATION OR SUCCESSION. 2.1 Agreement to Exchange Technology for Stock in Patriot Scientific (1) Corporation, incorporated by reference to Exhibit 2.1 to Form 8-K dated August 10, 1989 2.2 Assets Purchase Agreement and Plan of Reorganization dated June 22, (1) 1994, among the Company, nanoTronics Corporation and Helmut Falk, incorporated by reference to Exhibit 10.4 to Form 8-K dated July 6, 1994 2.2.1 Amendment to Development Agreement dated April 23, 1996 between the (1) Company and Sierra Systems, incorporated by reference to Exhibit 2.2.1 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 2.3 Form of Exchange Offer dated December 4, 1996 between the Company (1) and certain shareholders of Metacomp, Inc. incorporated by reference to Exhibit 2.3 to Form 8-K dated January 9, 1997 2.4 Letter of Transmittal to Accompany Shares of Common Stock of (1) Metacomp, Inc. Tendered Pursuant to the Exchange Offer Dated December 4, 1996 incorporated by reference to Exhibit 2.4 to Form 8-K dated January 9, 1997 3.0 ARTICLES AND BYLAWS. 3.1 Original Articles of Incorporation of the Company's predecessor, (1) Patriot Financial Corporation, incorporated by reference to Exhibit 3.1 to registration statement on Form S-18, file no. 33-23143-FW 3.2 Articles of Amendment of Patriot Financial Corporation, as filed (1) with the Colorado Secretary of State on July 21, 1988, incorporated by reference to Exhibit 3.2 to registration statement on Form S-18, File No. 33-23143-FW 3.3 Certificate of Incorporation of the Company, as filed with the (1) Delaware Secretary of State on March 24, 1992, incorporated by reference to Exhibit 3.3 to Form 8-K dated May 12, 1992 3.3.1 Certificate of Amendment to the Certificate of Incorporation of the (1) Company, as filed with the Delaware Secretary of State on April 18, 1995, incorporated by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year ended May 31, 1995
EX-2 106
Exhibit No. Document No. - ---------- -------- -- 3.3.2 Certificate of Amendment to the Certificate of Incorporation of the (1) Company, as filed with the Delaware Secretary of State on June 19,1997, incorporated by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year ended May 31, 1997 3.4 Articles and Certificate of Merger of Patriot Financial Corporation (1) into the Company dated May 1, 1992, with Agreement and Plan of Merger attached thereto as Exhibit A, incorporated by reference to Exhibit 3.4 to Form 8-K dated May 12, 1992 3.5 Certificate of Merger issued by the Delaware Secretary of State on (1) May 8, 1992, incorporated by reference to Exhibit 3.5 to Form 8-K dated May 12, 1992 3.6 Certificate of Merger issued by the Colorado Secretary of State on (1) May 12, 1992, incorporated by reference to Exhibit 3.6 to Form 8-K dated May 12, 1992 3.7 Bylaws of the Company, incorporated by reference to Exhibit 3.7 to (1) Form 8-K dated May 12, 1992 4.0 INSTRUMENTS ESTABLISHING RIGHTS OF SECURITY HOLDERS. 4.1 Specimen common stock certificate, incorporated by reference to (1) Exhibit 4.1 Form 8-K dated May 12, 1992 4.2 Form of Stock Purchase Warrant (Labway Corporation) dated February (1) 29, 1996, exercisable to purchase 253,166 common shares at $1.58 per share until August 31, 1996, granted to investors in connection with an offering of securities made in reliance upon Regulation S, incorporated by reference to Exhibit 4.2 to Form 10-QSB for fiscal quarter ended 2/29/96 4.3 Form of 6% Convertible Subordinated Promissory Note due September (1) 30, 1998 aggregating $1,500,000 to six investors incorporated by reference to Exhibit 4.3 to Form 10-QSB for fiscal quarter ended August 31, 1996 4.4 Form of 5% Convertible Term Debenture (CC Investments, LDC) due June (1) 2, 1999 aggregating $2,000,000 to two investors incorporated by reference to Exhibit 4.4 to Form 8-K dated June 16, 1997 4.5 Form of Stock Purchase Warrant (CC Investments, LDC) dated June 2, (1) 1997 exercisable to purchase an aggregate of 400,000 common shares at $1.69125 per share until June 2, 2002, granted to two investors in connection with the offering of securities in Exhibit 4.4 incorporated by reference to Exhibit 4.5 to Form 8-K dated June 16, 1997 4.6 Registration Rights Agreement dated June 2, 1997 by and among the (1) Company and CC Investments, LDC and the Matthew Fund, N.V. related to the registration of the common stock related to Exhibits 4.4 and 4.5 incorporated by reference to Exhibit 4.6 to Form 8-K dated June 16, 1997
EX-3 107
Exhibit No. Document No. - ---------- -------- -- 4.7 Form of Warrant to Purchase Common Stock (Swartz Family Partnership, (1) L.P.) dated June 2, 1997 exercisable to purchase an aggregate of 211,733 common shares at $1.69125 per share until June 2, 2002, granted to a group of investors in connection with the offering of securities in Exhibit 4.4 incorporated by reference to Exhibit 4.7 to Form 8-K dated June 16, 1997 4.8 Registration Rights Agreement dated June 2, 1997 by and among the (1) Company and Swartz Investments, LLC related to the registration of the common stock related to Exhibit 4.7 incorporated by reference to Exhibit 4.8 to Form 8-K dated June 16, 1997 4.9 Form of 5% Convertible Term Debenture (CC Investments, LDC) due June (1) 2, 1999 aggregating $1,000,000 to two investors incorporated by reference to Exhibit 4.9 to Form 10-KSB for the fiscal year ended May 31, 1998 4.10 Form of Stock Purchase Warrant (CC Investments, LDC) dated November (1) 24, 1997 exercisable to purchase an aggregate of 200,000 common shares at $1.50 per share until June 2, 2002, granted to two investors in connection with the offering of securities described in Exhibit 4.9 incorporated by reference to Exhibit 4.10 to Form 10-KSB for the year ended May 31, 1998 4.11 Form of Warrant to Purchase Common Stock (Swartz Family Partnership, (1) L.P.) dated November 24, 1997 exercisable to purchase an aggregate of 105,867 common shares at $1.50 per share until June 2, 2002, granted to a group of investors in connection with the offering of securities described in Exhibit 4.9 incorporated by reference to Exhibit 4.11 to Form 10-KSB for the year ended May 31, 1998 4.12 Form of Warrant to Purchase Common Stock (Investor Communications (1) Group, Inc.) dated June 16, 1997 exercisable to purchase an aggregate of 130,000 common shares at prices ranging from $2.50 to $7.50 per share until June 15, 1999 incorporated by reference to Exhibit 4.12 to Form 10-KSB for the year ended May 31, 1998 4.13 Warrant to Purchase Common Stock issued to Spellcaster (1) Telecommunications, Inc. dated April 28, 1998 exercisable to purchase an aggregate of 100,000 common shares at $1.25 per share until April 28, 2000 incorporated by reference to Exhibit 4.13 to Form 10-KSB for the year ended May 31, 1998 4.14 Investment agreement dated February 24, 1999 by and between the (1) Company and Swartz Private Equity, LLC for a maximum aggregate amount of $5,000,000 incorporated by reference to Exhibit 4.14 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998 4.15 Registration Rights Agreement dated February 24, 1999 by and between (1) the Company and Swartz Private Equity, LLC related to the registration of the common stock related to Exhibit 4.14 incorporated by reference to Exhibit 4.15 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998
EX-4 108
Exhibit No. Document No. - ---------- -------- -- 4.16 Form of Warrant to Purchase Common Stock (Swartz Private Equity, (1) LLC) dated February 24, 1999 exercisable to purchase commn shares in connection with the offering of securities in Exhibit 4.14 incorporated by reference to Exhibit 4.16 to Form 10-QSB/A for the fiscal quarter ended November 30, 1998 4.17 Amended and Restated Investment Agreement dated July 12, 1999 (2) by and between the Company and Swartz Private Equity, LLC for a maximum aggregate amount of $5,000,000 filed herewith 5.0 OPINION RE LEGALITY. 5.1 Legal opinion of Luce, Forward, Hamilton & Scripps LLP, attorneys at (2) law 10.0 MATERIAL CONTRACTS. 10.1 1992 Incentive Stock Option Plan of the Company, incorporated by (1) reference to Exhibit 10.1 to Form 8-K dated May 12, 1992 10.1.1 Amendment to 1992 Incentive Stock Option Plan dated January 11, (1) 1995, incorporated by reference to Exhibit 10.1.1 to Form S-8 dated July 17, 1996 10.2 1992 Non-Statutory Stock Option Plan of the Company, incorporated by (1) reference to Exhibit 10.2 to Form 8-K dated May 12, 1992 10.2.1 Amendment to 1992 Non-Statutory Stock Option Plan dated January 11, (1) 1995 incorporated by reference to Exhibit 10.2.1 to Form 10-KSB for fiscal year ended May 31, 1996 10.3 Lease Agreement between the Company's subsidiary Metacomp, Inc. and (1) Clar-O-Wood Partnership, a California limited partnership dated April 11, 1991 as amended November 11, 1992 and November 2, 1995 incorporated by reference to Exhibit 10.3 to Form 10-KSB for fiscal year ended May 31, 1997 10.4 Stock Purchase Agreement dated November 29 and 30, 1995, between the (1) Company and SEA, Ltd., incorporated by reference to Exhibit 10.4 to Form 8-K dated December 11, 1995 10.4.1 Letter Amendment to Stock Purchase Agreement dated February 21, (1) 1996, between the Company and SEA, Ltd., incorporated by reference to Exhibit 10.4.1 to Form 10-QSB for fiscal quarter ended 2/29/96 10.5 1995 Employee Stock Compensation Plan of the Company, incorporated (1) by reference to Exhibit 10.5 to Form 10-QSB for fiscal quarter ended 11/30/95 10.6 Letter Stock and Warrant Agreement dated January 10, 1996 between (1) the Company and Robert E. Crawford, Jr., incorporated by reference to Exhibit 10.6 to Form 10-QSB for fiscal quarter ended February 29, 1996 10.7 Non-Exclusive Manufacturing and Line of Credit Agreement dated (1) February 28, 1996, between the Company and Labway Corporation, incorporated by reference to Exhibit 10.7 to Form 10-QSB for fiscal quarter ended February 29, 1996 10.8 Distribution and Representation Agreement dated February 28, 1996, (1) between the Company and Innoware, Inc., incorporated by reference to Exhibit 10.8 to Form 10-QSB for fiscal quarter ended February 29, 1996
EX-5 109
Exhibit No. Document No. - ---------- -------- -- 10.9 Employment Agreement dated November 20, 1995 between the Company and (1) Elwood G. Norris, incorporated by reference to Exhibit 10.9 to Registration Statement on Form SB-2 dated March 18, 1996 10.9.1 First Amendment to Employment Agreement dated May 17, 1996 between (1) the Company and Elwood G. Norris, incorporated by reference to Exhibit 10.9.1 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 10.10 Employment Agreement dated November 20, 1995 between the Company and (1) Robert Putnam, incorporated by reference to Exhibit 10.10 to Registration Statement on Form SB-2 dated March 18, 1996 10.11 Sales Contractual Agreement dated March 19, 1996 between the Company (1) and Evolve Software, Inc., incorporated by reference to Exhibit 10.11 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 10.11.1 Two Year Stock Purchase Warrant dated March 19, 1996 Granted to (1) Evolve Software, Inc. Providing for the Purchase of up to 50,000 Common Shares at $2.85, incorporated by reference to Exhibit 10.11.1 to Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2 dated April 29, 1996 10.12 Employment Agreement dated as of May 8, 1996 between the Company and (1) Michael A. Carenzo, including Schedule A - Stock Option Agreement, incorporated by reference to Exhibit 10.12 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 10.13 1996 Stock Option Plan of the Company dated March 25, 1996 and (1) approved by the Shareholders on May 17, 1996, incorporated by reference to Exhibit 10.13 to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 10.14 Sales Contractual Agreement dated June 20, 1996 between the Company (1) and Compunetics Incorporated incorporated by reference to Exhibit 10.14 to Form 10-KSB for fiscal year ended May 31, 1996 10.15 Sales Contractual Agreement dated July 31, 1996 between the Company (1) and Premier Technical Sales, Inc. incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended May 31, 1996 10.16 Employment Agreement dated January 1, 1997 between the Company and (1) Norman J. Dawson incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended May 31, 1997 10.17 Employment Agreement dated January 1, 1997 between the Company and (1) Jayanta K. Maitra incorporated by reference to Exhibit 10.17 to Form 10-KSB for fiscal year ended May 31, 1997 10.18 Technology License and Distribution Agreement dated June 23, 1997 (1) between the Company and Sun Microsystems, Inc. incorporated by reference to Exhibit 10.18 to Form 10-KSB for the fiscal year ended May 31, 1997
EX-6 110
Exhibit No. Document No. - ---------- -------- -- 10.19 Employment Agreement dated March 23, 1998 between the Company and (1) James T. Lunney incorporated by reference to Exhibit 10.19 to Form 10-KSB for the fiscal year ended May 31, 1998 10.20 Employment Agreement dated July 28, 1997 between the Company and (1) Phillip Morettini incorporated by reference to Exhibit 10.20 to Form 10-KSB for the fiscal year ended May 31, 1998 10.21 Employment Agreement dated July 23, 1998 between the Company and (1) Lowell W. Giffhorn incorporated by reference to Exhibit 10.21 to Form 10-KSB for the fiscal year ended May 31, 1998 23.0 CONSENTS OF EXPERTS AND COUNSEL. 23.1 Consent of BDO Seidman, LLP (2) 23.2 Consent of Luce, Forward, Hamilton & Scripps LLP, attorneys at law (2) (included in Exhibit 5.1) 23.3 Consent of Harlan & Boettger, LLP, Certified Public Accountants (2) 99.0 ADDITIONAL EXHIBITS. 99.1 Form of ISO Plan Option (Gaspar) dated May 29, 1992, incorporated by (1) reference to Exhibit 28.2 to registration statement on Form SB-2, file no. 33-57858 99.2 Form of NSO Plan Option (Berlin) dated May 29, 1992, incorporated by (1) reference to Exhibit 28.3 to registration statement on Form SB-2, file no. 33-57858 99.3 Form of Incentive Stock Option Agreement to the Company's 1996 Stock (1) Option Plan (individual agreements differ as to number of shares, dates, prices and vesting), incorporated by reference to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 99.4 Form of NonQualified Stock Option Agreement to the Company's 1996 (1) Stock Option Plan (individual agreement differ as to number of shares, date, prices and vesting), incorporated by reference to Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2 dated May 23, 1996 99.5 Press Release of the Company dated November 4, 1996 incorporated by (1) reference to Exhibit 99.5 to Form 8-K dated January 9, 1997
- ---------- (1) Previously filed in indicated registration statement or report. (2) Exhibit filed herewith this Registration Statement on Form SB-2. EX-7 EX-4.17 2 EXHIBIT 4.17 1 EXHIBIT 4.17 PATRIOT SCIENTIFIC CORP. AMENDED AND RESTATED INVESTMENT AGREEMENT THE SECURITIES OFFERED HEREBY HAVE NOT BEEN REGISTERED WITH THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE OR OTHER SECURITIES AUTHORITIES. THEY MAY NOT BE SOLD OR TRANSFERRED EXCEPT PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT OR AN EXEMPTION FROM THE REGISTRATION REQUIREMENTS OF THE FEDERAL AND STATE SECURITIES LAWS. THIS INVESTMENT AGREEMENT DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO PURCHASE, ANY OF THE SECURITIES DESCRIBED HEREIN BY OR TO ANY PERSON IN ANY JURISDICTION IN WHICH SUCH OFFER OR SOLICITATION WOULD BE UNLAWFUL. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES AUTHORITIES, NOR HAVE SUCH AUTHORITIES CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. AN INVESTMENT IN THESE SECURITIES INVOLVES A HIGH DEGREE OF RISK. THE INVESTOR MUST RELY ON ITS OWN ANALYSIS OF THE INVESTMENT AND ASSESSMENT OF THE RISKS INVOLVED. SEE THE RISK FACTORS SET FORTH IN THE ATTACHED DISCLOSURE DOCUMENTS AS EXHIBIT J. SEE ADDITIONAL LEGENDS AT SECTIONS 4.7. THIS INVESTMENT AGREEMENT (this "Agreement") is made as of the 12th day of July, 1999, by and between Patriot Scientific Corp., a corporation duly organized and existing under the laws of the State of Delaware (the "Company"), and the undersigned Investor executing this Agreement ("Investor"). RECITALS: WHEREAS, the parties desire that, upon the terms and subject to the conditions contained herein, the Company shall issue to the Investor, and the Investor shall purchase from the Company, from time to time as provided herein, shares of the Company's Common Stock, par value $0.00001 per share (the "Common Stock"), as part of an offering of Common Stock by the Company to Investor, for a maximum aggregate offering amount of Five Million Dollars ($5,000,000) (the "Maximum Offering Amount"); and WHEREAS, the solicitation of this Investment Agreement and, if accepted by the Company, the offer and sale of the Common Stock are being made in reliance upon the provisions 2 of Regulation D ("Regulation D") promulgated under the Securities Act of 1933, as amended (the "Act"), and/or upon such other exemption from the registration requirements of the Act as may be available with respect to any or all of the purchases of Common Stock to be made hereunder. TERMS: NOW, THEREFORE, the parties hereto agree as follows: 1. Certain Definitions. As used in this Agreement (including the recitals above), the following terms shall have the following meanings (such meanings to be equally applicable to both the singular and plural forms of the terms defined): "20% Approval" shall have the meaning set forth in Section 5.26. "AAA" shall have the meaning set forth in Section 7.8. "Accredited Investor" shall have the meaning set forth in Section 3.1. "Act" shall mean the Securities Act of 1933, as amended. "Advance Put Notice" shall have the meaning set forth in Section 2.3.1(a), the form of which is attached hereto as Exhibit E. "Advance Put Notice Confirmation" shall have the meaning set forth in Section 2.3.1(a), the form of which is attached hereto as Exhibit F. "Advance Put Notice Date" shall have the meaning set forth in Section 2.3.1(a). "Affiliate" shall have the meaning as set forth Section 6.5. "Aggregate Issued Shares" equals the aggregate number of shares of Common Stock issued to Investor pursuant to the terms of this Agreement or the Registration Rights Agreement as of a given date, including Put Shares and Warrant Shares. "Agreed Upon Procedures Report" shall have the meaning set forth in Section 2.6.3(b). "Agreement" shall mean this Investment Agreement. "Automatic Termination" shall have the meaning set forth in Section 2.3.2. "Bid Price" shall mean the bid price of the Common Stock on the Company's Principal Market. "Bring Down Cold Comfort Letters" shall have the meaning set forth in Section 2.3.6(b). "Business Day" shall mean any day during which the Principal Market is open for business. 2 3 "Calendar Month" shall mean the period of time beginning on the numeric day in question in a calendar month (the "Numeric Day") and for Calendar Months thereafter, beginning on the earlier of (i) the same Numeric Day of the next calendar month or (ii) the last day of the next calendar month. Each Calendar Month shall end on the day immediately preceding the beginning of the next succeeding Calendar Month. "Cap Amount" shall have the meaning set forth in Section 2.3.11. "Capital Raising Limitations" shall have the meaning set forth in Section 6.6.1. "Capitalization Schedule" shall have the meaning set forth in Section 3.2.4, attached hereto as Exhibit K. "Closing" shall mean one of (i) the Investment Commitment Closing and (ii) each closing of a purchase and sale of Common Stock pursuant to Section 2. "Closing Bid Price" means, for any security as of any date, the last closing bid price for such security on the O.T.C. Bulletin Board, or, if the O.T.C. Bulletin Board is not the principal securities exchange or trading market for such security, the last closing bid price of such security on the principal securities exchange or trading market where such security is listed or traded as reported by such principal securities exchange or trading market, or if the foregoing do not apply, the last closing bid price of such security in the over-the-counter market on the electronic bulletin board for such security, or, if no closing bid price is reported for such security, the average of the bid prices of any market makers for such security as reported in the "pink sheets" by the National Quotation Bureau, Inc. If the Closing Bid Price cannot be calculated for such security on such date on any of the foregoing bases, the Closing Bid Price of such security on such date shall be the fair market value as mutually determined by the Company and the Investor in this Offering. If the Company and the Investor in this Offering are unable to agree upon the fair market value of the Common Stock, then such dispute shall be resolved by an investment banking firm mutually acceptable to the Company and the Investor in this offering and any fees and costs associated therewith shall be paid by the Company. "Commitment Evaluation Period" shall have the meaning set forth in Section 2.7. "Common Shares" shall mean the shares of Common Stock of the Company. "Common Stock" shall mean the common stock of the Company, par value $0.00001 per share. "Company" shall mean Patriot Scientific Corp., a corporation duly organized and existing under the laws of the State of Delaware. "Company Designated Maximum Put Dollar Amount" shall have the meaning set forth in Section 2.3.1(a). 3 4 "Company Designated Minimum Put Share Price" shall have the meaning set forth in Section 2.3.1(a). "Company Termination" shall have the meaning set forth in Section 2.3.14. "Conditions to Investor's Obligations" shall have the meaning as set forth in Section 2.2.4. "Delisting Event" shall mean any time during the term of this Investment Agreement, that the Company's Common Stock is not listed for and actively trading on the O.T.C. Bulletin Board, the Nasdaq Small Cap Market, the Nasdaq National Market, the American Stock Exchange, or the New York Stock Exchange or is suspended or delisted with respect to the trading of the shares of Common Stock on such market or exchange. "Disclosure Documents" shall have the meaning as set forth in Section 3.2.4. "Due Diligence Review" shall have the meaning as set forth in Section 2.6. "Effective Date" shall have the meaning set forth in Section 2.3.1. "Evaluation Day" shall have the meaning set forth in Section 2.3.7(b). "Exchange Act" shall mean the Securities Exchange Act of 1934, as amended. "Excluded Day" shall have the meaning set forth in Section 2.3.7(b). "Extended Put Period" shall mean the period of time between the Advanced Put Notice Date until the Pricing Period End Date. "Gross Discount Amount," for each Purchase of Put Shares, shall equal the product of (i) the difference of one minus the quotient obtained when the Put Share Price for such Purchase is divided by the Market Price for such Purchase, multiplied by (ii) the Put Dollar Amount paid to the Company by the Investor for the Put Shares in that Purchase. "Impermissible Put Cancellation" shall have the meaning set forth in Section 2.3.1(e). "Indemnified Liabilities" shall have the meaning set forth in Section 9. "Indemnities" shall have the meaning set forth in Section 9. "Indemnitor" shall have the meaning set forth in Section 9. "Individual Put Limit" shall have the meaning set forth in Section 2.3.1 (b). "Ineffective Period" shall mean any period of time that the Registration Statement or any Supplemental Registration Statement (each as defined in the Registration Rights Agreement) becomes ineffective or unavailable for use for the sale or resale, as applicable, of any or all of the Registrable Securities (as defined in the Registration Rights Agreement) for any reason (or in the 4 5 event the prospectus under either of the above is not current and deliverable) during any time period required under the Registration Rights Agreement. "Intended Put Share Amount" shall have the meaning set forth in Section 2.3.1(a). "Investment Commitment Closing" shall have the meaning set forth in Section 2.2.3. "Investment Agreement" shall mean this Investment Agreement. "Investment Commitment Opinion of Counsel" shall mean an opinion from Company's independent counsel, substantially in the form attached as Exhibit B, or such other form as agreed upon by the parties, as to the Investment Commitment Closing. "Investment Date" shall mean the date of the Investment Commitment Closing. "Investor" shall have the meaning set forth in the preamble hereto. "Key Employee" shall have the meaning set forth in Section 5.18, as set forth in Exhibit N. "Late Payment Amount" shall have the meaning set forth in Section 2.3.8. "Legend" shall have the meaning set forth in Section 4.7. "Major Transaction" shall mean and shall be deemed to have occurred at such time upon any of the following events: (i) a consolidation, merger or other business combination or event or transaction following which the holders of Common Stock of the Company immediately preceding such consolidation, merger, combination or event either (i) no longer hold a majority of the shares of Common Stock of the Company or (ii) no longer have the ability to elect the board of directors of the Company (a "Change of Control"); provided, however, that if the other entity involved in such consolidation, merger, combination or event is a publicly traded company with "Substantially Similar Trading Characteristics" (as defined below) as the Company and the holders of Common Stock are to receive solely Common Stock or no consideration (if the Company is the surviving entity) or solely common stock of such other entity (if such other entity is the surviving entity), such transaction shall not be deemed to be a Major Transaction (provided the surviving entity, if other than the Company, shall have agreed to assume all obligations of the Company under this Agreement and the Registration Rights Agreement). For purposes hereof, an entity shall have Substantially Similar Trading Characteristics as the Company if the average daily dollar trading volume of the common stock of such entity is equal to or in excess of $200,000 for the 90th through the 31st day prior to the public announcement of such transaction; (ii) the sale or transfer of all or substantially all of the Company's assets; or (iii) a purchase, tender or exchange offer made to the holders of outstanding shares of Common Stock, such that following such purchase, tender or exchange offer a Change of Control shall have occurred. 5 6 "Market Price" shall equal the lowest Closing Bid Price for the Common Stock on the Principal Market during the Pricing Period for the applicable Put. "Material Facts" shall have the meaning set forth in Section 2.3.6(a). "Maximum Put Dollar Amount" shall mean the lesser of (a) the Company Designated Maximum Put Dollar Amount, if any, specified by the Company in a Put Notice, and (ii) $2 million. "Maximum Offering Amount" shall mean Five Million Dollars ($5,000,000). "Nasdaq 20% Rule" shall have the meaning set forth in Section 2.3.11. "NASD" shall have the meaning set forth in Section 6.10. "NYSE" shall have the meaning set forth in Section 6.10. "Numeric Day" shall mean the numerical day of the month of the Investment Date. "Offering" shall mean the Company's offering of common stock and warrants issued under this Investment Agreement. "Officer's Certificate" shall mean a certificate, signed by an officer of the Company, to the effect that the representations and warranties of the Company in this Agreement required to be true for the applicable Closing are true and correct in all material respects and all of the conditions and limitations set forth in this Agreement for the applicable Closing are satisfied. "Opinion of Counsel" shall mean, as applicable, the Investment Commitment Opinion of Counsel, the Put Opinion of Counsel and the Purchase Warrant Opinion of Counsel. "Payment Due Date" shall have the meaning set forth in Section 2.3.8. "Pricing Period" shall have the meaning set forth in Section 2.3.7(b). "Pricing Period End Date" shall mean the last Business Day of any Pricing Period. "Pricing Period Extension" shall have the meaning set forth in Section 2.3.7(b). "Principal Market" shall mean the Nasdaq Small Cap Market, the O.T.C. Bulletin Board, the Nasdaq National Market, the American Stock Exchange or the New York Stock Exchange, whichever is at the time the principal trading exchange or market for the Common Stock. "Proceeding" shall have the meaning as set forth Section 5.1. "Purchase" shall have the meaning set forth in Section 2.3.7(a). 6 7 "Purchase Warrants" shall have the meaning set forth in Section 2.4.2. "Purchase Warrant Exercise Price" shall have the meaning set forth in Section 2.4.2. "Purchase Warrant Opinion of Counsel" shall mean an opinion from Company's independent counsel, substantially in the form attached as Exhibit O, or such other form as agreed upon by the parties, as to the issuance of Purchase Warrants to the Investor. "Put" shall have the meaning set forth in Section 2.3.1(d). "Put Cancellation" shall have the meaning set forth in Section 2.3.13(a). "Put Cancellation Notice Confirmation" shall have the meaning set forth in Section 2.3.13(c), the form of which is attached hereto as Exhibit S. "Put Cancellation Date" shall have the meaning set forth in Section 2.3.13(a). "Put Cancellation Notice" shall have the meaning set forth in Section 2.3.13(a), the form of which is attached hereto as Exhibit Q. "Put Closing" shall have the meaning set forth in Section 2.3.8. "Put Closing Date" shall have the meaning set forth in Section 2.3.8. "Put Date" shall mean the date that is specified by the Company in any Put Notice for which the Company intends to exercise a Put under Section 2.3.1, unless the Put Date is postponed pursuant to the terms hereof, in which case the "Put Date" is such postponed date. "Put Dollar Amount" shall be determined by multiplying the Put Share Amount by the Put Share Price with respect to such Put Date, subject to the limitations herein. "Put Notice" shall have the meaning set forth in Section 2.3.1(d), the form of which is attached hereto as Exhibit G. "Put Notice Confirmation" shall have the meaning set forth in Section 2.3.1(d), the form of which is attached hereto as Exhibit H. "Put Opinion of Counsel" shall mean an opinion from Company's independent counsel, in the form attached as Exhibit I, or such other form as agreed upon by the parties, as to any Put Closing. "Put Share Amount" shall have the meaning as set forth Section 2.3.1(b). "Put Share Price" shall have the meaning set forth in Section 2.3.1(c). "Put Shares" shall mean shares of Common Stock that are purchased by the Investor pursuant to a Put. 7 8 "Registrable Securities" shall have the meaning as set forth in the Registration Rights Agreement. "Registration Opinion" shall have the meaning set forth in Section 2.3.6(a). "Registration Opinion Deadline" shall have the meaning set forth in Section 2.3.6(a). "Registration Rights Agreement" shall mean that certain registration rights agreement entered into by the Company and Investor on even date herewith, in the form attached hereto as Exhibit A, or such other form as agreed upon by the parties. "Registration Statement" shall have the meaning as set forth in the Registration Rights Agreement. "Regulation D" shall have the meaning set forth in the Recitals hereto. "Reporting Issuer" shall have the meaning set forth in Section 6.2. "Required Put Documents" shall have the meaning set forth in Section 2.3.5. "Risk Factors" shall have the meaning set forth in Section 3.2.4, attached hereto as Exhibit J. "Schedule of Exceptions" shall have the meaning set forth in Section 5, and is attached hereto as Exhibit C. "SEC" shall mean the Securities and Exchange Commission. "Securities" shall mean this Investment Agreement, together with the Common Stock of the Company, the Warrants and the Warrant Shares issuable pursuant to this Investment Agreement. "Semi-Annual Commitment Shortfall" shall have the meaning set forth in Section 2.7. "Share Authorization Increase Approval" shall have the meaning set forth in Section 5.26. "Six Month Anniversary" shall mean the date that is the same Numeric Day of the sixth (6th) calendar month after the Investment Date, and the date that is the same Numeric Day of each sixth (6th) calendar month thereafter, provided that if such date is not a Business Day, the next Business Day thereafter. "Stockholder 20% Approval" shall have the meaning set forth in Section 6.12. "Supplemental Registration Statement" shall have the meaning set forth in the Registration Rights Agreement. 8 9 "Term" shall mean the term of this Agreement, which shall be a period of time beginning on the date of this Agreement and ending on the Termination Date. "Termination Date" shall mean the earlier of (i) the date that is three (3) years after the date of this Agreement, or (ii) the date that is thirty (30) Business Days after the later of (a) the Put Closing Date on which the sum of the aggregate Put Share Price for all Put Shares equal the Maximum Offering Amount, (b) the date that the Company has delivered a Termination Notice to the Investor, and (c) the date that all of the Warrants have been exercised. "Termination Notice" shall have the meaning as set forth in Section 2.3.14. "Third Party Report" shall have the meaning set forth in Section 3.2.4. "Transaction Documents" shall have the meaning set forth in Section 9. "Trigger Price" shall have the meaning set forth in Section 2.3.7(b). "Truncated Pricing Period" shall have the meaning set forth in Section 2.3.7(b). "Truncated Put Share Amount" shall have the meaning set forth in Section 2.3.13(b). "Unlegended Share Certificates" shall mean a certificate or certificates (in denominations as instructed by Investor) representing the shares of Common Stock to which the Investor is then entitled to receive, registered in the name of Investor or its nominee (as instructed by Investor) and not containing a restrictive legend, including but not limited to the Put Shares for the applicable Put and Warrant Shares. "Use of Proceeds Schedule" shall have the meaning as set forth in Section 3.2.4, attached hereto as Exhibit L. "Variable Priced Securities" shall have the meaning set forth in Section 6.6.1. "Warrant Shares" shall mean the Common Stock issuable upon exercise of the Warrants. "Warrants" shall mean Purchase Warrants. 2. Purchase and Sale of Common Stock. 2.1 Offer to Subscribe. Subject to the terms and conditions herein and the satisfaction of the conditions to closing set forth in Sections 2.2 and 2.3 below, Investor hereby agrees to purchase such amounts of Common Stock and accompanying Warrants as the Company may, in its sole and absolute discretion, from time to time elect to issue and sell to Investor according to one or more Puts pursuant to Section 2.3 below. 2.2 Investment Commitment. 9 10 2.2.1 [Intentionally Left Blank]. 2.2.2 [Intentionally Left Blank]. 2.2.3 Investment Commitment Closing. The closing of this Agreement (the "Investment Commitment Closing") shall be deemed to occur when this Agreement and the Registration Rights Agreement have been executed by both Investor and the Company, and the other Conditions to Investor's Obligations set forth in Section 2.2.4 below have been met. 2.2.4 Conditions to Investor's Obligations. As a prerequisite to the Investment Commitment Closing and the Investor's obligations hereunder, all of the following (the "Conditions to Investor's Obligations") shall have been satisfied prior to or concurrently with the Company's execution and delivery of this Agreement: (a) the following documents shall have been delivered to the Investor: (i) the Registration Rights Agreement, in the form attached hereto as Exhibit A, or such other form as agreed upon by the parties, (the "Registration Rights Agreement") (executed by the Company and Investor), (ii) the Investment Commitment Opinion of Counsel (signed by the Company's counsel), and (iii) a Secretary's Certificate as to (A) the resolutions of the Company's board of directors authorizing this transaction, (B) the Company's Certificate of Incorporation, and (C) the Company's Bylaws; (b) this Investment Agreement, accepted by the Company, shall have been received by the Investor; (c) [Intentionally Left Blank]; (d) the Company's Common Stock shall be listed for trading and actually trading on the O.T.C. Bulletin Board or the Nasdaq Small Cap Market; (e) other than continuing losses described in the Risk Factors set forth in the Disclosure Documents (provided for in Section 3.2.4), as of the Closing there have been no material adverse changes in the Company's business prospects or financial condition since the date of the last balance sheet included in the Disclosure Documents, including but not limited to incurring material liabilities; and (f) the representations and warranties of the Company in this Agreement shall be true and correct in all material respects and the conditions to Investor's obligations set forth in this Section 2.2.4 shall have been satisfied as of such Closing; and the Company shall deliver an Officer's Certificate, signed by an officer of the Company, to such effect to the Investor. 2.3 Puts of Common Shares to the Investor. 2.3.1 Procedure to Exercise a Put. Subject to the Individual Put Limit, the Maximum Offering Amount and the Cap Amount (if applicable), and the other conditions and limitations set forth in this Agreement, at any time beginning on the date on which the 10 11 Registration Statement is declared effective by the SEC (the "Effective Date"), the Company may, in its sole and absolute discretion, elect to exercise one or more Puts according to the following procedure: (a) Delivery of Advance Put Notice. At least ten (10) Business Days but not more than twenty (20) Business Days prior to any intended Put Date (unless otherwise agreed in writing by the Investor), the Company shall deliver advance written notice (the "Advance Put Notice," the form of which is attached hereto as Exhibit E, the date of such Advance Put Notice being the "Advance Put Notice Date") to Investor stating the Put Date for which the Company shall, subject to the limitations and restrictions contained herein, exercise a Put and stating the number of shares of Common Stock (subject to the Individual Put Limit and the Maximum Put Dollar Amount) which the Company intends to sell to the Investor during the Pricing Period (the "Intended Put Share Amount"). The Company may, at its option, also designate in an Advance Put Notice (i) a maximum dollar amount of Common Stock, not to exceed $2,000,000, which it shall sell to Investor during the Put (the "Company Designated Maximum Put Dollar Amount") and/or (ii) a minimum purchase price per Put Share at which the Investor may purchase Shares pursuant to such Put Notice (a "Company Designated Minimum Put Share Price"). The Company Designated Minimum Put Share Price shall be no less than X% (as defined in Section 2.3.1 (c)) of the Closing Bid Price of the Company's common stock on the Advance Put Notice Date. Notwithstanding the above, if more than two (2) Calendar Months have passed since the date of the previous Put Closing, the Company shall deliver the Advance Put Notice at least twenty (20) Business Days prior to any intended Put Date, unless waived in writing by the Investor. In order to effect delivery of the Advance Put Notice, the Company shall (i) send the Advance Put Notice by facsimile on such date so that such notice is received by the Investor by 6:00 p.m., New York, NY time, and (ii) surrender such notice on such date to a courier for overnight delivery to the Investor (or two (2) day delivery in the case of a Investor residing outside of the U.S.). Upon receipt by the Investor of a facsimile copy of the Advance Put Notice, the Investor shall, within two (2) Business Days, send, via facsimile, a confirmation of receipt (the "Advance Put Notice Confirmation," the form of which is attached hereto as Exhibit F) of the Advance Put Notice to the Company specifying that the Advance Put Notice has been received and affirming the intended Put Date and the Intended Put Share Amount. (b) Put Share Amount. The "Put Share Amount" is the number of shares of Common Stock that the Investor shall be obligated to purchase in a given Put, and shall equal the lesser of (i) the Intended Put Share Amount, and (ii) the Individual Put Limit. The "Individual Put Limit" shall equal the lesser of (i) 20% of the sum of the daily reported trading volume in the outstanding Common Stock on the Company's Principal Market during each Evaluation Day (as defined below) of the Pricing Period, as extended or shortened under the terms hereof, (ii) the number of Put Shares which, when multiplied by their respective Put Share Prices, equals the Maximum Put Dollar Amount, and (iii) 9.9% of the total amount of the Company's Common Stock that would be outstanding upon completion of the Put. (c) Put Share Price. The purchase price for the Put Shares (the "Put Share Price") shall equal the lesser of (i) the Market Price for such Put, minus $.05, or (ii) 11 12 X% (as defined below) of the Market Price for such Put, provided that the Put Share Price shall in no event be less than the Company Designated Minimum Put Share Price, where, for purposes hereof, "X" is defined as follows:
Market Price for the Put "X" Below $1.00 80% $1.00 or greater, but less than $2.00 85% $2.00 or greater 90%
(d) Delivery of Put Notice. After delivery of an Advance Put Notice, on the Put Date specified in the Advance Put Notice, or on the sixth (6th) Business Day following the last day of the previous Pricing Period, whichever is later, the Company shall deliver written notice (the "Put Notice," the form of which is attached hereto as Exhibit G) to Investor stating (i) the Put Date, (ii) the Intended Put Share Amount as specified in the Advance Put Notice (such exercise a "Put"), (iii) the Company Designated Maximum Put Dollar Amount (if applicable), and (iv) the Company Designated Minimum Put Share Price (if applicable). In order to effect delivery of the Put Notice, the Company shall (i) send the Put Notice by facsimile on the Put Date so that such notice is received by the Investor by 6:00 p.m., New York, NY time, and (ii) surrender such notice on the Put Date to a courier for overnight delivery to the Investor (or two (2) day delivery in the case of a Investor residing outside of the U.S.). Upon receipt by the Investor of a facsimile copy of the Put Notice, the Investor shall, within two (2) Business Days, send, via facsimile, a confirmation of receipt (the "Put Notice Confirmation," the form of which is attached hereto as Exhibit H) of the Put Notice to Company specifying that the Put Notice has been received and affirming the Put Date and the Intended Put Share Amount. (e) Delivery of Required Put Documents. On or before the Put Date for such Put, the Company shall deliver the Required Put Documents (as defined in Section 2.3.5 below) to the Investor (or to an agent of Investor, if Investor so directs). Unless otherwise specified by the Investor, the Put Shares of Common Stock shall be transmitted electronically pursuant to such electronic delivery system as the Investor shall request; otherwise delivery shall be by physical certificates. If the Company has not delivered all of the Required Put Documents to the Investor on or before the Put Date, the Put shall be automatically cancelled, unless the Investor agrees to delay the Put Date by up to three (3) Business Days, in which case the Pricing Period begins on the Business Day following such new Put Date. If the Company has not delivered all of the Required Put Documents to the Investor on or before the Put Date (or new Put Date, if applicable), and the Investor has not agreed in writing to delay the Put Date, the Put is automatically canceled (an "Impermissible Put Cancellation") and, unless the Put was otherwise canceled in accordance with the terms of Section 2.3.13, the Company shall pay the Investor $5,000 for its reasonable due diligence expenses incurred in preparation for the canceled Put and the Company may deliver an Advance Put Notice for the subsequent Put no sooner than ten (10) Business Days after the date that such Put was canceled. 12 13 2.3.2 Termination of Right to Put. The Company's right to require the Investor to purchase any subsequent Put Shares shall terminate permanently (an "Automatic Termination"), unless waived in writing by the Investor, upon the occurrence of any of the following: (a) the Company shall not exercise a Put or any Put thereafter if, at any time, either the Company or any director or executive officer of the Company has engaged in a transaction or conduct related to the Company that gives rise to (i) a Securities and Exchange Commission enforcement action, or (ii) a civil judgment or criminal conviction for fraud or misrepresentation, or for any other offense that, if prosecuted criminally, would constitute a felony under applicable law; (b) the Company shall not exercise a Put or any Put thereafter, on any date after a cumulative time period, including both Ineffective Periods and Delisting Events, that lasts for an aggregate of four (4) months; (c) the Company shall not exercise a Put or any Put thereafter if at any time the Company has filed for and/or is subject to any bankruptcy, insolvency, reorganization or liquidation proceedings or other proceedings for relief under any bankruptcy law or any law for the relief of debtors instituted by or against the Company or any subsidiary of the Company; provided that in the event that an involuntary bankruptcy petition is filed against the Company, the Company shall have sixty (60) days to obtain dismissal of such petition before such Put prohibition shall initiate; and (d) the Company shall not exercise a Put after the sooner of (i) the date that is three (3) years after the date of this Agreement, or (ii) the Put Closing Date on which the aggregate of the Put Dollar Amounts for all Puts equal the Maximum Offering Amount. 2.3.3 Put Limitations. The Company's right to exercise a Put shall be limited as follows, unless waived in writing by the Investor: (a) [Intentionally Left Blank]. (b) notwithstanding the amount of any Put, the Investor shall not be obligated to purchase any additional Put Shares once the aggregate Put Dollar Amount paid by Investor equals the Maximum Offering Amount; (c) the Investor shall not be obligated to acquire and pay for the Put Shares with respect to any Put for which the Company has announced a subdivision or combination, including a reverse split, of its Common Stock or has subdivided or combined its Common Stock during the Extended Put Period; (d) the Investor shall not be obligated to acquire and pay for the Put Shares with respect to any Put for which the Company has paid a dividend of its Common Stock or has made any other distribution of its Common Stock during the Extended Put Period; 13 14 (e) the Investor shall not be obligated to acquire and pay for the Put Shares with respect to any Put for which the Company has made, during the Extended Put Period, a distribution of all or any portion of its assets or evidences of indebtedness to the holders of its Common Stock; (f) the Investor shall not be obligated to acquire and pay for the Put Shares with respect to any Put for which a Major Transaction has occurred during the Extended Put Period; 2.3.4 Conditions Precedent to the Right of the Company to Deliver an Advance Put Notice or a Put Notice and the Obligation of the Investor to Purchase Put Shares. The right of the Company to deliver an Advance Put Notice or a Put Notice and the obligation of the Investor hereunder to acquire and pay for the Put Shares incident to a Closing is subject to the satisfaction, on (i) the date of delivery of such Advance Put Notice or Put Notice and (ii) the applicable Put Closing Date, of each of the following conditions, unless waived in writing by the Investor: (a) the Company's Common Stock shall be listed for and actively trading on the O.T.C. Bulletin Board, the Nasdaq Small Cap Market, the Nasdaq National Market or the New York Stock Exchange and the Put Shares shall be so listed, and to the Company's knowledge there is no notice of any suspension or delisting with respect to the trading of the shares of Common Stock on such market or exchange; (b) the Company shall have satisfied any and all obligations pursuant to the Registration Rights Agreement, including, but not limited to, the filing of the Registration Statement with the SEC with respect to the resale of all Registrable Securities and the requirement that the Registration Statement shall have been declared effective by the SEC for the resale of all Registrable Securities and the Company shall have satisfied and shall be in compliance with any and all obligations pursuant to this Agreement and the Warrants; (c) [Intentionally Left Blank]. (d) the representations and warranties of the Company are true and correct in all material respects as if made on such date and the conditions to Investor's obligations set forth in this Section 2.3.4 are satisfied as of such Closing, and the Company shall deliver a certificate, signed by an officer of the Company, to such effect to the Investor; (e) the Company shall have reserved for issuance a sufficient number of Common Shares for the purpose of enabling the Company to satisfy any obligation to issue Common Shares pursuant to any Put and to effect exercise of the Warrants; 14 15 (f) the Registration Statement is not subject to an Ineffective Period as defined in the Registration Rights Agreement, the prospectus included therein is current and deliverable, and to the Company's knowledge there is no notice of any investigation or inquiry concerning any stop order with respect to the Registration Statement; and (g) if the Aggregate Issued Shares after the Closing of the Put would exceed the Cap Amount, the Company shall have obtained the Stockholder 20% Approval as specified in Section 6.12. 2.3.5 Documents Required to be Delivered on the Put Date as Conditions to Closing of any Put. The Closing of any Put and Investor's obligations hereunder shall additionally be conditioned upon the delivery to the Investor of each of the following (the "Required Put Documents") on or before the applicable Put Date, unless waived or extended in writing by the Investor: (a) a number of Unlegended Share Certificates equal to the Intended Put Share Amount, in denominations of not more than 50,000 shares per certificate; (b) the following documents: Put Opinion of Counsel, Officer's Certificate, Put Notice, any required Registration Opinion, and any report or disclosure required under Section 2.3.6 or Section 2.6; (c) current Risk Factors; and (d) all documents, instruments and other writings required to be delivered on or before the Put Date pursuant to any provision of this Agreement in order to implement and effect the transactions contemplated herein. 2.3.6 Accountant's Letter and Registration Opinion. (a) The Company shall have caused to be delivered to the Investor, (i) whenever required by Section 2.3.6(b) or by Section 2.6.3, and (ii) on the date that is three (3) Business Days prior to each Put Date (the "Registration Opinion Deadline"), an opinion of the Company's independent counsel, in substantially the form of Exhibit R (the "Registration Opinion"), addressed to the Investor stating, inter alia, that no facts ("Material Facts") have come to such counsel's attention that have caused it to believe that the Registration Statement is subject to an Ineffective Period or to believe that the Registration Statement, any Supplemental Registration Statement (as each may be amended, if applicable), and any related prospectuses, contains an untrue statement of material fact or omits a material fact required to make the statements contained therein, in light of the circumstances under which they were made, not misleading. If a Registration Opinion cannot be delivered by the Company's independent counsel to the Investor on the Registration Opinion Deadline due to the existence of Material Facts or an Ineffective Period, the Company shall promptly notify the Investor and as promptly as possible amend each of the Registration Statement and any Supplemental Registration Statement, as applicable, and any related prospectus or cause such Ineffective Period to terminate, as the case may be, and deliver such Registration Opinion and updated prospectus as soon as possible 15 16 thereafter. If at any time after a Put Notice shall have been delivered to Investor but before the related Pricing Period End Date, the Company acquires knowledge of such Material Facts or any Ineffective Period occurs, the Company shall promptly notify the Investor and shall deliver a Put Cancellation Notice to the Investor pursuant to Section 2.3.13 by facsimile and overnight courier by the end of that Business Day. (b) (i) the Company shall engage its independent auditors to perform the procedures in accordance with the provisions of Statement on Auditing Standards No. 71, as amended, as agreed to by the parties hereto, and reports thereon (the "Bring Down Cold Comfort Letters") as shall have been reasonably requested by the Investor with respect to certain financial information contained in the Registration Statement and shall have delivered to the Investor such a report addressed to the Investor, on the date that is three (3) Business Days prior to each Put Date. (ii) in the event that the Investor shall have requested delivery of an "Agreed Upon Procedures Report" pursuant to Section 2.6.3, the Company shall engage its independent auditors to perform certain agreed upon procedures and report thereon as shall have been reasonably requested by the Investor with respect to certain financial information of the Company and the Company shall deliver to the Investor a copy of such report addressed to the Investor. In the event that the report required by this Section 2.3.6(b) cannot be delivered by the Company's independent auditors, the Company shall, if necessary, promptly revise the Registration Statement and the Company shall not deliver a Put Notice until such report is delivered. 2.3.7 Mechanics of Purchase of Put Shares. (a) Investor's Obligation and Right to Purchase Shares. Subject to the conditions set forth in this Agreement, following the Investor's receipt of a validly delivered Put Notice, the Investor shall be required to purchase (each a "Purchase") from the Company a number of Put Shares equal to the Put Share Amount, in the manner described below. (b) Pricing Period. For purposes hereof, the "Pricing Period," shall mean, unless otherwise shortened or lengthened under the terms of this Agreement, the period beginning on the Business Day immediately following the Put Date and ending on and including the date which is 20 Business Days after such Put Date; provided that, if a Put Cancellation Notice has been delivered to the Investor after the Put Date, the Pricing Period for such Put shall end at the close of trading on the last full trading day on the Principal Market that ends prior to the moment of initial delivery of the Put Cancellation Notice (a "Truncated Pricing Period") to the Investor. The applicable Pricing Period shall be extended (a "Pricing Period Extension") by one (1) Business Day for each Excluded Day during such Pricing Period, up to a maximum extension of five (5) Business Days; provided that no subsequent Put Notice may become effective until at least five (5) Business Days after the end of the previous Pricing Period, as extended or shortened. 16 17 For purposes of this Agreement: "Trigger Price" for any Pricing Period shall mean the greater of (i) the Company Designated Minimum Put Share Price, plus $.05, or (ii) (100% / X%) multiplied by the Company Designated Minimum Put Share Price, where "X" is defined in Section 2.3.1(c) above. An "Evaluation Day" shall mean each Business Day during a Pricing Period where the lowest intra-day trading price of the Common Stock is greater than or equal to the Trigger Price. An "Excluded Day" shall mean each Business Day where the lowest intra-day trading price of the Common Stock is less than the Trigger Price. 2.3.8 Mechanics of Put Closing. Each of the Company and the Investor shall deliver all documents, instruments and writings required to be delivered by either of them pursuant to this Agreement at or prior to each Closing. Subject to such delivery and the satisfaction of the conditions set forth in Sections 2.3.4 and 2.3.5, the closing of the purchase by the Investor of Put Shares shall occur by 5:00 PM, New York City Time, on the date which is five (5) Business Days following the applicable Pricing Period End Date (or such other time or later date as is mutually agreed to by the Company and the Investor) (the "Payment Due Date") at the offices of Investor. On each Closing Date, the Investor shall deliver to the Company, in the manner specified in Section 8 below, the Put Dollar Amount to be paid for such Put Shares, determined as aforesaid. The closing (each a "Put Closing") for each Put shall occur on the date that both (i) the Company has delivered to the Investor all Required Put Documents, and (ii) the Investor has delivered to the Company such Put Dollar Amount and any Late Payment Amount, if applicable (each a "Put Closing Date"). If the Investor does not deliver to the Company the Put Dollar Amount for such Put on or before the Payment Due Date, then the Investor shall pay to the Company, in addition to the Put Dollar Amount, an amount (the "Late Payment Amount") at a rate of X% per month, accruing daily, multiplied by such Put Dollar Amount, where "X" equals one percent (1%) for the first month following the date in question, and increases by an additional one percent (1%) for each month that passes after the date in question, up to a maximum of five percent (5%). 2.3.9 [Intentionally Left Blank]. 2.3.10 Limitation on Short Sales. The Investor and its Affiliates shall not engage in short sales of the Company's Common Stock; provided, however, that the Investor may enter into any short sale or other hedging or similar arrangement it deems appropriate with respect to Put Shares after it receives a Put Notice with respect to such Put Shares so long as such sales or arrangements do not involve more than the number of such Put Shares specified in the Put Notice. 2.3.11 Cap Amount. If the Company becomes listed on the Nasdaq Small Cap Market or the Nasdaq National Market, then, unless the Company has obtained Stockholder 20% Approval as set forth in Section 6.12 or unless otherwise permitted by Nasdaq, in no event 17 18 shall the Aggregate Issued Shares exceed the maximum number of shares of Common Stock (the "Cap Amount") that the Company can, without stockholder approval, so issue pursuant to Nasdaq Rule 4460(i)(1)(d)(ii) (or any other applicable Nasdaq Rules or any successor rule) (the "Nasdaq 20% Rule"). 2.3.12 [Intentionally Left Blank] 2.3.13 Put Cancellation. (a) Mechanics of Put Cancellation. If at any time during a Pricing Period the Company discovers the existence of Material Facts or any Ineffective Period or Delisting Event occurs, the Company shall cancel the Put (a "Put Cancellation"), by delivering written notice to the Investor (the "Put Cancellation Notice"), attached as Exhibit Q, by facsimile and overnight courier. The "Put Cancellation Date" shall be the date that the Put Cancellation Notice is first received by the Investor, if such notice is received by the Investor by 6:00 p.m., New York, NY time, and shall be the following date, if such notice is received by the Investor after 6:00 p.m., New York, NY time. (b) Effect of Put Cancellation. Anytime a Put Cancellation Notice is delivered to Investor after the Put Date, the Put shall remain effective with respect to a number of Put Shares (the "Truncated Put Share Amount") which shall equal the lesser of (i) 20% of the sum of the daily reported trading volume in the outstanding Common Stock on the Company's Principal Market during each Evaluation Day of the Truncated Pricing Period, (ii) the number of Put Shares which, when multiplied by their respective Put Share Prices, equals the Maximum Put Dollar Amount, and (iii) 9.9% of the total amount of the Company's Common Stock that would be outstanding upon completion of the Put. (c) Put Cancellation Notice Confirmation. Upon receipt by the Investor of a facsimile copy of the Put Cancellation Notice, the Investor shall promptly send, via facsimile, a confirmation of receipt (the "Put Cancellation Notice Confirmation," a form of which is attached as Exhibit S) of the Put Cancellation Notice to the Company specifying that the Put Cancellation Notice has been received and affirming the Put Cancellation Date. 2.3.14 Investment Agreement Cancellation. The Company may terminate (a "Company Termination") its right to initiate future Puts by providing written notice ("Termination Notice") to the Investor, by facsimile and overnight courier, at any time other than during an Extended Put Period, provided that such termination shall have no effect on the parties' other rights and obligations under this Agreement, the Registration Rights Agreement or the Warrants. Notwithstanding the above, any cancellation occurring during an Extended Put Period is governed by Section 2.3.13. 2.3.15 Return of Excess Common Shares. In the event that the number of Shares purchased by the Investor pursuant to its obligations hereunder is less than the Intended Put Share Amount, the Investor shall promptly return to the Company any shares of Common Stock in the Investor's possession that are not being purchased by the Investor. 2.4 Warrants. 18 19 2.4.1 [Intentionally Omitted]. 2.4.2 Purchase Warrants. Within five (5) Business Days of the end of each Pricing Period, the Company shall issue and deliver to the Investor a warrant ("Purchase Warrant"), in the form attached hereto as Exhibit D, or such other form as agreed upon by the parties, to purchase a number of shares of Common Stock equal to 15% of the number of Put Shares issued to Investor in that Put. Each Purchase Warrant shall be exerciseable at a price (the "Purchase Warrant Exercise Price") which shall initially equal 110% of the Market Price on the Pricing Period End Date, and shall have annual reset provisions. Each Purchase Warrant shall be immediately exercisable at the Purchase Warrant Exercise Price, and shall have a term beginning on the date of issuance and ending on date that is five (5) years thereafter. The Warrant Shares shall be registered for resale pursuant to the Registration Rights Agreement. Concurrently with the issuance and delivery of the Purchase Warrant to the Investor, the Company shall deliver to the Investor a Purchase Warrant Opinion of Counsel (signed by the Company's independent counsel). 2.5 [Intentionally Left Blank]. 2.6 Due Diligence Review. The Company shall make available for inspection and review by the Investor (the "Due Diligence Review"), advisors to and representatives of the Investor (who may or may not be affiliated with the Investor and who are reasonably acceptable to the Company), any underwriter participating in any disposition of Common Stock on behalf of the Investor pursuant to the Registration Statement, any Supplemental Registration Statement, or amendments or supplements thereto or any blue sky, NASD or other filing, all financial and other records, all SEC Documents and other filings with the SEC, and all other corporate documents and properties of the Company as may be reasonably necessary for the purpose of such review, and cause the Company's officers, directors and employees to supply all such information reasonably requested by the Investor or any such representative, advisor or underwriter in connection with such Registration Statement (including, without limitation, in response to all questions and other inquiries reasonably made or submitted by any of them), prior to and from time to time after the filing and effectiveness of the Registration Statement for the sole purpose of enabling the Investor and such representatives, advisors and underwriters and their respective accountants and attorneys to conduct initial and ongoing due diligence with respect to the Company and the accuracy of the Registration Statement. 2.6.1 Treatment of Nonpublic Information. The Company shall not disclose nonpublic information to the Investor or to its advisors or representatives unless prior to disclosure of such information the Company identifies such information as being nonpublic information and provides the Investor and such advisors and representatives with the opportunity to accept or refuse to accept such nonpublic information for review. The Company may, as a condition to disclosing any nonpublic information hereunder, require the Investor and its advisors and representatives to enter into a confidentiality agreement (including an agreement with such advisors and representatives prohibiting them from trading in Common Stock during such period of time as they are in possession of nonpublic information) in form reasonably satisfactory to the Company and the Investor. 19 20 Nothing herein shall require the Company to disclose nonpublic information to the Investor or its advisors or representatives, and the Company represents that it does not disseminate nonpublic information to any investors who purchase stock in the Company in a public offering, to money managers or to securities analysts, provided, however, that notwithstanding anything herein to the contrary, the Company will, as hereinabove provided, immediately notify the advisors and representatives of the Investor and, if any, underwriters, of any event or the existence of any circumstance (without any obligation to disclose the specific event or circumstance) of which it becomes aware, constituting nonpublic information (whether or not requested of the Company specifically or generally during the course of due diligence by and such persons or entities), which, if not disclosed in the Prospectus included in the Registration Statement, would cause such Prospectus to include a material misstatement or to omit a material fact required to be stated therein in order to make the statements therein, in light of the circumstances in which they were made, not misleading. Nothing contained in this Section 2.6 shall be construed to mean that such persons or entities other than the Investor (without the written consent of the Investor prior to disclosure of such information) may not obtain nonpublic information in the course of conducting due diligence in accordance with the terms of this Agreement; provided, however, that in no event shall the Investor's advisors or representatives disclose to the Investor the nature of the specific event or circumstances constituting any nonpublic information discovered by such advisors or representatives in the course of their due diligence without the written consent of the Investor prior to disclosure of such information. 2.6.2 Disclosure of Misstatements and Omissions. The Investor's advisors or representatives shall make complete disclosure to the Investor's counsel of all events or circumstances constituting nonpublic information discovered by such advisors or representatives in the course of their due diligence upon which such advisors or representatives form the opinion that the Registration Statement contains an untrue statement of a material fact or omits a material fact required to be stated in the Registration Statement or necessary to make the statements contained therein, in the light of the circumstances in which they were made, not misleading. Upon receipt of such disclosure, the Investor's counsel shall consult with the Company's independent counsel in order to address the concern raised as to the existence of a material misstatement or omission and to discuss appropriate disclosure with respect thereto; provided, however, that such consultation shall not constitute the advice of the Company's independent counsel to the Investor as to the accuracy of the Registration Statement and related Prospectus. 2.6.3 Procedure if Material Facts are Reasonably Believed to be Untrue or are Omitted. In the event after such consultation the Investor or the Investor's counsel reasonably believes that the Registration Statement contains an untrue statement or a material fact or omits a material fact required to be stated in the Registration Statement or necessary to make the statements contained therein, in light of the circumstances in which they were made, not misleading, (a) the Company shall file with the SEC an amendment to the Registration Statement responsive to such alleged untrue statement or omission and provide the Investor, as promptly as practicable, with copies of the Registration Statement and related Prospectus, as so amended, or 20 21 (b) if the Company disputes the existence of any such material misstatement or omission, (i) the Company's independent counsel shall provide the Investor's counsel with a Registration Opinion and (ii) in the event the dispute relates to the adequacy of financial disclosure and the Investor shall reasonably request, the Company's independent auditors shall provide to the Company a letter ("Agreed Upon Procedures Report") outlining the performance of such "agreed upon procedures" as shall be reasonably requested by the Investor and the Company shall provide the Investor with a copy of such letter. 2.7 Commitment Payments. On each six (6) month anniversary of the Investment Commitment Closing, if the Investor has not received at least an amount equal to the applicable Semi-Annual Commitment Fee, as set forth below, in aggregate Gross Discount Amounts for the preceding six (6) Calendar Months (each such period a "Commitment Evaluation Period"), the Company, in consideration of Investor's commitment costs, including, but not limited to, due diligence expenses, shall pay to the Investor an amount (the "Semi-Annual Commitment Shortfall") equal to the difference of (i) the applicable Semi-Annual Commitment Fee, as defined below, minus (ii) the aggregate of the Gross Discount Amounts received by the Investor during the preceding six (6) Calendar Months. In the event that the Company delivers a Termination Notice to the Investor, the Company shall pay to the Investor the greater of (i) the Semi-Annual Commitment Fee for the applicable Commitment Evaluation Period, less the Gross Discount Amount on amounts put to the Investor in that Commitment Evaluation Period, or (ii) the difference of (x) $200,000, minus (y) the aggregate of the Gross Discount Amounts for all Puts to date, and the Company shall not be required to pay the Semi-Annual Commitment Shortfall thereafter. For purposes hereof, the Semi-Annual Commitment Fee shall be as follows:
Commitment Evaluation Period Semi-Annual Commitment Fee ---------------------------- -------------------------- First 6 Calendar Months after Closing* $50,000** 6 through 12 Calendar Months after Closing $75,000 12 through 18 Calendar Months after Closing $100,000 18 through 24 Calendar Months after Closing $100,000 24 through 30 Calendar Months after Closing $125,000 30 through 36 Calendar Months after Closing $150,000
* = Investment Commitment Closing ** = If the date of effectiveness of the Registration Statement is more than 4 Calendar Months after the date of filing of the Registration Statement, and the Company has used its best efforts to cause such Registration Statement to become effective as soon as possible, the Semi-Annual Commitment Fee for the First 6 Calendar Months After Closing shall be reduced to $25,000. The Company shall not be required to deliver any payments to Investor under this subSection until Investor has paid all Put Dollar Amounts that are then due. 21 22 3. Representations, Warranties and Covenants of Investor. Investor hereby represents and warrants to and agrees with the Company as follows: 3.1 Accredited Investor. Investor is an accredited investor ("Accredited Investor"), as defined in Rule 501 of Regulation D, and has checked the applicable box set forth in Section 12 of this Agreement. 3.2 Investment Experience; Access to Information; Independent Investigation. 3.2.1 Access to Information. Investor or Investor's professional advisor has been granted the opportunity to ask questions of and receive answers from representatives of the Company, its officers, directors, employees and agents concerning the terms and conditions of this Offering, the Company and its business and prospects, and to obtain any additional information which Investor or Investor's professional advisor deems necessary to verify the accuracy and completeness of the information received. 3.2.2 Reliance on Own Advisors. Investor has relied completely on the advice of, or has consulted with, Investor's own personal tax, investment, legal or other advisors and has not relied on the Company or any of its affiliates, officers, directors, attorneys, accountants or any affiliates of any thereof and each other person, if any, who controls any of the foregoing, within the meaning of Section 15 of the Act for any tax or legal advice (other than reliance on information in the Disclosure Documents as defined in Section 3.2.4 below and on the Opinion of Counsel). The foregoing, however, does not limit or modify Investor's right to rely upon covenants, representations and warranties of the Company in this Agreement. 3.2.3 Capability to Evaluate. Investor has such knowledge and experience in financial and business matters so as to enable such Investor to utilize the information made available to it in connection with the Offering in order to evaluate the merits and risks of the prospective investment, which are substantial, including without limitation those set forth in the Disclosure Documents (as defined in Section 3.2.4 below). 3.2.4 Disclosure Documents. Investor, in making Investor's investment decision to subscribe for the Investment Agreement hereunder, represents that (a) Investor has received and had an opportunity to review (i) the Company's Annual Report on Form 10-KSB for the year ended May 31, 1998, (ii) the Company's quarterly report on Form 10-QSB for the quarters ended August 31, 1998, and November 30, 1998, (iii) the Risk Factors, attached as Exhibit J, (the "Risk Factors") (iv) the Capitalization Schedule, attached as Exhibit K, (the "Capitalization Schedule") and (v) the Use of Proceeds Schedule, attached as Exhibit L, (the "Use of Proceeds Schedule"); (b) Investor has read, reviewed, and relied solely on the documents described in (a) above, the Company's representations and warranties and other information in this Agreement, including the exhibits, documents prepared by the Company which have been specifically provided to Investor in connection with this Offering (the documents described in this Section 3.2.4 (a) and (b) are collectively referred to as the "Disclosure Documents"), and an independent investigation made by Investor and Investor's representatives, if any; (c) Investor has, prior to the date of this Agreement, been given an opportunity to review material contracts and documents of the Company which have been filed as exhibits to the Company's filings under the Act and the Securities Exchange Act of 1934, as amended (the "Exchange Act") and has had an opportunity to ask questions of and receive answers from the Company's officers and 22 23 directors; and (d) is not relying on any oral representation of the Company or any other person, nor any written representation or assurance from the Company other than those contained in the Disclosure Documents or incorporated herein or therein. The foregoing, however, does not limit or modify Investor's right to rely upon covenants, representations and warranties of the Company in Sections 5 and 6 of this Agreement. Investor acknowledges and agrees that the Company has no responsibility for, does not ratify, and is under no responsibility whatsoever to comment upon or correct any reports, analyses or other comments made about the Company by any third parties, including, but not limited to, analysts' research reports or comments (collectively, "Third Party Reports"), and Investor has not relied upon any Third Party Reports in making the decision to invest. 3.2.5 Investment Experience; Fend for Self. Investor has substantial experience in investing in securities and it has made investments in securities other than those of the Company. Investor acknowledges that Investor is able to fend for Investor's self in the transaction contemplated by this Agreement, that Investor has the ability to bear the economic risk of Investor's investment pursuant to this Agreement and that Investor is an "Accredited Investor" by virtue of the fact that Investor meets the investor qualification standards set forth in Section 3.1 above. Investor has not been organized for the purpose of investing in securities of the Company, although such investment is consistent with Investor's purposes. 3.3 Exempt Offering Under Regulation D. 3.3.1 [Intentionally Left Blank]. 3.3.2 No General Solicitation. The Investment Agreement was not offered to Investor through, and Investor is not aware of, any form of general solicitation or general advertising, including, without limitation, (i) any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television or radio, and (ii) any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. 3.3.3 Restricted Securities. Investor understands that the Investment Agreement is, the Common Stock and Warrants issued at each Put Closing will be, and the Warrant Shares will be, characterized as "restricted securities" under the federal securities laws inasmuch as they are being acquired from the Company in a transaction exempt from the registration requirements of the federal securities laws and that under such laws and applicable regulations such securities may not be transferred or resold without registration under the Act or pursuant to an exemption therefrom. In this connection, Investor represents that Investor is familiar with Rule 144 under the Act, as presently in effect, and understands the resale limitations imposed thereby and by the Act. 3.3.4 Disposition. Without in any way limiting the representations set forth above, Investor agrees that until the Securities are sold pursuant to an effective Registration Statement or an exemption from registration, they will remain in the name of Investor and will not be transferred to or assigned to any broker, dealer or depositary. Investor further agrees not to sell, transfer, assign, or pledge the Securities (except for any bona fide pledge arrangement to the extent that such pledge does not require registration under the Act or unless an exemption from 23 24 such registration is available and provided further that if such pledge is realized upon, any transfer to the pledgee shall comply with the requirements set forth herein), or to otherwise dispose of all or any portion of the Securities unless and until: (a) There is then in effect a registration statement under the Act and any applicable state securities laws covering such proposed disposition and such disposition is made in accordance with such registration statement and in compliance with applicable prospectus delivery requirements; or (b) (i) Investor shall have notified the Company of the proposed disposition and shall have furnished the Company with a statement of the circumstances surrounding the proposed disposition to the extent relevant for determination of the availability of an exemption from registration, and (ii) if reasonably requested by the Company, Investor shall have furnished the Company with an opinion of counsel, reasonably satisfactory to the Company, that such disposition will not require registration of the Securities under the Act or state securities laws. It is agreed that the Company will not require the Investor to provide opinions of counsel for transactions made pursuant to Rule 144 provided that Investor and Investor's broker, if necessary, provide the Company with the necessary representations for counsel to the Company to issue an opinion with respect to such transaction. The Investor is entering into this Agreement for its own account and the Investor has no present arrangement (whether or not legally binding) at any time to sell the Common Stock to or through any person or entity; provided, however, that by making the representations herein, the Investor does not agree to hold the Common Stock for any minimum or other specific term and reserves the right to dispose of the Common Stock at any time in accordance with federal and state securities laws applicable to such disposition. 3.4 Due Authorization. 3.4.1 Authority. The person executing this Investment Agreement, if executing this Agreement in a representative or fiduciary capacity, has full power and authority to execute and deliver this Agreement and each other document included herein for which a signature is required in such capacity and on behalf of the subscribing individual, partnership, trust, estate, corporation or other entity for whom or which Investor is executing this Agreement. Investor has reached the age of majority (if an individual) according to the laws of the state in which he or she resides. 3.4.2 Due Authorization. If Investor is a corporation, Investor is duly and validly organized, validly existing and in good tax and corporate standing as a corporation under the laws of the jurisdiction of its incorporation with full power and authority to purchase the Securities to be purchased by Investor and to execute and deliver this Agreement. 3.4.3 Partnerships. If Investor is a partnership, the representations, warranties, agreements and understandings set forth above are true with respect to all partners of Investor (and if any such partner is itself a partnership, all persons holding an interest in such partnership, directly or indirectly, including through one or more partnerships), and the person 24 25 executing this Agreement has made due inquiry to determine the truthfulness of the representations and warranties made hereby. 3.4.4 Representatives. If Investor is purchasing in a representative or fiduciary capacity, the representations and warranties shall be deemed to have been made on behalf of the person or persons for whom Investor is so purchasing. 4. Acknowledgments Investor is aware that: 4.1 Risks of Investment. Investor recognizes that an investment in the Company involves substantial risks, including the potential loss of Investor's entire investment herein. Investor recognizes that the Disclosure Documents, this Agreement and the exhibits hereto do not purport to contain all the information, which would be contained in a registration statement under the Act; 4.2 No Government Approval. No federal or state agency has passed upon the Securities, recommended or endorsed the Offering, or made any finding or determination as to the fairness of this transaction; 4.3 No Registration, Restrictions on Transfer. As of the date of this Agreement, the Securities and any component thereof have not been registered under the Act or any applicable state securities laws by reason of exemptions from the registration requirements of the Act and such laws, and may not be sold, pledged (except for any limited pledge in connection with a margin account of Investor to the extent that such pledge does not require registration under the Act or unless an exemption from such registration is available and provided further that if such pledge is realized upon, any transfer to the pledgee shall comply with the requirements set forth herein), assigned or otherwise disposed of in the absence of an effective registration of the Securities and any component thereof under the Act or unless an exemption from such registration is available; 4.4 Restrictions on Transfer. Investor may not attempt to sell, transfer, assign, pledge or otherwise dispose of all or any portion of the Securities or any component thereof in the absence of either an effective registration statement or an exemption from the registration requirements of the Act and applicable state securities laws; 4.5 No Assurances of Registration. There can be no assurance that any registration statement will become effective at the scheduled time, or ever, or remain effective when required, and Investor acknowledges that it may be required to bear the economic risk of Investor's investment for an indefinite period of time; 4.6 Exempt Transaction. Investor understands that the Securities are being offered and sold in reliance on specific exemptions from the registration requirements of federal and state law and that the representations, warranties, agreements, acknowledgments and understandings set forth herein are being relied upon by the Company in determining the applicability of such exemptions and the suitability of Investor to acquire such Securities. 25 26 4.7 Legends. The certificates representing the Put Shares shall not bear a Restrictive Legend. The certificates representing the Warrant Shares shall not bear a Restrictive Legend unless they are issued at a time when the Registration Statement is not effective for resale. It is understood that the certificates evidencing any Warrant Shares issued at a time when the Registration Statement is not effective for resale, subject to legend removal under the terms of Section 6.9 below, shall bear the following legend (the "Legend"): "The securities represented hereby have not been registered under the Securities Act of 1933, as amended, or applicable state securities laws, nor the securities laws of any other jurisdiction. They may not be sold or transferred in the absence of an effective registration statement under those securities laws or pursuant to an exemption therefrom." 5. Representations and Warranties of the Company. The Company hereby makes the following representations and warranties to Investor (which shall be true at the signing of this Agreement, and as of any such later date as contemplated hereunder) and agrees with Investor that, except as set forth in the Schedule of Exceptions attached hereto as Exhibit C: 5.1 Organization, Good Standing, and Qualification. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware, USA and has all requisite corporate power and authority to carry on its business as now conducted and as proposed to be conducted. The Company is duly qualified to transact business and is in good standing in each jurisdiction in which the failure to so qualify would have a material adverse effect on the business or properties of the Company and its subsidiaries taken as a whole. The Company is not the subject of any pending, threatened or, to its knowledge, contemplated investigation or administrative or legal proceeding (a "Proceeding") by the Internal Revenue Service, the taxing authorities of any state or local jurisdiction, or the Securities and Exchange Commission, The National Association of Securities Dealer, Inc., The Nasdaq Stock Market, Inc. or any state securities commission, or any other governmental entity, which have not been disclosed in the Disclosure Documents. None of the disclosed Proceedings, if any, will have a material adverse effect upon the Company or the market for the Common Stock. The Company has the following subsidiaries: Metacomp, Inc. (a California corporation) and Plasma Scientific Corporation (a Delaware corporation). 5.2 Corporate Condition. The Company's condition is, in all material respects, as described in the Disclosure Documents (as further set forth in any subsequently filed Disclosure Documents, if applicable), except for changes in the ordinary course of business and normal year-end adjustments that are not, in the aggregate, materially adverse to the Company. Except for continuing losses, there have been no material adverse changes to the Company's business, financial condition, or prospects since the dates of such Disclosure Documents. The financial statements as contained in the 10-KSB and 10-QSB have been prepared in accordance with generally accepted accounting principles, consistently applied (except as otherwise permitted by Regulation S-X of the Exchange Act), subject, in the case of unaudited interim financial statements, to customary year end adjustments and the absence of certain footnotes, and fairly present the financial condition of the Company as of the dates of the balance sheets included therein and the consolidated results of its operations and cash flows for the periods then ended,. Without limiting the foregoing, there are no material liabilities, contingent or actual, that are not disclosed in the Disclosure Documents (other than liabilities incurred by the Company in the 26 27 ordinary course of its business, consistent with its past practice, after the period covered by the Disclosure Documents). The Company has paid all material taxes that are due, except for taxes that it reasonably disputes. There is no material claim, litigation, or administrative proceeding pending or, to the best of the Company's knowledge, threatened against the Company, except as disclosed in the Disclosure Documents. This Agreement and the Disclosure Documents do not contain any untrue statement of a material fact and do not omit to state any material fact required to be stated therein or herein necessary to make the statements contained therein or herein not misleading in the light of the circumstances under which they were made. No event or circumstance exists relating to the Company which, under applicable law, requires public disclosure but which has not been so publicly announced or disclosed. 5.3 Authorization. All corporate action on the part of the Company by its officers, directors and stockholders necessary for the authorization, execution and delivery of this Agreement, the performance of all obligations of the Company hereunder and the authorization, issuance and delivery of the Common Stock being sold hereunder and the issuance (and/or the reservation for issuance) of the Warrants and the Warrant Shares have been taken, and this Agreement and the Registration Rights Agreement constitute valid and legally binding obligations of the Company, enforceable in accordance with their terms, except insofar as the enforceability may be limited by applicable bankruptcy, insolvency, reorganization, or other similar laws affecting creditors' rights generally or by principles governing the availability of equitable remedies. The Company has obtained all consents and approvals required for it to execute, deliver and perform each agreement referenced in the previous sentence. 5.4 Valid Issuance of Common Stock. The Common Stock and the Warrants, when issued, sold and delivered in accordance with the terms hereof, for the consideration expressed herein, will be validly issued, fully paid and nonassessable and, based in part upon the representations of Investor in this Agreement, will be issued in compliance with all applicable U.S. federal and state securities laws. The Warrant Shares, when issued in accordance with the terms of the Warrants, shall be duly and validly issued and outstanding, fully paid and nonassessable, and based in part on the representations and warranties of Investor, will be issued in compliance with all applicable U.S. federal and state securities laws. The Put Shares, the Warrants and the Warrant Shares will be issued free of any preemptive rights. 5.5 Compliance with Other Instruments. The Company is not in violation or default of any provisions of its Certificate of Incorporation or Bylaws, each as amended and in effect on and as of the date of the Agreement, or of any material provision of any material instrument or material contract to which it is a party or by which it is bound or of any provision of any federal or state judgment, writ, decree, order, statute, rule or governmental regulation applicable to the Company, which would have a material adverse effect on the Company's business or prospects, or on the performance of its obligations under this Agreement or the Registration Rights Agreement. The execution, delivery and performance of this Agreement and the other agreements entered into in conjunction with the Offering and the consummation of the transactions contemplated hereby and thereby will not (a) result in any such violation or be in conflict with or constitute, with or without the passage of time and giving of notice, either a default under any such provision, instrument or contract or an event which results in the creation of any lien, charge or encumbrance upon any assets of the Company, which would have a material adverse effect on the Company's business or prospects, or on the performance of its obligations 27 28 under this Agreement, the Registration Rights Agreement, (b) violate the Company's Certificate of Incorporation or By-Laws or (c) violate any statute, rule or governmental regulation applicable to the Company which violation would have a material adverse effect on the Company's business or prospects. 5.6 Reporting Company. The Company is subject to the reporting requirements of the Exchange Act, has a class of securities registered under Section 12 of the Exchange Act, and has filed all reports required by the Exchange Act since the date the Company first became subject to such reporting obligations. The Company undertakes to furnish Investor with copies of such reports as may be reasonably requested by Investor prior to consummation of this Offering and thereafter, to make such reports available, for the full term of this Agreement, including any extensions thereof, and for as long as Investor holds the Securities. The Common Stock is duly listed on the O.T.C. Bulletin Board. The Company is not in violation of the listing requirements of the O.T.C. Bulletin Board and does not reasonably anticipate that the Common Stock will be delisted by the O.T.C. Bulletin Board for the foreseeable future. The Company has filed all reports required under the Exchange Act. The Company has not furnished to the Investor any material nonpublic information concerning the Company. 5.7 Capitalization. The capitalization of the Company as of July 12, 1999, is, and the capitalization as of the Closing, subject to exercise of any outstanding warrants and/or exercise of any outstanding stock options, after taking into account the offering of the Securities contemplated by this Agreement and all other share issuances occurring prior to this Offering, will be, as set forth in the Capitalization Schedule as set forth in Exhibit K. There are no securities or instruments containing anti-dilution or similar provisions that will be triggered by the issuance of the Securities. Except as disclosed in the Capitalization Schedule, as of the date of this Agreement, (i) there are no outstanding options, warrants, scrip, rights to subscribe for, calls or commitments of any character whatsoever relating to, or securities or rights convertible into or exercisable or exchangeable for, any shares of capital stock of the Company or any of its subsidiaries, or arrangements by which the Company or any of its subsidiaries is or may become bound to issue additional shares of capital stock of the Company or any of its subsidiaries, and (ii) there are no agreements or arrangements under which the Company or any of its subsidiaries is obligated to register the sale of any of its or their securities under the Act (except the Registration Rights Agreement). 5.8 Intellectual Property. The Company has valid, unrestricted and exclusive ownership of or rights to use the patents, trademarks, trademark registrations, trade names, copyrights, know-how, technology and other intellectual property necessary to the conduct of its business. Exhibit M lists all patents, trademarks, trademark registrations, trade names and copyrights of the Company. The Company has granted such licenses or has assigned or otherwise transferred a portion of (or all of) such valid, unrestricted and exclusive patents, trademarks, trademark registrations, trade names, copyrights, know-how, technology and other intellectual property necessary to the conduct of its business as set forth in Exhibit M. The Company has been granted licenses, know-how, technology and/or other intellectual property necessary to the conduct of its business as set forth in Exhibit M. To the best of the Company's knowledge after due inquiry, the Company is not infringing on the intellectual property rights of any third party, nor is any third party infringing on the Company's intellectual property rights. There are no 28 29 restrictions in any agreements, licenses, franchises, or other instruments that preclude the Company from engaging in its business as presently conducted. 5.9 Use of Proceeds. As of the date hereof, the Company expects to use the proceeds from this Offering (less fees and expenses) for the purposes and in the approximate amounts set forth on the Use of Proceeds Schedule set forth as Exhibit L hereto. These purposes and amounts are estimates and are subject to change without notice to any Investor. 5.10 No Rights of Participation. Other than Swartz Investments, LLC, no person or entity, including, but not limited to, current or former stockholders of the Company, underwriters, brokers, agents or other third parties, has any right of first refusal, preemptive right, right of participation, or any similar right to participate in the financing contemplated by this Agreement which has not been waived. 5.11 Company Acknowledgment. The Company hereby acknowledges that Investor may elect to hold the Securities for various periods of time, as permitted by the terms of this Agreement, the Warrants, and other agreements contemplated hereby, and the Company further acknowledges that Investor has made no representations or warranties, either written or oral, as to how long the Securities will be held by Investor or regarding Investor's trading history or investment strategies. 5.12 [Intentionally Left Blank]. 5.13 Underwriter's Fees and Rights of First Refusal. The Company is not obligated to pay any compensation or other fees, costs or related expenditures in cash or securities to any underwriter, broker, agent or other representative other than the Investor in connection with this Offering. 5.14 Availability of Suitable Form for Registration. The Company is currently eligible and agrees to maintain its eligibility to register the resale of its Common Stock on a registration statement on a suitable form under the Act. 5.15 No Integrated Offering. Neither the Company, nor any of its affiliates, nor any person acting on its or their behalf, has directly or indirectly made any offers or sales of any of the Company's securities or solicited any offers to buy any security under circumstances that would prevent the parties hereto from consummating the transactions contemplated hereby pursuant to an exemption from registration under Regulation D of the Act or would require the issuance of any other securities to be integrated with this Offering under the Rules of Nasdaq. The Company has not engaged in any form of general solicitation or advertising in connection with the offering of the Common Stock or the Warrants. 5.16 [Intentionally Left Blank]. 5.17 Foreign Corrupt Practices. Neither the Company, nor any of its subsidiaries, nor any director, officer, agent, employee or other person acting on behalf of the Company or any subsidiary has, in the course of its actions for, or on behalf of, the Company, used any corporate funds for any unlawful contribution, gift, entertainment or other unlawful expenses relating to 29 30 political activity; made any direct or indirect unlawful payment to any foreign or domestic government official or employee from corporate funds; violated or is in violation of any provision of the U.S. Foreign Corrupt Practices Act of 1977, as amended; or made any bribe, rebate, payoff, influence payment, kickback or other unlawful payment to any foreign or domestic government official or employee. 5.18 Key Employees. Each "Key Employee" (as defined in Exhibit N) is currently serving the Company in the capacity disclosed in Exhibit N. No Key Employee, to the best knowledge of the Company and its subsidiaries, is, or is now expected to be, in violation of any material term of any employment contract, confidentiality, disclosure or proprietary information agreement, non-competition agreement, or any other contract or agreement or any restrictive covenant, and the continued employment of each Key Employee does not subject the Company or any of its subsidiaries to any liability with respect to any of the foregoing matters. No Key Employee has, to the best knowledge of the Company and its subsidiaries, any intention to terminate his employment with, or services to, the Company or any of its subsidiaries. 5.19 Representations Correct. The foregoing representations, warranties and agreements are true, correct and complete in all material respects, and shall survive any Put Closing and the issuance of the shares of Common Stock thereby. 5.20 Tax Status. The Company has made or filed all federal and state income and all other tax returns, reports and declarations required by any jurisdiction to which it is subject (unless and only to the extent that the Company has set aside on its books provisions reasonably adequate for the payment of all unpaid and unreported taxes) and has paid all taxes and other governmental assessments and charges that are material in amount, shown or determined to be due on such returns, reports and declarations, except those being contested in good faith and as set aside on its books provision reasonably adequate for the payment of all taxes for periods subsequent to the periods to which such returns, reports or declarations apply. There are no unpaid taxes in any material amount claimed to be due by the taxing authority of any jurisdiction, and the officers of the Company know of no basis for any such claim. 5.21 Transactions With Affiliates. Except as set forth in the Disclosure Documents, none of the officers, directors, or employees of the Company is presently a party to any transaction with the Company (other than for services as employees, officers and directors), including any contract, agreement or other arrangement providing for the furnishing of services to or by, providing for rental of real or personal property to or from, or otherwise requiring payments to or from any officer, director or such employee or, to the knowledge of the Company, any corporation, partnership, trust or other entity in which any officer, director, or any such employee has a substantial interest or is an officer, director, trustee or partner. 5.22 Application of Takeover Protections. The Company and its board of directors have taken all necessary action, if any, in order to render inapplicable any control share acquisition, business combination or other similar anti-takeover provision under Delaware law which is or could become applicable to the Investor as a result of the transactions contemplated by this Agreement, including, without limitation, the issuance of the Common Stock, any exercise of the Warrants and ownership of the Common Shares and Warrant Shares. The Company has 30 31 not adopted and will not adopt any "poison pill" provision that will be applicable to Investor as a result of transactions contemplated by this Agreement. 5.23 Other Agreements. The Company has not, directly or indirectly, made any agreements with the Investor under a subscription in the form of this Agreement for the purchase of Common Stock, relating to the terms or conditions of the transactions contemplated hereby or thereby except as expressly set forth herein, respectively, or in exhibits hereto or thereto. 5.24 Major Transactions. There are no other Major Transactions currently pending or contemplated by the Company. 5.25 Financings. There are no other financings currently pending or contemplated by the Company. 5.26 Shareholder Authorization. The Company shall, at its next annual shareholder meeting following its listing on either the Nasdaq Small Cap Market or the Nasdaq National Market, or at a special meeting to be held as soon as practicable thereafter, use its best efforts to obtain approval of its shareholders to (i) authorize the issuance of the full number of shares of Common Stock which would be issuable under this Agreement and eliminate any prohibitions under applicable law or the rules or regulations of any stock exchange, interdealer quotation system or other self-regulatory organization with jurisdiction over the Company or any of its securities with respect to the Company's ability to issue shares of Common Stock in excess of the Cap Amount (such approvals being the "20% Approval") and (ii) the increase in the number of authorized shares of Common Stock of the Company (the "Share Authorization Increase Approval") such that at least 12,000,000 shares can be reserved for this Offering. In connection with such shareholder vote, the Company shall use its best efforts to cause all officers and directors of the Company to promptly enter into irrevocable agreements to vote all of their shares in favor of eliminating such prohibitions. As soon as practicable after the 20% Approval and the Share Authorization Increase Approval, the Company agrees to use its best efforts to reserve 12,000,000 shares of Common Stock for issuance under this Agreement. 6. Covenants of the Company 6.1 Independent Auditors. The Company shall, until at least the Termination Date, maintain as its independent auditors an accounting firm authorized to practice before the SEC. 6.2 Corporate Existence and Taxes. The Company shall, until at least the Termination Date, maintain its corporate existence in good standing and remain a "Reporting Issuer" (defined as a Company which files periodic reports under the Exchange Act) (provided, however, that the foregoing covenant shall not prevent the Company from entering into any merger or corporate reorganization as long as the surviving entity in such transaction, if not the Company, assumes the Company's obligations with respect to the Common Stock and has Common Stock listed for trading on a stock exchange or on Nasdaq and is a Reporting Issuer) and shall pay all its taxes when due except for taxes which the Company disputes. 31 32 6.3 Registration Rights. The Company will enter into a registration rights agreement covering the resale of the Common Shares and the Warrant Shares substantially in the form of the Registration Rights Agreement attached as Exhibit A. 6.4 [Intentionally Omitted]. 6.5 Asset Transfers. The Company shall not (i) transfer, sell, convey or otherwise dispose of any of its material assets to any Subsidiary except for a cash or cash equivalent consideration and for a proper business purpose or (ii) transfer, sell, convey or otherwise dispose of any of its material assets to any Affiliate, as defined below, during the Term of this Agreement. For purposes hereof, "Affiliate" shall mean any officer of the Company, director of the Company or owner of twenty percent (20%) or more of the Common Stock or other securities of the Company. 6.6 Capital Raising Limitations; Rights of First Refusal. 6.6.1 Capital Raising Limitations. During the period from the date of this Agreement until the earlier of (i) the date that is one year after the Termination Date, or (ii) (a) in the case of a Company Termination, the date that is one (1) year after the date of such Company Termination, or (b) in the case of an Automatic Termination that is not waived by the Investor, the date that is six (6) months after the date of such Automatic Termination, the Company shall not issue or sell, or agree to issue or sell, for cash in private capital raising transactions (the following to be collectively referred to herein as, the "Variable Priced Securities"), any debt or equity securities which are convertible into, exercisable or exchangeable for, or carry the right to receive additional shares of Common Stock either (i) at any conversion, exercise or exchange rate or other price that is based upon and/or varies with the trading prices of or quotations for Common Stock at any time after the initial issuance of such debt or equity security, or (ii) with a fixed conversion, exercise or exchange price that is subject to being reset at some future date at any time after the initial issuance of such debt or equity security or upon the occurrence of specified contingent events directly or indirectly related to the business of the Company or the market for the Common Stock. During the period from the date of this Agreement until the Termination Date, the Company shall not issue or sell, or agree to issue or sell, for cash in private capital raising transactions any securities of the Company pursuant to an equity line structure or format similar in nature to this Offering without obtaining the prior written approval of the Investor of the Offering (the limitations referred to in this sentence are collectively referred to as the "Capital Raising Limitations"). Notwithstanding the above, during the period from the date of this Agreement until the date that is two (2) weeks after the date of this Agreement, this Section shall not prevent the Company from placing up to $750,000 in purchase price of Common Stock, which may be accompanied by warrants, and such warrants may contain a provision allowing for a reset of the exercise price, provided that the number of shares of common stock included in such warrants shall not increase as a result of such reset, and any such placement that is completed prior to the date that is two (2) weeks after the date of this Agreement shall not be included in the Investor's Right of First Refusal set forth in Section 6.6.2 below. 6.6.2 Investor's Right of First Refusal. For any private capital raising transactions of Variable Priced Securities or equity line structured investments which close after the Capital Raising Deadline and on or prior to the date that is six (6) months after the 32 33 Termination Date of this Agreement, not including any warrants issued in conjunction with this Investment Agreement, the Company agrees to deliver to Investor, at least ten (10) days prior to the closing of such transaction, written notice describing the proposed transaction, including the terms and conditions thereof, and providing the Investor and its affiliates an option during the ten (10) day period following delivery of such notice to purchase the securities being offered in such transaction on the same terms as contemplated by such transaction. 6.6.3 Exceptions to the Capital Raising Limitation and Rights of First Refusal. Notwithstanding the above, the Capital Raising Limitations and the Rights of First Refusal shall not apply to any transaction involving issuances of securities in connection with a merger, consolidation, acquisition or sale of assets, or in connection with any strategic partnership or joint venture (the primary purpose of which is not to raise equity capital), or in connection with the disposition or acquisition of a business, product or license by the Company or exercise of options by employees, consultants or directors. The Capital Raising Limitations also shall not apply to (a) the issuance of securities upon exercise or conversion of the Company's options, warrants or other convertible securities outstanding as of the date hereof, (b) the grant of additional options or warrants, or the issuance of additional securities, under any Company stock option or restricted stock plan for the benefit of the Company's employees, directors or consultants, or (c) the issuance of debt securities, with no equity feature, incurred solely for working capital purposes. 6.7 Financial 10-KSB Statements, Etc. and Current Reports on Form 8-K. The Company shall deliver to the Investor copies of its annual reports on Form 10-KSB, and quarterly reports on Form 10-QSB and shall deliver to the Investor current reports on Form 8-K within two (2) days of filing for the Term of this Agreement. 6.8 Opinion of Counsel. Investor shall, concurrent with the purchase of the Common Stock and accompanying Warrants pursuant to this Agreement, receive an opinion letter from the Company's legal counsel, in the form attached as Exhibit B or in such form as agreed upon by the parties, as to the Investment Commitment Closing and in the form attached as Exhibit I or in such form as agreed upon by the parties, as to any Put Closing. 6.9 Removal of Legend. If the certificates representing any Securities are issued with a restrictive Legend in accordance with the terms of this Agreement, the Legend shall be removed and the Company shall issue a certificate without such Legend to the holder of any Security upon which it is stamped, and a certificate for a security shall be originally issued without the Legend, if (a) the sale of such Security is registered under the Act, or (b) such holder provides the Company with an opinion of counsel, in form, substance and scope customary for opinions of counsel in comparable transactions (the reasonable cost of which shall be borne by the Investor), to the effect that a public sale or transfer of such Security may be made without registration under the Act, or (c) such holder provides the Company with reasonable assurances that such Security can be sold pursuant to Rule 144. Each Investor agrees to sell all Securities, including those represented by a certificate(s) from which the Legend has been removed, or which were originally issued without the Legend, pursuant to an effective registration statement and to deliver a prospectus in connection with such sale or in compliance with an exemption from the registration requirements of the Act. 33 34 6.10 Listing. Subject to the remainder of this Section 6.10, the Company shall ensure that its shares of Common Stock (including all Warrant Shares) are listed and available for trading on the O.T.C. Bulletin Board. Thereafter, the Company shall (i) use its best efforts to continue the listing and trading of its Common Stock on the O.T.C. Bulletin Board or to become eligible for and listed and available for trading on the Nasdaq Small Cap Market, the NMS, or the New York Stock Exchange ("NYSE"); and (ii) comply in all material respects with the Company's reporting, filing and other obligations under the By-Laws or rules of the National Association of Securities Dealers ("NASD") and such exchanges, as applicable. 6.11 The Company's Instructions to Transfer Agent. The Company will instruct the Transfer Agent of the Common Stock, by delivering instructions in the form of Exhibit T hereto, to issue certificates, registered in the name of each Investor or its nominee, for the Put Shares and Warrant Shares in such amounts as specified from time to time by the Company upon any exercise by the Company of a Put and/or exercise of the Warrants by the holder thereof. Such certificates shall not bear a Legend unless issuance with a Legend is permitted by the terms of this Agreement and Legend removal is not permitted by Section 6.9 hereof and the Company shall cause the Transfer Agent to issue such certificates without a Legend. Nothing in this Section shall affect in any way Investor's obligations and agreement set forth in Sections 3.3.3 or 3.3.4 hereof to resell the Securities pursuant to an effective registration statement and to deliver a prospectus in connection with such sale or in compliance with an exemption from the registration requirements of applicable securities laws. If (a) a Investor provides the Company with an opinion of counsel, which opinion of counsel shall be in form, substance and scope customary for opinions of counsel in comparable transactions, to the effect that the Securities to be sold or transferred may be sold or transferred pursuant to an exemption from registration or (b) a Investor transfers Securities to an affiliate which is an accredited investor pursuant to Rule 144, the Company shall permit the transfer, and, in the case of Put Shares and Warrant Shares, promptly instruct its transfer agent to issue one or more certificates in such name and in such denomination as specified by such Investor. The Company acknowledges that a breach by it of its obligations hereunder will cause irreparable harm to a Investor by vitiating the intent and purpose of the transaction contemplated hereby. Accordingly, the Company acknowledges that the remedy at law for a breach of its obligations under this Section 6.11 will be inadequate and agrees, in the event of a breach or threatened breach by the Company of the provisions of this Section 6.11, that a Investor shall be entitled, in addition to all other available remedies, to an injunction restraining any breach and requiring immediate issuance and transfer, without the necessity of showing economic loss and without any bond or other security being required. 6.12 Stockholder 20% Approval. Prior to the closing of any Put that would cause the Aggregate Issued Shares to exceed the Cap Amount, the Company shall obtain approval of its stockholders to authorize (i) the issuance of the full number of shares of Common Stock which would be issuable pursuant to this Agreement but for the Cap Amount and eliminate any prohibitions under applicable law or the rules or regulations of any stock exchange, interdealer quotation system or other self-regulatory organization with jurisdiction over the Company or any of its securities with respect to the Company's ability to issue shares of Common Stock in excess of the Cap Amount (such approvals being the "Stockholder 20% Approval"). 34 35 6.13 Press Release. The Company agrees that the Investor shall have the right to review and comment upon any press release issued by the Company in connection with the Offering which approval shall not be unreasonably withheld by Investor. 6.14 Change in Law or Policy. In the event of a change in law, or policy of the SEC, as evidenced by a No-Action letter or other written statements of the SEC or the NASD which causes the Investor to be unable to perform its obligations hereunder, this Agreement shall be automatically terminated and no further Commitment Fees shall be due. 7. Investor Covenant/Miscellaneous. 7.1 Representations and Warranties Survive the Closing; Severability. Investor's and the Company's representations and warranties shall survive the Investment Date and any Put Closing contemplated by this Agreement notwithstanding any due diligence investigation made by or on behalf of the party seeking to rely thereon. In the event that any provision of this Agreement becomes or is declared by a court of competent jurisdiction to be illegal, unenforceable or void, or is altered by a term required by the Securities Exchange Commission to be included in the Registration Statement, this Agreement shall continue in full force and effect without said provision; provided that if the removal of such provision materially changes the economic benefit of this Agreement to the Investor, the Investor, at its option, may terminate this Agreement or require that other terms of the Agreement be amended to compensate for such material economic changes. 7.2 Successors and Assigns. This Agreement shall not be assignable without the Company's written consent, If assigned, the terms and conditions of this Agreement shall inure to the benefit of and be binding upon the respective successors and assigns of the parties. Nothing in this Agreement, express or implied, is intended to confer upon any party other than the parties hereto or their respective successors and assigns any rights, remedies, obligations, or liabilities under or by reason of this Agreement, except as expressly provided in this Agreement. Investor may assign Investor's rights hereunder, in connection with any private sale of the Common Stock of such Investor, so long as, as a condition precedent to such transfer, the transferee executes an acknowledgment agreeing to be bound by the applicable provisions of this Agreement in a form acceptable to the Company and provides an original copy of such acknowledgment to the Company. 7.3 Execution in Counterparts Permitted. This Agreement may be executed in any number of counterparts, each of which shall be enforceable against the parties actually executing such counterparts, and all of which together shall constitute one (1) instrument. 7.4 Titles and Subtitles; Gender. The titles and subtitles used in this Agreement are used for convenience only and are not to be considered in construing or interpreting this Agreement. The use in this Agreement of a masculine, feminine or neither pronoun shall be deemed to include a reference to the others. 7.5 Written Notices, Etc. Any notice, demand or request required or permitted to be given by the Company or Investor pursuant to the terms of this Agreement shall be in writing 35 36 and shall be deemed given when delivered personally, or by facsimile or upon receipt if by overnight or two (2) day courier, addressed to the parties at the addresses and/or facsimile telephone number of the parties set forth at the end of this Agreement or such other address as a party may request by notifying the other in writing; provided, however, that in order for any notice to be effective as to the Investor such notice shall be delivered and sent, as specified herein, to all the addresses and facsimile telephone numbers of the Investor set forth at the end of this Agreement or such other address and/or facsimile telephone number as Investor may request in writing. 7.6 Expenses. Except as set forth in the Registration Rights Agreement, each of the Company and Investor shall pay all costs and expenses that it respectively incurs, with respect to the negotiation, execution, delivery and performance of this Agreement. 7.7 Entire Agreement; Written Amendments Required. This Agreement, including the Exhibits attached hereto, the Common Stock certificates, the Warrants, the Registration Rights Agreement, and the other documents delivered pursuant hereto constitute the full and entire understanding and agreement between the parties with regard to the subjects hereof and thereof, and no party shall be liable or bound to any other party in any manner by any warranties, representations or covenants except as specifically set forth herein or therein. Except as expressly provided herein, neither this Agreement nor any term hereof may be amended, waived, discharged or terminated other than by a written instrument signed by the party against whom enforcement of any such amendment, waiver, discharge or termination is sought. 7.8 Arbitration. Except as otherwise provided in Section 6.11 of this Agreement, any controversy or claim arising out of or related to the Transaction Documents or the breach thereof, shall be settled by binding arbitration in Wilmington, Delaware in accordance with the Expedited Procedures (Rules 53-57) of the Commercial Arbitration Rules of the American Arbitration Association ("AAA"). A proceeding shall be commenced upon written demand by Company or any Investor to the other. The arbitrator(s) shall enter a judgment by default against any party, which fails or refuses to appear in any properly noticed arbitration proceeding. The proceeding shall be conducted by one (1) arbitrator, unless the amount alleged to be in dispute exceeds two hundred fifty thousand dollars ($250,000), in which case three (3) arbitrators shall preside. The arbitrator(s) will be chosen by the parties from a list provided by the AAA, and if they are unable to agree within ten (10) days, the AAA shall select the arbitrator(s). The arbitrators must be experts in securities law and financial transactions. The arbitrators shall assess costs and expenses of the arbitration, including all attorneys' and experts' fees, as the arbitrators believe is appropriate in light of the merits of the parties' respective positions in the issues in dispute. Each party submits irrevocably to the jurisdiction of any state court sitting in Wilmington, Delaware or to the United States District Court sitting in Delaware for purposes of enforcement of any discovery order, judgment or award in connection with such arbitration. The award of the arbitrator(s) shall be final and binding upon the parties and may be enforced in any court having jurisdiction. The arbitration shall be held in such place as set by the arbitrator(s) in accordance with Rule 55. Although the parties, as expressed above, agree that all claims, including claims that are equitable in nature, for example specific performance, shall initially be prosecuted in the binding arbitration procedure outlined above, if the arbitration panel dismisses or otherwise fails 36 37 to entertain any or all of the equitable claims asserted by reason of the fact that it lacks jurisdiction, power and/or authority to consider such claims and/or direct the remedy requested, then, in only that event, will the parties have the right to initiate litigation respecting such equitable claims or remedies. The forum for such equitable relief shall be in either a state or federal court sitting in Wilmington, Delaware. Each party waives any right to a trial by jury, assuming such right exists in an equitable proceeding, and irrevocably submits to the jurisdiction of said Delaware court. Delaware law shall govern both the proceeding as well as the interpretation and construction of the Transaction Documents and the transaction as a whole. 8. Subscription and Wiring Instructions; Irrevocability. 8.1 Subscription (a) Wire transfer of Subscription Funds. Investor shall deliver Put Dollar Amounts (as payment towards any Put Share Price) by wire transfer, to the Company pursuant to a wire instruction letter to be provided by the Company, and signed by the Company. (b) Irrevocable Subscription. Investor hereby acknowledges and agrees, subject to the provisions of any applicable laws providing for the refund of subscription amounts submitted by Investor, that this Agreement is irrevocable and that Investor is not entitled to cancel, terminate or revoke this Agreement or any other agreements executed by such Investor and delivered pursuant hereto, and that this Agreement and such other agreements shall survive the death or disability of such Investor and shall be binding upon and inure to the benefit of the parties and their heirs, executors, administrators, successors, legal representatives and assigns. If the Securities subscribed for are to be owned by more than one person, the obligations of all such owners under this Agreement shall be joint and several, and the agreements, representations, warranties and acknowledgments herein contained shall be deemed to be made by and be binding upon each such person and his heirs, executors, administrators, successors, legal representatives and assigns. 8.2 Acceptance of Subscription. Ownership of the number of securities purchased hereby will pass to Investor upon the Warrant Closing or any Put Closing. 8.3 [Intentionally Omitted] 9. Indemnification. In consideration of the Investor's execution and delivery of the Investment Agreement, the Registration Rights Agreement and the Warrants (the "Transaction Documents") and acquiring the Securities thereunder and in addition to all of the Company's other obligations under the Transaction Documents, the Company shall defend, protect, indemnify and hold harmless Investor and all of its stockholders, officers, directors, employees and direct or indirect investors and any of the foregoing person's agents, members, partners or other representatives (including, without 37 38 limitation, those retained in connection with the transactions contemplated by this Agreement) (collectively, the "Indemnitees") from and against any and all actions, causes of action, suits, claims, losses, costs, penalties, fees, liabilities and damages, and expenses in connection therewith (irrespective of whether any such Indemnitee is a party to the action for which indemnification hereunder is sought), and including reasonable attorney's fees and disbursements (the "Indemnified Liabilities"), incurred by any Indemnitee as a result of, or arising out of, or relating to (a) any misrepresentation or breach of any representation or warranty made by the Company in the Transaction Documents or any other certificate, instrument or documents contemplated hereby or thereby, (b) any breach of any covenant, agreement or obligation of the Company contained in the Transaction Documents or any other certificate, instrument or document contemplated hereby or thereby, or (c) any cause of action, suit or claim, derivative or otherwise, by any stockholder of the Company based on a breach or alleged breach by the Company or any of its officers or directors of their fiduciary or other obligations to the stockholders of the Company. To the extent that the foregoing undertaking by the Company may be unenforceable for any reason, the Company shall make the maximum contribution to the payment and satisfaction of each of the Indemnified Liabilities which it would be required to make if such foregoing undertaking was enforceable which is permissible under applicable law. Promptly after receipt by an Indemnified Party of notice of the commencement of any action pursuant to which indemnification may be sought, such Indemnified Party will, if a claim in respect thereof is to be made against the other party (hereinafter "Indemnitor") under this Section 9, deliver to the Indemnitor a written notice of the commencement thereof and the Indemnitor shall have the right to participate in and to assume the defense thereof with counsel reasonably selected by the Indemnitor, provided, however, that an Indemnified Party shall have the right to retain its own counsel, with the reasonably incurred fees and expenses of such counsel to be paid by the Indemnitor, if representation of such Indemnified Party by the counsel retained by the Indemnitor would be inappropriate due to actual or potential conflicts of interest between such Indemnified Party and any other party represented by such counsel in such proceeding. The failure to deliver written notice to the Indemnitor within a reasonable time of the commencement of any such action, if prejudicial to the Indemnitor's ability to defend such action, shall relieve the Indemnitor of any liability to the Indemnified Party under this Section 9, but the omission to so deliver written notice to the Indemnitor will not relieve it of any liability that it may have to any Indemnified Party other than under this Section 9 to the extent it is prejudicial. 10. [Intentionally Left Blank]. [INTENTIONALLY LEFT BLANK] 38 39 11. [Intentionally Left Blank]. 12. Accredited Investor. Investor is an "accredited investor" because (check all applicable boxes): (a) [ ] it is an organization described in Section 501(c)(3) of the Internal Revenue Code, or a corporation, limited duration company, limited liability company, business trust, or partnership not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000. (b) [ ] any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person who has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment. (c) [ ] a natural person, who [ ] is a director, executive officer or general partner of the issuer of the securities being offered or sold or a director, executive officer or general partner of a general partner of that issuer. [ ] has an individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeding $1,000,000. [ ] had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. (d) [ ] an entity each equity owner of which is an entity described in a - b above or is an individual who could check one (1) of the last three (3) boxes under subparagraph (c) above. (e) [ ] other [specify] _________________________________________________________ 39 40 The undersigned hereby subscribes for ___________% of The Maximum Offering Amount and acknowledges that this Agreement and the subscription represented hereby shall not be effective unless accepted by the Company as indicated below. IN WITNESS WHEREOF, the undersigned Investor does represent and certify under penalty of perjury that the foregoing statements are true and correct and that Investor by the following signature(s) executed this Agreement. Dated this 12th day of July, 1999. - ------------------------------------ ----------------------------------- Your Signature PRINT EXACT NAME IN WHICH YOU WANT THE SECURITIES TO BE REGISTERED SECURITY DELIVERY INSTRUCTIONS: - ------------------------------------ ----------------------------------- Name: Please Print Please type or print address where delivered your security is to be ____________________________________ ATTN: _____________________________ Title/Representative Capacity (if applicable) - ------------------------------------ ----------------------------------- Name of Company You Represent Street Address (if applicable) - ------------------------------------ ----------------------------------- Place of Execution of this Agreement City, State or Province, Country, Offshore Postal Code NOTICE DELIVERY INSTRUCTIONS: WITH A COPY DELIVERED TO: - ------------------------------------- ----------------------------------- Please print address where any Notice Please print address where Copy is is to be delivered to be delivered ATTN: _______________________________ ATTN: _____________________________ - ------------------------------------- ----------------------------------- Street Address Street Address - ---------------------------------------------- - ------------------------------------------- City, State or Province, Country, Offshore City, State or Country, Offshore Postal Code Postal Code Telephone: _________________________________ Telephone: ______________________ Facsimile: _________________________________ Facsimile: ______________________ Facsimile: _________________________________ Facsimile: ______________________ THIS AGREEMENT IS ACCEPTED BY THE COMPANY IN THE AMOUNT OF 100% OF THE MAXIMUM OFFERING AMOUNT ON THE ____ DAY OF JULY 1999. PATRIOT SCIENTIFIC CORP. By: ------------------------------------------------ Lowell W. Giffhorn Address: PATRIOT SCIENTIFIC CORP. 40 41 10989 Via Frontera San Diego, CA 92127 Telephone No. (619) 674-5000 Fax: (619) 674-5005 41 42 ADVANCE PUT NOTICE PATRIOT SCIENTIFIC CORP. (the "Company") hereby intends, subject to the Individual Put Limit (as defined in the Investment Agreement), to elect to exercise a Put to sell the number of shares of Common Stock of the Company specified below, to _____________________________, the Investor, as of the Intended Put Date written below, all pursuant to that certain Investment Agreement (the "Investment Agreement") by and between the Company and Swartz Private Equity, LLC dated on or about July 12, 1999. Date of Advance Put Notice: ___________________ Intended Put Date :___________________________ Intended Put Share Amount: __________________ Company Designation Maximum Put Dollar Amount (Optional): ________________________________________. Company Designation Minimum Put Share Price (Optional): ________________________________________. PATRIOT SCIENTIFIC CORP. By: _____________________________________________ Lowell W. G Address: PATRIOT SCIENTIFIC CORP. 10989 Via Frontera San Diego, CA 92127 Telephone No. (619) 674-5000 Fax: (619) 674-5005 EXHIBIT E 43 CONFIRMATION OF ADVANCE PUT NOTICE _________________________________, the Investor, hereby confirms receipt of PATRIOT SCIENTIFIC CORP.'S (the "Company") Advance Put Notice on the Advance Put Date written below, and its intention to elect to exercise a Put to sell shares of common stock ("Intended Put Share Amount") of the Company to the Investor, as of the intended Put Date written below, all pursuant to that certain Investment Agreement (the "Investment Agreement") by and between the Company and Swartz Private Equity, LLC dated on or about July 12, 1999. Date of Confirmation: _____________________ Date of Advance Put Notice: _______________ Intended Put Date: ________________________ Intended Put Share Amount: ________________ Company Designation Maximum Put Dollar Amount (Optional): ________________________________________. Company Designation Minimum Put Share Price (Optional): ________________________________________. INVESTOR(S) ___________________________________ Investor's Name By: _______________________________ (Signature) Address: ___________________________________ ___________________________________ ___________________________________ Telephone No.: ___________________________________ Facsimile No.: ___________________________________ EXHIBIT F 44 PUT NOTICE PATRIOT SCIENTIFIC CORP. (the "Company") hereby elects to exercise a Put to sell shares of common stock ("Common Stock") of the Company to _____________________________, the Investor, as of the Put Date, at the Put Share Price and for the number of Put Shares written below, all pursuant to that certain Investment Agreement (the "Investment Agreement") by and between the Company and Swartz Private Equity, LLC dated on or about July 12, 1999. Put Date :----------------- Intended Put Share Amount (from Advance Put Notice):------------- Common Shares Company Designation Maximum Put Dollar Amount (Optional): ----------------------------------------. Company Designation Minimum Put Share Price (Optional): ----------------------------------------. Note: Capitalized terms shall have the meanings ascribed to them in this Investment Agreement. PATRIOT SCIENTIFIC CORP. By: --------------------------------------------- Lowell W. Giffhorn Address: PATRIOT SCIENTIFIC CORP. 10989 Via Frontera San Diego, CA 92127 Telephone No. (619) 674-5000 Fax: (619) 674-5005 EXHIBIT G 45 CONFIRMATION OF PUT NOTICE _________________________________, the Investor, hereby confirms receipt of PATRIOT SCIENTIFIC CORP. (the "Company") Put Notice and election to exercise a Put to sell ___________________________ shares of common stock ("Common Stock") of the Company to Investor, as of the Put Date, all pursuant to that certain Investment Agreement (the "Investment Agreement") by and between the Company and Swartz Private Equity, LLC dated on or about July 12, 1999. Date of this Confirmation: ________________ Put Date: ______________ Number of Put Shares of Common Stock to be Issued: ____________ Volume Evaluation Period: _____ Business Days Pricing Period: _____ Business Days INVESTOR(S) ___________________________________ Investor's Name By: _______________________________ (Signature) Address: _________________________________ _________________________________ _________________________________ Telephone No.: ________________________________ Facsimile No.: ________________________________ EXHIBIT H 46 PUT CANCELLATION NOTICE PATRIOT SCIENTIFIC CORP. (the "Company") hereby cancels the Put specified below, pursuant to that certain Investment Agreement (the "Investment Agreement") by and between the Company and Swartz Private Equity, LLC dated on or about July 12, 1999, as of the close of trading on the date specified below (the "Cancellation Date," which date must be on or after the date that this notice is delivered to the Investor), provided that such cancellation shall not apply to the number of shares of Common Stock equal to the Truncated Put Share Amount (as defined in the Investment Agreement). Cancellation Date: _____________________ Put Date of Put Being Canceled: __________ Number of Shares Put on Put Date: _________ Reason for Cancellation (check one): [ ] Material Facts, Ineffective Registration Period. [ ] Delisting Event The Company understands that, by canceling this Put, it must give twenty (20) Business Days advance written notice to the Investor before effecting the next Put. PATRIOT SCIENTIFIC CORP. By:____________________________________________ Lowell W. Giffhorn Address: PATRIOT SCIENTIFIC CORP. 10989 Via Frontera San Diego, CA 92127 Telephone No. (619) 674-5000 Fax: (619) 674-5005 47 EXHIBIT Q 48 PUT CANCELLATION NOTICE CONFIRMATION The undersigned Investor to that certain Investment Agreement (the "Investment Agreement") by and between the Company, and Swartz Private Equity, LLC dated on or about July 12, 1999, hereby confirms receipt of Patriot Scientific Corp.'s (the "Company") Put Cancellation Notice, and confirms the following: DATE OF THIS CONFIRMATION: ----------------- PUT CANCELLATION DATE: --------------------- INVESTOR(S) ----------------------------------- Investor's Name By: -------------------------------- (Signature) Address: ------------------------------------ ------------------------------------ ------------------------------------ Telephone No.: ------------------------------------ Facsimile No.: ------------------------------------ 49 EXHIBIT S EX-5.1 3 EXHIBIT 5.1 1 EXHIBIT 5.1 (Luce, Forward, Hamilton & Scripps, LLP Letterhead) July 14, 1999 Patriot Scientific Corporation 10989 Via Frontera San Diego, California 92127 Re: Registration Statement on Form SB-2 Ladies and Gentlemen: We are counsel for Patriot Scientific Corporation, a Delaware corporation ("Patriot"), in connection with the preparation of a Registration Statement on Form SB-2 of which this opinion is a part, to be filed with the Securities and Exchange Commission (the "Commission"), for the sale by certain selling shareholders (the "Selling Shareholders") of 15,598,770 shares of Patriot's common stock (the "Common Stock"). In connection with rendering our opinion as set forth below, we have reviewed and examined originals or copies of such corporate records and other documents and have satisfied ourselves as to such other matters as we have deemed necessary to enable us to express our opinion hereinafter set forth. Based upon the foregoing, it is our opinion that: The shares of Common Stock being registered for the account of the Selling Shareholders have been validly issued, and are fully paid and non-assessable. We hereby consent to the filing of this opinion as an Exhibit to the Registration Statement and to the reference to this firm under the caption "Legal Matters" in the Prospectus included in the Registration Statement. Very truly yours, /s/ LUCE, FORWARD, HAMILTON & SCRIPPS LLP EX-23.1 4 EXHIBIT 23.1 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Patriot Scientific Corporation San Diego, California We hereby consent to the use in the Prospectus constituting a part of this Registration Statement of our report dated July 17, 1998, except for notes 4 and 15, which are as of June 15, 1999 and note 16, which is as of July 14, 1999 relating to the consolidated financial statements of Patriot Scientific Corporation, which is contained in that Prospectus. Our report contains an explanatory paragraph regarding the Company's ability to continue as a going concern. We also consent to the reference to us under the caption "Experts" in the Prospectus. /s/ BDO Seidman, LLP Denver, Colorado July 14, 1999 EX-23.3 5 EXHIBIT 23.3 1 EXHIBIT 23.3 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Patriot Scientific Corporation San Diego, California We hereby consent to the use in the Prospectus constituting a part of this Registration Statement of our report dated December 17, 1996 relating to the financial statements of Metacomp, Inc., which is contained in that Prospectus. We also consent to the reference to us under the caption "Experts" in the Prospectus. /s/ HARLAN & BOETTGER, LLP San Diego, California July 14, 1999 -----END PRIVACY-ENHANCED MESSAGE-----